AI could quickly become the Fed’s new problem

A strong economy and a weak labor market don’t typically go together. For the Federal Reserve and other central banks, the playbook has long been straightforward: weak hiring calls for lower interest rates, while an overheating economy and inflation above target justify tighter policy. But with AI, that playbook may no longer work.

If companies can maintain or even increase output with fewer workers, traditional labor market signals could become harder to interpret. This raises the risk of policy mistakes with far-reaching consequences for financial markets, according to FXStreet analysis.

Growth without hiring: The productivity paradox

At first glance, this idea seems contradictory. After all, a successful company would typically need to hire more workers to increase output and meet rising demand. However, technological progress can allow firms to improve output with a stable, or even declining, workforce—provided productivity rises fast enough.

This relationship follows the production function: Q = A* f(K,L), where Q is output, A is productivity, K is capital, and L is labor. As long as gains in productivity are strong enough, output can continue growing even if labor input declines.

History offers striking examples. According to the USDA Economic Research Service, US farm output nearly tripled between 1948 and 2017, while agricultural labor declined by 76% and farmland contracted by more than 25%. Similar patterns appeared in manufacturing during the 1980s and the computer revolution of the late 1990s.

AI presents a unique twist on this pattern. Displaced workers are sometimes hired on temporary projects to create training data for more advanced AI models—which could eventually cause even more layoffs in their sectors.

Measuring AI’s impact proves nearly impossible

In 1987, economist Robert Solow famously said: “You can see the computer age everywhere but in the productivity statistics.” This quote highlights how challenging it is to measure technological advancements’ impact on productivity.

The estimates for AI vary wildly:

• Goldman Sachs analysts predict AI could drive a 7% increase in annual global GDP over 10 years—nearly $7 trillion
• MIT’s Daron Acemoglu offers a more conservative view: no more than a 0.71% increase in total factor productivity over 10 years

The debate has reached the Federal Reserve itself. Fed Governor Lisa Cook acknowledges AI can transform the labor market but notes we’re currently in a “low hire low fire regime.” Cleveland Fed President Beth Hammack told CNBC it’s unclear what AI will do to the economy. NY Fed President John Williams believes AI will likely boost productivity but says it will take a long time.

The Fed faces three challenging scenarios

Interest rates are a reactive, lagging tool. The Fed only raises rates after sufficient data convinces policymakers that inflation will stay high. It only cuts rates once there’s clear evidence the labor market is suffering. But rates can’t address structural employment changes from technology.

This creates three risky scenarios:

Scenario 1: Weak labor market with underestimated AI growth

The Fed would likely cut rates, but if AI-driven growth is stronger than expected, inflation could reaccelerate. This would force a policy reversal, hurting stocks and initially weakening the dollar before strengthening it as yields rise.

Scenario 2: Low hiring with resilient growth

The Fed might assess this as “productivity-led growth” and keep rates higher for longer. But if AI adoption accelerates and creates more layoffs, demand could weaken while high rates make things worse. Interest rates can’t fix this problem—it might require fiscal policy or AI regulation instead.

This scenario would initially support stocks due to higher profits and strengthen the dollar, but both effects would reverse once recession concerns grow.

Scenario 3: Cool labor market with minimal AI impact

If AI’s productivity impact proves irrelevant while the labor market remains cool, the Fed would likely cut rates in response to what looks like a cyclical slowdown. This would support stock markets while weighing on the dollar and bond yields.

The most likely outcome

The rise of AI adds new complexity to interpreting economic data. While this escalating risk of policy mistakes could drive innovation in data collection and assessment, the author believes AI adoption won’t lead to significant productivity improvements visible in GDP.

However, that won’t stop companies from trying to replace workers with AI to cut costs, at least in the near term. This makes a traditional economic slowdown followed by loose monetary policy the most likely scenario—good news for stocks, bad news for the dollar and bonds.

For the Fed, assessing the impact of this technological upheaval will be anything but straightforward.