Simultaneous shocks to consumer sentiment, corporate confidence, trade, financial markets as well as to prices, new orders and the labor market will tip the economy into recession in the current quarter.
Any further haphazard implementation of the current trade regime that results in a greater tightening of financial conditions will cause a much deeper downturn.
We have increased our recession probability to 55% over the next 12 months.
While we think that there is still time for the executive branch to limit the damage from the new tariff regime, it is too late to prevent the economy from grinding down to a slow crawl. A 23% effective tariff rate and the new 10% minimum tax on imported goods are tantamount to a $410 billion per year consumption tax on businesses and households.
It is important to note that any further haphazard implementation of the current trade regime that results in a greater tightening of financial conditions will cause a much deeper downturn.
The economic story taking place is a classic one. A policy shock involving a significant increase in tariffs is causing an increase in the cost curves of businesses. The inability to quickly adjust will result in firms accepting thinner profit margins, reducing outlays on capital expenditures and hiring fewer workers.
In turn, a contraction in capital expenditures, rising unemployment and falling real wages will curtail spending. The increase in inflation will cause personal disposable income growth to turn negative in the current quarter and remain there into next year.
In addition, because of the recent plunge in equity prices, there is a negative wealth effect that will cause higher-income households to reduce their spending. This dynamic provides downside risk to our forecast and could result in a deeper and longer recession than our core baseline scenario.
And with manufacturers now contending with elevated inventory-to-sales ratios, the downturn that is coming will look like a garden variety inventory-led recession that should require Fed rate reductions and tax cuts to put a floor under the economy.
Inventory-to-sales ratios for motor vehicles and parts, machinery, equipment, and lumber and construction equipment are significantly higher than normal and are where policymakers should look for signs of stress in the real economy, amid the compression of profit margins and rising unemployment.
Baseline scenario
The imposition of global tariffs on April 9 is the point of no return between a slow growth economy and an outright end to the business cycle. The imposition of punitive tariffs on U.S. trade partners is the policy tipping point at which we now expect a recession that should last approximately nine months.
Recession is our base case for this year in which we expect the economy to contract by 0.8% in the first quarter, by 1.2% in the second and by 0.5% in the third.
We are updating our call on the 10- year Treasury and expect it to average 3.75% in the current quarter and 3% in the second half of the year.
While falling rates will spur a refinancing boom in the housing sector, it will not be sufficient to offset falling real wages.
Until risk aversion abates and banks increase lending, the real economy will not benefit from lower real and nominal rates until later this year or early next year.
Our forecast implies an increase in the unemployment rate to 5.5% by the end of the year. We also expect the personal consumption expenditures price index, the Fed’s preferred gauge of inflation, to reach 4% and the PCE core index, which excludes the more volatile food and energy components, to hit 4.5% over the next 60 to 90 days.
Stabilization policy
The playbook for asymmetric trade shocks calls for aggressive action by the central bank. Our core baseline scenario anticipates both inflation and unemployment simultaneously rising in a way that places pressure on the Fed to fulfill its dual mandate of maximum sustainable employment and price stability.
Under such conditions, the Fed will lean in the direction of price stability and will not cut rates in May or June save a disruption to financial markets or real cracks in the domestic labor market.
Absent such casus belli, the Fed will not be able to mitigate the decline in economic activity and will most likely be late with its accommodation. At this point, we do not see an opportunity to cut rates until the second half of the year.
Once rate cuts begin, we expect the Fed to bring its policy rate down from the current range between 4.25% and 4.5% to a cyclical low of 3% to 3.25%.
Read more of RSM’s insights into the economy and the middle market.
At this time, we would expect 25 basis-point rate cuts at every meeting of the Federal Open Market Committee until the policy rate reaches our target.
Should financial markets face further dysfunction or unemployment surge, then the Fed would cut rates by 50 basis points at the first available opportunity.
Despite the recent market gyrations, the Fed is unlikely to intervene to restore the capital markets’ smooth functioning.
When the American economy goes into recession, it tends to fall off a cliff rather than slowly drift into contraction. It is typically an inventory correction, oil shock, or other kind of shock that causes a recession.
The proximate cause for a recession this year is a new trade regime that has been rapidly implemented without time for adequate preparation of U.S. business and households.
For the first time since Federal Reserve Chairman Paul Volcker jacked up interest rates to near 20% more than 40 years ago, the U.S. economy faces a policy-induced recession.
We expect that by the end of the year, the National Bureau of Economic Research will identify the trade shock as the origin of the economic contraction that will start in the current quarter.
Alternative to the baseline: Vibecession returns
In our alternative scenario, the economy experiences more of a slowdown in growth and avoids an outright recession. Under this scenario:
- The impact of tariffs would cause inflation to peak at 3% in the second quarter, with growth turning negative in the second quarter.
- Two consecutive quarters of negative growth but no recession because the economy should bounce back as the Fed cuts rates.
- The economy will remain at risk of a recession into the first half of next year.
- The Fed remains cautious because of elevated inflation and the economy will feel as if it is in recession.
- Labor slack develops by the end of the year.
- Potential tax cuts and Fed rate cuts would push the economy back on growing track by the end of the year.
