U.S. economic outlook: Economic resilience raises the rate floor

Key Themes

• Growth still appears to be solid. We expect real GDP to expand at a 3.0% annualized rate in Q3, largely reflecting robust consumer and business spending. Though a modest downgrade compared to our previous forecast, our pared-back expectation is mostly a net exports story.
• AI investment continues to propel strong rates of business investment, even after accounting for imports. We recognize that AI-spend must eventually slow. As investment matures, sustaining spending at elevated levels will provide a smaller incremental boost to growth than it has in recent quarters. That said, we do not anticipate outright declines, especially as capex broadens.
• Inflation is moving in the right direction, but not as quickly as the Fed would like. We expect a Q4-over-Q4 inflation rate of 3.2% with new methodological changes incorporated. But putting aside energy prices and a few idiosyncratic quirks, the trend in inflation is largely favorable. Tariff effects are fading, shelter inflation is cooling and budding price pressures are contained to a few categories related to the AI buildout.
• The labor market is neither hot nor cold. August's solid employment report served to further reduce labor market downside risk. We always caution against placing too much emphasis on just one print. However, the unemployment rate remains low, turnover is muted and the current pace of wage growth is not inflationary, suggesting the labor market remains in balance
• We expect the Fed to hike one more time. We have changed our fed funds forecast to 4.00-4.25% by year-end 2026, with no changes in 2027. It is hard to justify hiking beyond that when excess inflation is largely supply-driven and the labor market is not overheating.
• Long-term yields are not likely to fall substantially. The floor under longer-term interest rates has moved higher, reflecting solid growth expectations, robust corporate and treasury bond issuance and monetary policy uncertainty. As yields normalize to more typical historical norms, sensitive sectors like housing may bear the brunt.
• Global policy risks are skewed toward tighter for longer. The risk of persistent inflation continues to constrain major central banks, with several advanced economies facing a combination of renewed tightening risks and prolonged policy restraint, while emerging market policymakers are taking a more cautious and differentiated approach.

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