Warsh and Macklem Are Making the Same Mistake

Kevin Warsh, President Trump’s nominee to chair the Federal Reserve, used his confirmation hearing to defend a central plank of his macro framework. He argued that artificial intelligence will raise the economy’s productive potential, allowing output to grow faster without reigniting inflation. The implication of his argument is that a productivity-led expansion could open up room for easier monetary policy.

His 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. Of course, by the end of the decade, the Maestro was hiking rates, not cutting them.

Aside from the open question of whether the US 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 (r*). Fed Vice Chair Philip Jefferson put it plainly in a recent speech: “All other things being equal, persistent increases in productivity growth are likely to result in an increase in the neutral rate, at least temporarily.” Other members of the Federal Open Market Committee have made the same point.

The mechanism is straightforward. Stronger productivity raises the expected return on capital, which encourages firms to invest. At the same time, households that expect stronger future income growth may choose to save less of their income. Higher desired investment and lower desired savings are a textbook recipe for a higher neutral rate.

North of the border, the governor of the Bank of Canada has advanced what seems like the mirror image of Warsh’s argument. In a speech delivered earlier this year, Tiff 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.” 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.

What matters for r*, and the calibration of actual policy around it, is the balance between desired savings and investment. 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. 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.