Will Fed Policy Ignite a Sustained Market Rally in 2026? AI Growth Could Make it Last

The Federal Reserve formally shifted gears in December 2025, delivering a 0.25% rate cut to the 3.5%-3.75% target range. This move capped a year of emergency reductions but signaled a more nuanced approach: easing aimed not just at crisis management, but as a tool to sustain accelerating economic expansion while navigating sticky inflation pressures. The Committee justified the cut by citing moderate growth, elevated inflation, and rising employment risks, reiterating its dual mandate focus on maximum employment and a return to 2% inflation. However, dissent underscored deep divisions; some policymakers argued for either a larger cut or no action at all, highlighting uncertainty about the optimal easing path.

Looking ahead to 2026, the Fed's framework pivots towards growth-optimized easing, according to Goldman Sachs Research. While anticipating another cut in December 2025, they forecast a slower pace next year as GDP growth accelerates to a projected 2-2.5%. Policymakers may even pause in January 2026 before resuming cuts in March and June, ultimately settling at a terminal rate of 3-3.25%. This calibrated approach assumes core PCE inflation will finally dip below 2% by mid-year. Yet, a significant challenge looms: the labor market, particularly among college-educated workers. Goldman Sachs notes a concerning 50% surge in unemployment for this group since 2022, a persistent weakness that could force further rate reductions if job losses continue, complicating the Fed's delicate balancing act between growth support and inflation control.

AI-Powered Growth Engine: Efficiency Gains Driving Economic Momentum

Goldman Sachs Research anticipates stronger economic momentum next year, projecting U.S. GDP growth to accelerate to a range of 2-2.5% in 2026. This outlook assumes central bank policies begin to normalize as disinflation progresses, with the Federal Reserve expected to implement a December 2025 rate cut followed by a slower pace of easing through the year. While core inflation is forecast to fall below 2% by mid-2026, a significant headwind emerges: persistent labor market weaknesses, particularly a 50% rise in unemployment among college-educated workers since 2022. This segment's struggles could force policymakers to reconsider their easing path if job losses continue.

The stock market reflects optimism about the AI-driven productivity boost. Morgan Stanley projects the S&P 500 could climb 14% in 2026, positioning U.S. equities to outperform global markets. This outlook relies heavily on the anticipated efficiency gains from artificial intelligence investments, combined with anticipated fiscal reforms and central bank rate cuts. However, the firm cautions that uneven global growth, challenges financing AI infrastructure, and ongoing geopolitical tensions could dampen this surge.

The labor market weakness noted by Goldman Sachs tempers the broader growth narrative. A 50% unemployment spike among highly educated professionals since 2022 suggests AI adoption may be creating significant workforce disruptions that policymakers must monitor closely. While the 14% S&P 500 projection reflects confidence in AI's economic impact, Morgan Stanley's listed risks highlight that this growth engine faces real-world friction. The trajectory hinges not just on technological adoption but on managing the transition for workers displaced by automation.

Valuation Premium vs. Growth Justification: Assessing Market Positioning

Building on prior growth expectations, this section examines whether current valuation levels justify asset price projections. The S&P 500's P/E ratio stood at 27.35 as of December 12, 2025, significantly above its 5-year average range of 19.59 to 25.44 and its 10-year average, signaling overvaluation. Historical analysis shows this premium correlates strongly with negative forward returns, with statistical models forecasting approximately -5.72% over the next decade and an 80% prediction interval between -9.48% and -1.96%.

Meanwhile, Goldman Sachs projects 2026 GDP growth to reach 2-2.5% alongside cooling inflation, with core PCE expected to dip below 2% by mid-year. This modest expansion faces headwinds from labor market weaknesses, including a 50% unemployment surge among college-educated workers since 2022.

The tension emerges between these growth prospects and valuation realities. While some analysts previously projected double-digit index gains, the current premium and negative return forecast suggest markets may be pricing in more than fundamentals support. The critical inflation threshold of sub-2% core PCE remains pivotal – failing to breach it could delay monetary easing and pressure valuations further. Investors must weigh the modest growth outlook against the statistical likelihood of negative returns, tempered by the possibility of stronger-than-expected earnings growth.

Risks to the Growth Thesis: Where Optimism Could Stumble

Morgan Stanley's 14% S&P 500 projection for 2026 hinges on AI-driven productivity gains and fiscal reforms, but three headwinds could undermine this optimism. First, AI infrastructure financing faces significant hurdles: building data centers and acquiring specialized chips requires massive capital deployment, and funding costs could spike if interest rates remain elevated longer than anticipated, pressuring corporate margins and delaying ROI timelines. Second, uneven global growth may persist, with emerging markets lagging as U.S. firms benefit disproportionately from AI adoption and tax cuts, widening economic divergence. Third, escalating geopolitical tensions-particularly around supply chain disruptions and trade restrictions-could heighten volatility, forcing risk-averse investors to flee equities.

Historical parallels warn against complacency. The Federal Reserve slashed rates by 300 basis points in 2001 to counter a deepening recession, yet economic weakness lingered for over a year due to collapsing business investment and post-9/11 uncertainty. Even with aggressive monetary easing, sustained recovery required time as confidence rebuilt. Similarly, if AI-driven growth stalls or geopolitical shocks intensify, the S&P 500's rally could face prolonged headwinds, especially if corporate earnings disappoint. While U.S. markets currently enjoy fiscal tailwinds, investors should monitor whether these risks crystallize into tangible frictions-such as delayed AI rollout timelines or regional growth divergence-before fully committing to the upbeat scenario.