(Bloomberg) — To judge by a key bond-market signal, the AI boom is only worsening Kevin Warsh’s inflation problem.
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The incoming Federal Reserve chair previously lashed out at the central bank for failing to recognize that artificial-intelligence breakthroughs will increase productivity, creating a “significant disinflationary force” that would make it easier for policymakers to lower interest rates.
But with Warsh set to take office on Friday and the war-driven price shock sending 30-year bond yields to a nearly two-decade high, Wall Street analysts say a widely-used indicator is suggesting that the technology is, for now, having the opposite effect on inflation and, therefore, the trajectory of borrowing costs.
By one market measure — the so-called 5-year, 5-year real rate — the Fed’s benchmark interest rate needs to be roughly 2 percentage points higher than inflation over the medium term for it to be considered neutral, or a level that’s neither stimulating nor constricting growth in the economy. Given that the Fed’s rate of roughly 3.6% is now below the pace of inflation, that suggests that monetary policy is still stimulating the economy, reducing Warsh’s scope to cut interest rates.
A number of factors contribute to estimates of the neutral rate, including projections for longer-term growth and inflation. Central bankers note that it’s difficult to determine with precision.
But analysts say the emerging AI boom is playing a role in pushing it up by increasing demand for capital and fanning inflationary pressures.
For one thing, four of the biggest tech companies alone are planning to spend more than $700 billion this year as they investment in data centers, computer hardware and electricity infrastructure.
Secondly, there is so-called chipflation as demand surges worldwide for the semiconductors needed to serve the AI revolution, boosting their prices and also those of the products which rely on them. In the US, prices for computer software and accessories rose 14% in April from a year earlier, while BlackRock Inc. analysts note the price of DRAM chips, which help store memory, has risen 17-fold in the past year. Microsoft Corp. and Meta Platforms Inc. are among the companies raising prices on some of their products.
“Our firm base-case assumption is that AI will contribute to higher inflation in the years ahead,” said Christoph Rieger, head of rates and credit research at Commerzbank AG.
Treasuries are being put under further pressure as debt markets are flooded with new bonds from Microsoft, Amazon.com Inc., Alphabet Inc. and other tech firms, which have already sold more than $300 billion of debt to US investors to fund AI-related investment. The Dallas Fed estimated that the market impact of that is roughly equivalent to what would happen if the supply of longer-dated Treasury bonds jumped by more than 10%.
“AI-related issuance has raised the level of rates, and that has resulted in higher borrowing costs,” said Priya Misra, portfolio manager at JPMorgan Asset Management.
Faster-than-anticipated inflation and the jump in long-term bond yields are now adding to the challenge facing Warsh as he succeeds Jerome Powell. President Donald Trump nominated him after repeatedly claiming Powell was holding the economy back by not cutting rates more rapidly.
In an editorial in the Wall Street Journal in November, Warsh criticized the Fed’s policymakers for predicting that inflation would continue to be elevated, saying they were failing to account for AI fueled productivity gains. Last month, the oil-price spike helped send the consumer price index up 3.8%, the biggest annual jump since 2023, contributing to the recent bond-market selloff.
With prices spiking again, in part because of the US war with Iran and subsequent surge in the price of oil, futures traders are even speculating the Fed is likely to be forced to raise rates by December.
“Cutting interest rates based on a hypothetical is on shaky ground,” said Blake Gwinn, head of US rates strategy at RBC Capital Markets. “Markets aren’t really buying it.”
Jonathan Pingle, chief US economist at UBS Group AG, suggested Warsh may still argue against rate hikes on basis they risk impairing the investment in artificial intelligence. “We expect him to argue that the last thing good policy would do is work to restrain the investment today that might represent tomorrow’s disinflation,” he told clients in a report.
Warsh’s new colleagues at the Fed have cautioned against assuming that AI will automatically lead to lower rates. Several, including Vice Chair Philip Jefferson and Governor Michael Barr, have argued that the heavy business investment required to deploy the technology could itself push up the neutral rate by increasing demand for capital.
Some investors argue that Warsh could eventually be proven correct over time. Analysts at Vanguard Group Inc., one of the world’s biggest money managers, said increased spending on AI could eventually make the economy more productive, support growth and help ease inflation. For now, though, the firm said supply shocks and investment-driven demand are still pushing inflation higher, and it is watching for signs that those productivity gains are starting to show up in the broader economy.
Jon Hill, head of US inflation strategy at Barclays Plc, said anticipation that AI will lower costs over time may be helping anchor long-term inflation expectations, even during the recent oil-price jump.
“You don’t necessarily need to assume some mass unemployment scenario,” Hill said. “You just have to make the argument that we’re able to do more at a lower cost, and that leads to a lower wage story.”
History offers a cautionary parallel. During the dot-com boom of the 1990s, then-Fed Chairman Alan Greenspan correctly argued that rapid productivity gains would help restrain inflation.
But the central bank did not slash rates. Initially, it just held them steady. By the end of the decade, however, the Fed raised them sharply as investment surged and the economy accelerated.
“Higher-productivity environments actually raise the real rate,” said John Briggs, head of US rates strategy at Natixis North America. “The higher real-rate story is here to stay.”
–With assistance from Davide Barbuscia, James Hirai, Ryan Vlastelica and Christopher Anstey.
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