Warsh's Weakness Warning: Average Economy Hides Underlying Strains

Federal Reserve Chair Kevin Warsh delivered his first Jackson Hole speech emphasizing the economy's strength, a stable labor market, and inflation as the main concern. However, his assessment is incomplete as it focuses on averages that hide underlying weaknesses.

The unemployment rate remains at 4.1%, with business investment growing at its fastest pace since 2021 and profits increasing by over 20%. Consumers are still spending, but this growth is largely driven by a narrow expansion in the AI sector, which accounts for more than half of this year's investment growth.

Warsh acknowledged that housing and agriculture are under strain, with homebuilding experiencing its weakest summer since 2020. Real GDP grew 1.5% annualized in Q2, but most of this growth came from equipment and intellectual-property investment, while the rest of the economy contributed little.

The use of borrowed money to finance AI investments is a concern, with Goldman Sachs estimating that around one-third of hyperscaler capital spending will be debt-financed this year. This debt must be serviced regardless of whether the investments pay off, making productivity the central question for this expansion.