Citi: AI Investment Supports Half of American Economy, Market Overestimates Rate Hike Risk

Citi Research in its latest US economic research report has indicated that investment related to AI currently contributes to about half of the increase in the US real GDP, but this trend also brings the risk of distorting inflation data and sparks widespread controversy over interest rate trends in the market.

Citi Chief US Economist Andrew Hollenhorst and his team pointed out that in recent quarters, the US real GDP has been growing at a rate of about 2% to 3%, half of which comes from AI-related investments, including information processing equipment, software intellectual property rights, R&D expenditures, and data center construction, among others. The proportion of AI-related investments in the real GDP has risen by more than 1.5 percentage points in just a few years, serving as a key underpinning for the US economy's growth rate to lead other developed economies.

However, Citi also warns that there are downside risks hidden behind this boom. "If AI investment returns to its previous trend, the growth rate of real GDP is likely to fall below 1%, or even turn into negative growth," the report states, "a corresponding decline in stock prices may further drag down consumer spending through the wealth effect.""

PCE data "inflated", inflation signals in doubt

Citi analysts have noted that the demand for AI has driven core hardware prices such as memory to rise sharply, with the "computer software and accessories" PCE component recently rising by more than 60% year-on-year. This price movement is significantly driving up core PCE inflation, and PCE uses this component as a substitute indicator of consumer technology spending prices, but in reality, consumers are not bearing the same degree of price pressure.

Citi believes that compared to PCE, CPI assigns a more reasonable weight to this component, and the aforementioned factors are the root cause of the rare phenomenon of core PCE being higher than core CPI.

Citi forecasts that the core PCE will increase by 0.26% month-on-month in April, rising to 3.3% year-on-year, remaining at an elevated level; while the core CPI year-on-year is about 2.8%, the divergence between the two further highlights the comparability issue of the data.

Wash becomes chairman of the Fed, the market focuses on his stance on AI inflation

This week, Kevin Warsh officially took the oath of office as Chairman of the Federal Reserve, presiding over the interest rate meeting in June. Citi expects that Warsh will interpret the AI-driven price increases with a dovish stance - emphasizing that the AI price increases only affect a few categories of goods and that in the long run, they will form a deflationary force through productivity improvement.

The minutes of the FOMC meeting from April 28 to 29 showed that a "small number" of officials had clearly stated that AI-related prices "may not effectively predict future overall inflation". Warsh also expressed interest in the substitute inflation indicator of trimmed mean PCE during his congressional testimony, which is currently significantly lower than core PCE.

At the same time, Fed Governor Christopher Waller's speech this week effectively confirmed that the June policy statement will remove the implicit easy-going bias language. Citi believes that this more reflects Warsh's policy style of reducing forward guidance rather than a substantial hawkish shift.

Citi maintains its forecast of three rate cuts within the year, pointing to an overestimation of the risk of interest rate hikes

Although the market has fully digested the expectation of a 25 basis point rate hike this year, Citi still maintains that the market's pricing of the risk of interest rate hikes is significantly higher than it should be.

Citi's base forecast shows that the Fed will cut rates by 25 basis points each in September, October, and December, with the policy interest rate falling to the range of 2.75% to 3.0% by the end of the year. The core condition for triggering rate cuts is the expected weakening of labor market data affected by the "residual seasonal" effect in the next few months, with the unemployment rate estimated to rise to an annual average of 4.5%.

"The number of initial jobless claims is currently low, but in recent years, there is a seasonal increase from May to June, and this pattern may be repeated this year," Citi points out.

Citi maintains its tracking forecast for the second quarter's real GDP growth at 2.5% (annualized quarter-over-quarter), below the Atlanta Fed's GDPNow model's 4.3%.