Introduction to a Promising 2026
The ongoing artificial intelligence (AI) boom has been creating trillions of dollars in value for some of America’s largest companies. This has driven the S&P 500 stock market index to new record highs this year. However, there’s another reason for investors to feel optimistic as we head into 2026. On December 10, the U.S. Federal Reserve cut the federal funds rate for the third time this year, amid concerns about weakness in the jobs market. The Federal Open Market Committee (FOMC) also released its latest quarterly Summary of Economic Projections (SEP) report, revealing an expectation for even lower interest rates in 2026, alongside higher economic growth.
Understanding the Federal Reserve’s Dual Mandate
The Fed has a dual mandate: maintaining price stability, which means aiming for a rate of inflation of around 2% per year, and maintaining full employment, which involves creating economic conditions that support job growth. However, the central bank doesn’t have a specific target for the unemployment rate. The latest Consumer Price Index (CPI) reading showed an annualized inflation increase of 3%, which was far above the Fed’s target. To make matters worse, the CPI has trended higher since it bottomed out at an annualized rate of 2.3% in April.
The Impact of Unemployment on Interest Rates
The July edition of the monthly nonfarm payrolls report set off alarm bells for policymakers. The U.S. economy created 73,000 jobs for the month, which was below economists’ consensus forecast of 110,000. But that wasn’t the worst part, because the July report also came with significant downward revisions. The Bureau of Labor Statistics lowered the May and June numbers by a combined 258,000 jobs, signaling more weakness in the economy than initially thought. The U.S. economy has produced a series of sluggish nonfarm payrolls reports in the months since July, pushing the unemployment rate to a four-year high of 4.4%.
Higher Economic Growth Expected in 2026
In the September edition of the FOMC’s quarterly SEP report, policymakers were forecasting Gross Domestic Product (GDP) growth of between 1.8% and 1.9% for the U.S. economy in 2026. However, the December SEP report showed that most FOMC members are now anticipating GDP growth of between 2.2% and 2.5%, which is a noteworthy upward revision. Lower interest rates tend to fuel economic growth by reducing the cost of credit, which gives consumers and businesses more disposable income, and increases their borrowing capacity.
The Winning Combination for Stocks
Higher economic growth and lower interest rates are a winning combination for the stock market. Since lower interest rates can be a tailwind for businesses, they are also great for the stock market because corporate earnings typically drive returns. Plus, as the yields on risk-free assets like cash and government bonds trend lower, more investors park their money in growth assets like stocks instead, which generally drives the market higher. However, investors don’t want to see the Fed slashing interest rates because of an impending economic recession.
Conclusion
In conclusion, the combination of lower interest rates and higher economic growth expected in 2026 is a positive sign for the stock market. While there are risks to consider, such as inflation and potential economic shocks, the recent upward revision to the FOMC’s economic growth forecast for 2026 should leave investors feeling confident heading into 2026. Even if challenging conditions do arise, it’s essential to remember that the S&P 500 has always recovered to new highs even after the most dire economic events. Therefore, any weakness from here could be a great buying opportunity for long-term investors.
