AI-related investment, consumers likely boosted US economic growth in third quarter

By Lucia Mutikani

WASHINGTON, Oct 29 (Reuters) - US economic growth likely accelerated in the third quarter as resilient consumer spending and AI-driven business investment more than offset the impact of higher oil prices stemming from the conflict in the Middle East.

The anticipated strength would stand in stark contrast to households’ downbeat assessment of the economy, reflected in President Donald Trump’s record-low approval ratings and a sharp deterioration in consumer sentiment. The Commerce Department will publish its advance estimate of third-quarter gross domestic product on Thursday, less than a week before Tuesday’s midterm elections, which will determine control of Congress.

"People are very upset about high energy and food prices, and yet the fundamentals for consumers are still decent," said Gus Faucher, chief economist at PNC Financial. "We still have job growth, wage gains and there’s the strong stock market that’s supporting spending by high-income households, in particular, so consumers continue to increase their spending at a pretty steady clip." 

GDP likely increased at a 3.2% annualized rate last quarter, a Reuters survey of economists predicted. The economy grew at a 2.2% pace in the April-June quarter. But the survey was conducted before the release on Wednesday of September’s advance economic indicators report, which showed a widening of the goods trade deficit as strong demand for capital goods linked to the AI spending boom lifted imports to a record high. 

Economists estimated the trade shortfall subtracted at least 4 percentage points from GDP growth last quarter. But the drag was probably blunted by the AI-related investment, with business spending on equipment expected to have notched a third straight quarter of double-digit growth. 

AI also likely contributed to spending on intellectual property products. Inventories are also expected to have added to GDP growth last quarter.  

Investors are increasingly focusing on the rising costs of long-term AI projects in which the payoff is uncertain. Tech firms have borrowed huge sums over ​the past year for AI spending, a potential downside risk to equipment spending. Still, economists did not expect this to hinder the economy.

"There’s likely to be more discretion when it comes to investment in AI, but the underlying momentum remains quite strong," said Gregory Daco, chief economist at EY-Parthenon. "AI-related investment is likely to remain a key pillar of US economic activity, even if there are some risks of pullbacks and some questions as to the return on all of its investment." 

The economy is expanding at a pace that is well above what some Federal Reserve  officials regard as the non-inflationary growth rate of around 2%. The US central bank on Wednesday left its benchmark interest rate in the 3.75%-4.00% range while acknowledging that inflation "remains elevated."

Economists expected the Fed to raise rates in December. Fed Chairman Kevin Warsh told reporters that "economic activity is expanding at a strong pace," noting that "while uncertainty remains, owing in part to geopolitical developments, domestic spending has been resilient." 

ROBUST CONSUMER SPENDING EXPECTED

Consumer spending, which accounts for more than two-thirds of the economy, is projected to have increased at above a 3.0% pace after growing at a 3.8% rate in the second quarter. Historic low layoffs and moderate hiring are helping to underpin spending, though wage gains have at times lagged inflation. 

Households have been saving less and dipping into their nest eggs to fund spending. With average gasoline prices still above $4 a gallon as the US-Israeli war with Iran drags on, economists anticipated that consumer spending would pull back.

"It appears that households made a judgment when the conflict began earlier this year that the run-up in energy prices would prove mostly temporary," said Stephen Stanley, chief US economist at Santander US Capital Markets. "That assessment may prove wrong, so consumers may need, at some point, to tighten their belts." 

Rising mortgage rates because of the Middle East conflict are expected to have pushed residential investment back into contraction last quarter. Higher borrowing costs have overshadowed a moderation in house prices, putting homeownership out of the reach of young adults.

Homebuilding is also being constrained by land and labor shortages amid an immigration crackdown, and higher prices for materials due to tariffs on imports. The construction of data centers to support AI likely lifted business investment in nonresidential structures after stabilizing in the second quarter. A rebound in government spending is anticipated. 

A measure of domestic demand, which excludes inventories, trade and government, is expected to have surged last quarter. Final sales to private domestic purchasers grew at a 4.6% rate in the second quarter.

"The overall picture is that the economy is growing at a decent pace, but the primary factors are an AI-driven investment boom and consumption driven primarily by rising stock wealth," said Dean Baker, senior economist at the Center for Economic and Policy Research. "It’s unclear how long this can continue, but this is not a very stable picture, nor a very positive one for most working people."