How to Overcome the Inflation-Debt Paradox with AI Prosperity
Leveraging the super-enhanced productivity to reshape our economy into one where growth, low-to-no inflation, and debt reduction go hand in hand.
Imagine a new world where the same $100 bill can buy you significantly more goods and services than it does today, thanks to the deflationary impact of hyper-productivity. In this world, the Federal Reserve can lower interest rates without fear of stoking inflation, subsequently reversing the national debt and freeing up resources for growth and innovation.
But Now, Face the Economic Labyrinth Before Us
The current economic landscape is akin to navigating a impossible maze, where every turn presents the challenge of balancing inflation control with fostering economic growth, all while managing an ever-increasing national debt. The traditional tools wielded by the Federal Reserve, primarily the manipulation of the federal funds rate, have historically oscillated between stimulating growth and tempering inflation. However, this delicate equilibrium has been disrupted, evidenced by the unprecedented situation where the Fed was unable to transfer funds to the Treasury first time in history, and the national debt is projected to climb to a record 116% of GDP by the end of 2034, underscoring the urgency for innovative solutions to the burgeoning issue of national debt and its implications on fiscal policy.
Spending on interest exceeded a number of other budget categories
The Quest for a Sustainable Solution
The critical challenge lies in recalibrating the federal funds rate to stimulate economic activity without igniting inflationary pressures. This task involves a nuanced understanding of the velocity and magnitude at which rate adjustments can be made to cool an overheating economy without stoking the fires of inflation. The theoretical underpinning for this approach finds roots in the Keynesian economic model, which advocates for active government intervention to manage economic cycles. The model suggests that carefully calibrated fiscal and monetary policies can stimulate demand and growth in times of economic downturn, while controlling inflation during periods of expansion.
Strategizing Interest Rate Adjustments
Aiming for an interest rate slightly above the long-term inflation goal of 2% emerges as a strategic solution. This approach aligns with the Fisher Equation, which delineates the relationship between nominal interest rates, real interest rates, and expected inflation. By setting rates that are modestly above the inflation target, the economy can achieve moderate growth and employment gains without precipitating inflationary pressure. Moreover, this strategy facilitates a more sustainable framework for managing national debt, alleviating the fiscal strain on the Treasury.
Fisher Equation - Diagram
The AI Catalyst: Transforming Economic Dynamics
The advent of artificial intelligence (AI) and Artificial General Intelligence (AGI) introduces a paradigm shift. As Cathie Wood of Ark Invest suggests, these technologies are poised to serve as significant deflationary forces. The productivity boom fueled by AI—akin to the transformative impact of the Industrial Revolution—promises to elevate economic efficiency to unprecedented levels. This scenario is supported by Solow's productivity paradox, which observes that technological advancements initially may not reflect in productivity measurements until a significant integration period has passed. AI and AGI's full potential to revolutionize productivity and economic activity mirrors this concept, suggesting a future where the paradox is resolved, and productivity gains significantly outpace historical trends.
Enhancing Purchasing Power Through AI
In this new economic order, the concept of money itself undergoes a radical transformation. The deflationary impact of AI, coupled with its ability to exponentially increase productivity, could lead to a scenario where nominal inflation targets are maintained at 2%, yet the real inflation experiences a downward pressure, potentially reaching negative territories. This phenomenon is explained through the lens of the Quantity Theory of Money, which posits that the money supply's velocity and the volume of goods and services produced in an economy influence the price level. AI-driven productivity increases the volume of goods and services, thereby increasing the purchasing power of money.
A New Economic Renaissance
The emergence of an AI and AGI-driven economy not only promises to revolutionize our current financial systems but also fundamentally alters our understanding of money, interest, debt, and wealth. This shift introduces new economic theories and business practices, challenging and eventually replacing outdated models. The once-daunting challenge of national debt becomes a solvable problem, gradually clearing the path toward a future of financial stability and prosperity.
Recession never took over the economic steering gear. We have been in inflationary expansion since May 2003 till today Oct 20, 2023. Will situation change? At least the monthly chart is slow to tell.
Most analysis of the Fed's rate changes focuses narrowly on 2020, when the central bank slashed rates to near zero to fight the COVID-induced recession. But the timeline actually started earlier. The first rate cut came in July 2019, as global growth slowed amid trade tensions. The Fed then proceeded to cut rates 3 more times in 2019, putting them back near post-crisis lows even before the pandemic hit US shores.
This means that the Fed front-loaded stimulus ahead of the recession, getting out in front of the downturn far faster than in the past. Rate cuts usually happen slowly over the course of a recession. But in this case, the Fed compacted the equivalent of several years' worth of cuts into just 7 months.
They then reinforced those cuts with trillions of dollars in quantitative easing once the pandemic took hold. This ultra-accommodative monetary response was only possible because the Fed had gotten a head start.
- We May Already Be Near the End of a Short Recession
Most economists peg the pandemic recession as lasting just 2 months - the shortest in US history, thanks to unprecedented stimulus. After a quick V-shaped recovery, growth plateaued in 2022 before slowing again amidst inflation and geopolitical turmoil.
However, we could view the last 2 years as containing two distinct, brief recessions triggered by external shocks - the pandemic and the Ukraine war. Some indicators like jobless claims and consumer confidence suggest the US may now be emerging from the second mini-recession.
Recent comments from business leaders also hint at turning sentiment. Salesforce CEO Marc Benioff announced plans on September 15, 2023 to start rehiring employees laid off just months ago, suggesting he sees a recovery on the horizon.
Recent GDP and unemployment forecasts support this idea. The Atlanta Fed's GDPNow tracker shows the economy growing at a 2.9% pace in Q3 after two quarters of contraction. And the Congressional Budget Office has revised down its unemployment projections, with the jobless rate now expected to hold near 50-year lows through 2025.
This paints a picture of an economy approaching a "Goldilocks" state - not too hot, not too cold. With inflation still well above target, the Fed does not need to goose growth further with rate cuts.
- Core Inflation is Projected to Remain Above 2%
The Fed has made clear that fighting inflation is its top priority now. But private forecasts see core PCE inflation - the Fed's preferred gauge - remaining above the 2% target through at least 2025.
In their latest Summary of Economic Projections (SEP), Fed officials forecast core inflation to still be 2.3% in 2023 and 2.1% in 2024 before settling at 2% in 2025. Expectations remain unanchored.
With inflation so sticky and resilient, the Fed is highly unlikely to cut rates anytime soon and run the risk of igniting inflation further. Rate hikes are still firmly on the table.
- Major Crises Follow Rate Cuts, Not Precede Them
Historically, recessions and financial crises have tended to occur years after Fed rate cuts, not before. This pattern played out in both 2001 and 2008.
One hypothesis is that post-rate cut periods, characterized by easy money and booming markets, lead to excessive risk appetite that eventually results in a crash. Cutting rates from already low levels now could lay the seeds for the next crisis later this decade.
If this historical pattern holds, the next recession may not emerge until the late 2020s. This would likely postpone it until after the 2024 election, avoiding economic turmoil during President Biden's potential second term.
While the case for no rate cuts until 2025 looks reasonably strong, there are some counterpoints to address:
+Recession models from Wall Street banks show elevated risks of a downturn in 2023 as rate hikes compound.
+Rising geopolitical turmoil and energy shock risks from the Ukraine war could trigger a recession.
+Stubbornly high inflation may force the Fed to overtighten until something breaks, even though a mild US recession alone may not bring inflation down.
The Fed has historically eased policy preemptively when risks build to provide insurance and ensure a soft landing.
Ultimately the Fed remains data dependent. A material reassessment of the economic outlook could always change their calculus. But as things stand today, the path of least resistance appears to be toward restraint rather than accommodation over the next 2-3 years. The era of easy money is likely behind us for now.
On September 15, 2023, the last day of Salesforce 2023 Dreamforce event, Marc Benioff start rehiring employees that were just laid off? "It's okay. Come back!" So he must already know something about the economy and is scooping up talent before other companies realize things have changed.
