The Federal Reserve faces a momentous decision tomorrow on whether to raise interest rates, and the calculation will be whipsawed by multiple factors that cut in opposite directions: rising energy costs, a weakening labor market, and most recently, the multipronged revolt against AI, which itself has crosscutting implications.
The best argument in favor of a rate hike, which is now the consensus forecast, is the plain fact that prices keep increasing. Last Friday’s Consumer Price Index report of the Bureau of Labor Statistics for August was only trivially above the Fed’s expectations, but the shift was in the wrong direction. CPI inflation rose 0.4 percent over the month, and 3.4 percent over the past year. Real earnings fell, 0.3 percent on a yearly basis, for the fifth month in a row.
It’s all too clear that most of this inflation is driven by Trump’s Iran war, which is not going to end anytime soon—on the contrary, it is getting worse, with Iranian-backed groups seizing control of the Bab-al-Mandeb strait and seriously damaging a Saudi oil pipeline. Oil is back over $100 a barrel. Trump’s tariffs also add to shortages and hence price hikes.
Private markets keep bidding up interest rates. When this occurs, the Fed governors typically feel they have to act to slow expected inflation, even though the paradoxical effect of a Fed rate hike is to push other rates still higher (and thus inflation), at least in the near term until the economy starts slowing.
Arguing against a rate increase is the weak economy itself.
Mortgage rates keep climbing in anticipation of persistent inflation, and the bond market has taken on a life of its own as investors demand an inflation premium. Rates on the benchmark ten-year Treasury bond have climbed to a shade under 5 percent. Treasury Secretary Scott Bessent’s attempt to manipulate rates downward by selective Treasury purchases has proven laughably ineffective and has spooked markets further.
All of this argues for a rate hike. At the last meeting of the Federal Open Market Committee in July, a majority of the 12 members kept rates steady in a range of 3.5 to 3.75 percent. However, three of the 12 voted for a quarter-point rise. Now, prediction markets have placed the odds of a rate hike at around 85 percent.
But arguing against a rate increase is the weak economy itself. Though job creation in recent months has been decent—though not remotely close to what President Biden delivered—real wages keep declining.
Now, overlaying and further complicating all of the above is the increasing likelihood of a drastic pullback in what was very likely overinvestment in AI. On Monday, there was a worldwide decline in tech stocks, and for good reason. Big Tech companies have been heavily invested in each other, and a good deal of their recorded profit has been as a result of these gains.
If the AI bubble were to pop, the stock market bubble would pop with it. If Monday’s decline in stock prices turns into a Tuesday rout, that will weigh on the Fed’s decision.
Interest rates have been bid up because a large percentage of private-sector borrowing has been by AI companies and their tech allies. If there is a sudden AI pullback, that borrowing will diminish, reducing interest rates and softening the economy, even if the Fed does nothing.
The AI pullback is coming from multiple sources. Leading figures in the AI industry have suddenly decided that the risks of AI going rogue are real and are calling for some kind of pause. Meanwhile, there is a citizen revolt against the construction of AI data centers. And some skeptics argue that the market for AI has been overhyped all along and that the industry’s belated attack of conscience is at least partly a convenient rationale for an overdue pullback of investment plans.
It doesn’t matter which side of that argument you believe; some kind of pullback is coming. Which brings us back to the Fed.
To the extent that the economy and the stock market have both been propped up by AI, and some sort of correction is coming, should the Fed now add to that downdraft by raising interest rates? Or should the Fed encourage the AI pullback by making borrowing more expensive?
Conversely, should the Fed resist compounding the turmoil from an AI pullback by rejecting a rate hike that could worsen a collapse? And to the extent that inflationary pressures have mainly other sources such as the Iran war, should the Fed not be distracted by AI at all?
All of this will be the subject of intense discussion at the FOMC meeting today and tomorrow morning. The policy, to be announced Wednesday afternoon, is likely to be a split decision, which is never great for market confidence.
As always, the collateral damage from higher rates falls on people who have nothing to do with the Iran war or the AI hype—small businesses, farmers, student debtors, and families seeking mortgages.
Fed decisions on rate hikes are invariably fraught, this one more than most.
