The second quarter GDP will provide important information on productivity growth, perhaps the biggest question for the likelihood of the massive AI investment boom paying off. If there is any hope that the big AI companies, along with the hyperscalers and the chip manufacturers, are going to see huge profits, there must be a massive uptick in productivity growth. Instead of seeing growth in the range of 1.5-2.0 percent, it would take growth in the range of 4.0-5.0 percent for these AI investments to possibly make sense.

Thus far we clearly have not seen any evidence of this sort of uptick in productivity growth. Productivity grew at 1.6 percent rate in the 4th quarter of last year and at just a 0.3 percent annual rate in the first quarter. With GDP growth likely to be close to 2.0 percent for the quarter, and hours growing at a small positive rate, productivity growth will again be under 2.0 percent in the second quarter.

Things can be different going forward, and both the output and hours data can be revised, but to date we aren’t seeing any evidence of the productivity boom promised by AI promoters. As we see more quarters go by without a boom, their case becomes a more difficult sell.

Consumption Growth to Accelerate

Consumption grew at a weak 0.5 percent annual rate in the first quarter. The pace is likely to increase at least moderately in the second quarter but will still be considerably slower than the 3.7 percent rate of 2024 before the economy was disrupted by tariffs, mass deportations, and war.  

Auto sales are likely to be the biggest factor boosting consumption in the quarter, as June sales were exceptionally strong. Other components will show much weaker growth. In particular, growth in real spending on health care has been extraordinarily weak this year. This could reflect reduced health insurance coverage as a result of the ending of the enhanced subsidies in Affordable Care Act exchanges, as well as people being dropped from Medicaid.

The impact of higher gas prices will be a drag on discretionary categories of consumption. Transportation services, largely air travel, will show a decline from the first quarter. Restaurant spending has been weak since the second half of 2025. Growth in this sector will at best be a small positive and quite possibly negative.

AI-Related Spending Will Dominate Investment

Non-residential investment grew at a healthy 10.6 percent rate in the first quarter. This was primarily the result of AI-related spending. Investment in non-residential structures shrank at a 4.7 percent annual rate. Investment in factory construction has been especially weak; it is now down by almost 25 percent from its peak in the fall of 2024.

Equipment investment grew at a 15.8 percent rate in the first quarter. This was mostly the result of a 39.9 percent increase in investment in information processing equipment. Real spending in this category is now almost 40 percent above the level for the fourth quarter of 2024. There will be another sharp increase in information spending in the second quarter.

Other categories of equipment spending are not doing as well. Investment in industrial equipment is just 0.2 percent above its level of the third quarter of 2025. Investment in transportation equipment fell in the first quarter, putting it 11.5 percent below the level of the second quarter of 2025.

Housing May Show Modest Growth

Residential investment has been falling since the first quarter of 2022. It declined at a 7.8 percent annual rate in the first quarter. A jump in housing starts in March, with construction continuing through the quarter, likely led to a modest rise in residential construction for the quarter. The level of starts fell in subsequent months, so this increase will not be sustained into the third quarter.

Net Exports Will Again Slow Growth

Trade was a negative for growth in the last two quarters, and that looks like it will be the case again for the second quarter of this year. There was a sharp decline in exports, even as imports continued to rise at a healthy pace. Trade subtracted 0.22 percentage points from growth in the fourth quarter of 2025 and 0.37 percentage points in the first quarter. The drag is likely to be even larger in the second quarter.

Government Spending Will be a Boost to Growth: Impact of War Uncertain

State and local government spending grew at a 1.6 percent rate in the first quarter, virtually the same as the 1.5 percent rate in the fourth quarter. This is a sharp slowing from rates of 3.6 percent in the last two years of the Biden administration. Pressure from reductions in federal support is forcing cuts at the state and local level, which will continue to restrain spending in the second quarter.

Federal spending will likely show modest growth, with the war having some impact. Most of war-related spending will show up in future quarters as the government replenishes weapons used in the war.

Inflation Will Be Close to 4.0 Percent

War and tariff-driven price increases will push inflation, as measured by the GDP deflator, to near 4.0 percent. In addition to these factors, the AI boom is also leading to surging prices for computers and related equipment. This means investment goods will also show substantial inflation.

War and Tariffs Create Serious Uncertainty

Growth in the quarter will likely be on the slow side of respectable, just under 2.0 percent. But this will come with an inflation rate that is above the Fed’s 2.0 percent target. And with the prospects for the Iran War unclear, there could be an ongoing drag due to higher prices and shortages of oil and other essential inputs.

There is also the possibility that the AI bubble could burst at some point in the not distant future. Each quarter where we do not see evidence of an AI-driven productivity boom makes the AI bonanza story less plausible. The spread of low-cost open-weight Chinese AI also reduces the likelihood that US producers will be the main beneficiaries of whatever dividends accrue to the sector. The collapse of this bubble will be a major hit to growth when it occurs.