Everyone Is Focusing On The Wrong Thing

Why the Warsh Nomination Changes Everything, and Why It Should Not Have Surprised Anyone

Fascinating week.

Fascinating because we now know who President Donald Trump has nominated to be the next Chair of the Federal Reserve: Kevin Warsh.

Markets didn’t expect this. Many investors were positioned for what traders call a “dove”, someone inclined to cut rates aggressively and keep money loose. Instead, they got someone with a long-standing reputation as a “hawk.” Stocks dipped on the announcement. Treasury yields ticked higher. Precious metals collapsed. The dollar strengthened.

But if you have been paying attention, really paying attention, to what this administration has actually been saying and doing, this appointment should not have surprised anyone.

In fact, I think it is one of the most coherent and consequential economic policy decisions in decades. And I believe it is very positive for the U.S. economy, for U.S. companies, and for U.S. markets.

Let me explain, in simple English.

The “Hawk vs. Dove” Story Misses the Point

The market’s first reaction to any Fed story is always to sort it into one of two buckets: hawk or dove. That framing is convenient. It is also incomplete.

Warsh is not here to simply lower rates on command, nor to keep them high for the sake of being tough. He represents a fundamentally different philosophy about how the U.S. economy should be run, one that has been staring us in the face for over a year, if only people cared to look.

This nomination is a regime-change story, a shift in how policymakers think about growth, inflation, and the Fed’s role in markets. Consider the people at the table.

Scott Bessent, the Secretary of the Treasury, has been arguing that the economy needs to shift away from Wall Street–driven liquidity and back toward Main Street–driven credit. He has said plainly that the era of the Fed being the primary engine of financial markets should end.

Stephen Miran, a Governor at the Federal Reserve, has delivered two landmark speeches that together form the clearest blueprint for what is coming. One addressed banking regulation and the Fed’s balance sheet. The other, which I attended in Athens, argued that deregulation is deflationary. Two speeches. Two different types of regulation. Same destination: lower rates, a smaller Fed footprint, and faster growth. I will unpack both in detail below.

Kevin Warsh has spent years at the Hoover Institution arguing that the Fed’s balance sheet is bloated and that Quantitative Easing distorted markets. He famously described QE-driven growth as a “sugar high”, temporary and ultimately unhealthy. He has called for “regime change” at the Fed.

These are not three random appointments. This is a coordinated framework with profound implications for how the U.S. economy will be managed in the years ahead.

The Old Way: Putting the Carriage Before the Horse

To understand why this shift matters, you first have to understand what it is replacing.

For the better part of fifteen years, the dominant approach to economic management went something like this: the Fed buys massive amounts of Treasuries and mortgage-backed securities (Quantitative Easing), flooding the financial system with reserves. This pushes asset prices higher: stocks, bonds, and real estate. The people who own those assets feel wealthier. Through this “wealth effect,” they spend more. And since roughly 70% of U.S. GDP is consumption, the economy grows.

On paper, it sounds logical. In practice, it was like putting the carriage before the horse.

The top 10% of Americans, who own the vast majority of financial assets, did exceptionally well. The other 90%, the average worker, the small business owner, the person trying to buy their first home, were largely left behind. Wage growth was anemic. Inequality widened. Housing became unaffordable. And we saw all sorts of macro anomalies: persistently low growth despite massive monetary expansion, a disconnect between asset prices and the real economy, and a financial system that channeled liquidity into speculation rather than productive investment.

That was the old way. And it did not work for Main Street.

Back to Basics: Beyond the Fed, Empower the Banking System

The new approach is fundamentally different. Instead of relying on the Fed’s balance sheet to inject liquidity from the top down, the idea is to use the banking system to channel credit from the bottom up.

Reform banking regulations so that U.S. banks have greater balance-sheet capacity. Banks extend more credit to businesses and consumers, loans for homes, equipment, expansion, and working capital. This credit flows into the real economy, creating jobs and funding investment. Economic growth drives corporate earnings. Markets rise, not because the Fed is buying bonds, but because the underlying economy is genuinely stronger.

This is the horse before the carriage. Growth first. Market gains as a consequence.

The critical difference is that credit flowing through the banking system has a much higher multiplier effect than QE. When a bank lends to a business that hires ten people, those ten people earn income, pay taxes, spend at local shops, and generate activity that ripples outward. When the Fed buys a Treasury bond from a primary dealer, the money often ends up parked in reserves or recycled into financial assets. The transmission to Main Street is weak and indirect.

This is why Scott Bessent, Stephen Miran, and Kevin Warsh are not anti–Wall Street. They want markets to do well. But they understand that markets built on a genuinely growing economy are far more durable than markets propped up by central bank purchases.

A Smaller Fed Requires a Bigger Private Balance Sheet

Now we get to the plumbing, the part that most commentary ignores.

The Federal Reserve’s balance sheet consists of assets and liabilities. When the Fed holds more Treasuries and mortgage-backed securities, the banking system holds more reserves at the Fed. When the Fed holds fewer securities, the banking system holds fewer reserves, and the private sector must step in to absorb more government debt.

You cannot shrink the Fed’s footprint unless you also increase the private sector’s ability to hold government debt and provide money-market liquidity.

The Fed did shrink its balance sheet from roughly $8.9 trillion at its 2022 peak to approximately $6.5 trillion by late 2025, a reduction of over $2.2 trillion. As a share of GDP, the Fed’s securities holdings declined from 33% to about 20%. That is real progress. But it is still enormous by historical standards, and getting it meaningfully smaller requires someone else to step in as a buyer.

The Fed itself has acknowledged a fundamental tradeoff: a smaller balance sheet, stable short-term rates, and minimal market intervention cannot all be achieved simultaneously. You can pick two. Economists call this the balance-sheet trilemma.

So, when media headlines frame Warsh wanting a “smaller Fed balance sheet” as hawkish tightening, they are giving you a limited and misleading interpretation. What Warsh actually advocates is a package: shrink the Fed’s footprint while simultaneously expanding the private sector’s capacity to absorb what the Fed lets go. That is not tightening. That is a structural transformation of how liquidity works.

The SLR: The Bottleneck Nobody Talks About

This is where the nomination really matters, and where the rubber meets the road for everything I have described above.

The Supplementary Leverage Ratio, or SLR, is a capital rule introduced as part of the post-2008 regulatory overhaul. It is a blunt “capital against total exposure” constraint that, unlike risk-weighted regulations, does not distinguish between risky and risk-free assets.

This means U.S. Treasuries, backed by the full faith and credit of the United States government, and reserves held at the Federal Reserve, consume the same leverage capacity as a risky corporate loan.

At the same time, post-crisis liquidity rules, the Liquidity Coverage Ratio, or LCR, push banks to hold large quantities of “high-quality liquid assets.” In practice, that means lots of Treasuries and reserves.

We require banks to hold these assets for liquidity, then penalize them for holding the same assets under leverage rules. It is like being told you must carry an umbrella at all times, and then being fined every time you are seen carrying one.

This contradiction is not theoretical. In April 2020, regulators temporarily excluded Treasuries and reserves from the SLR calculation to ease strains in the Treasury market. It worked. Banks absorbed Treasuries without stress. When the exemption was removed in March 2021, banks shed deposits to stay within leverage limits, cash flooded into money market funds, and the Fed’s reverse repo facility ballooned to over $2 trillion, a direct consequence of the regulatory contradiction snapping back into place.

Fed Governor Miran laid this out in his November 2025 speech on “Regulatory Dominance of the Federal Reserve’s Balance Sheet.” His argument: the size of the Fed’s balance sheet is not primarily a monetary policy choice; it is a consequence of the regulatory framework. Banks are forced to hold massive reserves because regulation demands it. And because banks need those reserves, the Fed cannot reduce them without causing stress.

As he put it: “As we right-size the regulations, my hope is that it will allow us to further reduce the size of the balance sheet, relaxing the grip of regulatory dominance.”

What Exempting Treasuries Actually Achieves

If Treasuries and reserves are excluded from the SLR denominator, several things happen simultaneously.

Banks can hold more Treasuries without consuming leverage capacity. The private banking system can step in as a buyer when the Fed steps back as a seller. The transition from a Fed-dominated Treasury market to a privately intermediated one becomes possible.

Banks free up balance-sheet room for lending. Capacity that was locked up against safe assets can be redeployed into credit, to businesses, consumers, and communities. This is the direct channel from regulatory reform to Main Street.

The government’s borrowing cost falls. Better Treasury-market intermediation means lower yields. Bessent has argued this could save “tens of basis points.” On a national debt exceeding $36 trillion, even a few basis points translate to tens of billions in annual interest savings for taxpayers.

Treasury-market dysfunction risk declines. Miran described the exemption as a “small price to pay to deter potential dysfunction” in the world’s most important securities market, avoiding repeats of the March 2020 Treasury seizure or the UK gilt crisis.

With Warsh at the Fed, aligned with Scott Bessent at Treasury, and building on the intellectual groundwork Stephen Miran has laid, SLR reform is not just likely; it is virtually certain.

Why Inflation Fears Are Overstated

I know what many of you are thinking: “This all sounds great, Michael, but what about inflation? If you’re cutting rates, deregulating, and expanding bank credit, won’t prices spiral?”

As of late January 2026, the 10-year breakeven inflation rate was about 2.36%, and the 5-year/5-year forward expectation rate was about 2.19%. These are not the numbers of a market screaming “1970s.” They suggest inflation expectations remain well-anchored.

But beyond what the bond market is telling us, I believe investors are underestimating two massive structural deflationary forces. As I have written in previous publications, not all inflation is the same and cannot be treated the same way. These two forces are distinct, structural, and powerful.

Deflationary Force #1: China

I have written extensively about China on this Substack (see China’s Gold Rush and Japan Isn’t Losing Control), and the picture is not pretty.

China is facing severe internal dislocations: a property crisis that has wiped out trillions in household wealth, a demographic collapse that is accelerating, a credit overhang from years of state-directed lending, and a manufacturing sector producing far more than domestic demand can absorb. China’s M2 money supply is more than twice that of the United States, yet its economy is only about two-thirds the size of the United States’ economy. The excess capacity floods global markets with cheap goods, and with U.S. tariffs constraining traditional export routes, that surplus is being dumped at discounted prices everywhere else.

This is not a temporary phenomenon. It is structural. And it is a powerful disinflationary force, particularly through traded goods and supply chains.

Deflationary Force #2: Artificial Intelligence

Yes, AI spending is enormous right now. Hundreds of billions of dollars are flowing into chips, data centers, power infrastructure, and model training. That spending is real money, and in the short run, it pulls resources, energy, and capital into one sector, which can look inflationary.

But the productivity gains from AI, once adopted at scale, will be profoundly deflationary. When a task that required ten people can be done by two, when legal research that took weeks can be done in hours, and when coding that required large teams can be accelerated by an order of magnitude, the cost of delivering goods and services drops dramatically.

We are already seeing early evidence. In the third quarter of 2025, U.S. nonfarm business productivity rose at a 4.9% annualized rate, and unit labor costs fell 1.9%. Economists have explicitly linked this surge to increased AI investment.

And if the adoption rate of AI is faster than markets expect, and I believe it is, then the deflationary pressures will be larger and arrive sooner than anyone is currently modelling. The adoption curve is not gradual. It is steep. And each wave pushes costs lower.

Schumpeter Had the Answer 100 Years Ago

This is where economic theory and current events align beautifully.

In The Theory of Economic Development, Joseph Schumpeter described a pattern that is playing out right in front of us. He argued that innovators need new purchasing power to pull resources away from the existing economic flow. Banks provide this by expanding credit, which can temporarily push prices up. Schumpeter explicitly called this “credit inflation.”

But crucially, he argued that if the innovative venture succeeds, the economy ends up with more and better goods. The credit gets repaid. The initial price pressure is not permanent. He even went further: when innovation is truly successful, the result is not inflation at all, but deflation. Because the new goods and new efficiency more than compensate for the earlier increase in purchasing power.

The hundreds of billions being spent on AI infrastructure right now? That is Schumpeter’s credit inflation, the upfront cost of building new productive capacity. What productivity gains will follow? That is Schumpeter’s deflation, the payoff when the investment succeeds.

This is precisely why Kevin Warsh’s nomination is a good fit. He has explicitly criticized the Fed for underestimating how productivity growth, supercharged by AI, can keep inflation in check. He believes genuine prosperity comes from innovation and capital investment, not from the central bank’s printing press. Schumpeter would have approved.

Markets are pricing in the spending phase. They have not yet begun to price in the productivity phase. That gap is where the opportunity lies.

Deregulation: The Deflationary Force Nobody Is Modelling

A few weeks ago, I happened to be in Athens when Governor Stephen Miran delivered his second landmark speech, this time at the Delphi Economic Forum held at the National Gallery – Alexandros Soutsos Museum. U.S. Ambassador Kimberly Guilfoyle introduced him as “one of the sharpest economic minds” shaping the monetary policy conversation in Washington.

His topic: the implications of deregulation for the supply side and for monetary policy.

Miran drew a direct parallel between Greece’s recovery, which was only possible after painful deregulatory reforms, including liberalizing product markets, easing licensing burdens, opening restricted professions, and privatizing airports and ports, and what the United States is embarking on now. He called Greece’s turnaround “terrific” and said the country had “lit the path and shown us the way.”

His core argument: deregulation is a positive supply shock. It boosts productivity, increases competition, expands economic capacity, and puts downward pressure on prices. In standard economic terms, it is deflationary. And citing a key 2014 academic paper, he argued that if the central bank ignores this deflationary effect, it risks making policy too tight and causing an unnecessary contraction. The correct response to a deregulatory shock is to cut interest rates.

Miran discussed the Trump administration’s executive order “Unleashing Prosperity Through Deregulation,” which requires that for every new regulation adopted, ten must be abolished. Based on the pace of regulatory reduction in 2025, he estimated that 30% of the regulatory restrictions in the Code of Federal Regulations could be eliminated by 2030.

His calculation: this sustained deregulation could reduce the consumer price level by roughly half a percentage point per year through that period.

In a world where the Fed is agonizing over whether inflation is 2.7% or 2.5%, a sustained half-point annual drag from deregulation is enormous. It changes the entire calculus for monetary policy. And yet almost nobody in the market is modelling it.

The Real Strategy: Grow Your Way Out of Debt

Step back and look at the really big picture.

The United States has a national debt exceeding $36 trillion. Interest payments are now one of the largest items in the federal budget. At current interest rates, this is not sustainable if growth remains subdued.

There are only a few ways out of a debt problem this large: inflate your way out (which destroys purchasing power and, in the case of the US, does not really work because pension contributions are linked to inflation), default (which destroys the financial system), impose austerity (which destroys growth), or grow your way out.

The administration has clearly chosen the fourth option: grow your way out.

Every policy lever they are pulling is aimed at this: deregulation to raise potential output, SLR reform to lower the government’s borrowing cost, AI investment to drive generational productivity gains, and lower rates, justified by the deflationary impulses described above, to reduce the cost of servicing existing debt.

The math is straightforward: if nominal GDP growth exceeds the interest rate on the debt, the debt-to-GDP ratio falls over time. This framework is designed to raise the numerator while lowering the denominator’s drag.

This is not ideology. It is arithmetic.

The Shift in Front of Our Eyes

Put all these pieces together, and what you get is, in my view, the most significant shift in U.S. economic and macro policy in the last 20 years. Perhaps longer.

A shift from demand management to supply expansion, from stimulating spending through easy money to removing constraints on productivity, competition, and capacity.

A shift from the Fed’s balance sheet as the primary liquidity engine back toward private intermediation, letting banks and markets do what they were designed to do.

A recognition that fixing the plumbing, the SLR, Treasury-market liquidity, and reserve requirements can be as consequential as changing the policy rate.

And a policy apparatus, Treasury, the Fed, the intellectual framework, that is, for the first time in a long time, aligned around a single coherent set of principles.

What This Means for Markets

If the direction of this shift holds, the implications are significant.

U.S. growth should outperform. Not the kind driven by easy money and asset inflation, but the kind rooted in productivity gains, capital investment, and credit expansion through the banking system. That is more durable, more broadly shared, and ultimately more powerful for corporate earnings.

The inflation premium embedded in long-term rates may prove excessive. Between Chinese deflation, AI productivity, and the deflationary impact of deregulation, the structural case for persistently high inflation is weaker than the consensus believes. The bond market’s own inflation expectations are already hinting at this.

The U.S. is assembling a competitive advantage that no other major economy currently matches: AI leadership, regulatory reform, energy abundance, and a banking system on the verge of being freed from contradictory rules.

The cost of capital should come down, but in a healthier way. Not through the printing press, but through better market functioning, lower regulatory drag, and the natural disinflationary forces of technology.

None of this means a smooth ride. Senate confirmation of Warsh may face hurdles. Policy details will be debated. Markets will have moments of doubt. But the direction of travel is becoming clearer by the week.

The Bottom Line

Sometimes the most critical shifts happen while everyone is looking at the wrong thing.

The market was focused on whether the next Fed Chair would be a dove or a hawk. That was the wrong question.

The right question was: Does this administration have a vision for how the economy should work, and do they have the people to execute it? With Scott Bessent at Treasury, Stephen Miran’s framework embedded in the policy apparatus, and now Kevin Warsh at the Fed, the answer is yes.

The market wanted a dove. What it may have gotten is something much better: a framework that makes lower rates compatible with higher productivity, a smaller Fed footprint, and durable, broad-based growth.

Pay attention. This matters.