Stagflation Risk in the US Economy: The Mask of Resilience

The US economy presents a classic stagflation setup: headline resilience masking underlying fragility. On paper, the growth story looks robust. Goldman Sachs forecasts 2026 GDP growth of 2.5%, a notable beat against the consensus estimate of 2.1%. The engine is clear: the anticipated boost from business and personal tax cuts is expected to offset the earlier drag from tariffs. This creates a precarious balance, where the growth model depends heavily on volatile fiscal policy and AI-driven productivity gains, rather than broad-based, durable demand.

Yet beneath this surface strength, the labor market is in quiet deterioration. Job growth has slowed notably from mid-2024 to mid-2025. What's most telling is that this slowdown has not yet translated into a rising unemployment rate. The steady unemployment figure is a statistical artifact of a balanced slowdown, where labor supply and labor demand have slowed at a similar pace. This equilibrium masks deeper vulnerabilities. The bulk of recent hiring has been concentrated in just one sector, while labor force participation rates have been declining, signaling a weakening environment for workers. The market's "resilience" is thus a fragile equilibrium, not a sign of health.

The central investment question is whether this balance can hold. The thesis is that headline resilience-driven by tax policy and AI investment-is masking a labor market that is quietly deteriorating. For central banks, this creates a narrow path. They must manage inflation down without triggering a sharper slowdown in an already weakening job market. The risk is that the growth model, reliant on volatile fiscal impulses and capital-intensive AI spending, cannot sustain momentum if labor demand falters further. The setup is one of precarious stability, where the next shock could easily tip the economy toward the stagflationary scenario.

The Inflation and Policy Tightrope

The Federal Reserve finds itself on a narrow policy path, caught between the twin threats of sticky inflation and a fragile labor market. Goldman Sachs forecasts core inflation will fall to 2.1% by December, a solid decline from recent peaks but still above the Fed's 2% target. This gradual retreat is expected to be driven by the fading impact of trade tariffs and moderating service price pressures. Yet, the central bank cannot afford to celebrate. The inflation outlook is not a clean, one-way street; it is intertwined with the growth and labor market uncertainties that define the stagflation risk.

The Fed's official stance is one of patience. With the federal funds rate already at 3.5–3.75%, J.P. Morgan Global Research sees no cuts in January and expects the central bank to remain on hold through 2026. This hawkish hold is the baseline, but it is not without dissent. Vice Chair Michelle Bowman has issued a clear warning, arguing that the job market has become increasingly more fragile and could deteriorate quickly. She contends that the Fed should remain ready to adjust policy to support employment, cautioning against any premature signaling of a pause on cuts. This internal debate highlights the Fed's constrained toolkit. It cannot aggressively cut rates to stimulate growth without risking a resurgence of inflation, and it cannot raise rates to fight inflation without potentially pushing the already weakening labor market into a sharper downturn.

This is the core stagflationary risk. The scenario is not one of soaring growth with high inflation, but of weak growth and rising unemployment colliding with sticky price pressures. In such a case, the Fed's traditional levers lose their effectiveness. Cutting rates to fight unemployment would likely do little to lift inflation, which is already near target, and could undermine the progress made. Conversely, raising rates to combat inflation would only deepen the economic slowdown and increase joblessness. The evidence points to a setup where the policy response is severely limited. As Bowman noted, the central bank must be nimble, but its ability to act decisively is hampered by the very fragility it seeks to address. The path forward is one of holding steady, hoping for a soft landing, but the risk of a stumble toward stagflation remains elevated.

The AI Dependency and Consumer Weakness

The current growth trajectory is built on two pillars: a powerful but uncertain surge in capital investment and a consumer sector facing structural headwinds. The first pillar is artificial intelligence. Investment in AI is already having a sizable effect on the economy, supporting business spending and boosting equity prices. This creates a positive wealth effect that has helped drive consumer spending growth faster than wages. Yet, the sustainability of this momentum is the central vulnerability. The baseline forecast assumes AI investment will remain strong, but the model explicitly includes a sudden pullback in AI investment as a key assumption for its downside scenario. This is not a distant hypothetical. The rapid pace of spending on new technologies is inherently volatile, and a shift in corporate sentiment or a slowdown in returns could quickly drain this source of growth.

The second pillar, consumer spending, is projected to slow significantly. The forecast anticipates a decline in the growth rate to 1.6% in 2026. This deceleration is directly linked to the economy's demographic foundation. A recent rapid decline in immigration has led to a downward revision in net migration estimates, which in turn exerts a persistent drag on economic output. With fewer workers entering the country, the growth in the potential consumer base weakens, making it harder for spending to accelerate.

This consumer slowdown is mirrored in the labor market's underlying fragility. The picture of a steady unemployment rate is misleading. The data reveals a stark sector concentration: the vast majority of job growth in the first half of 2025 has been limited to a single industry-education and health services. Other broad sectors have either contracted or shown almost no growth. This uneven expansion signals a lack of broad-based demand. It is compounded by declining labor force participation rates, which suggest a weakening environment for workers. The labor market is not collapsing, but it is stagnating in key areas, creating a fragile foundation for durable consumer spending.

The bottom line is a growth model that is increasingly dependent on a volatile capital investment cycle while the consumer base faces demographic constraints. This combination sets up a clear downside risk. If AI investment falters, there is no broad labor market or consumer demand to fall back on. The economy's resilience is a mask, and the cracks are appearing in the very sectors that should be driving expansion.

Catalysts, Scenarios, and Investment Implications

The forward view hinges on a few critical variables that will test the fragile equilibrium of the current setup. For investors, the key is to monitor these catalysts not in isolation, but as interconnected signals that will define the path of growth, inflation, and policy.

The primary catalyst is the evolution of the labor market. The current picture of a steady unemployment rate is a statistical mirage, masking a sectoral and cyclical deterioration. The real test will be whether this fragility translates into a sustained acceleration in the jobless rate. As Vice Chair Michelle Bowman has warned, the labor market has become increasingly more fragile and could continue to deteriorate in the coming months. A clear break in the balanced slowdown-where job growth slows faster than labor force participation-would force a decisive policy pivot. It would validate the stagflation risk, compelling the Fed to prioritize supporting employment over fighting inflation, even as price pressures remain sticky.

A major downside risk is a sharp pullback in AI investment. The baseline growth forecast assumes this surge will persist, but the model explicitly includes a sudden pullback in AI investment in our downside scenario. This is not a distant possibility. The rapid pace of capital spending on new technologies is inherently volatile. If corporate returns disappoint or sentiment shifts, a swift deceleration in this investment cycle could quickly drain a primary source of economic momentum. This would pressure growth without necessarily relieving inflation, as the cost of AI infrastructure and services remains embedded in the economy. The result would be a classic stagflationary squeeze: weaker output colliding with persistent price pressures.

Against this backdrop, investors must watch the Fed's communication for consistency. The central bank's official stance is one of patience, with the funds rate at 3.5–3.75%. The key signal to monitor is whether this "data-dependent" approach remains intact or if officials begin to signal a pause. As Bowman emphasized, it is not a good idea to signal rate-cut pause without clear evidence of a sustained improvement. Any premature signaling would lock in restrictive policy at a time when the labor market's fragility suggests the need for flexibility. The monetary policy backdrop will be defined by this tension: holding steady to manage inflation while remaining ready to act if the labor market weakens further.

The investment implication is one of high sensitivity to labor market data and Fed rhetoric. The current setup offers no clear safe harbor. Growth is propped up by volatile capital investment and demographic headwinds, while inflation is in retreat but not dead. The path forward is narrow, and the catalysts are well-defined. The market's resilience is a mask, and the next major data point or policy statement could reveal the underlying fragility.