The US economy in 2026 is navigating a complex landscape of moderate growth, inflation risks, and labor market dynamics. As we move into the second half of the year, consumers continue to spend, albeit more cautiously, while businesses are investing heavily in artificial intelligence.
However, the economic environment is fraught with challenges, including renewed tensions in the Middle East, tariffs, and a labor market that is stuck in second gear. These factors are creating a delicate balance that could tip either way, depending on how these risks play out.
Moderate Growth Amid Consumer Caution
The US economy is advancing at a moderate pace, with consumers continuing to spend despite an ongoing income squeeze. Many households have become more frugal, and retailers are reporting increased price sensitivity. This cautious consumer behavior is compounded by higher input costs stemming from Middle East tensions and tariffs, which are pressuring margins.
Business investment continues to expand, led by the ongoing AI investment surge which is also contributing to higher prices for selected technology inputs, energy, and software. Trade flows are swinging widely, with businesses reporting a high degree of uncertainty surrounding the United States-Mexico-Canada Agreement and the potential impact of new Section 301 tariffs.
Looking ahead, moderate consumer spending growth and AI-led investment are expected to drive real GDP growth into 2027. The key downside risk to the outlook remains a renewed surge in energy prices, which could lift inflation further and force the Federal Reserve to tighten monetary policy. Such an outcome could tighten financial conditions and weigh on one of the economy’s primary engines of growth—AI investment.
Inflation Cools, but Risks Remain
The June Consumer Price Index (CPI) report revealed a much less inflationary backdrop than feared. Headline CPI fell 0.4% month over month, driven lower by plunging energy prices, lowering inflation by 0.7 percentage points to 3.5% year over year. Core CPI edged down 0.02%, marking its weakest reading outside a recession since 2017 and pushing core inflation 0.3 percentage points lower to 2.6% year over year.
Despite the encouraging report, three factors present upside risks to inflation in the coming months. Renewed tensions in the Middle East, including additional strikes and the US blockade, have pushed oil prices higher, raising the risk of renewed pressure on downstream commodity prices. Lingering tariff pressures also remain a concern, with a recent New York Fed study showing that roughly 45% of firms still plan to pass higher duties through to consumers.
Continued AI investment is likely to sustain pricing pressure in selected technology-related goods and software categories rather than broad consumer prices. Computer software prices, for example, are already up 17% year over year. Looking ahead, headline inflation is expected to move toward 3.4% year over year by December, while core CPI inflation eases toward 2.4%.
Labor Market Stuck in Second Gear
The June employment report came as a surprise only to those expecting a labor market reacceleration. Payrolls increased a moderate 57,000, while sizeable downward revisions totaling 74,000 to April and May payrolls aligned with the expectation that the labor market would stabilize following the weakness observed in 2026. The three-month average pace of job growth slowed to a modest, albeit uneven, 111,000.
The simplest way to characterize today’s labor market is that it remains stuck in second gear. While conditions appear stable on the surface, there is little evidence of renewed momentum. The low unemployment rate should therefore be interpreted alongside subdued and concentrated job growth. Labor demand remains highly selective amid structural labor supply constraints stemming from demographics and lower net migration.
Businesses continue to seek the right talent with the right skills at the right price, resulting in restrained hiring, selective layoffs, and continued moderation in wage growth. This selective approach to hiring is a reflection of the broader economic uncertainty and the need for businesses to carefully manage their costs in the face of inflationary pressures.
Fed Patience Running Thin
Recent Fed communication has increasingly converged around a simple message: After several months of upside surprises in core inflation, policymakers’ patience is running thin. The June CPI report was undoubtedly encouraging, but one favorable inflation print is unlikely to offset months of disappointing inflation data. If inflation does not begin moving lower “soon” (i.e., over the next one or two months), many Fed officials appear increasingly prepared to tighten policy further.
While a July rate hike remains highly unlikely, the September Federal Open Market Committee meeting could become the first meaningful test of whether the recent improvement in inflation proves durable. The base case remains that the Fed will stay on hold through the rest of the year, but it’s a 60–40 call. Indeed, the June median federal funds rate projections showed an even split, with nine Fed policymakers expecting at least one rate hike in 2026 and nine favoring no further tightening.
The views reflected in this article are the views of the author(s) and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.
