The Middle East conflict resulted in far less of a drag on the American economy than would have been thought at its outset.
The American economy is far less dependent on oil imports than it was 50 years ago, making it more resilient in the face of energy shocks like the one triggered by the Iran war.
The ratio of gross domestic product to oil consumption, as measured by GDP per unit of oil, has declined by approximately 56% over the past half century.
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Even with the extended closing of the Strait of Hormuz and the disruption of oil supplies, the economy still grew at a 1.5% rate during the first half of the year.
We expect that rate to accelerate to 2.5% in the current quarter and 2.1% during the final three months of the year, all of which should produce a 2.1% overall pace of growth for 2026.
And the pace could quicken. With headline inflation likely to ease, more than $100 billion in new defense spending on the way and a surging stock market boosting spending among higher-income households, overall economic activity is poised to accelerate.
Baseline quarterly forecast
Of course, all of this is contingent on what appears to be a murky and inconclusive end to the war.
The on-again, off-again nature of the ceasefire should be expected to cause further volatility across commodity, energy and asset markets.
Inflation outlook
While we think the geopolitical risk premium should result in an average oil price of $80 or more per barrel, pricing at that level will not cause a large drag on overall economic activity.
What’s more, the decline in oil prices from the peak in April should provide a modest tailwind to the economy in the second half of the year. Falling gas prices will support spending among the middle class, working class and the working poor ahead of the holiday spending season.
Consumers, after all, will welcome relief from the inflation that pushed the consumer price index from 2.4% to the current 4.2% that is primarily responsible for first-half GDP below the long-term 2% trend.
As long as oil prices remain around or below $80 per barrel—and there is no guarantee—inflation will ease in the second half of the year.
We expect the CPI to fall back toward 3.2% by the end of the year and the personal consumption expenditures index, which the Federal Reserve uses to formulate monetary policy, to show 3.5% growth in top-line inflation through December.
One reason that inflation is set to decline is that the initial pass-through of tariffs to the economy appears to have run its course.
Still, with the average effective tariff on all trade partners sitting at 6.9%, there is risk that it could migrate upward in the second half of the year as the fiscal authorities use the trade weapon as a lever in international trade and geopolitics.
Growth drivers
Private sector-led investment in artificial intelligence will continue to support overall economic activity.
We are in the midst of a historic cap-ex cycle which is spilling over into the broader economy in such a way that supports a modest level of hiring.
But one can now observe a significant level of AI-related imports which will place a drag on overall growth, which is why our forecast remains conservative.
The spending outlook should brighten modestly in the second half of the year as falling oil and gasoline prices bolster household consumption.
Yet our recent research implies that the upper 20% of income earners are responsible for between 36% and 57% of all spending, depending on how one measures it.
The upper quintile of income earners is responsible for more than half of all spending generated by rising equity prices.
Put differently, every $1 trillion in equity gains produces about $8 billion in direct consumer spending, or roughly $14 billion in total economic impact with the multiplier.
Applied to the current rally in equity markets—the S&P 500 has risen 21% since the third quarter of last year, adding an estimated $7 trillion in equity wealth—the total spending boost is about $53 billion, a quarter of a percent of personal consumption and roughly 30 basis points of gross domestic product.
The asset-based economy that defines the upper two quintiles of income earners, who are the primary beneficiaries of rising equity prices, is driving overall economic activity.
Employment
We expect the unemployment rate to remain near 4.3% this year and migrate upward to 4.4% on average throughout 2027.
The primary risk to our forecast a tightening labor market, were retirements and tighter immigration policies constrain hiring from the external sector. These trends should help the Federal Reserve place its focus on more on price stability and less on maintaining maximum sustainable employment.
Hiring will remain tepid, near 60,000 on average monthly in 2026, which will continue to be driven primarily by low-wage health care and education hiring.
To keep labor conditions stable, the economy needs to generate only between 25,000 and 40,000 jobs per month, which is why should there be even a modest acceleration in hiring it is conceivable that the unemployment rate could decline back toward 4%.
We do denote some risk that hiring may accelerate toward 100,000 per month on the back of the AI infrastructure buildout.
Wage growth at 3.5% is not an inflationary concern. While wage growth is not keeping up with inflation, which is why it was soft in the first half of the year, that will turn as inflation slows and gasoline prices fall.
Despite the large tax cuts enacted this year, the inflation shock resulted in a drawing down of savings and we do not anticipate any meaningful improvement in the national savings rate this year as middle class and lower-income households recover from the second inflation shock in five years.
Monetary policy and interest rates
We do not anticipate the Fed to raise interest rates this year as policymakers look through the current supply shock.
Those same policymakers will take some measure of relief from the recent decline in oil prices, and it is clear from recent comments by Fed Chair Kevin Warsh that he thinks that shock is transitory.
Despite the fact that PCE inflation has exceeded the Fed’s 2% target for five years, we do not see the Fed lifting rates anytime soon unless oil again spikes in price.
Our model of the determinants of the 10-year Treasury yield has a fitted yield of 4.54%. This estimate is comprised of the sum of expectations of the short-term policy rate of 3.95% and a term premium of 0.59%.
We anticipate the 10-year will remain range-bound between 4.4% and 4.6% with forays above that level should the economic expansion pick up steam.
We expect the 2-year yield at the front end of the curve to ease toward 3.75% to 4%, the 5-year should sit near 4.2% this year and the 30-year should remain near 5% with risk of a move higher.
U.S. financial conditions remain just under one standard deviation above neutral, which supports lending, liquidity, leverage and risk appetite across asset markets and the real economy.
The fortunes of the U.S. dollar will continue to be linked to events in the Persian Gulf. At this time, rising tensions tend to support a stronger dollar.
We tend to think that the pace of overall U.S. economic expansion should provide a modest boost to the greenback this year.
Three scenarios
The following is a brief sketch of our baseline forecast and our two alternative scenarios around what is an uncertain second half outlook because of events in the Middle East and volatility across commodity and asset markets.
Baseline: The economy normalizes (~50%)
- The economy grows near its long-term trend of about 2% as the rebound from the government-shutdown in the first quarter gives way to a more moderate pace of expansion.
- Headline inflation, which peaked above 4% in the spring as the Iran conflict sent oil prices to nearly $120 a barrel, retreats steadily as those energy costs roll out of the year-over-year comparison.
- Core inflation—the measure the Fed watches most closely—remains sticky near 3% but is not accelerating, which is the key distinction.
- The labor market is balanced. Job growth has slowed to roughly 50,000 to 70,000 per month, and wages are growing at a pace consistent with the Fed’s inflation target once you account for productivity.
- The Fed holds its policy rate at 3.50% to 3.75% through year-end 2026, then cuts twice in the second half of 2027 as confidence builds that the inflation overshoot was temporary.
Downside: The deal collapses (~35%)
- The ceasefire with Iran breaks down and Hormuz transit is disrupted again—this time with thinner inventories and less room for error.
- Oil returns to the mid-to-high $90s, and pipeline inflation in diesel, food, fertilizer and transport lingers for six to 12 months even after crude stabilizes.
- The Fed’s hawkish pivot, already visible in the June dot plot, materializes into an actual rate hike by December, tightening financial conditions into an already-slowing economy.
- Real wage growth turns negative and households prioritize necessities at the expense of discretionary spending—staycations, not vacations.
- GDP falls to about 1.4% in 2026 and closer to 1% in 2027 as the full weight of higher energy costs and tighter policy feeds through.
- Unemployment rises toward 5% by late 2027—not a deep recession, but an environment that will feel recessionary for many working households and middle market firms in consumer-facing and transport-intensive sectors.
- Bond yields remain elevated as markets demand a risk premium until Hormuz transit is fully restored and verified.
Upside: Diplomacy holds and energy falls further (~15%)
- A durable resolution reopens Hormuz fully, and Saudi price cuts accelerate the decline in crude toward the mid-$50s.
- Falling energy costs do three things at once:
- They pull headline inflation down faster than expected.
- They restore real wage growth for households that have been squeezed all year.
- They give the Fed room to begin easing before year-end.
- Fiscal tailwinds from the tax legislation and supplemental war spending provide a modest growth impulse, while AI-driven business investment—already running at double-digit rates in equipment and intellectual property—continues to lift productivity.
- The consumer, held back by energy costs in the first half, strengthens in the second half as gasoline prices fall and real incomes recover.
- GDP reaches the mid-2’s in both years, and unemployment drifts lower as the economy reaccelerates.
- The Fed cuts once or twice by December 2026 and continues easing into 2027, bringing the upper bound to 3.00% by year-end.
The takeaway
We expect a modest increase in economic activity during the second half of the year as relief through falling oil and gasoline prices, sustained strength in private sector non-residential investment, defense spending and a tailwind from rising equity prices all combine to send growth during the final six months of the year back above 2%.
The primary risk remains the situation in the Middle East and the impact it has on the middle class, working class and working poor through the inflation channel.
Financial conditions remain solid and supportive of greater risk appetite and the Fed figures to remain on hold for the remainder of 2026. Both of these factors are conducive to a stronger pace of economic activity to close out the year.
