What you need to know about the Federal Reserve’s policy on AI stocks

The Federal Reserve does not set its policy based on the valuation of AI stocks.

But that is not the view you would get from an interview with investment strategist Edward Yardeni in March. I think he confused Jerome Powell with Alan Greenspan when he suggested that the Fed was keeping interest rates high to slow a stock market bubble fueled by AI stocks, so Investors Business Daily.

I disagree with this view for three reasons:

• Powell’s approach to the Fed stands in sharp contrast to Greenspan’s.
• The dotcom stock boom is very different from that of generative AI.
• If the Fed cuts interest rates in September, the impact on generative AI stocks would likely be positive, but less significant than whether technology companies grow faster than investors expect.

Rather, I think the Fed is gearing its interest rate policy to keep inflation below 2% while avoiding a rise in the unemployment rate. Also, if the Fed were to cut rates next month, the impact on AI stocks would be less severe than Nvidia’s upcoming earnings report.

I asked Yardeni to share his thoughts on whether he thinks Powell is setting rates in a way that won’t burst a bubble in generative AI stocks, and how rate cuts in September would affect generative AI stocks.

In response, on August 25, he sent me a report he had co-authored entitled Market call: Did Powell just add fuel to the fire in the stock market? “For now, we are sticking with our base case ‘Roaring 2020s’ (with a subjective probability of 60%) and aiming for an S&P 500 price of 5800 by year-end, 6300 next year and 6825 in 2026 (chart),” said Yardeni – Brief impressions.

The report makes me curious to hear what he thinks about my questions – and also suggests that he believes the Fed should shape its policy so that equity valuations do not rise too much.

Edward Yardeni’s claim that Fed policy is determined by AI stock prices

In March, Yardeni suggested the Federal Reserve would keep interest rates high due to concerns about high AI stock prices. “The Fed may not directly signal its concern about a hot stock market,” said strategist Ed Yardeni IBD“but I think it’s the most important thing.”

Yardeni reportedly based this conclusion on the minutes of the Fed’s January meeting. IBD. However, in my opinion, there is little evidence that the high AI stock prices are related to Fed policy. According to the Federal Open Market Committee meeting minutes from January 2024, most of the minutes focused on inflation indicators, the unemployment rate, and the economic situation.

Of course, equity prices were also discussed in the minutes. “Stock prices reached new highs in the inter-meeting period, but these were driven primarily by strong earnings at large-cap technology companies; broader equity valuations were more subdued,” the Fed minutes from January said.

In my view, Yardeni’s conclusion is shaky. He assumes that the current Fed views the AI ​​stock boom the same way the central bank viewed the dot-com boom in 1996.

How so? Powell “has to be concerned that rate cuts will create and fuel irrational exuberance,” Yardeni said. IBD, He used former Fed Chairman Alan Greenspan’s famous phrase from 1996, when Internet stocks were soaring.

How Jerome Powell’s Fed differs from Alan Greenspan’s

Fed Chairman Jerome Powell does not follow the same approach as Alan Greenspan. For example, the two have very different approaches when it comes to communicating monetary policy to the public.

Alan Greenspan was known for his opacity – he made oracular announcements that confused the markets. Greenspan – Fed chairman from 1987 to 2006 – formulated his monetary policy statements “vaguely and unclearly so that he could avoid shocking the financial markets,” according to The Federal Reserve Bank of Richmond.

Although Greenspan did not share these concerns with the public, minutes released after he left the Fed showed that Greenspan was “obsessed with stock prices.” IBD‘s analysis of Fed minutes from 1998 and 1999: “Dot-com stocks are expected to fall.”

In contrast, Powell is much more outspoken about how the Fed sets interest rate policy. He holds a press conference after each FOMC meeting, and “the committee issues a statement after the meeting explaining both its current policy stance and its expectations for future policy developments,” according to the Richmond Fed.

Powell follows an orthodox approach to Fed policy that excludes stock prices. “We have a mandate for maximum employment and a mandate for price stability, and those are the two things we look at,” Powell said, according to IBD.

Simply put, just because Greenspan obscured his thinking doesn’t mean Powell will do the same.

Why the dotcom boom was very different from that of generative AI

Yardeni’s questionable conclusion is further weakened by his failure to define what constitutes an AI stock, nor to compare the AI ​​boom to the dot-com boom.

Definition of AI stocks

Yardeni appears to equate AI stocks with the large-cap technology companies mentioned in the Fed’s January minutes – such as Amazon, Apple, Google, Meta, Microsoft and Nvidia.

If that’s what he means by AI stocks, then only one of those companies – Nvidia – is clearly reporting significant revenue resulting from demand for its products. Other large-cap tech stocks – like Meta and Microsoft – have shown evidence of a revenue boost from AI.

In my view, there are more publicly traded stocks that benefit from the demand for generative AI. As I wrote in my new book, Brain RushThe generative AI ecosystem consists of four major industry segments: consulting, software, cloud services, and hardware.

From a sample of listed companies in each sector, my company-generative AI stock index found a June 2024 Forbes Post, outperformed the Nasdaq in 2023. (I’ve since added market researcher Gartner – bringing the total number of companies in the index to 20.) By August 23, however, the Nasdaq had caught up, as some AI stocks lost some ground between March and August.

Here are the most important figures:

• 2023: Generative AI stock index rises 86% – twice as fast as the Nasdaq
• 2024 until August 23: The Generative AI stock index rises by 21%, achieving the same performance as the Nasdaq.

Why the dotcom boom and the generative AI boom are different

A key difference between the generative AI boom and the dot-com boom is the number of startup IPOs. During the dot-com boom, 2,888 internet startups went public, compared to zero IPOs for generative AI startups, according to a March 2024 study. Forbes Split.

The difference in the number of IPOs is not only due to the relatively early stage of development of generative AI.

While in the 1990s, incumbent companies largely hoped that the Internet would disappear so they wouldn’t have to change their business models, today the generative AI boom is being driven by the largest technology companies – most notably Amazon, Google and Microsoft – looking to boost demand for their cloud services.

Microsoft has invested $13 billion in ChatGPT provider OpenAI – much of which is thanks to the AI ​​chatbot developer’s ability to use the software giant’s Azure cloud service.

In researching Brain RushI’ve spoken to many technology executives and companies who expressed fear of being left behind if they don’t invest in generative AI. While an estimated $150 billion will be spent on AI investments in 2024, according to Sequoia Capital, boards are very afraid of the legal costs of AI hallucinations.

This conflict between AI FOMO and the fear of hallucinations could make it difficult for companies to get a return on their investments, a July 2024 report found. Forbes Post.

I find Yardeni’s conflation of Greenspan’s views on dot-com stocks and Powell’s use of Fed policy to prevent the generative AI bubble from bursting to be unfounded.

Yardeni seems to confuse what he thinks with what Powell does. Powell “is a student of history and has certainly studied the Greenspan Fed’s experience with the dot-com bubble,” Yardeni said IBD.

How a rate cut affects Generative AI’s share prices

With the market expecting a Fed rate cut in September, the question is, will the actual cuts have an impact on the Generative AI Stock Index?

I suspect institutional investors are making bets on the size of the Fed’s rate cut. If those bets are highly leveraged and largely overly optimistic—the Fed expects a half-percentage-point cut—then a smaller cut—say, a quarter-point—would likely drive tech stocks lower.

This would happen if institutions were forced to hedge their bad bets by selling profitable positions – such as bets on technology stocks.

However, for generative AI stocks, interest rates play a secondary role in the long term.

Put simply, the AI ​​stock boom depends on a company generating real revenue from selling its AI chips. The value of the generative AI index could take a significant hit on August 28 – when Nvidia releases its latest earnings report – unless the company beats expectations and raises its guidance.

There is a potential long-term positive effect of the Fed’s rate cuts. The IPO market has been silent since November 2021, when news leaked that Powell was re-elected to fight inflation.

When the IPO market reopens due to expected interest rate cuts, some generative AI startups may go public. If that happens and the prices of these companies increase significantly, we could see a dotcom-like bubble with generative AI.

While this could happen, it would be a side effect of interest rate cuts aimed at preventing unemployment from rising after the Fed gets inflation under control.