How Ai Has Got The Fed In A Bind

Federal Reserve Chair Kevin Warsh says artificial intelligence will ultimately provide a “huge benefit” to the economy. But a cooling off of investment in the skyrocketing technology might actually help him right now.

The rapid construction of AI data centers across the nation is stoking inflation by juicing financial markets and creating shortages in electricity and construction. Yet it’s also a massive engine for the economy, fueling spending by consumers enriched through rising stock prices and by businesses, which are pouring money into tech-related investments.

That creates a dilemma for Fed policymakers: Raise interest rates too sharply to fight inflation and risk damaging a key driver of the economy. Move too slowly and risk entrenched inflation. But if the AI industry’s growth were to moderate on its own, that would make it easier for the Fed to tame inflation.

“The demand behind the AI build-out is so intense that it’s putting pressure on the supply of goods and services that are needed to do the AI build-out,” said Claudia Sahm, a former Fed staffer who is now chief economist at New Century Advisors. “So if that demand for the build-out just took a little bit of wind out of the sails, well, then maybe the production could catch up and we wouldn’t have these bottlenecks.”

The stakes for the central bank are high, as Warsh and his colleagues are aiming to cool inflation without wrecking the job market or causing financial turmoil. But given the frenzy around the new technology, the bulk of AI investment isn’t likely to be affected by Fed rate hikes unless borrowing costs go significantly higher, which the central bank for now has not signaled it intends to do.

That means inflation could stay stubbornly high even if the Fed raises rates, which investors expect the central bank will do in December, rather than now, just days out from congressional elections. Fed officials will announce their next interest rate move Wednesday.

In other words, it would be one fewer headache for the Fed if markets themselves tempered the boom without any intervention from the central bank.

Indeed, there are mounting fears that AI’s role in economic growth is under threat as investors become jittery about the immense spending plans by tech giants like Meta and over the cash flow prospects for data center builders like CoreWeave.

But Neil Dutta, head of U.S. economic research at Renaissance Macro Research, expressed doubt that investor behavior is enough to fundamentally shift the situation.

“Is that really enough to actually stop the data center build-out? Probably not,” he said. Banking on a scenario in which AI investment cools but doesn’t dangerously collapse is “like an inside straight,” added Dutta, referring to a poker hand in which you need to draw a specific card, making success less likely.

To be sure, any slowdown could spiral into a bigger problem for the economy.

If investments in AI turn out to be only a fraction of what's expected, “the equity market may sell off,” said Vishy Tirupattur, global director of fixed income research at Morgan Stanley. “Which will also hit consumption because at the moment a lot of GDP growth is being held up by AI and the consumer, especially the high-end consumer," who is bolstered by the stock market.

“The domino effect is not something that the Fed can easily flip the switch back on and control,” he added.

For now, the central bank is trying to manage a complex constellation of risks, given that prices are being driven higher in particular by soaring oil prices stemming from the war in Iran.

Those rising costs could eventually slow the economy, so Fed officials are being cautious in assessing how much they will need to raise borrowing costs. And fighting the AI money spigot head on could be counterproductive, as it is part of what is helping keep the economy resilient in the face of ongoing shocks, which also include tariffs.

Warsh earlier this month acknowledged that AI and inflation were connected, saying during an event in Bangkok that “it’s obviously hitting the demand side of the economy before it’s hitting the supply side.” But he has not specified how big of a factor it is.

He maintained that the technology would have “a huge benefit to the global economy and the U.S. economy over the horizon.” Still, he said the path is “likely to be a very bumpy one.”

Tirupattur said the Fed is unlikely to cause an investment pullback on its own, absent much more aggressive action, noting that more than 75% of AI-related capital expenditures are coming from four tech giants with high credit ratings: Microsoft, Meta, Amazon and Alphabet. That money is “unconstrained or undeterred by the increase in borrowing costs that we have seen,” he said.

“If there is a constraint in this … it’s not going to be because either there is not enough capital or the borrowing costs are too high,” he added. “It’s really going to be constraints on [electrical] power and potentially regulatory policy — you know, things like restrictions on constructing new data centers.”

Christina Skinner, who until August worked on financial stability issues at the Treasury Department under Secretary Scott Bessent, said investors were beginning to impose discipline on the AI sector and argued against further rate increases.

“I don’t think the Fed has a role at all in restraining AI,” said Skinner, who is a professor at the Wharton School at the University of Pennsylvania.

“Right now, what we see is that the AI build-out is putting some pressure on specific sectors,” she said. “A Fed rate hike is the wrong medicine for those kinds of inflationary pressures because a rate hike is just going to cool the economy broadly and overrestrict some segments of the economy that are already pretty tight, like the housing sector.”