Federal Reserve Chair Kevin Warsh has several possible ways to help bring inflation back toward the central bank’s target. However, raising interest rates remains the most direct and dependable option, even though it is also one of the most difficult choices for the economy.
Other approaches include reducing the Federal Reserve’s balance sheet to withdraw excess liquidity from financial markets and relying on stronger productivity growth driven by artificial intelligence. While both could eventually ease inflationary pressures, neither appears to be as effective or straightforward as higher interest rates when the immediate objective is price stability.
Recent U.S. economic data have given the Fed some additional room to assess its next move. However, if inflation stays well above the 2% target, pressure on Warsh to take stronger action is likely to increase. Neither a smaller balance sheet nor an AI-driven productivity surge is likely to provide a quick solution.
Rate Policy Works With a Delay
Increasing interest rates does not produce an immediate effect on inflation. Monetary policy operates with a delay, historically estimated at roughly 12 to 24 months. The exact timing, however, varies from one economic cycle to another.
That delay may now be shorter because of changes in how policymakers communicate their plans, including forward guidance, as well as rapid technological development and increasingly digitized financial markets. Fed Governor Christopher Waller has estimated that the impact could appear within roughly nine to 12 months.
Changes to the Fed’s balance sheet and improvements in productivity would probably take even longer to influence inflation meaningfully, assuming their effects are strong enough to do so.
Limits of a Smaller Fed Balance Sheet
The Federal Reserve has already made substantial progress in reducing its balance sheet since the pandemic-era peak. The balance sheet fell by more than a quarter, declining from $9 trillion in April 2022 to $6.6 trillion at the end of last year. Relative to the size of the U.S. economy, it dropped from more than 40% of GDP in 2022 to 28%.
Further quantitative tightening, however, could reduce bank reserves and overall liquidity too sharply. That could create financial-market stress by causing money-market rates to rise rapidly.
The Fed has already begun gradually expanding its balance sheet again through purchases of Treasury bills. The objective is to maintain adequate liquidity as the economy expands and avoid allowing reserves to fall to dangerously low levels.
Warsh may have support within the 19-member Federal Open Market Committee for reducing the Fed’s presence in financial markets. However, using balance-sheet reductions as the main weapon against inflation could be more difficult to justify. The challenge would become even greater if the central bank were simultaneously purchasing Treasury bills.
Treasury Secretary Scott Bessent also supports a smaller Federal Reserve balance sheet. At the same time, he wants lower yields on longer-term Treasury securities. Those goals could conflict if the Fed increases the supply of bonds available to markets by reducing reinvestments or selling securities.
TD Securities strategist Oscar Munoz estimates that any substantial reduction in the Fed’s balance sheet would take years.
AI Productivity May Not Deliver Quickly
Artificial intelligence could eventually help reduce inflation by allowing workers to produce more and businesses to lower labor costs. Yet waiting for an AI-driven productivity boom may take too long to address current inflation concerns.
In the short term, AI investment could actually add to price pressures. Spending on data centers, semiconductor chips, software, construction and electricity is expected to reach trillions of dollars over the coming years, creating additional demand across the economy.
U.S. labor productivity has already shown strength. Productivity, measured by output per hour worked, increased at a 1.4% annualized rate in the second quarter, compared with an upwardly revised 0.8% in the first quarter. On a year-over-year basis, productivity has remained slightly above 2% since 2019.
Broader productivity measures, however, present a less encouraging picture. The San Francisco Federal Reserve’s Total Factor Productivity index has recorded more limited improvement, while its utilization-adjusted measure turned negative on a rolling four-quarter basis.
San Francisco Fed economists wrote in May that broader efficiency improvements linked to AI had not yet materialized.
John Silvia, CEO and founder of Dynamic Economic Strategy, argues that historical data do not show a statistically significant connection between annual U.S. productivity growth and personal consumption expenditures inflation from 1982 onward.
For that reason, relying on productivity gains or further balance-sheet reductions to control inflation remains uncertain. With inflation still a concern, interest-rate policy remains the Federal Reserve’s clearest and most established tool.
