Economy | Winter 2026

Toward the end of 2025, the U.S. economy showed signs of weakness without clear indications of a sharp macroeconomic downturn the latter months of 2025. While the government shutdown precluded the collection of certain economic data, the available data showed continued deceleration of the economy and stagnation in the labor markets. Despite these weak economic conditions, business survey data indicates a potential recovery in 2026.

Heightened interest rates and policy uncertainty have been major contributors to the economic slowdown in 2025. Since the surge of inflation in 2022, the Federal Reserve has kept short-term interest rates and other financial market policies at contractionary levels. This contributed to a broad slowdown in economic activity, including a slowdown in the housing market. Moreover, the global trade war that began last April caused a spike in uncertainty that likely contributed to the deceleration in business activity and a dampening in the employment outlook. To the extent that policy uncertainty contributed to an economic slowdown, policy clarity could contribute to a rebound in economic activity in the coming months.

The Fed reduced its short-term interest rate in October, citing the growing downside risk in labor markets, despite inflation persisting above 2 percent target. Whether the Fed continues lowering interest rates in will depend on whether the central bank believes that the recent uptick in inflation is transitory or persistent. One of the biggest contributors to inflation has been the shelter component, which comprises roughly one-third of the Consumer Price Index. Because of its large relative weight in the index, its trajectory plays a major role in predicting the outlook for inflation. Despite remaining elevated since the pandemic-era surge, shelter inflation has been trending downward and is expected to continue decelerating in the coming months. Tariffs have also contributed to inflation, although the magnitude of its effect remains disputed. Regardless, many economists expect the impact of tariffs on inflation to be temporary.

Source: Federal Reserve Bank of Atlanta, and Baker, Bloom, and Davis accessed via FRED

Along with the October rate cut, the Fed announced a major shift in its balance sheet operations, which is expected to impact financial markets—particularly mortgage rates—in the coming months. These balance sheet operations, popularly referred to as Quantitative Easing and Tightening, first began in response to the 2008 financial crisis, when the Fed began purchasing long-term assets, including mortgage-backed securities (MBS). Despite efforts to shrink its balance sheet in the years preceding the pandemic, the Fed once again surged its purchases of long-term Treasurys and MBS in response to the pandemic, causing interest rates to plummet. By mid-2022, the Fed ceased its purchases of these assets and began shrinking its balance sheet as it received interest payments on the assets. Most recently, in its October 2025 meeting, the Fed announced that it would stabilize its balance sheet by purchasing short-term Treasury assets with interest payments received from its long-term assets. While doing this does not directly affect the interest rates on long-term assets, including mortgage rates, it will likely ease broader financial market conditions, which may lead to lower interest rates in long-term asset markets. Looking ahead to 2026, this policy will likely contribute to downward pressure in mortgage rates, which could improve the housing market outlook.

Despite the broad macroeconomic slowdown throughout 2025, business sentiment data shows that the outlook for 2026 may be improving. Several surveys, including the Survey of Business Expectations provided by the Federal Reserve Bank of Atlanta, a survey of businesses conducted by the National Federation of Independent Businesses, and a Texas-specific survey of businesses conducted by the Federal Reserve Bank of Dallas all show an improvement in the outlook for hiring in the months to come.

Looking ahead to 2026, the economy is likely to see improvement. As the Fed shifts towards accommodative monetary policy and the trade policy outlook becomes clearer, businesses will be able to move forward with greater certainty under improved financial market conditions. Although factors like immigration remains a headwind to economic growth, accommodative fiscal policy from the 2025 tax reforms and the productivity boost from artificial intelligence are expected to yield a near-term improvement in economic output.

Jorge Barro, Ph.D. ([email protected]) is a research economist with the Texas Real Estate Research Center