Although the Federal Reserve implemented interest rate hikes during its September 2026 meeting, we anticipate a shift back toward rate cuts throughout 2027 and 2028. This transition is expected as inflationary pressures ease and economic expansion moderates. Lower rates should allow gross domestic product growth to regain momentum in the later stages of our forecast period.
GDP growth has followed a downward trajectory, landing at 2.1% in 2025, which is 0.7 percentage points below the 2.8% average seen from 2022 to 2024. A key theme remains policy shifts, including the influence of tariffs and changing population growth. Total private fixed investment—excluding technology sectors bolstered by artificial intelligence—has been in decline since 2025.
We expect these economic headwinds to continue. Meanwhile, the GDP boost provided by AI will likely wane as spending levels normalize. This will cause GDP growth to soften slightly by 2028. As economic growth slows, the demand for labor will decrease, leading us to project an increase in the unemployment rate to an average of 4.7% in 2028, up from 4.3% in 2025.
Easing monetary policy, a recovery in population growth, and other variables should facilitate a rebound in GDP growth during the latter part of our forecast.
In 2025, the previous downward trend in inflation were attributed to the impact of tariffs on core goods. For 2026, inflation is projected to average roughly 3.4%. The primary catalyst is the war in Iran, as elevated oil prices are expected to contribute about 0.8 percentage points to our 2026 inflation outlook.
We anticipate that inflation will decline in the coming years. Lower energy costs will create a negative impulse for inflation in 2027, and the impact of tariffs is expected to dissipate. Furthermore, the significant slowdown in wage growth should assist in returning services inflation to more typical levels, while housing inflation also continues its downward trend.
Financial markets currently anticipate three or four rate hikes between now and mid-2027. Equally significant is the market expectation that the current target range of 4.25%-4.50% will be maintained indefinitely as the “terminal” rate.
Our outlook aligns with the market in the near term, as we also expect two rate hikes through the end of 2026. Beyond that, our projections diverge. Based on our analysis of inflation, GDP growth, and unemployment, we expect the Fed to resume cutting rates after this year. We anticipate that progress on core inflation combined with cooling growth will prompt the Fed to implement two rate cuts in the second half of 2027. We project an additional four cuts in 2028, a year in which we expect unemployment to average 4.7%, exceeding the Fed’s 4.1% forecast.
In total, this will bring the federal-funds rate to 2.50%-2.75% by the end of 2028, which is 1 percentage point lower than the current rate. Our expectations sit 175 basis points below market consensus, as we believe the market’s terminal rate estimate is significantly too high.
We believe substantial further interest rate reductions will be necessary to lower long-term borrowing costs and support sustained, robust economic growth. An additional 1.00 percentage point in federal-funds rate cuts through 2028 should help bring the 10-year yield to an average of 3.50% by 2029, which aligns with our long-run expectation.
Long-term interest rates are currently at or above their peak levels, even though federal-funds rates remain below the 2023-24 highs. As noted, this is due to a combination of rising terminal rate expectations and the term premium. Regardless, this means that essential borrowing costs for the real economy, such as 30-year mortgage rates, remain painfully high.
Currently, AI is stimulating aggregate demand and exerting upward pressure on interest rates. This effect is driven by massive investment spending and a significant rise in stock prices, which has created a consumer wealth effect. However, for these investment levels and stock valuations to be justified, we will almost certainly see significant job cuts eventually. While such cuts have not yet materialized, their eventual arrival will dampen aggregate demand. If those job cuts do not occur, AI-related spending will likely contract due to a lack of return on investment. Either way, the upward pressure AI exerts on interest rates will eventually subside to a significant degree.
