The AI boom drives up inflation: Why is it difficult for the Fed's rate hikes to hit the mark precisely?

The Federal Reserve is increasingly recognizing that the artificial intelligence (AI) boom is fueling inflation. This puts Fed officials in a bind: to suppress price pressures amplified by the AI industrycomprising prominent companies such as Amazon, Apple, and Anthropicthey may have to cool other sectors of the economy. These giants are relatively less affected by rate hikes. Fed officials are aware that the "blunt instrument" of rate hikes does not affect all parts of the economy evenly. As AI companies spend almost regardless of cost, economists believe the pain of rate hikes will land elsewhere: businesses and households more reliant on credit, and small and medium-sized enterprises that scale back investment plans due to rising borrowing costs. AI Investment Becomes an Inflation Driver, Rate Hikes Hit Unevenly "The path exists," ADP chief economist Nela Richardson said of the Fed's 2% inflation target, which has not been met for more than five years. "It's just that not every road is open." She cited the housing market, which has already weakened, and the labor market, which is not seen as likely to push inflation higher through wage increases. "So what's left? Small businesses, because they need bank loans; consumers who need to pay bills with debt and credit cards... and maybe the stock market," she said. The stock market is seen as supporting spending by wealthier households but tends to be vulnerable to rising interest rates. Indeed, stocks fell last week after an unexpectedly strong inflation report reinforced expectations that the Fed will have to raise rates further. Cleveland Fed President Beth Hammack recently pointed to subdued stock market gains and slowing activity outside the AI boom as channels through which higher rates may cool the economy "at the margin." "I like growth... I'm not trying to stop growth, I just want to pull it back a bit so that its pace doesn't create too much price pressure," Hammack said last Monday. Remarks by Hammack and others at the National Association for Business Economics (NABE) conference further illustrated a less-discussed aspect of the Fed's rate hikes: the channels through which higher borrowing costs may transmit to the current economy and ultimately bring inflation down. Warsh Acknowledges AI Shock, but How Rate Hikes Will Lower Inflation Remains Short on Detail The Fed will meet on October 27-28 and is expected to keep rates unchanged at 3.75%-4.00%. Fed officials say further rate hikes may still be needed and are discussing the pace and magnitude of increases. Fed Chair Kevin Warsh acknowledged last week at an International Monetary Fund (IMF) meeting in Thailand that AI investment is a "shock" to prices and demand, though he believes wealth and productivity gains will only materialize "far out." "If you're a central banker whose job is to ensure price stability and full employment, you have to recognize this is a shock," Warsh said. But he did not address how the Fed might need to respond to accumulating price pressures, nor what that means for sectors outside the AI industry. That industry is expected to invest about $1 trillion next year, roughly 3% of U.S. gross domestic product (GDP). At a press conference after last month's policy meeting, Warsh said he did not believe the Fed "needs to damage the labor market" to bring inflation back to 2%. Earlier in the summer, he noted that housing and agriculture were "showing stress" from rising borrowing costs, though he did not consider credit conditions "restrictive." He has not elaborated on how higher rates might reduce inflation or where economic pain might emerge. "Warsh has said he doesn't see a conflict between inflation and unemployment. That deserves more explanation. That's it," former Chicago Fed President Charles Evans said at a NABE central bank panel. "The risks and consequences of further rate hikes to reduce inflation are well known." Employment a Poor Lever for Cooling, Order Backlogs Show Demand Still Strong The trade-off between lower employment and lower inflation is not always accompanied by severe shocks. The decline from pandemic-era high inflation brought only a modest rise in unemployment. Companies' reluctance to lay off workers who were hard to hire during the pandemic, combined with President Trump's immigration policies restraining labor force growth, has kept unemployment in a low 4.0%-4.3% range for more than two years. This has led Fed officials to believe they can raise rates without causing a sharp rise in unemploymentor any rise at all. But it also means that a typical path to lower inflationslower consumer spending after unemployment risesmay also be closed. Policymakers including Richmond Fed President Tom Barkin and St. Louis Fed President Alberto Musalem believe inflation can fall without severely hitting growth, spending, or employment. They argue that a credible central bank that persists in raising rates may prompt businesses and households to moderate wage and price demands, thereby bringing inflation down. Hammack and others suggest the challenge is that demand may be accelerating, and not just within AI companies. A wide range of businesses are benefiting from the AI boom, especially those building data centers or manufacturing components for them. These companies have order backlogs and need to invest to meet supply. "The backlogs are real," KeyCorp CEO Christopher Gorman, based in Cleveland, told NABE attendees. Business clients list risks one by one, including immigration and tariffs, "and then they talk about how good business is," outlining investment and price increase plans. Oil Prices, Tariffs, and Fiscal Variables: Disinflation Will Not Be Painless Factors affecting inflation could also move in the Fed's favor, including any resolution to the Iran war lowering oil prices, a halt to Trump's tariff escalation, or more cautious data center construction given growing local opposition. Wellington Management macro strategist Juhi Dhawan also noted that upcoming fiscal policy changes could help: public health benefits will be cut, and about 0.5% of GDP in tax breaks will expire. But that does not make the path to 2% inflation painless. She noted that the stock market outside AI hyperscalers is not that strong, corporate earnings are not expected to be as strong next year, and there is evidence that low-income consumers are close to cutting back spending. Dhawan said inflation will only fall if housing takes another step down, construction outside data centers takes another step down, and many non-AI businesses find financing costs too high to bear; for consumers, "there is fragility at the bottom because real wages are at best flat."