The views of Kevin Warsh, a candidate for Federal Reserve Chairman nominated by Donald Trump, suggest that the Fed's independence is at historically high levels in some areas but significantly lower in others. Multiple former Fed officials told CNBC that Warsh's statements are ambiguous and, if taken to extremes, could lead to the Fed losing control over core policy tools such as its balance sheet. Warsh's proposal for a new agreement framework between the Fed and the U.S. Treasury has also sparked market skepticism.

While most people are unfamiliar with and need not concern themselves with monetary swap lines, this financial instrument could be key to understanding the unique perspective of Fed Chair nominee Kevin Warsh on central bank independence. Warsh has stated clearly that the Fed should maintain absolute independence in setting monetary policy. However, he also expressed willingness to cooperate with Congress and the Trump administration on non-monetary policy matters.

Responding to questions from senators after his nomination hearing on April 21, he elaborated: "In areas such as international finance, Fed officials should not enjoy the same special decision-making exemptions and independent authority." Warsh also repeatedly mentioned establishing a new Fed-Treasury agreement to regulate the operations of the Fed's balance sheet, though he has not disclosed specific details.

Six former Fed officials interviewed for this analysis believe Warsh's remarks are, at best, ambiguous and confusing. At worst, his interpretation of Fed independence is concerning. Potential outcomes range from minor adjustments to existing practices to severe restrictions on the Fed's ability to use balance sheet tools during crises. Due to the vagueness of Warsh's statements, the former officials have not reached definitive conclusions.

Former Fed officials hold divergent views. Jeffrey Lacker, former president of the Richmond Fed and a long-standing hawk on interest rates and balance sheet reduction, stated he could accept a new Fed-Treasury agreement if it allows the Fed to focus on monetary policy while transferring credit policy responsibilities to the Treasury. Under this framework, the Fed might be restricted to purchasing only U.S. Treasuries, barred from buying mortgage-backed securities or other financial assets.

However, Lacker also warned: "There is a risk of a poorly constructed agreement that enables the Treasury to use the Fed's balance sheet to bypass congressional approval, perpetuating inappropriate operations and ultimately undermining Fed independence." An anonymous former senior Fed official added: "If his logic is followed to its conclusion, the Fed could completely lose control over its own balance sheet."

Warsh's distinction between monetary and non-monetary policy remains unclear. If confirmed by the Senate, he may provide further clarification. For now, legal experts, economists, and Fed watchers must interpret his ambiguous statements from the Senate hearing. Warsh declined to comment for this analysis.

Market observers face a significant challenge: the boundary between a central bank's monetary and non-monetary policy functions is inherently blurry. Several former Fed officials pointed out that currency swap lines fall within this gray area. These tools are typically used during financial crises: the Fed provides dollars to foreign central banks in exchange for an equivalent amount of their local currency. The Fed views this as injecting dollar liquidity into overseas markets to prevent or mitigate global dollar runs, thereby avoiding spillover risks to U.S. markets.

U.S. Treasury Secretary Scott Bessent recently noted that several Gulf nations, including the UAE, have requested swap lines. The Treasury could follow its recent approach with Argentina and use its own funds to establish such lines. The market's question is whether Bessent prefers the Fed to provide these facilities. Senators asked Warsh in written questions whether the Fed should comply with Treasury requests for swap lines; Warsh did not provide a direct answer.

Former Fed officials argue that currency swap lines at least partially fall under monetary policy: first, they require approval from the Federal Open Market Committee (FOMC), which sets monetary policy; second, activating swap lines and supplying dollars to foreign central banks directly expands the Fed's balance sheet. According to data from Hayward Analytics, during the 2008 financial crisis, swap lines expanded the Fed's balance sheet by nearly $600 billion, accounting for 25% of its size at the time. During the COVID-19 pandemic, swap lines peaked at $450 billion.

Warsh's comments may not lead to immediate policy changes. In practice, during crises, the Fed and Treasury have collaborated to stabilize markets, as seen during the 2007-2008 financial crisis when Warsh served as a Fed governor. Final decision-making authority, however, has remained with the Fed, based on systemic disruptions in dollar liquidity.

Another anonymous former Fed official expressed concern: "The worst-case scenario is the Fed's balance sheet becoming a tool for foreign aid." This is a potential risk in providing swap lines to Gulf states like the UAE. These countries currently face no urgent dollar liquidity crisis, making such facilities appear more political than economically necessary. Even if liquidity strains emerge in the Gulf region, there is no dollar funding shortage in the U.S. The UAE itself is financially robust, with substantial foreign reserves and a sovereign wealth fund. Concurrently, amid tensions with Iran, the U.S. government has political incentives to strengthen alliances in the Middle East. Multiple officials noted that dollar swap lines would grant the UAE a financial status traditionally reserved for G7 economies.

Warsh has also hinted at deeper operational changes for the Fed. He envisions revising the Treasury-Fed agreement to constrain the size and composition of the Fed's balance sheet in unspecified ways. This suggests Warsh does not view balance sheet policy as an inherent component of monetary policy, unlike other Fed officials. The specifics of this new agreement remain unclear, but the Fed's asset purchases and sales, requiring majority FOMC approval, are fundamentally monetary policy decisions.

Warsh resigned in 2011 over balance sheet issues. Both Warsh and current Treasury Secretary Bessent have criticized the Fed for maintaining an oversized balance sheet during non-crisis periods. Indeed, Warsh left his role as a Fed governor in 2011 due to his opposition to the Fed's slow balance sheet reduction following the Great Recession.

Bessent has likened the Fed's expanding balance sheet to a dangerous laboratory experiment, calling it a "functional expansion" that excessively involves the Fed in the economy and usurps powers that should belong to the Treasury and the executive branch. When asked about Warsh's ideas on April 14, Bessent told CNBC: "After the financial crisis, many political decisions that should have been the Treasury's were shifted to the Fed. Warsh and I agree on this point." However, he did not elaborate on specific areas of agreement, stating he was "not entirely sure what Warsh means by the Treasury-Fed agreement."

Lacker has long criticized the Fed for overstepping into "credit policy," which he defines as the purchase of any assets other than U.S. Treasuries. During the Great Recession, the Fed began buying mortgage assets, and during the pandemic, it purchased corporate bonds directly. Warsh's proposed agreement could strictly limit Fed asset purchases to Treasuries.

But such an agreement could severely constrain the Fed's flexibility. If the Fed required Treasury approval for asset purchases and selection, it would lose policy agility. Eric Rosengren, former president of the Boston Fed, noted: "In a severe crisis, if fiscal policy responds slowly and the Fed is restricted by agreement on balance sheet size and composition, requiring approval for actions, monetary policy's ability to flexibly counteract would be significantly weakened." He recalled that the Fed's purchase of mortgage assets was partly to avoid over-concentration in the Treasury market, which could disrupt its structure.

Michael Feroli, chief U.S. economist at J.P. Morgan, wrote in a recent report that most Fed officials view balance sheet policy as essentially another form of interest rate policy when short-term rates approach the zero lower bound.

A greater concern among former Fed officials is that if the Treasury can direct the central bank to purchase specific amounts and types of assets, Fed independence would be substantially eroded. This could undermine bond market confidence, interpreted as the Fed directly financing fiscal deficits and allocating credit based on political preferences—a criticism the Fed has faced for its asset purchases, equating to indirect Treasury pressure for monetary easing.

Jim Bullard, former president of the St. Louis Fed, stated that ideas about Fed-Treasury cooperation to limit the Fed's asset purchases have been discussed before. He agrees with Bessent's criticism that the Fed tends to rapidly expand its balance sheet during crises but is slow to reduce it afterward. However, he also noted that some of Bessent's comments suggest a "deeply integrated cooperation" model, which has historically had negative outcomes.

Warsh's vision for the Fed-Treasury relationship may align with traditional paths. In practice, the Fed already follows executive branch guidance on bank supervision, though this remains contentious. Under the Biden administration, the Fed incorporated climate risk costs into bank supervision; after Trump's re-election, it abandoned this approach and aligned with government goals to reduce regulatory burdens on banks.

Such policy shifts stem from the fact that Fed supervision policies must be coordinated with other agencies led by politically appointed officials. On dollar exchange rate policy, the Fed has long deferred to Treasury jurisdiction.

J.P. Morgan notes that while there are voices within the FOMC supporting balance sheet reduction, implementation would take considerable time. Feroli stated: "The other 11 FOMC members will counterbalance any abrupt shifts in monetary policy under Warsh's leadership."

Warsh's logic may be that by proactively shedding non-core functions, the Fed can better protect its independence in setting benchmark interest rates—a core function even the nominating president cannot interfere with. He hinted at this during his nomination hearing: "Every president wants lower rates, but the Fed's independence must be defended by the Fed itself."