Citi: AI investment supports US growth, but makes the Fed’s next move harder to predict

Why does strong growth still worry Citi?

US real GDP grew at an annualized rate of 3.4% quarter over quarter in the third quarter, with business investment contributing 3.3 percentage points and private domestic final demand growing 5%. But GDP grew 2.1% year over year, a figure Citi believes is closer to the economy’s potential growth rate.
Citi estimates that AI-related investment has contributed an average of nearly 1 percentage point to growth in recent quarters. If that investment pulls back, economic growth could fall to zero or turn negative. Over the past two weeks, investors’ concerns about returns on AI spending have risen, and markets have also repriced a downside growth scenario.
A significant share of the technology goods used in AI buildout is imported, and a widening trade deficit weighs on GDP growth. Citi notes that if AI investment slows in the future, imports falling from high levels could in turn support GDP.

Consumption had remained resilient even as real income growth slowed, but real consumer spending was flat month over month in September. Citi expects annualized quarter-over-quarter real GDP growth to slow from 3.4% in the third quarter to 1.5% in the fourth.
Data center construction has recently supported private nonresidential construction spending, but Citi believes high interest rates may continue to restrain construction investment outside AI. In housing, single-family permits fell further and builder confidence was weak.
Manufacturing has also benefited from AI infrastructure and tax incentives for business investment. Citi expects AI investment activity to remain strong in 2027, though its growth may slow and the boost from tax incentives will also fade.

The Fed held interest rates steady at its October meeting. Chair Warsh believes the economy is not overheating and that productivity growth means stronger growth does not necessarily bring inflation; he also said financial conditions have tightened but are not yet restrictive. Citi therefore believes officials are still considering further rate hikes, though they are in no hurry.
Citi’s baseline scenario is a 25-basis-point rate hike in December, followed by cuts starting in mid-2027. If stocks fall further or economic activity data weaken, the Fed may pause rate hikes in December, and its next move would more likely be a cut.
Inflation remains a constraint on policy: the core PCE price index rose 0.32% month over month and 3.1% year over year in September. Citi expects core inflation to cool in the fourth quarter, but data for the previous two months exceeded expectations, and officials may need to see more signs of easing before they are confident inflation is returning to target in a timely manner.

Citi expects nonfarm payrolls to increase by 65 thousand in October, above the 29 thousand recorded in September and the survey median of 55 thousand; it expects the unemployment rate to remain at 4.2%. However, the bank believes slower population growth and low hiring overall skew medium-term employment risks to the downside.
Job postings have recently been broadly flat, while temporary services employment has stabilized and edged down in recent months after growing in the first half of the year. Citi believes that if financial conditions continue to tighten, the labor market could weaken again more noticeably in the first half of 2027.
Employment signals are mixed: indicators such as continuing unemployment claims point to a possible decline in the unemployment rate, while consumers reporting that jobs are hard to find and weak small-business sales point to a possible increase.