December 5, 2025
The economy is facing some headwinds such as a widening income gap between high and low income workers, unaffordable housing for many, uncertainty caused by tariffs, and deporting thousands of immigrants. They are all weighing on business and consumer confidence and should ordinarily result in sluggish GDP growth. However, significant gains in productivity triggered by massive amounts of AI investment should boost GDP growth to a steamy 2.9% pace in 2026 and continue to stimulate growth for years to come. At the same time the combination of the Federal Reserve eliminating the surplus liquidity it created after the 2020 COVID recession, and steadily declining rents should allow the inflation rate to shrink by about 0.5% in 2026 to 2.5%. Reduced inflation should allow the Fed to cut rates a couple more times but it cannot go far.
The GDP outlook for next year will be partially determined by what happens to consumer spending which is two-thirds of the GDP pie. At first blush, the outlook might seem anemic because every measure of consumer sentiment is at a record low level as consumers fret about all of the issues described above.
But something does not fit. If consumers are so nervous they should be cutting back on spending. It happened in 2008-2009 and again in 2020. But thus far there is little evidence of a pullback in spending. How can that be?
We would suggest that the surprising behavior is attributable to a record high level of stock prices combined with the dramatic 5-year climb in home prices. As a result, consumer net worth has accelerated in recent years to a record high level. There is certainly a psychological boost as net worth climbs as well as a much bigger cash cushion in the event something bad happens. As a result, consumers have shrugged off their worries and continue to spend. We expect consumer spending to continue at a 1.7% pace in 2026.
We believe that housing is at the end of the prolonged slump triggered by the dramatic increase in mortgage rates from 3.0% in early 2022 to 6.3% today, and by the 50% increase in home prices in the past five years.
The outlook for the housing market next year will be largely determined by what happens to affordability which is determined by three things – mortgage rates, home prices, and consumer income. Mortgage rates should continue to decline as the Fed cuts rates further and as inflation slows. Home prices have already begun to decline slowly. And if the economy continues to crank out jobs and wages rise, consumer income will climb. All three of these factors are going to make housing more affordable and boost sales next year.
Driven by spending on technology – AI in particular — business investment has accelerated in recent quarters as every business in the country has begun to use AI or will soon do so. They have to. If they do not, the competition will. Those firms will cut costs, become more productive, boost profits, and your firm will not. Because the use of AI has just begun, we expect nonresidential investment to climb by 8.0% next year and continue to climb rapidly for years to come.
The dramatic increase in tariffs announced by President Trump in January scared everybody. Imports would surely decline. Exports would also drop as other countries retaliated. Inflation would rise. The result was a surge in imports in the first quarter as firms raced to import goods ahead of the imposition of tariffs in early April, and an offsetting drop in imports in the second quarter. Those swings in imports reduced first quarter GDP growth by 4.5% and boosted second quarter growth by 5.5%. But the situation has settled down as the initial tariff hikes have been reduced and trade deals reached with a number of countries. But the uncertainty remains as businesses try to rejigger their supply chains and recalculate their cost of materials. Consumers try to determine whether the rising prices of imported goods will be a one-time event or will allow businesses to steadily increase prices for a protracted period of time. Our sense is that in 2026 both exports and imports will decline slightly, and the difference between the two, known as net exports, will change little. If so, the trade component of GDP will have little impact on GDP growth next year.When we combine all these components of GDP we end up with a projected GDP growth rate next year of 2.9%.
One might ask how we can end up with a robust pace of economic activity given the lack of jobs growth. Payroll employment growth has slowed from 170 thousand per month in 2024 to just 60 thousand. Most economists and the Fed believe that the slowdown in jobs is indicative of reduced demand and a harbinger of slower growth ahead. Thus, the Fed needs to counter slower growth by cutting rates both quickly and significantly. While there is almost certainly some reduced demand, we suggest that the major factor in reduced jobs growth is a drop in the availability of workers.
Job openings have dropped from a record level of 12.0 million in early 2022 to 7.2 million which suggests that the demand for workers has dropped significantly. But it is dropping from a record high level. Job openings were inflated at that time because the economy snapped back more quickly than anticipated following the 2020 recession. Firms had to rehire many of the workers they had just laid off. Thus, the 12.0 million job openings was inflated and could never be sustained. As it declined economists suggested that it was reflective of reduced demand for workers. That is probably true to some extent. But it is worth noting that today’s 7.2 million job openings are exactly where they were prior to the recession. Nobody suggested that the labor market was weak at that time, but now the same level of openings is supposed to be reflective of a labor market that is on the brink of collapsing. That it not how we see it.
The labor force had been increasing by about 100 thousand per month for years. But since January it has been unchanged. During that period of time the U.S.-born labor force climbed but was offset by a drop in the foreign born labor force.
Since January the foreign-born labor forced has declined by 1.2 million. That works out to about 150 thousand per month. Why? Because they were deported. Presumably, those people had jobs prior to being forced out of the country. If we had not changed our immigration policy payroll employment growth would once again be close to 200 thousand. So rather than being indicative of a sharp drop in demand, we would suggest that the bulk of the reduced pace of jobs creation is attributable to a change in immigration policy. Fed rate cuts will do little to restore jobs growth. A better solution would be to change our immigration policy.
The elimination of federal government jobs gets some eye-catching headlines, but the reality is that it will do little to change the jobs outlook Payroll employment is 160 million. Federal government jobs are just 3 million or 2.0% of the total. If the goal is to cut federal jobs by 10% that would be 300 thousand workers spread out over time. But everybody forgets that virtually all of these workers will quickly be re-hired by the private sector. Government jobs decline, private sector jobs rise. The bottom line is that the elimination of 300 thousand federal government workers is not going to have a significant impact on the overall labor market.
We expect jobs growth to continue to climb at a slow pace in 2026. The reason that GDP growth can continue to be robust is because of AI-enticed growth in productivity. Productivity growth in the past year has jumped to 2.5%. Over the past 10 years it has risen 1.2% annually. Its growth rate has doubled recently. That reflects productivity gains caused by AI. As we see it productivity should climb by about 2.5% for years to come as the use of AI technology spreads rapidly.
If productivity growth accelerates for a protracted period of time the economy’s potential GDP growth rate (or its economic speed limit) will also increase. Economists estimate potential growth by adding the growth rate of the labor force to the growth rate of productivity. To boost output firms can either hire more workers or make their existing employees more productive. For the past decade potential growth consisted of 0.8% growth in the labor force plus 1.2% growth in productivity or 2.0%. Going forward we expect labor force growth of 0.5% plus 2.5% growth in productivity or potential growth of 3.0%. Because potential growth has been estimated at 2.0% for so long some may have difficulty imagining a 3.0% potential growth rate. But potential growth exceeded 3.0% for six consecutive years from 1996-2002. Why? The internet was introduced. Why can’t a technological breakthrough like AI have the same impact? This means that instead of GDP growth around the 2.0% mark we should expect GDP growth to fluctuate around 3.0%. That will boost wage growth, enhance corporate earnings, boost the stock market, and help to keep inflation in check.
Consumers are very concerned about inflation. Tariffs are clearly boosting inflation. After years of being essentially unchanged, goods sector prices have risen 1.5% in the past year. Since this is the sector most impacted by tariffs we suggest that tariffs have added about 0.5% to the CPI inflation rate in the past year. Rather than 3.0%, core goods prices would have risen about 2.5% in the past year.
But the money supply and rents should help reduce inflation next year. The money supply surged in 2020 and 2021. The Fed was concerned about the massive number of job losses and chose to boost liquidity by increasing the money supply. It did so by purchasing Treasury securities. When the runup in inflation did not prove to be temporary, the Fed reversed course and began to shrink its balance sheet. It has only now eliminated the $4.0 trillion of surplus liquidity it created. That should allow the inflation rate to resume its gradual decline.
Rents are one-third of the entire CPI index. Rents growth has slowed from a peak of 8.2% to 3.5%. But BLS calculates rent prices by looking at house prices and uses that to determine what happens to rents about one year later. Given that home prices have only recently begun to drop, it is almost a sure bet that rents growth will continue to slide to perhaps 2.5% by the end of next year which should, in turn, subtract about 0.4% from the CPI inflation rate in 2026.
The Fed is likely to react to a slower rate of inflation by cutting rates a couple of times between now and the end of next year, but it cannot go far. The funds rate currently is 3.8%. The Fed thinks its policy is neutral when the funds rate is at 3.0%. Hence its policy currently seems slightly restrictive. But if that is the case, why is the stock market at a record high level? Why is the economy still chugging along at a 2.5% pace? And why is inflation not continuing to slow towards the 2.0% mark? We would suggest that the neutral level for the funds rate is higher than the Fed thinks it is. We would guess it is currently about 3.5%. If that is true, the current level of 3.8% is not far from where it should be. The Fed may be able to eek out a few for rate cuts in 2026, but it cannot go far.
On balance we expect GDP growth next year of 2.9% — little growth in jobs combined with a significant boost in AI-induced productivity. The unemployment rate should dip slightly to 4.2%, Inflation is likely to slow from about 3.0% currently to 2.5%. That should allow the Fed to cut the funds rate slightly from 3.8% to 3.3%. And mortgage rates should fall from 6.25% to about 5.5%. We are more positive about the economic environment next year than many of our colleagues apparently because we are counting on a significant contribution from faster growth in AI-induced gains in productivity.
As always, we will see.
Stephen Slifer
NumberNomics’
Charleston, S.C.
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