Entering 2025, it appeared that the economy would avoid recession but only achieve 2% real GDP growth, with inflation falling to 2% and the unemployment rate hovering at around 4%.
It is customary, in a U.S. economic forecast, to focus on the baseline and only briefly mention issues that could cause the economy to veer from that path. However, entering 2026, while a baseline forecast is relatively easy to construct, it is the alternative scenarios that deserve the most attention, as significant policy and financial market issues continue to swamp other considerations in mapping out the direction of the economy.
Entering 2025, it appeared that the economy would avoid recession but only achieve 2% real GDP growth, with inflation falling to 2% and the unemployment rate hovering at around 4%. However, policy changes from the new administration, combined with AI enthusiasm and a continued stock market boom, have had significant impacts that are likely to continue into 2026.
First, dramatic increases in U.S. tariffs have generated very significant revenue, averaging over $29 billion between June and October. So far, most of the cost of the tariffs appear to have been absorbed by U.S. retailers. However, we expect an increasing share of this cost will be passed on to consumers in the fourth quarter and in 2026. Provided tariff levels don’t change from here, we expect tariffs to boost year-over-year inflation and drag on real consumer spending through the first half of 2026 but then fade as a macroeconomic force thereafter.
Second, the immigration crackdown continues to impact labor supply. Accurate data on legal immigration and involuntary deportations are very spotty, while illegal immigration and self-deportations are even harder to track. That being said, available evidence suggests a dramatic decline in net immigration, likely triggering an absolute decline in the working-age population – a trend we expect to continue in 2026 and beyond. This suggests that, even with some increase in labor force participation, very slow job growth should still be consistent with a roughly stable unemployment rate. This slow job growth would, however, negatively impact overall real GDP growth both in 2026 and beyond.
While higher tariffs and lower immigration are slowing growth, other factors are supporting it.
First, as this is being written, the S&P 500 is up 17% year-to-date in what has been, so far, a third consecutive blockbuster year for U.S. equities. This is generating very substantial gains in wealth, supporting spending on high-end services and goods even as low-end spending remains sluggish. This is contributing to a so-called “K-shaped” economic expansion, with richer households getting richer even as lower and middle-income households feel squeezed.
Second, AI investment is booming as tech giants race to acquire the chips, data centers and electrical supplies necessary to feed their voracious training projects and accelerating inference demand. At its current pace, capex is already significant by historical standards, with data center capex amounting to 1.2-1.3% of GDP (although not all investment boosts GDP because of imported equipment), and continued investment growth is expected. Business adoption is also accelerating, with 9% of U.S. firms reporting the integration of AI in production and 44% of firms now paying for some kind of AI model or platform. While it is too soon to ascertain productivity impacts in the data, there are indicators consumers are already benefiting from the usage of AI technologies.
Third, the OBBBA is boosting demand. This year, the stimulus is largely in the form of investment incentives as the legislation provides for full expensing of spending on equipment and R&D. Other new tax breaks for households became effective at the start of 2025. However, because the IRS has not yet adjusted income tax withholding schedules in accordance with the new law, these tax breaks should show up as a bumper crop of tax refunds early in 2026.
Putting it all together, our base case forecast sees real GDP growth slowing to a roughly 1% pace in the fourth quarter, picking up to above 3% growth in the first half of 2026, and then slowing again to between 1% and 2% growth later in the year, as the stimulative impact of refunds fades. This growth only yields an average of 50,000 new jobs per month, partly reflecting a lack of available workers. However, constrained labor supply prevents sharp layoffs, with the unemployment rate peaking at only 4.5% in late 2025 and early 2026, before declining slightly thereafter. Year-over-year inflation rises through June 2026. However, CPI inflation still peaks below 4% year-over-year, due to lower oil prices and sliding shelter inflation, and falls to 2% by the end of 2026.
Risks to the forecast
Such is the baseline forecast. However, a number of factors could significantly impact this outlook.
First, the Supreme Court could rule that the president lacked the authority to impose country-specific so-called “reciprocal” tariffs under the International Emergency Economic Powers Act of 1977. If it does so, we expect the administration to cobble together alternative tariffs under different laws. However, these tariffs could raise less revenue than current tariffs and such a ruling could necessitate substantial refunds to U.S. companies that have already paid the tariffs. If this happens, expect slightly stronger economic growth in 2026 with lower inflation.
Second, if the economy weakens going into the second half of next year, Congress might pass further fiscal stimulus to boost consumer spending ahead of the mid-term elections. If this occurs, possibly in the form of so-called “tariff rebate checks,” both economic growth and inflation would likely be higher later in 2026.
Third, the boom in tech stocks and AI spending could lose its luster, even if temporarily. While few doubt the potential transformative impact of AI, a shift in momentum could be triggered by a range of factors (i.e. a miss on mega cap earnings, a supply crunch on power or critical materials or an external liquidity shock). Given the significance of AI investment, such a slowdown could cause a recession and/or bear market, or at minimum pressure the AI-linked wealth gains that have lifted consumption. The rising cost of AI is also a risk and increases the likelihood of corporate belt-tightening to fund AI strategies, which may result in hiring freezes or increased layoffs.
In short, our baseline forecast is that after a modest surge in inflation and economic growth, both slowly slide to subdued levels by the end of 2026. But as has been the case in 2025, there is plenty of potential for a considerably bumpier ride.