US economic growth slows in second quarter despite strong domestic demand

WASHINGTON (Reuters) – U.S. economic growth slowed in the second quarter amid a widening trade deficit, but robust consumer spending and business investment in the buildout of artificial intelligence infrastructure underscored strong domestic demand.

The moderation reported by the Commerce Department in its Thursday snapshot of gross domestic product also reflected continued inventory drawdowns to meet strong domestic demand. The report suggested the economy largely weathered the Middle East conflict last quarter, though renewed hostilities between the United States and Iran posed a downside risk to growth in the second half of the year.

Generous tax refunds this year from President Donald Trump’s “One Big Beautiful Bill,” which helped to fuel consumer spending last quarter, are behind, leaving households without a cushion as gasoline prices resume their upward trend. With the saving rate at a four-year low, consumers are unlikely to continue dipping into savings to maintain their spending, adding to the economy’s growing vulnerabilities, economists said.

“Underlying growth is solid, but unlikely to be sustained,” said Oliver Allen, senior U.S. economist at Pantheon Macroeconomics.

Gross domestic product increased at a 1.5% annualized rate last quarter, the Commerce Department’s Bureau of Economic Analysis said in its advance estimate of second-quarter GDP. Economists polled by Reuters had forecast GDP rising at a 2.1% pace. Estimates ranged from 0.8% to 2.9%.

But the survey was conducted before the release of June’s advance economic indicators report, which showed a moderate contraction in the goods trade deficit and retail inventories unchanged. That data prompted some economists to cut their GDP estimates by as much as 0.8 percentage point. The economy grew at a 2.1% pace in the first quarter.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, surged at a 3.2% rate after abruptly slowing to a 0.5% growth pace in the January-March quarter.

In addition to larger tax refunds, spending was boosted by higher-income households that are benefiting from strong growth in asset prices, but a recent stock market sell-off could slow the momentum. The recently concluded FIFA World Cup tournament also likely strengthened the field, as did midterm election-related spending by nonprofits.

The AI investment boom, which shows no signs of slowing despite investor concerns that valuations of many technology companies have become stretched, also helped boost domestic demand. Business spending on equipment increased at a 15.2% pace, notching a second straight quarter of double-digit growth.

AI Buildout Pulling in Imports

But the AI buildout is heavily reliant on imports, contributing to a widening of the trade deficit. The trade shortfall shaved 1.01 percentage points off GDP growth, the most since the first quarter of 2025.

A large increase in imports is normally offset by a rise in inventories. But inventories have remained depleted due to strong domestic demand. Inventories subtracted 0.67 percentage points from GDP growth. Government spending contracted at a 0.8% pace, with federal outlays declining at a 4.1% rate, imposing a small drag on GDP growth.

Final sales to private domestic purchasers, which exclude trade, inventories and government spending, increased at a 3.9% pace. That was the fastest increase in this measure of domestic demand since the first quarter of 2023 and followed a 1.7% pace of growth in the January-March quarter.

U.S. stocks opened higher. The dollar slipped against a basket of currencies. U.S. Treasury yields rose.

The Federal Reserve on Wednesday left its benchmark overnight interest rate in a 3.50%-3.75% range. Three members of the U.S. central bank’s policy-setting committee dissented. They “preferred” a quarter-percentage-point hike.

The Fed described economic activity as “expanding at a solid pace despite elevated uncertainty that owes, in part, to the conflict in the Middle East.”

Economists expected the Fed to raise interest rates as soon as September to quell inflation, which also factored into their slower economic growth expectations in the second half. Average gasoline prices have risen back above $4 a gallon.

The strength in demand last quarter was accompanied by a surge in inflation. The price index for gross domestic purchases, a key measure of inflation in the U.S. economy, increased at a 5.7% pace. That was the fastest in four years and followed a 3.6% rate of increase in the first quarter. The Personal Consumption Expenditures price index rose at a 5.1% rate after advancing at a 4.6% pace in the January-March quarter.

Excluding food and energy, the so-called core PCE inflation increased at a 3.4% pace. The Fed tracks PCE inflation measures to meet its 2% target. Though other BEA data on Thursday showed PCE inflation easing in June, economists shrugged off the moderation and expected price pressures to rise amid the escalation of the Middle East conflict.

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