January 9, 2026

Data released in the past several weeks have not only beaten expectations, they have crushed them. For now it is hard to dispute the notion that the economy is on a roll. The trade deficit is shrinking rapidly and is contributing significantly to faster-than-expected GDP growth. Productivity is surging thanks to AI. The acceleration in productivity has also been contributing to faster GDP growth and will continue to do so well into the future. As a result our economic speed limit known as potential growth has apparently climbed from 2.0% to around 3.0%. Faster growth in productivity is also reducing labor costs which makes it likely that going forward the inflation rate is going to resume its slowdown and begin to approach the Fed’s 2.0% target. Could it be that the U.S. economy has entered a dream cycle? We think so.

Two days before Christmas we learned that the long-delayed GDP report for the third quarter came in at 4.3% which was a full percentage faster than the economic gurus had anticipated.

Many economists suggested that the growth surge was temporary, probably distorted by the prolonged government shutdown, and fourth quarter GDP growth will almost certainly be slower. Don’t be so sure of that.

The trade deficit for October narrowed by nearly $19.0 billion to $29.4 billion. That follows additional narrowing in August and September. That is the narrowest trade deficit since June 2009!  If the trade deficit were to stay at its current level in November and December the trade component of GDP would add nearly 2.0% to fourth quarter GDP growth. The highly regarded Atlanta GDP Nowcast pegs fourth quarter growth at an eye-popping 5.1%. We are not quite as high as that but still anticipate fourth quarter growth of 4.3%. Keep in mind that follows GDP growth in the second quarter of 3.8%, 4.3% in the third quarter, and now perhaps 4.3% growth in the fourth quarter. The notion that the current pace of economic growth cannot be sustained without more job creation has been snuffed.

The only way this can happen is if our workers have become more productive. And, voila, that is happening.

This past week we learned that productivity grew by a stunning 4.9% in the third quarter which follows impressive 4.1% growth in the second quarter. The 4.9% growth rate consisted of a 5.4% surge in output combined with a 0.5% increase in employee hours worked. In other words the economy kept roaring along without any significant job creation. And guess what? Productivity is going to register yet another growth rate of similar size in the fourth quarter. If fourth quarter GDP growth turns out to be 4.3% we now know that hours worked rose 0.5% in that quarter. Doing the subtraction implies an increase in fourth quarter productivity growth of 3.8% and productivity growth for the year of 2.6%.

To put that in context, in the past 20 years productivity has risen on average 1.2%. Its growth recently has been double that rate. As a result, the potential GDP growth rate for the U.S. appears to have accelerated from 2.0% to about 3.0%. Economists estimate potential growth by adding two numbers – the growth rate of the labor force to the growth rate for productivity. That is because firms can boost growth only by adding more workers or making their current employees more productive. Until recently those growth rates were 0.8% for the labor force and 1.2% for productivity or 2.0% for potential growth. Estimates of potential growth have been steady at about 2.0% for a decade. Until now.

The growth rate for the labor force may slip in 2026 as slower birth rates and reduced immigration take a toll. We suggest it will be about 0.5%. If productivity continues to climb a its current 2.5% pace, then by adding those two numbers we suggest potential growth is in the process of climbing to the 3.0% mark. Perhaps because estimates of potential growth have been stuck at 2.0% for so long many economists are reluctant to conclude that it could be faster.

The last time potential growth was significantly faster was in the last half of the 1990’s. In fact, potential growth was in excess of 3.0% for six consecutive years from 1996-2002. What happened then? The introduction of the internet. A monumental technological advancement boosted productivity growth and potential growth for years. The catalyst today is AI. Why can’t AI do the same thing?

If potential GDP growth is really 3.0% rather than 2.0%, it would mean that we will see GDP growth rates bouncing around the 3.0% mark in the quarters ahead rather than 2.0%. Faster GDP growth means more growth in income and faster growth in both corporate profits and the stock market. In fact, potential growth is often regarded as a proxy for growth in our standard of living.

At the same time the acceleration in productivity will have a positive impact on the inflation rate because it will lower unit labor costs. Most economists keep a close eye on average hourly earnings which in the past year have risen 3.8%. Because that is faster than the Fed’s 2.0% targeted inflation rate they conclude that labor costs will prevent the inflation rate from slowing. But what economists should look at is something called unit labor costs which is labor costs adjusted for inflation. If nominal wages are rising 3.0% and productivity growth is 0.0%, then unit labor costs have risen 3.0% and firms would almost certainly be inclined to raise prices which would boost the inflation rate. But what if nominal wages are rising 3.0% and productivity is growing by 2.5%? In that case unit labor costs have risen by the difference between the two rates or by 0.5%. Business owners would have no incentive to raise prices in that situation. In fact growth in unit labor costs of 0.5% could well lead to an inflation rate BELOW the Fed’s targeted 2.0% pace.

We learned recently that unit labor costs actually declined slightly in the second and third quarters and could do the same thing in the fourth quarter. Everybody is all worried about the inflation rate accelerating. As long as unit labor costs continue to behave, the surprise could be that the inflation rate actually slows in 2026 and begins to approach the Fed’s 2.0% target.

Most economists continue to believe that the reduced pace of jobs growth implies the economy is weakening and they remain concerned. But jobs growth has been anemic since April. That has occurred as GDP growth roared along in the second and third quarters and is likely to continue at a steamy pace in the fourth quarter. Something is different. AI has changed the game. Growth going forward is going to be faster than expected. At the same time as productivity offsets most or all of the rise in wages, unit labor costs should decline, and the inflation rate should slow.

That is not the scenario that is on anybody’s radar at the moment. We expect positive surprises on both fronts in the months ahead.

Stephen D. Slifer
NumberNomics
Charleston, S.C.