US economy enters higher-rate era as inflation, AI boom persist

The U.S. economy may be entering a prolonged period of higher interest rates as resilient growth, persistent inflation, heavy government borrowing and a surge in artificial intelligence investment put upward pressure on longer-term borrowing costs, AP reported.

US President Donald Trump renewed his criticism of the Federal Reserve after the central bank raised its benchmark interest rate on Wednesday. But economists say the Fed has less influence over longer-term rates than broader economic forces, including inflation, government borrowing and demand for capital, AP said.

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The economy has continued to expand despite a series of shocks and could be accelerating, while inflation remains elevated. At the same time, major technology companies are borrowing heavily to finance data-center construction and other AI infrastructure, while the federal government continues to run large annual budget deficits.

The combination is pushing the economy away from the low-growth, low-inflation environment that prevailed for much of the period following the Great Recession.

Mortgage rates, which fell into the 3% range during the 2010s and dropped even lower during the COVID-19 pandemic, have moved sharply higher. The average 30-year mortgage rate reached 6.95% last week, its highest level in more than a year and a half, AP reported.

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Joe Brusuelas, chief economist at RSM, told The Associated Press that the economy has undergone a structural shift from the post-financial-crisis period, when weak consumer and business demand restrained inflation, to an environment where stronger spending is running into supply constraints and other bottlenecks.

Higher oil and gas prices linked to the Iran war have added to inflationary pressures, while the rapid expansion of AI infrastructure has increased demand for computer chips, electronic equipment and workers.

Companies and government compete for capital

The current environment in some ways resembles the economy before the 2007-09 financial crisis. In the years following the downturn, households focused heavily on reducing debt, businesses faced limited investment opportunities, and several large technology companies accumulated substantial cash reserves.

That dynamic has changed

Companies, including major technology firms, are now deploying large amounts of capital to build AI data centers and are increasingly turning to debt markets to finance those investments. Consumers have also continued to spend at a relatively healthy pace despite widespread concerns about the cost of living.

A recent increase in retail sales prompted Bank of America economists to forecast annualized economic growth of about 3% in the July-September quarter.

Federal Reserve Chairman Kevin Warsh has also pointed to the dramatic increase in capital flowing into AI infrastructure. The surge in investment represents a sharp contrast with the years after the financial crisis, when economists expected excess capital to remain on the sidelines because of limited investment opportunities, according to remarks reported by AP.

The increased demand for capital has contributed to higher yields on longer-term government bonds. The yield on the 10-year Treasury note rose above 5% this year for the first time since 2023, even before the Fed's latest move on its benchmark short-term rate.

Inflation keeps pressure on borrowing costs

Despite continued economic growth, many households are struggling with elevated prices. Consumer sentiment surveys and political polling show affordability remains a major concern ahead of the midterm elections.

Inflation has also exceeded annual wage growth for five consecutive months, according to data cited by AP.

Brusuelas described the expansion as uneven, with much of the momentum coming from AI investment and spending by wealthier households that have benefited from rising stock prices and expectations of stronger corporate profits from AI.

The persistence of inflation is particularly important for longer-term borrowing costs. When investors expect inflation to remain elevated, they typically demand higher yields on longer-dated Treasury securities. The 10-year Treasury yield, in turn, is a key benchmark for mortgage rates and other borrowing costs.

After the Fed raised its benchmark rate to 3.9% on Wednesday, Trump called for U.S. interest rates to be reduced to 1%.

However, AP reported that some of the administration's policies have contributed to inflationary pressures. Higher energy prices associated with the Iran war, for example, can feed into broader price increases and reinforce expectations for higher interest rates.

The result is an economy in which the Federal Reserve's short-term policy decisions are only one part of the interest-rate equation. Stronger demand for capital, persistent inflation, increased government borrowing and the massive investment required to build AI infrastructure could keep longer-term borrowing costs elevated even if the Fed eventually moves toward lower short-term rates.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)