Economic Commentary: Inflation Eases, Growth Relies on Tech and AI Investment

We begin the new year with an incomplete picture of the economy, as lingering effects of the government shutdown have delayed the release of key economic data. At the same time, the Federal Open Market Committee (FOMC) remains heavily reliant on timely data to guide monetary policy decisions. This combination has produced one of the widest divergences of views within the FOMC in recent memory regarding the appropriate policy path. Compounding the uncertainty, economic growth is being disproportionately supported by a single sector — technology. In particular, growth has become increasingly reliant on AI development and the expansion of related data center infrastructure. Outside of tech, much of the economy continues to experience sluggish growth and likely requires additional monetary support to gain momentum.

Moderating Inflation Trends

The November Consumer Price Index (CPI) report incorporated two months of data — October and November — into a single release. Headline CPI rose 2.7% year-over-year in November, down from 3.0% in September. Core CPI also showed notable improvement, increasing 2.6% year-over-year. On a shorter-term basis, the three-month annualized trend in headline CPI is now 2.1%, while Core CPI is running at just 1.5%. By comparison, the three-month Core CPI trend stood at 3.5% a year ago.

Encouragingly, easing shelter costs are beginning to flow through to CPI calculations, a trend expected to continue. Shelter accounts for approximately one-third of headline CPI and about 44% of Core CPI. After peaking at 8.2% year-over-year in March 2023, shelter inflation has slowed to 3.0% and is projected to continue declining through 2026. Along with the expected fading of tariff-related price pressures in the first quarter of 2026, these developments point to moderating inflation in the year ahead.

The delayed release of the third quarter 2025 real GDP report showed the economy expanding at a 4.3% annualized rate, following 3.8% growth in the second quarter. This marked the strongest quarterly performance since the fourth quarter of 2021. On a year-over-year basis, real GDP is growing at a 2.5% annual rate. Given the distortions from swings in trade and inventories this year, a clearer measure of underlying demand is final sales to private domestic purchasers, which rose at a 3.0% annualized pace, the strongest reading of the year. Corporate profits rose 4.2% in the third quarter, the most so far in 2025. Margins have tightened but remain well above levels prior to the pandemic.

Consumer Spending Relies on Savings

Consumer spending was the primary driver of third quarter growth, rising at a 3.5% annualized rate, the fastest pace of 2025. Investment related to AI accounted for roughly 14% of total quarterly growth. Over the first nine months of 2025, AI-related categories contributed 37% of real GDP growth. While overall growth is expected to soften in the fourth quarter due to the government shutdown, the One Big Beautiful Bill Act (OBBBA) should provide support for stronger growth in 2026.

A notable concern in the third quarter GDP report was the lack of growth in real disposable personal income. With incomes flat, consumers — who remain the main engine of economic growth — relied increasingly on savings to sustain spending. Nearly all of the 3.5% annualized increase in consumer spending came from a drawdown in personal savings. As a result, the personal saving rate declined from 5.2% in the first quarter of 2025 to 4.2% in the third quarter. Consumers are expected to receive a one-time income boost in early 2026 from larger tax refunds tied to changes in tax rates under the OBBBA.

Manufacturing Contracts, Services Show Resilience

The ISM Manufacturing Index for December fell for the third consecutive month to 47.9, its lowest level since October 2024. Readings below 50 indicate contraction, underscoring ongoing weakness in the sector amid elevated costs and economic uncertainty. Only two of the 18 industries surveyed reported growth, tying for the second-lowest number of expanding industries since April 2009. New Orders, Backlogs, New Export Orders and Employment all remained in contraction.

In contrast, the ISM Services Index rose to 54.4 in December, its highest level in a year, reflecting continued resilience in service-oriented industries. New Orders climbed to 57.9, the strongest reading since September 2024, suggesting positive momentum heading into 2026. The Employment sub-index moved above 50 for the first time since May, indicating some stabilization in labor conditions. Despite these improvements, only nine of the 18 service industries reported expansion — down from 11 in November — and overall commentary remained cautious.

Labor Market Weakens as Productivity Rises

The December employment report presented mixed signals. Non-farm payrolls increased by 50,000, which was below expectations, and job gains for October and November were revised downward by a combined 76,000. The unemployment rate edged down to 4.4% from 4.5%, reflecting a slight decline in labor force participation and fewer workers on temporary layoff. Fourth quarter 2025 marked the weakest period of non-farm job growth since the pandemic. For the full year, payrolls rose by 584,000 jobs (+0.4%), compared with an increase of 2.0 million (+1.3%) in 2024.

In December, the share of unemployed individuals out of work for more than six months rose to 26%, the highest level since February 2022. Hiring activity remains subdued, and job openings continue to decline, with only 91 openings available for every 100 unemployed workers. By contrast, in the spring of 2022, there were roughly 200 openings per 100 unemployed.

Education and health services were the sole sectors to generate meaningful job growth in 2025. Absent gains in this category, the labor market would have experienced a net loss of more than 100,000 jobs.

According to the Challenger report, employers announced 1.2 million job cuts in 2025, a 58% increase from the prior year. Hiring fell 34% compared to 2024, marking the lowest annual level of hiring since 2010.

The economy’s ability to continue expanding despite labor market softening can largely be attributed to rising productivity. Productivity increased at a 4.8% annualized rate in the third quarter of 2025.

Fed Cuts Rates Amid Divergence

At its December meeting, the Federal Reserve lowered the federal funds rate by 25 basis points, bringing the target range to 3.50%–3.75%. This marked the third consecutive rate cut. Notably, the decision included three dissents — two members favored holding rates steady, while one supported a larger cut. Several additional members expressed “silent dissents,” believing no cut was warranted but ultimately supporting the majority decision. The updated Summary of Economic Projections showed a significantly higher growth outlook for 2026, and a modestly lower inflation forecast, though the dispersion of projections was the widest seen in recent history.

Financial markets are currently pricing in two additional rate cuts by year-end 2026, which would bring the federal funds rate close to 3.0%, which is generally viewed as the neutral policy level. However, should labor market weakness persist or intensify, consumer spending and GDP growth would likely slow, prompting a more aggressive response from the Federal Reserve.