‘Inflationary surge’: Fed economists warn that AI hype is overheating the economy, regardless of whether the technology ultimately delivers

(SeaPRwire) –   While many Americans feel anxious about AI taking their jobs, business leaders and tech enthusiasts continue to champion its potential — an optimistic view that is shared across both Silicon Valley and Wall Street. But all of this hype could actually harm the economy in the short run.

In a blog post from the St. Louis Federal Reserve Bank, economists argue that optimism around AI can drag on productivity and act as a “news shock” that alters how households and businesses make decisions. The authors, Fed economists Miguel Faria-e-Castro and Serdar Ozkan, explain that when households encounter a news shock like the spread of AI adoption, they read it as a signal of future pay increases, choosing to spend more today because they expect more income later. The same logic applies to businesses: if you buy into the promise of a transformative innovation that cuts labor costs and lifts productivity, you will ramp up investment in the technology. All this extra enthusiasm drives short-term inflation, as total demand outpaces available supply.

“Together, these forces create an inflationary surge in aggregate demand — the defining feature of the news shock’s initial phase,” the post’s authors wrote.

AI hype is everywhere. It appeared in tech entrepreneur Matt Shumer’s viral February post, which compared the current pace of AI development to the month before the COVID pandemic upended the entire world. It shapes the views and public statements of top tech leaders, from Elon Musk to Dario Amodei to Mustafa Suleyman. The technology is now making its way into the daily work of employees at law firms, startups, and consulting firms.

Expected productivity gains and the dot-com bubble

While consumer prices have stabilized after hitting a peak of roughly 9% in June 2022, inflation remains stubbornly higher than pre-pandemic levels. In the most recent reading, the consumer price index rose 0.3% from the prior month, and 2.4% year-over-year. Though it is hard to confirm that AI hype is pushing prices higher, the researchers argue the technology could be driving up current price levels. They caution, however, that their assessment is only qualitative: they can predict inflation could rise in the short term, but they cannot forecast exactly how large that increase will be.

The economists compare current AI hype to the optimism around dot-com technology at the turn of the 21st century. “Computers are everywhere except in the productivity data,” Ozkan said, paraphrasing Nobel laureate Robert Solow, who commented on IT improvements in the 1980s — an observation that held true again during the dot-com bubble. In both the dot-com era and today’s AI hype cycle, there is a gap between widespread technological optimism and actual economic results. During the dot-com era, the economists explain, promised gains never showed up in economic data, which ultimately led the bubble to burst.

AI seems to be everywhere today, so it is reasonable to assume it is already boosting economic growth. But the actual economic returns from the technology have not yet emerged. As the authors note, TFP growth has averaged just 1.11% per year since ChatGPT launched in 2022. That is below the historical average of 1.23%, according to data from the Federal Reserve Bank of San Francisco.

Even so, the authors lay out two possible scenarios for how AI hype could impact the economy. Everything depends on whether reality eventually matches the current hype. If the expected gains do materialize — if businesses become more productive because of AI — the economy will see faster output growth, which will be paired with falling inflation as the economy’s potential output expands.

On the other hand, if those gains never materialize, the economy could fall into a “prolonged period of weak growth and persistently elevated inflation.”

But there are major differences between the two hype cycles. For one, during the dot-com era, most of the new infrastructure that was built — such as fiber-optic cables — remained underused for years. Today, demand for AI’s core infrastructure, data centers, is extremely high, with vacancy rates of just 1.4%, according to commercial real estate firm CBRE. Even so, infrastructure buildout continues, with a small concentrated group of tech firms investing a massive $700 billion in AI infrastructure.

But the economists caution that there is still high uncertainty around AI’s eventual payoff. “We don’t really know what those productivity gains will end up being,” Faria-e-Castro said. “We don’t know when they will materialize — or even if they will materialize at all.”