This week Kevin Warsh – the President’s nominee as the new Chair of the US Federal Reserve – testified before the Senate Banking Committee. Mr Warsh needs to be confirmed by Congress. His confirmation isn’t assured, but he is eminently qualified and by all accounts he largely avoided any pitfalls in front of senators.
Meanwhile, the path of interest rates will continue to be a focus of attention – particularly given that the President is keen to see policy rates come down. Here Warsh has had some interesting things to say. In his hearing, he affirmed his commitment to Central Bank independence, at least when it comes to setting interest rates, which was largely as expected. He has also expressed the view that the Fed has been too involved in the economy, specifically by buying government bonds (so-called Quantitative Easing). He would like to reduce the size of the Fed’s balance sheet. At the same time he has acknowledged that it needs to be done very carefully, given concerns that Fed actions in the bond market could push Treasury yields higher.
The third interesting comment came around the impact of Artificial Intelligence (AI). Warsh believes that AI can drive significant productivity gains and act as a deflationary force. That would allow the Central Bank to bring down policy rates on a sustainable basis.
We wanted to think about this third point a bit more. Here there are a few points to make. First, the long-term trend in US productivity has been quite consistent over the past 70 years even as we’ve seen significant changes in the economy (see chart below). Second, we do think we have seen a bit of a pick-up in productivity in recent years, probably thanks to IT spending. Third, we’ve heard this argument before. Former Fed Chair Alan Greenspan made similar arguments about the impact of IT investment on productivity in the mid-1990s. Some argue that as a result the Greenspan Federal Reserve kept interest rates lower for longer than it should have, prompting an unhealthy build-up in financial leverage.
But it’s also worth thinking about whether AI will prove to be deflationary. If AI works as well as hoped, we could clearly see a pick-up in productivity – allowing businesses to achieve more, faster and with fewer employees. In macro terms, that could mean higher unemployment, lower wage growth and possibly lower inflation. And we’ve already seen announcements of significant layoffs from some tech businesses. But we’re also seeing massive investment as companies build out AI infrastructure. That means demand for commodities, for construction materials and energy resources. In some cases, limited availability (for instance of power) has meant delays. Anecdotally, the AI build out has meant increased demand for roles like electricians or Heating, ventilation and air conditioning ((HVAC) engineers – who have seen their day rates increase significantly.
So, where does this get us? We think over time that AI will help drive faster productivity growth. But the path to get there will take time and significant resources and investment. We’re not yet convinced that AI will be the deflationary force, in the short-term, that will allow the Central Bank to bring down policy rates sharply. All that said, we think AI spending will remain an important trend affecting the global economy and markets, and it’s something we’ll continue to monitor closely.
*As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. Past performance is no guarantee of future results. It is important to consider your risk tolerance and investment objectives before proceeding.
