Despite resilient economy, US consumers are not very happy

Weakness in Chinese investment is spreading

Benchmark revision shows less worrisome US inflation

Recent increases in US long-term rates surprisingly little impacted by inflation expectations

Even with strong capex, US nonfinancial corporations are generating more cash than they are investing

Investor sentiment worldwide is positive, especially in AI-led Asia

Sectoral shift in US job openings

Meteoric rise in AI-related semiconductor exports fueling South Korea's export boom

Regional Fed surveys showing further manufacturing acceleration in August

Sharp drop in China demand for oil helping to limit impact of Middle East conflict on the price

Decades high real price of copper posing physical challenge to investment boom

Rising US long-term real yields point to strong demand for investment funding

US retail sales accelerate even as consumers remain gloomy

Retail gasoline price still well above pre-conflict level and now rising again

PMIs showing widespread revival of global economy

Crude oil price has returned to pre-conflict level but traffic through Hormuz still subpar

Surging orders for computers and electronics propelling durable goods orders

Next year's inflation forecasts are on the rise and above target

Disrupted global supply chains placing upward pressure on US goods prices

Construction of data centers has overtaken transportation construction in US

Elevated energy prices putting intense upward pressure on input prices around the globe

US is big leader in global surge in private AI investment

Larger-than-usual income tax refunds this year are supporting consumer spending

Sharply rising share of AI-related jobs

Inflationary impact of surge in oil prices larger in Europe than in the US

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Andrew Cates

The Federal Reserve, Bank of Canada, European Central Bank and Bank of Japan meet this week against a difficult backdrop. An energy shock has pushed inflation higher just as households and businesses are contending with expensive borrowing. Economic growth has proved resilient, but the question for policymakers is how secure that resilience really is. There is a strong case for caution before tightening monetary policy further.

The immediate dilemma is familiar. Central banks cannot prevent an oil price shock, but they must guard against its spreading into wages, other prices and inflation expectations. At the same time, higher energy bills reduce spending power and raise costs for businesses. Further increases in interest rates could compound that pressure, even as the effects of earlier tightening are still being felt.

For now, there is little evidence that higher energy prices are feeding into broader inflation. The foundations of demand also deserve closer scrutiny. Government borrowing, rising asset values and investment based on expectations of future returns have all supported spending. Those supports may be less durable than the headline growth figures suggest.

The danger is that policymakers mistake this spending for lasting economic strength. Until productivity gains translate into broader income growth, further tightening risks undermining both today’s demand and the revenues needed to justify tomorrow’s investment. That does not mean central banks should overlook persistent inflation. It does mean they should weigh the evidence for it against the fragility of the growth they are seeking to restrain.

**The evidence on inflation**
Latest data for September show that core CPI inflation, which strips out food and energy, is 2.6 per cent in the United States, 2.5 per cent in the euro area and 2.4 per cent in Japan. None has moved materially higher over the past six months, and the American and Japanese measures are lower than a year ago. So far, the rise in headline US inflation to nearly 4 per cent has not been accompanied by a comparable increase in core inflation.

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The cost side offers a similar picture. Unit labour costs are rising at a y/y pace of 1.5% in the United States and 2.6% in the euro area, rates close to those consistent with a 2% inflation target. Japan is different: unit labour costs are rising by 4.1 per cent and accelerating, giving the Bank of Japan reason to assess the risks differently. Elsewhere, there is limited evidence so far that the energy shock is feeding into more persistent wage and cost pressures.

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There is an important qualification. Weak productivity can itself make inflation harder to contain, so the absence of a productivity boom is not sufficient reason to hold rates. Policymakers must judge whether higher energy costs are spreading into wages, services prices and longer-term expectations. If inflation becomes more persistent, further restraint may be necessary. If it does not, the case for waiting is stronger, particularly when the sources of demand are themselves vulnerable.

**The growth foundations are weaker than they look**
Recent resilience is encouraging, but its foundations matter. An economy supported by public deficits, rising asset values and investment undertaken in anticipation of future profits may respond differently to higher rates from one in which productivity is already lifting incomes across businesses and households.

Let’s start with the consumer. Real household disposable income per head is growing by 0.6% y/y in the United States and 0.4% in the euro area. In the UK it is falling by 0.3 per cent and in Japan by 1.8 per cent. Consumption has nonetheless held up more broadly, implying a decline in saving where consumption has grown faster than disposable income.

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**The role of wealth**
In the United States, rising asset values appear to have encouraged households to spend a larger share of their income. This need not involve additional borrowing: households can also save less. But spending supported by confidence in wealth is vulnerable to a change in that confidence. Falling markets or weaker employment prospects could encourage households to rebuild saving.

The relationship is in fact quite striking in the US data. When household net worth runs ahead of its trend relationship with income, households tend to save less out of current income; when wealth falls behind, saving tends to rise. Across more than a hundred quarters the correlation is -0.77. The latest observation sits at the far right of the distribution, with net worth some 92 percentage points of disposable income above trend. Almost all of that excess is in equities.

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US household net lending against the deviation of net worth from trend, quarterly, 1999 to 2026. Source: Federal Reserve Board and Oxford Economics via Haver Analytics; author calculations.

This leaves consumption more exposed to asset valuations. A fall in equity prices would reduce wealth and could encourage households to save more out of current income, adding to the pressure on demand.

**The investment boom is narrow**
AI investment has provided another support. Spending on data centres, computing equipment and electricity infrastructure generates activity now, against the expectation of substantial returns later. As I argued last week in “AI’s costs are arriving before its benefits”, those returns ultimately depend on customers able to benefit from using the technology and willing to pay for it. The industry’s investment plans are therefore partly a claim on the future incomes of the wider economy.

What is striking is how concentrated that investment has become. Since the end of 2023, real spending on information processing equipment and software has risen by 41% while all other business investment has fallen by 1%. That category now accounts for 44% of real business investment, against 31% before the pandemic, and for roughly half the increase in real GDP over the past year. This is a concentrated capital spending cycle.

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Productivity is central to the argument. If AI allows businesses to produce more efficiently, it can support profits, real incomes and further investment. But while those gains remain concentrated or uncertain, infrastructure spending can run ahead of the customer revenues needed to sustain it. Confidence in future income is supporting expenditure before that income has arrived.

**Fiscal policy is already stretched**
Let’s look finally at fiscal policy. Government borrowing has supported incomes and employment through a succession of shocks. And that support has been valuable. But some of the spending sustaining activity depends on deficits that governments may eventually seek to reduce. Rising interest costs make the choice harder: maintaining support becomes more expensive, while withdrawing it risks weakening growth.

Growth does not require every sector to borrow more. But if households seek to save more, businesses restrain investment and governments reduce deficits together, another source of spending must offset them if demand is to hold up. Otherwise sales, employment and incomes may weaken. Financial balances help reveal where the adjustment may occur; they do not make a downturn inevitable. The vulnerability is that several important sources of spending could retreat at once.

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Who has been spending, and who has been saving. Source: IMF World Economic Outlook October 2026 and Federal Reserve Board via Haver Analytics; author calculations.

The exhibits above and below illustrate how saving and spending differ across economies. China, Japan and the euro area have private sectors that save more than they invest, while government borrowing absorbs part of those surpluses. For the global outlook, the question is how domestic demand evolves across these economies as spending elsewhere slows.

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Government, private and current account balances, and the same balances in US dollars. Source: IMF World Economic Outlook October 2026 via Haver Analytics; author calculations.

**How tightening could expose the weakness**
Higher interest rates could accelerate that retreat. They raise financing costs, squeeze borrowers’ disposable incomes and can weigh on asset prices. They also affect prospective customers of the AI industry. A business facing weaker sales and expensive finance may postpone the integration, training and organisational changes needed to adopt AI. Spending on the technology could fall short just as providers need revenues to validate their investment.

The consequences could extend beyond technology. Disappointing revenues could weaken infrastructure investment and equity valuations, with further effects on employment, household wealth and consumption. Central banks would then be restraining an economy whose apparent strength had depended partly on expectations their decisions were helping to unsettle. Further tightening therefore needs a clear justification in the inflation evidence.

**Resilience is not the same as durability**
The balance of risks will differ across economies. Fiscal restraint could reinforce monetary restraint, while stronger domestic demand or more persistent inflation elsewhere could justify a different response. The relevant test is both whether spending is pressing against productive capacity and how durable that spending is. A shared energy shock does not require an identical interest rate decision.

A more secure expansion would see productivity gains translate into stronger real incomes and profitable investment across a wider range of businesses. That would help customers afford the technology and validate the infrastructure being built to supply it. Until those gains spread, growth remains exposed to shifts in borrowing, saving and confidence in future returns. Central banks should take that fragility very seriously before tightening further.

Why Central Banks Should Tread Carefully

Charles Steindel

The Federal Reserve Bank of Philadelphia’s state coincident indexes in September showed moderate growth. In the one-month changes, three states, located in three corners of the nation--had increases greater than .5 percent (South Carolina, Nevada, and New Hampshire). However, 10 saw declines. Over the three months ending in September Nevada’s index rose more than 2 percent, and South Carolina’s was up more than 1.5 percent. Alabama and Hawaii saw declines. Over the last twelve months Nevada’s index rose a marked 4.77 percent, South Carolina was also up more than 4 percent, and 9 other states saw increases of over 3 percent. Of the remaining states, 34 had increases of at least 1 percent, while Hawaii, Alabama, and Connecticut registered small declines.no state saw an increase of 4 percent or more—Nevada’s 3.76 percent was the highest (six other states had increases above 3 percent). Alabama and Connecticut were down, and six others saw increases of less than one percent.  r percent (Idaho was up 3.62 percent), and six others were at or higher than three percent.

The independently estimated national estimates of growth over the last three and twelve (respectively, .45 and 1.91 percent) appear to be a bit lower than what the state numbers would have suggested.

State Coincident Indexes in September 2026

The AI boom faces a problem beyond the technology itself: its prospective customers must be able to afford it. Investment in computing capacity is adding to demand for power, equipment and capital before comparable productivity gains have spread across the economy. If those pressures weaken customers’ spending power, they may also constrain the revenues needed to justify the build-out. AI can fulfil its technical promise while disappointing those who finance it.

This helps explain why weakness outside technology should concern technology investors. The immediate beneficiaries of infrastructure spending are easy to identify. The eventual returns depend on a much broader group of businesses earning enough from AI to pay for its services. Those two stages need not proceed at the same pace.

**The costs arrive first**
Every investment boom creates demand before it creates productive capacity. For AI, the timing matters because several essential inputs are slow to expand. Power stations, grid connections and transformers take years to deliver. A well-funded buyer can secure priority without increasing what is immediately available to everyone else.

Electricity makes the constraint tangible. Data centres add demand to networks already serving competing needs. Fuel prices, weather and available generating capacity also matter, so rising power costs cannot simply be attributed to AI. Nevertheless, the build-out can intensify local shortages. For other users, the consequences include higher operating expenses and delays to investment, even if they have yet to adopt the technology.

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Finance adds another hurdle. Infrastructure must earn enough to cover depreciation and the cost of capital as well as operating expenses. Wider technology credit spreads suggest greater scrutiny of that calculation. Broader corporate spreads have remained comparatively stable: evidence of a general AI-driven credit squeeze is still lacking. The immediate concern is that substantial commitments are being financed before their customer revenues are secure.

**The customer must earn a return**
For an adopting business, the relevant calculation extends beyond the subscription. Integration, training and organisational change require money and management time. The savings or additional sales must justify the full cost. A company facing weak demand or pressure on margins has reason to proceed cautiously, negotiate harder or defer spending.

There is encouraging evidence of diffusion. Reported AI use among US businesses rose from below 18% in January to almost 24% in early October. But adoption often remains confined to a limited range of functions. Growing use does not yet establish how much customers will spend, or how profitable that spending will be for suppliers.

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Productivity growth and subdued unit labour costs leave room for optimism. Benefits may already be emerging. The uncertainty concerns their breadth and timing relative to the capital committed. Strong orders within the infrastructure supply chain cannot indefinitely substitute for returns earned by eventual users.

**The test for markets**
The potential feedback is therefore clear. An investment surge puts pressure on scarce inputs. Some prospective customers face higher costs before enjoying the savings. Their caution then constrains suppliers’ pricing and revenues, just as those suppliers must service a larger capital base. This is a vulnerability to test, rather than an established explanation for recent market weakness.

The financing outlook could make that test harder. Blue Chip forecasts envisage Aaa corporate yields above 6% through much of 2027 while nominal GDP growth slows towards 4.5%. This comparison is no direct measure of corporate profitability. It nevertheless points to a less forgiving environment for projects whose returns arrive late.

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The decisive evidence will be measurable savings for users and sustained cash generation for providers. Those gains would strengthen customer spending and validate the infrastructure. Weak margins and disappointing monetisation would expose the gap between investment commitments and the income available to support them. AI’s capabilities may be extraordinary. Its financial returns still depend on customers with the means and incentive to pay.

Viewpoints: October 2024

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