AI Investment Frenzy Emerges As Overlooked Driver of Inflation Risk

The Iran energy story may be masking a bigger inflation worry. The AI boom is building a head of steam in prices under the surface, and it’s a boom that will likely outlast any hiatus in the Gulf. Everyone, not least the major central banks, is watching every twitch of crude prices around the Iran conflict for the cost-of-living hit. Yet the eye-watering AI investment frenzy is also stoking construction, factory activity and potentially prices, as bottlenecks and shortages in memory chips, tech equipment and software costs emerge worldwide.

This whopping business investment outlay is expected to exceed $800 billion this year alone and run into the trillions over the years ahead. It is already moving company earnings, projections and stock prices, as well as aggregate GDP. The direct effects on consumer prices are being pored over closely too.

Public concern about AI centers mostly on its long-term impact on jobs and the possible deflationary effects that could follow. Few have yet focused on the inflation pressure that likely comes first.

A curious and detailed Federal Reserve paper late last month, co-authored by then-Fed board governor and arch dove Stephen Miran, spotlights one area where the AI boom may already be fueling consumer prices, before dissecting the readings to expose what may prove to be measurement errors.

It examined a sharp rise in the “Computer Software and Accessories” component of the Fed’s preferred personal consumption expenditures (PCE) inflation gauge and threw up remarkable readings as the AI investment surge unfolds. Although the category carries a relatively small weighting in the overall consumer price basket, it recorded an unprecedented rise between November and March. 

The core goods component of the PCE rose 5.5 percent annualized over those four months, with software accounting for 2.8 percentage points of that increase, or more than half. The contribution was more than nine standard deviations above historical averages, it says. The research made clear a large driver of this was a 70 percent increase in flash drives, or memory sticks, over a period when memory chip shortages were building in South Korea due to gigantic chip demand pressures around the global data center build.

The paper then argues that the prices recorded by statisticians may be misleading, unable to keep pace with rapid technological development and quality upgrades, and possibly imputed incorrectly.

The PCE calculation draws inputs directly from the consumer price index (CPI), and a mismatch between PCE and CPI categories alone may account for a quarter of the outsize gain. Together with other measurement errors, up to half the gain may be overstated.

Not everyone is ready to dismiss these pressures as statistical noise. Whatever the doubts about methodology, the price rises are very real. And that is before considering how AI-driven input costs ripple through other chip-intensive products, from autos to energy. “The AI Capex Boom is inflationary,” Deutsche Bank strategist George Saravelos said in a note on Monday. “There is no compelling evidence of an impact on the labor market but a lot of evidence of demand-side inflation. AI is currently putting upward, not downward, pressure on rates.” Morgan Stanley’s baseline differs and its view of US inflation is relatively sanguine compared with an increasingly hawkish market take. Even so, the bank’s alternate scenarios flag the risk that AI heat feeds price rises more aggressively, including the possibility that a “combination of AI-related price pressures through categories like chips, memory, semiconductors, and software means core inflation firms and the Fed hikes.”—Reuters What’s more, Morgan Stanley also outlines the possibility that AI “animal spirits” tighten the labor market as the broader economy accelerates. In that scenario, headline inflation could end the year where it is now at just under 4 percent, with core inflation picking up - likely prompting the Fed to consider up to 100 basis points in hikes. Morgan Stanley puts the probability at 15 percent.