The Hot Factory, Cool Consumer Economy

An analysis delivered by Blackrock this week painted a somewhat alarming picture of the economy as depicted in the Federal Reserve’s recent Beige Book.

The Beige Book indicates a shift in growth patterns, notably favoring sectors like manufacturing, defense, data centers, energy, and nonresidential construction. Observations made by Apollo point out that consumers, small businesses, and housing—along with other sectors sensitive to interest rates—are beginning to feel the strain. Essentially, there’s a separation occurring between the capital-spending economy and the consumer economy, a situation they’ve dubbed the “Gator Jaw” economy, likening the visual difference to an open mouth.

Facts presented seem to generally hold up. However, the implication that this divergence signals a problematic trend might be misguided. What if this two-speed economy isn’t a sign that a soft landing is falling short? What if this distinction actually represents the soft landing itself?

The Fed is focused on reducing consumer inflation, which it gauges through the personal consumption expenditures price index. It does not aim to stifle production in factories, halt utility construction, or dissuade tech companies from investing in artificial intelligence. The goal is, ideally, a scenario where consumer demand becomes less inflationary while investment, production, and employment maintain their strength.

This seems to be developing as expected.

Consumers Cool While Factories Accelerate

The Beige Book outlines a modest growth across ten out of the twelve Federal Reserve districts. Consumer spending has only increased slightly, with car sales remaining muted, and residential construction on the decline. Consumers are becoming more conscious of prices, making it tougher for businesses to pass along increased costs.

Conversely, manufacturing is gaining strength in most districts. The Philadelphia Fed reported a notable uptick in factory activity, with orders and shipments significantly surpassing normal levels outside of recession periods. The Cleveland Fed noted strong demand as well. In New York, manufacturers enjoyed healthy order and shipment growth, along with increased backlogs and decreasing inventories. The Chicago Fed described growth in sectors like metals, machinery, and automobiles, while the Dallas Fed found consistent strength in transportation equipment and computers.

The strongest labor demand appeared in manufacturing and construction sectors. Factories are hiring more employees, increasing overtime, and boosting wages for skilled workers, even as retail and hospitality sectors cut back.

Given the five years of persistent inflation, this current distribution of economic activity is rather exceptional. Businesses catering to consumers are losing pricing power, whereas producers of capital goods are gaining orders.

Now, one might ask: don’t businesses with rising costs inevitably pass those on to consumers? It’s a common belief, but it lacks strong support in economic theory or experience. Sure, businesses may attempt to transfer costs, yet competition for market share often gets in the way. And without an influx of money into consumers’ hands, it’s hard to see how all businesses could raise prices at once. Where would that money originate?

This explains why tariffs did not significantly affect consumer prices as critics of Trump’s trade strategy anticipated. Businesses couldn’t just shift the cost of tariffs onto customers, partly due to their widespread nature. Instead, they absorbed those costs into their profit margins, optimized efficiency to reduce expenses elsewhere, and attempted to negotiate lower prices with foreign suppliers.

Currently, firms are finding it challenging to pass their costs onto consumers, as suggested by the Beige Book. Households are opting for cheaper alternatives, delaying purchases, and resisting price hikes. Industrial inflation seems to be confined upstream while the inflationary pressure at the consumer level recedes.

A Rare Civilian Capital Boom

The strongest areas of the economy share a notable feature: they are enhancing productive capacity. There’s a rapid expansion of private capital occurring, even while monetary policy constrains household spending.

Higher interest rates tend to have less impact on projects that promise remarkable returns. It’s quite understandable. A family can hesitate on buying a house, hoping that lower rates in the future will make homeownership more feasible. However, a technology firm racing to maintain its leadership in AI cannot simply wait to secure computing power and energy.

This type of investment fuels demand today while also setting up supply for tomorrow. A consumption-driven boom utilizes what’s currently available, whereas a capital-driven boom generates even more.

Don’t Fear the Echoes of ’66 and ’56

Expansion driven by investment under strict monetary policy is rare because higher rates usually dampen housing, consumption, and business investment all at once. History offers two cautionary tales: capital booms can spur inflation if accompanied by excessive government demand or lead to recession if businesses invest in more capacity than the economy can support.

The risk of inflationary government spending can be seen in the 1966 economy. Business fixed investment reached an all-time high of 10.7 percent of gross national product, yet rigid monetary policy limited housing access to mortgages. Housing starts plummeted from an annual rate of 1.5 million in the first quarter to just 1 million by the fourth. While the economy skirted recession, it failed to achieve disinflation. Consumer prices, which had only risen slightly over one percent in 1964, began their rapid ascent towards what would become the Great Inflation of the 1970s.

A significant factor contributing to this situation was the government’s war efforts—both the conflict in Indochina and domestic poverty initiatives. The Vietnam War ramped up federal demand right when LBJ’s Great Society was injecting fiscal stimulus. With unemployment already below four percent, competition for workers among government contracting and business investment escalated in a capacity-limited economy.

Monetary controls also had uneven effects. Interest-rate caps caused deposits to flow out of banks, tightening the credit landscape for mortgages and homebuilding. As housing faltered, federal spending remained comparatively shielded from interest rate impacts. Tight monetary policies transformed growth patterns without sufficiently reducing overall demand to tame inflation.

This contrast between 1966 and the current environment is important. There’s no comparable surge in defense spending that could smother consumer restraint. Defense manufacturing may be robust, but even conflicts like the one in Iran are not pushing the Pentagon’s budget to Vietnam-like extremes. The capital boom we’re observing is mainly civilian and private.

This distinction matters for inflationary pressures. Defense spending injects current demand without necessarily enhancing the future productive capacity of the civilian economy, unlike civilian capital investment which does both. Initiatives like building power plants, expanding computing capacity, or installing industrial equipment create demand for labor and materials today while also positioning the economy for greater output tomorrow. If these investments succeed, we see better productivity per worker and reduced unit production costs.

Not coincidentally, we’re observing the largest improvement in durable goods manufacturing productivity since the late 1990s.

The second historical caution stems from 1956 and 1957. During the Eisenhower administration, private investment remained strong while tight credit undermined housing. The crux of the issue arose when companies realized that their expansion expectations were overly optimistic. This realization led to a pullback in investment and inventory accumulation, pushing the economy towards recession.

This seems to be a more relevant concern today. The surge in AI could result in overcapacity in data centers. Supply bottlenecks might hike costs. A downturn in tech investment could abruptly halt the expansion. Those familiar with the late 1990s dot-com and telecommunications bubble might find this scenario particularly reminiscent.

Building Our Way Out of Inflation

Fortunately, the broadening growth in the manufacturing sector reduces the likelihood of such a negative outcome. Strength is extending beyond just data centers into machinery, transportation equipment, and industrial infrastructure. This increasingly resembles a comprehensive expansion of America’s productive capacity.

Blackrock’s Gator Jaw Economy captures the widening gulf between capital investment and consumer spending. However, this divergence might be precisely how disinflation can succeed without triggering a recession: monetary restrictions dampen the sectors that drive consumer inflation while productive investments sustain employment and future productivity.

It seems that America is building its way to disinflation.