Fed Watch: Can AI Productivity Gain Cut Inflation?

As Kevin Warsh prepares to become Federal Reserve chair, the "P" word is having a moment. That's "P" as in "productivity," which Warsh believes can improve thanks to AI, allowing the economy to grow more quickly without unpleasant side effects like inflation and interest rate hikes.

At the most basic level, productivity measures output per worker. Productivity has generally risen over the long run, but there have also been periods of minimal change.

Currently, there are expectations that AI will drive productivity growth by allowing individual workers to produce more goods and services. That view was reinforced recently by a series of highly publicized layoffs that reached a crescendo in late February when payments firm Block (XYZ) cut 40% of its workforce, saying it's moving toward "smaller, highly talented teams using AI to automate more work."

If technology enables fewer workers to create more output, then productivity would likely rise, and recent quarters show solid gains, though the AI impact is debated.

The AI boom is "the most productivity-enhancing wave of our lifetimes—past, present and future," Warsh said, according to a recent New York Times article. He called AI "structurally disinflationary," as some say the internet was when it first started making an economic impact roughly 30 years ago.

This theory has triggered debate about whether the Fed could let the economy safely "run hot" under an AI-driven productivity surge by lowering rates. Investors might find out with Warsh at the helm, though he'd still be just one vote among central bank policymakers who don't all share his views on this matter.

"I expect that the AI boom is unlikely to be a reason for lowering policy rates," Fed Governor Michael S. Barr said in February.

There are reasons for skepticism. AI productivity gains aren't necessarily proven, and even if they do show up in data, that's not necessarily a slam dunk for lower rates. In fact, it could be an argument to raise rates.

"People are making the case for much greater productivity that will allow the economy to grow faster without inflation," said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, or SCFR, in a recent podcast. "But keep in mind, higher real growth requires higher real interest rates."

Productivity climbed a healthy 5.2% in the third quarter of 2025 on an annualized basis before pulling back to a still-solid 2.8% in the fourth quarter, according to the government's preliminary estimate. However, unit labor costs rose 2.8% in the final quarter of 2025, not showing signs of productivity-driven easing that might cool inflation, which remained near 3% year over year according to the December Personal Consumption Expenditures (PCE) price index.

Typically, the Fed raises rates to fight inflation when economic growth climbs, because stronger growth often triggers additional corporate hiring and capital expenses, putting upward pressure on wages and prices.

There's a historic example of how the Fed acted during a technology burst. Its response then might inform Warsh and other policymakers today.

During the internet boom of the late 1990s, the federal funds rate rose from below 4% in late 1993 to 6.5% by mid-2000, even as quarterly productivity gains advanced from a negative reading to 4% over roughly the same period. Some believe that economic advance reflected internet-driven technology use surging at the time.

Inflation didn't swell then—annual consumer price growth generally stayed below 3% between 1995 and 2000—but worries that it would appeared to have driven the Fed's thinking.

When the Fed hiked rates 50 basis points in May 2000 to the very top of dot-com-era levels, it said, "Increases in demand have remained in excess of even the rapid pace of productivity-driven gains in potential supply, exerting continued pressure on resources."

It warned that this scenario "could foster inflationary imbalances that would undermine the economy's outstanding performance."

That Fed statement followed the central bank's May 2000 Beige Book of regional economic conditions, which observed, "There were more frequent reports of intensifying wage pressures as shortages of workers persisted in all Districts. Increasing input prices were noted in nearly every region."

In retrospect, one might argue the Fed should have given the economy more room to grow at lower rates, which might have eased the severity of the 2001 recession. That said, some market historians credit then-Fed Chairman Alan Greenspan for not raising rates even more, saying he connected rising productivity with technology gains.

Jobs growth didn't pick up as much as analysts had expected after the 2001 recession ended, possibly evidence that technology-related productivity improvement boosting economic gains didn't create the kind of robust jobs markets of past growth cycles.

"On the one hand, the economy continued to grow as it benefited from the integration of the internet," wrote Liz Ann Sonders, chief investment strategist, and Kevin Gordon, head of macro research and strategy, both at SCFR, in a recent analysis. "On the other hand, there was a dearth of hiring, and the unemployment rate continued to rise well into 2003."

That's an example Warsh might share in his confirmation hearings to reinforce the argument that revolutionary technology can boost productivity without causing employment and possibly wages to spike, fueling inflation.

The Fed again embarked on steady rate hikes between 2004 and 2006 as productivity surged above 6% during that period.

Consumer prices climbed more than 3% in 2005 and 2006, perhaps shaping the Fed's strategy, and undercutting the argument that tech-driven productivity gains always prevent inflation.

Fed Governor Barr agreed that in a long-lasting productivity boom generated by AI, wages and economic growth could grow more than they would otherwise without putting upward pressure on inflation. That scenario doesn't automatically lead to lower rates, however.

"Demand for capital would rise because of the strong business investment required to take advantage of the technology, putting upward pressures on interest rates, and household savings could fall due to expectations of stronger real wage growth and thus higher lifetime earnings, also putting upward pressure on interest rates," Barr said.

In the short term, he added, investment in AI could also be inflationary. For instance, if electricity supply constraints from inefficiencies in the power grid collide with strong energy demand from the building of data centers.

It's also not clear how anyone would measure AI's impact on productivity—if and when it happens—making it more difficult for the Fed to decide if AI-driven productivity or some other factor, including lighter hiring, might explain a future inflation retreat.

The Fed would likely be wary of misjudging the reasons behind an economic trend, especially after failing to accurately predict or quickly respond to the post-COVID inflation surge of 2022.

"What Warsh is suggesting is that we're going to have a productivity boom that allows the economy to grow at a faster rate without generating inflation. Therefore, interest rates could be lowered," Schwab's Jones said. "But there are risks. The main one is that productivity is difficult to measure in real time, let alone forecast. It's especially hard in a service-oriented economy. If the Fed acts on interest rate policy and is wrong on productivity, it can mean higher inflation."