The Economy Is Heating Up. Why the Experts Keep Getting It Wrong.

U.S. gross domestic product rose at a 4.3% annual pace in November, exceeding expectations. That marked the biggest expansion in two years. (Spencer Platt/Getty Images)

Key Points

• Third-quarter U.S. GDP grew at a 4.3% annualized pace, exceeding expectations and marking the largest expansion in two years.
• Excluding volatile trade and inventory swings, real final sales to private domestic purchasers rose 3%, indicating strong underlying demand.
• A K-shaped economy, driven by higher-income consumers and AI-related investment, accounted for nearly 70% of total growth.

The U.S. economy just delivered another shock. Third-quarter gross domestic product grew at a 4.3% annualized pace, far exceeding expectations and marking the biggest expansion in two years. Growth was well above consensus forecasts, and stronger than even the most optimistic forecasts.

The added sizzle raises new questions that have little to do with the impact of tariffs, government spending, or other details contained in the GDP report. What if the economy isn’t defying gravity, but operating under a different set of rules than analysts and economic models assume?

Increasingly, that seems to be the case. Business and consumer spending are on an impressive upward trajectory, notwithstanding still-elevated inflation and interest rates, trade disruptions, and a cooling labor market—which also may be hotter than official data suggest. The economy’s strength was explained away in the past two quarters as temporary or distorted. But the numbers have improved anyway, suggesting a rethink is in order.

Third-quarter GDP was boosted, in part, by unusual trade dynamics: Exports rose by 8.8% and imports fell by 4.7%, adding roughly 1.6 percentage points to headline growth. That contribution is unlikely to persist and may partially reverse in coming quarters. But the report also showed something harder to dismiss.

Excluding volatile trade and inventory swings, real final sales to private domestic purchasers rose 3%, a measure economists view as one of the cleanest reads on underlying demand. Consumer spending grew at a 3.5% pace, far stronger than in the first half of the year. Business investment increased as well, led by spending on equipment and intellectual property.

In other words, domestic demand was strong, even as borrowing costs stayed high and hiring slowed.

One of the most puzzling features of the expansion is the growing disconnect between output and jobs. Payroll growth has slowed over the past year, and the unemployment rate has edged higher, recently reaching its highest level in more than two years. On its face, that looks like an economy losing momentum.

Yet, GDP growth is accelerating. One possible explanation is a boost in productivity. Capital-intensive investment, particularly in technology and artificial-intelligence-related equipment, boosts output without requiring large additions to payrolls.

Another is the K-shaped economy. Spending by higher-income households, which are less sensitive to interest rates and labor market shifts, continues to drive a disproportionate share of consumption.

“A closer look at the data shows the K-shaped economy at work: Household consumption driven by higher-income consumers and AI-related investment accounted for just under 70% of total growth during the quarter,” said Joe Brusuelas, chief economist for RSM US. “This disconnect helps explain why the public, particularly those with lower incomes, remains sour on the economy heading into the holiday season.”

There is also a measurement question. Traditional labor-market data may be capturing less of the economy’s true activity than they once did. Gig work, contract labor, informal employment, and multiple job-holding complicate headline payroll figures.

Immigration flows and demographic shifts also blur the signal. That means the data may be less effective at gauging economic heat in a capital-heavy, technology-driven expansion.

Several forces suggest the economy could continue running above trend into 2026. A number of favorable tax provisions for businesses are set to take effect next year, including incentives tied to capital investment. Those changes arrive at a moment when companies are already pouring money into automation, data centers, and other AI infrastructure.

Asset prices matter too. Equity markets have climbed steadily, rebuilding a wealth effect that supports consumer spending, particularly among upper-income households. Home prices have held up better than many expected, even as mortgage rates rose.

And, as Charles Lieberman of Advisors Capital tells Barron’s, GDP showed that inventories were “nearly flat after a large decline in the second quarter.”

That implies that “future growth will not be hurt by any need to destock and may even get some boost from a need to rebuild inventories,” he says.

The economy also has proved more resilient than expected in the face of high interest rates. Businesses have adapted. Consumers have adjusted. Balance sheets aren’t pristine, but they aren’t particularly fragile, either.

None of this means the expansion is unstoppable. Stubbornly elevated inflation remains an issue, with core price growth still above the Federal Reserve’s target. The personal consumption expenditures price index, the Fed’s preferred inflation gauge, rose faster than expected in the third quarter. If growth stays strong, inflation risks could re-emerge, possibly forcing the Fed to raise, or at least pause lowering interest rates.

The Fed’s ability to balance slowing job growth against persistent inflation will be tested in the months ahead. Cutting rates by too much, too soon, or holding them too high for too long could destabilize the expansion.

A sharp correction in equity markets could also undermine GDP growth. A wobble in technology stocks would “likely lead to a tightening of lending conditions, which could squeeze capex and hurt those high-income households via negative wealth effects,” wrote James Knightley, chief international economist at ING.

Federal Reserve data show that the top 20% of U.S. households by income owns 70% of the wealth in America. “That style of financial hit would be the most likely event to lead to a change in their spending patterns,” said Knightley.

Trade is a third wild card, or “the elephant in the room,” said Adrian Helfert of Westwood. “The U.S.-China trade framework deal reached in November extended the 24% reciprocal tariff reduction through Nov. 10, 2026, providing some near-term certainty,” he wrote. “However, ongoing negotiations throughout 2026 will be critical—any escalation or inability to reach a longer term agreement could reignite volatility.”

For now, though, growth keeps beating expectations and domestic demand is holding up. The usual warning signs keep flashing, but the slowdown is nowhere in sight.

If this economy can generate strong output growth with fewer jobs, driven by capital investment, asset prices, and productivity gains, then policymakers and forecasters may need to rethink how they define overheating and how they measure success. The question for 2026 may be not whether the economy will cool, but whether the frameworks used to understand it need revision.

Write to Nicole Goodkind at nicole.goodkind@barrons.com