In the last few quarters, the US economic story has changed meaningfully.

Inflation has remained persistent, with both supply and demand dynamics conspiring to keep upward pressure on prices. The war in Iran has continued to drag on longer than anticipated, which has kept oil prices elevated and the price of some energy products – namely, diesel – near the highest levels on record.

A massive AI investment cycle has added to inflationary pressures, and record corporate profits have kept financial markets buoyant, contributing to a wealth effect with resilient consumer spending keeping prices firm. Easy fiscal policy has also boosted demand, and the US economy, on balance, looks closer to experiencing a cyclical upswing rather than any “soft-landing” or late-cycle dynamics that might otherwise encourage caution from investors.

Rate risks shift higher, sooner

On the monetary policy front, new Federal Reserve Chair Kevin Warsh turned more hawkish than expected when he was nominated to the role early this year.

Warsh’s speech at the Jackson Hole Economic Symposium in late August decisively signaled a hawkish turn and, after raising interest rates by 25 basis points in mid-September, we expect another 50 basis points worth of rate hikes from the Fed, with risks tilted towards more front-loaded hikes. 

As Chair Warsh said in his September 16 press conference, the Fed was beginning to remove “a dose of accommodation” and, under his watch, the Fed “must be confident that underlying inflation is moving to our [2%] objective, clearly and at sufficient speed” – a standard that “has not been satisfied.” The financial market’s views on the Fed has evolved. Investors initially discounted Fed rate hikes in the form of “insurance” that could later be reversed; the present path for the Fed looks more likely to result in a sustained higher policy rate. Investors remain highly attuned to the risk of an even more forceful hiking cycle.

Inflation’s direct impact on Fed policy draws outsized investor attention, but other economic data have also impressed, showing that negative supply shocks aren’t the only source of pricing pressures in the US economy. Real GDP growth over the last four quarters averaged 2.1%, the unemployment rate as of August stood at 4.1%, and a broad range of measures show consumers, corporates, and the government spending more and saving less.

This mix of higher growth, elevated inflation, and a more hawkish Fed has also changed dynamics in the bond market, where Treasury yields at durations ranging from 5-year notes to the 30-year bond are near multi-decade highs. We now expect the yield on 10-year Treasuries at the end of 2027 to be 5%, up from a previous view of 4.5%.

Political uncertainty unlikely to reshape policy outlook

Political uncertainty remains ahead of November’s vote, but the risks from this event appear less singular against the current financial market backdrop. The economic dynamics we’ve outlined – higher costs for goods and services and higher costs to borrow – do not appear favorable for incumbent Republicans, in our view.

However, we do not expect any likely combination of House or Senate control scenarios in November will meaningfully improve the fiscal outlook. Elevated deficit spending is likely to continue and, while priorities may change depending on which party controls which chamber of government, legislative shifts that offer support for lower Treasury yields in the near- to medium-term are unlikely.

The primary forces that have reshaped the US economic story, in our view, thus appear likely to remain in place in the near-term. Interest rates look set to rise. A quick re-opening of the Strait of Hormuz looks increasingly challenged. Multiple sources of demand appear durable, and the broad shape of fiscal policy is unlikely to change.

Looking further out, we believe contemplating how AI ultimately feeds into the economy offers interesting scenarios for investors and policymakers alike to consider. The investments being made into the AI boom are considerable, and estimates regarding the magnitude of this spending continue to rise. Beyond the infrastructure buildout which has largely defined AI’s economic contribution thus far, we believe a productivity boom which pushes down inflation and drives real growth higher informs both the Fed Chair’s and Trump administration’s policy approach. We look forward to exploring these scenarios in depth in the future.