The Federal Reserve is about to restart the "rate-cutting cycle." Goldman Sachs: Dual fiscal and monetary easing, a new Fed chair, and AI stimulus will all push up assets and inflation next year.

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The Federal Reserve is expected to start its first rate cut of the year next week, followed by continued rate cuts until the end of the year.

However, Goldman Sachs strategists warn that while the Fed's upcoming rate cut cycle will be relatively straightforward this year, it may face a complicated situation in 2026—fiscal policy turning more accommodative, the dovish inclination of a new Fed chair, and productivity gains driven by AI could all push up asset prices and inflation expectations.

Clear path for rate cuts, softening labor market provides support

Goldman Sachs believes that the U.S. labor market is currently on a softening trend. The comprehensive indicator of labor market tightness—which includes the unemployment rate, job vacancies, quit rate, and business and consumer survey data—will briefly stabilize at the end of 2024 or the beginning of 2025, then decline again.

Although there is considerable uncertainty regarding the actual pace of employment growth, the unemployment rate has already increased. Under political pressure, the Fed does not want to fall behind the curve in policy adjustment and therefore prefers to normalize (lower) the policy rate to a level closer to neutral.

Goldman Sachs expects that even if tariffs may temporarily push core PCE up to 3.2% in Q4, this will only be a temporary price level shock. In labor-intensive industries, inflation should steadily decline, as the weakening labor market will further suppress wage growth.

Physical assets to benefit, inflation expectations rise

But when the policy rate approaches 3%, the Fed’s decisions will become more complex. Goldman Sachs points out that unless the labor market deteriorates sharply and signs of recession appear, there will be multiple intersecting influencing factors in 2026.

The market will continue to price in a dovish premium for the terminal interest rate during a Trump term, especially after a new Fed chair takes office. In other words, the likelihood of rate increases during a Trump term is lower, which is already reflected in the probability distribution of the terminal rate.

Since early June, the U.S. financial conditions index has further eased by 75 basis points, with each component contributing, the stock market being the largest driver. Meanwhile, potential GDP is expanding at a rate of about 2.25%, with strong productivity growth offsetting the negative effects of reduced immigration.

Goldman Sachs expects that as the drag from high tariffs diminishes and fiscal policy turns more expansionary, the U.S. economy will gradually accelerate back to its potential growth level by 2026. The key question now is: to what level can AI technology elevate this number?

Goldman Sachs concludes that in the modal scenario where there is no recession, if rate cuts continue next year, policy adjustments could become more difficult. Facing loose financial conditions, active fiscal stimulus, and tail risks from AI technology, a dovish new Fed chair increases the chance of reacceleration of the economy next year, which will provide support for physical assets and inflation premium.

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