Economy Commentary
The Economy
Road Ahead Rockier And More Uncertain
April 2025
In last month’s edition we discussed our growing concerns over the state of the U.S. economy. Though atypically harsh winter weather in both January and February made it difficult to gauge, it seemed clear that the economy had lost some of the momentum it carried into 2025. Consumer and business sentiment were quickly souring, while a growing sense of uncertainty over the course of policy was weighing on businesses trying to plan for a future that seemed increasingly likely to look different than the future they had expected. Though we did not make a recession our base case, we did acknowledge that the risks to our baseline outlook were weighted to the downside.
A month later, we’re more, not less, concerned about the state of the U.S. economy. Though it was clear that higher and more broadly based tariffs were on the way, the tariffs announced on April 2 exceeded what many envisioned would be the worst-case outcome and would push the trade-weighted effective tariff rate to the highest in over one hundred years. With global trade and supply chains upended in such drastic fashion, it’s all but given that the near-term effects will be slower economic growth and higher prices. What are now meaningfully higher downside risks to the labor market in turn pose risks throughout the economy, while businesses must rethink investment plans and map out what could be dramatically different supply chains.
The longer-term outcome is so uncertain that it seems futile to even try to assess what that may look like at this point in time. What none of us know at this point is whether, or to what extent, there is room for the tariffs announced on April 2 to be softened, and how long that might take. What we also do not know is to what extent and in what manner foreign countries will retaliate against higher U.S. tariffs, though China helped answer that question with their quick and stern response. While our April baseline forecast reflects a meaningfully more downbeat outlook, the reality is that there is so much uncertainty looming over the economy and financial markets that it’s hard to have much, if any, confidence in any forecast made at this point. It may be better to view forecasts being made at present as more of a directional guide than a destination, and it is likely of no more comfort to anyone else than it is to us, which is to say none at all, that the last time we felt this way was at the onset of the pandemic. Still, one thing we routinely stress is that starting points matter, and in that context, we think the following points are worth making.
To the extent that firms and households have taken steps over the past few months to avoid the impacts of higher prices and disjointed supply chains, that poses the risk of a sharp and sudden slowdown in the middle quarters of 2025. For instance, we’ve pointed to notably strong spending on consumer durable goods over the final months of 2024, and that carried into this year as consumers have been pulling purchases of goods such as motor vehicles, appliances, electronics, and furniture forward to avoid tariff-related price hikes later this year. We can make the same point about retailers pulling orders forward and manufacturers pulling purchases of raw materials and intermediate goods forward for the same reasons. To the extent that such pre-emptive buying/inventory stocking supported Q1 real GDP growth, there will be payback, likely harsh, in the Q2 data.
Additionally, corporate profit margins remain meaningfully above historical norms, particularly compared to the years immediately prior to the pandemic, which gives firms capacity to absorb at least some portion of the increased costs of higher tariffs. It could be that many will go this route for some period of time to assess just how entrenched higher tariffs may prove to be before making longer-term decisions on capital spending and the size of their workforces. To that point, though by no means as hot as had been the case, the labor market is still solid. Total nonfarm employment rose by 228,000 jobs in March, and while some of that increase reflected payback for weather-related disruptions in January and February, the trend rate of job growth is right in line with the pre-pandemic average and growth in aggregate labor earnings continues to outpace inflation. To be sure, between fallout from trade wars and cuts to federal government employment and spending, nonfarm employment will grow at a much slower pace, if not contract, while the unemployment rate will push higher. The disruptions in the labor market, however, would be even more severe were labor market conditions significantly weaker than has been the case up until now.
In last month’s edition, we pointed to declines in equity prices triggering negative wealth effects as an emerging downside risk. Given the extent to which equity prices sank in the wake of the April 2 tariff announcements, that downside risk now seems significantly more pronounced. That said, we know from the Flow of Funds data that household net worth ended 2024 at $169.4 trillion, easily the highest on record, of which one key component is owner equity positions in residential real estate being stronger than has been the case in decades. Even if we allow for a hit of over $10 trillion in the form of lower equity prices thus far this year, that would leave net worth right at where it was at the start of 2024. Still, while there is considerable financial capacity in the household sector to absorb an adverse shock, one issue is that the most vulnerable households have no such cushion.
On the whole, the U.S. economy was on fairly solid ground prior to April 2, and while that cannot forestall the coming storm, it can at least help cushion the blow. The extent to which it does so, however, largely depends on whether April 2 was itself a starting point rather than the final word. One area in which the starting point clearly does not work in our favor is the fiscal condition of the federal government, a topic we discussed in our July 2024 edition. While the Congressional Budget Office’s (CBO) late-March update shows not much has changed, i.e., budget deficits expected to hover near $2 trillion per year over the next several years before getting even larger later in subsequent years, we think this is a topic worth revisiting in light of mounting trade tensions, particularly given the extent to which the U.S. relies on foreign capital to help finance the federal government’s budget deficits. Simply put, to the extent the U.S. begins to see diminished capital inflows as a result of disruptions in global trade flows, there are only two alternatives – either the federal government takes steps to substantially reduce the size of its budget deficits, or the aggregate level of investment in the U.S. economy falls dramatically, meaning lower long-term real GDP growth and higher inflation.
The Flow of Funds data show net domestic saving in the U.S. was negative in Q4 2024, equivalent to 0.16 percent of GDP. In other words, dissaving in the government sector more than absorbed the entire stock combined business and household saving. Recall that for any economy the aggregate level of investment must equal the aggregate level of saving which, for the U.S., means that foreign saving has been critical in sustaining high levels of investment in the U.S. economy. It also helps recall that, by definition, the flip side of a trade deficit is a capital inflow, meaning any factor that leads to diminished trade flows will also lead to diminished capital flows. Should a more fragmented global trade environment ultimately lead to the dollar ceding, even if only partially, its role as the de facto global reserve currency, that would put upward pressure on the interest rates at which the federal government will be able to find buyers of its debt obligations. At least in theory, steps being taken to reduce the size and scope of the federal government will contribute to the U.S. getting its fiscal house in order, though it is very much of an open question whether the totality of these steps will make a meaningful dent in the path of deficits projected out over the next decade-plus. Either way, the bottom line is that a diminished global footprint for the U.S. highlights the need for the U.S. to get its fiscal house in order.
Sources: Bureau of Economic Analysis; Bureau of Labor Statistics; Federal Reserve Board; Congressional Budget Office
As of April 9, 2025
