Should the Fed raise rates if demand is AI driven and Ai expected returns are potentially so high that Ai investment is interest rate insensitive? Yes! Let's ignore whether the current price pressure comes from AI demand or an energy supply shock and work through the general equilibrium effects of an AI investment demand shock alone with a thought experiment where a new technology creates inflation… Imagine a new miracle machine is invented. This machine is costly to build - we have to divert goods and services from consumption today to investment to build these machines. But if we invest a few percent of our output today and build these machines, the economy will produce much more output (100%+ increase) a few years in the future. How does the unexpected invention of these machines alter market prices and inflation today? First these new machines increase scarcity today because they consume resources to build but don’t deliver more output until the future. The return to building these machines is so high that firm's issue lots of stocks and bonds offering high expected returns to attract resources from other investment options or consumption. This moves real resources from consumption today into investment today. Second, we have a general equilibrium conflict if interest rates don't change. Humans are risk averse. We generally think about risk aversion as preferring a constant stream of consumption over a more variable stream with the same average (Prefer $1000 to a coin flip that pays $0 or $2000). But the human preference for smooth consumption works across time as well as across states of the world. Because of these new machines everyone now expects to be much richer in the future, and they prefer to smooth consumption by selling claims to their future consumption and using those sales to buy more consumption today. Think about what would happen if I told a worker who makes $100K and has a $1m stock portfolio that I was raising his income to $1m per year starting five years from now. That worker would not want to consume the same as before this news. He would want to move some of that future consumption to today so he could smooth consumption over time. i.e. he would sell his stock portfolio and consume more today. The worker can do this because he is one man and he can find others who will buy his stock (they consume less today to purchase stock and consume more in the future because they have more stock). But in the aggregate, we can’t all consume more today! Remember these machines don’t increase production until the future. Output today hasn't increased and some of our consumption today must now be invested in building these machines. To clear the market the real interest rate must go up sufficiently high that workers see such a high real return on savings that they are willing to work and consume less today even knowing that they will be very rich in the future. i.e. the return must be high enough that they are happy with a variable consumption stream. The general equilibrium effect is why interest rates must rise to finance the investment boom and the real increase in rates is made even worse by the desire of workers to smooth consumption by selling claims (bonds) to future consumption. Bonds aren’t time machines! They don’t move output across time. You and I could use a bond to smooth our consumption but in the aggregate we can’t all consume more today so rates have to rise until people are happy consuming much less today than in the future. So now we know real interest rates have to rise. How do we get there? We could just let rates rise. But if the short end is an administered rate (like Fed Funds) what would happen if the fed kept the rate fixed? The real rate has to increase but the nominal rate can’t move. Therefore, we would need expected deflation in the future or some other asset to offer much higher returns. Therefore, we need long bond prices to fall a lot, or we need the price of goods and services today to move up a lot relative to their prices in the future (or a combination of the two). If the Fed keeps the nominal short rate fixed and everyone wants to consume more today, the price of goods and services today must rise relative to the price of stocks and bonds or the price of goods and services in the future. i.e. inflation or long bond rout or a combination of both. We saw these dynamics during COVID when the government said don’t work and also gave sufficient income support that almost no one was poorer. People wanted to consume the same, but output was way down so the price of goods had to rise to clear the market. If the FED wants price stability they can arrest some of the price increase by increasing the nominal interest rate. This will make consumers that expect AI to make them much richer in the future happy to forgo more consumption today and prevent the rationing of today’s scarce resources via higher prices. This is a thought experiment to illustrate how interest rates increase can arrest inflation even when the demand for AI investment is so strong that it remains virtually unchanged in the face of the rate increase. In my opinion, there’s definitely some of these general equilibrium effect in play. We see it in security issuance to fund AI investment and the diversion of resources. But we also have a good old fashion energy shock as well. Whether we should raise interest rates because of that is another question.