A key bond market signal suggests the AI boom may only exacerbate the inflation challenges facing Kevin Warsh, rather than easing them as he previously argued.
The incoming Federal Reserve Chair has previously criticized the central bank for failing to recognize that breakthroughs in artificial intelligence would boost productivity, creating a "significant disinflationary force" that would make it easier for policymakers to cut interest rates.
However, as Warsh prepares to take office on Friday, the 30-year Treasury yield has recently surged to its highest level in nearly two decades, driven by war-induced price shocks. Wall Street analysts note that a widely followed market metric currently indicates AI's impact on inflation is the opposite of what Warsh predicted, which in turn is influencing the trajectory of borrowing costs.
According to the "five-year, five-year forward break-even rate" – a market gauge – the Fed's benchmark policy rate would need to exceed the inflation rate by about 2 percentage points over the medium term to be considered neutral, meaning it neither stimulates nor restrains economic growth. With the current Fed funds rate around 3.6%, which is below the pace of inflation, monetary policy is still seen as stimulative, thereby narrowing Warsh's room to cut rates.
Many factors influence estimates of the neutral rate, including long-term growth and inflation expectations. Central bank officials acknowledge the difficulty in pinpointing it precisely.
But analysts argue the emerging AI boom is pushing the neutral rate higher by increasing capital demands and intensifying inflationary pressures.
First, just the four largest technology companies plan to invest over $700 billion this year alone to build data centers, computer hardware, and power infrastructure.
Second, soaring global demand for semiconductors that power the AI revolution has sparked so-called "chipflation," driving up prices for chips and related products. In the U.S., computer software and accessory prices rose 14% year-over-year in April. Analysts at BlackRock note that prices for DRAM chips, used for memory storage, have surged 17-fold over the past year. Companies like Microsoft and Meta Platforms Inc. have raised prices on some of their products.
"Our baseline assumption is that AI will push inflation higher over the coming years," said Christoph Rieger, Head of Rates and Credit Research at Commerzbank.
U.S. Treasuries are facing additional pressure as tech giants like Microsoft, Amazon.com, and Alphabet issue massive amounts of new debt. These firms have issued over $300 billion in debt to U.S. investors to fund AI-related investments. The Dallas Fed estimates this market impact is roughly equivalent to a more than 10% increase in the supply of long-term Treasuries.
"AI-related issuance is pushing up rates, which leads to higher borrowing costs," said Priya Misra, Portfolio Manager at J.P. Morgan Asset Management.
Faster-than-expected inflation and the surge in long-term bond yields present greater challenges for Warsh as he succeeds Jerome Powell. Before nominating Warsh, former President Trump repeatedly accused Powell of not cutting rates quickly enough, hindering economic growth.
In a commentary last November, Warsh criticized Fed policymakers for their forecasts of persistently high inflation, arguing they failed to account for the productivity gains from AI. A surge in oil prices pushed the Consumer Price Index up 3.8% year-over-year in April, the largest annual increase since 2023, intensifying the recent bond market sell-off.
With prices rising again – partly due to U.S.-Iran tensions and the resulting oil price spike – futures traders have even begun betting the Fed may be forced to hike rates by December.
"It's not tenable to cut rates based on assumptions; the market isn't buying it," said Blake Gwinn, Head of U.S. Rates Strategy at RBC Capital Markets.
Jonathan Pingle, Chief U.S. Economist at UBS, suggests Warsh may still argue against rate hikes, positing they could harm AI investment. In a note to clients, he stated, "We expect him to argue that good policy should not suppress investment today that could be a source of future disinflation."
Warsh's new colleagues at the Fed have also cautioned against assuming AI will automatically lead to lower rates. Several officials, including Vice Chair Philip Jefferson and Governor Michael Barr, have noted that the massive corporate investment required to deploy the technology could itself push the neutral rate higher by increasing capital demand.
Some investors believe Warsh may ultimately be proven right over time. Analysts at Vanguard, one of the world's largest asset managers, say increased spending on AI could eventually boost economic productivity, support growth, and help ease inflation. But for now, supply shocks and investment-driven demand are still pushing inflation higher, and the firm is watching closely for signs of productivity gains spreading more broadly across the economy.
Jon Hill, Head of U.S. Inflation Strategy at Barclays, suggests that the expectation AI will lower costs over time could help anchor long-term inflation expectations even during the recent oil price surge.
"You don't necessarily need to assume a scenario of massive job losses," Hill said. "You just need to argue that we can do more work for less cost, and that leads to lower wage growth."
History offers a cautionary parallel. During the dot-com bubble of the 1990s, then-Fed Chair Alan Greenspan correctly argued that rapid productivity gains would help restrain inflation.
But the Fed did not cut rates aggressively in response, initially holding them steady. However, by the late 1990s, as investment surged and the economy accelerated, the Fed raised rates significantly.
"An environment of rising productivity actually pushes real rates higher," said John Briggs, Head of U.S. Rates Strategy at Natixis North America. "We are in for a period of higher real rates."
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