By George Brown, Senior Economist, Schroders.
THE US ECONOMY HOLDS UP AGAINST THE ENERGY SHOCK
The US economy appears destined to remain relatively insulated from the global energy shock. As a net energy exporter, it is less exposed than most advanced economies to disruptions in oil flows. Households also benefit from an expansionary fiscal policy, with tax refunds currently about 25% higher than in 2025. And with initial unemployment claims near multi-decade lows, wage growth could well shift upwards to offset the higher cost of living.
RISING INFLATION AND PRESSURE ON INCOMES
Ultimately, we expect to see a real squeeze on household disposable income. The extent will depend on how oil prices evolve from here and whether this leads to second-round effects. Based on our baseline assumptions, we forecast the CPI to rise from a pre-war level of 2.4% to a peak of around 4%. Our forecast then sees inflation beginning to moderate towards the end of the year, although core CPI will not fall below 3% until the second half of 2027. On a calendar year basis, this corresponds to an average CPI of 3.5% in 2026 and 2.7% in 2027.
SLOWED GROWTH IN 2026 AND 2027
According to our estimates, the inflation shock should subtract about 0.6% from growth in 2026. Beyond that, our updated projections now incorporate the delayed Q4 GDP data, which was not available during our last forecast cycle. This heavily reduced our expectations due to a government shutdown impact greater than we had anticipated. Overall, this lowers our growth forecast for 2026 from 3% to 2.2%. And for 2027, we expect a repeat expansion of 2.2%, down from the previous 2.5%, due to continued pressure on real incomes.
THE FED BETWEEN INFLATION AND RATE CUTS
Persistently above-target inflation presents a headache for the new Fed chairman. Although Kevin Warsh (pictured) adopted dovish tones during his confirmation process, it will be a tough task to convince the majority of the committee to vote for rate cuts this year. Some voting members have even floated the possibility of hikes. In April, three regional presidents opposed the FOMC statement language, which they said implied the next rate move would be downwards. For cuts to materialize this year, we believe either a deep recession or a rapid de-escalation will be necessary.
It is unclear how the Fed will react to the bilateral risks it faces. Warsh considers policy too restrictive, but other committee members appear more focused on inflation risks. Our base case is that the Fed will use tough rhetoric but ultimately keep rates steady rather than respond to a one-off energy-driven inflation. This would also give Warsh more room to push for cuts in 2027, once attention shifts back to labor market risks.
LONG-TERM RISKS FOR MONETARY POLICY
But it is an open challenge. If growth remains resilient as we expect and second-round effects emerge, the Fed could end up falling behind the curve, requiring a more forceful response later. Over the longer term, we are skeptical that easing can proceed without consequences. Solid growth and inflation above target at a time when the policy rate is still higher than the FOMC’s long-term rate suggest that the neutral rate is higher than generally assumed. Cutting based on presumed AI-driven disinflation would therefore be a gamble, risking the buildup of problems for 2028 and beyond.
