Thoughts on the Market — Special Encore: What’s Driving U.S. Growth in 2026

December 31, 2025
Host: Morgan Stanley
Speaker: Michael Gapen, Chief U.S. Economist

Episode Overview

This episode features an encore presentation of Morgan Stanley's 2026 U.S. economic outlook, presented by chief U.S. economist Michael Gapen. The discussion covers projected trends in GDP, inflation, labor markets, the Federal Reserve’s policy response, and the pivotal role of AI-driven capital spending in shaping the next phase of American growth. The tone throughout is measured optimism, highlighting the transition from uncertainty and policy volatility to steadier, moderate growth and disinflation.

Key Themes and Discussion Points

1. Setting the Stage for 2026

Timestamps: 01:03 – 02:00

• 2025 Recap: The year was marked by slower growth, stubborn inflation, and surprising market resilience—primarily due to an AI-capital spending surge ("AI driven capital spending boom").
• Looking Forward: The economic outlook for 2026 is "brighter," with modest global and U.S. growth acceleration, eased inflation expected in the second half, and improving real incomes.

"If 2025 was the year of Fast and Furious policy changes, then 2026 is when the dust settles."
— Michael Gapen (01:18)

2. Growth, Inflation, and Policy Dynamics

Timestamps: 02:00 – 03:30

• Growth Forecast: Morgan Stanley forecasts U.S. GDP growth at 1.8% in 2026 and 2% in 2027—transitioning from slow to moderate growth.
• Inflation: Core and headline PCE inflation expected at 2.6% and 2.5%—above the Fed's 2% target through 2027.
• Policy Influence: The fading impact of 2025’s strict trade and immigration policies, though some tariff risks linger.

"In other words, the inflation fight isn't over, but the worst is behind us."
— Michael Gapen (02:35)

3. Risks and the Role of AI

Timestamps: 03:30 – 04:30

• Tariffs Remain a Risk: Potential for near-term price increases and constrained hiring due to tariffs and inability of firms to fully pass on costs.
• AI as a Growth Driver: AI-related business investment continues to be robust, particularly benefiting upper-income consumers and capital-intensive sectors.

"After all, AI related business spending remains robust and upper income consumers are faring well. There is reason for optimism."
— Michael Gapen (03:58)

4. Labor Market and Fed Policy

Timestamps: 04:30 – 05:40

• Labor Market: A “low hire, low fire” environment prevails, mainly due to immigration controls and tariffs. Unemployment is forecasted to peak at 4.7% in Q2 2026, dropping to 4.5% by year-end.
• Fed Actions: The Fed is cutting rates “as insurance against labor market weakness,” with 75 basis points in cuts projected by mid-2026, potentially at the expense of allowing inflation to stay above target.
• Fed’s Dilemma: Striking a balance—prioritizing job stability over hitting the 2% inflation target quickly.

"Think of it as the Fed walking a tightrope. Lean too far towards jobs and inflation lingers. Lean too far toward inflation and growth stumbles. For now, the Fed has chosen the former."
— Michael Gapen (05:32)

5. AI’s Economic Impact (Net Contribution)

Timestamps: 05:40 – 06:10

• Growth Contribution: AI infrastructure investment is expected to provide a 0.4% boost to GDP growth in both 2026 and 2027—about 20% of total growth.
• Offset by Imports: The net impact is diluted after factoring in imports of technology but remains a foundation for a new innovation cycle.
• Productivity: AI boosts productivity by 25–35 basis points annually in the forecast.

"AI is planting the seeds now for bigger gains later."
— Michael Gapen (06:00)

6. Upside/Downside Scenarios & Closing

Timestamps: 06:10 – 06:49

• Three Key Risks:
  • Demand Upside: Fiscal stimulus/business optimism overheats growth and inflation, possibly pausing Fed rate cuts or even causing reversals.
  • Productivity Upside: AI delivers outsized productivity, accelerates disinflation, and rates can drift lower.
  • Mild Recession: Tariffs and tight fiscal policy bite harder, GDP goes negative, and the Fed slashes rates to near 1%.
• Summary: 2026 will be a "transition year," marked by nuance—steadying growth, moderation in inflation, and ongoing AI-driven transformation.

"AI keeps rewriting the playbook."
— Michael Gapen (06:45)

Notable Quotes

• "If 2025 was the year of Fast and Furious policy changes, then 2026 is when the dust settles." (01:18)
• "The inflation fight isn't over, but the worst is behind us." (02:35)
• "Think of it as the Fed walking a tightrope... For now, the Fed has chosen the former." (05:32)
• "AI is planting the seeds now for bigger gains later." (06:00)
• "2026 looks to be a transition year with less drama but more nuance—as growth returns and inflation cools, while AI keeps rewriting the playbook." (06:45)

Key Segment Timestamps

• 2025 review, 2026 outlook begins: 01:03
• Growth/Inflation/Policy setup: 02:00
• AI and labor market commentary: 03:30 – 05:40
• Fed’s rate path and rationale: 05:00
• AI's net impact and risks: 05:40
• Summary and concluding thoughts: 06:10

Conclusion

This encore episode delivers a concise yet comprehensive outlook for U.S. growth in 2026, emphasizing the transition from policy-driven market turbulence to steadier but moderate expansion. While risks remain—especially from tariffs and persistent inflation—the ongoing surge in AI-driven investment is set to anchor productivity and growth prospects for years to come. Michael Gapen summarizes: "2026 looks to be a transition year with less drama but more nuance—as growth returns and inflation cools, while AI keeps rewriting the playbook." (06:45)