Our Chief U.S. Economist Michael Gapen breaks down how growth,
inflation and the AI revolution could play out in 2026.
Read more insights from Morgan Stanley.
----- Transcript -----
Michael Gapen: Welcome to Thoughts on the
Market. I’m Michael Gapen, 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 10am in New York.
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.
Looking ahead, we see a return to modest growth of 1.8 percent in
2026 and 2 percent in 2027. Inflation should cool but it likely
won’t hit the Fed’s 2 percent target. 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.
So, if 2025 was slow growth and sticky inflation, then 2026 and
[20]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. There 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 percent in 2026 and 1.8
[percent] 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.
We see unemployment peaking at 4.7 percent in the second quarter
of 2026, then easing to 4.5 percent 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 3.0-3.25 percent. Why? To insure against
labor market weakness. But that insurance comes with a price:
inflation staying above target longer. 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.
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 0.4 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. After accounting for
imported tech, AI’s net contribution falls sharply. Still, we
expect AI to boost productivity by 25-35 basis points by 2027,
over our forecast horizon, marking the start of a new innovation
cycle. In 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 percent.
So 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.
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