The Economy’s Structural Transformation Signals End of Low-Cost Era

The recent hike in interest rates by the Federal Reserve has sparked a familiar chorus of complaints from President Donald Trump. However, economists point out that this is less about the Fed’s actions and more about broader economic trends. The low-cost era that defined the economy for nearly 15 years after the Great Recession is indeed over.

The AI buildout has become a key driver of this shift. Tech firms are investing enormous sums in data center construction, using cash reserves accumulated during the pre-pandemic era when consumer and business demand was weak. As healthy consumer and business spending collides with supply shocks and bottlenecks – including higher oil and gas prices due to the Iran war – investors demand higher interest rates on longer-term Treasury bonds.

This structural transformation of the economy, as Joe Brusuelas, chief economist at RSM, describes it, is a return to the pre-2007 era. After the downturn ended in 2009, consumer and business spending remained weak. Americans focused on paying down debt instead of investing, while big tech firms stockpiled cash.

The AI buildout has changed everything. Companies like Alphabet’s Google and Meta’s Facebook are using their vast resources to build out AI data centers, borrowing even more money to do so. American consumers continue to spend at a healthy pace despite surveys showing they’re pessimistic about the economy. Retail sales picked up last month, leading economists at Bank of America to forecast growth will reach 3% at an annual rate in the July-September quarter.

Federal Reserve Chairman Kevin Warsh highlighted this shift in his speech at the central bank’s annual conference in Jackson Hole, Wyoming last month. He noted that after 2008, there was a widely held view that excess capital would sit on the sidelines for a long time due to lack of investment opportunities. However, times have changed – ever-expanding pools of capital are pouring into AI-related infrastructure.

The additional spending and investment have contributed to higher longer-term interest rates on government bonds competing for lenders. The yield on the 10-year Treasury bond topped 5% this year for the first time since 2023, even before the Fed raised its benchmark short-term rate Wednesday.

Many Americans are struggling to keep up with rising prices, and affordability remains a top concern heading into the midterm elections. Even as the economy expands, inflation has outpaced the annual growth in average wages for the past five months.

The AI-fueled economy is an imbalanced expansion, dependent on strong spending by wealthier consumers who have benefited from rising stock prices driven by hopes that AI will lift profits. This raises questions about the sustainability of this growth and its impact on the broader population.

Higher inflation leads to higher rates – a simple yet crucial point often lost in the noise surrounding interest rate hikes. Investors demand higher interest rates on longer-term Treasury bonds when inflation persists, which strongly influences mortgage rates. Trump’s policies have contributed to higher borrowing costs, particularly the Iran war that has driven up gas prices.

As Elizabeth Pancotti, vice president of policy, advocacy and research at the progressive Groundwork Collaborative, pointed out, “The president can say he wants interest rates lower all he wants, but yet he continues to push the button on all the policies that raise rates.” This disconnect between Trump’s rhetoric and his policies is a reminder that the economy is more than just monetary policy – it’s a complex interplay of supply and demand, investment and spending.

The AI-fueled economy may be a new era for America, but its consequences are far from clear. As we move forward, one thing is certain: this shift will have lasting impacts on interest rates, inflation, and the lives of ordinary Americans.