Times Like These

• Oil prices have risen sharply since February, creating a renewed headwind for real income growth and raising downside risks to consumer spending at a time when the labor market is already soft. While higher energy costs complicate the outlook, we do not believe current conditions are sufficient on their own to derail the expansion.
• Employment growth has stalled over the past year and real personal income excluding transfers is already under pressure from slowing wage growth and persistent inflation. A sustained increase in gasoline prices would mechanically push inflation higher in the near term and could lead to outright declines in real income over the next few months.
• That said, the sensitivity of aggregate consumer spending to energy shocks has diminished over time. Services account for a larger share of total consumption, demographics are cushioning aggregate demand and fiscal support is providing an offset to weaker labor income.
• Our simulations suggest that a moderate oil price shock would slow, but not reverse, real PCE growth. It would take a larger and more persistent increase in oil prices to generate the kind of broad based spending contraction typically associated with recession.
• We have only incrementally changed our baseline growth forecast at this time. However, the balance of risks has shifted to the downside, particularly if higher energy prices prove persistent or spill over into broader financial conditions.
• While recession risks have risen, we continue to see enough sources of support to growth for the expansion to continue over the next year.
• Despite recent market volatility, our U.S. rates outlook is unchanged: still two 25 bps cuts this year and a 4.25% year-end 10‑year Treasury yield, with risks two-sided (later/less easing vs. deeper cuts only if recession tail risks materialize).

March Rate Cut Unlikely Amid Signs of Labor Market Stabilization

• We have not made any significant changes to our economic growth forecast. Recent data reinforce our view that real GDP growth remains on a solidly positive trajectory, largely reflecting sturdy consumer spending and a strengthening rate of business investment. Looking ahead, we continue to foresee an above-consensus pace of real GDP growth for 2026 with expansionary fiscal policy, less restrictive monetary policy, robust AI investment and reduced economic policy uncertainty.
• Labor market conditions remain far from energetic, yet recent months' data have shown signs of stabilization. Against a backdrop of solid economic growth, we continue to see a modest pick-up in hiring as the year progresses and look for nonfarm payroll growth to average 70K per month in 2026. Firming job growth should help to keep the jobs market roughly in balance and leave the unemployment rate at 4.3% in Q4-2026.
• The inflation data continue to come in somewhat cooler than expected as moderating services prices partially offset a tariff-related lift to goods costs. We suspect the inflationary impulse from tariffs has yet to transmit fully through supply chains and forecast the core PCE deflator to tick up to 2.9% year-over-year in Q1. Further out, we look for a disinflationary trend to resume and anticipate the average year-over-year rate on the core PCE deflator to fall to 2.6% in Q4-2026 and 2.3% in Q4-2027.
• We have made a minor change to our monetary policy outlook. In our view, the recent stabilization in the labor market significantly lowers the likelihood of a March rate cut. However, additional cuts later this year are still on the table given the more benign inflation outlook. We still see two more 25 bps cuts this year, but now look for the reductions to occur at the June and September FOMC meetings. Given our generally constructive forecasts for the labor market and inflation, we acknowledge the balance of risks remain tilted toward fewer rate reductions this year.

Powell's Final Act

• Jerome Powell's eight-year tenure as Chair of the Federal Reserve is coming to a close during a period of intense pressure on the U.S. central bank and divided views among policymakers about the appropriate stance of monetary policy. What can we expect from Powell's final act as Chair against this backdrop?
• The labor market remains modestly on the wrong side of full employment. Private sector job growth has been near zero in recent months, and while the unemployment rate ticked down in December, it remains above most estimates of the longer run, natural rate.
• Meanwhile, the recent inflation data have been encouraging. The December reading for core CPI was 2.6% year-over-year, down from 3.1% in August. Shutdown-related quirks may be depressing core CPI inflation by a tenth or so, and the Fed's preferred inflation measure, the PCE deflator, likely has not shown quite as much improvement. But the direction of travel for core inflation entering 2026 is clear, in our view.
• Thus, we see scope for the FOMC to continue to nudge the federal funds rate toward neutral in the coming months. We are sticking with our previous forecast of two 25 bps rate cuts in March and June, followed by a long pause at 3.00%-3.25% for the federal funds rate.
• But the window for additional cuts is starting to close, in our view. Fiscal stimulus from the One Big Beautiful Bill Act should start to be felt in the spring/summer, and the risks to U.S. tariff rates appear skewed to the downside, another potential catalyst for faster economic growth later this year. The lagged impact from the 75 bps of Fed easing over the past three months also should help at the margin.
• If the labor market and inflation data are on the hotter side over the next couple of months, Chair Powell and company may elect to stand pat and hand the reins to the next Chair with policy unchanged. That individual may face some skepticism from a committee that has endured increasing pressure from the Trump administration. Our belief that economic growth will be firming throughout the spring/summer months only would add to the case to remain on hold.
• For now, we are sticking with our call, but we think the risks to our forecast for the federal funds rate are skewed toward later and/or less policy easing than our base case projection.

We look for U.S. real GDP growth of 2.3% (annual average) in 2026. The improved outlook reflects a more supportive fiscal policy environment, a less restrictive monetary policy setting and a tariff regime that is not characterized by near-constant escalation as it was this year.

• The resilient consumer continues to help shore up economic activity, though consumer spending is not poised to be an outperforming driver of growth in 2026. Tax policy changes in the One Big Beautiful Bill Act (OBBBA) offer some relief in the year ahead, particularly for lower- and middle-income households, where help is needed most.

• Business fixed investment has been, and will continue to be, sustained by the splurge on all things tech- and AI-related. Investment-friendly tax policy changes help on the margin, and so will lower rates and an anticipated decline in policy uncertainty next year. These factors should help support investment growth in more traditional capex categories, which have struggled of late.

• Tariff rates are not going back to 2024 levels anytime soon, but we think 2026 will show that 2025 was the peak for the U.S. average effective tariff rate. This in turn bodes well for U.S. economic growth in 2026 as trade policy becomes directionally less restrictive.

• Inflation has been stuck around 3% amid a tug-of-war between slowing services prices but a tariff-induced pickup in goods prices. We expect inflation to still be above 2% by the end of next year. That said, our base case forecast for core PCE inflation to be 2.6% on a Q4/Q4 basis in 2026 would mark a directional improvement, with the softer labor market, well-anchored inflation expectations and the prospect for some tariff relief next year helping lead inflation lower.

• Amid the blackout of government data due to the shutdown, alternative indicators paint a mixed picture of the jobs market: not clearly improving, but not falling apart either. Sturdier economic growth and reduced uncertainty should generate some improvement in hiring next year and keep the unemployment rate from climbing above 4.5%.

• Our base case remains for the FOMC to reduce the fed funds rate by 25 bps at its December meeting, although recent Fed speak makes it a close call as we go to print. For 2026, we look for two additional 25 bps rate cuts by mid-year, which would put the terminal rate at 3.00%-3.25%.

• While the global economy can continue to demonstrate resilience, the pace of global growth in 2026 is unlikely to match the rate of expansion achieved in 2025. Easier central bank monetary and fiscal support from select countries can put a floor under global growth; however, protectionist trade policies may restrain global activity.

• Select foreign central banks can lower interest rates, but rate reductions similar to 2025 are unlikely to be repeated. A monetary policy divergence theme should build in early 2026 that weighs on the dollar; however, once Fed easing ends, the dollar can rebound and discussions about the greenback losing its reserve FX status should diminish.

Awaiting the Data Deluge

• We have become modestly more constructive on the outlook for economic growth and now expect U.S. real GDP to expand 2.0% in 2025 and 2.3% in 2026 on an annual average basis, a bit stronger than our September update. Our forecast for growth in 2027 remains essentially unchanged at 2.3%.
• Our upgraded growth forecast follows stronger readings on consumer spending. Although some U.S. consumer segments are under stress against a backdrop of weaker real income growth, the latest spending data point to aggregate personal consumption expenditures growing at an annualized rate of 3.0% in Q3-2025, an accelerated pace from the first half of the year.
• Growth in business investment, in part due to robust AI and other high-tech investment, is another short-run support factor. However, the headwinds from elevated capital costs, trade policy changes and increased uncertainty will likely become more evident as the year rounds to a close.
• Emerging strains in the labor market have become more challenging to discern with the federal government shutdown putting the September employment report on hold. Alternative data, such as ADP's payroll report, suggest that employment growth is still soft, a trend we expect to continue in the near term.
• Inflation remains above the FOMC's 2% target. The core PCE deflator was up 2.9% year-over-year in August. Services prices continue to moderate, while higher goods prices are exerting an upward force on inflation. Given the impacts of recent trade policy changes have not been fully realized, core inflation of 2.9% year-over-year in Q3 and 3.0% in Q4 seems likely in our view. We then forecast a gradual easing through 2026 and 2027 as trade policy impacts dissipate.
• We maintain our view that the FOMC will "look through" a temporary uptick in inflation from tariffs and put more weight on the downside risks to the labor market. As such, we continue to see a 25 basis point cut at both the October and December FOMC meetings, with two additional 25 bps rate reductions in the first half of 2026. This would bring the terminal federal funds rate range to 3.00%-3.25% by the middle of next year.

So Long Summer, Hello Rate Cuts

• Summer has come and gone, but the next stage of the FOMC's rate cutting cycle is just beginning. We look for the FOMC to cut the federal funds rate by 25 bps at each of its next three meetings, pushing the target range down to 3.50%-3.75% by year-end. We project two more 25 bps rate cuts at the March and June meetings next year, resulting in a terminal fed funds rate of 3.00%-3.25%.
• The U.S. labor market is in a precarious position, in our view, and this is the primary driver of our more dovish monetary policy outlook. The three-month moving average on nonfarm payroll growth was a measly 29K in August, and data from private sector sources corroborate the trend in the BLS data. Slowing labor supply growth can account for some of this deceleration, but the unemployment rate hit a fresh cycle-high of 4.3% last month, and the soft data continue to point to souring sentiment among workers about job availability.
• Admittedly, the inflation half of the Fed's dual mandate remains in tension with additional rate cuts. The core PCE deflator is up 2.9% year-over-year and at a 3.0% annualized pace in the three months ended in July. Rising prices for physical goods have kept inflation stubbornly above the central bank's 2% target despite tamer service sector inflation since the start of the year.
• Although progress has stalled on bringing inflation back to 2% this year, the rise in prices since Liberation Day largely has been in line with economist expectations. Furthermore, economic theory tells us that the supply-side inflation from higher tariffs should be transitory as long as inflation expectations remain anchored, and inflation expectations generally have been well-behaved of late.
• Continued above-target inflation will keep the FOMC from cutting below neutral for the foreseeable future, in our view, but with the fed funds rate still 100 bps-150 bps above our estimate of neutral, there is capacity to support the labor market without overdoing it.
• With so little forward momentum in the labor market, near-term recession risks have ticked higher. We assign a 35% probability of a recession in the United States in the next 12 months, and the next six months or so strike us as the most precarious stretch as higher tariffs and restrictive monetary policy continue to bite.
• As we look ahead to 2026, we feel more optimistic about the outlook for economic growth. Fiscal stimulus is coming next spring when households file their taxes and take advantage of the tax cuts enacted in the One Big Beautiful Bill. The lagged effect of monetary policy easing should start to be felt next year, and as long as there are no more major increases in tariff rates (we grant that is a big caveat), the hit to economic growth from higher tariffs should gradually fade as 2026 progresses. We look for an above-consensus 2.4% Q4/Q4 growth rate for real GDP next year.

Brilliant Disguise

• Our forecast has not materially changed in this update, although our confidence in it has improved. The data have moved roughly in line with our expectations in the past month, demonstrating a slowdown in underlying domestic demand and hiring figures to support it.
• Trade has been the tail that wagged the dog in the first half of the year, and with trade policy still in flux, volatility isn't going anywhere. That said, the most massive swings in trade are likely behind us, and we expect underlying economic growth to slow further from here.
• The July jobs report brought with it material revisions that shaved over 250K jobs off of employment growth in the prior two months. While surprising, it provides some support to why we've seen a choosier consumer in recent months.
• Households have cut back on discretionary services spending and purchases of discretionary goods have been met with an air pocket after an initial pull-forward ahead of the first major round of tariffs.
• We have not changed our expectations for Fed easing. We still expect the FOMC to lower the federal funds rate by 25 bps at each of the remaining meetings this year in September, October and December. The target range for the federal funds rate would finish the year at 3.50%-3.75%. With downside risks to the Fed's employment mandate and upside risks to inflation, we think the Committee will move monetary policy toward a more neutral stance.
• The pivot to a more decidedly downbeat assessment in the economic data is the top-of-the-fold headline in August, but fiscal policy is set to be a tailwind for economic activity at the start of next year. That, in tandem with a less restrictive monetary policy backdrop, ought to be supportive of an acceleration in real GDP in 2026.

U.S. Economy Appears to Be Losing Some Steam

• The 0.5% contraction in real GDP that occurred in the first quarter of the year reflects, at least in part, the surge in imports as businesses pulled forward purchases ahead of tariff implementation. "Core" GDP, which grew at an annualized rate of nearly 2% in Q1, shows the modest decline in overall GDP overstates the weakness of the economy at the beginning of the year.
• Conversely, our projection of 1.8% real GDP growth in Q2 may overstate the strength of the economy at present. We estimate that real consumer spending rose only 1.3% in Q2, while business fixed investment and residential investment both weakened during the quarter.
• Labor market indicators also suggest the economy has decelerated a bit. Private sector payrolls rose at an average monthly pace of 107K in the first six months of the year, down from the average monthly rate of 130K over the course of 2024.
• Despite the softer pace of underlying economic activity, we think the FOMC will decide to keep its target range for the federal funds rate unchanged at its next meeting at the end of July. With core PCE inflation still running above the FOMC's target of 2%, we do not think a critical mass of Fed policymakers are on board yet to approve a rate cut at the conclusion of the Committee's policy meeting on July 30.
• If, as we forecast, any rise in inflation in the coming months proves to be a bump rather than a spike and the labor market softens further, then we believe the FOMC will cut rates by 25 bps at its meeting on September 17. We then look for the FOMC to follow up its September rate cut with two more similar reductions on October 29 and December 10.
• We readily acknowledge that the risks to our outlook are skewed toward the Fed waiting longer to ease policy than we currently forecast. We do not have a strong conviction about the timing of rate cuts, but we think the fed funds target range will be roughly 75 bps lower this time next year than it is currently.

Second-Half Slowdown Despite Improved Fundamentals

• Data since our previous monthly update suggest consumers are still spending, businesses are still hiring and activity is still expanding. Yet, uncertainty continues to weigh on the outlook. We’ve boosted our domestic growth forecasts in this update on the back of upward revisions to prior data and a U-turn in imports, but it's still early days yet in terms of the potential tariff-induced slowdown.
• Upward growth adjustments primarily stem from revisions to household income and a weaker trajectory for import growth. The stronger near-term trend in income will provide some more cushion for consumption, while the sharp reversal in April imports will boost GDP growth in Q2 and suggests a weaker path of imports over the course of the year.
• Even after accounting for our upward adjustments, we still project growth will end the year at the slowest annual pace outside a recession going back to at least the early 1990s. The temporary lowering of China tariffs would be reassuring had that not come amid continued trade threats, not to mention court challenges which serve to muddy rather than clarify future trade policy.
• The headline metrics are fraught with trade distortions. Real final sales to private domestic purchasers offers a better read today than GDP does. This measure looks past growth in inventory, net exports and government spending to assess underlying domestic demand (i.e., consumer spending and business fixed investment). By this measure, we project that domestic demand will contract in the second half of the year, even after accounting for our upward revisions.
• Price data are only beginning to reflect tariff-related costs and the degree of persistent price growth remains an open question. Hiring also remains stable, suggesting the timing and degree of Fed easing may be pushed out and scaled back. We could still see the Fed cutting rates in September if the labor market stumbles in the next month or so, but we have scaled back the degree of cumulative easing this year to 75 bps, down from 100 bps previously.
• While U.S. economic growth held up reasonably well in the first half of the year, increased uncertainty about where tariffs and fiscal policy are headed from here is leading to hesitation among businesses and consumers. We still expect growth to moderate under the weight of this unpredictability.