SF FedViews: Uncertainty Clouds the Outlook on Inflation and the Economy

Why It Matters

Persistently high core goods inflation and modest growth raise downside risks for the U.S. economy, prompting markets to anticipate tighter monetary policy and signaling challenges for consumer spending and corporate investment.

Key Takeaways

• Q1 2026 real GDP grew 1.6% annualized, below 2% trend.
• AI infrastructure investment drove most of the quarterly growth.
• Core goods inflation remains above 3%, keeping overall inflation high.
• Unemployment stable at 4.3%; real wages slipped as inflation outpaced earnings.
• Markets now expect possible Fed rate hikes, no cuts through 2027.

Pulse Analysis

The latest San Francisco Fed assessment underscores a nuanced growth picture. While the economy posted a 1.6% annualized expansion in the first quarter, the pace lags behind the Fed’s 2% long‑run target, highlighting the drag from subdued consumer demand. Business investment, especially in AI‑related infrastructure, emerged as the primary engine of growth, suggesting that technology spending continues to offset weaker household spending. However, geopolitical tensions—most notably the uncertainty around maritime traffic in the Strait of Hormuz—have kept oil and commodity prices high, feeding into broader price pressures.

Inflation dynamics remain a central concern. Both the headline PCE and CPI sit at 3.8% year‑over‑year, with core goods inflation staying above 3% despite anchored long‑term expectations. Supply‑chain bottlenecks stemming from Middle‑East conflicts have amplified price pressures on energy, agricultural, and industrial inputs, reinforcing a trend that began in late 2024. While services inflation shows modest signs of easing, the persistence of “supercore” inflation in non‑housing services and the stubborn rise in core goods prices suggest that the Fed’s 2% target may not be achieved until the end of 2028.

Labor market indicators present a mixed view. Unemployment has held steady at 4.3%, but real hourly earnings have slipped as wage growth lags behind price gains, eroding household purchasing power. State‑level jobless claims remain stable, yet the Fed’s own projections anticipate a slight uptick in unemployment later in 2026. Financial markets have adjusted, pricing in a higher probability of rate hikes rather than cuts through 2027, reflecting expectations that tighter policy will be necessary to curb inflationary momentum. For businesses, this environment signals the need for careful cost management, strategic investment in productivity‑enhancing technologies, and vigilance around consumer sentiment as price pressures persist.