Could AI-Driven Inflation Lead to Fed Rate Hikes?
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KEY TAKEAWAYS
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AI-related spending is driving inflation and could lead to higher Federal Reserve interest rates.
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While AI may boost productivity and lower prices long term, its current demand is raising costs.
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Higher energy prices and AI-driven inflation are key concerns for the Federal Reserve’s policy decisions.
Everything may get cheaper one day thanks to artificial intelligence—but first, AI investments could lead to sticker shock.
There are endless debates over AI, from how much it’ll displace workers to whether it’ll make the economy more productive over time. But what’s clear is that AI-related spending is driving growth today, analysts say, which could spur inflation and force the Federal Reserve to raise interest rates.
The AI buildout “has created an insatiable demand for capital,” Ed Yardeni, a veteran economist and president of Yardeni Research, wrote recently. Jobs in AI-related fields are growing, as are those in the construction and manufacturing sectors, as new data centers get built, Yardeni noted.
Buoyant stock markets “have made investors feel wealthier and spend more freely,” he wrote. And memory chip prices have “skyrocketed,” he added, forcing consumer technology companies like Apple to raise prices and adding to AI-related inflationary pressures.
“Over the long term, it should deliver disinflationary productivity growth,” Yardeni wrote, with AI keeping the “Roaring 2020s” economy thriving. But right now, he added, AI is “currently fueling Fed hawkishness.”
Why This Matters
AI could reshape inflation before it lowers costs, influencing borrowing costs, markets, and the broader economy. The Fed’s response could affect consumers, businesses, and investors through higher interest rates.
It isn’t the only factor making Fed rate hikes more likely. The war in Iran has disrupted energy supplies and driven up gas prices, helping push inflation to an annual pace of 3.5% in June, significantly above the Fed’s 2% goal.
This year’s inflation rebound has been largely about supply, wrote Richard de Chazal, macro analyst at William Blair, but demand is also playing a role. Consumer software and accessory prices surged at an annual pace of 17.4% in June, according to the Bureau of Labor Statistics.
The prices that producers pay for semiconductors are up even more, de Chazal wrote, a worrying trend if they are becoming an input into everything, much like oil has for decades.
“To us, this still spells the need for higher rates—not dramatically higher, but high enough and for long enough to both bring down inflation and inflationary expectations,” he wrote.
Hot Fed Debate
The Federal Open Market Committee will likely debate AI-driven inflation at its July 28 meeting. Analysts expect the FOMC to keep rates flat this month, though markets are gearing up for at least one rate hike this year amid the energy shock from the war in Iran.
Higher energy prices are the main reason why Fed officials believe inflation risks are “tilted to the upside,” as the minutes of their last meeting showed. But most Fed officials think AI-related spending could “contribute to more persistent inflationary pressures,” the minutes said.
Some officials highlighted the potential for AI to make the economy more productive, pushing down prices as goods and services become more abundant. But they noted “this effect would likely take time to materialize,” the minutes said.
Dallas Fed President Lorie Logan, who’s been among the more hawkish FOMC officials, said on Thursday that AI “may eventually generate a surge in productivity.” But the size and timing of those effects aren’t clear, she cautioned, and the surge in AI investment is already having an impact.
“The demand effects are here already. And when demand outstrips supply, the result is higher prices,” Logan said, arguing for “modestly higher interest rates.”
The AI buildout “does not show signs of slowing,” Fed Governor Lisa Cook said Wednesday. There is an understandable worry that AI will displace workers, she said, but thus far the most dire fears “have not come to fruition.” And in the meantime, persistent inflation “imposes an unacceptable burden on American families,” Cook said.
“If we do not see signs of disinflation soon, I am prepared to act,” Cook said, signaling she might support higher rates as well.
‘Good Family Fights’
The Fed’s new chair, Kevin Warsh, appears a bit less concerned about AI-driven inflation.
At a Senate hearing on Wednesday, Warsh said it’s one of the “good family fights” that the Fed will have under his tenure. AI investment will likely raise prices over the next year, but that inflationary boost may prove temporary, Warsh argued.
The effects on demand happen “much more quickly” than those on supply, he said. And unlike a foreign conflict—where the supply of key goods tends to be reduced—Warsh argued that AI could raise supply and thus the economy’s potential.
“I don’t view a one-time change in prices as necessarily being inflationary, because I think there’s a supply response,” Warsh said.
The Fed is attuned to the risk of AI’s disruption to the U.S. workforce, Warsh said, though he noted it also offers a “huge opportunity” over the longer term.
“The United States is extremely well positioned to be at the cutting edge and extract more productivity—which should be good for U.S. companies and U.S. workers—than any other country in the world,” he said.
The precise effects, however, remain far from clear. Economists inside and outside the Fed have published countless papers exploring the trade-offs that AI poses to the global economy.
For his part, Warsh announced a task force that will explore the impacts of AI on productivity and the job market. It will be co-led by Marc Andreessen, the venture capitalist and cofounder of Andreessen Horowitz; Charles I. Jones, a Stanford University economist who’s on leave at the AI firm Anthropic, and Asha Sharma, the CEO of Microsoft’s XBOX division.
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