CLEVELAND, Oct 19 (Reuters) – The AI boom, increasingly recognized by the Federal Reserve as a factor contributing to inflation, has left U.S. central bank authorities facing the challenge of slowing the rest of the economy to ease price pressures amplified by a sector of big names such as Amazon, Apple and Anthropic, deemed immune to interest-rate hikes.
Fed officials know that their blunt tool of raising borrowing costs has an uneven impact. With AI companies spending as if money were no object, economists see the effect of rate increases falling on other sectors: on firms and households more dependent on credit, or on small and medium-sized businesses that modulate their investment plans as borrowing costs rise.
“There are paths to get there,” said ADP Chief Economist Nela Richardson about the Fed’s 2% inflation target, not achieved in more than five years. “But not all routes are open,” with the housing market already weakened, for example, and the labor market not being seen as a source of inflation through rising wages.
“What remains? Small businesses, because they need bank lending; consumers who need to finance payments to pay down debt and credit cards… Perhaps the stock market,” seen as a factor that supports spending by wealthier families, but often vulnerable to higher rates, she said.
Stocks, in fact, fell last week after inflation data unexpectedly strong reinforced expectations that the Fed will have to raise rates further.
The president of the Cleveland Fed, Beth Hammack, recently pointed to modest stock-market gains and the slowdown in activity outside the AI boom as ways higher rates could cool the economy “on the margins.”
“I like growth… I’m not trying to stop growth. I’m just trying to moderate it a bit so that it progresses at a pace that doesn’t put too much pressure on prices,” Hammack told Reuters last Monday.
The remarks by Hammack and other participants at a conference of the National Association for Business Economics (NABE) deepen a less-discussed aspect of the Fed’s rate hikes: how higher borrowing costs could ripple through the economy and lead to a more moderated inflation?
‘MORE EXPLANATIONS ARE NEEDED’
The Fed will meet on October 27-28 and is expected to hold rates steady in the 3.75%-4.00% range. Fed officials say that new hikes are likely necessary and are now debating the pace and extent of those increases.
The Fed chair, Kevin Warsh, in a speech last week at a gathering of the International Monetary Fund in Thailand, acknowledged that AI investments have represented a “shock” to prices and demand, even as he sees wealth and productivity gains “on the horizon.”
“If you are a central banker and your mission is to ensure price stability and maximum employment, you need to recognize this as a shock,” Warsh said.
What he did not address was how the Fed might respond to mounting price pressures and what that would mean beyond the bounds of a sector that is expected to invest about $1 trillion next year, representing roughly 3% of GDP.
In his post-meeting press conference after last month’s monetary-policy meeting, Warsh said he did not think the Fed “would need to hurt the labor markets” to bring inflation back to 2%. Earlier in the Northern Hemisphere summer, he observed that the housing and agricultural sectors were “showing strains” due to higher borrowing costs, although he did not consider credit conditions “restrictive.”
The details were not given on how higher rates might reduce inflation or where potential economic impacts could be felt.
“Warsh said he did not see a trade-off between inflation and unemployment. That deserves a more detailed explanation. End of story,” said Charles Evans, former president of the Chicago Fed, on a NABE panel on central banks. “The risks and consequences of raising rates further to reduce inflation are well known.”
‘THE LAGS ARE REAL’
The trade-off between fewer jobs and lower inflation has not always been dramatic.
The drop in Covid-era inflation led to only a modest uptick in unemployment. Between firms’ reluctance to lay off workers who were hard to hire during the pandemic and the immigration policies of the current president Donald Trump, which curb labor-force growth, the unemployment rate stayed in a low range, between 4.0% and 4.3%, for more than two years.
That gave Fed policymakers the confidence that they could raise rates without causing a marked rise in unemployment—if there would be any at all. But that also means that the typical path to lowering inflation—the cooling of consumer spending that would likely follow higher unemployment—may also be closed.
Policymakers, including the president of the Richmond Fed, Tom Barkin, and the president of the St. Louis Fed, Alberto Musalem, say that inflation could fall without strongly affecting growth, consumption or employment. A credible central bank that proceeds with rate hikes, they argue, could prompt companies and households to moderate their wage and price demands, leading to lower inflation.
The challenge, as Hammack and others suggested, is that demand may be rising, and not only among AI companies.
A broad range of firms is benefiting from the AI boom, particularly those that build data centers or manufacture components for them, with order backlogs and the investments required to meet demand.
“Order backlogs are real,” said Christopher Gorman, CEO of Cleveland-based KeyCorp, to NABE attendees. Corporate clients list the risks they face, including immigration and tariffs, “then talk about how business is doing well” and lay out plans for both investments and price increases.
Factors that affect inflation could favor the Fed, including any resolution to the war with Iran that lowers oil prices, a suspension of Trump’s tariff-imposing initiative, or a more moderate expansion of data centers in light of growing local opposition.
Juhi Dhawan, macroeconomic strategist at Wellington Management, also highlighted imminent shifts in fiscal policy that could help, with cuts to public health benefits and the end of tax incentives that amount to about 0.5% of GDP.
But that does not make the path to 2% inflation free of hurdles. The stock market, outside of the AI giants, has not proven as robust, she noted; corporate profits are not expected to be as strong next year; and there are signs that lower-income consumers are about to curb their spending.
Inflation declines “if the housing market takes another hit, if construction—probably outside the data-center sector—suffers another downturn, and if many non-AI firms begin to view financing costs as prohibitive,” Dhawan said, while for consumers, “there is underlying fragility, as wages adjusted for inflation are, at best, stagnant.”
