15.05.202611:03 Forex Analysis & Reviews: Michael Barr vs. Kevin Warsh: Federal Reserve erupts in row over balance sheet ahead of power transition

On Thursday, a day before the formal transfer of authority, Federal Reserve Vice Chair Michael Barr launched a sharp public critique of plans to shrink the central bank's balance sheet, effectively challenging Jerome Powell's successor, Kevin Warsh.

Speaking to a group of market experts at New York University, Barr said bluntly: "Balance sheet reduction is the wrong goal, and weakening the resilience of the banking system is the wrong means." He warned that proposals to reduce the Fed's balance sheet would undermine banks' resilience, hamper market functioning, and ultimately threaten financial stability. He called cuts to liquidity requirements a direct threat to the whole banking architecture.

Barr did not name Warsh explicitly, but the intended recipient of the message was obvious. The incoming chair has repeatedly argued for a substantial reduction of the Fed's balance sheet, which was swollen to $6.7 trillion during the financial crisis and the pandemic. The Senate confirmed Warsh on Wednesday by a slim margin, and he is due to be sworn in on Friday after Jerome Powell's term ends.

Barr is not alone in this debate. In March, New York Fed President John Williams questioned changing reserve requirements, and Fed Governor Christopher Waller called a return to a scarce-reserves regime "stupidity." In effect, a substantial part of the current Fed leadership has lined up against Warsh.

Notably, despite the toughness of his stance on the balance sheet, Barr identified inflation — not the labor market — as the main risk to the economy. "For me, the greater risk now is that inflation will behave unpredictably," he said, adding that the labor market, despite its instability, worries him less. This is an important signal: the outgoing Fed leadership is handing Warsh a regulator where the inflation agenda is back front and center, placing the new chair in a difficult position given President Trump's likely expectation of a more rate-friendly Fed.

Michael Barr also indicated he met Kevin Warsh in person on Thursday and expects Warsh to do much good at the Fed. Public debate, it seems, does not preclude working dialogue. Still, the fate of the $6.7 trillion balance sheet remains unresolved — and the new chair will have to address it from day one.

All these developments are providing significant support to the US dollar in FX markets.

EUR/USD

Buyers should focus on taking 1.1660. Only that would allow a test of 1.1680. From there, the currency pair can climb to 1.1705, but doing so without support from major players will be difficult. The farthest target is 1.1725. On the downside, I expect serious buying only around 1.1630. If no buyers appear there, it would be prudent to wait for a new low at 1.1610 or to open long positions from 1.1590.

GBP/USD

Pound buyers need to take the nearest resistance at 1.3350. Only that would allow a move to 1.3385, above which a breakout will be difficult. The farthest target is 1.3420. On the downside, bears will try to take control of 1.3320. If they succeed, a break of the range would deal a serious blow to bulls and push GBP/USD to 1.3280 with the prospect of moving to 1.3250.