Inflation seemed to be making good progress at the end of 2025 and start of 2026, with the Federal Reserve actually starting to cut interest rates. The start of the conflict in the Middle East in February, however, threw a wrench in that progress, as inflation turned course and began to elevate once again.
Now, after the Fed chose to raise rates at its September meeting, inflation has reached a “disappointing” state, as outlined by Federal Reserve Governor and Vice Chair for Supervision Michelle Bowman.
In a speech to the Council on Foreign Relations focusing on the current economic outlook, Bowman said that the Fed’s “progress on lowering inflation has disappointed,” but bringing down inflation does remain a “priority” for the organization.
As inflation has elevated, housing has felt the strain. Mortgage rates have been on the rise, recently returning to the 7% range. Affordability has been constrained for buyers, not just due to rate, but also due to inflation affecting their purchasing power and ability to save up for down payments.
Bowman said she remains vigilant on “monitoring expectations about AI and energy prices” and their influence on risks to lowering inflation, and she continues to “focus on interpreting the underlying trends in the economy and the evolution of financial conditions.”
“While I continue to expect that several of the factors currently boosting inflation will abate next year, currently inflation has proven to be more persistent than I had anticipated,” she continued. “It is also important to gain greater clarity on the effect of recent market volatility on financial conditions.”
Bowman said what is currently holding back progress on inflation is a “confluence of shocks,” stemming from Middle Eastern conflict, tariffs imposed from the Trump Administration and “AI-related price pressures.”
“It is important to ensure that those inflationary pressures do not intensify, further broaden, or become embedded in consumer and business expectations,” she said. “But today’s consumer price index data suggest that inflation pressures may persist for longer.”
The Middle East, with a side of AI
Bowman, appointed by President Donald Trump in his first term and elevated to vice chair in 2025, said the U.S.’s conflict in the Middle East continues to exert downward pressure on the economy, but pressure is also sourcing from the AI boom and “buildout,” as she characterized it.
As for how these two issues could affect inflation in the future, Bowman said that she can see “sustained supply-chain pressures from the AI buildout greater pass-through of higher energy costs could cause inflation pressures to persist.”
However, she also said she could “envision a scenario in which the effects of the Middle East conflict and the tech investment boom wane or unwind quickly,” in which case core PCE inflation (meaning price increases excluding volatile energy fluctuations) would return toward the Fed’s 2% target in a “timelier” fashion.
In terms of the Middle East, Bowman said that as the conflict persists, energy prices could remain elevated, keeping inflation on the rise “because of increased pass-through to consumer prices of higher production and transportation costs.” Additionally, if conflict were to escalate, she said it could have “more meaningful effects on real activity because of higher uncertainty and the larger impact of energy prices on lower- and middle-income consumers.”
On the potential of a “quick resolution” to the conflict, Bowman noted that it “may take some time for energy prices to normalize” even in the aftermath.
As for AI, Bowman said she “expect(s) the AI shock to play out over some time” as plans for new data centers continue to “surge.” However, she noted that as AI investment is “increasingly being financed with external funds,” there are other potential risks it presents to the economy.
One such risk is the potential of workers being displaced. Bowman said that even though any monetary policy can’t “address that transition directly,” it can still “support a dynamic labor market that facilitates the necessary retraining and mobility of workers across jobs.”
Another risk is the financing of AI, as Bowman said that “AI revenues have been rising quickly but are not yet sufficient to pay for the expense of maintaining existing and developing new AI models and data centers.” As such, she also noted that “AI-related debt has been rising rapidly, with notable gains in corporate bonds, private credit, and project finance, and is on track to exceed $800 billion this year.”
The rapid expansion of AI has also put some “upward pressure on a number of price categories,” as Bowman noted, specifically to the prices of memory chips, semiconductors, computers and more. However, she said that she expects “production capacity to catch up to demand gradually over time.”
Bowman did point out that the risks from AI “seem to be concentrated in only a few large firms that provide AI services.”
Overall, Bowman said that if “AI-related revenues fall short of sharply rising costs, especially as public sentiment and local opposition could lead to increased regulation and delays, we could see a sharp correction in equity prices for AI firms, higher financing costs, and reduced access to credit.”
“This shock would likely slow the AI buildout and soften both economic activity and inflation,” she concluded.
The path ahead
Bowman said that looking ahead, her expectation is that “policies designed to boost the economic potential of the U.S. economy would continue to support productivity, growth, and business confidence.” Such policies include “pragmatic regulations, lower taxes, and more supportive policies toward businesses.”
Bowman went on to say that she does expect the labor market, which has performed resiliently through most of 2026, to “remain stable.” She also expects for inflation to “slow” as “special factors currently holding inflation elevated gradually wane or unwind next year.”
“Over time, I also expect increased AI adoption to raise productivity and put some downward pressure on inflation as lower production costs are passed through to consumer prices,” she continued.
Bowman said as these “shocks” to the economy and inflation fall back, her forecast is for “core PCE inflation to move closer to 2% next year.”
Right now, she said that the pressures persist, indicating that “there is still work to do to bring inflation closer to 2%.”
