Why the AI boom makes inflation harder to tame

By David Goldman, CNN

(CNN) — The US economy may have a new problem: It’s too strong.

America’s cost-of-living concerns and a bond market meltdown aren’t functions of a sputtering economy that’s running out of gas. Quite the opposite.

Prices and interest rates are rising too quickly for comfort for three primary reasons: the global energy shock from wars in Iran and Ukraine, an escalating trade war and an unprecedented corporate spending spree on artificial intelligence.

Policy decisions (wars and tariffs) are garnering significant attention as gas and diesel prices surge and a US trade war buds with Canada. But economists are increasingly concerned about the mind-boggling amounts of Big Tech money committed to the AI data center buildout.

The many trillions of dollars expected to be spent on AI infrastructure over the next several years would facilitate a fundamental reshaping of the US economy. All that spending risks overheating the economy at a time when it’s already running hot: The unemployment rate is low, and consumer spending is strong.

That’s a recipe for higher inflation. And inflation is already too high.

Nonstop spending spree

It’s hard to overstate how extraordinarily massive the AI spending boom has become after it rapidly exploded onto the scene.

AI infrastructure spending – on data centers and the chips and servers that go inside them – is expected to hit around $1 trillion this year, according to JPMorgan. That’s more than the federal government spends annually on the military.

But we’re just in the beginning stages of the AI buildout.

Through 2032, that number will reach $10.3 trillion, claims Columbia University economist Stijn Van Nieuwerburgh in a paper published Wednesday by the Brookings Institution. For perspective: Remember the $1.2 trillion bipartisan infrastructure law signed by then-President Joe Biden in 2021 that became an inflation bugaboo? Projected AI expenditures are equivalent to spending every last dollar allocated from one of those bills each year over the course of a decade.

That spending – just on AI infrastructure, not on the technology itself – is on pace to comprise 1.9% of all US economic activity this year, according to Goldman Sachs. But that’s forecast to effectively double: On average, AI infrastructure spending will top 3.6% of America’s gross domestic product each year through 2032, according to Van Nieuwerburgh.

That projection is gargantuan, equivalent to the output from mammoth American economic engines, such as transportation, restaurants and hotels. But those are all mature industries. Even more shockingly, Van Nieuwerburgh projects the AI buildout will make up a larger share of total US economic output than any of America’s previous investment booms – bigger than when the United States built its canals, railroads, electrical grid, highways and telecommunications networks.

“All of this will result in a structural transformation of the US economy to one organized around artificial intelligence,” said Joe Brusuelas, chief economist at RSM US.

Inflation nation

OK, so it’s big. Really big.

There’s nothing inherently wrong with that. If the tech companies are building something customers want, that wouldn’t necessarily create an inflation problem. Supply and demand would be in balance. And if AI yields its promised productivity gains, that should prevent inflation from rising out of control.

But companies are still very much in the “if you build it” phase of this “Field of Dreams” analogy. The promised revolution is still a long way away. The foundation needs to be constructed first.

In the meantime, the massive AI spending supercycle has created a developing economic problem.

“A demand shock is creating inflation,” said Daniel Yue, who teaches about the economic effects of AI at Georgia Tech.

Data center spending is already causing inflation to rise, because of off-the-charts demand for memory and storage chips, building supplies, electricity and laborers – construction workers, plumbers and electricians – to build the data centers. Prices for certain goods and services are going through the roof.

Supply constraints, regulations, the immigration crackdown, permitting issues and many other practical realities have prevented all those goods and labor supplies from coming into balance with the extreme demand. And all of that is starting to permeate throughout the economy, showing up particularly in labor shortages and higher costs for building supplies across other industries.

That has raised alarm bells for Austan Goolsbee, president of the Federal Reserve Bank of Chicago.

In a speech in London on September 21, Goolsbee said he is closely watching whether “AI data center construction is spilling out of its own lane” and creating more economic activity than the economy can absorb. If so, it could be a sign that demand is overheating.

“And if demand overheats, there is no ambiguity about how the Fed needs to respond,” Goolsbee said, predicting the central bank would have to further raise its target interest rate to help bring inflation down.

Too hot to handle

The massive amount of AI spending is coming on top of an already hot economy that never cooled down after its post-pandemic sugar rush.

US manufacturing activity in August was the highest recorded since July 2021, according to a Purchasing Managers’ Index reported by S&P Global last week. Unemployment is at 4.1%, a level economists consider “full employment.” US retail sales surged by 1.2% in August.

Those are not signs of a weak economy.

In large part, the already-hot economy has been fueled by an AI-fueled stock market boom. The eight most valuable stocks in the S&P 500 are all effectively AI companies, and they make up a combined 38.8% of the total value of the stock market.

Portfolio gains for wealthier investors gave permission to the top 40% of earners to keep spending, despite all the cost-of-living concerns Americans in the lower-income thresholds have faced. Those higher earners are responsible for 70% of all consumer spending, according to the New York Fed.

That’s given companies the ability to raise prices, particularly as they contend with record diesel and shipping costs on top of a resurgence in tariffs.

That’s why inflation, which has sat well above the Fed’s 2% target for more than five years, remains a problem that won’t be easily solved, even if the Iran war ended and tariffs went away.

“Anything that touches AI is on fire – tech investment, data center construction, even manufacturing of parts to go into these data centers,” said Heather Long, chief economist at Navy Federal Credit Union. “But most of Main Street is just getting the cost increases without much of the financial gain. Rising borrowing costs only compound that feeling of someone is getting rich here, and it’s not me.”

Those rising bond yields and higher target rates from the Fed are increasing the cost of borrowing for businesses, too. That should, in theory, slow down spending and ultimately reduce inflation.

There’s a problem with that premise, though: AI is a runaway freight train.

“To be sure, rising borrowing costs may lead to some second thoughts and cancellations in planned business investment,” said Oren Klachkin, an economist at Nationwide. “But AI investment is rate-insensitive and unlikely to slow down soon.”

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