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The Federal Reserve's primary tool, raising interest rates, is a blunt instrument. It's used to slow down the entire economy (reduce overall demand) to offset specific inflationary problems it can't directly control, such as tariffs, oil supply shocks, or high energy consumption from new technologies like AI.
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A spike in oil prices could keep CPI inflation above 3%. In this environment, the Fed cannot cut rates to support a weakening economy, as doing so would spook bond traders, risk higher long-term rates, and make financial conditions even tighter, effectively taking them 'off the table.'
Historical precedent is unequivocal: central banks do not cut interest rates in response to an oil shock. Despite the negative growth impact, their primary concern is preventing the initial price spike from embedding into long-term inflation expectations. Market hopes for easing are contrary to all historical data.
Recent inflation was primarily driven by fiscal spending, not the bank-lending credit booms of the 1970s. The Fed’s main tool—raising interest rates—is designed to curb bank lending. This creates a mismatch where the Fed is slowing the private sector to counteract a problem created by the public sector.
In the short-term, AI's economic impact is inflationary. The surge in demand from data center investments and stock market wealth effects is outpacing the supply-side gains from productivity. This imbalance argues for higher, not lower, interest rates to manage current inflation.
Raising interest rates is a tool to cool an over-exuberant economy. It is completely ineffective against inflation driven by external supply shocks, such as an energy crisis caused by war. No amount of rate hikes can solve a geopolitical problem, meaning central banks are using the wrong tool for the job.
The Federal Reserve is in a 'pickle,' using interest rate hikes—a tool that curbs demand—to fight inflation that is largely driven by supply-side factors like energy costs and supply chain disruptions. This approach may not effectively address the root causes of rising prices and primarily impacts already soft, interest-rate-sensitive sectors of the economy.
Traditional monetary policy tools like interest rate hikes are poorly suited to combat modern inflation drivers. They fail to address price pressures from specific industrial booms (e.g., AI memory chips) or the inflationary effects of large, persistent government deficit spending.
Certain sectors, like AI infrastructure and air travel, exhibit highly inelastic demand. Companies and consumers continue spending despite huge price hikes, suggesting the Fed's interest rate tool may be ineffective at cooling these key inflationary drivers.
From a short-term policy perspective, the source of excess demand doesn't matter. Whether it's a housing boom, consumer spending, or an AI investment surge, if it threatens to overheat the economy, the Fed's response is the same: raise interest rates. The long-term productive benefits of investment are a separate consideration.
When oil prices spike, they create widespread inflation. This prevents the Fed from using its primary tool—cutting interest rates—to help a struggling economy, as doing so would risk runaway inflation. The Fed is effectively caged until oil prices fall, leaving the market without its usual safety net.
