US economy expands 2% on AI spending surge amid Iran war, inflation edges up to 3.2%

The US economy grew at an annualised 2 per cent in the first quarter of 2026, driven by a surge in artificial intelligence-linked investment and resilient consumer demand, even as the Iran war pushed up energy prices and lifted inflation pressures to a two-year high.

According to the Bureau of Economic Analysis, growth in the January–March quarter was anchored by a strong expansion in business investment, particularly in technology infrastructure tied to the ongoing AI buildout. Inflation, meanwhile, accelerated on rising fuel costs linked to geopolitical disruptions in West Asia.

AI investment emerges as key growth engine

Business investment surged 10.4 per cent in the quarter, marking the fastest pace in nearly three years and emerging as the primary driver of GDP growth. Spending was concentrated in information processing equipment, software and data infrastructure, reflecting aggressive AI-related capital expansion across corporate America.

The investment cycle is being powered by Big Tech’s escalating AI arms race. Recent earnings from major US technology companies show combined AI-related capital expenditure is now projected to exceed $700 billion in 2026.

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Alphabet led the sector with a 63 per cent surge in Google Cloud revenue, its strongest growth on record, while Microsoft Azure grew 40 per cent and Amazon Web Services rose 28 per cent.

Across the sector, capital intensity remains elevated. Alphabet has raised its 2026 capex forecast to as much as $190 billion, Microsoft has outlined nearly $190 billion in spending plans, Amazon continues to invest close to $200 billion annually, and Meta has lifted its capex guidance to as high as $145 billion.

This wave of investment is feeding directly into US economic activity through equipment purchases, data centre construction and software deployment, making AI one of the most important contributors to growth in the current cycle.

Consumption steady, trade drags on growth

Consumer spending rose 1.6 per cent, supported by services such as healthcare and financial activities. Government expenditure also rebounded after earlier disruption, helping offset weaker external demand.

However, net exports subtracted from growth as imports surged, likely driven by strong demand for high-end computing equipment linked to AI infrastructure expansion.

Inflation-adjusted final sales to private domestic purchasers rose 2.5 per cent, suggesting underlying demand remained solid despite external volatility.

Inflation rises as West Asia conflict feeds energy shock

Inflationary pressures picked up during the quarter, with the core personal consumption expenditures (PCE) index rising 3.2 per cent year-on-year. The monthly PCE increase of 0.7 per cent in March marked the sharpest rise since 2022.

The acceleration was largely driven by higher energy and transportation costs following disruptions caused by the Iran conflict, which has tightened global oil supply routes and pushed crude prices to multi-year highs.

The war has also disrupted shipping lanes and increased input costs across supply chains, raising concerns about second-round inflation effects in goods and services.

Resilience with growing risks

Despite geopolitical shocks, the US economy has so far remained resilient, supported by strong corporate investment and steady household demand. Labour market conditions remain tight, with layoffs near historic lows, while AI-driven capital expenditure continues to provide structural support to growth.

However, economists warn that the durability of expansion will depend on whether inflation stabilises and whether consumers begin to respond more cautiously to sustained price increases.

Policy challenge for the Federal Reserve

The stronger inflation print complicates the Federal Reserve’s policy outlook. While officials acknowledge the economy’s resilience and the AI-led investment boom, they remain wary of easing monetary policy amid persistent price pressures.

Fed Chair Jerome Powell has pointed to “apparently insatiable demand” for data centres as a key growth driver, even as policymakers monitor the inflationary spillovers from energy markets and global conflicts.

The US Federal Reserve kept interest rates unchanged on Wednesday, holding its benchmark policy rate in the 3.50 to 3.75 per cent range.