A tale of two narratives: consumer sentiment falls while AI spending surges

That new narrative is, of course, the boom in infrastructure spending to support the artificial intelligence (AI) revolution. The big shift in spending on AI began just before the COVID recession and was only slightly affected by the downturn. Beginning in 2021, growth rates for investment in intellectual property products (which captures much AI investment) were in double-digits for six quarters in a row. This spending shows no sign of letting up as this measure was again in the double-digits for two of the most recent four quarters. This is not unprecedented, but we have not seen this pace of growth of spending in this category since the late ‘90s.

The AI investment story hinges on the tremendous optimism that AI adoption will lead to productivity gains for years into the future. The consumer sentiment story is based on labor market uncertainty and the recent re-emergence of inflation. The narratives point in opposite directions, and the result of these forces coming together is economic growth that looks red-hot from one point of view and barely getting along from another point of view.

U.S. Real GDP growth in the 1st quarter was 1.6%. This second estimate for the quarter was revised down from the 2.0% initially reported in April. Real GDP for the 4^th quarter of 2025 was also revised down to 0.5% from the 1.4% reported previously. Real consumer spending grew at a 1.4% rate (the second lowest rate in three years). Gross private domestic investment grew at a 7.0% rate with double-digit gains in both equipment and intellectual property products offsetting negative growth in both nonresidential and residential structures. Government spending grew at a 4.4% rate which was not enough to offset the 5.6% decline in the 4^th quarter (during the government shutdown). Exports grew at a 13.1% rate (highest in over three years), and imports grew at a 21.1% rate (highest since 2025Q1). (All growth rates are seasonally adjusted annual rates.)

As Figure 1 shows, 1st quarter GDP growth was up from the 4th quarter, but well below most quarters in the last three years. The main areas of weakness are slower growth in consumer spending, reduced residential investment, cuts to federal government spending, and a surge in imports (which subtract from GDP). If it were not for AI investment, GDP growth for the last two quarters would be closer to zero and getting very close to recession territory.

Consumer spending growth contributed 0.95% to the 1.6% overall GDP growth rate, which is well below the average contribution. Investment growth contributed 1.19% to overall growth. For investment to contribute more than consumption to GDP growth is somewhat unusual compared to recent experience. As Figure 2 shows, consumption's contribution to GDP was highest in quarters 2 and 3 of 2025, the quarters were GDP growth averaged about 4%.

The contribution of net exports has been volatile in recent quarters due to changes in tariffs. The reduction in imports in quarters 2 and 3 of 2025 is showing signs of reversal as consumers and businesses adjust to new prices.

In the short-term, one reason for increased concern for the consumer narrative is the return of inflation. The Consumer Price Index (CPI) rose 0.9% in March and 0.5% in April. The most visible price shock for consumer is at the gas pump, but increased transportation costs are working their way into the price of food and other consumer goods.

This is significant because consumers are often slow to adjust their driving habits in the short-term, especially if the rise in gas prices is seen to be temporary. As a result, they cut back in other areas.

In addition, higher inflation will make it hard for the new Federal Reserve Chair, Kevin Warsh, to convince the rest of the Federal Open Market Committee to lower the federal funds rate. Currently, fed funds futures are predicting no rate cuts this year with a significant probability of a rate increase by late this year or early 2027. Higher inflation and higher interest rates would increase labor market uncertainty and tighten the squeeze on the already burdened consumer.

In the long-term, we are seeing changes in the makeup of consumer spending that could be problematic in the event that the AI narrative would falter. Much has been said recently about the so-called "K-shaped economy" which is a reference to the different experiences of high income and low income consumers. High income consumers are the upper leg of the K with faster growth while low income consumers, the lower leg of the K, are losing ground.

A recent article from the Federal Reserve quantifies how much more K-shaped consumption spending has become since the COVID recession. Using Census data, the authors find that overall average monthly retail spending has increased 14.7% from 2018 to 2024. However, spending by low income households has only increased by 7.9%--only slightly more than half as much as the average--in the same period. High income households increased their retail spending by 16.7%.

The reason this matters is that it is likely the case that at least some of the explanation for the dramatic increase in spending by high income households is their increased wealth from stock investments, which has largely been driven by AI investment in recent years. As the AI investment curve inevitably starts to flatten, high income households may slow their spending growth, which would accelerate any negative effects on GDP.

Regional economic performance followed national performance in the 1st quarter. The State Coincident Index from the Philadelphia Fed was essentially unchanged for both Iowa and Illinois following slight increases in the 4th quarter.

The Federal Reserve's Beige Book, which reports on economic conditions in the 12 Federal Reserve districts across the country, provided some useful commentary on conditions in the Chicago district (where the Quad Cities is located) in April. Among the observations made by the Fed's business contacts in the district include:

• "Contacts overwhelmingly reported stable labor market conditions, with low turnover and a wait-and-see approach to hiring. A contact at a temporary employment agency said demand was up as companies hesitated to hire long-term employees amidst elevated uncertainty."
• "One contact reported greater wage pressures for electricians, who were being offered substantially higher wages by data center developers."
• "Manufacturing demand rose modestly in late February and March."
• "Expectations for 2026 District farm income declined overall during the reporting period as input costs rose faster than agricultural product prices. Fertilizer and fuel prices increased, though a substantial share of farmers had preordered fertilizers and locked in pricing prior to the reporting period."

Overall, the report paints a picture of a region that is responding to the same basic pressures that are affecting the national economy.

The Weekly State-Level Economic Conditions Index started the quarter indicating slower than long-run growth and below average U.S. growth for both Iowa and Illinois. However, the indexes for both Iowa and Illinois rose during the quarter and finished in positive territory, indicating faster than long-run average growth.

Source: Christiane Baumeister & Danilo Leiva-León & Eric Sims, 2024. "Tracking Weekly State-Level Economic Conditions," The Review of Economics and Statistics, MIT Press, vol. 106(2), pages 483-504, March.

The diverging narratives surrounding negative consumer sentiment and optimism over AI present a difficulty for forecasters. The additional pressure on inflation from higher oil and gasoline prices that appeared in this quarter have only added to the problem.

For the moment, AI investment is helping to keep U.S. GDP growth on the positive side. With less exposure to AI investment, the Midwest economy generally and the Quad Cities economy specifically, may be more sensitive to changes in the consumer narrative. With a stable labor market and modest increases in manufacturing, the regional economy is likely to grow at approximately the long-run average rate in the near future.

Downside risks include higher inflation and interest rates, lower farm income, and pullback in AI investment. Upside risks include lower oil prices from a potential resolution to conflict in the Middle East, higher productivity from AI adoption, and stronger manufacturing activity.

Elsewhere in this Quarterly Market Report, our Business Outlook Survey shows that the sentiment of local business leaders corresponds well with the regional and national trends discussed here. Our survey also shows that local manufacturers are becoming somewhat more optimistic about the next few months, which lines up well with comments from the Fed's Beige Book.

Overall, the economy is not likely to be exclusively tied to one single narrative in the near future. At least as long as the AI buildout continues, the fate of the consumer alone will not necessarily determine if we fall into a recession. Even so, especially for low income consumers, inflation pressure has the potential to cause significant disruption.