Bond Market Sees AI Boom Differently from Warsh, "Driving Up Long-Term Rates"

5y5y Real Rate About 2% Above Inflation
23.3% Probability of Rate Hike at September FOMC

As Kevin Warsh prepares to take office as the new Federal Reserve (Fed) Chair, the bond market is moving in the opposite direction of his claims regarding "artificial intelligence (AI) productivity." Warsh has argued that AI technology will boost productivity, leading to strong disinflation and thus supporting interest rate cuts. However, key bond market indicators are signaling that AI is actually fueling inflation.

Kevin Warsh, Nominee for Fed Chair. Photo by AP Yonhap News

According to Bloomberg on May 20 (local time), the "5-year, 5-year forward real rate," a metric used in the bond market as an indicator of the neutral interest rate, is currently about 2 percentage points higher than inflation.

The problem is that reality falls short of this benchmark. The current U.S. federal funds rate stands at 3.50%–3.75%. Last month, the Consumer Price Index (CPI) surged 3.8% year-on-year, marking the highest level since 2023, as energy prices soared due to the aftermath of the Iran war.

Because the policy rate is lower than the pace of inflation, Bloomberg pointed out that monetary policy effectively remains in an accommodative mode.

This contradicts Warsh's argument that AI-driven productivity improvements should be exerting disinflationary pressure. In an op-ed for the Wall Street Journal last November, Warsh criticized the Fed for underestimating productivity gains from AI advancements while remaining concerned about persistent inflation. He argued that AI innovation would lower costs and boost productivity, eventually easing upward pressure on prices.

However, contrary to Warsh's claims, analysis on Wall Street suggests that the AI boom is, in fact, stoking inflation. First, increased investment in data centers and power infrastructure is driving a surge in capital demand. Major big tech companies such as Microsoft, Amazon, and Alphabet are planning to invest more than $700 billion in AI-related facilities just this year.

The phenomenon of "chipflation" observed amid the spread of AI is also cited as a factor increasing price pressures. As demand for semiconductors needed for AI servers and data centers has skyrocketed, related prices have risen accordingly.

According to BlackRock, the price of memory semiconductors (DRAM) has increased 17-fold in the past year. Computer software and accessory prices in the United States also jumped 14% year-on-year in April. Some companies have moved to raise product prices.

The large-scale issuance of corporate bonds to raise funds for AI investments is also identified as a factor pushing up long-term interest rates. Big tech companies have already issued more than $300 billion in bonds, and the Federal Reserve Bank of Dallas estimated that the impact is similar to a more than 10% increase in long-term Treasury supply.

Christoph Rieger, Head of Rates and Credit Research at Commerzbank, said, "The base scenario is that AI will act to raise inflation over the next few years." Priya Misra of J.P. Morgan Asset Management also assessed, "AI-related bond issuance has lifted the overall level of rates and led to higher borrowing costs."

According to FedWatch, the probability that the Fed will keep the policy rate unchanged at the July and September FOMC meetings stands at 86.8% and 72.6%, respectively. The likelihood of a 0.25 percentage point hike (to 3.75%–4.00%) was calculated at 10.3% and 23.3%, respectively.

However, in the long run, there are counterarguments that AI will eventually help stabilize prices by enhancing productivity. Vanguard believes that AI investments can boost growth rates and deliver cost savings. However, it assessed that, at present, supply shocks and increased demand from expanded investment are fueling inflation.

The dot-com bubble of the 1990s is also being revisited as a precedent. At the time, Fed Chair Alan Greenspan believed productivity innovation could reduce inflation, but the Fed did not lower interest rates. When the investment boom and overheating of the economy followed, the Fed instead raised rates sharply.

This content was produced with the assistance of AI translation services.