The most consequential development last week was the Federal Reserve’s (Fed’s) decision to pause despite stronger growth and persistent inflation. The October 28 Federal Open Market Committee meeting, policymakers left fed funds rates unchanged at 3.75%–4.00%, with a 10–2 vote and two hawkish dissents from Lisa Cook and Beth Hammack. More importantly, the statement upgraded the Fed’s assessment of economic activity from “solid” to “strong,” while retaining the view that inflation remains elevated. Fed Chair Kevin Warsh acknowledged that financial conditions had tightened following September's hike, including in artificial intelligence (AI)-related financing, but stopped short of describing them as tight. He also argued that stronger productivity could allow growth to remain robust without necessarily generating further inflation. We would retain the December hike as the base case, although Warsh's reluctance to provide forward guidance suggests the Fed wants to preserve flexibility. The October meeting was a hawkish pause, but with less urgency than September. Moreover, the Committee appears increasingly willing to assess the effects of earlier tightening before acting again.
Third-quarter (Q3) gross domestic product (GDP) reinforced the resilience of the US economy, but also its growing dependence on AI investment. Real GDP accelerated to 3.4% quarter over quarter (q/q) annualized from 2.2% in the second quarter, while real final sales to private domestic purchasers (or net domestic demand) increased an even stronger 4.9% q/q. Consumer spending rose 3.8%, while non-residential investment remained particularly strong, led by information-processing equipment. Tech spending, which accounts for just about 7.5% of GDP, contributed a significant 1.4 percentage points to year over year (y/y) GDP growth. Meanwhile, September’s 13.5% y/y increase in core capital goods orders confirms that the AI-driven manufacturing rebound remains intact. However, residential investment declined 3.3%, reinforcing the divergence between AI-related activity and interest-rate-sensitive sectors. The GDP report strengthens the case for continued near-term growth resilience, but not necessarily a more broadly based expansion.
The more concerning development was the deterioration in real household purchasing power. September headline personal consumption expenditures (PCE) inflation accelerated to 3.6% y/y from 3.4%, while core PCE rose to 3.1% from 3.0%, with the latter increasing 0.3% month over month (m/m). Nominal consumer spending increased 0.5%, but real spending was unchanged, while real disposable income declined 0.3%. The saving rate fell to 3.8%, its lowest since September 2022. Real goods spending fell 0.3% and durable goods spending 0.8%, pointing to some loss of momentum beneath the strong Q3 consumption numbers. While households have relied on savings and credit to sustain consumption, the greater risk is that elevated prices increasingly constrain real spending, particularly among lower-income households.
See more: The Fed Risks a Policy Error Fighting Oil Prices
Meanwhile, a more significant shift in the AI investment narrative may be underway, with financing becoming an increasingly important constraint. The Financial Times reported that OpenAI reduced its latest fundraising target from US$30 billion to US$20 billion and its proposed valuation from US$1.4 trillion to US$1.25 trillion, amid weaker investor appetite and concerns about the scale of AI spending. This follows growing scrutiny of debt-financed infrastructure projects and the returns required to justify exceptionally large capital commitments. However, the distinction between financing pressures among highly leveraged AI companies and the spending capacity of cash-rich hyperscalers remains important. The immediate risk is not necessarily a collapse in AI investment, but a gradual tightening in financing conditions that could eventually weaken capital expenditure and equity-market wealth effects.
Treasuries rallied further despite the stronger GDP and inflation data, with the curve steepening as the short end outperformed. The moves suggest that weaker risk sentiment, Warsh’s more patient tone and demand for duration are outweighing persistent inflation concerns. However, with the federal debt-to-GDP ratio reaching 100% of GDP in September (the first time the ratio has hit the triple-digit mark since 1946), the long end remains exposed to large fiscal financing requirements, AI-related capital demand and uncertainty over Treasury issuance. The November 4 Treasury refunding announcement will be particularly relevant for assessing whether coupon issuance assumptions need to change.
The US dollar (USD) was broadly unchanged over the week despite the decline in US yields. The USD continues to benefit from relatively elevated yields and US growth outperformance. However, it lacks a clear catalyst for sustained appreciation. Developments elsewhere also matter. The Bank of Canada raised rates 25 basis points to 2.50%, the Bank of Japan signaled further tightening despite holding at 1.25%, while the European Central Bank maintained rates but highlighted upside inflation risks. Monetary-policy divergence is therefore becoming less favorable for the USD. We expect to see tactical rallies around inflation or Fed tightening, but with limited conviction, particularly if US yields continue to decline or the AI-related equity correction deepens.
Nikhil Mohan, Economist Research Analyst
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