September 11, 2026
The spike in oil prices this past week has created concern about a sharp pickup in the inflation rate and the possibility of a recession. We think the markets are overreacting but that is what markets always do. Going forward the economy is going to be bolstered by a moderate increase in consumer spending. For consumers to cut back significantly the stock market is going to have to fall much more sharply than it has thus far. In addition the investment portion of GDP will continue to expand rapidly as the AI buildout broadens. That is not going to stop any time soon. On the inflation front the combination of moderate growth in the money supply, a minuscule increase in labor costs, and a modest decline in rents, will cause the inflation rate to approach the Fed’s 2.0% target by the end of next year.
The war with Iran and its ultimate impact on oil prices and inflation are, admittedly, hard to handicap. A prolonged, dramatic increase in oil prices could lead to the unpleasant scenario that the markets fear. But is that going to happen? Our sense is that neither side is going to be able to afford such a development. While the Islamic Revolutionary Guard is not going to give in easily, the complete naval blockade by U.S. forces appears to be dramatically weakening the Iranian economy. You can talk tough, but at some point the economic reality and an inability to replenish weapons sets in. Meanwhile, in the U.S. the Republicans seem likely to lose control of one or both houses of Congress in the November election which should curtail Trump’s ability to continue the war. Not to mention the fact that the war is already extremely unpopular. While the fighting may not “end”, a resumption of full scale fighting seems unlikely.
If we can take off the table a dramatic increase in oil prices the pace of economic activity next year should be relatively robust. Consumer spending has been bolstered by middle and upper income families dipping into their stock market gains to bolster spending while lower income families cut back. The stock market feels like it has fallen dramatically, but the reality is that today’s level of the S&P 500 is only 2% below its record high level. It is not even remotely close to a 10% decline which is generally regarded as a “correction”. Furthermore, earnings will be supported in 2027 by the further buildout of AI. If the stock market hangs in there consumer spending should continue at a moderate pace next year.
At the same time the investment portion of GDP should grow at a double-digit pace in 2027 as the AI revolution broadens. It is a necessity for businesses today. Firms that choose not to spend money on AI will fall behind. Their competitors will grow more quickly and be more productive and profitable.
For what it is worth, we expect GDP growth in 2027 to be 2.8% compared to a 2.4% pace this year.
On the inflation front, both the core CPI and the core personal consumption expenditures deflator should slow next year to 2.2% which is getting very close to the Fed’s 2.0% target. Three factors seem important.
First, the money supply has grown at a 5.3% pace in the past year compared to a 6.0% growth rate prior to the recession. All of the surplus liquidity the Fed created in 2021 and 2022 which triggered the acceleration in inflation has been eliminated. Once the recent run-up in oil prices has worked its way through the economy, inflation should begin to abate and approach the Fed’s 2.0% target.
Second, the rate of growth of home prices has been slowing for several years and they are now beginning to decline. The rent component of the CPI follows home prices with a lag of about a year. Thus, rents have been steadily slowing for the past couple of years and the current rate of growth of 3.0% should slip to 1.8% in 2027. This is a big deal because rents represent one-third of the entire CPI index. That component alone should reduce the growth rate of inflation next year by 0.4%.
Finally, unit labor costs (the growth in worker compensation adjusted for the gain in productivity) should grow by about 1.2% next year. That would consist of 3.7% growth in compensation partially offset by a projected 2.5% increase in productivity. Growth in unit labor costs of 1.2% is entirely consistent with a 2.0% inflation rate.
These pieces of information suggest to us that the inflation rate next year should slow to 2.2% which is (finally) roughly in line with the Fed’s 2.0% target.
Even if the Fed shares our 2027 forecast for inflation it will be forced to respond to the current 3.3% growth rate in the PCE deflator. Fed Chair Warsh has indicated clearly that the Fed intends to bring inflation down to its 2.0% target. To not raise rates this week would jeopardize its credibility. We expect it to raise the funds rate from 3.6% to 3.8% this week and boost it again in December to 4.1%. If the inflation rate slows as expected, it would maintain a 4.1% funds rate throughout 2027. Will a 0.5% increase in the funds rate push the economy over the edge into a recession? We do not think so.
The issue is what is a “neutral” rate for the funds rate? Unfortunately, nobody knows. It is not an observable rate. We are all guessing. The Fed believes that the neutral rate is 3.1%. The current funds rate is 3.6%. This suggests that Fed policy is slightly restrictive. Rubbish. If that were the case, why is GDP growth zipping along at 2.4?. Why is the inflation rate stuck between 2.5- 3.0%? Why is the stock market at a record high level? Clearly, a neutral funds rate is much higher. We peg it at 4.0%. Interestingly, one-half of the Fed’s FOMC committee thinks it is in a range between 3.5-4.0%, Raising the funds rate to 4.1% seems unlikely to be high enough to induce a recession. Instead, it will be about where it should have been for the past year.
It seems fashionable these days to come up with a doomsday scenario where oil prices climb, inflation surges, the Fed overreacts and triggers a recession. It’s a good story but we do not buy it.
Stephen Slifer
NumberNomics
Charleston, S.C.
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