A speech built around AI and a firm 2% target
The Jackson Hole address opened in an unusual way, leading with AI, large language models (LLMs), and tokens before turning to monetary policy. Inflation came in better than expected, but the underlying trends have not meaningfully changed. The Fed is sticking to its 2% target, firm and fixed, and that is where the focus sits. The core message: innovation and policy will bring inflation back to target, yet the economy is changing faster than old models can comfortably explain.
The main argument is a supply-side bet. Labor force growth is weak. For the economy to keep growing without producing more inflation, productivity has to carry more of the load, and AI is the obvious candidate. AI could raise productivity and ease inflation, but no one yet knows how large the gains will be or who will get them. Because the Fed cannot see that future either, it should not overpromise a path for interest rates. The call is for a quieter, more modest Fed. There was stated discomfort with forward guidance.
The market reaction turned hawkish
Over the last 25 minutes of the speech, stocks dropped, the dollar firmed, and yields rose. The curve flattened, led by the short end rising. Traders had put the chance of a September Fed rate hike near 50%, and after the speech it settled back to a coin toss. Placing responsibility for 65 straight months of inflation above the 2% target squarely on the Fed sounded very hawkish.
An investment boom without the productivity payoff
The economy runs at two speeds. There is a large capital boom in data center chips and software, financed at some of the highest real rates in years - a big bet that AI will deliver. In Q2, equipment and intellectual property (IP) investment made up roughly 80% of GDP growth. Yet productivity growth slowed last year from 1.5% to 0.8%, even as AI spending surged. The payoff has not shown up.
If AI delivers, faster productivity lets the economy produce more without more inflation, lifts real incomes, and makes today's real rates and debt load easier to service. If AI disappoints, high real rates become much harder to carry for households, businesses, and the federal government.
Outside the AI sector, the bulk of the economy is stuck because of higher rates. Real incomes have barely grown from a year ago. Households are spending out of savings and borrowing at a higher rate. Interest-rate-sensitive sectors like housing are struggling.
Housing under strain, rates still restrictive
The whole yield curve has moved up. The 2-year rose, the 10-year Treasury rose, and the 30-year recently traded above 5.3%, a level not seen since 2007. That keeps rates on credit cards, mortgages, and corporate borrowing restrictive even without a rate hike. The restraint is coming from the bond market, which is part of why the Fed has not raised rates this year. This is an election year, and the White House is calling for lower rates - also part of the calculus.
The labor market was described as stable, with a low unemployment rate and little churn, read as improved job matching that took place during the pandemic when people were quitting and changing jobs rapidly. Housing shows strains, yet broad financial conditions were not called restrictive. The housing data is weak: permits and starts are lower year to date, the weakest since 2017, and home sales are the weakest since 2020. Americans are staying put.
Is monetary policy the wrong tool for housing?
Question: Is monetary policy a blunt tool for the housing market, and does more need to happen on the fiscal side? Answer: Part of why rates are elevated is the debt on the fiscal side. Fiscal deficits are as high as they have been in a long time, and continued Treasury issuance keeps pressure on long yields. Combined with the AI capital boom and its borrowing, this will keep rates elevated and continue to hurt home builders and the housing market.
