Kevin Warsh, President Donald Trump's nominee to chair the United States Federal Reserve, used this week's confirmation hearing to defend a central plank of his macro framework, said Desjardins in a note dated April 22.
Warsh argued that artificial intelligence will raise the economy's productive potential, allowing output to grow faster without reigniting inflation. His argument implies that a productivity-led expansion could open up room for easier monetary policy, noted the bank.
Warsh's theory echoes one associated with a former Fed chair. Back in the 1990s, Alan Greenspan showed a willingness to support rather than restrain the economic expansion, in part because it was being driven by productivity growth. However, by the end of the decade, Greenspan was hiking rates, not cutting them, noted Desjardins.
Aside from the open question of whether the U.S. is actually in the midst of a durable productivity renaissance, Warsh's conclusion appears to run counter to the standard savings and investment logic underpinning estimates of the neutral rate of interest, known also as r-star, said the bank.
North of the border, Governor Tiff Macklem of the Bank of Canada has advanced "what seems like the mirror image" of Warsh's argument, according to Desjardins.
In a speech delivered earlier this year, Macklem argued that when weak growth reflects lower productive capacity rather than a cyclical shortfall in demand, cutting rates risks both "stoking future inflation" and delaying "needed structural change", Desjardins noted.
The mistake both Warsh and Macklem make is to assume, or at least imply, that changes in potential output can map directly into the appropriate setting of policy rates, it addd.
What matters for r-star, and the calibration of actual policy around it, is the balance between desired savings and investment, said Desjardins. A sustained productivity boom generally pushes that balance toward a higher neutral rate by lifting the demand for capital. Conversely, a trade-induced deterioration in growth prospects would typically push in the opposite direction by weakening investment demand and increasing the supply of savings, it noted.
"For both Warsh and Macklem, the error is the same: interpreting changes in how fast the economy can grow as a guide to where interest rates belong. Operationalizing that mistake could end up delivering the exact opposite of what each economy needs," Desjardins added.