Special Encore: What’s Driving U.S. Growth in 2026

0:002025 started with an expectation of slower economic growth and stubborn inflation. While growth did cool, the real surprise was the disconnect between the economy and financial markets. Unemployment ran higher than projected, yet markets showed resilience, powered largely by an AI-driven capital spending boom. Looking ahead to 2026, the backdrop is brighter. Global growth should accelerate modestly. Inflation should ease in the second half of the year, and real incomes look poised to improve. We expect the U.S. to lead the charge and remain most constructive on the U.S. market. Thank you for listening throughout 2025 as we've navigated these issues and events that shape financial markets and society.

0:44We hope that you'll join us next year as we continue to bring you the most up-to-date information on the financial world. This week, please enjoy some encores of episodes over the last few months, and we'll be back with all new episodes in January. From all of us at Thoughts on the Market, happy holidays and a very happy new year. Welcome to Thoughts on the Market. I'm Michael Gapin, Morgan Stanley's Chief U.S. Economist. Today, I'll review our 2026 U.S. Economic Outlook and what it means for growth, inflation, jobs, and the Fed. It's Tuesday, November 25th at 10 a.m. in New York. If 2025 was the year of fast and furious policy changes, then 2026 is when the dust settles.

1:32Last year, we predicted slow growth and sticky inflation, mainly because of strict trade and immigration policies. And this proved accurate. But this year, the story is changing. We see the U.S. economy finally moving past the high uncertainty phase. Looking ahead, we see a return to modest growth of 1.8 % in 2026 and 2 % in 2027. Inflation should cool, but it likely won't hit the Fed's 2 % target. By the end of 2026, we see headline PCE inflation at 2.5%, core inflation at 2.6 % and both stay above the 2 % target through 2027. In other words, the inflation fight isn't over, but the worst is behind us.

2:19So if 2025 was slow growth and sticky inflation, then 2026 and 27 could be described as moderate growth and disinflation. The impact of trade and immigration policies should fade, and the economic climate should improve. Now, there are still some risks. Tariffs could push prices higher for consumers in the near term, or if firms cannot pass through tariffs, we worry about additional layoffs. But looking ahead to the second half of 2026 and beyond, we think those risks shift to the upside, with a better chance of positive surprises for growth. After all, AI-related business spending remains robust, and upper-income consumers are faring well.

3:02There is reason for optimism. That said, we think the most likely path for the economy is the return to modest growth. U.S. consumers start to rebound, but slowly. Tariffs will keep prices firm in the first half of 2026, squeezing purchasing power for low - and middle-income households. These households consume mainly through labor market income, and until inflation starts to retreat, purchasing power should be constrained. Real consumption should rise 1.6 % in 2026 and 1.8 % in 2027. Better, but not booming. The main culprit is a labor market that's still in low-hire, low-fire mode, driven by immigration controls and tariff effects that keep hiring soft.

3:51We see unemployment peaking at 4.7 % in the second quarter of 2026, then easing to 4.5 % by year-end. Jobs are out there, but the labor market isn't roaring. It'll be hard for hiring to pick up until after tariffs have been absorbed. And when jobs cool, the Fed steps in. The Fed is cutting rates, but at a cost. After two 25 basis point rate cuts in September and October, we expect 75 basis points more by mid-2026, bringing the target range to 3 to 3.25%. Why? To insure against labor market weakness. But that insurance comes with a price, inflation staying above target for longer. Think of it as the Fed walking a tightrope.

4:41Lean too far towards jobs, and inflation lingers. Lean too far toward inflation, and growth stumbles. For now, the Fed has chosen the former. And how does AI fit into the macro picture? It's definitely a major growth driver. Spending on AI-related hardware, software, and data centers adds about four-tenths of a percent to growth in both 2026 and 2027. That's roughly about 20 % of total growth. But here's the twist. Imports dilute the impact. After accounting for imported tech, AI's net contribution falls sharply. Still, we expect AI to boost productivity by 25 to 35 basis points over our forecast horizon, marking the start of a new innovation cycle.

5:30In short, AI is planting the seeds now for bigger gains later. Of course, there are risks to our outlook. And let me flag three important ones. First, demand upside, meaning fiscal stimulus and business optimism push growth higher. Under this scenario, inflation stays hot and the Fed pauses cuts. If the economy really picks up, then the Fed may need to take back the risk management cuts it's putting in now. That would be a shock to markets. Second, there's a productivity upside, in which case AI delivers bigger productivity gains, disinflation resumes, and rates drift lower. And lastly, a potential mild recession where tariffs and tight policy bite harder, GDP turns negative in early 2026, and the Fed slashes rates to near 1%.

6:23So in summary, 2026 looks to be a transition year with less drama, but more nuance, as growth returns and inflation cools, while AI keeps rewriting the playbook. Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share thoughts on the market with a friend or colleague today. The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.