The Fed is facing these 5 powerful forces now boosting the economy and markets

By Brian Bethune

Businesses are managing tariffs, and AI is raising productivity - the Fed will need to be cautious

Shipping containers sit at the Port of Oakland in Oakland, Calif. U.S. businesses have largely absorbed the shock from higher import tariffs.

The glide path to lower rates in 2026 is not going to be linear.

U.S. businesses and the economy will continue to dynamically adjust and forge ahead in 2026. The business sector demonstrated remarkable capabilities for dynamic, on-the-fly adjustments last year, setting the stage for a stronger 2026.

By the fourth quarter of 2025, businesses generated productivity gains and the economy was seeing solid growth. So 2026 opens under highly constructive conditions for the economy. Five compelling forces in particular are combining now to form a positive outlook for U.S. business performance, employment, profit margins and equity markets in 2026.

First and foremost, the cost shock from tariffs was substantially rolled back in the second half of 2025, and economic-policy outlook in 2026 is expected to improve dramatically. Policy uncertainty in 2025 reached an apex in March, April and May with the Trump administration's announcement of a broad range of reciprocal country-level tariffs ranging from 11% to 50%. The average tariff rate soared to about 28% in April and May from 2.4% in January. Based on the state of the tariff world at that time, it looked like trade Armageddon had started.

But the second half of 2025 was markedly different. Many of the tariffs were modified or reduced; the average trade-weighted tariff (January 2025 trade weights) dropped to 15% in June before edging up to about 17% at the end of 2025. Significant shifts in product classifications and supply-chain purchasing patterns during 2025 mitigated the increase in average effective tariffs by about 2.5 percentage points, to about 14.5% at the end of 2025.

Thus, 2026 begins with an average effective tariff rate of about 15% - a far cry from the peak of 28% in April and May.

Businesses saw their carefully constructed business plans upended last year and were forced to make significant fiscal adjustments to mitigate the cost shock from the higher tariffs and potential hit to profit margins. Those efforts were remarkably rapid and successful, as corporate profit margins stabilized overall in 2025.

But this came at the expense of significant reductions in the pace of hiring by large businesses and outright employment reductions by small- and medium-sized enterprises with fewer than 250 employees.

Small businesses simply did not have access to the range of revenue enhancements, supply chain redirecting and other cost-containment options available to large businesses. ADP reported that employment levels in small- and medium-sized companies with less than 250 employees saw declines from March to November of 116,000 workers, compared with significant gains in larger businesses. The evidence on reduced employment at small companies indicates that low-cost immigrant labor is a complement to full-time employment - not a substitute.

This "jobless expansion" in 2025 has led to a sharp rise in unemployment. But it would have been far worse without the offsetting tailwinds from lower gasoline and diesel prices.

Second, businesses have been able to recalibrate 2026 business plans and incorporate conservative baseline assumptions for the hit from full-year tariff costs. Last year's full stop on hiring is loosening up a bit.

Third, the pace of cost savings from AI implementation will continue in 2026. The AI revolution is expected to be significant, but the supply-side constraints on the build-out of the AI ecosystem in the near term are formidable.

The stampede to move to AI to offset tariff costs has put significant upward pressure on the costs for equipment, software and construction of hyperscale data centers. Demand is advancing at a much higher rate than supply. That stands in stark contrast to the earlier waves of innovation in the 1980s and 1990s, when supply exceeded demand and prices of equipment and software declined.

Fourth, disinflation will continue, but at an extremely slow pace. There also may be some backpedaling as firms implement price increases in early 2026. Small- and medium-sized businesses were adversely impacted by the high costs of borrowing in 2025, and the Federal Reserve has already lowered rates to a more neutral stance, with the federal-funds rate near 3.75%. This should provide a badly needed injection of adrenaline to the beat-up small business sector.

But the glide path to lower rates in 2026 is not going to be linear. Given the limits on supply-constrained AI to drive productivity improvements, the Fed will have little choice but to exercise caution.

Read: U.S. economy's secret weapon surges in third quarter, lifting hopes for an AI payoff

Fifth, the containment of cost pressures will see tailwinds from relatively low prices for crude oil, gasoline and diesel. Major new production sources are coming from Guyana and Brazil, for example. The potential for significant additional increases in production from Venezuela is undeniable, but additional supply from that source is a wild card. The outlook for crude oil prices in 2026, at this moment, is skewed to the downside.

Brian Bethune is an economics professor at Boston College.

More: Investors are waiting on Friday's jobs numbers. They should be more worried about this other labor report.

Also read: The Fed will be forced into deep rate cuts in 2026 - boosting gold and breaking the dollar

-Brian Bethune

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01-10-26 1217ET