Fed risks getting stuck as oil, AI and strong earnings complicate rate decision

The Fed’s rate decision is no longer straightforward

The Federal Reserve’s meeting was once expected to be relatively uneventful.

June brought weaker employment growth and softer inflation, reducing the immediate need for another interest-rate increase. But markets quickly changed direction as hostilities in the Gulf intensified and oil prices surged above $100 a barrel.

At one point, federal funds futures placed the probability of a quarter-point rate hike close to 40%.

The escalation then appeared to lose momentum over the weekend, helping Brent crude fall below $90 at the start of Asian trading. That reduced part of the inflation risk, but it did not eliminate expectations that the Fed could still tighten policy.

The result is a central bank facing pressure to pivot in opposite directions.

Lower oil and softer inflation support patience. Strong employment, robust corporate earnings and continued AI investment make it harder to argue that monetary policy is excessively restrictive.

Oil remains the fastest-moving inflation risk

Energy prices have been the main driver of the latest change in rate expectations.

Brent’s move above $100 directly increased the risk of higher headline inflation. It also threatened to raise transportation, manufacturing and distribution costs that could eventually reach consumers.

Those concerns intensified when the US returned to military escalation and Iran threatened shipping access through the Strait of Hormuz and Bab el-Mandeb. Disruption in Bab el-Mandeb would also threaten access to the Suez Canal, creating wider risks for global trade and freight costs.

A quieter weekend reversed some of that pressure, pulling Brent below $90. Reports that the US may lack the ammunition required for a larger escalation also reduced expectations of an immediate expansion in the conflict.

Still, the oil market remains volatile enough to prevent the Fed from relying on a lasting decline in energy prices.

Employment data complicate the case for lower rates

The labour market is sending a different signal from the softer June payroll figures.

Weekly initial jobless claims recently fell to their lowest level since 1969, suggesting that US companies remain extremely reluctant to dismiss workers.

A single weekly reading can be volatile, but the broader message is important. Employers may be hiring more slowly, yet they are not conducting widespread layoffs.

That resilience makes it more difficult for the Fed to justify lower rates while inflation remains above target.

A weakening labour market would normally strengthen the case for easing. A stable employment backdrop gives policymakers more freedom to focus on inflation, especially if energy prices or tariffs begin lifting costs again.

Tariffs return as another source of inflation

US trade policy is adding another layer of uncertainty.

New tariffs of 10% have been introduced across a range of goods under measures linked to combating forced labour.

The direct effect will depend on which products are covered and whether companies absorb the additional cost. But tariffs generally create the risk of higher import prices, particularly when businesses already face rising energy and shipping expenses.

That places the Fed in a difficult position.

Policymakers may be willing to look through a short-lived oil shock. It becomes harder to remain patient when tariffs, energy costs and resilient demand are all moving in the same inflationary direction.

The AI trade is also changing

A second major market pivot is taking place in artificial intelligence.

For several years after the launch of ChatGPT, investors rewarded the large technology companies spending heavily to dominate the new industry. Amazon, Alphabet, Meta, Microsoft and Oracle benefited from expectations that AI would transform cloud computing, advertising, software and productivity.

Over the past year, however, the strongest enthusiasm shifted toward semiconductor manufacturers and other companies supplying the infrastructure behind the AI buildout.

That relationship is now being questioned.

After reporting stronger-than-expected revenue and earnings, Alphabet also announced another increase in capital expenditure. Instead of rewarding the company’s growth, investors focused on the cost of building AI infrastructure.

Both the hyperscalers and semiconductor suppliers have since come under pressure.

Investors want evidence that AI spending will pay

The market is beginning to ask whether technology companies will fully follow through on their enormous capital-spending plans.

If hyperscalers reduce investment, semiconductor and infrastructure suppliers could lose part of the demand that supported their valuations. If spending continues, the large technology companies must prove that AI revenue will grow fast enough to generate attractive returns.

This does not mean the AI trade has peaked.

Apple, Amazon, Meta and Microsoft are all due to report earnings, giving investors more information on data-center spending, cloud demand, AI monetization and free cash flow.

But the market is no longer treating every increase in AI investment as automatically positive.

The next phase of the trade will depend on whether companies can demonstrate that spending is producing sustainable revenue and profit growth.

Strong earnings weaken the case for stimulus

Corporate earnings remain surprisingly strong despite the concerns over AI spending and higher interest rates.

Projected second-quarter earnings per share for the S&P 500 continue to rise, suggesting that corporate America is not showing an urgent need for monetary support.

That matters for the Fed.

If profits remain healthy, employment is stable and investment is strong, current interest rates may not be restrictive enough to generate a significant economic slowdown.

The strength of earnings also challenges the argument that the Fed needs to cut rates to protect growth.

At the same time, raising rates based on temporary oil volatility could create unnecessary economic damage if energy prices continue falling.

This tension explains why the most likely outcome may still be another hold.

AI creates conflicting inflation signals

Artificial intelligence is also complicating the Fed’s economic framework.

The long-term argument is that AI should improve productivity, reduce costs and become a disinflationary force.

The short-term reality may be different.

Building data centers, semiconductor facilities and energy infrastructure requires enormous investment. That spending increases demand for electricity, construction, specialized equipment and highly skilled workers.

AI may therefore be inflationary during the buildout stage before becoming disinflationary once productivity gains spread through the economy.

Markets are now questioning both parts of that assumption. Investors are less certain that the capital expenditure will deliver sufficient returns, while policymakers cannot be sure when the promised productivity benefits will appear.

Trump’s preferred market outcome moves further away

The latest shifts are also working against the Trump administration’s main market objectives.

The administration has favored a weaker dollar, lower Treasury yields, cheaper oil and stronger equity prices.

Renewed escalation in the Gulf pushed those targets in the opposite direction. Oil rose, inflation concerns increased, bond yields came under upward pressure and technology stocks weakened.

A calmer geopolitical environment could reverse part of that move. But repeated changes in US policy have made it harder for markets to price a stable path for energy, interest rates and risk assets.

The Fed must make its decision against that unstable backdrop without appearing to respond directly to political pressure.

Why the Fed may remain on hold

Despite the renewed rate-hike debate, the Fed may decide that the evidence is still too mixed to justify an immediate move.

Oil has already fallen back below $90 after moving above $100. June inflation was softer. Employment growth has slowed even though layoffs remain low. AI spending is supporting activity, but questions are emerging about how long that investment boom can continue.

A rate hike could prove unnecessary if the decline in oil persists.

A rate cut would be difficult to defend while earnings remain strong, layoffs are low and inflation stays above target.

Holding rates gives policymakers time to determine whether the Gulf conflict produces a lasting energy shock and whether AI investment continues strengthening demand.