The Zhitong Finance App learned that the Federal Reserve is increasingly aware that the artificial intelligence (AI) boom is boosting inflation. This leaves Federal Reserve officials with a problem: to reduce the price pressure amplified by the AI industry, which is comprised of well-known companies such as Amazon, Apple, and Anthropic, they may have to cool down other sectors of the economy. And these giants were relatively less affected by interest rate hikes.
Federal Reserve officials know that the impact of the “blunt tool” of interest rate hikes is uneven. As AI companies spend almost no cost, economists believe the pain of interest rate hikes will fall elsewhere: businesses and households that rely more on credit, and small and medium-sized enterprises that shrink their investment plans due to rising borrowing costs.
AI investment is driving inflation, and the impact of interest rate hikes is uneven
“The path to that is there,” ADP chief economist Nella Richardson said of the Federal Reserve's 2% inflation target. That goal has not been met for more than five years. “It's just that not every road is open.” As an example, she said that the housing market is already weak, and the labor market is not seen as boosting inflation through rising wages.
“So what's left? Small businesses because they need bank loans; consumers who need debt and credit cards to pay their bills... and maybe the stock market.” she said. The stock market is seen as supporting the consumption of wealthier households, but it is often vulnerable to rising interest rates.
In fact, the stock market declined last week, after an unexpectedly strong inflation report strengthened market expectations that the Federal Reserve would have to raise interest rates further.
Cleveland Federal Reserve Chairman Beth Hammark recently pointed out that suppressing stock market gains and slowing activity outside of the AI boom is a way for higher interest rates to “marginally” cool down the economy. “I love growth... I'm not trying to stop it; I just want to pull growth back a little bit so that it doesn't put too much pressure on prices.” Hamak said last Monday.
The remarks made by Hamack and others at the National Association for Commercial Economics (NABE) conference further explained the less discussed aspect of the Federal Reserve's interest rate hike: through which channels higher borrowing costs may be transmitted to the current economy and ultimately depress inflation.
Walsh acknowledged the impact of AI, but details on how to cut interest rate increases to reduce inflation are still lacking
The Federal Reserve will meet from October 27th to 28th and is expected to keep interest rates unchanged at 3.75%-4.00%. Federal Reserve officials said that further interest rate hikes may still be needed, and the pace and extent of interest rate hikes are currently being discussed.
Federal Reserve Chairman Kevin Walsh acknowledged at the International Monetary Fund (IMF) meeting in Thailand last week that AI investment is an “impact” on prices and demand, although he believes that wealth and productivity gains will not be realized until the “long term.” “If you are the governor of a central bank and your responsibility is to ensure price stability and full employment, you must be aware of this as a shock.” Walsh said.
But he didn't discuss how the Federal Reserve might need to deal with the growing price pressure, nor did he explain what this means outside of the AI industry. The industry is expected to invest around $1 trillion next year, accounting for about 3% of the US gross domestic product (GDP).
At a press conference after last month's policy meeting, Walsh said he didn't think the Federal Reserve “needed to damage the labor market” to get inflation back to 2%. Earlier this summer, he pointed out that housing and agriculture are “under pressure” due to rising borrowing costs, although he doesn't think credit conditions are “restrictive.”
He has yet to elaborate on how higher interest rates may reduce inflation or where economic pain may occur.
“Walsh has said he doesn't see a conflict between inflation and unemployment. This point deserves more explanation. That's it.” Former Chicago Federal Reserve Chairman Charles Evans said at the NABE central bank group meeting. “The risks and consequences of further interest rate hikes to reduce inflation are well known.”
Employment is difficult to cool down, and the backlog of orders shows that demand is still strong
The trade-off between reduced employment and lower inflation is not always accompanied by sharp shocks. The fall from high inflation during the COVID-19 pandemic only led to a moderate rise in unemployment. Companies are unwilling to cut workers that are difficult to recruit during the pandemic. Coupled with US President Trump's immigration policies curbing labor growth, the unemployment rate has remained low at 4.0% to 4.3% for more than two years.
This convinced Federal Reserve officials that they can raise interest rates without causing a sharp rise in unemployment, or even no increase at all. But it also means that a typical path to reducing inflation — a slowdown in consumer spending after rising unemployment — may also be shut down.
Policymakers, including Richmond Federal Reserve Chairman Tom Barkin and St. Louis Federal Reserve Chairman Alberto Mussalem, believe inflation can fall without severely impacting growth, consumption, or employment. They argue that if a credible central bank persists in raising interest rates, it may induce enterprises and households to ease wage and price requirements, thereby driving inflation down.
Hamak and others suggest that the challenge is that demand may be accelerating, and not only within AI companies. A wide range of businesses are benefiting from the AI boom, particularly those that build data centers or manufacture components for them. These companies have a backlog of orders and need to invest to meet supply.
“The backlog of orders is real,” Cleveland headquartered KeyCorp CEO Christopher Gorman told NABE attendees. Business customers will list the risks they face, including immigration and tariffs, “then talk about how good the business is,” and explain investment and price increase plans.
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Factors affecting inflation may also develop in favor of the Federal Reserve, including any solution to the Iran war to lower oil prices, the cessation of Trump's push to impose tariffs, or more prudent construction of data centers in light of increased local opposition.
Judy Dawan, macro strategist at Wellington Management, also pointed out that fiscal policy is about to change, which may help: public health benefits will be cut, and tax relief equivalent to about 0.5% of GDP will expire.
But that doesn't make the path to 2% inflation painless. She pointed out that stock markets other than AI hyperscale companies are not that strong, corporate profits are not expected to be that strong next year, and there is evidence that low-income consumers are close to cutting their expenses.
Dawan said that if housing is to the next level, buildings other than data centers may be taken to the next level, and many non-AI companies may find financing costs too high to bear, before inflation falls; for consumers, “the bottom layer is vulnerable because inflation-adjusted wages remain flat at best.”