Insights From the Q3 Economic Outlook: Deficits, Disruption, and What’s Next for Government

For local government leaders, quarterly forecasts are useful only if they translate into budget decisions. This quarter’s webinar, hosted by Dr. William Yu of UCLA Anderson alongside Neumo’s Tom Adams and Fran Mancia, delivered exactly that: a labor market that looks weaker than it is, an energy shock that’s proving manageable, and two California tax rulings that expand what “taxable” means in a digital economy.

Below are the findings most relevant to local government leaders planning budgets and revenue forecasts for the second half of 2026.

The Labor Market Is Sending Two Different Signals

Real GDP growth is holding near 2.5%, in line with the pre-pandemic decade. Non-farm payroll job growth, however, is approaching zero on a year-over-year basis. Historically, that combination signals recession. Right now, it doesn’t: unemployment sits at a healthy 4.3%, and labor force participation, at 62%, is the lowest recorded since the 1970s, outside of the pandemic disruption itself.

Dr. Yu attributes the gap to a mix of factors: retiring baby boomers, tighter immigration enforcement reducing the labor supply, and potentially early AI-driven productivity gains. No single cause dominates yet, and the data isn’t conclusive.

The more important distinction is how AI enters the picture. Dr. Yu framed two paths forward:

1. Labor substitution, in which AI adoption replaces workers and further widens the K-shaped economy already separating high- and low-income outcomes.
2. Labor augmentation, where AI is layered onto existing teams rather than replacing them, producing something closer to the 1990s internet boom: strong GDP growth, strong job growth, and gains distributed across income tiers.

Which path dominates will shape municipal hiring, service delivery, and constituent sentiment well beyond this budget cycle.

Inflation Is Cooling, Despite Middle East Volatility

Headline CPI declined from 4.2% in May to 3.5%, and core inflation (excluding food and energy) eased from 2.8% to 2.6%. The improvement follows a temporary spike tied to conflict in the Middle East.

Two structural factors are keeping the situation contained.

1. First, record domestic oil production is offsetting lost supply from the region and stabilizing prices; WTI crude has held in the low-$80s even amid a ten-day escalation, well short of the $100+ levels seen during prior spikes.
2. Second, San Francisco Fed analysis attributes only about half of the 2021 inflation surge to demand-side pressure, with the current cycle showing a far smaller demand-side contribution. That distinction matters for finance directors modeling revenue: the drivers behind today’s inflation are different from those in 2021 and less likely to compound in the same way.

Fran Mancia noted that a repeat surge in oil past $100 would still hit household budgets meaningfully, with gasoline already accounting for roughly 2.9% of average household spending and estimates suggesting a further 12–14% increase at the pump if that threshold is crossed. For jurisdictions dependent on sales tax from discretionary and fuel-adjacent purchases, this remains a watch item.

A New Fed Chair Signals a Different Playbook

The Federal Reserve’s new chairman, previously a Fed governor between 2006 and 2011 with direct experience in crisis responses at Bear Stearns, Lehman Brothers, and AIG, is setting a distinct tone. Price stability is the stated priority, along with freeing up balance-sheet capacity to support housing and small-business lending.

Communication style is shifting too. The chairman has so far skipped participation in the Fed’s quarterly “dot plot” rate projections, signaling a more guarded, Volcker-and-Greenspan-style approach that avoids telegraphing moves ahead of meetings. Five new internal task forces have been established, covering communication practices, balance sheet policy, data quality, productivity and jobs (specifically assessing AI’s impact on the labor market), and inflation measurement frameworks.

The panel’s consensus for the Fed’s next meeting: rates hold steady, with little appetite to raise rates given housing market softness and the proximity of the midterm election. Dr. Yu’s longer-term forecast puts short-term rates converging toward 3%, with mortgage rates ideally settling near 5–5.5%, a level intended to avoid both the runaway housing markets of the zero-rate era and the affordability crunch of recent years.

AI Investment Isn’t (Yet) Showing Bubble Signals

Private investment as a share of GDP has held in the 17–18% range over the past two years, below the 19%+ levels seen during the 2005–2006 housing boom and the dot-com peak around 2000. Elevated data center spending is being offset by weaker residential construction, keeping the aggregate ratio balanced.

Household consumption as a share of GDP also remains stable, while retail sales, adjusted for inflation, have shown robust growth since January 2026.

One caveat: government data shows the top 20% of income households account for roughly 40% of consumption, not the 60% figure sometimes cited in media coverage. The gap matters for jurisdictions modeling sales tax sensitivity to income distribution.

California Expands What Counts as Taxable

Two developments give local governments a rare opening: new revenue sources rather than new rate increases.

1. Utility Users Tax now applies to streaming.

Roughly 150 California cities, about 30% of the state, have a Utility Users Tax (UUT) on services such as electricity, gas, cable, and telephone. Santa Barbara modernized its ordinance over a decade ago to apply the UUT to streaming services on a technology-neutral basis, then began enforcement against Disney. The case moved through multiple rounds of California courts, and the city has prevailed at every stage, with only a narrow federal appeal window remaining.

For the roughly 70% of UUT cities with unmodernized ordinances, this is a clear signal to revisit ordinance language before the cord-cutting shift to streaming continues eroding the cable-tax base.

2. California sales tax now applies to prewritten digital software, including SaaS.

As part of the recent state budget, the sales tax base expanded from tangible goods to digital software, though narrowly: e-books, e-music, streaming, and cryptocurrency remain excluded under separate provisions. The change reflects the same underlying pattern as the UUT ruling: tax codes built for a goods-based economy catching up to a digital one.

Both developments carry a coalition dimension. As Fran Mancia noted, cities banding together on shared legislative asks, such as prior efforts in Texas around sales tax data access, have moved state policy faster than individual jurisdictions acting alone. For governments in states without enabling statutes, organizing toward that kind of change is a reasonable next step.

The Bottom Line

The economic outlook remains constructive: stable GDP growth, cooling inflation, and a labor market that reads weaker in aggregate than it behaves on the ground. The Fed’s new leadership adds a layer of predictability around price stability, even as its more guarded communication style takes some adjustment.

For local government leaders, the actionable takeaway sits in California’s two rulings. Ordinance modernization and legislative coalition-building are concrete, near-term levers, rare in a landscape where new revenue sources don’t come along often.

Watch the full recording of the latest economic forecast webinar for more detailed state and local government implications.