The U.S. economy spent the third quarter doing two things at once: growing faster than most forecasters expected and generating more inflation than most people wanted. The second of those prompted the Federal Reserve to raise interest rates in September for the first time in more than three years, a move that would have seemed far-fetched when the year began.
Starting with growth, GDP grew at an annualized rate of 2.2% in the second quarter, a bit below 2.5% for the first quarter, but the headline understates the economy’s underlying strength. Real final sales, a cleaner read on demand from households and businesses, grew at a 4.2% annualized pace. Consumer spending rose 3.4%, and business investment in equipment jumped 13.6%, much of it tied to the buildout of AI infrastructure. Third-quarter data, if anything, have been stronger. Retail sales rose 1.2% in August, rebounding from a decline in July, and the Atlanta Fed’s real-time GDP model was tracking third-quarter growth near 5% as of mid-September.
Looking more closely at the consumer, it is really a tale of two stories. At the top, households are sitting on record stock market gains and still booking vacations, filling restaurants, and spending freely online. Further down the income ladder, the math gets tighter. Wages are growing at roughly 3%, about the pace of inflation, so a $4-plus gallon of gas crowds out other discretionary spending. The personal saving rate has thinned to 3%, department stores keep losing ground to discounters, and consumer sentiment in September fell to 47.8, within reach of the lowest reading in the survey’s history. It is an odd combination: the data say the consumer is still spending, and the consumer says things are not going well. Both are true, depending on which consumer you ask.
Inflation is the crux of the issue. The Middle East conflict, which had appeared to be easing in the Spring, flared again over the summer, and renewed attacks on shipping in the Strait of Hormuz sent oil back above $100 per barrel. Headline inflation has drifted back toward 3.5% as a result. Core inflation, which strips out food and energy, is better behaved but still not at the Fed’s 2% target, and the new round of tariffs that took effect in late July adds some pressure on goods prices.
Against that backdrop, the Fed under Chair Kevin Warsh raised the federal funds rate by 0.25% to a range of 3.75% to 4% at its September meeting, with a unanimous vote. Warsh described the move as removing a dose of accommodation, noting bluntly that “inflation is too high, and has been for too long.” Sixteen of eighteen committee members expect at least one more rate increase before year-end. What makes this tightening cycle unusual is that the Fed is leaning against an economy it considers strong rather than one that needs rescuing. Warsh called business investment “the most striking feature” of the expansion, and as mentioned above, equipment spending grew at a 13.6% annualized pace in the second quarter, driven by the data centers, chips, and power infrastructure behind AI.
The economy enters the fourth quarter with real momentum, powered by a capital spending boom and by consumers at the high-end, whose spending has so far carried the rest. But that same momentum is now the Fed’s problem as much as its comfort. Based on where we stand today, the key questions are whether energy prices ease as the conflict in the Middle East unfolds, whether higher fuel costs bleed into core inflation, and how much of the tightening bond market ends up doing the Fed’s bidding. We do not expect a slowdown in growth in the near term, but we do expect the path forward to be bumpier than the growth figures alone would suggest.
