A modest economic tailwind fueled by expansionary fiscal policies, rate cuts by the Federal Reserve, the full expensing of capital investments, and deregulation should push overall growth in the United States to an above-trend 2.2% in 2026.
Because of those policy changes and tailwinds, we have reduced our probability of a recession over the next 12 months to 30% from our previous estimate of 40%.
We anticipate that the push to build the infrastructure for artificial intelligence, including a more robust energy grid, will be the primary driver of growth for at least another year.
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During this time, we anticipate that upper-end consumers will maintain their spending, which will help push growth above the long-term trend this year.
Perhaps just as important, the noise from the policy sector will most likely ease as trade-related uncertainty winds down and the economy adjusts to permanently higher trade taxes.
We think that the tariffs’ drag on growth of nearly 1% in 2025 will fade, helping to spur a solid reacceleration of growth in 2026.
We expect inflation to remain well above the Fed’s 2% target, with the yield curve steepening as short-term rates ease and 10-year Treasury rates remain above 4%, potentially moving higher if inflation does not fall below 3%.
We anticipate another year in which inflation rises faster, with public discontent continuing to simmer as declining affordability and standards of living become more of an issue for consumers.
In addition, as a five-year period of labor hoarding by large companies ends, we expect hiring to slow to nearly 50,000 new jobs per month, accompanied by an increase in the unemployment rate to 4.5% with a risk of moving higher.
Below we offer three scenarios for the economy in 2026.
Baseline scenario
Our baseline assumes no new shocks to the economy and that current trends will continue throughout 2026, with trade uncertainties fading and interest rates easing modestly.
We attach a 45% probability of above-trend growth, accompanied by nearly 3% inflation and 4.5% unemployment.
We expect further easing from both fiscal and monetary policy, which should help lift growth above 2%.
The Fed should cut its policy rate to a range of 3% to 3.25% by the end of the year, which should support improved financial conditions and risk-taking.
We expect the 10-year Treasury yield will average 4% throughout the year, with a modest risk of higher rates because of persistent inflation.
With immigration policies remaining strict, the combination of solid economic gains and job growth of between 30,000 and 50,000 per month should keep the unemployment rate near 4.3%.
We expect that inflation will remain above the Fed’s 2% target, with the consumer price index staying at or above 3%. But as the short-term effects of tariffs fade, we expect the personal consumption expenditures index, the Fed’s preferred measure of inflation, to average 2.7% over the next year.
First alternative scenario: Stronger growth
Given the large tax cut, rate reductions at the Fed and deregulation that supports risk-taking, we think there is ample upside risk to growth in 2026. For this reason, we are attaching a 25% probability that growth will increase to 2.5% or higher as inflation eases and the Fed pushes its policy rate to 3% more quickly than investors are pricing in.
Investors have monitored the improvement in productivity in the postpandemic era as businesses have integrated sophisticated technology into their operations.
We are growing more optimistic that the positive effects of artificial intelligence on investment and productivity may materialize sooner than expected.
Should productivity improve, those gains would create the conditions for a quicker return to the Fed’s 2% inflation target, which would provide the ingredients for stronger growth, lower Fed rates and a decline in the 10-year Treasury yield.
Second alternative scenario: Downside risk
The adverse policy shocks associated with higher tariffs and restrictive immigration policies resulted in what we think is a 1% drag on growth in 2025. In addition, the longest shutdown in the federal government’s history created an additional 1.5% drag on growth in the fourth quarter.
It isn’t difficult to imagine further policy discord out of Washington, which would result in persistent uncertainty that dampens both spending and business investment and pushes the growth rate below 1%.
That scenario would exacerbate the current “stagflation lite” conditions that are contributing to the souring of consumer sentiment.
An increase in inflation to 3.5% or above would create the conditions for a reversal in monetary policy, with the Fed quickly returning to a policy rate of 4% or above and the unemployment rate rising to 5% or higher.
We attach a 30% probability of this outcome next year.
As demand for workers slows and inflation-adjusted wages stagnate, the risks to the labor market are also material. As a result, the impact on income growth would be large enough to keep consumer spending sluggish.
We take the affordability crisis, which is the primary cause of historically weak consumer confidence, seriously.
Given current inflation dynamics, prices could increase more than 3% and remain elevated for longer if fiscal expansion coincides with labor shortages and supply chain constraints—especially if trade tensions between the U.S. and China fail to ease.
Risks to the outlook
Over the past year we have made the case that low rates, liquidity and leverage are the holy trinity of new finance. This equation is part of the growth narrative in the upper spur of the K-shaped economy, which has supported financial markets and the domestic economy. Should expected rate cuts not materialize and liquidity grow tight, though, these sources of growth will materially weaken, dampening economic activity.
In our estimation, risks to the outlook reside in three channels.
Leverage across the financial sector—in private credit, private equity and cryptocurrency—is a risk if liquidity tightens and both the banking and shadow banking communities tighten lending.
One does not have to be a financial markets expert to understand how even a modest curtailment of liquidity and leverage would affect financial markets and equity valuations, which would then slow spending among upper-end consumers.
Uncertainty around inflation amid expansionary fiscal policies results in competition for scarce capital and higher interest rates. With inflation increasing at a 3.6% annualized pace through the end of the third quarter of 2025 and service sector pricing proving sticky, there is ample reason for the Fed to move cautiously in further reducing the federal funds policy rate.
One interesting risk is that should three-year U.S. government paper, which was yielding 3.56% as of Nov. 12, move notably above the federal funds rate, which was standing between 3.75% and 4%, the front end of the yield curve would steepen dramatically.
That kind of move would trigger an avalanche of reserves held by banks into the market, creating the conditions for a much more pronounced increase in inflation as households and firms flush with cash increase demand faster than supply can expand.
In addition, with upper-end consumers flush with cash and benefiting from a strong wealth effect, there is little to suggest that demand for services is going to ease anytime soon.
Lower-income consumers whose wage growth is slowing will experience a greater squeeze in what is left of any disposable income as inflation remains at 3% or above.
Labor demand heading into the final days of 2025 has undeniably slowed as large firms move to reduce head count while midsize and small businesses hold off on further expansion of their workforce.
With growth in the labor market slowing to an average of 29,000 jobs a month in the third quarter, conditions are ripe for an increase in unemployment if the monthly jobs growth fall short of the 50,000 or so that we think is necessary to keep labor market conditions stable.
Given the fine line between sagging demand and nearly no growth in the domestic labor supply, it would not take much to tip the labor force into a period of contraction. Such a scenario would then put the growth of the real economy at risk.
The takeaway
We expect economic growth to rebound to 2.2% in 2026, with the PCE inflation rate reaching 2.7% and the unemployment rate rising to 4.5%.
Better economic conditions should feature a steeper yield curve that will foster risk-taking by banks and the shadow banking community, all which favor a quicker pace of economic activity.
We anticipate that the Fed will cut its policy rate to 3% over the coming year, with the two-year Treasury yield falling toward 3% and the 10-year yield remaining at or just above 4%.
But the primary risk to the economy continues to be the affordability crunch associated with our stagflation-lite baseline scenario that includes rising inflation and slower real wage growth.
