A big wild card for US interest rates is the trajectory of the artificial-intelligence investment boom and its impact on stock market valuation.
The boom is currently pushing interest rates up in two ways. First, the investment spending is boosting economic growth and straining the nation’s financing capacity. Second, the boom has been accompanied by a buoyant stock market, which is lifting household wealth and bolstering consumer spending.
The effect on short- and long-term interest rates is difficult to predict because we can’t be confident about the magnitude and duration of the investment boom and its impact on stock market valuation. But a few things seem likely. First, the direct impact on US economic growth is likely to diminish next year because the increase in investment spending in 2027 — it’s the change, not the level, that matters for growth — is likely to be smaller than the rise in 2026. This reflects in part capacity constraints in building new data centers, tougher financing conditions for those AI providers with little cash flow from other operations, and political opposition. Voters are unhappy about the impact of the AI buildout on electricity prices and are concerned about how AI will affect their livelihoods.
Second, in contrast, the impact on real interest rates caused by the pressure of AI investment on the nation’s saving pool will continue to increase. That is because the pressure on the supply of saving is driven by the level of investment, not its change.
Thus, the upward pressure the AI boom puts on interest rates is likely to be more nuanced in 2027 — less from economic growth but more from the pressure on savings. Interest rates have to rise to push down consumer spending on durable goods, housing and non-AI related business investment to generate the capacity to accommodate a higher level of AI spending.
In the longer term, the upward pressure on rates will reverse as the AI investment boom peaks and then declines. When the boom inevitably unwinds — either because the buildout is complete or because AI providers can’t obtain the outside funding they need — things will run in reverse: AI investment will be a drag on growth and will take down less of the saving pool. At the same time, the equity market will likely retrench as the boom-generated profits subside. The combination will slow the economy, the Fed will reverse course and cut short-term rates, and longer-term rates will decline.
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The problem for investors (and the Fed) is that the timing and intensity of this reversal remain highly uncertain. My view is that it will most likely occur sooner than anticipated. That’s because I’m skeptical that the AI providers will be able to generate sufficient revenue to achieve an acceptable return on investment. Moreover, before we get to that point, those AI providers without strong cash flows will lose access to the capital markets.
So what does this imply for US interest rates? In my view, the pattern will first be up — perhaps significantly more than anticipated — rather than down, when the Fed will respond to the bust by cutting interest rates sharply. Interestingly, this is not what financial market participants expect. This can be seen in SOFR futures prices, which extend into the early 2030s (unlike the federal funds market) and are consistent with about 75 basis points of additional hikes by June 2027 and then remain relatively flat thereafter. Although this could just represent disagreement between those who think the boom will prove more persistent and those who don’t, regardless of the reason, I think this is an unlikely path. If short-term rates rise by 75 basis points or more, a sharp down cycle seems likely to follow because that would be more consistent with how the AI boom is likely to affect the economy and determine the Fed’s response.
So what about next week’s Federal Open Market Committee meeting? Is the Fed behind the curve or not? I think the Fed should act more quickly for two reasons. First, the AI boom is pushing the economy along fast enough to keep the labor market at the Fed’s mandate of full employment. Second, this is happening when inflation is still elevated, with the Fed almost certain to miss its 2% inflation target for the sixth consecutive year. In addition, the risks of a policy mistake remain very much tilted to the inflation side because further persistent misses could cause inflation expectations to become unanchored. If that were to happen, the Fed’s credibility would be damaged, and that would make it more difficult for the central bank to push inflation back down to its target.
The FOMC is not going to raise its federal funds rate target next week. Comments by the two vice chairs — New York Fed President John Williams (the FOMC) and Phillip Jefferson (the Board of Governors) — which seemed designed to temper market expectations, were no accident. The so-called troika, which consists of the chair and the two vice chairs and became the dominant decision-making group and a consistent means of communication beginning with former Chair Ben Bernanke, still seems to be operative. I reach this conclusion because Chair Kevin Warsh essentially endorsed Williams and Jefferson’s sentiments last week in remarks at the annual meetings of the International Monetary Fund and World Bank in Bangkok.
While Warsh demurred from providing forward guidance, he did note that the global economy had broadly conformed to the Fed’s expectations since the September FOMC meeting. With futures markets pricing in only about a 15% probability of tightening next week, it would be shocking if Warsh contradicted the signal from financial markets that he has worked to keep untainted by not providing forward guidance. Moreover, a move would be noteworthy because it would essentially mark the end of consistent messaging by the troika members.
When I was part of the troika with former chairs Bernanke, Janet Yellen and Jerome Powell, from 2009 to 2018, I made sure that my remarks lined up with their preferences and what the committee would actually do at the coming meeting. And if market pricing was wrong, I might — with the blessing of the chair — try to set things right. For example, in August 2015, it was no accident that I said: “At the moment, the decision to begin the normalization process at the September meeting seems less compelling… .” That comment was designed to reset market expectations.
While next week’s Fed meeting is likely to be a bit of a snooze, buckle your seat belt because over the next few years, that will not be true.
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