Now is an unusual time to call for a rate cut

The most straightforward argument against cutting rates is that inflation is still running high while unemployment remains low. Wages are increasing, consumer spending seems resilient even with fluctuating gas prices, and the market appears to have largely abandoned hopes that the Fed will ease rates this year.

Traditionally, the Fed lowers interest rates when the economy shows signs of trouble. Conversely, when inflation is high, tightening or not cutting rates is the norm.

With Kevin Warsh set to take over as Fed chair, his approach could be different.

Monetary policy is no longer just about demand

The new Fed chair has hinted at considering factors like artificial intelligence and productivity enhancements. While this sounds somewhat political, there is an academic basis to it as well. Basically, monetary policy is not only about stimulating demand; it can also influence supply.

This concept is outlined in a paper titled “The Supply-Side Effects of Monetary Policy” by David Bakay from UCLA, alongside Emmanuel Farhi and Kunal Sanghani from Harvard. They argue that monetary policy can actually boost productivity by reallocating resources across businesses. In an environment where companies have varying markups and pricing power, interest rate strategies can do more than simply influence demand—they can impact how businesses operate.

A high-cost company tends to price products significantly above production costs, which is often due to brand strength, market position, or lack of close competition.

This matters because monetary policy can determine which firms thrive and which struggle, thereby impacting the efficiency of labor and capital utilization.

Traditionally, the Fed operates under the assumption that productivity is something that happens ‘offstage.’ They drive demand while supply is determined by technology, competition, and capital formation. So, inflation is typically viewed as a sign that demand has outstripped supply.

But what if the Fed has a role in influencing supply itself?

Baqaee-Farhi-Sanghani argue that the right kind of monetary policy could potentially boost not just the economy’s demand, but also its efficiency. When monetary conditions are loose, nominal spending and wage costs rise—a classic case of demand-side economics. However, companies don’t all respond identically to cost increases. Firms with tight margins often increase prices quickly, while those with better margins might absorb some of those costs instead of passing them fully onto consumers.

This alters relative pricing, as those more profitable companies can appear more affordable compared to their lower-margin counterparts, which leads customers and resources to gravitate toward them. This shift allows the economy to optimize its output since firms that had previously restricted production to maintain margins would now increase output, thus lifting productivity.

Reducing interest rates as a path to higher supply

This thinking isn’t just a minor aspect of the model. Lowering interest rates can actually result in increased production, making inflation lower than traditional demand-focused models would predict. Moreover, hiking rates might hurt productivity without addressing spending.

Warsh’s perspective suggests that we don’t need rate cuts simply because the job market is failing—because it isn’t. The unemployment rate remains low, although job growth has tapered off largely due to a shrinking labor force. Unemployment claims are still relatively low historically. It doesn’t mean we should dismiss rising headline inflation either, which wouldn’t be accurate.

The crux is that the current inflation issues aren’t driven primarily by a demand surge. They stem from an energy crisis layered onto an economy that’s undergoing significant supply-side changes.

The conflict in Iran has driven energy prices up. This might create a mechanical bump in overall inflation, affecting transportation and production costs. Still, the Fed doesn’t have the tools to resolve such issues—like pumping oil or reopening shipping routes. Plus, energy price shocks can lead to secondary contraction effects, as consumers have to spend more on fuel, leaving less for other expenses.

At most, the Fed can decide whether to exacerbate these energy crises and financial limitations. That would be a mistake Warsh ought to avoid.

If AI is increasing demand for chips, servers, electrical equipment, and other components, the economy will need more capital, not less. Recent data indicates surging prices in several AI-related fields, hinting that demand is closing in on supply in high-tech manufacturing. US companies in this sector need to expand production capacity. Policies that keep interest rates high may appear anti-inflationary in the short term but could hinder long-term supply-side efforts.

Here, Warsh might be turning conventional thinking on its head.

The Fed Shouldn’t Fight a Productivity Boom

The prevailing idea is that the Fed must avoid cutting rates because inflation is rising and the job market is stable. Conversely, a supply-side perspective suggests that the Fed could cut rates precisely because the economy is expanding its productive capabilities.

This isn’t a reckless strategy; it’s a carefully considered approach to stimulate supply.

Warsh will likely remain cautious regarding energy costs and inflation expectations. He may focus on median and adjusted inflation metrics rather than solely the headline CPI, which can be distorted by oil prices. Current data shows workers’ share of production dropped to 54.1% recently, the lowest since 1947, suggesting productivity gains aren’t being entirely consumed by labor expenses. He could assert that low unemployment isn’t necessarily inflationary if companies are expanding their capacity and investment is on the rise, lifting overall productivity.

The essential takeaway is clear: the Fed shouldn’t be working against a productivity surge.

A 25 basis point rate cut this summer would not equate to submission to inflation. It would signal a recognition that the economy isn’t merely a demand engine that cools off with rising prices but a productive system whose capabilities can be compromised by excessive suppression. If inflation remains manageable, the Fed could opt for further cuts in the fall and winter.

However, Warsh faces both political and institutional challenges. Some Fed officials might resist a rate cut following two months of rising inflation, raising concerns about reliability. Plus, market expectations are shifting away from hoping for a rate cut, and the media might interpret any easing as capitulation to political pressure.

Yet, the stronger counterargument is that this wouldn’t just negate those optics; it would replace them with improved theories.

Historically, interest rate cuts have been justified as a safeguard against recession. Warsh has a chance to reframe them as insurance for productivity.

That’s a separate topic, and perhaps the most accurate reflection of what the economy currently needs.