The Fed is divided. But its ‘hawks’ are likely to prevail and face Trump’s wrath

July 9, 2026 — 12:08pm

Minutes of last month’s Federal Open Market Committee meeting show that, in Kevin Warsh’s first meeting as the Donald Trump-appointed chairman of the US Federal Reserve Board, active dissent among the committee’s members may have disappeared, but division hasn’t.

In recent Fed meetings, the committee had shown an increasing split between the Fed officials over whether to hold, increase or cut the Fed’s policy rate in the face of increased inflation and amid intense pressure from Trump to lower US interest rates.

At the June meeting of the Fed’s Open Market Committee (the FOMC), there was unanimous agreement that (a) the rate should remain on hold and (b) the “easing” bias inserted into previous Fed statements, which was one source of the dissent, should be excised.

The minutes, however, did show a major divergence within the officials’ thoughts about the future.

“Many” of the 19 voting members of the committee thought the federal funds rate (akin to the Reserve Bank’s cash rate) would remain at, or be slightly below, its current range of 3.5 per cent to 3.75 per cent by the end of the year.

But, “many” other, more “hawkish”, participants in the meeting thought the rate would be above the current targeted range at year-end.

If you look at the reasoning behind that divergence of views, it would seem the likelihood is that the second group – those who expected the Fed would need to lift its policy rate this year – will be proven right.

The FOMC considered a range of scenarios for the way the US economy might evolve and what they might mean for monetary policy.

One was where the inflation pressures stemming from Trump’s past imposition of tariffs, the higher energy and input costs flowing from the war in the Middle East and the impact of the boom in artificial intelligence abated or, in effect, were transitory.

Under that scenario, it would be appropriate to maintain and eventually lower the target range for the federal funds rate.

Another scenario was where, with the labour market (with inflation, the other element in the Fed’s dual mandate) stable, inflation would remain elevated because of the strong AI-related demand, the war in the Middle East and the effects of the tariffs.

If that were the outcome, “almost all” of the participants thought “some policy firming” would probably be required if the Fed was to return inflation to its target of 2 per cent.

Since that June meeting, inflation data for May has been released, showing a rise in inflation.

The Fed’s preferred measure, the personal consumption expenditures index (PCE), rose from 3.8 per cent to 4.1 per cent. “Core” PCE (excluding volatile food and energy prices) increased 0.3 percentage points to 3.4 per cent.

The key recent drivers of inflation haven’t disappeared.

Trump keeps announcing new tariffs, the boom in AI spending and the costs of semiconductors, infrastructure and energy associated with it are intensifying and the war in the Middle East has erupted again, with Trump declaring the three-week ceasefire agreed with Iran that had led to the oil price subsiding to pre-war levels “over”.

The war and the closure of the Strait of Hormuz had disrupted global energy supply chains and caused petrol and diesel prices, along with fertiliser and other industry by-products, to soar globally.

The ceasefire prompted a fall in oil prices to about $US70 ($100) a barrel, but the new outbreak of hostilities this week caused it to jump back to about $US80 a barrel.

The cost pressures from the AI boom are increasing as competition for semiconductors, a boom in the construction of data centres that is struggling to keep pace with demand, the increased demand for electricity and recent material increases in the pricing of AI tools for businesses as the loss-making developers try to improve their parlous economics flow through the economy.

The three key drivers of the recent surge in inflation are not just still present, but expanding and prolonging their impacts on costs to businesses and consumers.

Trump is replacing the universal tariff walls torn down by the US Supreme Court with a new global tariff regime, using a different legislative mechanism, while also seeking to displace the US-Mexico-Canada free trade agreement with bilateral deals that would lead to higher prices for US companies and consumers.

In other words, the three key drivers of the recent surge in inflation are not just still present, but expanding and prolonging their impacts on costs to businesses and consumers.

The longer those cost pressures persist, the more likely it is that they will feed more widely into the economy – where the most visible impact of elevated oil prices might be at the petrol pump. If they are sustained, their impact on transport costs will eventually feed into the cost of goods generally.

Having been burnt once by misjudging the effects of the pandemic on global supply chains and inflation, the Fed is unlikely – if the war, the AI boom and Trump’s tariffs remain in place – to dismiss their contributions to a rising inflation rate as “transitory”.

While the tariff-driven price pressures will eventually pass through the economy and the war will presumably end, the AI boom is – even if the sharemarket bubble associated with it bursts – likely to have lasting effect on the economy.

There are Fed governors, including Warsh, who believe that AI will eventually lead to significant increases in productivity and act, in his words, as “a significant disinflationary force” that will enable the Fed to lower interest rates without risking a breakout of inflation.

Before assuming the chair of the Fed, he argued the Fed should be more proactive in cutting rates in anticipation of “the biggest productivity wave our generation will experience”.

There are two question marks over that view of AI’s transformational effects on productivity and inflation.

One is that before those anticipated structural improvements in productivity emerge, there will be continuing and very substantial AI-driven cost pressures as AI labs use rapidly increasing volumes of the material inputs to their models and the infrastructure that supports them and businesses absorb the costs associated with acquiring access to AI tools and reorganising their workplaces and workforces to deploy them.

There is the extraordinary and growing demand for capital to fund AI, which by itself will put pressure on interest rates because it has created a very large and still-expanding new source for competition for capital.

The degree to which AI might lower costs, reduce employment and improve productivity might also be being overstated, at least within the timeframes that matter for central bank monetary policy decisions.

Despite the massive investments in AI by the sector and businesses, there is yet to be any discernible improvement in productivity rates or economic growth at this early phase of AI development and deployment.

There’s also what’s known as the “AI paradox”, where workers spend so much time reviewing and fixing AI-generated output that the resulting net productivity benefits from investing in AI is immaterial, at best.

In the long run, perhaps Warsh’s optimistic view of AI’s impact on productivity and inflation will prove correct.

Meanwhile, the Fed has to respond to what the current economic settings are, not what they might eventually be.

While it might disappoint Trump, who chose Warsh because he believed he would deliver the big cuts to US interest rates that Trump has continually demanded, the second scenario the FOMC considered, where tariffs, war and AI lead to a continuing increase in the inflation rate - and force the Fed to respond with higher interest rates - seems the more likely to prevail.

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