U.S. economic growth slowed to an annualized 1.5% in the second quarter while annual inflation dipped to 3.3% in June, according to federal data published Thursday. The cooling price pressures have traders pricing in an increased likelihood of an interest rate hike by the Federal Reserve later this year.
Economic Growth Slows Amid Energy Pressures and Trade Deficits
Gross domestic product increased at a 1.5% annualized rate during the second quarter, coming in below Wall Street’s consensus expectations of 2.1% growth, according to the Commerce Department’s Bureau of Economic Analysis. Economists polled by Reuters had forecast a stronger expansion, with individual estimates ranging from a 0.8% rate to a 2.9% pace.
The slowdown follows a 2.1% growth pace in the first quarter. Analysts point to a widening in the trade deficit and the ongoing economic fallout from the Middle East conflict as primary headwinds. The war has disrupted shipping in the Strait of Hormuz and driven up global energy costs, with a surge in oil prices lifting U.S. gasoline prices from an average of $2.98 a gallon just before the war started in late February to well over $4.
Consumer Resilience and the Artificial Intelligence Investment Boom
Despite mounting energy costs and a squeeze on real incomes, consumer spending surged at a 3.2% rate last quarter, rebounding sharply from an abrupt slowdown to 0.5% growth in the January-March period. Households absorbed the shock through several distinct channels.
Nationwide Chief Economist Kathy Bostjancic noted that consumers benefited from a healthy labor market, tax refunds and reductions, and positive wealth effects from the equity market. Any shortfall resulting from higher energy prices was bridged by drawing down personal savings.
In addition to generous tax refunds from President Donald Trump’s One Big Beautiful Bill,
higher-income households benefiting from rising asset prices drove retail activity. The recently concluded FIFA World Cup tournament and midterm election-related spending by nonprofits also provided a lift to domestic demand.
Simultaneously, robust business investment in equipment related to the buildout of artificial intelligence infrastructure continued to prop up domestic demand. This AI investment boom showed no signs of slowing, despite investor concerns that valuations across many technology companies had become stretched.
Inflation Cools Down as PCE Meter Registers Relief
Separate government data released Thursday by the Bureau of Economic Analysis showed that the Federal Reserve’s preferred inflation gauge, the Personal Consumption Expenditures index, cooled last month. Annual inflation was 3.3% in June, down from 3.4% in May, marking the highest annual rate since October 2023 at 3.5%.
Core PCE, which strips out volatile food and energy items, rose 3.3% last month. While the reading matches consensus economist estimates, it remains above the central bank’s targeted 2% threshold.
Internal Fed Division and Growing Bets on a Rate Hike
The policy-setting Federal Open Market Committee voted on Wednesday to leave its benchmark overnight interest rate steady in a range of 3.50% to 3.75%. However, the decision revealed notable internal dissent.
Three members of the committee dissented from the decision to hold rates, preferring a quarter-percentage-point increase: Dallas Fed President Lorie Logan, Minneapolis Fed President Neel Kashkari, and Cleveland Fed President Beth Hammack. During a press conference, Fed Chair Kevin Warsh emphasized the central bank’s zero tolerance for persistently elevated inflation.
Financial markets are already adjusting to the prospect of further monetary tightening. Traders using CME Group’s FedWatch tool have priced in a 59.2% probability of the Federal Reserve raising interest rates in September. Those odds climb steadily through the remainder of the year, hitting 71% in October and reaching 83.5% by December.
Weighing Growth Risks Against Future Inflation Projections
Financial analysts remain divided on how the central bank should navigate competing economic signals. While softer inflation data suggests room for patience, weaker GDP prints indicate the economy may be losing momentum faster than anticipated.
Chris Zaccarelli, chief investment officer for Northlight Asset Management, noted that while the weaker-than-expected GDP numbers could signal that the economy is slowing too quickly, the lower PCE readings should give the Fed some leeway to avoid raising interest rates prematurely.
Oxford Economics projects that core inflation will remain elevated, ending the year at 3.1% annually, warning that core inflation is unlikely to head sustainably lower until next year. Meanwhile, households attempting to maintain spending levels by drawing down savings face a precarious path as retail gasoline prices hover above $4 a gallon.
