San Francisco Fed President Mary Daly stated on Wednesday that she supports the Federal Reserve's decision to hold interest rates steady in July, but cautioned that inflation could become a more persistent problem if price pressures from tariffs, rising energy costs, and artificial intelligence (AI) investment spread. In such a scenario, the central bank might need to adopt more aggressive rate hikes.
“I fully support the decision to hold rates steady in July,” Daly said at an event in Tokyo. However, she outlined two potential inflation paths. In the first scenario, current pressures from tariffs, energy prices, and AI investment are merely short-term shocks that gradually ease, allowing the Fed to maintain its current rate level. The second, more concerning scenario involves these factors compounding and spreading localized inflation pressures into a broader, sustained upward trend. If this occurs, the Fed may need to act more quickly rather than gradually.
“If we see that the second scenario is unfolding, the question might become: why bother with gradual adjustments?” Daly remarked. Last week, the Fed held the federal funds rate steady at 3.5%-3.75% for the fifth consecutive meeting, a decision opposed by three officials who advocated for an immediate 25-basis-point hike. Daly is not a voting member of the Federal Open Market Committee (FOMC) this year but participates in policy discussions. The key internal debate currently centers on whether tariffs, energy prices, and the AI boom are temporary disruptions or drivers of a broader inflation resurgence.
While Fed Chair Kevin Warsh has remained tight-lipped about the rate outlook, he is advancing a different logic: that productivity gains from AI could lower inflation and ultimately create room for rate cuts. Unlike his predecessors, Warsh has deliberately reduced hints about the future rate path since taking office, abandoning the traditional “forward guidance” approach. He argues that over-guiding market expectations limits the Fed’s flexibility and prevents market prices from fully reflecting real economic changes.
At the press conference following the July meeting, Warsh described this as “a better shift,” suggesting that markets should bear more responsibility for interpreting the economic landscape rather than relying on the Fed for a clear roadmap. Warsh is notably positive about AI, repeatedly emphasizing that AI infrastructure investment is boosting the economy’s supply capacity and could spark a productivity wave similar to the internet revolution. He has stated that AI-related investments are “laying the foundation for future growth” and could serve as a significant force in reducing inflation.
Thierry Wizman, global FX and rates strategist at Macquarie Group, noted that Warsh’s most explicit view is his belief that AI-driven supply improvements will have a disinflationary effect. “His only relatively clear view is that the supply side of the economy may improve due to AI investment, thereby lowering inflation,” Wizman said. Warsh has also established a productivity research group focused on how AI enhances economic efficiency. Derek Tang, a policy economist at Monetary Policy Analytics, believes Warsh aims to keep the “productivity boost” narrative as a rationale for future rate cuts. The theoretical basis for AI-driven productivity is that if companies can produce more goods and services at lower costs, increased supply capacity can ease demand pressures and reduce inflation.
However, Warsh’s strategy is raising concerns. While he emphasizes the importance of fighting inflation, he has not issued a clear signal for rate hikes even as inflation has persistently exceeded the Fed’s 2% target. Instead, he suggests that financial markets have already completed part of the tightening task through rising bond yields. After the July meeting, Warsh pointed out that a significant rise in long-term Treasury yields means financial conditions have tightened noticeably, making immediate policy rate adjustments unnecessary.
“Market participants are learning to watch the ball, not the referee,” Warsh said, arguing that market prices will adjust based on their own judgment. Critics warn this approach carries risks: if markets misinterpret the Fed’s intentions, it could lead to excessive financial volatility. Meanwhile, the 30-year Treasury yield briefly rose to a 19-year high, indicating that investors are demanding higher risk premiums for long-term inflation and policy uncertainty.
Daly’s warning highlights growing inflation concerns within the Fed, with a faction preparing for action if inflation re-emerges. This contrasts sharply with Warsh’s optimism about AI’s impact, as he bets on a productivity revolution to ease price pressures. As inflation data, energy prices, and AI investment trends become clearer in the coming months, the internal debate over whether to “wait further” or “act early” is likely to intensify.
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