Most economists, including us, were wrong about the ‘ensuing’ recession back in 2022 and 2023 as the US Federal Reserve (Fed) increased interest rates to fight higher inflation. Typically, very high interest rates push real investment lower, especially real investment in residential construction, and the economy goes into recession, slowly or due to a shock, as interest rate-vulnerable sectors give in.
But that time was different, as non-residential investment remained afloat and relatively immune to high interest rates due to, among other things, a surge in investment in manufacturing plants incentivized by the IRA and the CHIPS Act. We can see the surge in the percentage point contribution from real investment in manufacturing plants in dark blue in the graph below, from a sector that is relatively small but was pulling above its weight during the period from 2022 to almost 2024. Today, it is not real investment in manufacturing plants, but real investment in information processing equipment, which has increased its contribution to the growth of real gross fixed private investment and has been relatively immune to high interest rates, as shown in light blue the graph below.
The contribution to the growth of real gross fixed private investment from the information processing equipment sector during the first quarter of 2025 was an impressive 5.8 percentage points of the 6.4 percentage points contributed by real investment in equipment, the highest quarterly contribution from this sector since 1980.
Although investment in AI seems to have been pushing real investment in information processing equipment over the last year or so, the surge in Q1 2025 could also be explained by companies front- loading purchases of these capital goods ahead of the implementation of tariffs. However, it is also clear, from the graph below, that even if that is true, the surge in real imports of capital goods of information processing equipment started before tariffs were a real threat and continued to remain strong during the second quarter of the year, as shown by the graph below.
Thus, although economic activity has been weakening in the face of very high interest rates, a new sector, which seems immune to high interest rates due to the expectations of strong profitability over time, the AI sector, seems to continue to keep real investment, i.e., the most volatile sector of the economy, above ground.
The convergence of soft and hard data
During the first part of the year, but especially since the start of this administration’s successive tariff announcements, soft data has been showing a weakening economy, while hard data, especially the employment numbers, have been showing a still strong economic performance. This changed on August 1, 2025, when the Bureau of Labor Statistics showed a weak nonfarm employment number for July, up 73,000, while at the same time it made large downward revisions to previously reported strong employment numbers in May and June. The two previous months’ downward revision was very large, showing 258,000 fewer jobs created than originally estimated for the two months taken together. This means that, on average, jobs created during the last three months ending in July were just 35,333, with just 19,000 jobs created in May, 14,000 in June, and 73,000 in July.
If these revisions, which have been large and mostly lower since the start of the year, continue, we may see negative employment numbers before the end of the year, especially starting in October, which is when most of the Federal Government employees who accepted the buyout will start dropping off the US Government payrolls.
All of this information means that, finally, hard data, which had been looking better than soft data, is catching up with the weaker soft data, and this could mean trouble for economic activity during the second half of the year.
For now, as we stated in the first section, the AI revolution seems to be keeping the US economy (and the stock market) afloat. However, the US economy cannot, at this time, afford much weaker employment and thus, much weaker income growth because it could tip economic growth lower. At the same time, if we get further weakening in real investment going forward, especially in real residential investment, not even investment in AI is going to prevent the economy from falling into a recession.
All these arguments are in line with our view that the Fed needs to lower interest rates as soon as possible.
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