Inflation and the AI Productivity Paradox

Kevin Warsh is the new Federal Reserve Chair. Appointed by President Trump, his vision for monetary policy offers a distinct contrast to the approach of his predecessor, Jerome Powell. Under Powell’s leadership, the Fed cautiously kept interest rates elevated to navigate a number of factors that are keeping inflation stubbornly above the 2% target: a resilient labor market, strong consumer spending, high fiscal deficits, tariffs, and now, renewed geopolitical uncertainty and the associated energy price shocks. However, Warsh has argued for a change of course. He believes high borrowing costs are no longer appropriate, especially as new technology promises to increase labor productivity.

How Productivity Prevents Inflation

Warsh’s main argument for cutting rates relies on the economic relationship between productivity and inflation. Higher productivity allows an economy to generate more output from the same amount of labor and capital. This creates wealth without triggering inflation because it fundamentally expands the economy’s aggregate supply to match rising incomes.

When output per hour increases, companies generate more revenue per worker. This allows them to increase wages and expand profit margins simultaneously. Because the economy is physically producing more goods and services, this additional income represents genuine purchasing power—an increase in real wealth and standard of living. Inflation only occurs when aggregate demand outpaces aggregate supply (too much money chasing too few goods). Productivity prevents this by ensuring the supply of goods grows alongside wages.

Warsh argues that the AI boom will expand the supply of goods and services fast enough to naturally keep prices down, giving the central bank reason to lower interest rates. However, capturing these deflationary benefits requires weathering the large, upfront inflationary costs of deploying new technology.

The 1990s Precedent

There is historical precedent for Warsh’s optimism. In the early 90s, despite the initial deployment of PCs and the internet, productivity growth remained mediocre, averaging approximately 1.5% per year—essentially the same pace the U.S. had seen throughout the 1970s and 1980s. But in the second half of the decade, as personal computers, the internet, and new telecom technologies became more deeply embedded into the workplace, productivity nearly doubled, averaging 2.5% to 3% per year. By the year 2000, productivity growth hit 4.3%.

Rather than raising rates to cool down a fast-growing economy, then-Fed Chair Alan Greenspan kept interest rates relatively low—mostly in a tight band between 4.75% and 5.5%. The strategy seemed to work initially as productivity gains came from the deployment of new technology.

The Warning: The Dot-Com Bubble and Rate Reversals

However, the full 1990s story comes with a warning. While Greenspan’s lower rates seemed to work at first, the stock market eventually overheated, leading to the dot-com bubble. To stop demand from spiraling out of control, Greenspan had to reverse course and raise rates aggressively in the year 2000, pushing them up to 6.5%. The bubble burst soon after. Today, the concern is if Warsh cuts rates too soon, he could accidentally fuel a similar bubble, forcing the Fed to hike rates later.

The Immediate Challenge: The Productivity J-Curve

We are still in the early days of the AI rollout. Tech companies are spending hundreds of billions of dollars to build data centers and buy enough electricity to run them. This huge spending spree risks driving prices up before we get the full benefits from increased productivity. Economists call this the “productivity J-curve.”

In the short term, adopting new technology costs a lot of money and drives up demand, which causes inflation. The promised efficiency gains—the part that brings prices down—only come years later. If Warsh cuts rates now expecting instant productivity, it could just be pouring gasoline on today’s inflation fires.

What This Means for Your Portfolio

For investors, success lies in balancing AI-driven growth with exposure to companies featuring strong free cash flow, pricing power, and the resilience to withstand potential delays in productivity gains. Beyond the tech sector, leading companies in industries like healthcare, industrials, and financials offer valuable inflation protection and portfolio diversification.