There's a Mammoth Disagreement Brewing Within the Federal Reserve Over Artificial Intelligence (AI) -- and It May Reshape Monetary Policy

Roughly three decades ago, the advent and proliferation of the internet began changing corporate America forever. Enabling businesses to move beyond their physical storefronts marked a new era for corporate sales and marketing, as well as sent the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) to the moon.

The internet also paved the way for the retail investor revolution by tearing down information barriers that had existed between Wall Street and Main Street for more than a century.

For decades, investors have waited, often impatiently, for the next game-changing technology to do for Wall Street and the U.S. economy what the internet did in the mid-1990s. After a long wait, artificial intelligence (AI) has answered the call.

Empowering software and systems with the tools to make split-second, autonomous decisions is a technology that PwC analysts believe can create up to $15.7 trillion in global economic value by 2030.

Jerome Powell's final day as Fed chair was May 15, leaving Kevin Warsh as the new head of the Fed. Image source: Official Federal Reserve Photo.

But AI is also a polarizing technology -- even within America's foremost financial institution, the Federal Reserve. Public disagreements are brewing about how AI can reshape monetary policy, with Jerome Powell's successor, Kevin Warsh, anticipating a disinflationary effect, and Chicago Fed President Austan Goolsbee predicting higher inflation, if not stagflation!

Jerome Powell's successor views the AI revolution as disinflationary

At one end of the spectrum is Kevin Warsh. During his April 21 testimony before the Senate Banking Committee, Warsh laid out his thesis on AI productivity and its implications for interest rates.

While noting that AI comes with risks and challenges, Warsh painted a picture of AI disruption led by America that leads to significant productivity gains. In his response to Sen. Lisa Blunt Rochester's (D-DE) request for comment about AI productivity gains showing up quickly in U.S. economic data, Warsh opined:

[I] think it has two elements. One is the increase in capital expenditures to build data centers, and the rest. That will have an effect on demand. That will increase demand, my guess is a few tenths of one percent. But on the supply side of the economy, to increase the potential output of the economy, that could be considerably bigger.

In other words, the inflationary effects of sizable upfront spending on AI data center infrastructure should be more than offset by wage growth and a mammoth productivity boost for corporate America. Even with higher capex, the projected offsetting increase in productivity will afford the Federal Open Market Committee (FOMC) the luxury of lowering interest rates. The FOMC is the 12-person body, including the Fed chair, responsible for setting the nation's monetary policy.

What makes Kevin Warsh's structural disinflation view with AI so intriguing is that his FOMC voting record paints him as a clear hawk.

During his previous tenure as a voting member of the FOMC (Feb. 24, 2006 – March 31, 2011), Warsh frequently argued against lower interest rates, fearing that price increases may accelerate. Even as the unemployment rate soared during the financial crisis, Warsh stuck to his historically hawkish stance.

Chicago Fed President Austan Goolsbee at an FOMC meeting in January 2024. Image source: Official Federal Reserve Photo.

Chicago Fed President Austan Goolsbee foresees AI spurring inflation

At the opposite end of this debate is Chicago Fed President Austan Goolsbee, who takes part in Fed monetary policy discussions but isn't a voting member of the FOMC in 2026 (he's currently an alternate voting member).

On May 8, Goolsbee delivered a prepared speech at the Hoover Institution Monetary Policy Conference, where he examined the differences between expected and unexpected increases in technologically driven productivity.

In his discussion, Goolsbee noted that the internet-driven growth acceleration in the mid-1990s came on unexpectedly, allowing the Alan Greenspan-led Fed to enact several quarter-point rate cuts between July 1995 and November 1998.

But it's a different story when businesses and investors know productivity gains from an innovative technology are on the way. In this scenario, businesses and consumers will pull spending forward ahead of the tangible productivity boost, thereby overheating the economy and leading to a noticeable increase in inflation. Goolsbee even pointed to this happening in 1999 and 2000, when Greenspan and the FOMC had to back track and raise the federal funds target rate on six occasions.

Goolsbee also took a direct jab at Wall Street in making his point:

Higher investments in data centers driven by rising stock market valuations driving up the cost of land, electricians, computer chips, etc., for non-AI industries. All of these may suggest productivity growth pushing the ideal interest rate higher, not lower.

Although Goolsbee didn't use the feared "s" word during his speech, stagflation, his commentary implies a scenario where spending gets so far ahead of capacity that it limits job and economic growth while lifting the inflation rate.

Stagflation is the nightmare of all scenarios for the Fed, because there's no easy way to tackle it. Lowering interest rates to promote job/economic growth can fuel already high inflation, while higher rates threaten to further weaken the economy and job market.

Truth be told, it's too early to tell which argument will be correct. But if rapidly expanding capital expenditures from Wall Street's "Magnificent Seven" fail to meaningfully move the productivity needle, the likelihood of Goolsbee's cautionary tale becoming reality significantly increases.

Though Kevin Warsh and Austan Goolsbee have cautioned about the risks of waiting to make monetary policy moves in light of AI's disruptive potential, the wrong move could be an incredibly costly one for the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.