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LivestreamMenuIt’s been clear for weeks that investors are wincing at the pain of runaway AI investment before seeing the economic gain that’s promised. When Alphabet CEO Sundar Pichai last week explained another surge in expected capital spending by saying, “We are in very early innings of what feels like a secular shift,” traders hit the sell button, preferring to glimpse an assured destination rather than sit tight for a journey that’s just started. Wall Street now faces a related pain-before-gain debate around monetary policy. Should Federal Reserve officials respond with tighter policy to the AI capex binge that’s consuming vast amounts of capital, pressuring corporate-debt yields higher and generally running parts of the economy hot, while war-propelled energy prices lift headline inflation? Or, as Fed Chairman Kevin Warsh and many of his devotees have argued, can this short-term price pain be tolerated in anticipation of AI proliferation to begin suppressing inflation and quickening productivity growth, allowing the economy to grow faster without stoking inflation or requiring higher interest rates? Since taking over as Fed chief in May, Warsh has not explicitly endorsed the AI-productivity story that some monetary doves are promoting. But in the months before being nominated by a President who unabashedly stumps for lower rates, Warsh was happy to air this case. One year ago, he told CNBC, “AI is going to make almost everything cost less. The U.S. can be a big winner and it is a hugely exciting moment. If I were to step back for a minute, if I were the president, what I would be worried about is a central bank that doesn’t see any of that…and doesn’t recognize that we are at the front of a productivity boom, and that they might think that economic growth is somehow going to be inflationary. I think that we are probably in the early innings of a structural decline in prices.” There’s that insistence on it being “early,” again. Greenspan-period analogy The overt analogy here is the way Fed Chair Alan Greenspan resisted calls to tighten policy for most of the late-1990s, even as the economy grew briskly, unemployment was low and a huge debt-enabled tech-investment boom raged. The result was a decade free of recession, with inflation held in check, underwriting stupendous wealth creation in the equity market – until the boom grew excessively speculative and (after a year of eventual Fed rate hikes) imploded. Still, while there are obvious parallels between the Internet buildout and the current AI frenzy, the 1990s “productivity miracle” had key drivers outside of the technology revolutions that are not present today. At a surface level, the contribution of tech hardware and software investment to real GDP growth appears quite similar, and if anything, is occurring more quickly now. But also helping to restrain inflation and interest rates in the 90s, and to allow the private sector to lay claim on more cheap capital, was the steady improvement in the U.S. fiscal position. The chart below shows the Federal deficit (or, briefly, surplus) as a percentage of GDP. Borrowing shrank as a proportion of economic activity for a few reasons. One was the “peace dividend” that allowed cuts to defense spending after the Cold War ended – in contrast to the present rapid expansion of the military budget. Another was split government which in 1994 resulted in Republicans thwarting heavier domestic spending by President Clinton, whose own advisors also tried to placate the bond market with fiscal discipline. Surging tax receipts thanks to roaring equity-market gains helped, too. Needless to say, the present spending path and heavy interest burden are keeping deficits near 6% of GDP in a sturdy economy. One cause of this growing burden: An aging citizenry alongside stagnant working-age population growth. As seen here, the number of “dependent” seniors as a percentage of working-age Americans was declining through the ’90s and is now rising steeply. This probably leaves less room for productivity gains to pervade the economy through more efficient work. Another crucial tailwind for the “Goldilocks” mix of disinflationary growth in the ’90s: rapid globalization of supply chains and the elimination of trade barriers. The outsourcing of manufacturing to lower-cost venues accelerated that decade. We are now rushing to reverse this movement, “re-shoring” and building redundancy into production processes to reacquire jobs and ensure domestic supply. There are plausibly strong reasons to do this, but on a net basis it does not suppress inflation or inherently boost productivity. Fed decision Wednesday Taken together, these realities raise the hurdle for doves to persuade the current entrenched hawkish FOMC that a disinflationary escape hatch will soon open thanks to rapid adoption of new technologies. This likely does little to alter the contours of the Fed’s decision on Wednesday. The bond market has begun to brace for an appreciable chance, if not an odds-on likelihood, of a rate hike this week, while continuing to price at least one bump in rates later in the year. Even a hike or two to “take back” last year’s “insurance cuts” would not necessarily scramble the macro fundamentals or undermine the case for an AI productivity impulse. It’s reassuring that market-based inflation expectations are not flaring much of a warning signal, giving cover for a further wait-and-see approach by the Fed, at a time when real (inflation-adjusted) long-term Treasury yields are already at multi-year highs and could act as a restraint on the economy and markets. But with opinions on the committee ranging from doves banking on an AI productivity shock to hawks fearing a 1970s-style “second wave” of inflation, there’s plenty of material to fuel the “family fight” that Warsh says he wants in Fed policy discussions.
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