The year ahead presents both challenges and opportunities for businesses of all sizes. For small and medium businesses, understanding the broader economic landscape can help guide decisions related to hiring, pricing, investment, and growth. This white paper outlines the key economic forces expected to shape 2026 and discusses their implications for business conditions. 

Where the Economy Stands

Real GDP growth was approximately 2.3% through mid-2025, based on data from the Federal Reserve Bank of St. Louis. Federal Reserve projections point to moderate growth near 2% in 2026. This pattern is consistent with continued expansion without clear signs of overheating.

Figure 1: FOMC GDP Growth Projections

When examining the drivers of growth, consumer spending and exports are the primary contributors, while investment growth is close to zero in the third quarter of 2025. For business owners, this matters. The slowdown in investment reflects a broader reality: high interest rates have made borrowing expensive. Credit isn't cheap, and many businesses are holding off on major capital expenditures until rates come down.

Figure 2: Contributions to GDP Growth (Q3 2025)

Inflation: Still Above Target, But Cooling

The Consumer Price Index increased 2.7% over the last 12 months. That's above the Federal Reserve's 2% goal, but it's a significant improvement from the post-pandemic years. Shelter costs rose 0.4% in December and remain the biggest contributor to inflation. Because housing inflation tends to adjust with a lag, improvements in overall inflation may take longer to translate into relief for renters and homebuyers.

Cost pressures therefore remain, especially for firms exposed to commercial rents or housing-related benefits. At the same time, recent inflation trends are consistent with continued cooling rather than renewed acceleration.

The Labor Market: Walking a Tightrope

Unemployment stands at 4.4% as of December. The labor market appears relatively balanced, with continued job growth in food services, healthcare, and social assistance, while retail trade lost positions. This balance is fragile. Small shifts could tip the market toward either labor shortages or rising unemployment.

Given the Federal Reserve's dual mandate—managing both inflation and unemployment—monetary policy decisions will likely remain cautious. Labor market conditions do not currently suggest an urgent need for aggressive rate cuts, while inflation remains above target. As a result, policy adjustments are likely to occur gradually.

Understanding Tariffs and Their Real Impact

One of the biggest wildcards for 2026 is tariff policy. For businesses importing goods, selling to exporters, or competing with foreign products, understanding how tariffs work and why they matter is essential.

What Tariffs Actually Do

A tariff is a tax on imports. A key point that is often overlooked is that tariffs can also act indirectly as a restriction on exports. U.S. imports and exports tend to move together, reflecting the role of exchange rates in trade adjustment.

Figure 3: U.S. Imports and Exports Over Time

Consider a concrete example. When a U.S. buyer purchases a Mercedes from Germany, they need to exchange dollars for euros. This increases the supply of dollars in foreign exchange markets. Like any market, when supply goes up, the price goes down—so the dollar depreciates.

A weaker dollar isn't automatically bad. In fact, it makes U.S. goods cheaper for foreign buyers, which boosts exports. This is the natural adjustment mechanism that keeps trade flowing in both directions.

What Happens When Tariffs Are Imposed

Now suppose the U.S. government imposes a 100% tariff on German cars to protect domestic auto jobs. A $50,000 Mercedes suddenly costs $100,000. Demand for German cars drops sharply, and U.S. consumers switch to domestic vehicles. Resources flow into the protected industry, preserving jobs there.

But the story doesn't end there. Since Americans are buying fewer Mercedes, they're exchanging fewer dollars for euros. The reduced supply of dollars causes the currency to appreciate. A stronger dollar makes U.S. goods more expensive for foreign buyers, and exports decline.

Tariffs can protect jobs in specific industries, but they can also reduce employment in export-oriented sectors through exchange-rate appreciation. In the longer run, resources may shift toward less competitive industries, which can reduce aggregate efficiency. The net effect is often lower productivity growth and weaker overall economic performance.

In the short term, before domestic production can expand to replace imports, higher import costs drive up production expenses. This fuels inflation and can disrupt supply chains—particularly painful for small businesses that depend on reliable, affordable inputs.

Why the Predicted Export Collapse and Inflation Surge Haven't Materialized

Tariffs don't operate in a vacuum. Other economic factors—market uncertainty, relative growth rates, inflation differentials, government debt levels, and investor confidence—all influence the dollar's value in foreign exchange markets. While tariffs reduce the supply of dollars by decreasing imports, their ultimate impact depends on how demand for the dollar responds to these other forces.

General uncertainty has contributed to dollar depreciation despite tariff expectations. Both the dollar-to-euro and yuan-to-dollar exchange rates show a weakening dollar.

Figure 4: Dollar to Euro Exchange Rate (Weakening Dollar)

Figure 5: Yuan to Dollar Exchange Rate (Strengthening Yuan)

A weaker dollar tends to support exports by making U.S. goods relatively cheaper abroad. Data from the Bureau of Economic Analysis shows the trade deficit has decreased since the beginning of the year, with imports falling while exports rise (data through October 2025).

Figure 6: US current account 

The Inflation Question: Why Prices Haven't Spiked Yet

There's a century-old debate in economics about whether prices are "sticky" - meaning firms resist changing them frequently. The evidence suggests that many prices adjust slowly, because firms compete for customers and hesitate to raise prices when the cost increase may be temporary. In that setting, raising prices too quickly risks losing customers to competitors.

When there's uncertainty about how long import prices will remain elevated due to tariffs, many firms choose to absorb the cost through lower profit margins rather than alienate their customer base. This significantly delays price increases.

What to Expect from Monetary Policy

Monetary policy typically responds to changes in inflation and unemployment. Both metrics are close to optimal levels right now, which means the Federal Reserve is likely to take a conservative approach to interest rate adjustments. FOMC projections suggest a gradual path for the federal funds rate, with a longer-run level near 3.1%.

Figure 7: FOMC Federal Funds Rate Projections

Implications for Small and Medium Businesses

The economic environment in 2026 calls for careful planning. Here are the key takeaways:

• Interest rates will likely remain elevated. For businesses waiting for cheaper credit to make major investments, dramatic relief is unlikely in the near term. The Fed will move cautiously. Companies should plan capital needs accordingly and consider whether projects can be phased to reduce upfront borrowing.

• Supply chain costs may remain volatile. Tariff policy continues to create uncertainty. Businesses that depend on imported materials or components should build in contingency plans. Looking for domestic alternatives where feasible or negotiating longer-term contracts with suppliers to lock in pricing are prudent strategies.

• Pricing power is limited. With corporate profits under pressure and firms reluctant to raise prices, many businesses may not be able to pass increased costs directly to customers. Focusing on operational efficiency and cost control rather than counting on revenue growth through price increases will be critical.

• Labor markets are tight but stable. Hiring should remain feasible, but wage pressures are unlikely to ease significantly. Retention strategies remain important. Non-wage benefits and workplace flexibility can serve as tools to attract and keep talent.

• Export opportunities exist. The weakening dollar makes U.S. goods more competitive internationally. Businesses whose products or services can be exported may find 2026 a favorable time to explore foreign markets. Even indirect export exposure—selling to companies that export—can be advantageous.

The year ahead is unlikely to bring either a severe downturn or unusually rapid growth. Steady, moderate expansion remains the baseline scenario. Business performance will depend in part on how effectively firms manage higher borrowing costs, supply chain uncertainty, and pressure on margins. Firms that remain flexible and maintain cost discipline are likely to be better positioned under these conditions.

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