September 25, 2026
The economic data in recent weeks have been surprisingly strong and many market participants fear that the economy is overheating and the Fed will need to push rates sharply higher to slow it down. But not so fast. Thanks to a pickup in productivity growth the economy’s potential growth rate appears to have climbed from 2.0% a few years ago to perhaps 3.0%. Potential growth is the economy’s speed limit which means that GDP can grow at that rate for a protracted period of time without an acceleration in inflation. We expect GDP growth of 2.4% this year and a steamy 2.8% in 2027. If the Fed thinks the economy’s speed limit is still 2.0% than it should raise rates significantly to cool off growth and prevent an acceleration in the inflation rate. But thanks to AI productivity growth has accelerated to 2.5% in the past three years and, given that AI is still in its infancy, it should continue to climb at roughly that same pace for years to come. That means that the economy’s potential GDP growth rate is quickening to perhaps 3.0%. If GDP growth next year comes in at 2.8% the Fed should welcome growth of that magnitude, not fear it. It should not be concerned until sustained growth exceeds the 3.0% mark. Keep in mind that potential growth exceeded 3.0% for six consecutive years in the second half of the 1990’s. What happened then? The introduction of the internet. A technological event sparked a prolonged increase in both productivity and the economy’s potential GDP growth rate. Why shouldn’t AI do the same thing?
For what it is worth, we peg third quarter GDP growth at 3.5%. The Atlanta Fed’s GDP Now forecast estimates growth in that quarter at 5.0%. But keep in mind that second quarter growth was an anemic 1.5%. Over the two quarters combined growth should be about 2.5% which is close to what growth for the year as a whole will be. For the past twenty years economists believed that the country’s potential growth rate was about 2.0%. If that is still the case the likely GDP growth rates for this year and next should be worrisome. But we suggest that the economy’s potential growth rate has picked up and is now at about 3.0% in which case GDP growth of 2.5-3.0% should not be feared. It is not rapid enough to produce an acceleration in the inflation rate. How do we reach that conclusion? We base it on the recent acceleration in productivity.
For the past three years productivity growth has averaged 2.2%. But in the 10-year period just prior to the 2020 recession, productivity growth averaged 1.2%. It has clearly accelerated because of AI. And because AI adoption is still in its infancy it should continue to climb at perhaps a 2.5% rate for years to come. This has important implications for estimates of the economy’s potential growth rate.
Economists still seem to believe that the economy’s potential growth rate is 2.0%. They get that by adding the growth rate of the labor force to the growth rate for productivity. Those are the only two ways to boost a firm’s output. Hire more workers or make your existing employees more productive. In the decade prior to the 2020 recession labor force growth averaged 0.8%. Productivity growth averaged 1.2%. Adding them together produces an estimate of the economy’s potential growth rate at 2.0%. That is supposed to represent the economy’s speed limit. If GDP grows faster than that for a protracted period of time inflation will accelerate. If potential growth is 2.0% our projected growth rate next year of 2.8% would be problematic. But what if our potential growth rate is higher than 2.0%?
Going forward we believe that labor force growth is likely to slip to 0.5% as fewer foreign workers immigrate to the U.S. We estimate that productivity growth will average 2.5% for years to come. Adding those two numbers produces our estimate of potential growth of 3.0%. But economists generally are stuck on their earlier 2.0% estimate. They cannot conceive that potential growth could be faster than that. But consider the following.
In the second half of the 1990’s potential growth was in excess of 3.0% for six consecutive years. What happened then? The introduction of the internet. A technological advancement boosted productivity and potential growth for a protracted period of time. The introduction of AI should do the same thing.
While the Fed still believes potential growth is 2.0%, Fed Chair Warsh is well aware of and has highlighted the faster growth in productivity so our guess is that the Fed’s estimate of potential growth may be climbing. Regardless of what Fed officials may think about the long term, its leaders believe GDP growth next year will be 2.4% and they anticipate no additional tightening in 2027 following a likely further 0.25% hike in December. Our estimated GDP growth rate next year of 2.8% is not very different. The markets have priced in four rate hikes between now and the end of next year. We believe investor fears are overblown.
Stephen Slifer
NumberNomics
Charleston, S.C.
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