US: Economy entered 2025 with momentum but policy uncertainty weighs on the outlook

The US economy entered 2025 with a fair amount of momentum. However, GDP growth in the first quarter of the year looks to be soft. Real consumer spending declined in January, although the weakness may be attributable, at least in part, to bad weather.

Furthermore, the surge in imports in January, which mechanically reduce GDP (everything else equal), will also weigh on output growth in Q1. In our view, the surge in imports reflects front-running ahead of potential increases in tariff rates.

Tariff announcements have come and gone in recent weeks. In terms of our forecast, we assume that the 20% tariff on China will remain in place through the end of our forecast period (Q4-2026). We are also assuming a 10% effective tariff on the European Union along with effective tariff rates of 5% on Mexico and Canada as well as on countries in the rest of the world. In each case, we assume that foreign countries will retaliate on the United States with their own equivalent tariffs.

In our view, these assumptions strike a reasonable balance between upside and downside risks. Notably, these assumptions, which are based on the ebb and flow of tariff announcements in recent weeks, are not meaningfully different from the assumptions we have been using over the past few months.

We look for real GDP growth to downshift in the second half of 2025 as tariff hikes lead to a modest uptick in inflation that erodes growth in real income, which weighs on growth in real consumer spending.

We think the FOMC will "look through" the one-off tariff-induced increase in the price level and refrain from tightening monetary policy. Indeed, we have added an additional 25 bps rate cut to our outlook due to the softer labor market conditions we expect by midyear. We look for the FOMC to cut rates by 25 bps at each of its policy meetings in June, September and December.

We readily acknowledge that uncertainty related to tariffs and reductions in federal government employment amid signs of slowing growth raise the probability of an economic downturn this year, but it is not our base-case scenario, because the underlying fundamentals of the U.S. economy generally remain healthy.

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