MNI POLICY: Fed Warms To Productivity Step-Up, Rethinks Risks

The Federal Reserve is cautiously embracing a U.S. productivity boom story with dovish short-run implications for interest rates but more debatable longer-term outcomes.  

Policymakers last month upgraded their growth forecast without higher inflation or significant changes to unemployment, citing in speeches ever-more productive businesses after a pandemic-era reallocation of workers and accelerated automation and adoption of emerging technologies like AI. 

Fresh data from the Bureau of Labor Statistics Thursday showed U.S. labor productivity growth in the nonfarm business sector soared to a 4.9% annualized rate in the third quarter. Over the past two and a half years, it has picked up to 2.3% from 1.4% the five years before Covid-19.

"I never thought I would see a time when we had five, six years of 2% productivity growth," Fed Chair Jerome Powell said after the December FOMC meeting, in which officials marked up growth next year to 2.3% from 1.8% in September. "Productivity has just been almost structurally higher for several years now. So if you start thinking of it as 2% per year, you can sustain higher growth without more job creation."  

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An AI-fueled productivity boom like that of the 1990s has been a key argument of National Economic Council Director Kevin Hassett, a leading contender to be the next Fed chair, for lowering interest rates. Productivity gains topped 3.3% between 1997 and 2004, at the dawn of the Internet era, when the unemployment rate sank to its lowest in decades. 

The U.S. economy grew 4.3% in the third quarter, the fastest rate in two years, while employers added an average of just 51,000 jobs a month, suggesting a sharp increase in worker productivity. Fiscal stimulus in the tax bill and deregulation this year adds more fuel. 

New research by a St. Louis Fed economist and others found generative AI may have increased labor productivity by up to 1.3% since the introduction of ChatGPT.

The Powell Fed won't quickly decide whether the numbers reflect a one-off efficiency gain or the start of a sustained economy-wide surge led by AI. The median FOMC official expects just one rate cut next year, and Powell has hinted rates may stay on hold until new data show inflation is falling again or the labor market weakening. 

But recognizing diminished inflation risk also opens the door for easier policy as tariff effects fade.    

"A number of participants noted that structural factors such as technological progress and higher productivity growth, possibly reflecting increasing use of AI, could boost economic growth without generating price pressures and could also damp job creation. These participants remarked that it could be difficult in real time to determine the extent to which economic conditions reflect such structural factors as opposed to cyclical ones," the minutes of the December FOMC meeting said. (See MNI INTERVIEW: Fed's Miran Sees Substantial Rate Cuts In 2026)

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Over a longer period of time, a faster growing economy tends to require somewhat higher real interest rates, especially if AI turbocharges demand and increases the risk of overheating. Hawks on the FOMC have pointed in part to the AI-fueled growth boom for their skepticism about the restrictiveness of monetary policy.  

A "golden age of AI" narrative can additionally fuel speculative excess, prompting the Fed to lean on tighter monetary policy to maintain financial stability. But an administration that is prioritizing easy monetary policy could also be more tolerant of higher inflation, creating less certainty over future policy. 

Powell himself was noncommittal when asked at the December press conference whether a productivity boom was likely to raise the neutral level of interest rates: "All things equal, yes. But all things aren’t equal. There are many, many things pushing in different directions on where the neutral rate would be. But, yes, that argument does come up."