The U.S. has a dynamic and resilient economy that will continue to absorb the trade-centered headwinds that have slowed growth this year. We now expect growth to slow to 1.1% this year, inflation to rise above 3% and a 4.4% unemployment rate.
We see inflation accelerating faster than overall economic growth in the second half of the year which will keep the Federal Reserve on the sidelines until December, when we anticipate a 25 basis-point rate cut.
Call it stagflation lite, or a period of slow growth, rising inflation and increasing, though tolerable, unemployment.
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That is, because of the retirement of baby boom workers and policy choices on trade and immigration, the economy is likely to observe a period of slow growth in the 1% to 2% range, inflation in the 3% to 4% range and unemployment in the 4% to 4.5% range.
But this slowing won’t be enough to cause a recession, in our estimation. Solid job growth and steady, if slowing, income gains will be enough to avoid that kind of a downturn.
Through May, the increase in inflation-adjusted spending has cooled to 1.6% on a three-month average annualized basis, which is down from 4% at the end of last year.
Those income gains beyond job growth are linked to stepped-up Social Security payments and to provisions in the recent tax legislation that will take effect immediately and offset the drag on activity and the modest increase in inflation caused by tariffs.
Still, the trade headwinds and risk around rising inflation expectations have pushed the chance of recession higher than we are comfortable with.
We forecast a 40% probability of recession over the next 12 months as growth slows to 1.1%, rebounds to 2.2% next year as expansionist fiscal policies kick in, followed by a reversion back toward the long-run trend of 1.8% in 2027 once the sugar high of expansionary fiscal policies recedes.
Trade-related headwinds caused gross domestic product to contract by 0.5% in the first quarter, which we think rebounded at a 2.5% rate in the second quarter.
Volatility in trade policy—and the distortions in purchasing and inventories that it led to—caused growth to slow to near 1% on average through the first half of the year, down from 2.9% at the end of last year.
Fiscal policy and GDP
We expect a modest economic boost to support the current expansion as large companies use freed-up cash flows to bolster capital expenditures and as tax measures increase disposable income.
That is why we anticipate the recent appropriations legislation to contribute a modest 0.2% to growth this year and 0.7% next year.
Inflation rising
As tariffs take hold, the inflation data for June, July, August and September will rise toward 3.5% in the consumer price index and 3% in the personal consumption expenditures index, the Fed’s preferred gauge.
The effective tariff rate on July 8 stood at 8.85% for all trade partners and we expect that rate to reach 15% to 17% as announced tariffs are implemented.
With the effective rate on Chinese imports at 48.25%, Japan 14.1%, South Korea 12.26%, Germany 11.02%, Mexico 4.33% and Canada 1.88%—they all could go much higher—it is clear where inflation risks reside.
While those rates on their own should push back any expectations of Fed rate cuts until later in the year, the key will be if they cause inflation expectations to increase.
The Federal Reserve Bank of New York’s one-year inflation expectations stand at 3.02%, the University of Michigan’s one-year estimate resides at 5% and the Fed’s five-year, five-year, forward breakeven implies a 2.4% pace over the medium to long term.
If near-term inflation expectations increase and long-term expectations do not remain well anchored, then the Fed will have to postpone reducing its policy rate to our estimate of 3%.
But if inflation expectations remain well anchored then the Fed can look through a short-term bump and move to cut rates twice this year.
We expect that the current inflationary impulse caused by tariffs will be a one-time short-term increase and that the Fed should feel more comfortable reducing its policy rate at the end of the year.
The Fed and rates outlook
The combined impact of higher tariffs and expansionary fiscal policies will require Federal Reserve policymakers to move cautiously on reducing the federal funds policy rate from its current range of 4.25% to 4.5% to its terminal rate of 3%.
Inflation risks caused by tariffs are just starting to show up in the hard data and policymakers will need time to ascertain the pricing risk around tax cuts and increased government spending.
We expect the Fed to cut rates once this year, most likely in December, as the economy chugs along at sub-2% growth and central bankers assess the delicate interplay of rising inflation on the back of tariffs and a likely fiscal boost from the tax cuts.
While it is possible the Fed could make an additional rate cut of 25 basis points this year, that would require modest increases in inflation at a monthly pace of 0.2% or less through early fall.
Our model of the Federal Reserve’s reaction function shows an optimal policy rate of 4.65%, implying that the chance of no rate cut this year cannot be discounted and would require much more benign inflation readings than what we have forecast.
We expect the 10-year yield to trade between 4% and 4.5% under conditions of elevated volatility and now expect it to finish the year near 4.35% with risk of lower rates depending on the Fed’s appetite for cuts.
We expect the 10-year yield to trade between 4% and 4.5% and finish the year near 4.35%.
The economy and, most important, the labor market would have to crack for interest rates to move below the recent range established at the long end of the curve.
Beyond the direct influence of monetary policy, interest rates are determined by expectations of economic growth and the ability to sustain higher rates of return.
Low interest rates imply an economy unable to support normal rates of return on investment,
The years of extremely low interest rates after the financial crisis, and again after the pandemic, were aberrations that reflected a struggling global economy.
As of July 9, the yield on a 10-year Treasury bond was 4.33%, which can be broken down to its components of the real, or inflation-adjusted, rate of 1.99% plus the compensation for the break-even rate of inflation of 2.34%.
Another model of the 10-year yield is derived from expectations of a federal funds rate of 3.64% plus a term premium of 0.64% to compensate for the risk of holding that bond until maturity.
The presence of a term premium accounts for the Fed not being able to sustain the funds rate at 3.64% over that 10-year period because of an inflation shock or a growth shock.
Employment: Muddling through
We expect job gains to slow to an average of 90,000 per month in the second half of the year and the unemployment rate to increase to 4.4% as labor demand slows.
Private hiring during the first half averaged 107,333 and is slowing as businesses move cautiously to bring new wage and benefit obligations onto their balance sheets.
While hiring has slowed, firings remain restrained, and our forecast strongly implies that there will not be an increase in unemployment that will send the economy into recession.
As the administration continues to tighten immigration policy and crack down on migrant labor then it is likely that the number of workers who need to be hired to keep employment conditions stable may decline from 100,000 to 50,000 per month.
But if immigration enforcement puts a dent in the labor supply, then the unemployment rate will be capped as the number of available workers declines.
Paradoxically, that dynamic would put upward pressure on wages, which would raise inflation later next year.
The takeaway
The current economic expansion will continue, albeit at a reduced pace compared to recent years.
The recent appropriations legislation will support activity in the second half of the year through increased personal income and business fixed investment, which we expect will be driven by large outlays among tech firms.
We expect a modest increase in inflation to 3% in the consumer price index with risk of a quicker pace should the current effective rate of tariffs be pushed higher toward 20%.
Our forecast implies that Federal Reserve will be on hold with any rate cuts until the end of the year at the earliest and that the 10-year Treasury should end the year at or near 4.35%.
