Fed's Next Mistake? Ex-Fed President Warns Of Market Fallout | Thomas Hoenig

Thomas Hoenig · Mercatus Center at George Mason University

Warsh is a new sheriff: tighter balance-sheet control, markets set direction, and determined to cut inflation.

Hoenig sees Kevin Warsh as taking a different approach from Powell, with better control of the Fed's balance sheet and letting markets work out the direction rather than the Fed leading. He also believes Warsh is determined to bring inflation down, a goal he says Powell stated but did not achieve.

“...I think Kevin [Warsh] wants to bring better control to the balance sheet, and let the markets figure things out rather than being led by the Fed... and I think he's also determined to bring inflation down.”at 4:08

Thomas Hoenig · Mercatus Center at George Mason University

Holding rates near zero in 2010 was below neutral, favoring debtors and speculation.

In 2010 the economy was recovering, with industrial production and GDP improving, so zero rates were unnecessary. Hoenig argues that keeping rates artificially low below neutral misallocated resources, favored debtors over savers and encouraged speculation. He warned that returning from a near-zero equilibrium for an economy of this size would be chaotic.

“It favors debtors over savers, and without a good reason. It also favors high levels of speculation when you hold interest rates artificially low, below the neutral rate.”at 8:36

Thomas Hoenig · Mercatus Center at George Mason University

Real rates near zero are too accommodative with inflation near 4%; policy should be moderately restrictive.

The Fed's target range is 3.5-4% while inflation is about 4%, so real policy rates are almost zero and highly accommodative. Hoenig asks what stimulus is being aimed at with inflation that high. He argues policy should be organized toward returning inflation to 2% with a moderately restrictive stance, which he says the FOMC knows but is ignoring.

“So real interest rates are still highly accommodative, almost zero. ... Stimulate the economy more, and when we have inflation almost 4%? ... a moderately restrictive policy would be much more appropriate than an easy policy of almost zero real interest rates.”at 13:08

Thomas Hoenig · Mercatus Center at George Mason University

The Fed's balance sheet is still very large, so its growth should stay restrained.

Although the balance sheet is no longer growing, it remains very large and provides a lot of liquidity. Hoenig argues the FOMC chair knows it needs to be held back from growing, and that this is a judgment call the Fed must make going forward.

“I would also tell you that their balance sheet, while it is not growing, is still very large. So there's a lot of liquidity out there.”at 14:39

Thomas Hoenig · Mercatus Center at George Mason University

If the Fed holds rates in October, a December hike becomes nearly a must unless the war ends.

He would be somewhat disappointed if the Fed does not raise rates at the upcoming meeting, though not surprised. If it holds, December becomes almost a must for a hike. The exception would be a real surprise such as the war ending and energy prices falling sharply, which would give temporary relief to inflation pressure. He does not see that happening.

“...if they don't raise rates tomorrow, I will be not surprised, but I will be somewhat disappointed. But I think then December becomes an almost must time for them to raise rate, unless we have a real surprise in terms of the war ending, energy prices coming down dramatically...”at 16:43

Thomas Hoenig · Mercatus Center at George Mason University

Banks' unrealized securities losses are a major risk, hidden by accounting rules that let them avoid capital charges.

Large banks hold longer-term securities with sizable unrealized losses. Under the rules, they do not have to charge those losses against capital as long as earnings can cover them, and US government securities carry zero risk weight. This relies on the market looking through the losses. Silicon Valley Bank showed how quickly a public realization that losses overwhelm capital can trigger a liquidity crisis.

“Well, I think it is a major risk, obviously, and what you see is the accounting of it that is keeping that from the incoming more serious problem.”at 19:31

Thomas Hoenig · Mercatus Center at George Mason University

Banks have indirect AI exposure through private credit lending and are growing more cautious.

There is more bank exposure to AI and the tech sector, some direct and more indirect, because banks lend to private credit entities that lend to tech. Banks are comfortable because they expect private credit will absorb losses with its own capital rather than go bankrupt. Hoenig expects banks to remain more cautious for the foreseeable future.

“there is more bank exposure, if not directly, and there's some directly, but also indirectly. Banks are lending to private credit, entities who are lending to the tech sector.”at 28:11

Thomas Hoenig · Mercatus Center at George Mason University

Bank lending to AI, tech and onshoring projects is driving money supply growth despite higher rates.

The banking industry creates money through lending, and it has been increasing lending where opportunities arise in AI and technology. Government subsidies from 2025 to build factories and production capacity encourage banks to lend to these institutions. That credit and deposit growth lets money supply increase, so banking is growing even as the Fed's balance sheet is restrained.

“the Fed isn't the only one who creates money. The banking industry creates money. And what they've been doing is increasing their lending... as the opportunity presents itself with AI and other times of primarily technology.”at 31:15

Thomas Hoenig · Mercatus Center at George Mason University

Recognizing securities losses in capital would slow lending, but regulators are unlikely to change the rule soon.

Requiring banks to recognize unrealized securities losses in capital would have to be phased in once the economy settles. It would slow some lending and push banks to fund operations with capital rather than borrowed funds or deposits, producing a stronger industry. But the government wants banks to keep buying its debt, which needs very low capital charges, so Hoenig doubts the rule will change soon.

“you could slowly change that rule... it would slow some forms of lending... I doubt I don't see that they would change that rule anytime soon, because the government itself can hardly afford to do that.”at 32:52

Thomas Hoenig · Mercatus Center at George Mason University

Long-end yields rising is a form of tightening, partly driven by the Fed letting its balance sheet shrink.

The Fed has raised its policy rate only a quarter point since Warsh came on board, but its balance sheet has stopped growing and it is letting long-term yields rise. That rise is tightening. The policy rate is still near zero, which is why the Fed is cautious.

“certainly having the long end of the yield curve going up is a form of tightening, there's no question about it.”at 16:11

Thomas Hoenig · Mercatus Center at George Mason University

Global bond selloff reflects end of central bank monetization and deficit-driven debt; no one wants to go long.

Central banks such as the ECB, the Fed and the BoE have a history of monetizing national debt, but they are no longer doing so as they once did. Fiscal policy is out of control in the US, France and the UK, with US debt around $40 trillion and France's at 120% of GDP. Because no fiscal solution is in sight, long-term yields must rise and bond prices may fall further.

“there has been a long history of central banks monetizing their national debts... the central banks are not monetizing that debt as they did once, that interest rates have to go up... Who would want to go long in bonds under those conditions?”at 17:57

Thomas Hoenig · Mercatus Center at George Mason University

Government borrowing of $2T a year will raise rates for private borrowers, including AI, slowing the economy.

The government with $40 trillion in debt and $2 trillion of new debt every year will borrow no matter what rates are. This pushes rates up generally and raises borrowing costs even more for the private sector, including AI firms and Oracle. They will be unable to borrow, invest and build as much, which slows the economy. If debt keeps growing, rates must rise and weaken the economy, but if Congress addresses the debt, the economy could adjust slowly, as in the mid-nineties.

“the government with its 40,000,000,000,000 of debt and $2,000,000,000,000 of new debt every year will borrow no matter what, no matter what the rates are. That means rates will rise generally and the private sector... their rates are gonna go up even more.”at 24:14

Thomas Hoenig · Mercatus Center at George Mason University

Congress shows no sign of addressing national debt, raising the risk of a future financial crisis.

Hoenig argues that resolving the debt problem would help the economy. If debt is addressed as it was in the mid-1990s, the government stops competing with the private sector for available credit, which frees more capital for private investment and can produce good outcomes. He says he sees no indication that Congress wants to address the national debt problem. Until it does, he argues, the US faces increasing risk of a financial crisis at some unspecified point in the future.

“I see no indication on the part of congress that it wants to address our national debt problem. And until they do that, we are going to face increasing risk about having a financial crisis sometime in the future.”at 38:18

Thomas Hoenig · Mercatus Center at George Mason University

Powell miscalculated inflation's fall because fiscal stimulus and onshoring spending offset Fed tightening.

Powell intended a gradual glide path toward 2% inflation, but strong fiscal stimulus from Congress after COVID and spending to onshore industrial production interfered. Those forces made it hard to bring inflation down, and Powell did not realize it soon enough to get to the 2% goal during his term.

“the very strong stimulus coming from the fiscal side of the economy, from the Congress, the amount of spending that was going on following the COVID and following other efforts to onshore industrial production back to The United States.”at 6:25

Thomas Hoenig · Mercatus Center at George Mason University

2% US growth is unimpressive; the economy can do more and should not be satisfied with it.

He calls 2% growth for an economy like the United States not particularly impressive. He argues the economy is capable of more, which he uses to argue that tighter policy is not damaging a weak economy.

“2% growth for an economy like The United States, I think is not particularly impressive. The economy is capable of more than that. And I think we should not be satisfied with 2%.”at 12:25

Thomas Hoenig · Mercatus Center at George Mason University

Higher rates will squeeze the most leveraged AI builders first, limiting their borrowing and build-out.

More highly leveraged firms are the first to feel pressure, and that is what is happening with the AI borrowers referenced. If rates keep rising and refinancing of leveraged private credit and other borrowers gets harder, cash flows and financial outlooks will be affected and confidence in the industry could fall. Higher rates would make it harder for AI and other firms to borrow, invest and develop new systems.

“Firms who are more highly leveraged than others are gonna be the first to see the pressure, and that's what you're seeing going on there.”at 22:29

Thomas Hoenig · Mercatus Center at George Mason University

Private credit risk is rising through interlinked private equity, life insurers and lending, and markets are pricing it.

Private equity firms have bought life insurers, which provide deposits to private credit funds, and those funds lend to other private equity subsidiaries. This creates an intertwined, more leveraged industry. Hoenig says the market is beginning to pay attention to these risks because investors have money at stake, and an unwinding process may still take place.

“you have private equities who have bought life insurance companies... So you have a intertwined industry now becoming more complicated and leveraged. And those are all risks that I think the market is beginning to pay attention to.”at 23:12

Thomas Hoenig · Mercatus Center at George Mason University

Foreign capital shifting from Treasuries into US stocks is raising equity demand relative to bonds.

Foreign private investors used to buy US government securities but are now buying the stock market. This increases demand for equities relative to bonds, which explains why the equity market has been calm despite the bond market risk. The flow will persist until investors become more concerned about cash flows and net free cash flow in equity markets.

“Foreign private sector would invest in government, US government securities, but now they're investing in the stock market of all things. So they're actually increasing the demand for equities relative to the demand for bonds.”at 25:40

Thomas Hoenig · Mercatus Center at George Mason University

The dot-com bust hit equities more than credit; the AI bust has more bank and credit exposure.

During the dot-com bust there was less credit at risk than equity, so equities took the hit. Some banks were under pressure, but there was no major meltdown in bank lending or credit quality, and the Fed stepped in with liquidity. Today the AI build-out has more bank exposure, both direct and indirect through private credit, so the credit channel is a bigger risk than in 2000.

“there wasn't as much credit at risk as there was equity. So the equities took the hit.”at 26:52