The Hot Factory, Cool Consumer Economy
An analysis from Blackrock this week offered a scary-sounding description of the economy emerging from the Federal Reserve’s latest Beige Book.
The Beige Book suggests that growth is becoming concentrated in manufacturing, defense, data centers, energy, and nonresidential construction, Apollo observed, while consumers, small businesses, housing, and other rate-sensitive sectors show signs of strain. The capital-spending economy is separating from the consumer economy. Monetary restraint is working unevenly. They call it the “Gator Jaw” economy because the divergence looks like an open maw.
As far as the facts go, most of that is broadly accurate. Yet the conclusion suggested by this divergence—that this is a negative development—may be backward. What if the two-speed economy is not evidence that the soft landing is failing? What if the divergence is the soft landing?
The Fed is trying to bring down consumer inflation, which it officially measures by the personal consumption expenditures price index. It is not trying to stop factories from producing machinery, prevent utilities from building power plants, or persuade technology companies to abandon investments in artificial intelligence. The ideal outcome is one in which consumer demand becomes less inflationary while investment, production, and employment remain strong.
And that appears to be exactly what is happening.
Consumers Cool While Factories Accelerate
The Beige Book describes an economy growing modestly across ten of the twelve Federal Reserve districts. Consumer spending increased only slightly, and automobile sales were subdued. Residential construction declined. Consumers became increasingly price-conscious, limiting the ability of businesses to pass on increased costs.
At the same time, manufacturing strengthened across most districts. The Philadelphia Fed reported a surge in factory activity, with orders and shipments running significantly stronger than during normal non-recessionary periods. The Cleveland Fed reported robust demand. In New York, manufacturers saw solid order and shipment growth, rising backlogs, and falling inventories. The Chicago Fed reported gains in metals, machinery, automobiles, and trucks. The Dallas Fed found persistent strength in machinery, transportation equipment, computers, and metals.
Labor demand was healthiest in manufacturing and construction. Factories added workers, increased overtime, and raised wages for scarce skilled employees even as retailers and hospitality companies pulled back.
In an economy still straining from five years of high inflation, that is an unusually favorable division of economic activity. Consumer-facing companies are losing pricing power while capital-goods producers are gaining orders.
Here’s the thing. The Fed doesn’t target the costs to businesses of equipment, components, materials, or labor. It targets consumer inflation. An industrial boom can produce higher prices for metals, electricity, freight, and construction without generating an equivalent increase in measured consumer inflation.
But don’t businesses facing higher costs inevitably pass those on to consumers? That’s a frequently voice claim but it has little basis in economic theory or experience. Business will try to pass on costs but competition for market share can prevent this. And absent a monetary expansion that puts more money in the hands of consumers, they certainly cannot all raise prices at the same time. Where would the money come from?
This is one reason tariffs had far less of an effect on consumer prices than the critics of Trump’s trade policies predicted. Businesses couldn’t simply pass the cost of tariffs on to customers, in part because the tariffs were so broad. So they absorbed them in their profit margins, improved efficiency to cut costs elsewhere, and pushed the costs back on to foreign manufacturers by demanding lower prices.
And the pass-through doesn’t seem to be happening now. The Beige Book repeatedly describes firms struggling to pass their costs along to consumers. Households are trading down, postponing purchases, and resisting price increases. Industrial inflation is being contained upstream while consumer inflationary pressure diminishes.
A Rare Civilian Capital Boom
The strongest parts of the economy share a defining characteristic: they are building productive capacity. America is experiencing rapid private capital formation even while monetary policy remains restrictive at the household level.
Higher rates do not have as much of an effect on projects promising extraordinary returns. And it is easy to understand why. A family can postpone buying a house, hoping lower rates in the future will make homes more affordable. A technology company worried about losing the AI race cannot casually postpone securing computing capacity and electricity.
This investment creates demand today and supply tomorrow. While a consumption boom uses existing capacity. A capital boom creates more of it.
Don’t Fear the Echoes of ’66 and ’56
Investment-led expansions under tight monetary policy are unusual because higher rates ordinarily weaken housing, consumption, and business investment together. The exceptions offer two warnings: capital booms can become inflationary when accompanied by excessive government demand, or they can end in recession when businesses build more capacity than the economy needs.
We can see the first risk—inflationary government spending—in the economy of 1966. Business fixed investment reached a record 10.7 percent of gross national product even as tight money starved housing of mortgage credit. Housing starts fell from an annual rate of 1.5 million in the first quarter to 1 million in the fourth. The economy avoided recession, but it did not achieve disinflation. Consumer prices, which had risen little more than one percent in 1964, began the sustained acceleration that became the Great Inflation of the 1970s.
A big part of the reason for this disaster was the government’s war machine—the war on communism in Indochina and the war on poverty in America. The Vietnam buildup produced a surge in federal demand just as LBJ’s Great Society was adding fiscal stimulus at home. Unemployment had already fallen below four percent. Government procurement and business investment were competing for workers, metals, machinery, and industrial capacity in an economy with little room to spare.
Monetary restraint also operated unevenly. Interest-rate ceilings caused deposits to flow out of banks and thrifts, concentrating the credit crunch in mortgages and homebuilding. Housing collapsed while federal spending remained comparatively insulated from interest rates. Tight money changed the composition of growth without reducing overall demand enough to extinguish inflation.
That is the central difference between 1966 and today. There is no comparable Vietnam-scale increase in defense spending waiting to overwhelm consumer restraint. Defense manufacturing may remain strong, but even the war in Iran is not contributing to a Vietnam-like surge in the Pentagon’s budget. The capital boom is primarily civilian and private.
And the distinction between private investment and war spending matters for inflation. Defense spending adds current demand without necessarily increasing the civilian economy’s future productive capacity. Civilian capital investment does both. Doing stuff like building a power plant, installing industrial machinery, or expanding computing capacity creates demand for labor and materials today, but it also allows the economy to produce more tomorrow. If the investment succeeds, output per worker rises, and unit production costs fall.
Not coincidentally, we’re seeing the greatest improvement in durable goods manufacturing productivity since the late 1990s.
The second historical warning comes from 1956 and 1957. Back during the Eisenhower administraiton, private investment remained strong while tight credit weakened housing. The problem came when companies eventually discovered that some of their expansion plans had been based on overly optimistic expectations. Investment and inventory accumulation reversed, helping push the economy into recession.
That is the more relevant danger today. The AI buildout could produce excessive data-center capacity. Power and equipment bottlenecks could drive costs higher. A reversal in technology investment could bring the expansion to a sudden halt. Anyone who lived through the dot-com and telecommunications bubble of the late 1990s will find this familiar.
Building Our Way Out of Inflation
Fortunately, the widening breadth of factory growth makes that outcome less likely. Strength is spreading beyond data centers into machinery, metals, electrical equipment, computers, transportation equipment, and industrial infrastructure. This increasingly resembles a general expansion of American productive capacity.
Blackrock’s Gator Jaw Economy captures the widening gap between capital spending and consumption. But that divergence may be precisely how disinflation succeeds without recession: monetary restraint cools the sectors feeding consumer inflation while productive investment sustains employment, output, and future productivity.
America appears to be building its way to disinflation.
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