What Rising Interest Rates Mean for AI, Part 2: Why It Still Makes Sense to Forge Ahead

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U.S. Three-Month Treasury Bill Secondary Market Interest Rate, Discount Basis

Dear friends,

Last week, I wrote about how rising interest rates are likely to lead investors and other finance professionals to focus on short-term returns rather than longer-term investments. Nonetheless, I believe this is still a good time to invest in long-term bets on AI. Why? In a nutshell, (i) the real interest rate (adjusted for inflation) remains very low, and (ii) the transformative value of AI is more financially powerful than interest rates.

Although the news is full of rising interest rates, today’s rates are still quite low from a historical point of view. Interest rates (technically, the three-month U.S. treasury bill rate) peaked at over 15% in the 1980s. In contrast, they varied between nearly 0% and about 2.5% over the past decade.

A few percentage points of interest aren’t very significant in the face of historic gains in the value of innovative technology. Given the transformative impact of AI — which is making it possible to automate more tasks than ever — I believe that many projects will deliver returns (as measured by, say, share prices) much higher than the interest rate.

For instance, if you have an idea for a project that can create a 150% return, it matters little if interest rises by 5% and reduces the present value of your project slightly. The returns from high-risk, high-reward AI projects vary so widely — and have so much upside potential — that a modest change in interest rates should have little impact on the decision whether to go for it.

Rising interest rates aren’t the only factor that influences how we should view AI investments. Inflation is going up as well. This makes it relatively attractive to invest in building AI projects now, rather than wait and pay a higher price in the future.

Let’s say you’re debating whether to invest in a $100 GPU to speed up your work. A high interest rate — say, 10% — is a disincentive to spend the money: If you can postpone the investment, you save your $100 for a year, end up with $110 after that period, buy the GPU, and pocket the extra $10. But what if you know that inflation will cause the GPU to cost $110 in a year (10% inflation), or even $120 in a year (20% inflation)? Then it’s more attractive to spend the money now.

In fact, many people are underestimating how much inflation reduces the real cost of interest. The real interest rate, which takes inflation into account, is roughly the nominal (not adjusted for inflation) interest rate minus the rate of inflation. Because inflation is high, short-term real interest rates (technically, the risk-free rate) going out to 5 years are actually negative right now. Thus, in my view, it remains a good time to continue to make significant investments in technology that you believe will pay off.

The great investor Warren Buffet once said he tries to be “fearful when others are greedy, and greedy when others are fearful.” Current market conditions are making many investors fearful. I don’t advocate greed, but I do think for many teams this is a good time to charge ahead bravely and pursue ideas that you believe in. Just as many great companies were founded around the time of the Great Recession of 2007 to 2009, today’s economic headwinds, by sweeping away weaker projects, will clear the way for the strongest teams and ideas to leap ahead.

In case you’re wondering, I plan to put my money where my mouth is. AI Fund, the venture studio I lead, will continue to build companies with energy and enthusiasm. Even though some bets on AI will fail, I’m more concerned about aggregate underinvestment than overinvestment in AI.

I don’t advocate ignoring the market downturn. This is a good time to make sure you’re operating efficiently and your teams are appropriately frugal and have good fiscal discipline. Despite the gloomy market, I intend to charge ahead and keep building valuable projects — and I hope you will, too.

Keep learning!

Andrew

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