AI Investment Mania Has Started to Flood the Economy, and the Fed Has Started to Worry About the Consequences

Yves here. It’s not like the Fed, or central banks in general, think much about possible asset bubbles, since they look like wealth increases to investors and observers until they don’t. We quoted an op-ed in the Sydney Morning Herald by former Reserve Bank of Australia governor Ian Macfarlane on this issue in 2007. German categories:

One major challenge begins with the realization that as an economy develops, its financial side grows much faster than its real side. As a result, the economic results will depend more on what happens in the asset markets and less on what happens in the real side of the economy, such as in the goods and labor markets….If a major financial shock were to occur, such as a major drop in the price of a share or commodity, the economic effect would be greater than before.

So the main question is whether booms and busts in the stock market are possible in the future…

If inflation and deflation are likely to be at least as common as they have been for the past two decades and their effect on the economy will be large, what can monetary policy do about it? …

So, if inflation offers no insurance, what should a central bank do if it suspects that inflation may be unsustainable, especially when inflation is financed by debt?…

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify the emerging bubble, it may be very difficult for the central bank to fight it for two reasons.

First, monetary policy is a blunt instrument. When interest rates are raised to deal with rising asset prices in one sector, such as housing prices, the entire economy is affected. If confidence is very high in a booming sector, it may not be affected initially by high interest rates, but the entire economy may be affected.

Second, there is a major issue concerning the authority that central banks have been given. It is widely accepted that central banks are tasked with preventing inflation, but nowhere, as far as I know, are they tasked with preventing an increase in asset prices, which most people would consider an increase in public wealth. So, if he were to take on this additional role, he would face a huge task of convincing the public of the need.

Even if the central bank was convinced that a deflationary bubble would appear, and that its bursting would be devastating, the public would not know that this would happen, and will not know until the whole episode has been allowed to play itself out. If the central bank continues to raise interest rates, it will be accused of risking a recession to avoid a concern, but not the public. If in the best case scenario, the central bank raised interest rates by a small amount and prevented the bubble from growing to dangerous levels, and did so at a relatively small cost compared to the wage and job growth that was foregone, would it get any thanks? Probably not…In all likelihood, the episode will be viewed by the public as a monetary policy blunder because what could have happened would not have been seen.

So Wolf was right to use the word “fret”. Most lending now takes place outside of banks so regulators have imposed credit controls or sent word that lending to certain sectors will receive more scrutiny.

By Wolf Richter, editor at Wolf Street. Originally published in Wolf Street

“AI” was mentioned 21 times in the minutes of the FOMC meeting on June 16-17, released today – up from 8 mentioned in the minutes of the previous FOMC meeting in April – in these combinations:

• “AI buildout” (4 times) and “AI infrastructure” (2 times)
• “AI-related investment” (3 times), “AI business investment,” “AI investment,” “AI-related capital spending,” “AI-related spending”
• “AI discovery” (2 times)
• “Implications of AI for Business Profitability”
• “Price pressures related to AI”
• “Need related to AI”
• “Hope for AI.”

Additional:

Some participants noted that AI may, over time, affect employment opportunities in other categories of workers…

Strong corporate earnings and continued investor optimism related to AI contributed to the rise in foreign equity prices.

AI investment mania is now a force driving demand and driving up consumer prices including electronics and technology products, stock prices, and input costs for companies to try to pass them on. And that’s now.

But the expected productivity gains and inflationary pressures from AI are considered uncertain even in the future:

Some participants noted that the productivity gains associated with the adoption of AI will ultimately lower production costs and increase aggregate supply, which should put downward pressure on inflation, although they noted that this may take time to materialize.

Also:

Some participants suggested that those [AI] investment is likely to increase productivity growth and potential output in the coming years. These participants noted, however, that significant uncertainty remained regarding the timing and magnitude of potential productivity gains, which were expected to slow the continued growth of AI adoption by demand.

In contrast, the other two Fed bogymen, “strength” due to the Iran war and “rates” were mentioned only 13 and 7 times respectively in the minutes today.

“Electricity” was mentioned once, but in the context of AI increasing electricity prices, as well as the prices of technology products, thereby increasing inflation:

Many stakeholders noted that continued strong demand for AI infrastructure may put upward pressure on the prices of technology and electronics products.

Here are some mentions:

Many stakeholders noted that continued strong demand for AI infrastructure may put upward pressure on the prices of technology and electronics products.

However, the majority of participants also pointed to situations where, in the context of stable labor market conditions, inflation will remain high due to strong demand related to AI, the Middle East conflict, or cost effects.

Most of the participants noted that the growth of economic activity beyond what is possible, due to the strong investment of the AI ​​business, may contribute to the continued pressure of inflation.

Some participants noted that broader financial conditions were supporting demand. These participants specifically pointed to higher equity prices and noted that those prices were driven by strong corporate earnings and optimism about AI.

Participants generally expected strong real GDP growth to continue throughout the remainder of the year and pointed to several factors that could support continued expansion, including continued investment related to AI, housing consumption, and monetary policy.

The AI ​​investment frenzy – the hundreds of billions of dollars investors want to cough up and are being thrown around left and right – and the demand and inflationary pressures generated by those hundreds of billions of dollars, have begun to erode the economy. And the Fed has begun to worry about the consequences.

It’s refreshing that the Fed is taking this threat to price stability seriously, rather than trying to “watch” these pressures from investment AI and wait for them to go away on their own somehow, while those pressures could fuel a second wave of inflation.

So there was a pivot to the Fed at the June FOMC meeting, as the minutes of today’s meeting: The discussion was about raising rates, with “a few” participants even admitting that “there was a case” for hiking at the June meeting.

On the contrary, in meetings last year and early this year, the discussion was about reducing rates – and the Fed did cut rates three times last fall.

It’s rare for the Fed to hike one rate and it’s done. In most cases, a rate hike means a new round of hikes to keep inflation under control.

Core measures of inflation and measures of overall inflation have been above the Fed’s target for more than five years. The Fed-favored core PCE price index, which excludes energy and food, has increased since mid-2025 and reached 3.4% in May. The PCE price index was released two weeks after the Fed meeting, and participants only had estimates of it, not actual data.

The six-month core PCE price index, which reflects the current trend, accelerated to 4.1% on the year, the worst in three years, and this does not include components of spiking energy. The main drivers were non-real estate services, energy, and technology products.

The six-month core PCE services price index, the main driver behind the core PCE price index, has accelerated since mid-2025 and hit 4.2% in May. Essential services dominate consumer spending. And this time, it’s the non-housing services that are making the noise. If electricity was included in essential services, it would look even worse:

The PCE price index for all things, on which the Fed’s 2% target is based, has been above the Fed’s 2% target since March 2020, for more than five years, and now the thought is spreading, including right here, that the Fed’s de-facto target has been quietly moved to the 3-4% range, and is just a lip-paste copy of 2%.

If the Fed wants to end that thinking, it will have to get busy. If the dillydallies look at this inflation, it would be evidence that the Fed has actually removed the de-factor target in the range of 3-4%, and Warsh may go out and say it and thus allow long-term Treasury yields and mortgage rates, which are still stuck at the 2% illusion, fly off the handle.

In case you missed it: Consumers Are Already Getting the Drift, “Rise Expectations” Throw the Fed Another Curveball.