US Midyear Outlook: Geopolitical Shocks, the New Fed Era, and Growth

U.S. Economic Performance and Surprises

• Job growth has unexpectedly accelerated over the last four months, rising above the "break-even rate" of 50,000–60,000 monthly jobs required to keep unemployment stable, despite geopolitical tensions and oil price spikes.
• The resilient labor market contradicts historical patterns where rising oil prices typically dampen discretionary spending and employment in service sectors.
• Inflation has proven stickier than anticipated; rather than returning to 2%, it is projected to stabilize closer to 3% due to war effects and AI-related price mismeasurement.
• The June CPI print is viewed as an outlier that underestimates the underlying inflation trend rather than signaling a definitive inflection point.

Inflation Drivers and Outlook

• Tariffs: Previously expected to drop out of year-over-year calculations, their ongoing monthly impact on inflation is now deemed negligible.
• Geopolitics: The war in Iran and subsequent oil price volatility are identified as the primary "wildcard" and biggest upside risk, with the peak sequential price impact likely occurring in Q2.
• AI Demand: Exaggerated effects of AI demand in the PCE index are expected to sequentially soften in H2 2026 but are not entirely behind.
• Core Metrics: Net of tariffs, war, and AI measurement issues, core inflation has run reasonably close to 2% for some time.
• Forecast: Goldman Sachs Research expects core PCE inflation to settle around 2.0%–2.1% (approx. 20 basis points above 2%) for the remainder of the year.

Federal Reserve Policy and Forward Guidance

• Rate Decision: The Fed is expected to maintain interest rates on hold in July, with the next move potentially being a cut in 2027.
• Policy Stance: The FOMC is shifting away from analyzing specific inflation drivers (tariffs, wars, measurement errors), adopting a view that sustained high inflation requires a response regardless of the source to prevent entrenched expectations.
• Market vs. Fed Views: While markets price in a 50–50 chance of 2–3 hikes, Goldman Sachs estimates the probability of hikes at roughly 25%, viewing the market's "hike-and-a-half" pricing as slightly overestimating the risk.
• Balance Sheet: No significant interest exists in reverting to an "ample reserves" system via balance sheet shrinkage; however, the composition of assets remains an open question, with debates centering on whether to hold Treasury bills to reduce profit volatility or mirror Treasury issuance.
• Communication Changes: New Chair Kevin Warsh opposes "forward guidance with commitment," though soft, non-committal guidance remains inevitable when discussing economic impressions.
• SEP Projections: There is consideration of eliminating the median projections from the Summary of Economic Projections (SEP) to avoid signaling a unified committee forecast, though dispensing with the entire SEP is viewed as unlikely due to transparency concerns.

Growth Forecast and Risks

• GDP Outlook: Real GDP growth is forecast at 2% for the remainder of the year, slightly below potential (2.5%), driven by weaker consumption and housing offset by strong business investment.
• Consumer Dynamics: Median real income growth is projected to be mediocre with low savings rates; tax refund payments have likely peaked.
• Wealth Effect: Rising stock markets are estimated to boost consumer spending by 0.3–0.4 percentage points annually via the wealth effect.
• Primary Risk: The escalation of the Middle East war remains the critical risk, primarily due to its potential to spike inflation and force a tighter monetary policy stance that could destabilize financial markets.