We have been here before – the Fed monetizing a productivity surge. There are two important differences this time, though, full of danger. No wonder the dollar and gold are emitting stark red warning signals.
First, the monetization has started well ahead of any convincing evidence that a sustained productivity surge is in fact under way. Second, tinder-box conditions now exist in the financial marketplace where a further inflammation of asset inflation could be economically deadly. Widespread revulsion against the Fed-suppressed rates of return across a wide range of near-money assets is a critical factor here.
“Monetizing a productivity surge” means the Fed takes advantage of the downward pressure on goods and services prices, which stems from a sustained acceleration of productivity growth, to run a “stimulatory” monetary policy. The Fed reckons with a continuing camouflage of monetary inflation in the goods and services markets.
Until now there has been no experiment in the laboratory of history where monetization has occurred on the basis of an upcoming economic miracle which may well yet turn out to be a mirage. There have been several experiments based on effective monetization of an established surge in productivity – the essence of so-called miracle. Political forces which stimulate this inflationary response include the power of debtors, the popularity of asset inflation and the benefit of lower interest rates in reducing government debt servicing costs.
Camouflaged inflation in goods and services markets goes along with asset inflation. That was the story of 1922-8, 1952-65, 1995-2006. In this small sample size, the stories have a bad end, partially distinct for each. The last two mentioned episodes ended in substantial goods and services inflation, abetted by slowing productivity gains from their peak. The sequels included asset market crash and great recession.
A notable aspect of the modern episodes under the 2 per cent inflation standard (from the mid-1990s) is that the Fed acts deliberately rather than passively. It recognizes the productivity surge as an opportunity for pursuing “stimulatory” policies without any near-term upset and meanwhile producing goodies for a range of key actors in the political arena.
Asset inflation in itself may be popular with key groups of voters and with important financial backers. Big government itself can be a gainer. The asset inflation of 1995-2006 in its first half went along with a ballooning of tax revenues – notably from capital gains – suiting well the Clinton Administration reaching agreement with Congressional Republicans on budget deficit reduction and indeed elimination.
Unlike for the great monetary inflation of 1996-2005/6, the productivity growth surge supposedly starting in 2025 is still a matter of speculation only, even if based on strong convictions about AI and supply side economic policies. Yet Fed and Administration senior officials have already claimed that the looming surge provides the scope for low interest rates. Yes, there have been two or three quarters now of well above trend productivity growth in the US. But this is not sufficient – especially given the wild swings in the trade balance related to expectations about tariffs – to call with high confidence a sustained multi-year productivity surge.
Endorsing a stimulatory monetary policy on the basis of a boasted productivity surge which is far from certain is a form of inflation-mongering. The Fed policymakers are in effect taking a big risk of triggering eventually higher consumer price inflation. They remain quiet about the danger, however, in their publications and speeches, instead pumping up the story of productivity surge and fighting deflation.
There is a notorious precedent to modern monetization of productivity surges. New York Fed Governor Strong in Summer 1927, in the midst of the US second industrial revolution of that decade, wrote to Governor Moreau of the Bank of France that his notorious cut in the discount rate was a “coup de whiskey” for the Stock Market, which had been recently a little sickly. Strong, however, never made the connection between the actual US productivity surge and asset inflation as transmitted by monetary inflation. He would not have recognized anyhow the concepts of asset inflation and trend productivity growth. These were not yet in use by monetary policy makers or indeed economic or market commentators.
Greenspan through the mid-late 1980s and early 2000s did not admit to stirring up asset inflation (though he did give that notorious speech about irrational exuberance in December 1996) by keeping monetary conditions soft on the basis of a spurt in productivity growth. Instead, he took credit as the maestro for in effect delivering the early gifts of unannounced and unrecognized monetization. And so it is today, the Treasury Secretary and all the potential Fed Chair candidates have been claiming that the hypothesized actual surge in productivity growth (whether due to AI or supply side policies of the Administration) will allow rates to come down further consistent with the 2 per cent inflation target. Kevin Warsh, the successful candidate, made that claim as the central point in his Wall Street Journal article of November 16, 2025.
The Trump Administration welcomes the low rates not just because of their beneficial influence on the public finances. There is the explicit political benefit of assuaging homeowner concerns in difficult real estate markets and relieving highly indebted business borrowers especially in the private equity area. So long as the high economic growth persists there is a possible realization of a benign path for the public finance without pain. Keep public spending rising only very slightly in real terms, whilst tax revenues increase with incomes and also capital gains.
A bad end is most likely though even in the best case of AI proving to be a hugely beneficial innovation in terms of long run living standards. The build-up of asset inflation with its corollaries of mal-investment and over-leverage will impose costs. The extent of speculation together with the threat of goods and services inflation further ahead means that the Federal Reserve is likely to reverse policies away from monetary “stimulus”, most plausibly after the mid-term elections. At some stage the Fed is at big risk of being caught out by the end of the productivity surge, or some new supply shock, meaning a climb in reported goods and services inflation.
There is an unwelcome scenario in which recent productivity gains fizzle early. This could become reality if recent faster recorded economic growth turns out to be due in large part to consumers and businesses switching from foreign to domestic goods and services where possible ahead of a probable curtailment of tariffs by the Supreme Court. Meanwhile the continuing asset inflation will play a role in stoking demand in goods markets – both business and consumer spending.
At any point the long-term interest rate market might get an attack of nerves, as participants give new higher probabilities to scenarios of an outbreak of troublesome CPI inflation. A bond market crash could be the beginning of the end for the already longest asset inflation in modern history. The bond market may well see through a pre-election containment of CPI inflation by short-term fixes or induced positive supply shocks (for example a suspension of some tariffs)
The present monetary regime – the so-called 2 per cent inflation standard – has empowered asset inflation and its longer-term influence on goods and services inflation. A wide span of near-money assets has their interest rate tightly allied to the Fed’s policy rate which is itself tightly manipulated around levels which are lower on average than what would be case under a sound money regime.
This class of assets includes Treasury bills, short-term government bonds, short-term and highly liquid private sector debt paper, bank deposits and money market funds whose liquidity and safety is largely provided for by various forms of government help in contingency. Individuals realizing by now that over time the cumulative returns from these instruments are depressed by the monetary regime in place look elsewhere. These assets outside the class of money and near-money, however, come to command premium prices and become subject to the irrationalities of the asset inflation process.
In sum beware! Appearances of productivity surge, now touted by the Administration, could reverse. The scenario of a crash in the long-term bond market looms large. That would play a terminal role in the in the present asset inflation process.
