Coming into 2026, investors had been positioned for an interest rate easing cycle. Markets are now pricing in multiple rate hikes into 2027, and Federal Reserve Governor Christopher Waller has said additional rate hikes will likely be needed to tame current inflationary pressures. Much of that pressure, however, is supply-driven inflation, which rate hikes are poorly equipped to address. Yields have also been on the rise, with the 10-year at 5.09% and the 30-year at 5.43% as of October 16th.
Most of the focus has, understandably, been on the pivot from rate cuts to hikes, but the more important question is whether today's sources of inflation will respond to rising interest rates. A meaningful share of current inflation originates in war-driven supply disruption, layered with unprecedented demand for certain computer and software accessories central to developing and running artificial intelligence models. None of these drivers respond directly to rising interest rates because price increases are the result of sticky supply constraints, over which the Federal Reserve has little control.
The Supply-Side Drivers of Inflation
Headline CPI inflation peaked at 4.2 percent year-over-year in May, eased to 3.4 percent in July and August, and rose again to 3.7 percent in September. The composition of price pressure has shifted in ways that complicate the policy response.
Research published in late August by the Federal Reserve Bank of Minneapolis estimates tariffs contributed between 0.2 and 0.4 percentage points to core PCE inflation as of July. The more striking finding is that even excluding tariffs entirely, core PCE would still be running roughly a full percentage point above the Federal Reserve’s 2 percent target.
A second driver has emerged from the unprecedented AI buildout. According to the same analysis, video and information processing equipment, a category carrying a 2.4 percent weight in core PCE, has posted abnormally high inflation driven by demand and constrained supply rather than trade policy, adding approximately another 0.4 percentage points. The Federal Reserve’s own July 2026 Monetary Policy Report cited rapid price gains in software and accessories, computers and other electronics in the early months of the year. While the AI capital expenditure cycle is powering corporate earnings, it is simultaneously bidding up the cost of the equipment it consumes.
Energy has been a consistent undertone in the inflationary picture as PCE energy prices rose 24 percent over the twelve months ending in May, per the Fed’s Monetary Policy Report, and disruption through the Strait of Hormuz has lifted oil and gas, fertilizer and helium prices simultaneously. The limitation for the Federal Reserve is that higher interest rates cannot increase crude oil production, reverse tariff policy or accelerate the manufacture of advanced semiconductors and high bandwidth memory equipment.
Tightening Into Accommodative Conditions
Further complicating the Federal Reserve's inflation mandate is the fact that financial conditions remain broadly accommodative despite climbing long-term yields.
Investment-grade spreads remain tight relative to historical standards, bank lending flows are stable, and the S&P 500 closed above 7,800 for the first time in early October.
Credit markets have absorbed remarkable supply along the way, with bond issuance among the largest investment-grade cloud computing firms nearing $100 billion in the first quarter of 2026 alone, according to the Federal Reserve’s May 2026 Financial Stability Report. Technology borrowers and the U.S. Treasury are competing for the same pool of capital, and investors have absorbed both without a meaningful widening in spreads. This is not the typical behavior of a tight financial system.
Economic growth has also remained stable, with the Bureau of Economic Analysis reporting real GDP growth of 2.5 percent annualized in the first quarter (revised in its September 30 release) and 2.2 percent in the second. Federal Reserve Board research published in July finds that AI-related components, led by software and computer equipment, have been the largest positive contributors to GDP growth since 2025, while the Fed’s July Monetary Policy Report noted only a very modest gain in consumer spending in the first quarter. The consumer-driven segments most sensitive to interest rates are not contributing meaningfully, while the segment driving growth is funded through issuance and equity markets that a policy rate affects only indirectly.
Some commentators argue that markets may be pricing a more aggressive rate hike path than will ultimately materialize, given headline inflation has already fallen from its May peak, and core CPI remains relatively contained at 2.6 percent. This suggests that inflationary pressures monetary policy cannot easily suppress may also fade on their own as markets adjust to supply-demand imbalances.
Positioning Across Regimes
Forecasting the potential path of interest rates is a futile exercise for institutional investors, with the focus being better placed on building a portfolio that can perform across various market cycles.
Within public equities, diversification across regions, styles and strategies matters more when a single capital expenditure cycle accounts for an outsized share of economic growth and an outsized share of index returns. In private markets, venture capital and growth equity provide access to the AI theme at an earlier stage and offer a differentiated opportunity set compared to public markets.
In fixed income, a cycle-aware approach that remains broadly neutral to duration is appropriate when inflation is driven by factors policy influences only partially. Higher all-in yields have made the asset class investable again, though credit selection matters when spreads are this tight. Real assets, including real estate and infrastructure, warrant particular attention, as supply-driven inflation is precisely the kind that financial assets hedge poorly and real assets hedge well.
Expectations are for the Federal Reserve to raise rates again in late 2026 and early 2027. However, it is clear that the Federal Reserve is not capable of resolving the supply constraints behind the key drivers of current inflation. Therefore, a quick resolution to today’s higher prices will likely remain elusive. Investment portfolios built to withstand varied market outcomes amid a rapidly changing landscape are better positioned to weather potential volatility than those relying heavily on short-term tactical positioning.
