Notes on the Economy – Q3 2026 Summary

U.S. Budget Deficit: Is the Sky the Limit?

The United States economy remains in good shape despite elevated energy prices. According to the advance estimate by the Bureau of Economic Analysis, real GDP increased at an annualized rate of 1.5% in the second quarter of 2026. Both main growth engines were firing. Consumer spending grew at an annualized rate of 3.2%. Business fixed investment increased at a 7.0% rate, as growth in spending on information processing equipment was joined by higher investment in industrial and transportation equipment.

Several challenges remain. The situation around the Strait of Hormuz is still unresolved. Inflation is elevated, with the Personal Consumption Expenditures price index most recently growing at an annual rate of 3.7%, significantly above the Federal Reserve’s (Fed) 2.0% target. Stubborn inflation and sustained large government budget deficits are exerting pressure on long-term government bond yields. 10-year yields, now above 4.6%, put an additional strain on government finances. High inflation, elevated energy prices, and low saving rates present risks to growth in consumer spending. Finally, a boom in artificial intelligence (AI) technology, which led to an increase in valuations of AI-related stocks and a surge in investment in data centers and other AI infrastructure, is at risk of overheating.

The global economy remains resilient. In its July 8, 2026, World Economic Outlook update the International Monetary Fund (IMF) expected global GDP growth to reach 3.0% in 2026, only slightly lower than the 3.5% growth achieved in both 2024 and 2025. The IMF currently forecasts global growth to rebound in 2027 and reach 3.4%, with slightly slower growth in China and in the United States outweighed by faster expansion in Europe, India, and in the Middle East.

HEADLINES – WHAT’S IMPORTANT

1. Inflation Remains Elevated – Easing energy prices and low-wage pressure mean that inflation may begin falling in early 2027. Elevated inflation expectations mean that a return to the Fed’s 2.0% target is not guaranteed.
2. Government Debt—Growing to the Sky? – Years of budget deficits resulted in gross U.S. government debt exceeding $40 trillion for the first time in August. There is little chance of slowing down growth in the near term.
3. Equities Are in a Good Place, Quality Matters – Earnings growth in AI and non-AI sectors alike is likely to continue driving the S&P 500 toward 8,000 this year.
4. Long-Term Yields Are Rising, but Spreads Remain Tight – The unusual environment in fixed income markets warrants caution. Growing divergence between weaker and stronger issuers creates opportunities but reinforces the importance of careful security selection.

LOOKING AHEAD

GDP growth will likely remain close to, or slightly above, the economy’s potential in the coming quarters. Annualized quarterly growth rates will likely be around 2.5%. A stable labor market and gradually falling inflation may sustain growth in real incomes and consumer spending. Growth in AI infrastructure spending may slow down but remain positive. Business investment in traditional sectors of the economy will likely maintain growth momentum. Residential investment may finally recover in 2027.

Economic policy will likely remain largely unchanged. Elevated inflation limits the Fed’s room for maneuvering. Its federal funds rate target range will likely remain at the current level of 3.50-3.75% well into 2027 and possibly beyond. Fiscal policy is also unlikely to significantly change. Despite large budget deficits and growing government debt, the political gridlock ahead, and likely after the midterm elections in November, suggests that any meaningful action on deficit reduction is wishful thinking.

The global economy will remain resilient. Higher energy prices have increased inflation worldwide and convinced a few major central banks to tighten policy, including in Japan and in the Euro Area. However, economic damage has proved to be limited due to large oil inventories and strong household and business balance sheets. Unless the situation in the Strait of Hormuz escalates again, the global economy is likely to resume robust growth in 2027.