The Fed’s AI Puzzle: Will High Rates Slow the Boom?
For months, a common view of the artificial-intelligence boom has been that it is propping up the U.S. economy and it is too big and too flush with cash to care about interest rates. Federal Reserve Chairman Kevin Warsh said Wednesday he wasn’t so sure about either assumption. (…)
“There was a narrative for quite a while, maybe even in this room over the course of the last several press conferences,” that tighter monetary policy is “not going to have any effect on AI because the returns that investors are expecting are so different,” Warsh said. “I was skeptical of that view. Interest rates get in the cracks. Interest rates affect, directly or indirectly, almost everything.”
And since the Fed raised rates last month, there was evidence investors had become more discriminating about their investments, Warsh said, pointing to how borrowing costs for some riskier companies have jumped. (…)
Warsh’s remarks on AI bear on the question of how high rates ultimately need to go, and the answer may depend on how much the technology sector responds to borrowing costs. The case that it is highly insensitive to modest increases in rates rests on the assumption that firms expect returns large enough to dwarf the cost of money, and they see the contest as winner-take-all. “You want to be one of the winners, and that means you’ve got to get there first,” said William English, a former Fed economist now at the Yale School of Management.
If the boom shrugs off higher borrowing costs, the Fed would have to throttle housing, commercial real estate, small businesses, low- to middle-income consumers and other rate-sensitive sectors that weren’t big sources of inflation to begin with. (…)
“The idea that there’s no interest-rate sensitivity from anything related to AI, to me, is very extreme,” said Marc Giannoni, chief U.S. economist at Barclays. The largest tech companies may not have to borrow to pay for their spending, but for data-center operators and other firms building alongside them that do, “interest rates on their debt is a big factor,” he said.
The Fed’s challenge is that the boom as a whole can look unfazed while strains build at the edges. As more of the build-out is financed with debt, higher rates reach it through credit markets, hitting the weakest borrowers first and the cash-rich giants last. Each increase might seem to do little until financial conditions suddenly crack. (…)
Warsh’s second position cuts the other way. “It is convenient to say that the strength of the economy is all about this new technology wave,” he said. In fact, business investment is “not just strong, but it is broadening.”
Warsh was quick to note that he doesn’t see strong growth as something that would necessarily push up inflation, which would justify higher interest rates.
“He’s basically saying, ‘We need to do more, but it may not be all that much more,’ ” said Reinhart.
Still, Reinhart thinks the risks lean toward the Fed having to do more than it thinks in the short run, in part because energy and commodity prices appear to be settling in at a higher level. “Other prices are going to have to catch up to that, so they may find out that inflation is more durable, in which case, they get impatient in 2027 and have to tighten more,” he said.
Richard Bernstein at Janus Henderson last week built a case suggesting that secular inflation may be what’s in store after 30 years of disinflation.
His 2 main supporting charts:
- The US is now importing inflation: core import prices are rising faster than core CPI.
- Businesses are generally raising prices at a pace even higher than pre-NAFTA and pre-globalization.
This Yardeni chart shows that US businesses are raising prices because cost inflation is very high:
The October Flash PMI confirms September’s:
- US economic growth is broadening and accelerating to “booming conditions”.
- Employment growth is also accelerating, “at the fastest rate since June 2022”.
The Atlanta Fed composition-adjusted wage tracker pinned the low point in overall wage growth at 3.5% last April. It was 3.9% in August. Wage growth for job switchers also troughed in April at 3.7%. It jumped to 4.7% in August. - Corporate costs are also surging due to “material shortages, low stock levels, overloaded suppliers, labour shortages, rising back orders and shipping or import delays”.
- Strong demand allows businesses to broadly boost selling prices.
From the Atlanta Fed survey of 1500 senior finance and managerial businesspeople Oct. 12-23:
BTW: General Motors Co. last week said that worsening inflation will add about $400 million in additional expenses this year, citing record copper prices and key steel products at a four-year high. Ford said commodity inflation will be a nearly $2.5 billion headwind in 2026, up from its previous forecast for just above $2 billion. (Bloomberg)
As John Authers observed,
In September, when the Fed raised rates, economic activity was increasing at a “solid” pace. Now, it’s growing at a “strong” pace — so the Fed thinks the economy is accelerating further, despite that hike. (…)
Once Warsh’s press conference — which you can see here — reached its Q&A section, Colby Smith of the New York Times started by asking exactly that: “Why not just raise rates today?”
Warsh said that he’d expected the question. His response lasted three minutes and 16 seconds. He never came close to answering it. Among the lines he offered during his ramble:
- “We’ve doubled down on the 2% target.” [It’s been in place informally since 1996 and formally since 2012.]
- “We’ve laid out our framework in Jackson Hole.” [That’s what central bankers do when they’re in Wyoming.]
- “We didn’t just talk about acting. In September we acted.” [We knew that — the question was why they didn’t act again in October.]
- “The period right in front of us is information-rich.” [More so than other periods? Or is this code for knowing the midterm results by December?]
- “We interrogated reality.” [Good, but it would be alarming if the Fed didn’t do that.]
(…) his last response made perhaps his most interesting statement: “The goal isn’t to throw sand in the the gears of the economy and throw people out of work.” Again, it would have been very big news if he had said the opposite. But many took his emphasis and choice of words as a “tell” that this Fed isn’t prepared to risk forcing a recession. (…)
I think that Ed Yardeni highlighted the most interesting part: “Warsh disputed that robust growth necessarily implies overheating: “That isn’t the judgment of most of my colleagues.” Improving productivity, much of it predating recent AI advances, may have raised potential growth without fueling inflation.”
Ed adds:
We agree that September’s hike “removed a dose of accommodation,” but believe another 50bps is needed to remove the rest. The Fed doesn’t need to throw sand in the economy’s gears. It just needs to take its foot off the accelerator. We wouldn’t rule out a 50bps hike in December.
Goldman: “We continue to expect a second and final hike in December. A third hike in March is also possible if inflation comes in higher than we expect.”
Authers continues:
Overall market reaction was tame, but a rise in market-based inflation expectations, which had been under control, suggest that Fed credibility was coming into question:
The last two spikes in expectations can be attributed to policy own-goals by the administration; this one looks like the Fed’s fault.
As for the stock market, the juxtaposition between the reaction to Warsh’s words and the results from Alphabet Inc. and Microsoft Corp. tended to confirm that these days, hyperscalers are of macroeconomic importance:
Speaking of GM above:
Yesterday, General Motors announced plans to decamp from the venerable bourse after a 115-year stint, shifting its listing to Nasdaq as of Nov. 17. “GM’s customer-focused, technology-driven strategy is creating value for our stockholders, making Nasdaq a natural home for our listing as we grow,” CFO Paul Jacobson stated.
Instructively, the press release noted that the move renders GM eligible for inclusion in the Nasdaq 100 Index.
Though the legacy automaker doesn’t exactly look the part, with shares changing hands at six times forward earnings versus 26 times for the tech-centric gauge, and three-year projected earnings growth of only 18% versus 52% for the median NDX member (hat tip to Bloomberg’s Liam Denning), that prospect helped put some spring into GM investors’ step. Shares advanced by nearly 6% on Tuesday, good for their strongest daily showing in an even nine months. (ADG)
That should make every tech investor happy to know that buying NDX shares provides exposure to GM.
BoC Policy Monitor: Up, up and away
(…) Supporting the move was “higher and more persistent” inflation and risk management considerations aimed at preventing the spread of energy prices more broadly. Further, the economy was judged to be on firmer footing and proving more resilient, consistent with earlier comments from the Governor.
While there was an acknowledgement that the economy could slow in Q4 due to tariffs, this doesn’t even dent the GDP growth outlook which was revised up at least two ticks in 2026, 2027 and 2028.
But most striking was the Bank’s fundamental rethink on the inflation outlook, underscored by a 1.1%-pt upward revision to their 2027 CPI projection. To be clear, price stability is not expected to be achieved anytime soon. (…) Macklem and Rogers indicated as much when they noted there was a strong consensus around the decision.
With the tightening cycle underway, the attention turns to the next meeting on December 9th. The communique fails to explicitly tee up a follow-on move and even suggests that they would “proceed carefully”. But judging by their updated forecasts and fundamental rethink on inflation, it’s hard to make the case to go slowly.
Ultimately, incoming data and the evolving balance of risks will guide the Bank, but baring a de-escalation in the Middle East and/or a material escalation in the Canada-US trade war, we’d lean toward them hiking again in December.
And as we explored recently, the Bank has a strong tendency to begin tightening cycles with consecutives hikes. (…)
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American tariffs on Canada were particularly counterproductive because so many Canadian goods are intermediate inputs for American factories, and Canada is one of the few countries where the US actually ran a surplus in manufactured goods. The damage on the American side of the border has been larger, even if Canada’s situation is more existential because its economy is proportionally smaller.
CAPITAL IS CAPITAL
Wall Street’s AI Debt Machine Is Starting to Choke on Supply
A new anxiety is gripping Wall Street as it bankrolls the vast network of data centers and chips behind the artificial intelligence boom: Early signs suggest that the credit market is approaching the limits of how much more debt it can absorb.
One after another, yields are soaring into the double digits on bonds and loans funding the AI infrastructure buildout. Bankers are finding it more difficult to offload risk to insurers and other investors. Elon Musk himself warned the other day that hundreds of so-called neoclouds risk going under as firms get cut off from fresh financing. (…)
The concern is that, with trillions more in debt needed over the coming years, there appears to be a growing disconnect between what Silicon Valley’s top executives believe can be raised, what financiers say they can deliver, and what money managers are willing to take down.
“When you have such a large quantum of debt coming, at some point the challenge could be less about finding an investment-grade backstop, and more about finding the actual buyers willing to absorb more of the risk coming from the same handful of investment-grade backstop providers,” said Citadel analyst Tucker Roberts.
In conversations with more than 30 bankers, money managers, private equity executives and others involved in recent and current data center financing talks, all acknowledged that raising cash has become significantly more difficult than it was just months ago.
A key reason is the growing concern among investors over cancellation rights and other contractual off-ramps that could leave them exposed if a major customer walks away. (…)
Another major challenge has been offloading risk to free up capacity for new deals.
The head of technology, media and telecom lending at a large European bank said the firm is approaching the limit of what it can lend to the sector given its already sizable exposure. Selling the debt or transferring the risk can take five months, limiting its ability to recycle capital into new financing, the person said, asking not to be identified discussing internal matters.
Some insurers, which often take on a share of the credit risk on such loans, were indicating months ago that they were nearing or had already reached their limits on data center exposure, according to a survey from Willis Towers Watson.
Data center operators are also being hurt by higher interest rates, particularly in the asset-backed securities market, where rental income is often locked in under long-term leases.
“At the beginning of 2026, the highest-rated data center bonds offered yields below 5%. Today similar bonds are yielding closer to 7%, and that increase matters enormously for companies trying to finance multibillion-dollar facilities,” Morgan Stanley ABS strategist Carolyn Campbell said in a podcast earlier this month. “When borrowing costs approach 8%, issuing these bonds becomes significantly more challenging.” (…)
Oaktree Co-Chief Executive Officer Armen Panossian said the firm has become “very, very cautious” about the structure and quality of assets backing data-center deals, citing risks from technological change and construction delays to permitting hurdles and access to power.
“We’re seeing in the last several weeks a widening of those spreads that indicates that the credit markets are becoming either full, saturated of the loans that are out there, or concerned about some of these factors that are lurking in the background,” Panossian said in a recent client webcast. (…)
At least 18 data-center financings across the junk-bond and leveraged loan markets now carry double-digit yields, according to data compiled by Bloomberg. Even new deals are feeling the strain. JPMorgan Chase & Co. and Goldman Sachs Group Inc. had to offer steeper discounts and higher interest payments to drum up demand for neocloud Volta Infrastructure Holdings Ltd.’s $5 billion syndicated loan, pushing its yield above 11%.
Credit investors are starting to recognize that much of the debt neoclouds still need to raise may ultimately depend on backing from tech giants already burdened with their own massive financing needs, Citadel’s Roberts said. Whether via explicit guarantees, long-term contracts or simply the expectation that they’ll step in if projects run into trouble, chipmakers and hyperscalers could find themselves shouldering an increasing share of the risk, he added. (…)
The pressure is showing up in their borrowing costs, too. The average yield on bonds in the Bloomberg Investment Grade Technology Index has surged to about 6%, about 1.4 percentage points higher than a year ago.
“The banks and companies raising capital have been relatively transparent that they do not care about pricing it wider and marking down paper you’ve bought,” said John Yovanovic, co-head of leveraged finance at MetLife Investment Management. “So you’re being asked to finance a deal that has likelihood of being less than par in the near term, even when it has attractive long returns. Who wants to step in front of that?” (…)
KKR & Co. is steering clear of data centers in remote locations amid concerns that the facilities could be difficult to repurpose once their leases expire, according to a person familiar with the matter, while Carlyle Group Inc. has passed on a number of recent deals as it emphasizes portfolio diversification and selectivity.
“People are just getting more conscious of their concentration risk in the sector,” said Felicity Juckes at TwentyFour Asset Management. Investors “are going to be increasingly picky.”
Washington, we have a problem!
Vance Reaches Out to Iranian Hard-Liner in Bid to Restart Peace Talks
Vance sent a letter to Mohsen Rezaei, the secretary of Iran’s top security body, the Supreme National Security Council, and previously Iran’s longest-serving commander of the Islamic Revolutionary Guard Corps, according to the people. (…)
Vance is testing whether Tehran and Washington could find enough common ground to persuade Trump not to give a final order for a short, intense attack on Iran in the coming weeks. (…)
Vance’s letter and subsequent discussions between U.S. and Iranian officials haven’t included specifics for a peace proposal, but instead focused on a possible framework for negotiations, said a person familiar with the matter. Rezaei said last week that Iran wouldn’t negotiate with Washington until specific core demands were met. (…)
Rezaei, who led the Revolutionary Guard through Iran’s 1980s war with Iraq, has emerged as an influential yet hawkish voice amid looming U.S. threats. Earlier this month, he said Tehran could target the United Arab Emirates, which has largely escaped being attacked since late spring, as well as data centers and internet cables across the region.
On Sunday, Rezaei took the rare step of meeting with security chiefs from Saudi Arabia, Pakistan and Turkey in Tehran, as all sides sought de-escalation. Most previous visits involved diplomats instead. (…)
The U.S. insists upon upfront nuclear concessions by Iran while Tehran demands immediate economic relief. (…)
Axios wrote: “The letter to Mohsen Rezaei, which focused on the possibility of restarting negotiations between the U.S. and Iran, is the most senior-level outreach by the U.S. to Iran in several months.”
The White House said Trump approved the letter. Not sure he read it.
Trump told reporters Wednesday that Vance’s letter was about helping Iran obtain needed medical supplies. “Basically, it’s getting supplies in to help people that are not well,” he said.
So many people are not well.
Yesterday: Pezeshkian: Regional States Can Resolve Challenges Without US – Tasnim (See my yesterday post about that)
Maybe that’s “the other side” Bessent is talking about: “Bessent also reiterated that both he and Trump believe that once the US gets “on the other side” of the Iran conflict, the oil market will be well supplied. He’s argued that that will help alleviate inflation and bring down borrowing costs.”
The last two spikes in expectations can be attributed to policy own-goals by the administration; this one looks like the Fed’s fault.





