Conflicting trade and fiscal policy signals

• US outlook: Over the past month, a flurry of policy moves has reshaped the global trade landscape, suggesting a transition toward a new — albeit still ill-defined — status quo. The US administration announced a temporary 90-day reduction in tariffs on Chinese goods, lowering rates from a peak of 145% to 30%, while China reciprocated by cutting tariffs on US exports from 125% to 10%. Simultaneously, a broad framework for a US–UK trade agreement was introduced, signaling efforts to diversify trade partnerships amid a volatile geopolitical environment.
• Equity markets have reacted with unwarranted optimism, overlooking the persistent economic drag posed by elevated tariffs. Policymakers introduced a tariff ceiling and floor framework, yet the 90-day suspension of the Reciprocal Tariffs Policy poses a renewed risk around July 9. While the average US tariff rate has declined from 25% to 14% due to this temporary reprieve, it remains the highest since 1939, underscoring the enduring nature of this supply-side shock.
• Compounding the outlook is the downgrade of the US credit rating. While largely expected, it reaffirms concerns over an unsustainable fiscal trajectory that will continue to embed a structural premium into borrowing costs.
• Private sector sentiment remains subdued, as softer labor market fundamentals, margin compression, weakening retail sales and resurgent inflationary pressures suggest a slow yet persistent passthrough of tariffs. Demand erosion may become more visible as elevated bond yields — driven by concerns over the cost of tax legislation progressing through Congress —constrain business investment. A persistently weak dollar reflects investor unease and a growing shift toward portfolio diversification.
• In light of recent developments, we have modestly raised our real GDP growth forecast for both 2025 and 2026 by 0.2 percentage points (ppt) to 1.3%. We continue to anticipate that growth will approach stall speed by Q4 2025, with year-over-year (y/y) real GDP growth at just 0.6%. Nevertheless, we have lowered the probability of a recession in the next 12 months from 45% to 35%. While the near-term outlook is more constructive, risks remain tilted to the downside.
• Cooling labor market trends: The all-around solid April jobs report indicates the labor market was still cruising along at a healthy pace when the tariff storm engulfed the economy. Employers added 177,000 jobs in April, the unemployment rate remained steady at 4.2% and labor force participation edged higher. While the data sent a reassuring signal, the downside risks to the labor market and consumer outlook have escalated in recent weeks. Going forward, we expect labor market momentum will downshift markedly as the tariff shock reverberates through the US and global economy. We foresee job growth decelerating from 160,000 per month in 2024 to around 90,000 in 2025 while the decline in net immigration flows will constrain labor supply dynamics.
• A looming demand cliff: Consumers ended the first quarter on a strong note as they pulled forward some purchases of big-ticket items in anticipation of tariff price hikes and showed some appetite for services such as dining out and hotel stays. Inflation-adjusted personal outlays increased 0.7% in April, driven by a jump in durable goods outlays, which saw their largest increase since January 2023. While the data points to a robust carry-over into Q2, it’s a partial mirage stemming from a pull-forward of demand. We expect consumer spending growth will downshift in coming quarters as tariffs weigh on households’ purchasing power and lead to weaker labor market dynamics. We foresee real consumer spending growth of 2.2 % in 2025 and 1.1% in 2026, following a 2.8% advance in 2024.
• Transitory inflation reacceleration: Prices were on a solid disinflationary trend ahead of the significant tariffs increases in early April. Headline inflation slipped to 2.3% y/y in April — its lowest level since February 2021 and within striking distance of the Fed’s 2% target. Core inflation, meanwhile, held at 2.8% y/y, its lowest since March 2021. Looking ahead, higher tariffs will lead to a renewed inflation impulse, but the China tariffs détente has led us to revise down our year-end CPI inflation forecast by 0.4ppt to around 3.3% y/y. We see inflation cooling to 2.2% in Q4 2026.
• Reactionary Fed on hold until September: For the Fed, tame inflation dynamics and resilient labor market conditions support the case for holding rates steady beyond mid-year. With little clarity on the final status quo for trade policy and Fed policymakers unlikely to preempt any growth or inflation developments, we now anticipate only two Fed rate cuts (instead of three), and believe the first rate cut will come in September (instead of July).