Boom-Bust Cycle
Why the U.S. Economy’s Strength in 2026 May Lead to Instability in 2027
The central issue for the U.S. economy in 2026 is not whether the economy retains momentum. It does. The more important question is whether the policies sustaining it are increasing the likelihood of greater instability later, in 2027 or beyond.
Anticipating the course of the U.S. economy is always difficult, but the challenge is unusually great at present. The country is navigating trade and military conflicts, funding a massive and growing national debt, and dealing with a difficult transition in Federal Reserve leadership. These developments do not operate independently. They interact, shaping the outlook for inflation, interest rates, and economic growth and stability.
The near-term outlook may be stronger than many expect, but the forces supporting that growth may be reinforcing inflationary pressures, setting the stage for a more difficult adjustment later.
A Political and Fiscal Starting Point
A useful point of departure is the political setting in which fiscal and monetary decisions are being made. Congress, both parties, and the administration remain focused primarily on short-run political objectives, above all reelection. Accordingly, it is reasonable to assume that the nation’s chronic deficit and budgetary problems will continue to be deferred rather than addressed. That helps explain why near-term growth is likely to remain firm. It also suggests, however, that short-run economic support is being purchased at the cost of greater long-run vulnerability.
Sources of Near-Term Economic Strength
The case for continued growth through 2026 is straightforward. Fiscal policy is expansionary and likely to remain so over the next year. The fiscal stimulus that began in January will continue to support GDP growth through the remainder of the year. The new tax cuts put in place in January will remain in effect. There will be no meaningful reduction in spending, and there will be a further increase in spending for the war in Iran.
These measures alone are sufficient to support aggregate demand.
The government sector, however, is not the sole source of momentum. The private sector is also contributing materially to the economy’s current strength. U.S. investment in AI will exceed $500 billion this year. Corporate earnings remain strong, and investment in other sectors should remain modest but steady. Consumers who have benefited from rising asset values will continue to spend out of those gains. Labor markets should remain steady as lower demand for labor is offset by lower supply. Labor productivity also remains a notable positive, at 2% or better, as technology continues to advance.
Taken together, these conditions form a strong case for continued expansion through 2026.
The Inflationary Character of the Expansion
The fact that growth may continue does not mean that the expansion is well balanced. The principal concern is that the same policy environment supporting activity is also imparting an inflationary bias. Expansionary fiscal policy in an economy that already has momentum adds demand to the system and raises the probability that inflation, asset and consumer prices, accelerates above a level consistent with long-term stability.
The distributional effects of this environment are also important. Consumers with rising asset wealth can continue spending, supported by appreciating portfolios and balance-sheet gains. Lower-income households, by contrast, face a more difficult situation. Their wealth is limited, and their incomes struggle to keep pace with inflation. Accordingly, some of what appears in the aggregate data as broad consumer resilience is, beneath the surface, more concentrated and less durable than headline figures suggest.
Energy, Trade, and the Risk of Stagflation
A second source of concern lies in the interaction of energy shocks and tariff-related disruptions. These pressures push inflation higher while also weighing on real growth — raising the risk of stagflation. The OECD estimates inflation will reach 4.2% later this year. If that occurs in the context of weaker trade efficiency, higher energy costs, and persistent fiscal expansion, the risk of stagflation becomes real.
Stagflation is especially difficult because it limits the effectiveness of any policy response. Measures designed to support growth may worsen inflation, while measures designed to restrain inflation may deepen the slowdown in growth. Cost shocks, trade frictions, and war-related pressures can become embedded in expectations, and should that occur, the line between a temporary inflation problem and a more persistent one becomes harder to maintain.
Fiscal Imbalance and the Debt Overhang
The fiscal backdrop intensifies these concerns. The federal deficit will exceed $2 trillion, and the debt will exceed $40 trillion by year-end. These figures are consequential not merely because of their scale, but because of the constraints and incentives they create. Persistent deficits place pressure on Treasury markets, reduce fiscal flexibility, and increase the likelihood that policymakers will rely more on monetary accommodation to ease the burden of financing. Over time, large and recurring borrowing requirements affect the relationship between the Treasury and the central bank, particularly when political incentives favor low nominal rates and continued spending.
The fiscal problem is therefore not separate from the inflation problem. It is part of it. Large deficits, when sustained into a period of already firm growth, make it more difficult to restore price stability without either tightening financial conditions significantly or tolerating further inflation. That tradeoff becomes more severe as debt levels rise.
The Dollar and External Pressures
The outlook for the dollar adds another layer of uncertainty. The U.S. dollar may remain temporarily strong as a safe haven, particularly in a world marked by geopolitical conflict and financial stress. But that strength should not be treated as permanent or self-sustaining.
Tariffs, persistent trade deficits, and possible shifts in capital flows tied to geopolitical developments could weaken the dollar over time. A weaker dollar would add to inflation pressure through higher import prices and could further complicate the already difficult balance between economic growth and price stability.
The Federal Reserve and the Problem of Accommodation
The Federal Reserve also is central to this outlook, and under present conditions it appears more likely to accommodate fiscal policy than to resist it. It has adopted the implicit mandate of ensuring liquid, smoothly functioning money and government debt markets, even if that means inflation remains above its announced 2% target.
The nominal Fed policy rate is 3.6%, but when adjusted for 3% inflation, the real policy rate is less than 1%. That is an accommodative setting in today’s economy, and it will become more so if inflation rises further, as it did last month, unless Fed raises nominal policy rates. The politicians and Wall Street, however, will put heavy pressure on the Fed to keep nominal rates low. While the Fed may resist cutting rates, it will also be very hesitant to raise them unless inflation moves above 4% and remains there for some period.
There is also the matter of balance-sheet policy. Since last December, the Fed has restarted its purchases of Treasury securities, adding more than $210 billion of securities to its balance sheet. In practical terms, that converts government debt into money. This is the essence of debt monetization. It makes fiscal deficits easier to finance and harder to discipline through market mechanisms.
The justification for these purchases is the need to preserve orderly market functioning. No policymaker wants disorder in money or Treasury markets. But market stabilization does not eliminate the tradeoff. If the Fed accommodates too much for too long during a period of large deficits and persistent political pressure, the likely result is not stable expansion. It is higher asset and price inflation in the near term and a more difficult correction later.
Outlook for 2026 and Early 2027
Sorting through the turmoil, the most plausible near-term outlook is that the U.S. economy will experience a mild inflationary boom through most of 2026. Real growth should exceed 2% as fiscal and monetary stimulus temporarily overshadow tariff and energy shocks.
Looking beyond this year, the outlook is less favorable. As the economy moves into 2027, inflation is likely to have risen and to remain elevated as the fiscal conditions worsen and lagged effects of higher energy prices, trade frictions, and war work further into the economy. If nothing is done to alter that trajectory, the Federal Reserve will eventually be forced to raise rates. And if it acts only after inflation has become more deeply embedded, the response will need to be more forceful, and the risk of a slowdown or recession greater.
This outcome is not inevitable. But it should be central to any serious assessment of the next two years. Strong growth in the near term may conceal the extent to which inflationary and financial pressures are accumulating beneath the surface.
New Fed Leadership and the Treasury–Fed Relationship
The coming transition in Fed leadership introduces an important additional question. Kevin Warsh, the nominee to replace Jay Powell as Fed Chair, has indicated a commitment to avoiding the outcome described above. He has proposed a Treasury–Fed accord, similar to the one established in 1951, under which the Fed would conduct policy independently of the Treasury’s debt-management needs.
That accord reestablished the principle that monetary policy would be guided by long-term price stability, not short-term fiscal convenience.
Warsh’s apparent goal is to honor that principle by having the Fed, with Treasury’s cooperation, shrink the size of its balance sheet, change its composition, and in doing so promote stable growth and moderate interest rates. It is a worthy objective, but it will be difficult to achieve given the current outlook.
During the 1950s, when the earlier Treasury-Fed accord was in force, federal deficits averaged a relatively low 3% of GDP, and Congress ran budget surpluses in three instances. Those conditions eased pressure on Treasury markets and gave the Fed more room to pursue price stability without having to raise rates aggressively.
The present environment is markedly less favorable. Deficits exceed 6% of GDP and are expected to remain elevated through the next decade. That makes it far more difficult to simultaneously shrink the balance sheet and keep rates low. Warsh and the FOMC nevertheless will face immense pressure from Congress and the administration to monetize the accelerating national debt and suppress rates. Thus, the challenge isn’t just the Fed’s to manage. It is political. Government deficits must be addressed first.
Conclusion
The U.S. economy may remain stronger in the near term than some expect. There is real momentum coming from fiscal policy, private investment, labor productivity, and spending. But strong near-term performance should not be confused with long-term stability. If deficits remain unchecked, if monetary policy stays too accommodative, and if inflation continues to build, the eventual adjustment will be harder, not easier.
The outlook is not fixed. Deficits can be restrained. Monetary policy can find better balance. Growth can continue without allowing inflation to become the defining feature of the expansion. But that outcome will depend on discipline in fiscal policy, discipline in monetary policy, and a willingness to look beyond the short run.