Back from the Brink

Data through June 2025
Shading represents NBER recessions
Source: Federal Reserve Banks of New York, Philadelphia and Dallas, Chief Executive Group, University of Michigan, Conference Board, S&P Global, National Federation of Independent Businesses, MacKay Shields.

Despite the improved outlook, the second half of the year is not without its challenges. First, the full effects of tariffs on prices and consumer spending still lie ahead, given front-running by households and businesses prior to tariff implementation. As an indication of the delayed effects, the effective tariff rate has begun to rise but still remains below where it is likely to settle, in the 15 to 20 percent range. In addition, recent developments suggest non-negligible risks that trade tensions could flare up again. Most importantly, President Trump has stated that the new August 1 date for reciprocal tariff implementation will not be pushed out again, and he has also announced a new 50 percent tariff rate on copper imports and threatened a higher tariff rate on Canadian imports. A comprehensive trade agreement with China has also yet to be hammered out, and there has been no clear guidance on the state of negotiations with the European Union. 

The Effective Tariff Rate Has Only Just Begun to Move Higher

Data through May 2025
Source: Department of the Treasury, Census Bureau. The effective tariff rate is the monthly sum of daily customs and excise tax revenue deposits into Treasury's General Account, divided by the dollar value of monthly goods imports.

Outside of trade-related risks, the housing market also presents a headwind for the economy given significant affordability issues for homebuyers. Home sales and residential investment are unlikely to pick up meaningfully absent some combination of home price declines and lower mortgage rates that brings potential buyers back into the market. Recent months have seen some downward pressure on home prices as inventories have risen, and this is likely to continue in the second half of the year. Mortgage rates, however, are unlikely to move significantly lower until the FOMC has made more progress in returning the policy rate to a neutral setting. Meanwhile, the Treasury Department will remove one potential impediment to lower mortgage rates, signaling that longer-maturity Treasury auction sizes will remain stable for the foreseeable future even as the deficit picture has worsened. Any increases in Treasury supply will be concentrated in shorter-maturity securities, and bills in particular, limiting the potential impact of increased supply on long-term Treasury and mortgage rates.

The Trump administration’s migration policies represent a final challenge to the outlook, and one with longer-term consequences for economic growth. Immigration remains a hotly contested political issue, but the surge in unauthorized immigration during the Biden presidency nonetheless had a positive impact on labor supply, contributing to a strong rate of economic growth without boosting inflation. With an aging native-born population, limitations on immigration as well as increased deportations will reduce labor force growth. This is a key reason why we expect only a modest improvement in growth next year. In addition to monetary policy easing, the investment incentives and household tax breaks in the new tax legislation will provide demand-side support for the economy, especially as the legislation’s cuts to transfer payments are more backloaded. But the economy’s ability to boost output in response to fiscal easing will likely be constrained by weak labor supply growth.

Labor Force Growth by Nativity

Data through June 2025
Source: Bureau of Labor Statistics, MacKay Shields

An environment of subpar growth but tariff-related price pressures creates a challenging environment for the Federal Reserve, especially given recent disappointing progress in returning inflation to the two percent objective. The minutes from the June FOMC meeting indicate that most Committee participants are focused on “the risk that tariffs could have more persistent effects on inflation.” So long as the economy looks likely to avoid a recession, the risk of persistent inflation effects will keep the Fed in wait-and-see mode, perhaps delaying a resumption of rate cuts until the fourth quarter.

Disinflation Progress Has Stalled

Data through May 2025
Source: Bureau of Economic Analysis, MacKay Shields, Federal Reserve Bank of Dallas. Trimmed mean PCE inflation calculates the average price change across the basket of PCE goods and services after first "trimming" the distribution of prices changes to remove outliers. Market-based core PCE includes goods and services components with observed market transactions for which there are price measures.

International Developments

The substantial shift in US trade policy is leading to a broad-based deceleration in global growth compared to 2024, with country-level outcomes a function of export exposure to the US market and the scale of the domestic policy response. For many economies, the disinflationary impulse from tariffs creates space for central bank rate cuts. In the Euro area, the economic outlook for the remainder of 2025 is one of modest growth, supported by monetary easing over the past year. Growth should improve next year, as the fiscal impulse gathers steam. Germany in particular has loosened the fiscal reins, but the recent NATO agreement to increase defense spending implies a shift to looser fiscal policy in much of the euro area.

The outlook for China has improved given the de-escalation of trade tensions with the US. Nonetheless, even if more prohibitive tariff levels have been avoided, higher tariff rates will weigh on the export sector. The Trump administration has also increased its focus on using tariffs to thwart efforts of Chinese firms to offshore production to other East Asian manufacturing hubs, such as Vietnam.  Overall, Chinese exports have demonstrated resilience, successfully navigating US tariffs by expanding into alternative markets. But this risks a backlash from other countries, including many in Europe, against what is perceived as Chinese dumping, The strength in the external sector also highlights the persistent weakness in domestic demand, which has yet to show signs of a significant recovery.