Fed's Rate Cuts Risk Prolonging Inflation Amidst Economic Transition
TL;DR
- The Fed's rate cuts, intended to insure against labor market weakness, will likely cause inflation to remain above the 2% target through 2027, necessitating a delicate balance between supporting jobs and controlling prices.
- AI-related business spending is projected to contribute approximately 0.4% to annual growth in 2026-2027, yet imports significantly dilute its net impact, delaying substantial productivity gains until after the forecast horizon.
- Tariffs are expected to keep prices firm in early 2026, constraining purchasing power for low- and middle-income households and contributing to a subdued labor market characterized by low hiring and firing rates.
- The U.S. economy is transitioning to moderate growth (1.8% in 2026) and disinflation, as the effects of restrictive trade and immigration policies fade, leading to an improved economic climate.
- Unemployment is forecast to peak at 4.7% in Q2 2026 before easing, indicating a labor market that is not yet robust and will likely see hiring pick up only after tariffs are absorbed.
- Risks to the outlook include demand upside from stimulus and optimism, which could lead to persistently hot inflation and a Fed pause on rate cuts, potentially shocking markets.
Deep Dive
2026 is poised to be a year of economic transition, moving past the policy volatility and sticky inflation of 2025 towards modest growth and disinflation. While the immediate impact of trade and immigration policies will continue to constrain purchasing power, robust AI-driven business spending and resilient upper-income consumers offer upside potential. However, the Federal Reserve faces a delicate balancing act, cutting rates to insure against labor market weakness, which risks prolonging above-target inflation, highlighting a tightrope walk between supporting jobs and controlling price increases.
The US economy is expected to achieve modest growth of 1.8% in 2026 and 2% in 2027, with inflation gradually cooling but remaining above the Federal Reserve's 2% target, projected at 2.5% for headline PCE and 2.6% for core inflation by year-end 2026. This disinflationary trend, however, will not fully restore purchasing power for low- and middle-income households in the first half of 2026 due to persistent tariffs. Real consumption is forecast to rise by 1.6% in 2026 and 1.8% in 2027. The labor market will remain in a low-hire, low-fire state, with unemployment peaking at 4.7% in Q2 2026 before easing to 4.5% by year-end, constrained by immigration controls and tariff effects that inhibit hiring. In response to this labor market weakness, the Fed is anticipated to implement further rate cuts, totaling 75 basis points by mid-2026, bringing the target range to 3.0-3.25%. This monetary policy stance, while intended to support employment, inherently delays inflation's return to target. AI is a significant growth driver, contributing approximately 0.4% to growth in 2026 and 2027, though its net impact is diluted by imports; nevertheless, AI is projected to boost productivity by 25-35 basis points by 2027, signaling the beginning of a new innovation cycle. Key risks to this outlook include a demand upside scenario where stimulus and optimism lead to hotter inflation and paused Fed cuts, a productivity upside scenario driven by larger AI gains resulting in disinflation and lower rates, and a mild recession scenario where tariffs and tight policy trigger negative GDP growth and aggressive Fed rate cuts.
Ultimately, 2026 represents a nuanced transition year where the return of modest growth and cooling inflation are accompanied by the ongoing influence of AI and the Fed's careful navigation of labor market support against inflationary pressures.
Action Items
- Track AI spending impact: Measure 2026 contribution to growth (0.4%) and net impact after imports for 3-5 key sectors.
- Analyze tariff effects: Quantify impact on consumer purchasing power for low/middle-income households in H1 2026.
- Model Fed rate cut scenarios: Assess inflation risk (2.5-2.6% PCE) vs. growth impact for 75 bps cuts by mid-2026.
- Evaluate AI productivity gains: Project 25-35 bps boost by 2027 and its effect on disinflationary trends.
Key Quotes
"If 2025 was the year of fast and furious policy changes, then 2026 is when the dust settles. Last 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."
Michael Gapen explains that 2026 is anticipated to be a period of stabilization following a year of significant policy shifts. He notes that previous predictions of slow growth and persistent inflation due to trade and immigration policies were accurate, but the economic landscape is now evolving. Gapen indicates that the economy is expected to emerge from a phase of high uncertainty.
"By the end of 2026, we see headline PCE inflation at 2.5 percent, core inflation at 2.6 percent, and both stay above the 2 percent target through 2027. In other words, the inflation fight isn’t over, but the worst is behind us."
Michael Gapen projects that while inflation is expected to decrease in 2026, it will likely remain above the Federal Reserve's 2 percent target. He states that headline PCE inflation is forecast to be 2.5 percent and core inflation 2.6 percent by the end of 2026, continuing this trend through 2027. Gapen clarifies that this indicates progress in combating inflation, but the challenge is not yet fully resolved.
"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. We see unemployment peaking at 4.7 percent in the second quarter of 2026, then easing to 4.5 percent by year-end."
Michael Gapen identifies the labor market's subdued activity as a primary factor affecting economic momentum. He attributes this "low-hire, low-fire" state to immigration controls and the impact of tariffs, which collectively suppress hiring. Gapen forecasts that the unemployment rate will reach a high of 4.7 percent in the second quarter of 2026 before gradually declining to 4.5 percent by the end of the year.
"Think of it as the Fed walking a tightrope--lean too far toward jobs, and inflation lingers. Lean too far toward inflation, and growth stumbles. For now, the Fed has chosen the former."
Michael Gapen uses a tightrope analogy to describe the Federal Reserve's balancing act between supporting employment and controlling inflation. He explains that prioritizing job growth risks allowing inflation to persist, while focusing too heavily on inflation could hinder economic expansion. Gapen concludes that the Fed's current policy direction favors supporting jobs.
"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 20 percent of total growth. But here’s the twist, imports dilute the impact."
Michael Gapen highlights the significant contribution of Artificial Intelligence (AI) to economic growth, estimating it will add approximately 0.4 percent to growth annually in 2026 and 2027, representing about 20 percent of the total projected growth. He points out a crucial caveat: the impact of AI spending is diminished due to the significant portion of imported technology involved.
Resources
External Resources
People
- Michael Gapen - Morgan Stanley's Chief US Economist
Organizations & Institutions
- Morgan Stanley - Employer of Michael Gapen
- Fed (Federal Reserve) - Mentioned in relation to interest rate policy and inflation targets
Other Resources
- AI (Artificial Intelligence) - Discussed as a major growth driver and productivity booster
- PCE inflation (Personal Consumption Expenditures inflation) - Metric used to track inflation
- Core inflation - Metric used to track inflation excluding volatile components
- Headline inflation - Metric used to track overall inflation
- GDP (Gross Domestic Product) - Metric used to measure economic output