Breitbart Business Digest: The Bond Market Is Already Doing Warsh's Work

The Return of the Price of Capital

What if the Bond Market Slows AI Even without the Fed?

In a newsletter published Tuesday, the Wall Street Journal‘s Greg Ip argues that investors who believe AI is immune to monetary tightening are kidding themselves. The Fed doesn’t have to make artificial intelligence unprofitable to stop the investment boom. All it would need to do is tighten financial conditions enough to make financing the boom unsustainable.

Ip is surely right about the vulnerability of the AI boom to higher interest rates and tighter financial conditions. But there’s no reason those conditions have to be imposed by the Fed. Capital markets can tighten financial conditions all on their own. Indeed, long-term interest rates have already been rising, and Federal Reserve Chairman Kevin Warsh thinks the AI investment boom itself is partly responsible.

At his September 16 press conference, Warsh was asked why long-term Treasury yields were climbing. He pointed to stronger economic growth and competition for capital from the technology giants building AI infrastructure.

“The so-called hyperscalers are out in the market raising funding,” Warsh explained. “And so the competition for capital is real.”

Fed Governor Christopher Waller made a similar argument at a Bloomberg event in New Delhi last week. Rising Treasury yields, Waller said, primarily reflect economic strength rather than mounting inflation expectations. He identified AI investment as one of the factors driving borrowing costs higher. And he said that was a good thing: “I’d rather have higher growth and higher yields than low growth and low yields.”

This is how capital markets are supposed to work. An increase in profitable investment opportunities raises demand for financing. The price of capital rises, encouraging more saving while discouraging investments whose prospective returns no longer justify their costs.

For years, economists worried that the so-called “natural rate” of interest had fallen to exceptionally low levels because the world—and China in particular—had too much saving and too few attractive investment opportunities. The AI revolution may be reversing that relationship.

An Emerging Consensus at the Fed

The idea that the natural rate of interest may be rising has been gaining ground among Federal Reserve officials.

Back in February, Fed Governor Lisa Cook observed that AI-related investment in data centers and semiconductors was soaring despite interest rates that remained elevated by the standards of the preceding two decades.

“With investment contributing to strong aggregate demand, it is possible that the current neutral rate is higher than before the pandemic,” Cook said in a speech to the National Association for Business Economics.

Fed Vice Chair Philip Jefferson developed the argument further in a July speech at Stanford University. Faster productivity growth, he explained, would increase the expected return on investment and demand for capital. Households anticipating higher future incomes might also save less.

Under those circumstances, Jefferson said, the natural interest rate would likely rise.

Of course, Jefferson and Cook are still Fed officials and talk like Fed officials. So they couched this talk of a rising natural rate with caveats. The eventual impact on equilibrium rates remains uncertain and so on. But the similarity of the direction of thought among Fed officials about the forces at work is striking. Warsh, Waller, Jefferson, and Cook are describing different aspects of the same transformation: AI is changing the demand for capital, and interest rates are responding.

Warsh’s Monetary Revolution

This idea fits remarkably well with Warsh’s broader ambitions for monetary policy.

At Jackson Hole in August, Warsh described the AI revolution as a turning point after decades of concern about secular stagnation and a global saving glut. He also argued that financial markets had become excessively dependent on signals from the Fed.

His complaint was that investors spent too much time anticipating central bankers and too little time assessing economic fundamentals. The result was what he called a “hall-of-mirrors problem,” with markets taking their cues from the Fed and the Fed taking its cues from markets.

Warsh wants markets to produce independent signals about economic conditions. Rising long-term yields driven by stronger growth and competition for capital would be exactly such a signal.

There’s an important implication for monetary policy. If the AI boom has raised the natural rate of interest, the Fed may need a higher policy rate to achieve the same degree of restraint. But if longer-term market rates are already adjusting upward, the Fed may not need to raise its overnight rate as much.

Higher bond yields are already making mortgages more expensive and putting pressure on other interest-sensitive investments. Some of the resources demanded by the AI boom can be freed up through this process without additional Fed intervention.

Of course, the rise in yields is not purely about AI financing. There’s still a hall of mirrors effect in the market, where investors require higher yields now because they expect the Fed’s policy rate to be higher. And the strength of the AI boom and expectations for higher rates probably means that the Fed’s policy rate can be higher without hurting employment or growth much. As long as inflation remains elevated and the risk to employment low, it makes sense for investors to bet policy rates go higher and stay there.

And this does not necessarily run against Warsh’s objectives. Expectations of higher future Fed rates should not be viewed as a distortion of market signals. If investors expect the Fed to maintain higher rates because the natural rate has risen, they’re responding to economic fundamentals and anticipating that the Fed will do the same. That’s quite different from a world in which the Fed holds down longer-term rates with forward guidance promising to keep rates low for longer than fundamentals would otherwise warrant. In this case, investors are simply expecting the Fed to respond appropriately to economic conditions.

In short, the bond market appears to be already implementing Warsh’s monetary revolution. The market is rediscovering its role in determining the price of capital, and the Fed is rediscovering the value of letting it.

Ip is right that higher interest rates and tighter financial conditions can kill the AI boom. But those forces are already at work in the bond market, where the price of capital is adjusting to a technological revolution. The question for the Fed is how much more tightening the economy actually needs.