By Christopher Combs, Chief Investment Officer, Silicon Valley Capital Partners, December 28, 2025
The next turning point in U.S. monetary policy may be a steady economy on paper, paired with a labor market that quietly loses momentum—while productivity rises in the background.
If that sounds contradictory, it’s because it challenges the intuition most of us learned from prior cycles. Traditionally, strong output and inflation pressure went hand-in-hand with tight labor markets. When the labor market softened, growth slowed, inflation cooled, and the central bank eventually cut interest rates.
But what happens if the economy continues to produce, not because it’s hiring aggressively, but because technology—particularly AI—allows firms to do more with the workforce they already have? In that world, the economy can look “fine” in aggregate while job creation flattens, hiring becomes cautious, and wage pressure eases unevenly across occupations.
For the Federal Reserve, that combination matters for one reason above all: it changes the balance of risks. And if policymakers develop real confidence that AI-driven productivity gains are taking hold at the same time the labor market is flattening, the monetary-policy bias would tilt toward cutting rates—not as a rescue mission, but as a recalibration away from unnecessary restriction.
To understand why, it helps to anchor the conversation in a concept that sits quietly behind many policy debates: the output gap.
The output gap: the central bank’s “too hot or too cold?” compass
Economists define the output gap as the difference between:
- Actual output (what the economy is producing now, usually real GDP), and
- Potential output (what the economy can produce sustainably—without sparking persistent inflation).
When actual output runs above potential, the economy is typically described as “running hot,” with resource constraints and inflation risk. When actual output runs below potential, there’s slack—unused capacity, weaker labor demand, and less inflation pressure.
The output gap is not a headline that flashes on television screens, but it influences how policymakers interpret virtually everything they do see: inflation data, job reports, wage trends, and financial conditions.
There’s one problem, and it becomes decisive in an AI-driven economy: potential output is an estimate, not a direct measurement. It’s built from assumptions about labor supply, capital investment, and—most importantly—productivity. When productivity changes quickly, the estimate of potential output can lag. If potential is moving and the models are slow to recognize it, policymakers can misread the economy’s true temperature.
That’s where AI and the labor market converge in a way the Fed can’t ignore.
Two forces reshaping the business cycle: productivity up, labor momentum down
AI’s macro impact can be distilled into two channels that may unfold simultaneously:
- Rising productivity: Firms use AI to increase output per hour, streamline workflows, reduce rework, accelerate cycle times, and improve decision-making.
- Flattening labor markets: Hiring slows, openings decline, hours worked stabilize, and certain roles face substitution—often without a sudden crash in overall output.
These forces can co-exist because productivity growth can offset slower growth in labor input. An economy can keep producing even as it stops adding jobs at the pace it once did.
That combination—steady output, softer hiring—can look puzzling from a traditional business-cycle lens. For monetary policymakers, though, it creates a clear decision framework once confidence is established.
Why confidence in productivity gains plus labor flattening points toward rate cuts
The key word is confidence. If policymakers become convinced that productivity is rising in a durable, broad-based way—and that labor market flattening is real and persistent—then the case for maintaining restrictive interest rates weakens materially.
Here’s the logic.
Productivity gains raise the economy’s capacity and reduce inflation pressure
When productivity rises, the economy can produce more without needing the same incremental labor and capital. That effectively raises potential output—meaning the economy can sustain more activity with less inflationary strain.
From the Fed’s perspective, this is the best kind of progress: a supply-side improvement that can allow inflation to cool without requiring a deep contraction.
A flattening labor market reduces the risk of overheating
A labor market that is “flattening” is not necessarily collapsing. But if hiring is slowing, hours are no longer rising, and wage pressure is easing—especially across a broader set of sectors—then demand is less likely to be outrunning supply.
In other words, the classic overheating signature fades.
Put them together and the risk management shifts toward easing
Once policymakers believe both conditions are true—more capacity and less labor-market heat—the asymmetric risk becomes the opposite of what it was during inflation’s surge:
- The bigger risk is leaving policy too tight for too long, driving avoidable labor-market deterioration and pushing the economy below its now-higher capacity.
- The smaller risk is cutting modestly, because productivity-driven capacity gains reduce the chance that easier policy immediately re-ignites inflation.
This is the central point that often gets lost: credible productivity gains don’t argue against rate cuts. They can argue for them—especially when labor markets are cooling. Higher productivity can lower the “inflation cost” of easing, and labor-market flattening raises the “employment cost” of staying too tight.
In that scenario, the bias is toward cutting rates to reduce restrictiveness, not to “stimulate” the economy, but to avoid overtightening into a labor market that is already losing momentum.
The complicating factor: productivity can move before policymakers recognize it
Even if AI is lifting productivity, the Fed won’t see it in a neat, immediate way. Productivity data are noisy. They get revised. And AI gains may show up unevenly—strong in certain sectors, subtle in others.
That creates a transition period where the economy can appear “above potential” using older potential estimates, even as true potential has risen. In output-gap terms, the economy can look hotter than it really is.
This is exactly the kind of environment where a central bank can make an understandable—but costly—error: keeping policy too restrictive based on a framework that assumes capacity hasn’t moved.
That’s why the bar for “confidence” matters, and why the Fed’s messaging would likely become more conditional before it becomes more aggressive.
What would convince policymakers that productivity gains are real
If the Fed is going to lean into cuts while employment momentum slows, it will want a mosaic of confirmation. Not one quarter of data—an accumulation of evidence.
Policymakers would likely look for:
- Sustained productivity improvement, not a one-off spike
- Unit labor costs that cool (wage growth that is increasingly offset by productivity)
- Broadening adoption signals (investment, process redesign, diffusion beyond a small set of firms)
- Stable or improving output with less labor input, without an offsetting rise in inflation
In practice, the Fed’s confidence tends to rise when the “plumbing” indicators line up—especially unit labor costs and services inflation, which often capture the wage-to-price link more directly than headline unemployment figures.
What “flattening” looks like to the Fed—and why it matters even if GDP is steady
A flattening labor market is a nuanced signal. It can show up as:
- job gains that slow to a pace closer to trend labor-force growth
- reduced job openings and hiring rates
- declining quits (workers less confident about switching jobs)
- easing wage growth in formerly tight categories
- stable headcount but fewer hours (a classic early adjustment mechanism)
For central bankers, this matters because it suggests the labor market is moving toward balance—or potentially toward slack—without requiring the kind of output collapse that typically triggers urgent easing.
If productivity is rising, firms can maintain output without adding workers; that means a softening labor market can become a leading indicator of cooling, even when GDP remains resilient.
How monetary policy would likely respond in the “confidence” scenario
If policymakers become confident in the “productivity up, labor flattening” story, the most likely monetary response is a persistent easing bias—rate cuts framed as removing restraint rather than fueling excess.
In practice, that would probably look like:
A gradual path of cuts, communicated as recalibration
Expect language that emphasizes:
- policy remains restrictive,
- inflation is trending toward target,
- labor markets are cooling,
- and rates can move closer to neutral over time.
A higher bar for further hikes, a lower bar for modest cuts
In this regime, hikes require clear re-acceleration in inflation or demand. Cuts can be justified by a steady set of signals: easing cost pressures and a labor market that’s losing momentum.
Greater emphasis on the “under-the-hood” indicators
The Fed would likely focus more on:
- productivity trends and revisions
- unit labor costs
- hours worked
- services inflation
- margins and pricing power
That’s how policymakers separate “healthy disinflation driven by productivity” from “temporary disinflation driven by weakening demand.”
The business cycle impact: the economy may run “job-light,” and policy must adapt
If AI reshapes production functions across the economy, the business cycle may not disappear—but its shape can change.
Expansions could become more “job-light.” Slowdowns could show up first in hiring freezes and reduced hours rather than immediate layoffs. Output may look steadier while labor-market anxiety rises.
For monetary policy, the implication is straightforward: the Fed can’t wait for a classic recession signature if the labor market is flattening in a way that is consistent with cooling inflation pressure.
In the confidence scenario—where productivity is rising and labor momentum is slowing—the cost of waiting too long can exceed the cost of moving earlier. That’s why the policy bias, all else equal, points to cutting rates.
Bottom line
If AI-driven productivity gains are real, broad, and durable, they raise the economy’s capacity and reduce inflation pressure. If the labor market is flattening, it reduces overheating risk and raises the cost of keeping financial conditions too tight.
When policymakers believe both at once—rising productivity and flattening labor—the policy conclusion is not paradoxical. It’s practical:
Monetary policy should become less restrictive, and the bias shifts toward cutting interest rates—because inflation risk is falling and employment risk is rising.
The challenge is not the logic. The challenge is confidence—and the willingness to adjust in time.
Disclosures
copyright 2026 Silicon Valley Capital Partners. This commentary is provided for informational purposes only and does not constitute investment, legal, tax, or accounting advice. The views expressed are those of the author as of the date of publication and are subject to change without notice. There is no guarantee that any forecasts, estimates, or forward-looking statements will be realized.
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