A Shock Absorbed, a Cut Deferred

The second quarter of 2026 opened in the fog of war and closed in a fragile calm. The US/Israel-Iran conflict that erupted at the end of the first quarter had pushed oil above $100 a barrel, gasoline past $4 a gallon and consumer sentiment to 47.6 in early April, the lowest reading in the nearly 75-year history of the University of Michigan survey. By the end of June the war was winding down, the Strait of Hormuz had reopened to roughly half its pre-war traffic, gasoline had slipped back below $4, and headline inflation had seemingly peaked. In ninety days, the dominant question shifted from how much damage the oil shock would inflict to how quickly the relief would arrive.

The quarter’s deeper story was patience. The economy absorbed a genuine supply shock without breaking. Payrolls kept growing, and business investment ran hard on the strength of the artificial intelligence (AI) buildout, even as the labor market stayed unusually calm. The Federal Reserve, now under new leadership, spent the quarter steadily pushing its first expected rate cut further into the future. The defining feature of the second quarter was a posture more than any single number: an economy that bent without breaking, and a central bank that kept finding reasons to wait.

Executive Summary

• • The energy shock that opened the quarter reversed course by its end. Oil sat above $100 a barrel and gasoline above $4 in early April, with consumer sentiment at a record low of 47.6, yet by late June the Strait of Hormuz had reopened to nearly half its normal traffic, gasoline had fallen back below $4, and Oxford Economics had trimmed its subjective recession odds to 20%.

• • Inflation completed a round trip of its own. Headline consumer prices spiked on a more than 20% surge in gasoline in March and climbed to a Consumer Price Index (CPI) rate of 4.2% by May, with the Personal Consumption Expenditures (PCE) measure reaching 4.1%, a level that might just mark the peak. Producer prices ran hotter still, with the Producer Price Index (PPI) reaching 6.4% in May before the Institute for Supply Management (ISM) factory price gauge dropped sharply in June.

• • The Federal Reserve grew steadily more patient as the quarter wore on. A baseline that began the year expecting cuts by June moved to December after the April Federal Open Market Committee (FOMC) meeting turned hawkish, and by late June some economists had pushed the first expected cut toward the back end of 2027. Financial markets moved the opposite way, pricing in a rate increase as soon as October.

• • The consumer ran on borrowed fuel. An unusually large tax refund season under the One Big Beautiful Bill Act (OBBBA) offset the gasoline burden by roughly two to one through the spring, but as that support faded the personal saving rate fell to 3%, from 4.6% in 2025, and 2026 consumption forecasts fell along with it.

• • The labor market held firm throughout. Payrolls beat expectations in April, rising 115,000, and again in May, rising 172,000. The unemployment rate held in a 4.3% to 4.4% range,[1] and jobless claims stayed in a narrow band near their lows, which left wage growth too tame to pose an inflationary threat and gave the Fed room to wait.

• • Artificial intelligence was the quarter’s defining structural force. The AI buildout drove the strongest business-equipment investment cycle in years, running near a 17% annualized pace in the first quarter, yet a matching surge in imported chips and equipment left the buildout adding almost nothing to gross domestic product (GDP) on a net basis, while the same demand kept goods inflation elevated, with producer prices for electronic components up 27% over the year.

The Energy Shock’s Round Trip

The second quarter began where the first had ended, under the shadow of the US/Israel-Iran war. Oil traded above $100 a barrel, gasoline pushed past $4, and the University of Michigan consumer sentiment index fell to 47.6 in early April, the lowest reading in the survey’s nearly 75-year history. Across multiple ceasefires and openings and closings of the Strait of Hormuz to commercial traffic, we saw crude futures rise to nearly $120 and fall back toward $80 all while equities reached record high. Federal Reserve research suggests the peak drag on business investment and hours worked from a geopolitical shock of this size arrives two to three quarters after the event, so the worst of the damage may still lie ahead even as the headlines have improved.

The path back proved bumpy. Gasoline stayed above $4 through April and much of May, and sentiment sank to a fresh record low of 44.8 in mid-May before the trend turned. By June the direction had clearly changed. A memorandum of understanding between the United States and Iran lowered the oil-price path enough for 2026 CPI forecasts to drop to 3.3% from 3.6%, gasoline fell from $4.40 toward $4.10 over the first half of the month, and by late June a gallon slipped below $4 for the first time since March, as consumer sentiment recovered to 49.5.

The plumbing of the economy told a reassuring version of the same story. Oxford Economics’ supply-chain stress tracker reached its highest level since 2022, but the pressure came from freight costs tied to expensive fuel rather than the broad seizure of 2021 and 2022, and those costs should ease as crude retreats.

• • Key Takeaway: The oil shock that defined the quarter proved severe but not permanent. By late June, with the Strait reopened and gasoline back below $4, the recession odds that had spiked in the spring were receding, and the economy faced the lagged damage from a position of relative calm.

Inflation: A Peak Made, a Core That Would Not Cool

Inflation made a round trip through the quarter, rising sharply before cresting. The March CPI, reported in early April, jumped 0.9% in a single month as retail gasoline surged more than 20%, yet core prices rose just 0.2%, a sign that the underlying disinflation remained intact beneath the energy noise. Headline inflation climbed through the spring, reaching a CPI rate of 4.2% in May and a PCE rate of 4.1%, which might stand as the peak now that gasoline has fallen close to 10% in June.

The producer pipeline ran even hotter. The PPI reached 6.0% in April and 6.4% in May, its highest since November 2022, on diesel costs that at one point had risen 60% since the war began. The clearest sign of a turn came at quarter-end, when the ISM factory price gauge dropped 9.3 points in June, pointing to a producer-price peak near at hand.

The stubborn part of the story sat in the core, and its source was telling. Producer prices for electronic components rose 27% over the year on an AI-driven shortage of memory chips, and by late June the pressure had reached the shelf, with Apple raising prices on its computers and tablets by nearly 20% and Microsoft lifting console prices. Core PCE inflation held near 3% for most of the quarter and ticked up to 3.4% by May, kept aloft by AI goods demand and energy passthrough rather than by services, where price growth stayed moderate. A rate hike does little to cure a semiconductor shortage, which is part of why the Fed found the episode so awkward.

• • Key Takeaway: Headline inflation peaked around 4% as the energy shock crested, and the producer pipeline showed its first clear signs of cooling by June. The core proved stickier, held up by an AI hardware boom that monetary policy can do little to cool.

The Fed: From Two Cuts to Two Years of Waiting

No institution embodied the quarter’s patience like the Federal Reserve, which spent three months finding new reasons to wait. The year had opened with a baseline expecting rate cuts around midyear. The April FOMC meeting changed the tone, upgrading the inflation description to ‘elevated’ and drawing three dissents over language that implied the next move would be a cut, a shift that pushed the expected first cut to December. The April minutes, released in late May, went further, listing so many preconditions for easing that financial markets began pricing rate hikes over the following year.

The quarter also brought a change at the top. Jerome Powell’s final meeting gave way to the arrival of Kevin Warsh, who took the chair with two stated ambitions, lower rates and a smaller balance sheet, and quickly found that inflation left little room for either. At his first meeting in June, he stripped the policy statement to a bare summary and declined to publish his own projections, while the committee split almost evenly, with nine participants projecting hikes this year and a similar number expecting cuts only by the end of 2027. Markets read the division as hawkish and moved to fully price a rate increase as soon as October. Warsh then imposed a communication blackout that left the data to speak for the committee.

• • Key Takeaway: The Federal Reserve changed chairs and communication styles during the quarter, but its central dilemma did not change. With inflation too high to cut and the labor market too steady to force its hand, the committee waited.

The Consumer: From Refund Fumes to Rebuilt Reserves

The consumer carried the economy through the quarter, but increasingly on borrowed fuel. An unusually generous tax refund season under the OBBBA did much of the work, offsetting the higher gasoline burden by a ratio of roughly two to one through the spring. That windfall powered a 1.7% jump in March retail sales, but more than 80% of the refunds had gone out the door by late April, and the cushion was largely spent by early summer.

Underneath the spending, the foundation thinned. The personal saving rate fell to 3.6% in the first quarter and then to 3% by late June, well below the 4.6% average of 2025, as households leaned on savings and, at the higher end, on stock-market wealth to keep spending. Real disposable incomes were flat against a year earlier. 2026 consumption forecasts fell to 1.9% from 2.6% in 2025, and the second-quarter tracking estimate drifted from 2.2% in mid-June to 1.9% by month-end.

The strain fell unevenly, deepening a divide that has defined this cycle. The top 20% of households by income account for roughly 40% of all spending, and those households, insulated by equity gains, kept spending freely while lower-income families absorbed the gasoline tax that nobody voted for. The stress showed up in the data, with the share of credit-card balances more than 90 days delinquent climbing to its highest level since 2011. Confidence tracked the energy story, with the Conference Board measure posting its first post-war decline in May before steadying as gas prices eased.

• • Key Takeaway: The consumer proved resilient, but for reasons that cannot easily repeat. Tax refunds and a falling saving rate financed spending through the quarter, and with both nearly exhausted, the burden of carrying consumption into the second half shifts squarely onto the labor market.

The Labor Market: The Shock Absorber That Held

If one variable held the quarter together, it was employment. The labor market behaved like a shock absorber, compressing under the weight of the oil shock without transmitting it to the rest of the economy. Payrolls beat expectations in April, rising 115,000, and again in May, rising 172,000 with upward revisions to the prior two months. The unemployment rate held in a 4.3% to 4.4% range throughout, and jobless claims stayed in a narrow band, between roughly 200,000 and 215,000 from mid-February onward.

The calm owed as much to supply as to demand. Net immigration running near 160,000 a year, together with an aging population, has driven the break-even pace of hiring, the number of jobs needed to hold unemployment steady, down toward zero, which allowed modest payroll gains to keep the jobless rate flat. Wage growth stayed near 3.5%, and with productivity running close to 3% and unit labor costs falling, compensation posed no threat to the inflation target.

Beneath the placid surface, two currents ran. Artificial intelligence began thinning payrolls at the leading edge, with technology firms announcing roughly 10,000 job cuts by mid-April and the information sector’s layoff rate diverging from the broader private sector. By quarter-end, the market was warming at the top line, with private payrolls in the Automatic Data Processing (ADP) report rising 98,000 in June and claims steady at 215,000, even as workers themselves felt little of it, since the quits rate stayed depressed and wage growth for job switchers went nowhere.

• • Key Takeaway: The labor market was the quarter’s unsung hero, absorbing the oil shock while generating no wage pressure. That combination of steady employment and tame pay is precisely what allowed the Federal Reserve to keep waiting.

The AI Economy: The Engine That Adds Everything and Nets Nothing

The through-line of the entire quarter was artificial intelligence, which shaped growth, prices and trade at once. The AI buildout drove the strongest business-equipment investment cycle in years, running near a 17% annualized pace in the first quarter before easing toward the low double digits in the second. Investment in information-technology equipment and software alone added more than a full percentage point to first-quarter GDP, and the full up-front expensing of equipment under the OBBBA gave firms every incentive to pull that spending forward.

The paradox is that all this activity has added almost nothing to net growth. Because most chips and advanced equipment are made abroad, a surge in AI-related imports offset the investment gains almost dollar for dollar, leaving the buildout’s net contribution to first-quarter GDP near zero. Imports of AI-related equipment nearly doubled over the year while all other imports fell, and by late June capital goods imports were still running 42% above a year earlier. The same demand that powered the investment cycle kept goods inflation elevated and widened the trade deficit, producing a two-speed economy in which AI surged while much of the rest idled.

Housing was the clearest laggard in that two-speed economy, frozen by mortgage rates above 6% and weighed down by a stock of completed unsold homes near levels last seen in 2009. New-home sales were volatile, dropping 7.3% in May to what is hopefully a floor rather than the start of a decline, and by quarter-end the sector was finding firmer footing, with residential investment on track for its first quarterly gain since late 2024. The more durable shift was conceptual, as equities now make up a larger share of household wealth than real estate, so housing no longer drives the business cycle the way it once did, and the AI-and-equities engine has taken its place.

• • Key Takeaway: Artificial intelligence was the quarter’s dominant force, powering the investment cycle and the import surge at once while keeping goods inflation elevated. That it added almost nothing to net GDP is the paradox that will define how much the boom ultimately delivers.

Final Thoughts

The second quarter of 2026 will be remembered as the quarter the economy proved it could take a punch. A genuine oil shock drove sentiment to a record low and headline inflation toward 4%, yet payrolls kept growing and business investment ran hard. By late June, the war was winding down, and gasoline had fallen back below $4. The structural supports held. Productivity ran near 3% while the AI investment cycle showed no sign of quitting. The labor market, for its part, stayed steady enough to give the Fed room to wait. What changed was the calendar of relief: the energy shock that opened the quarter was fading by its close, and the recession odds that spiked in the spring had receded. The unfinished business is the core of inflation, still sticky in AI-driven goods, and a Federal Reserve whose first rate cut now likely sits further out into the future. The economy bent in the second quarter, but it did not break. Whether the second half rewards that resilience depends on whether the energy relief that arrived late in the quarter can outrun the lagged damage the shock set in motion months ago, and on whether the Fed’s patience proves to be wisdom or delay.

¹20260526 DI US – Consumer Confidence – p.2, para.2 

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