The Next U.S. Monetary Policy Regime
From Interest Rates to Liquidity
A quiet but potentially decisive shift is taking place in how U.S. monetary policy should be interpreted.
At the center of this debate is Kevin Warsh, a former Federal Reserve governor who has recently argued that inflation is not an unavoidable macroeconomic outcome, but the direct result of central bank choices.
His framework challenges the way markets currently read policy.
For most investors today, the dominant question remains simple.
When will the Fed cut rates?
But Warsh’s argument points in a very different direction.
In his view, the most powerful monetary policy instrument is not the policy rate.
It is liquidity.
Or more precisely, the size and behavior of the central bank’s balance sheet.
This distinction matters much more today than it did in the pre-QE world.
How the Fed is operating today
The current operating framework of the Federal Reserve is still largely interpreted through the lens of interest rates.
Markets focus on the terminal rate, the number of expected cuts, and the timing of the first easing move.
However, a structural change has already occurred.
Quantitative tightening has effectively stopped, and liquidity is again being supplied through the system.
From a balance-sheet perspective, the tightening cycle is no longer doing the heavy lifting.
From Warsh’s perspective, this is not a technical detail.
It is the policy signal.
Why Warsh focuses on liquidity, not rates
Warsh’s core argument is straightforward.
Inflation is driven primarily by excess liquidity and inflation expectations, not by the level of the policy rate itself.
Interest rates influence behavior.
Liquidity shapes the entire financial system.
For this reason, his preferred policy sequence is fundamentally different from today’s market narrative.
First, normalize liquidity.
Second, stabilize inflation expectations.
Only then, discuss rate cuts.
In this framework, rate cuts are not a starting tool.
They are a result.
The political tension behind monetary policy
This approach also exposes a structural tension with the political environment.
Donald Trump has consistently favored lower interest rates to support growth, asset prices, and financial conditions.
Warsh’s priorities are different.
His focus is on policy credibility, the long-term value of money, and the anchoring of inflation expectations.
In short, the objectives are not aligned.
Growth and markets on one side.
Credibility and expectations on the other.
Why the current environment conflicts with Warsh’s philosophy
Today’s policy setup creates a clear conflict with Warsh’s framework.
Interest rates are being held steady, but balance-sheet tightening has stopped and liquidity is increasing again.
From Warsh’s perspective, supplying liquidity before inflation is fully and convincingly under control sends the wrong signal to markets.
It weakens the central bank’s credibility in anchoring inflation expectations.
If Warsh were to lead the Federal Reserve, the first policy lever to move would not be interest rates.
It would be the balance sheet.
What would likely change under a Warsh-led Fed
The most realistic policy adjustments would look like this.
Policy rates would remain broadly unchanged for a period of time.
Quantitative tightening would return to the center of the policy framework.
Liquidity support programs would be gradually scaled back.
In other words, the tightening or easing signal would come primarily through the balance sheet, not through the policy rate.
A political compromise is also possible.
Small rate cuts could be delivered, while liquidity withdrawal is resumed at the same time.
On the surface, this would look like easing.
In practice, it would be a mixed stance.
Rate easing combined with balance-sheet tightening.
This combination would be designed to manage political pressure while still protecting inflation expectations.
A shift in communication strategy
Another important change would be the Fed’s communication.
Under the current chair, Jerome Powell, the Fed consistently emphasizes the balance between inflation and employment.
A Warsh-style framework would likely simplify that message.
Price stability, centered explicitly on the 2.0 percent target, would be placed clearly above all other objectives.
The message would become:
No return to sustained easing until inflation credibility is fully restored.
What markets should really watch
The most important implication for investors is simple.
Stop focusing exclusively on the timing of the next rate cut.
Start watching the Federal Reserve’s balance sheet.
The true policy stance in the coming cycle will be revealed less by the level of the federal funds rate and more by whether the Fed is actively withdrawing or supplying liquidity.
U.S. monetary policy now stands at a potential regime shift.
From an interest-rate-driven framework
to a liquidity-driven framework.
If Kevin Warsh’s philosophy gains influence, the balance sheet, not the rate path, will become the primary signal of monetary policy.
