Since the American economy emerged from the shocks of the pandemic, we have made the case that it is undergoing a fundamental structural change.
The end of historically low interest rates, the adoption of policies aimed at bolstering vital national industries and the influx of foreign capital have all pushed the economy into a new era of faster growth, low unemployment—and higher inflation.
It is nothing less than a regime change, and it is at the core of our forecasts for growth, inflation, employment and interest rates over the past three years. Understanding what is happening requires a new analytical framework.
In the year ahead, our baseline forecast sees the American economy growing at a pace of 2.5% or more, which is well above the 1.8% long-term trend that held in the years after the financial crisis. We assign a 55% probability to this scenario.
Such a pace of growth will support an unemployment rate of around 4.2% with household spending at or above 3%.
The combination of current growth dynamics and the likely expansionary fiscal policy that will be adopted next year will support a solid pace of growth and higher interest rates at the long end of the curve.
These factors will result in changed inflation dynamics, which will remain at or above 2% as a nascent productivity boom also helps drive growth.
Given the fiscal expansionary policy—which includes tax cuts and increased spending, as well as less regulation—we think that the economy may continue to outperform. That would push growth and inflation higher with a possibility of lower unemployment, rising wages and rising interest rates.
These dynamics would cause the Federal Reserve to slow its pace of rate cuts, resulting in a shallower terminal rate near 3.5% in contrast with the current 2.9% implied by the central bank’s Summary of Economic Projections.
We think it is quite possible that the Fed will slow rate cuts to one 25 basis point reduction per quarter until it reduces the federal funds policy rate to around 3.5%. The Fed, though, could end up cutting its policy rate even more slowly than that.
In addition to our baseline forecast, we also have an alternative forecast, which we attach a 30% probability to. And there is the chance that an exogenous shock or a significant domestic policy error will push the economy into recession, which we assign a 15% probability to.
Save for those events, though, we see the economy continuing to generate positive returns on investments and strong household spending.
Regime change
Twenty years of subdued inflation, low interest rates, a reduced cost of capital and financial leverage have given way to a new regime.
For many investors and firm managers, this era is unfamiliar. Consider what is now in play:
- The term premium along the Treasury curve is positive.
- Higher interest rates have pushed up the weighted average cost of capital, raising the cost of doing business.
- Sticky inflation has altered household consumption.
- A transformed global policy framework is pushing firms to relocate production back to more friendly and expensive locales.
These dynamics are among the many driving the economy toward a less fragile stance.
What was an era characterized by the export of deflation by China, with its inexpensive goods shipped around the world, has given way to the embrace of industrial policies by nations that now want to nurture and protect sectors that are vital to their interests.
These changing dynamics are reshaping the global economic landscape.
The resulting economy will be more resilient and less prone to the type of catastrophic errors of capital allocation like the housing bubble and excessive leverage that preceded the financial crisis. This new period will also be accompanied by a wider dispersion of returns among industries and consumers.
But the tradeoff for a more secure environment will be that many things become more expensive, and labor will seek to capture an increasing share of profits compared to the past half century.
Workers will have a job, but they will pay more
Financialization—which occurs when the financial sector gains more sway in decision making—helped drive the economy in the previous era. Now, policies that emphasize financial security and growth of the real economy are taking precedence.
Call it the anti-fragile agenda.
While financialization will not disappear, it may be redirected toward more domestically focused projects that are intended to harden supply chains and bolster the overall economy.
Efforts to encourage the reshoring or friendshoring of industrial production will lead to modest constraints placed upon global finance and investment. If anything, those constraints will become more onerous.
Only now are we starting to understand the profound impact of the pandemic-era shocks.
Firms and industries that operated on the assumption of zero interest rates suddenly find themselves challenged to meet current debt and growth expectations.
This regime change is the foundation of our evolving outlook on the American real economy.
Growth outlook
Next year will mark a new phase for the U.S. economy when the Federal Reserve’s rate cuts take hold just as the expansionary fiscal policies of a second Trump administration are implemented.
We expect that the Tax Cuts and Jobs Act from 2017 will be renewed, with a chance that income taxes for firms may be reduced and that many households may have state and local tax deductions restored. These policies would stimulate spending.
But the economic performance will affect the Fed’s path for rate cuts. Should the economy get too hot, those rate cuts may be scaled back.
With a second Trump administration just over the horizon, we want to address possible economic disruptions.
- Tariffs: First, because of the constraints of basic law, we are not anticipating an across-the-board 10% tariff early next year. Those tariffs may arrive once those procedural hurdles are cleared and possibly implemented through legislation. But the administration will act quickly to place tariffs on goods from China. Those levies should be understood as one-time increases to the price level, but in the absence of a full-blown trade war and currency devaluation, they will not be a source of a sustained elevated inflation.
- Immigration: Second, it will be some time before tighter immigration policies directly affect the supply of labor. Deporting millions of people is quite expensive and would take years to implement. We do not anticipate any major disruption of the labor supply in the first half of the year. Given the tighter restrictions already in place, we think that the labor market is heading back toward needing to create only 100,000 and 150,000 jobs per month to keep employment conditions stable. But should that occur it would create conditions for a wage-induced bout of inflation through a tight labor supply and falling unemployment.
- Fiscal policy: Third, the fiscal outlook will be far more in focus as financial markets price in the likelihood of unfunded tax cuts and spending increases. Already, that prospect has translated into higher long-term interest rates. The logic of economic populism is predicated on spending and tax cuts that are not paid for. It is natural for investors to question the sustainability of fiscal expansionary policy and are pushing long-term rates higher.
Populist policies create a good deal of uncertainty. Whether it’s labor markets, trade balances, capital flows, interest rates, inflation rates or the cost of capital, each of these are far less certain today as a new administration prepares to take office.
Capital markets are telling us that the investment community is slowly inching toward a consensus that involves higher rates.
Those higher rates along with strong growth will be the primary economic narrative early next year. In this framework, we foresee three possible scenarios for the American economy next year.
Baseline scenario: Sturdy growth
We expect a faster pace of growth next year under this new regime. Real gross domestic product, which is adjusted for inflation, is projected to grow by 2.5%, higher than the pre-pandemic norm of 1.8%.
Our current assumption is that Trump-era expansionary fiscal policies will take hold later next year or more likely in 2026.
Until then, strong household spending will be the major driver of growth. In addition, increased risk taking because of anticipated lower taxes and a lighter regulatory framework is also likely to fuel growth.
We anticipate that risk taking to reflect improved conditions in the financial sector (banks, private equity and private credit), technology, artificial intelligence, and life sciences. These factors may bolster wealth in equity markets, and spur growth.
Mergers and acquisitions will almost certainly pick up as financing costs decline and the regulatory environment eases.
Growth near 2.5% with inflation ranging between 2% and 2.5% does not pose any material risk to the inflation with an economy at full employment and productivity increasing at or above 2% per year.
This forecast could change, though, for a number of reasons: The economy could overheat, a full-blown tariff war could break out, or inflation could spiral higher under the new administration’s fiscal and trade policies.
Inflation outlook: Price stability amid policy risk
We expect inflation, measured by the personal consumption expenditures price index, to average around 2.2%, allowing the Fed to gradually lower interest rates to support full employment.
Strong productivity gains should on the margin dampen inflationary pressures as would the sustained strength of the U.S. dollar. We are sanguine on the inflation outlook early next year.
Goods deflation will be the primary driver of easing inflation, in addition to falling energy prices and the flood of cheap Chinese goods around the globe.
Ironically, China’s attempt to export the burden of adjustment to the era of debt and deleveraging will almost certainly stoke trade tensions with the U.S. its trade partners, which do not want to accept a lower global share of manufactured trade.
Apart from that, central bankers will be concerned with service sector inflation, which remains sticky.
Should the unemployment rate decline on a slower pace of labor supply growth or outright contraction because of tightened immigration policies, wages will move higher and that would certainly translate into higher costs of doing business.
Under this new regime, as new trade and industrial policies take hold, the cost of goods and services is going to rise. We expect an inflation rate of between 2.5% to 3% over the medium to long term.
Federal Reserve policy
The Federal Reserve is likely to reduce its policy rate by one percentage points next year—four 25 basis-point rate cuts. This would bring the policy rate to near 3.5%.
As of the middle of November, financial markets were pricing in between 75 and 100 basis points of rate cuts next year.
The Fed is aiming for a rate that is neither restrictive nor accommodative. If the real neutral interest rate is 1.21% and the non-accelerating inflation rate of unemployment is 4.2%, the optimal policy rate would be 3.46%. This estimate is the foundation of our 3.5% forecast on the endpoint of the Fed’s rate cutting cycle.
Even as the Fed reduces rates, the strength of the American economy, particularly compared to its major trading partners, could help push up the value of the U.S. dollar against the major trading currencies.
That strength is attracting large capital inflows into the United States, which will foster robust investment and growth.
Given those growth conditions, we think that financial markets and the Fed will need to reassess the terminal rate at which monetary policy is neither restrictive nor accommodative.
The current terminal rate implied by the Fed is 2.9%, which we think is too low. We think that the Fed’s new Summary of Economic Projections, to be released in December, will point to a higher terminal funds rate.
Our year-end target on the U.S. 10-year yield is 4.5% with risk of a sustained move toward 5% should the economy continue to grow around 3%.
Since the Trump reelection, investors have been pricing in higher long-term yields. Unfunded taxes cuts and higher spending lead to a rising term premium on all Treasury issuance and higher yields along the spectrum.
Should investors judge that expansionary fiscal policy is unsustainable, then long-term rates could exceed 5%.
This outlook implies the Fed curtailing its rate cutting to just 50 more basis points, which is a worst-case scenario.
Instead, we expect rates to fall along the short end of the Treasury curve between two years and five years over the next year, consistent with Fed intentions, but rise along the long end between 10 and 30 years based on the strength of the economy.
We look forward to a vigorous debate over whether higher yields are a vote of confidence in a growing economy, or are a reflection of concerns about the U.S.’s deteriorating fiscal position.
Employment conditions
With supportive monetary policy and low inflation, the unemployment rate should average 4.2% over the next year, which is a sustainable long-term rate that will contribute to inflation. This scenario reflects what the financial media will call a soft landing or what we refer to as a robust midcycle expansion.
We expect monthly job gains to arrive between 100,000 and 125,000 through the first half of next year. The economy needs to generate between 100,000 and 150,000 to keep employment stable.
If the supply of labor slows or contracts because of tighter immigration policies, then that number would fall, and conditions would be ripe for a declining unemployment rate back toward 3.5% and higher wage gains.
Housing outlook
Housing affordability will continue to be an issue because of the steeper yield curve and higher 30-year mortgage rates. Mortgage rates, though, should fall as the federal funds rate comes down.
But with the arrival of the new administration, investors have been pushing up longer-term yields, which only drives up the price of housing.
A resurrection of residential investment led by Fed rate cuts is not in the cards, given the prospect of deficit finance expansionary fiscal policy.
From our vantage point, the U.S. economy is short approximately 3.8 million homes because of demographic changes, a shortage that has been growing worse since the financial crisis.
Moreover, with 90% of those who hold 30-year fixed mortgages with rates at or below 5%, there will continue to be a dearth of supply coming to market. These factors will continue to provide upward pressure on prices despite rising rates at the end of the curve.
The sweet spot on mortgage rates that would spur purchasing activity stands between 5% and 6%. With the 30-year fixed rate in November standing at or above 7%, this is not conducive to an improved outlook for residential investment.
For this reason, housing starts will remain near an anemic 1.35 million annualized pace, adding to the shortage of housing.
This housing shortage is a clear long-term problem inside an otherwise robust outlook for the economy. This problem is not going away, and to be blunt, the housing market is not properly functioning and continues to provide a much smaller supply relative to the robust demand.
We think that a national housing policy that supports improved supply conditions will move to the forefront of the national discussion.
Risks to the outlook
We see five major risks to the economic outlook.
Slower rate cuts: Growth that exceeds 3% will result in a shallower path of interest rate cuts. This slowing of rate reductions would in turn result in a higher terminal rate and a higher real neutral interest rate, known as r-star, at which the monetary policy is neither restrictive nor accommodative.
- Policy uncertainty: Uncertainty and domestic political risk linked to trade and immigration policies would disrupt growth conditions, inflation dynamics and the path of interest rates. Tariffs, for example, can be inflationary if they translate into a sustained trade war. In addition, restrictive immigration policies pose a near-term risk to the labor supply. Should the unemployment rate decline as immigration declines and the economy heats up, talk of a wage price spiral will restart just as the Fed has obtained price stability.
- Commercial real estate, near term: Higher interest rates do not bode well for commercial real estate. There is well over $1 trillion in loans that need to be rolled over, with local and regional banks holding 70% of them. Even as remote work continues to evolve, there is undeniably a period of haircuts ahead. The turmoil among regional banks in 2023, for example, was linked to risks to the banks’ outsized CRE portfolio. As the loans are worked out, more local and regional banks will fail and there will be consolidation. While the CRE industry does not pose any systemic risk to the economy, it will certainly be a drag in areas with a high amount of vacant office space.
- Commercial real estate, longer term: The wall of commercial debt coming due next year is just under $1 trillion. That is the vintage 2020 debt issued at extraordinarily low rates. But in 2026, there will be $1.14 trillion that will need to be rolled over, $1.25 trillion in 2.27 and $1.13 trillion in 2028. This is a risk that will weigh heavily on decisions of central bankers and investors. Still, American capital markets are smoothly functioning and should be able to absorb the refinancing wave. The longer-term risk is that, if longer-term yields continue to rise, corporates may find themselves crowded out of capital markets that suddenly have increased competition for scarce capital.
- Geopolitical tensions: Global tensions will proliferate. Typically, security tensions in the Middle East and Asia result in higher oil prices and shipping costs, which lead to higher energy and consumer prices. But for now, with a global surplus of oil coming to market, those geopolitical tensions are not causing spikes in energy prices. Consider American oil production. It is expected to exceed 14 million by 2026, which reflects the energy independence of the U.S. and is an important element in the sturdy economic growth we see continuing.
Alternative to the baseline: Economic outperformance
The chance for the economy to outperform our estimates is significant, especially because of the expansionary fiscal policies likely under a second Trump administration.
Under this scenario, tax cuts, a reduced regulatory framework and pro-growth tax decisions could push gross domestic product above 3%.
On top of that, should the recent increase in productivity return to its pre-pandemic trend of 1% to 1.5%, that could result in higher inflation and lead the Fed to pause rate cuts.
Under such a scenario, the unemployment rate could fall to between 3.5% and 4%, and wages would accelerate, all of which would push interest rates higher.
That means far fewer rate cuts next year and a policy rate of 3.5% to 4% by the end of next year. The 10-year yield as a result should be well above 5%, with a risk of reaching 6%.
Whether this is sustainable beyond 2025 or not will depend a lot on how the Fed perceives risks to the inflation outlook.
Alternative to the alternative: Recession
The risks from geopolitical tensions, a potential trade war, commercial real estate, and corporate debts on top of government policy missteps are nontrivial, and we give that scenario a 15% chance of happening.
The economy would underperform the 1.8% long-term growth trend we saw before the pandemic or even fall into a recession.
The most realistic example would be a rebound in inflation, which would prompt the Fed to keep interest rates unchanged or even hike them, which would push the unemployment rate higher.
Growth would slow as well, particularly once the impact of the expected upcoming tax cuts fades.
Should longer-term rates increase toward 6%, such an increase would require a period of fiscal consolidation and create conditions for much slower growth, or even contraction. The economy would also be more vulnerable to external or unexpected domestic shocks than over the past few years due to a lack of financial cushion.
The takeaway
The economy is expected to grow between 2.2% and 2.5% in the year ahead amid full employment and price stability. The Federal Reserve will cut rates four times by 25 basis points each in 2025 while we expect the yield on the 10-year Treasury to move higher toward 4.5% with risk of moving higher to 5% by the end of next year.
The expansionary policies of a second Trump administration imply faster growth, higher interest rates and higher inflation. But we think that is a 2026 economic narrative. The economy, though, will continue to grow. We think that there is only 15% probability of a recession over the next 12 months.
Aside from the near-term forecast, the economy continues to undergo a regime change that will bring less volatility and greater resilience to shocks.
Trade restrictions and the protection of industries vital to national interests are likely to be a feature of public policy that focuses on the hardening of critical domestic supply chains and plentiful domestic energy sources.
That change over time is resulting in faster growth requiring higher interest rates, competition for scarce capital and higher inflation over the medium to long term.
Businesses will have to adapt. They will have to long-term investments to improve productivity and carefully manage a labor supply that may face constraints in the years ahead.
