2 big things to watch in the economy: AI & Trump's Fed pick

Key Concepts

• Federal Reserve Chair Succession: Discussion around Kevin Hassett as a potential successor to Jerome Powell.
• Economic Growth Projections (2026): Forecasts for GDP growth, with an emphasis on trend growth.
• AI's Economic Impact: Analysis of AI spending's contribution to GDP growth and its potential risks.
• Federal Reserve Policy: Outlook on interest rate cuts, the influence of a dovish chair, and Fed credibility.
• Labor Market Dynamics: Job growth projections, factors influencing hiring, and the interpretation of unemployment rate changes.
• Government Shutdown Impact: Assessment of the economic consequences of a government shutdown on Q4 GDP.
• Federal Reserve Independence: Emphasis on the importance of an independent Federal Reserve.

Economic Outlook and AI's Role

2026 GDP Growth Forecast: Wolf Research anticipates a "decent" year for GDP growth in 2026, with a pickup from the current slightly below-trend performance. This improvement is expected to be partly driven by consumer benefits from tax season, particularly aiding the mid to lower-income consumer. While not projected to be a "very robust" year, it should be "fairly decent."

AI Spending and Contribution to GDP:

• Current Level: AI-related capital expenditures (capex) currently represent approximately 1.5% of GDP. This is significantly lower than historical investment bubbles, which ranged from 3.5% to 4.5% of GDP, indicating that the economy is not in "bubble territory" regarding AI investment levels.
• Contribution to Growth: AI spending is estimated to be contributing about a quarter of the current GDP growth. While not considered "game-changing" by Wolf Research, this is a "fairly substantial portion" of observed growth, contrasting with some estimates suggesting it accounts for half of GDP growth.

Risks Associated with AI Investment:

• Marginal Risk: A slowdown in AI investment is considered a "risk at the margin" because it has been an "important driver of growth."
• Shift to Debt Financing: The economy is beginning to shift towards debt-financed growth in AI, as opposed to being primarily funded by cash flow. This shift "becomes incrementally more risky."
• Overinvestment Concerns: While not currently in "frothy territory," there is a potential for overinvestment. Companies are investing to avoid being left behind in the AI investment cycle. The "real benefits of AI from an economic perspective" will take longer to materialize. The risk of overinvestment and potential negative consequences is acknowledged but considered "a ways away."

Federal Reserve Leadership and Policy Outlook

Potential Fed Chair: Kevin Hassett: Bloomberg reports Kevin Hassett as the frontrunner to replace Jerome Powell as Fed Chair. Hassett, currently Director of the National Economic Council, has been on the "short list" and is considered a potential nominee from the current administration.

Impact of a Dovish Fed Chair:

• Committee Vote: Despite the potential for a more dovish chair, policy decisions are made by a "vote by committee." A dovish chair would still need to gain consensus from other FOMC members.
• Inflationary Environment: In an environment where inflation remains elevated and interest rates are closer to what FOMC members view as neutral, it will be more challenging to push through "dovish policy."
• Interest Rate Cut Projections: Wolf Research anticipates approximately two more interest rate cuts, with the possibility of further cuts becoming more difficult as rates approach neutral levels (e.g., 3.25% to 3.75%). Cuts are more likely after the next Fed chair is in place. The December meeting is seen as an "easy argument" for a cut as many members still believe rates are restrictive.

Fed Credibility Concerns:

• Lingering Concern: While fears about Fed credibility have "died down to some extent," it remains a lingering concern, though "certainly not as severe as what was earlier the case."
• Post-Cook Case Unity: The "Cook case" is cited as a point where Fed members, specifically Bowman and Waller, have shown more unity by voting with the committee rather than dissenting, which would have signaled "fraying" at the margin.
• Regional Fed President Nominations: The risk of difficulty in getting regional Fed presidents renominated in February is seen as reduced due to this increased unity.

Labor Market Dynamics

Job Growth Projections for 2026: Wolf Research forecasts job growth to average around 80,000 for 2026, an increase from the recent average of closer to 70,000 or 60,000 over shorter windows. This suggests a "better hiring backdrop kind of across the board."

Drivers of Job Growth:

• Cyclical Areas: A pickup is expected in cyclical areas of the economy, including retail, finance, leisure, and manufacturing. These sectors have been negatively impacted by economic uncertainty and the slowdown.
• Bottoming of Growth: A stabilization and slight pickup in economic growth and activity are assumed to lead to increased hiring in these areas.
• Turning Headwinds: Factors that have acted as headwinds this year, such as immigration and AI, along with the broad economic slowdown, are expected to turn into "marginal tailwinds" next year.

September Jobs Report Analysis (Kevin Hassett's Perspective):

• Payroll Growth: The September jobs report showed payrolls rising by 119,000. Outsized growth was observed in education and healthcare workers, with a sectoral increase in demand for healthcare workers noted as a continuing trend.
• Construction Surge: A significant surge in construction employment was highlighted. This is attributed to the "big beautiful bill" and expensing factory construction, indicating new factories are beginning to break ground. This is seen as a "really positive sign for the outlook going forward."
• GDP Context: GDP was running at approximately 4.2% for Q3 and 4% in Q2, suggesting the economy was "full steam ahead" and "as good as an economy gets" prior to the government shutdown.
• Unemployment Rate Interpretation: Hassett distinguishes between two scenarios for an rising unemployment rate:
  • Bad Sign: If labor force participation decreases and unemployment rises, it indicates people are giving up on job searches.
  • Good News: If labor force participation increases and unemployment rises, it signifies more people coming off the sidelines to look for work.
• Labor Force Participation: The report showed a "big uptick in labor force participation," which Hassett interprets as the economy "getting people off the sidelines and making them look for work." This, combined with construction hiring, makes it a "really strong report."

Impact of Jobs Report on December Rate Cut: The strong September jobs report makes a rate cut in December "less likely." Hassett argues that while previous news (government shutdown reducing GDP, better-than-expected CPI) supported a cut, the jobs report's strength might not be enough to offset those headwinds.

Government Shutdown and its Economic Impact

Disruption to Q4 GDP: The government shutdown is seen as a significant headwind for fourth-quarter GDP. Hassett notes that it occurred at "just about the worst possible time" and mentions anecdotal evidence from airline CEOs about disruptions to Thanksgiving holiday travel. The full extent of its destructiveness on Q4 GDP is not yet fully understood.

Federal Reserve Independence and Policy Philosophy

Hassett's Stance on Fed Independence: Hassett emphasizes that he, like other potential candidates, "puts a high priority on Federal Reserve independence."

Disagreements with Current Fed Policy: Hassett states that any disagreements with Jerome Powell stem from "bad policy decisions" and policies that appear misaligned with the data, rather than personal issues. He believes in "sound money policies and getting interest rates aligned with the data."

Synthesis and Conclusion

The discussion highlights a cautiously optimistic economic outlook for 2026, with AI playing a substantial but not dominant role in driving growth. Wolf Research anticipates a "decent" year, with a pickup in hiring in cyclical sectors. The Federal Reserve's policy path is expected to involve a limited number of interest rate cuts, even with a potentially more dovish chair, due to ongoing inflation concerns and the need for committee consensus. The labor market is projected to strengthen, with a notable increase in construction jobs linked to recent legislation. The government shutdown is identified as a significant drag on Q4 GDP. Kevin Hassett emerges as a key figure in the discussion of future Fed leadership, emphasizing his commitment to Fed independence and data-driven policy. The overall sentiment suggests a period of moderate growth and a careful approach to monetary policy, with potential risks associated with AI investment financing and the lingering effects of government actions.