The White House Just Closed Its Investigation of Fed Chair Powell. Here's What It Means for Markets.

Key Points

The end of the Fed probe will likely clear the way for Warsh to be confirmed.

If he's confirmed, Warsh has plans to shake up how the Fed works.

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Financial markets may have just dodged a bullet.

Early on Friday, the Department of Justice (DOJ) ended its investigation into the Federal Reserve and its Chair, Jerome Powell, regarding the central bank's pricey building renovation.

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The closing of the controversial investigation means the Fed will very likely avoid a confusing and potentially litigious period during which Powell's term as Chair ends but there is no new Fed chief to replace him.

Because the Fed is so important to the smooth functioning of the economy and financial markets, a vacancy at the top of the Fed, or uncertainty about its leadership, is almost guaranteed to cause market volatility and perhaps even a stock market sell-off, especially if investors begin to believe the U.S. central bank is leaderless.

Such a situation looked increasingly likely in recent weeks. Powell's term is scheduled to expire on May 15, yet the confirmation of President Trump's nominee to replace him, former Fed governor Kevin Warsh, has been held up by Republican Senator Thom Tillis, who repeatedly vowed to block Warsh from taking the job until the DOJ investigation is closed.

For context, in 2017, the Fed approved a renovation of the Marriner S. Eccles building, its Washington, D.C. headquarters, built in 1937. The cost of the project has increased over the years and now stands at $2.5 billion.

The Trump administration found that to be extravagant and launched an investigation into possible fiscal mismanagement by the Fed, and even fraud. Yet many observers believed the investigation was merely an attempt by the White House to pressure Powell into cutting interest rates. And in March, a Federal District Court judge blocked several DOJ subpoenas and called them an attempt "to harass and pressure Powell" into lowering interest rates.

Warsh promises independence from the White House

Earlier this week, the Senate Banking Committee held a confirmation hearing for Warsh, though no vote on the nomination has yet occurred. Senator Tillis has remained steadfast in his promise to hold up the nomination until the completion of the Powell investigation.

With the investigation coming to a close this week (though the DOJ said it reserved the right to reopen it), it looks likely that the Senate Banking Committee will schedule a vote on Warsh, leading to a vote by the entire Chamber. Because Republicans control both the committee and the Senate, Warsh's confirmation looks likely.

And in his testimony this week before the Senate committee, Warsh pledged to conduct monetary policy independently from Trump and the White House.

Warsh did, however, say he wants to overhaul or revise several ways the Fed operates. Those include ending current forward guidance practices, which the Fed uses to telegraph its plans to markets; limiting press conferences after interest rate-setting meetings; and more rigidly interpreting the Fed's 2% inflation target rate, which was loosened under Powell's leadership.

And in recent months, Warsh has advocated a dramatic reduction in the Fed's balance sheet, which ballooned to nearly $9 trillion as the Fed worked to inject liquidity into the U.S. economy during the COVID-19 downturn by purchasing bonds. The size of the balance sheet has since dwindled to about $6.7 trillion, but Warsh argues that's still enough to distort markets and cause inflation.

The stock market thrives on liquidity, as unused cash often flows into stocks, driving their prices higher. Any sudden or dramatic decrease in the amount of money in the economy will likely be a headwind to the market moving higher.

The bottom line is that the Fed will likely avoid a succession crisis -- a huge relief to markets -- but changes at the central bank in the coming months are still likely, some of which could roil markets.

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