Viewpoint
June 26, 2026 | 13:47
Economy on a Firmer Footing—Inflation Still a Problem
Economics
Economics
Economics
Economics
Economy on a Firmer Footing—Inflation Still a Problem |
| The focus of the Fed will remain squarely on inflation as the economy reveals consistent signs of resilience as the second quarter comes to an end. There is little doubt now that the economic expansion has regained its footing after a lackluster 0.5% annualized GDP growth rate to end 2025. The third and final estimate of first quarter GDP showed a larger-than-normal upward revision to 2.1% from 1.6%, driven by big upgrades to net exports, inventories, and intellectual property investment, even as consumer spending saw a sizable markdown to a lackluster 0.5% a.r. growth rate on slowing services spending. |
| Fear not for this expansion, however, as the consumer spending pause in Q1 gives households a bit more cushion in Q2 even as rapidly rising prices take a big bite out of budgets. The personal savings rate for May was reported at a much more comfortable 3.0%, up from 2.6% in April (nearly a four-year low), due to the frugal spending over the first three months of the year (Chart 1). The impressive 0.7% rebound in personal spending in May—and 0.3% increase after adjusting for inflation—puts real spending on track to rise at a healthy 2.1% annualized pace in Q2. With the Q1 GDP upward revision, first-half GDP growth is expected to average an above-potential 2.1% in 2026, compared to a 1.6% average pace in the first half of 2025. A better-than-expected personal savings rate, and the 3.1% a.r. rebound in real disposable personal income growth in May, puts real consumer spending and GDP growth on a better foundation for the third quarter, too. We raised our Q3 real consumer spending forecast by two-tenths to 1.8%, and Q3 GDP growth by a tenth to 1.9%. Bloomberg Economic Surprise Indexes elegantly capture the strengths and weaknesses of the current economic environment and how they have improved from a year ago. In June 2025, the economy was still recovering from the shock of the trade war and the Liberation Day tariffs. Today, we can see far more positive economic surprises coming from a broad range of indicators (PMI surveys, retail and wholesale trade, the labor market, and manufacturing sector) than we did a year ago (Chart 2). Housing is the one sector that is clearly bucking this trend with surprises turning highly negative on rising mortgage rates, fading new home sales, and rising inventories and building costs. With GDP growth back above potential for six months in a row and likely to stay at or above that level for the foreseeable future, the Fed will need to remain vigilant on the inflation front. We estimate PCE inflation in Q2 at a hefty 5.7% annualized with core inflation around 3.6% annualized. While we have cheered the drop in crude oil and gasoline prices since the MOU was signed and some shipping through the Strait has resumed, we know the slog back to the Fed’s 2.0% inflation target will be longer than anyone wants to see (Chart 3). Even with our recently lowered base-case forecast for crude oil prices into year-end, we still see PCE inflation year-on-year in Q4 at 3.5% and core PCE at 3.3%, both well above their Q4 2025 levels. It’s getting late in the game, and the Fed still has a lot of ground to make up. |
Producing Resilience |
| Manufacturing is on the mend. After contracting for two years, the sector expanded 1.4% y/y in May. That’s still modest growth for a sector that accounts for a tenth of GDP. Nonetheless, what was once a steady headwind for the economy has now become a mild tailwind. In fact, the latest purchasing managers’ surveys suggest the sector may even be gaining steam. The ISM’s May reading (54.0) was the highest in four years, while S&P Global’s flash June tally (57.7) marked a six-year peak. New orders for capital goods, excluding aircraft and military goods, jumped 1.6% in May and are up a sizzling 20% annualized in the past three months, flagging a strong pipeline for future production. Factories have even increased payrolls this year after shedding staff for much of the past three years. Some of the recent strength in manufacturing likely reflects front-running in anticipation of higher prices and supply disruptions stemming from the Iran war. But there is more to the story. The revival mostly derives from the AI boom, notably the need to equip data centers with computers, servers, and supporting gear. Production in high-technology industries rose 13% y/y in May. Data on new orders and production suggest the AI boom has spilled over to other industries, such as machinery and metals. Lending a hand is the trade-weighted dollar’s 3% decline in the past year. Despite pulling back in May, goods exports are still up 15% year-to-date. A weaker dollar is also restraining imports, but surging purchases of advanced technology products (38% y/y in April) are mitigating the positive effect on GDP. Not all industries have gained traction, however. Production of most nondurable goods, including food, clothing, and chemicals, is down in the past year to May. Despite tariffs, motor vehicle and parts output has dropped 2% y/y. While hefty duties on steel and aluminum are supporting these industries (up 9% and 4%, respectively), it's premature to attribute the manufacturing revival to reshoring. Bottom Line: The AI wave is lifting all boats, including now the manufacturing sector. |
Is Job Growth Really Picking Up? |
| After nearly stalling in 2025, the payrolls of American businesses and governments are rising again, and at a surprisingly solid rate despite higher fuel costs. Is this the start of a new growth cycle for American workers, or merely a head-fake? The former would add grit to an already sturdy economy, tempting the Fed to raise rates, while the latter would tamp down inflation and help keep rate cuts on the table. Last year was a tough one for job seekers. Nonfarm payrolls grew just 10,000 per month on average, down from 122,000 in 2024 and 210,000 in 2023. The federal government slashed its workforce by more than a quarter million, and the private sector struggled to pick up the slack. Monthly private payroll gains averaged just 25,000—and would have shrank by 33,000 if not for solid hiring by health care and social assistance providers. |
| But payrolls rebounded by over half a million in the first five months of this year (Chart 1). The monthly average of 114,000 greatly exceeded the breakeven rate required for a steady unemployment rate, widely estimated at between zero and 50,000, given limited labor force growth. Federal job cuts eased, while private-sector hiring strengthened, averaging 106,000 per month and 51,000 excluding health care and social assistance. Even factories chipped in after a lengthy drought. Confirming the pickup in the BLS’s measure of private-sector payrolls is the ADP’s tally, which improved to an average of 73,000 per month this year from 33,000 in 2025. Unfortunately, most other job indicators tell a different story than payrolls. The BLS’s household survey shows 1.2 million job losses this year (Chart 2), largely full-time positions. The only reason the unemployment rate has fallen slightly (to 4.3%) is that the labor force shrank more than employment, reflecting a lower participation rate (increased retirements) and weak population growth (immigration cuts, deportations). The ISM’s surveys of factories and service providers suggest employment continued to contract in May. Small firms have scaled back hiring plans this year, according to the NFIB’s survey. Although total job openings have risen, the hiring rate has not. This suggests businesses are having difficulty filling positions, possibly because immigration cuts have reduced the pool of qualified help (Chart 3). Due to limited hiring, unemployment duration has lengthened. Households surveyed by the Conference Board perceive that job availability is the worst in a decade, excluding the pandemic years. This might explain why so few workers are quitting, or even asking for a raise. The Atlanta Fed’s Wage Growth Tracker slowed to 3.5% y/y in May, a five-year low. The good news for workers is that layoffs are not pervasive. However, they have turned up in one sector: technology (Chart 4). Tech firms announced more than 100,000 job cuts this year, the second most on record within a five-month span for the sector. This reflects continued post-pandemic restructuring and, apparently, increased AI adoption (Chart 5). Junior coders, in particular it seems, have Claude Code to blame. AI was cited as the primary reason for 40% of all-sector layoff announcements in May, although this still represents a negligible 0.02% of the aggregate workforce. Firms may also be hiring less because their existing staff can produce more. Labor productivity rose 2.8% in the year to Q1, above the postwar mean of 2.2%. Indeed, U.S. businesses have posted the longest stretch of solid productivity gains since the turn of the century. Decades of heavy investment in information technologies may be paying off. Of course, it’s entirely possible that job growth has improved. Labor force growth, and therefore the breakeven rate, may be underestimated. In this case, however, faster job creation would not necessarily reduce the unemployment rate. Inflation could still retreat, keeping Fed rate cuts in play. Alternatively, hiring may have increased because businesses have gained confidence in the economy’s ability to withstand shocks, after it largely shrugged off new tariffs and higher fuel costs. If so, a lower jobless rate could fan inflation and compel the Fed to tighten policy. Still, unless the upturn in payrolls persists—starting with the June report—or is confirmed by other data, we remain somewhat skeptical. Indeed, the sturdy figures could get washed away, given the recent pattern of annual benchmark revisions. We expect monthly payroll gains to decelerate to around the upper end of the breakeven range (50,000) in the year ahead. While real GDP growth is expected to remain sturdy at around 2%, the main driver will be productivity rather than employment. This could keep the jobless rate slightly above the Fed’s estimate of neutral (4.2%), opening the door for rate cuts in 2027. |
