The tariffs had a whipsaw effect where trade was a huge negative for GDP in the first quarter, as consumers and businesses rushed to import items ahead of the imposition of tariffs. In the second and third quarters it was a large positive, as imports fell back to more normal levels after the big accumulations in the first quarter. It is likely to again be a substantial positive in the fourth quarter as imports drop to lower levels in response to the tariffs. `

This pattern in trade flows led to the negative first quarter GDP figure, followed by very strong growth in the second and third quarters. For the first three quarters growth averaged 2.5 percent. It is likely to be close to this pace in the fourth quarter.

Productivity Growth Will Slow

There has been an extraordinary increase in productivity growth since the second quarter of 2023. Through the third quarter of last year productivity growth averaged 2.7 percent. (This number will be revised up by 0.1-0.2 percentage points as a result of the benchmark revisions showing considerably lower payroll employment.) With hours growing at close to a 1.0 percent rate in the fourth quarter, productivity growth will be close to 1.5 percent.

However, the productivity data are highly erratic. It is still likely we are on a faster productivity growth path. AI is likely playing a role in this upturn, but since the uptick first shows in the data in early 2023, it doesn’t seem plausible it can be the whole story.

Consumption Growth Will Again Be Strong

Consumption growth will again be healthy in the fourth quarter, but likely somewhat below 2.5 percent, down from its 3.5 percent rate in the third quarter. Consumption in the third quarter was boosted in part by a boom in small package purchases before the end of the de minimis exemption from tariffs in late August.

There was also extraordinary growth in health care services, which rose at a 6.7 percent annual rate in the third quarter. After falling sharply during the pandemic, health care spending has been growing rapidly in the last four years. This is true measured in real terms, but the increase is even more noticeable in nominal terms, with health care inflation outpacing the overall rate of inflation.  

It will also be worth noting spending on prescription drugs. Trump has made reducing drug prices a high priority, but spending on prescription drugs was up more than 7.0 percent year-over-year in the third quarter.

Mixed Story on Investment: Equipment Up, Structures Down

Investment in non-residential structures has been trending downward for the last two years. This pattern will continue in the fourth quarter. In particular, construction of factories has been trending downward following a sharp surge in 2022 and 2023.

Equipment investment has been strong, supported by the AI boom. This will continue with equipment growing at a modest pace, as non-AI components have been weak. Investment in intellectual property products will also be a modest positive, with expenditures on software showing good growth, but investment in entertainment and artistic products trending downward.

On net this should translate into growth for investment at close to a 5.0 percent rate. This would be roughly halfway between the 7.3 percent growth in the second quarter and 3.2 percent growth in the third quarter.

Housing Still Heading Downward

Housing investment has been headed downward through the first three quarters of 2025. Residential investment is likely to again be modestly lower in the fourth quarter. High mortgage interest rates continue to depress the housing sector.

Inventories Will Again Make a Big Contribution to Growth

There was a large drop in inventories in both the second and third quarters, as businesses began to sell off their huge accumulations from the first quarter. It looks like inventories will be little changed in the fourth quarter, which would mean a large positive in GDP. They could add roughly half a percentage point to growth for the quarter.

State and Local Spending to Show Moderate Growth, Federal Spending Will Decline

State and local government expenditures grew at a 2.0 percent rate in the third quarter. They are likely to grow at roughly the same rate in the fourth quarter. Federal spending will decline modestly due to the shutdown. This will have a limited impact on growth for the quarter, since domestic discretionary spending (the area subject to the shutdown) accounts for only a bit more than 2.0 percent of GDP. And much of the government was not actually shut down. As a result, it will only shave around 0.1 percentage point from growth for the quarter.

Trade Deficit to Move Towards a Moderate Downward Path

The wild gyrations in the trade deficit in the earlier part of the year are likely behind us, barring new tariffs or other trade restrictions. However, tariffs and the fall in the value of the dollar since the start of President Trump’s second term will have the predictable effect of reducing imports. This will mean some reduction in the trade deficit, although other policies — like limiting foreign students and tighter visa restrictions — will reduce service exports. Also, over the longer term, cutting back government research spending and lawsuits against universities will dampen innovation and reduce the US trade surplus on intellectual property claims.

Fourth Quarter: Strong Growth, But Heavily Dependent on AI

Getting through the trade gyrations, it is clear that the economy is riding an AI bubble. Investment is being largely supported by investment in data centers and other AI-related areas. Perhaps more importantly, consumption growth is being supported by the stock market bubble as aggregate wage growth has been lagging consumption growth for the last three years.

Inflation, which had been falling towards the Fed’s 2.0 percent target before the election, seems likely to remain close to 3.0 percent for the near-term future. The economy can sustain a path of healthy growth and moderate but slightly elevated inflation until the AI bubble bursts.