Washington, DC—The global economy is growing more strongly than expected this year, despite rising trade tensions and high uncertainty around US economic policy. Optimism about artificial intelligence (AI), particularly in the United States, has offset some of the drag from these factors for now. Still, growth is expected to slow across most major economies in 2026.
Real global GDP is projected to rise 3.1 percent in 2025 and 2.9 percent in 2026, down from 3.3 percent last year, according to an analysis presented by Karen Dynan at the Peterson Institute for International Economics Fall 2025 Global Economic Prospects event.
Crosscurrents define the US outlook
Last spring in the United States, policy changes this year—especially substantial new tariffs—were expected to weigh heavily on private domestic demand. So far, however, economic momentum has proved more resilient than anticipated. The effects of the policy shifts appear to be unfolding only gradually, while optimism about AI has boosted demand. Robust investment in AI-related categories—such as information processing equipment, software, and research and development—has more than compensated for softer investment elsewhere. Consumer spending growth has slowed, but it would likely have declined further if surging stock prices, driven by AI enthusiasm, had not boosted household wealth.
In the US labor market, the effects of much more restricted immigration can be seen in sharply slower job growth. Yet unemployment and other indicators of labor market slack have risen little this year, suggesting that the reduced supply of immigrant workers has been met by a comparable drop in demand. Wage growth has been roughly steady, consistent with a labor market that has not deteriorated much.
Tariffs, now at their highest levels in 90 years, are contributing to a modest pickup in goods price inflation, though the effect on overall inflation has been largely masked by a decline in shelter inflation. The inflationary effects of tariffs have likely been muted so far by importers front-loading shipments to avoid new duties, holding goods in bonded warehouses, and absorbing costs to an unusual degree. These practices are unlikely to be sustainable, suggesting that the tariffs' impact on prices mostly still lies ahead. Quarterly consumer inflation, as measured by the personal consumption expenditures price index (PCE), is projected to peak just above 3.5 percent in early 2026 and remain above 3 percent through year-end.
With tariffs reducing purchasing power, US GDP growth is projected to moderate to 1.7 percent in 2026 from 1.9 percent in 2025. Less-restrictive monetary policy should help cushion demand. The Federal Reserve is likely to cut interest rates twice more in 2025 and once in 2026, reflecting concerns about a softening labor market and an inclination to "look through" temporary tariff-related increases in inflation. On balance, the unemployment rate is projected to rise modestly to about 4.5 percent and remain near that level through the end of 2026.
Global growth remains uneven across regions
Economic growth in the euro area remains mixed, with southern countries remaining robust and those in northern Europe facing headwinds. In Japan, fiscal stimulus under new leadership should lift growth temporarily in 2026, but the boost is likely to fade as inflation rises and policies subsequently tighten. The United Kingdom continues to experience muted growth amid fiscal restraint, a strong pound, and weak productivity.
Among the large emerging-market economies, India and China continue to lead even under tariff pressures. In China, exports have held up, but the property downturn continues to weigh on domestic demand. In India, strong domestic demand is sustaining growth and helping offset the drag from tariffs. By contrast, Brazil faces slower growth as tight monetary policy continues to restrain demand. Russia's economy remains weak, held back by low oil prices and financial sanctions.
The outlook is fragile
Global growth has held up better than expected this year, and that resilience is welcome news. Looking ahead, however, individual economies face different headwinds and risks. An important vulnerability is that the United States' continuing gains depend on whether today's optimism about AI is sustained. The expanding use of AI is likely to boost productivity and output substantially over time, but the path to those gains may be uneven. With business investment and household spending so dependent on confidence in AI's potential, any setback could sap momentum and expose the underlying drag from tariffs, immigration restrictions, and other policy changes.
US inflation risks
Adam S. Posen, PIIE president, said both the US Federal Reserve and financial markets significantly underestimate the likely level and persistence of US inflation over the next two years. Headline inflation is likely to be 4.5 percent or more by mid-2026 into 2027. Posen said that inflation will be higher than expected due to a combination of macroeconomic and policy factors.
The overlooked factors, Posen said, include eroded Fed credibility, overestimates of current monetary policy restrictiveness, loose fiscal policy, and the lagged transmission of price increases due to trade and migration restrictions.
China's trade surplus
Arvind Subramanian, senior fellow, discussed two perspectives on China's trade surplus based on work with Shoumitro Chatterjee (Johns Hopkins University). As China's trade surplus rises again, anxieties have been expressed about a China Shock 2.0. But the magnitudes and pace of increase are very different from the original China shock, especially in light of the fact that much of China's low-skill exports can no longer be produced in rich economies.
In contrast, the China shock, in magnitude and pace, is now very serious for low- and middle-income countries (LMICs), aggravated by the diversion of Chinese exports away from the US. The striking fact is that China continues to produce lower-skilled products despite wages becoming multiples of those in LMICs. If China aspires to global leadership, vacating space for poorer countries is imperative. Renouncing special status in the trading system and offering duty free access to LMICs is a good start, but in practice it must renounce mercantilism, especially if sustained through distortionary policies, toward them.
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