The Federal Reserve issues an 11-word warning: If inflation expectations spiral out of control, the cost could far exceed imagination

A seemingly ordinary statement in the Federal Reserve's June meeting minutes is raising market concerns. Policymakers warned that after years of inflation running above target, it “could begin to affect inflation expectations and wage- and price-setting decisions.”

This sentence means that the Fed's concerns have extended beyond just a particular month's inflation data, and are now about whether consumers and businesses have begun to believe that high inflation will persist in the long run.

Once this expectation is formed, the Federal Reserve may have to take tougher actions. For the highly valued and AI investment-driven US stock market, this could become a significant risk facing the S&P 500 Index.

In June, the Fed kept the federal funds rate target range unchanged at 3.5% to 3.75%. The meeting minutes showed that market participants generally expected rates to remain unchanged at the time, but expectations regarding the future path of rates had already been revised upward.

What the Fed truly fears is not a one-time inflation rebound

The Fed has set its long-term inflation target at 2%. The effectiveness of this target is not only due to monetary policy itself, but also because consumers, businesses, and financial markets believe the Fed ultimately has the ability to bring inflation back near the target.

The issue is that if prices stay above 2% for several consecutive years, this trust may gradually waver.

When workers start to believe that prices will continue to rise in the future, they will demand higher wages; businesses, to cope with higher labor and production costs, will raise prices for goods and services. Rising wages and prices can reinforce each other, potentially forming the so-called “wage-price spiral.”

In May, the US Consumer Price Index (CPI) rose 4.2% year-over-year, the largest increase since April 2023; although June's year-over-year CPI growth then fell back to 3.5%, it remains clearly above the Fed's target.

What's more concerning for the Fed is that some companies have already indicated they are facing clear cost pressures and are considering how much of these costs can be passed on to consumers. Once price increases and wage hikes become the default choices for businesses and households, inflation may evolve from an external shock to a more stubborn endogenous cycle.

Painful lessons from the 1970s

The United States went through a similar situation in the 1970s.

After years of high inflation and oscillating policy, the public gradually came to believe that prices would keep rising, and businesses and employees began setting prices and wages in line with this expectation.

Ultimately, then-Fed Chair Paul Volcker had to adopt extremely aggressive tightening policies. The federal funds rate approached 20% in 1981, after which the US economy entered a recession and the unemployment rate rose to 10.8% in 1982.

The high cost eventually brought inflation down, but historical experience also shows that once inflation expectations get out of control, restoring central bank credibility often requires higher rates, more severe economic slowdowns, and greater market volatility.

In contrast, the inflation shock of 2022 did not develop into a similar crisis. The US CPI surged as much as 9.1% year-over-year in that year, but the Fed hiked rates quickly, and long-term inflation expectations remained generally stable, so a typical wage-price spiral did not materialize.

The signal this history sends to markets is that the Fed must act before inflation expectations spiral out of control—otherwise, the costs to pay in the future might be higher.

Why could rate hikes pop the AI boom?

For today's market, the danger is that the Fed might not need to raise rates to 20% to cause a significant impact on asset prices.

Currently, the US economy and capital markets rely much more on low-cost financing than decades ago. Especially in artificial intelligence infrastructure construction, huge investments are required to build data centers, purchase chips, power equipment, and network infrastructure—many of these projects may take years to produce stable income.

Some data center financing models are hinged on a key assumption: future interest rates will fall, allowing companies to refinance at lower cost.

But if inflation stays above target for a long time and the Fed not only refrains from cutting rates but must raise rates again, the financing logic for these projects could change entirely.

There’s also a risk that part of the AI infrastructure funding comes from private credit, meaning loans from investment funds rather than traditional banks. Since this market has expanded rapidly in recent years and has yet to go through a full high-interest-rate and recessionary cycle, its risk tolerance remains untested.

According to the original article’s author, if the Fed waits too long and is forced to increase rates by 1-2 percentage points in the future, many data centers and AI projects dependent on refinancing may face soaring costs, financing difficulties, or even downward revaluation.

This would not only affect capital expenditures by technology companies, but could also hit a stock market at historically high valuations with gains concentrated in AI-related themes.

The S&P 500 faces dual risks

The current market dilemma is that whatever the Fed chooses to do, risks may arise.

If the Fed loosens policy too early, inflation expectations may rise further, forcing greater rate hikes down the road; if the Fed hikes rates again now, corporate financing costs will rise, and overvalued tech stocks and AI infrastructure investment may be the first to come under pressure.

According to the economic projections released by the Fed in June, there are clear differences among officials about the future path of interest rates, but most policymakers think the appropriate rate at end-2026 will not be significantly lower than the current range, and some officials even expect rates to rise further.

Meanwhile, the Fed's meeting minutes show that market pricing at one point reflected a possible rate hike in 2027, although officials believe part of this change relates to higher term premiums.

This means that the quick rate cuts and lower financing costs expected by investors are no longer a certain scenario.

If energy prices rise again due to the Iran situation and drive up overall inflation, the probability of a Fed rate hike this year could increase further.

What should investors focus on?

For investors, this warning from the Fed minutes doesn’t necessarily mean rate hikes are inevitable, but it shows that policymakers are closely watching whether inflation is turning from a temporary price increase into a long-term change in household and business behavior.

Going forward, the market should focus on three key signals:

First, whether consumer long-term inflation expectations rise significantly; second, whether wage growth and service sector inflation re-accelerate; and third, whether businesses start to pass through energy, tariffs, and labor costs to consumers on a larger scale.

If these signs all appear simultaneously, the Fed may be forced to hike rates earlier—while the economy and market can still withstand it.

Such action may not be welcomed by investors in the short term, but relative to taking aggressive measures only once inflation expectations are completely out of control, a sooner and milder tightening might have a lower cost.

For the S&P 500 Index, the real risk isn’t just one rate hike, but a complete break in the low-rate expectations supporting the AI boom. Once the market starts to reprice higher and longer-lasting interest rates, data center financing, technology company capex, and high-valuation AI stocks could all be affected simultaneously.