How the Federal Reserve Could Inflate or Pop an AI Bubble

Concerns about an AI bubble have some on Wall Street warily eyeing Silicon Valley, but others say they’re looking in the wrong direction. Washington, D.C.—specifically the Eccles Building, where the Federal Open Market Committee sets monetary policy—is where the fate of an AI bubble may be decided, they say. 

“I think you’re going to have a very hard time popping a bubble when the Fed is cutting rates,” said Jeff deGraaf, Chair and Head of Technical Research at Renaissance Macro Research, on a recent episode of the firm’s weekly Youtube series. The Dotcom bubble, the U.S. housing bubble, and the Japanese bubble of the late 1980s all popped either while or shortly after central banks hiked rates, according to deGraaf. 

Artificial intelligence has propelled stocks to record highs this year, but recent developments have raised some red flags. A series of circular deals by the likes of AI bellwethers Nvidia (NVDA) and OpenAI have drawn comparisons to the vendor financing agreements that fueled bubbles in the 1990s. The Magnificent Seven account for 35% of the S&P 500, evidence of an increasingly concentrated stock market. And the benchmark index’s price-to-earnings ratio isn’t far off the Dotcom Bubble’s peak.

“I think it’s early,” DeGraaf said of a potential AI bubble, evidence of which he argued doesn’t appear to be “rampant” yet. Though, he warned, “you could have [a] world play out where the economy softens, the Fed is forced to get more aggressive, and the market absolutely goes into the stratosphere because they’re looking at the liquidity. And I think that’s a big disconnect that people don’t appreciate.”

UBS analysts made a similar case last month. The Fed, they noted, raised interest rates by 1.75 percentage points from June 1999 and May 2000, and those rate hikes were a primary catalyst for the Dotcom bubble’s bursting in early 2000.

“The current monetary policy environment is very different from back then,” the analysts wrote. The Fed cut interest rates for the second consecutive meeting on Wednesday, and the consensus on Wall Street is that the only direction interest rates are headed anytime soon is lower.

Interest Rate Outlook Is Murky

Policymakers are walking a tightrope as they pursue both ends of their mandate to control inflation and promote maximum employment. Hiring ground to a halt in recent months while inflation accelerated to its highest rate since January. Fed officials have recently expressed openness to cutting interest rates to support the weakening labor market despite inflation concerns. 

Fed Chair Jerome Powell on Wednesday reminded investors that the trajectory of interest rates may be less predictable than expected. “A further reduction in the policy rate at the December meeting is not a foregone conclusion—far from it,” said Powell.

For one, economists expect inflation to continue accelerating in the coming months, and consumers’ inflation expectations ticked up in October, which could set the stage for one-time price increases to become sustained inflation. On the other hand, a weak job market could hamper wage growth, relieving some inflationary pressure in the process. 

Analysts at LPL Financial also note that the reason behind interest rate cuts can matter as much for borrowing costs and liquidity as the cuts themselves. Cutting rates five times while inflation is stuck above the Fed’s 2% target “could send a signal that the central bank is prioritizing growth over inflation control,” which may raise long-term Treasury yields and, subsequently, interest rates on an array of consumer and commercial loans. On the flip side, if the Fed cuts rates less than investors expect, bond prices would likely fall, boosting yields and associated interest rates.

Powell on Wednesday expressed doubt that the Fed’s interest rate decisions would have much of an impact on the AI investment that’s at the heart of Wall Street’s bubble concerns. “I don’t think interest rates are an important part of the data center story,” he said. Rather, he added, investment is being funded by strong businesses at large companies acting on demand signals.