Kevin Warsh's Federal Reserve Is Split on Artificial Intelligence, and It Could Have Dire Consequences for Investors

Few technologies have had as big an impact on both everyday life and financial markets in recent years as generative artificial intelligence (AI). AI services powered by large language models have permeated the workplace, with many businesses suggesting AI investments will pay off in greater worker productivity. Meanwhile, hyperscalers such as Alphabet and Microsoft, are spending hundreds of billions of dollars to build new data centers and outfit them with chips and networking equipment to train and run their AI models.

There's no doubt AI has already had a huge impact, but how it will affect our future is at the core of a recent debate within the Federal Open Market Committee (FOMC). Chairman Kevin Warsh was appointed earlier this year to oversee the board responsible for the central bank's monetary policy, with the dual mandate of price stability and full employment. At the most recent meeting in June, the governors noted that AI is having a significant impact on inflation. The debate within the group, however, is what the long-term impact will be and what to do about it.

Federal Reserve Chair Kevin Warsh. Image source: Federal Reserve.

How will artificial intelligence impact pricing?

It's hard to argue that the surging demand for artificial intelligence hasn't put upward pressure on prices for many goods and services in the country.

That's most plainly seen in technology products. Apple even caved to the pricing pressure on its components earlier this year, announcing a round of price hikes for its products, following several other consumer electronics companies.

The staggering energy requirements for AI data centers have also put upward pressure on electricity pricing. Electricity prices were 4% higher in June than a year ago, ahead of the overall consumer price index (CPI) numbers. With the broader impact of energy pricing on goods and services, it's only a matter of time until those costs trickle through to other line items in the Bureau of Labor Statistics' monthly inflation report.

The FOMC minutes from the June meeting highlight the debate about how the participants view the impact of AI infrastructure spending on pricing.

"Most participants remarked that growth in economic activity that exceeded that of potential output, owing in part to strong AI business investment, could contribute to more persistent inflationary pressures," the minutes read. In other words, the demand from AI infrastructure and power requirements currently exceeds the output capacity of the economy, leading to higher pricing that could persist long-term if the Fed doesn't act to cool down activity. A demand shock like the AI build-out is much more easily handled by monetary policy than a supply shock like the one we saw earlier this year with the war in Iran.

On the other hand, "some participants remarked that productivity gains associated with AI adoption would eventually reduce production costs and increase aggregate supply, which should put downward pressure on inflation," according to the minutes. That's the crux of the argument against implementing monetary policy to curb the AI-related demand shock. The very technology driving big increases in demand for goods could also produce a huge increase in supply, offsetting the impact on prices. In fact, Chairman Warsh argues AI will be disinflationary over the long run thanks to the productivity increase it enables.

The Fed is walking a tightrope

The Fed needs to find a balance between overly restricting the AI build-out and facilitating it to the point of causing a bubble. That's far easier said than done, especially if the near-term consequences push it further away from its goals, while the long-term potential could help fulfill its dual mandate of stable prices and maximum employment.

However, some members of the Fed note that monetary policy decisions shouldn't be based on speculation. It's unknown how AI will ultimately affect productivity and if the supply growth promised by businesses implementing AI solutions will ever materialize to the extent they expect. What's knowable is how the AI infrastructure demand is influencing prices right now and in the near future. That's why the market now expects the Fed to raise interest rates multiple times before the end of the year.

Tighter monetary policy could lead to slower earnings growth for both large companies, like those in the S&P 500 (SNPINDEX: ^GSPC) investing heavily in artificial intelligence, and smaller companies, like those in the Russell 2000, which are more reliant on debt for growth. Additionally, higher interest rates for longer would lead to lower equity pricing, as investors demand a higher discount rate for future earnings in response to rising interest rates on less risky debt investments. But if the policies ultimately produce slower inflation and a healthier economic balance, it could lead to sustained growth in equity prices (albeit slower growth).

If the Fed makes a misstep, raising rates when it doesn't need to or vice versa, or waiting too long to act in one direction or another, it could have dire consequences for investors. Lower interest rates could lead to a sharp rise in inflation or a bubble in AI stocks. On the other side of the equation, over-tightening could weigh on stock prices and prevent the market from climbing higher.

While the cost of capital is an important input into any business, investors who focus on companies with excellent operations and outstanding opportunities to expand those operations over the long run will find some great investments. If stocks suffer a downturn, you might have an opportunity to buy those companies at a discount.

Adam Levy has positions in Apple. The Motley Fool has positions in and recommends Apple. The Motley Fool has a disclosure policy.