CLEVELAND, Oct. 19 — The artificial intelligence boom is increasingly being recognized by Federal Reserve officials as a contributor to inflation, creating a challenge for policymakers seeking to cool price increases without unnecessarily slowing the broader economy.
With major companies such as Amazon, Apple and Anthropic continuing to invest heavily in AI, economists warn that higher interest rates could place a disproportionate burden on businesses and households that depend more heavily on borrowing.
Small and medium-sized businesses, in particular, could face rising financing costs that force them to scale back investment plans, even as major AI companies continue spending aggressively.
“There are paths to get there,” said Nela Richardson, chief economist at ADP, referring to the Fed’s 2% inflation target, which has remained unmet for more than five years. “It’s just not every road is open.”
Richardson pointed to weakness in the housing market and the labor market’s limited role in driving inflation through wage increases.
“What’s left? Small businesses, because they need bank loans, consumers who need to fund payments out of debt and credit cards…Maybe the stock market,” she said, noting that stock-market gains can support spending among wealthier households but may be vulnerable to higher interest rates.
Stocks fell last week after an unexpectedly strong inflation report increased expectations that the Fed would need to raise rates further.
Cleveland Fed President Beth Hammack recently said slower stock-market gains and weaker activity outside the AI sector could help higher rates cool the economy “at the margins.”
“I like growth…I’m not trying to stop growth. I’m just trying to pull it back a little bit so that it’s moving at a pace that doesn’t put too much pricing pressure out there,”
Her remarks, along with comments from other officials at a National Association for Business Economics conference, highlighted a less-discussed question surrounding monetary policy: how higher borrowing costs might reduce inflation in today’s economy, and which parts of the economy would bear the consequences.
‘Worthy of More Explanation’
The Federal Reserve is scheduled to meet on October 27-28 and is expected to keep interest rates steady at 3.75%-4.00%. Officials say additional increases may be necessary and are debating their pace and extent.
Fed Chairman Kevin Warsh acknowledged last week at an International Monetary Fund meeting in Thailand that AI investment was a “shock” to prices and demand, although he also expects potential wealth and productivity gains over time.
“If you’re a central banker and you’re in the business of trying to ensure stable prices and full employment, you’ve got to recognize this as a shock,” Warsh said.
However, he did not explain in detail how the Fed might respond to the inflationary pressure or where the economic costs of higher rates might fall beyond an industry expected to invest about $1 trillion next year, equivalent to roughly 3% of gross domestic product.
At a press conference following last month’s policy meeting, Warsh said he did not believe the Fed would “need to do harm to the labor markets” to bring inflation back to 2%.
Earlier in the summer, he acknowledged that housing and agriculture were “showing strains” from higher borrowing costs, although he did not consider overall credit conditions “restrictive.”
Former Chicago Fed President Charles Evans said Warsh needed to explain more clearly how the central bank could bring inflation down without creating a conflict between price stability and employment.
“Warsh has said he does not see a conflict between inflation and unemployment. This is worthy of more explanation. Full stop,” Evans said at a central bank panel hosted by the National Association for Business Economics.
“The risks and consequences of raising interest rates higher to bring down inflation are well known,” he added.
‘Backlogs Are Real’
The relationship between slowing inflation and rising unemployment has not always been straightforward.
Inflation declined from its COVID-19-era highs with only a modest increase in unemployment. Companies’ reluctance to dismiss workers they had struggled to recruit during the pandemic, combined with President Donald Trump’s immigration policies limiting labor-force growth, has helped keep unemployment within a relatively narrow range of 4.0%-4.3% for more than two years.
That stability has encouraged some Fed officials to believe that higher interest rates could cool inflation without significantly increasing unemployment.
But it also limits one traditional way of reducing inflation: weaker consumer spending as job losses rise.
Policymakers including Richmond Fed President Tom Barkin and St. Louis Fed President Alberto Musalem argue that inflation can decline without seriously damaging economic growth, consumer spending or employment.
They contend that a credible central bank willing to follow through on rate increases can persuade businesses and households to moderate their wage and price demands, easing inflationary pressure.
The difficulty, Hammack and other officials have suggested, is that demand may be strengthening, including beyond the AI industry.
A wide range of businesses is benefiting from the boom, particularly companies building data centers or supplying their components. Many face heavy order books and are investing to expand capacity.
“The backlogs are real,” said Christopher Gorman, chief executive of Cleveland-based KeyCorp, at the conference.
Gorman said commercial clients often list risks such as immigration restrictions and tariffs before discussing strong business conditions, planned investments and potential price increases.
Factors Could Ease Inflation Pressure
Several developments could help bring inflation down without requiring substantially higher interest rates.
A resolution to the Iran war could reduce oil prices, while a pause in Trump’s tariff campaign could limit additional cost pressures. A more measured pace of data-center construction, amid growing local opposition, could also help ease demand.
Juhi Dhawan, a macro strategist at Wellington Management, pointed to upcoming fiscal-policy changes that could provide additional relief. These include reductions in public health benefits and the expiration of tax breaks worth about 0.5% of GDP.
Even so, returning inflation to 2% could involve significant economic pain.
Dhawan noted that stock-market performance outside major AI companies has been relatively weak and that corporate earnings are not expected to be as strong next year. There are also signs that lower-income consumers may be approaching a point where they reduce spending.
Inflation could ease if housing weakens further, construction activity outside data centers declines and non-AI businesses find borrowing costs too expensive, she said.
For consumers, she warned, the underlying situation remains fragile because inflation-adjusted wages are “flatlining at best.”
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