The AI boom is driving inflation; why is it difficult for the Federal Reserve to target interest rate hikes accurately?

Odaily Finance APP has learned that the Federal Reserve is increasingly aware that the artificial intelligence (AI) boom is fueling inflation. This presents Fed officials with a dilemma: to curb the price pressures amplified by the AI industry—which includes giants like Amazon, Apple, and Anthropic—they may have to cool off other sectors of the economy. These giants, however, are relatively less affected by interest rate hikes.

Fed officials are aware that interest rate hikes, as a "blunt instrument," do not affect all sectors equally. As AI companies spend almost without concern for cost, economists believe the pain of higher rates will land elsewhere: on businesses and households that are more reliant on credit, as well as small and medium-sized enterprises that scale back investment plans due to rising borrowing costs.

AI Investment Drives Inflation, Uneven Impact of Rate Hikes

"There is a path to get there," said Nela Richardson, Chief Economist at ADP, referring to the Fed's 2% inflation target, which has not been achieved for over five years. "It's just that not all roads are open." She noted, for instance, that the housing market is already weak, and the labor market is not seen as likely to drive 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 stated. The stock market is viewed as supporting the spending of wealthier households but is often sensitive to rising interest rates.

Indeed, the stock market dropped last week after an unexpectedly strong inflation report reinforced expectations that the Fed would have to raise rates further.

Cleveland Fed President Beth Hammack recently pointed out that restrained gains in the stock market and a slowdown in activity beyond the AI boom are ways that higher rates may "marginally" cool the economy. "I like growth… I'm not trying to stop growth, I just want to pull it back a bit so the pace doesn’t bring excessive price pressures," Hammack said last Monday.

Comments from Hammack and others at the National Association for Business Economics (NABE) conference further highlighted an aspect of Fed rate hikes that is less often discussed: the channels through which higher borrowing costs might transmit through the current economy and ultimately bring down inflation.

Waller Acknowledges AI Impact, But Details on Rate Hikes' Anti-Inflation Effects Remain Lacking

The Fed will meet on October 27-28 and is expected to keep rates unchanged at 3.75%-4.00%. Officials say further rate hikes may still be needed, and are currently discussing the pace and scale of such increases.

Fed Chair Kevin Waller acknowledged at last week’s International Monetary Fund (IMF) meeting in Thailand that AI investment constitutes a "shock" to prices and demand, though he believes wealth and productivity gains won’t materialize until "farther down the road." "If you’re a central bank governor whose job is to ensure price stability and full employment, you have to recognize this as a shock," Waller said.

However, he did not discuss how the Fed might need to respond to the accumulating price pressures, nor what this means for sectors outside the AI industry. The industry is expected to invest about $1 trillion next year, around 3% of U.S. GDP.

At the press conference after last month’s policy meeting, Waller stated he does not believe the Fed "needs to harm the labor market" to bring inflation back to 2%. Earlier this summer, he pointed out that housing and agriculture were "showing pressure" from rising borrowing costs, though he didn’t see credit conditions as "restrictive."

He has yet to elaborate on the specific ways higher rates might reduce inflation, or where economic pain might emerge.

"Waller has said he doesn’t see a conflict between inflation and unemployment. That deserves more explanation. That’s all," former Chicago Fed President Charles Evans said at the NABE central bank panel. "The risks and consequences of raising rates further to bring down inflation are well known."

Jobs Unlikely to Cool Things Down; Order Backlogs Show Demand Remains Strong

The tradeoff between employment reductions and falling inflation doesn’t always come with a hard landing. The retreat from pandemic-era high inflation came with only a modest rise in unemployment. Companies were unwilling to lay off workers who had been hard to recruit during the pandemic, and restrictive immigration policies under President Trump suppressed labor force growth, keeping unemployment between 4.0% and 4.3% for over two years.

This has led Fed officials to believe they can hike rates without causing a sharp rise in unemployment, or perhaps any rise at all. But this also means a typical path to lower inflation—rising unemployment leading to a slowdown in consumer spending—may similarly be closed off.

Policymakers, including Richmond Fed President Tom Barkin and St. Louis Fed President Alberto Musalem, believe inflation can fall without severely hurting growth, consumption, or employment. They argue that a credible central bank that keeps raising rates may prompt businesses and households to moderate wage and price demands, thus bringing inflation down.

Hammack and others noted the challenge is that demand may be accelerating—not just within AI companies. A wide range of businesses are benefiting from the AI boom, especially those building data centers or making components for them. These companies have order backlogs and need to invest to meet supply.

"The order backlog is real," said Christopher Gorman, CEO of KeyCorp, based in Cleveland, to NABE attendees. Commercial clients list the risks they face, including immigration and tariffs, "and then they talk about how good business is," along with investment and price increase plans.

Oil Prices, Tariffs, and Fiscal Variables: The Path to Lower Inflation Won't Be Painless

Factors influencing inflation could also turn in the Fed's favor—such as a resolution to the war in Iran lowering oil prices, an end to Trump’s push for tariff hikes, or a more cautious approach to data center construction due to growing local opposition.

Wellington Management macro strategist Juhi Dhawan also pointed out that fiscal policy is about to change and may help: public health benefits are being reduced and tax cuts worth about 0.5% of GDP are set to expire.

But this won’t make the path to 2% inflation painless. She noted that, outside the ultra-large AI firms, the broader stock market is not so strong, corporate earnings are not expected to be as robust next year, and there is evidence low-income consumers are already on the verge of cutting spending.

Dhawan said if housing takes another step down, construction outside of data centers falls further, and many non-AI companies find financing costs too high to bear, only then will inflation fall; for consumers, "there is an underlying vulnerability, because real wages, adjusted for inflation, are at best flat."