The growth outlook is sanguine, but for inflation risks are clear.
The US economy continued to perform strongly through the turn of the year despite acute uncertainty. According to the latest Atlanta Fed GDPnow nowcast, not even the longest Federal Government shutdown on record was enough to slow GDP growth to trend, let alone below it. In 2026, growth is likely to normalise towards trend after five years of outperformance, but the prospect of a sustained period of disappointing momentum currently seems remote. Despite the Administration’s preference for lower rates, there is little cause for the FOMC to continue cut materially from here.
Now available to January, nonfarm payrolls growth looks to be forming a base, having edged backwards during the six months to October but averaging monthly gains of 73k since. The unemployment rate has also oscillated between 4.2% to 4.4% since February 2025 – evidence of stabilisation not an upward trend.
Other labour market indicators also point to a fully employed labour force and balance between new entrants and job listings. Most notably, the Employment Cost Index and hourly earnings from the establishment survey both continue to point to robust nominal income gains, and the ISM employment indexes have recently bounced back from depressed levels.
US household wealth is meanwhile at record highs and continuing to grow thanks to broad-based gains across equities and real estate, albeit with the latter tracking a modest pace. Established households are benefiting from comparatively low debt levels and the historically low interest rates locked in following the pandemic. Marginal borrowers are also beginning to see adjustable rates edge lower – a 5-year fixed rate which then converts to a variable rate versus the traditional standard 30-year fixed rate.
Household cash flows and wealth therefore stand ready to offer robust support to renovation activity, new home purchases and discretionary consumption from 2026. Sentiment is the risk, however, with households still acutely aware of the cost to real incomes brought by sustained elevated inflation.
On that front, the latest readings are a concern, with the University of Michigan measure of sentiment 13% below its 5-year average and 32% below its full history average as at February. That is in large part due to backward-looking perceptions of household finances, despite the aforementioned nominal gains.
While there is less hard evidence, many businesses are arguably similarly placed to households, benefiting from robust conditions but concerned over what tomorrow may bring. For companies, the risk is two-sided, being exposed to supply constraints related to tariffs and reduced labour supply on the one and with consumers’ financial anxiety limiting their ability to reprice on the other. We therefore expect to see firms invest for efficiency and productivity through 2026 but, in aggregate, to eschew expanding capacity – the hyperscalers being an obvious exception.
This backdrop highlights a concern of ours not only for 2026 but also 2027 and into the medium term. Put simply: if consumption remains above trend, the labour market fully employed and businesses (in aggregate) capacity-constrained, it will be extremely difficult for the FOMC to bring inflation sustainably back to their 2.0%yr target from circa 2.5%yr pace in January. Indeed, given the persistent weakness seen in business investment since the GFC, an acceleration in inflation pressures remains a distinct possibility – annual core services inflation was 2.9%yr in January, and close to 5.0% on an annualised basis.
In light of the above, we have pushed out the last cut forecast for the FOMC this cycle from March to June 2026. We also must make clear that we have low conviction in this call, believing the economy is more likely to outperform than disappoint on activity and / or prices, in which case the FOMC would be justified to remain on hold for the foreseeable future.
We recognise this view deviates considerably from market pricing, which currently has two cuts by year-end and a high chance of another by June 2027, much of this reflecting expectations of a shift in approach once Kevin Warsh takes over from Jerome Powell as FOMC Chair in May. But, for the data to warrant such a course by the FOMC, we would need to see a material deterioration in the labour market, or the rapid abating of inflation pressures and associated risks. These outcomes are possible but, at present, seem unlikely.
This analysis first appeared in Westpac Economics’ February Market Outlook which also includes our latest forecasts for Australia, the global economy and financial markets.
