Federal Reserve Chair Jerome Powell has likened setting monetary policy in the absence of updated official economic data to driving a car in the fog. No longer can the Fed be sure how rapidly the labor market might be deteriorating or how quickly inflation might be rising due to earlier import tariff hikes. In those circumstances, Powell has suggested that the Fed would be well advised to slow down the pace of its interest rate cuts as it aims to fulfill the Fed’s dual mandate of maximum employment and price stability.
Hopefully, the government shutdown will soon end and the flow of official economic statistics will resume. However, the Fed will then have to deal with the many uncertainties arising from the Artificial Intelligence (AI) revolution that is now underway. How quickly might AI be boosting productivity, reducing price inflation, and causing an increase in unemployment? Is the AI revolution creating a stock market and credit market bubble by inflating expectations as to how it might boost economic growth? What impact might the bursting of any such bubbles have on the overall economy?
Anyone who thinks that the AI revolution is not having a profound impact on the economy has not been paying attention. According to UBS, global AI investment will reach $350 billion in 2025 and rise to $500 billion next year as large amounts of money are being invested in data centers to support the large language learning models. US AI investment is estimated to have accounted for around half of GDP growth in the first half of the year. More recently, a slew of large companies have announced meaningful employment reductions related to the adoption of AI.
AI is also having a profound impact on the stock market, which keeps recording record highs on the back of optimism about AI’s potential to boost long-run economic growth. Stock price increases of the so called Magnificent Seven companies that are the dominant players in the AI space have accounted for more than 50 percent of the stock market’s overall gain this year. They now constitute over one-third of the S&P 500’s overall value. They have also been largely responsible for the increase in the S&P 500’s overall valuation on a Cyclically Adjusted Price Earnings Ratio (CAPE) to a little over 40. That is more than double its long-run average and is reminiscent of the level prevailing on the eve of the 2001 bursting of the dot.com bubble.
The uncertainty about the pace of AI’s impact on productivity and employment highly complicates the chances of the Fed delivering on its dual mandate. If it turns out that the pace of AI’s impact is faster than the Fed has been expecting, President Trump might turn out to have been right in accusing the Fed of having been too slow in reducing interest rates. On the other hand, if AI is having less of an impact on the economy than the Fed currently believes, then it might turn out that the Fed should have pursued a tighter monetary policy to prevent a renewed pick-up in inflation.
More important for the economy’s longer run performance is whether or not we are in an AI induced stock market and credit market bubble that could at some stage burst. If it turns out that we are in a bubble, when the bubble eventually bursts the Fed’s critics will be asking why the Fed was asleep at the wheel when the bubble was forming? Why did the Fed not step on the monetary policy brakes earlier to forestall that bubble from inflating? If, on the other hand, it turns out that the Magnificent Seven’s earnings growth justifies their currently very elevated valuations, Powell might earn plaudits for not having precipitated an unnecessary stock market and credit market correction that could have had untoward spillover effects to the rest of the economy.
All of this is to say that keeping the US economy on an even keel is not an easy task at the best of times. At a time of an AI revolution whose future is difficult to divine, it is all the more challenging to successfully steer the US economy. This makes me inclined to think that Powell is right not to make big changes in monetary policy at this juncture and to be guided by the incoming data when it eventually resumes to make his interest rate decisions. Powell would also seem to be right in resisting Trump’s calls for a jumbo interest rate cut for fear of further inflating possible stock market and credit market bubbles.