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The Fed Pauses Rate Cuts, but the Bigger Story Is What Comes Next

Investors can be forgiven for missing the Federal Reserve’s most recent rate decision, which saw them holding the benchmark fed funds rate at 3.50% to 3.75%. Markets were almost universally expecting a pause, which removed any newsworthiness from the announcement.¹

But that doesn’t mean the meeting was irrelevant.

Parsing through some of the Fed governors’ framings and positionings, it was clear that the Fed’s stance had shifted. In prior months, the debate had centered more on whether inflation was gradually moving back toward target. In the April meeting, the Fed appeared to be emphasizing renewed upside risks, particularly from energy. The “wait-and-see” mindset was more prevalent than it had been in recent meetings.

This distinction is notable as the Fed approaches a leadership transition. Kevin Warsh is poised to take over as Fed Chair in June, and he appears likely to bring a different framework to how the Fed operates, particularly around communication, inflation measurement, and the size of the Fed’s balance sheet. The media swirl around Warsh’s nomination may make it seem like these changes could be disruptive, but I don’t think that’s the case at all.

For starters, the Fed is not a one-person institution. A chair can shape the debate, set the tone, and guide the committee. But monetary policy is still made by a group of governors and regional Fed presidents, many of whom appear reluctant to move quickly while inflation remains above target and energy prices are rising.

That committee structure also helps explain why the more extreme concerns about Fed independence did not come to fruition. There had been worries that the Fed’s institutional structure could be disrupted or that leadership changes could alter the balance of power inside the central bank. None of that happened. Recently, the regional Fed presidents’ terms were extended, high-profile personnel changes did not materialize, and the Fed remains a committee-driven institution. For markets, the uncertainty around these somewhat political issues has all but faded, in my view.

The Fed will probably look more like business as usual, but I do foresee a gradual shift in emphasis. One area where Warsh’s views are especially important is the Fed’s balance sheet. Warsh served as a Fed governor under Ben Bernanke during the 2008 Global Financial Crisis, when the Fed dramatically expanded its use of quantitative easing. Warsh is often associated with the view that the Fed should have emergency balance-sheet powers, but that the bar for using them should be high.

The Fed’s balance sheet remains very large, at more than $6 trillion, even after several years of runoff from its pandemic-era peak. Warsh has argued in the past that the Fed’s balance sheet should be smaller, and a Warsh-led Fed may place more emphasis on reducing the central bank’s footprint in Treasury and mortgage markets. In my view, however, Warsh is likely to proceed cautiously. Balance-sheet runoff is a form of liquidity tightening. If the Fed drains reserves too quickly or reduces its holdings too abruptly, it can put upward pressure on longer-duration interest rates. That could create issues for mortgages, corporate borrowing costs, and equity valuations—none of which Warsh will want.

To offset the effects of balance sheet tightening, we may see more coordination with the U.S. Treasury and an effort to push regulatory reforms that allow banks to hold fewer reserves. Adjustments to liquidity requirements or related bank regulations could, in theory, make it easier for the Fed to operate with a smaller balance sheet. This will be the thing to watch during Warsh’s term, in my view.

To be sure, I still think Warsh will make the case for lower interest rates. His argument will likely be that the recent oil shock is a supply-side issue, not evidence of demand-driven inflation. He may also point to improving productivity as a disinflationary force, especially if artificial intelligence and other technologies allow businesses to produce more output with fewer cost pressures. In the 1990s, stronger productivity growth helped the economy grow at a healthy pace without generating the kind of inflation that might otherwise have forced the Fed into a more restrictive stance. If productivity is rising again, which it currently is (see chart below), Warsh may argue that the Fed should not focus only on backward-looking inflation data.

U.S. Labor Productivity, % Change from Quarter 1-Year Ago

Warsh may be more inclined to look through supply-driven inflation, but the committee may not be ready to do the same. And in my view, that’s not necessarily a negative. If growth remains positive, earnings continue to expand, and inflation does not accelerate materially, stocks do not necessarily need Fed cuts to move higher.

Bottom Line for Investors

The Fed’s decision to pause rate cuts was expected, but the bigger story is the policy environment taking shape for the rest of 2026 and beyond. A Warsh-led Fed may bring a different framework to monetary policy, with more attention paid to productivity, supply-driven inflation, and the size of the Fed’s balance sheet. Worries about collapsing Fed independence or a Fed doing the bidding of the executive branch are overblown, in my view. The Fed remains a committee-driven institution, and many voting members will likely want clearer evidence that inflation is moving back toward target before easing policy. For investors, the key point right now is that markets appear to have already adjusted to the possibility of no rate cuts this year. That lowers the risk that a prolonged pause becomes a major negative surprise. In my view, the next phase of Fed policy may be less about whether the Fed cuts by 25-basis points, and more about how it manages liquidity, inflation expectations, and the long end of the yield curve.

Disclosure