The consensus view among forecasters is that inflation will continue its gradual descent toward the Federal Reserve’s 2 percent target through 2026. Similarly, market pricing suggests investors believe the Fed has largely won its inflation battle.
In our view, however, this optimism is premature. We think it is more likely that inflation will surprise to the upside—potentially exceeding 4 percent by the end of 2026. The core drivers are the lagged effects of tariffs, an expansion in the fiscal deficit (which could exceed 7 percent of GDP this year), a tighter labor market reflecting the effects of the shift in immigration policy, monetary policy that is looser than commonly appreciated, and inflationary expectations that are drifting upwards. We believe these factors outweigh the downward‑pressure trends that consensus has been fixated on—namely, the ongoing decline in housing inflation and gains in productivity.
The Tariff Transmission Lag
The pass-through of tariffs to consumer prices has been modest to date, suggesting US importers have been absorbing the bulk of the tariff changes. That will change in the first half of 2026. The many reasons for the lagged pass-through include businesses pricing based on when their inventories arrived (and have since run out) and concerns around being seen as raising prices too rapidly (so they are instead gradually increasing them).
This won’t last—historical evidence shows that tariff pass‑through tends to be gradual, with consumer prices rising only as firms revise pricing with a lag. That pattern is playing out again: companies have now depleted the inventories they stockpiled ahead of tariff implementation. And although CEOs have been reluctant to impose a sharp, one‑time increase, they are raising prices in smaller increments over a longer period. By mid‑2026, the delayed pass‑through should be substantially complete.
This could add 50 basis points to headline inflation by mid-year. Then the question becomes whether the effect washes out of the inflation numbers, because the higher prices are also in the base of last year. Precisely because the pass-through has been so slow, we are skeptical that the impact of the tariffs will disappear so quickly.
Immigration Policy and the Labor Market
Multiple Federal Reserve banks now estimate that the breakeven employment level—monthly job gains needed to keep unemployment stable—has fallen dramatically, from approximately 150,000 in early 2024 to below 90,000 by mid-2025, as does Jed Kolko of the Peterson Institute. Reduced immigration is the primary driver. This means the labor market is tighter than headline unemployment suggests, even as employment growth has moderated.
And yet, despite the daily news about deportations, documented employment in the sectors most dependent on migrant labor—agriculture, food processing, residential construction, health and child care—has remained essentially flat. There’s no evidence of native-born workers filling these positions, no surge in automation investment, and no meaningful wage increases in these industries, yet output has stayed up.
When deportation effects fully materialize, labor shortages in migrant-dependent sectors will intensify, forcing wage increases that feed into services inflation–home health care costs are already rising at a 10 percent annual rate, near decade highs. These increases in wages will also put upward pressure on inflation in 2026.
Fiscal Policy Looser Than It Appears
The fiscal outlook for 2026 is more expansionary than most recognize – and may add a percent of GDP or more in additional stimulus this year.
Even without a ruling from the Supreme Court that invalidates the tariffs imposed under the International Emergency Economic Powers Act (IEEPA), the tariff burden is already decreasing—tariff revenues are declining from their November peak as companies shift sourcing, secure exemptions, and reduce import volumes. (This will mitigate, but not eliminate, the rise in inflation from the tariffs discussed above.)
Meanwhile, a variety of new spending is possible. Some variant of enhanced Affordable Care Act (ACA) subsidies—roughly $30 billion annually—appear increasingly likely given bipartisan signals and midterm political incentives. Tariff “dividend” checks to lower-income households remain under serious discussion, with cost estimates ranging from $300 to $600 billion depending on income limits. And the reduction in funding for the IRS is empirically likely to reduce tax collections.
A larger fiscal deficit would also add to inflation.
Monetary Conditions More Accommodative Than Recognized
Actual financial conditions matter more than the federal funds rate for inflation. By this metric, monetary policy remains looser than the FOMC seems to appreciate. Household debt service ratios sit near historic lows. Credit spreads are exceptionally tight. Household net worth exceeds $180 trillion. These indicators suggest ample capacity for continued spending.
Moreover, monetary transmission has weakened. Large technology companies largely finance investment through cash flow rather than debt markets. Private credit has reached nearly $2 trillion, providing an alternative financing channel that responds differently to rate changes (as research by the Federal Reserve itself confirms).
Another way of making this point is that the neutral rate—r-star in the jargon—is almost certainly higher than the Fed’s current estimate. Sustained defense and industrial policy spending, elevated returns to capital from artificial intelligence investment, reduced Treasury inflows due to geopolitical fragmentation, and decreased precautionary saving all point to a higher equilibrium rate. If r-star has risen by 50 to 75 basis points, as Cleveland Fed models suggest is plausible, then current policy is more accommodative than it appears.
De-Anchoring Expectations
Finally, recent research, including work by Joseph Gagnon and Steven Kamin at the Peterson Institute, demonstrates that lived experience with inflation has lasting effects on expectations. Households remember salient price increases—eggs, meat, child care, home repairs—far more vividly than aggregate statistics.[1] These memory effects persist for years or even generations.
Inflation expectations may appear anchored in surveys of professional forecasters, but household expectations tell a different story. Research demonstrates that consumers’ perception of inflation is based on the frequency of purchase rather than how much of their budget goes toward an item. This explains why a high-frequency item like eggs—despite comprising less than 0.2 percent of the consumption basket for CPI calculations—can disproportionately skew inflation perceptions during supply shocks like the avian flu. As staggered price increases in salient categories materialize over the next year, household expectations could drift upward, which also puts upward pressure on actual inflation.
cConclusion
Taken individually, lagged tariff pass‑through, tightening labor supply, looser fiscal policy, and accommodative financial conditions would each push inflation modestly higher. Taken together—and interacting with increasingly fragile household inflation expectations—they create a macro environment in which inflation rising above 4 percent by the end of 2026 is not only plausible but arguably the most likely scenario.
