Williams says productivity gains may lift real rates above 2%

New York Fed President John Williams said faster productivity growth will push up real interest rates in the long run, a dynamic that could keep borrowing costs elevated even as the central bank battles inflation running near 4%.

"Real-time identification of structural change is extraordinarily difficult, and expectations of future growth tend to adjust gradually to changes in underlying productivity growth," Williams said in prepared remarks Thursday for the Reykjavik Economic Conference in Iceland.

The fed funds rate sits at 5.25% to 5.50%, unchanged since July 2023, while the personal consumption expenditures index has run above the Fed's 2% target for five consecutive years, with cumulative price increases approaching 25%. Two-year Treasury yields have traded above the policy rate since mid-March, and fed futures markets have priced out all bets on 2026 rate cuts, with the next move seen as a potential hike within 12 months.

Williams noted that a shift higher in productivity can raise the real interest rate that prevails in the economy, but the policy response depends on whether the growth is unexpected or anticipated. If markets expect future productivity gains, increased spending today could overheat the economy before the boom arrives, potentially requiring tighter monetary policy — a scenario that pits the Fed's inflation fight against the White House's preference for lower rates.

The New York Fed chief did not comment on the near-term monetary policy outlook. His speech focused on the analytical challenge of distinguishing temporary productivity shifts from permanent ones, a debate that has intensified as the U.S. economy shows signs of accelerated productivity growth during the artificial intelligence boom.

The AI-driven investment surge is creating chip and energy supply bottlenecks that may sustain higher inflation well beyond any crude oil price shock, according to a Reuters analysis. Chicago Fed President Austan Goolsbee has argued that the more markets expect productivity gains, the more monetary policy may need to tighten to prevent demand from outstripping supply.

Market Pricing Reflects Hawkish Turn

Fed funds futures have fully priced out any rate cuts for 2026 since mid-March, and the 2-year Treasury yield has held above the policy rate — a configuration that typically signals expectations of tighter policy. About 50% of global fund managers surveyed by Bank of America in mid-May still expected at least one Fed cut by year-end, a disconnect that new Fed Chair Kevin Warsh may need to address.

Warsh was sworn in last week, and President Donald Trump appeared to shift tone, telling his appointee to "just do your own thing" on rates — a departure from his persistent demands for lower rates under predecessor Jerome Powell. Whether that restraint lasts depends partly on the trajectory of the Iran conflict and its impact on energy prices, which have added to inflation pressures.

The dollar implications are also significant. If the Fed keeps rates higher for longer, the dollar could strengthen further, complicating the administration's presumed preference for a weaker greenback to support re-industrialization. Former White House economist Glenn Hubbard recently argued that pushing for a weaker dollar would worsen affordability pressures and harm the fiscal position, calling it "the wrong instrument" for reviving U.S. industry.

The last time a Fed official delivered a similar speech on productivity-driven rate dynamics was during the late-1990s tech boom, when then-Chair Alan Greenspan argued that productivity gains were suppressing inflation even before they appeared in the data — a scenario that allowed the Fed to hold rates steady. The current environment is the inverse: anticipated AI-driven productivity gains may force the Fed to keep rates restrictive to prevent demand from outstripping supply.

The next Federal Open Market Committee meeting is scheduled for June 9-10, where the Fed is widely expected to hold rates steady.

This article is for informational purposes only and does not constitute investment advice.