The Decisive | Season 3 Ep.23 - Reduced Speed Ahead: Outlook for the US Economy

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Kristen Hallam:

You are listening to the Decisive Podcast – insights and analysis to empower confident decision making.

Alyssa Grzelak:

Thank you all for joining. My name's Alyssa Grzelak, head of country default and banking risk within S&P Global Market Intelligence. Our speakers today are Ben Herzon, executive director and co-head of US Economics; Pat Newport, executive director and co-head of US Economics; Mike Konidaris, economics associate director; and Juan Turcios, economics associate director.

Welcome. Is the US entering a recession. Why has the US dollar been weakening and what's the outlook for the dollar? What is the outlook for US federal deficits, and should we be concerned about the federal debt? Before we dive into these questions specifically, Juan will share our view of the US macroeconomic outlook. Juan?

Juan Turcios:

Thanks, Alyssa. I'll be happy to give an overview of our outlook for the US economy and first, and in order to not bury the lead, while we believe economic growth will slow, we do not forecast that the US will enter a recession. Over 2025 growth slows to a lackluster average of 0.8% per quarter, which is a marked slowdown from the 2.5% average over 2024.

There are a few key factors that contribute to the slowdown. Most prominently, the fallout from a large round of tariffs that while scaled back from one month ago, are still much higher than what was anticipated heading into 2025.

Second, Fed policy remains restrictive and past Fed tightening will continue to have an ongoing effect on borrowing costs. In addition, some fiscal tailwinds from the Infrastructure Investment and Jobs Act, as well as the Inflation Reduction Act, we believe have more or less run their course and will no longer be a boost to growth.

Lastly, even with the recent recovery in financial markets, we still expect equity values that will sag over the near term. Given this period of below potential growth, the unemployment rate rises to a quarterly average of 5.0% by late 2026. On the Fed front, the Fed takes a more cautious approach, giving the elevated policy uncertainty and a potential incoming inflationary bump.

The Fed is on pause until December of this year and then cuts the target range to a range of two and three quarters to 3% by late 2026. So first, let's step back briefly to the beginning of April. When we released our April forecast on April 8th, markets were in turmoil as they digested the recently announced reciprocal tariff policy.

The S&P 500 had fallen about 10%, and the VIX had spiked to about 50, and talk of recession was beginning to gain steam. We did not forecast a recession in our April baseline. But it was conditional on some financial healing taking place. Indeed, that financial healing has taken place over the near term, and then some. The S&P 500 has risen robustly since the trough of April 8th, and indeed is now trading above our Q2 end of period forecast.

A similar story is occurring with the VIX, which has come down swiftly since April 8th, and is currently below our Q2 average of 2025. So now, given that this financial healing has taken place, our forecast for no recession has remained intact in our May forecast. While we expect the US economy will continue to grow, growth will slow.

The outlook has generally weakened over the first half of this year, and a natural point of comparison is our November forecast, which would have been the last forecast to not include any assumptions about incoming policy shifts. The largest shift, as discussed previously, is the large round of new tariffs, and even after the recent step back to lower trade tensions and tariff rates, the average effective tariff rate is still expected to be at historic highs.

Ultimately, tariffs are inflationary and we expect that consumer price inflation turns up this year. The core PCE price index reaches 3.9% on a four-quarter change basis. One thing to note is that as of April and the latest CPI report, there is still no clear evidence of a hit on consumer prices, but we have begun to see major retailers prepping consumers to expect price increases over the summer months.

The flip side of higher inflation than was previously expected is tighter monetary policy for longer. After a hundred basis point cuts over the last four months of 2024, the Fed has remained on pause thus far in 2025. With the inflationary impacts of tariffs still unclear, but creating a new upside risk to inflation, the Fed takes a more cautious approach and extends their pause until December of this year.

Higher for longer rates imply tighter financial conditions generally and a higher path for the 10-year treasury rate, all else equal. The higher rates raise the cost of borrowing throughout the economy and act as an additional headwind to grow. Higher treasury yields would normally act to boost the dollar.

Indeed, that is what occurs in our modeling. Of course, what has captured more of the headlines recently is the weakening of the dollar post the reciprocal tariff announcements. Other factors are likely at play in the recent weakening.

Still, even with this recent weakening our May forecast for the dollar runs above our pre-tariff policy projections and the relative strong dollar will weigh on exports through the rest of this year. As mentioned previously, the tariff policy now perhaps looks more dovish than it did one month ago, but it looks substantially more hawkish than at the beginning of the Trump administration just four months ago.

Where it will stand six months from now is difficult to pin down with any level of confidence. In addition to historically high trade policy uncertainty, the Fed's battle to bring down the post-pandemic inflation surge will continue to affect business investment decisions. Real corporate borrowing costs are the highest they have been in 15 years.

Elevated corporate borrowing combined with the high levels of policy uncertainty, make a lousy environment for business investment. Combined, both act as headwinds and we expect that growth in non-residential investment will slow markedly in 2025 and turn negative in 2026 before to starting in 2027.

Mortgage rates rose sharply in recent years, and we project that they remain elevated over the near term. Higher mortgage rates weigh on housing demand and overall housing activity. As a result, housing starts fall modestly over the next couple of years in our forecast. Also of note are the supply side effects on housing.

Construction costs in the housing sector are exposed to both increased material costs due to tariffs on construction inputs such as lumber and increased labor costs due to a more restrictive immigration policy that could reduce the supply of available construction workers. Finally, we believe that two pieces of legislation that have been supportive to growth over the last couple of years will no longer be a boost the growth.

The Inflation Reduction Act incentivized a surge in investment in manufacturing structures in recent years. We expect that investment in these kind of structures will moderate over the near-term forecast. The Infrastructure Investment in Jobs Act has supported growth through increased investment by state and local governments.

The upswing in state and local gross investment has plateaued, and we no longer expect that it will act to support growth in the forecast.

Taken together, the various headwinds and receding boost from previous tailwinds imply a period where growth slows below potential. This is a growth recession where growth does not out and out turn negative, but slows enough so that slack in the labor market emerges, and the unemployment rate rises above the natural rate.

The unemployment rate is a lagging indicator, and so it continues to rise to the peak of 5.0% as a quarterly average by the fourth quarter of 2026. So while we continue to expect that the US economy will grow, albeit at a lackluster pace, the risk of recession has grown, and uncertainty is abound, and this is probably a good place to start thinking more about what those additional risks could be.

Alyssa?

Alyssa Grzelak:

Thank you, Juan. So Ben, as Juan indicated, your baseline forecast is for no recession. Why aren't we concerned about a recession?

Ben Herzon:

Thanks, Alyssa. Well, I wouldn’t say we're not concerned. We are concerned. We definitely think that we're not out of the woods yet. Recession is a real possibility. Lemme tell you how we're thinking about it in broad terms.

So, recessions are all different, but at least recent recessions have shared a couple of common threads. There's usually a big shock, right, that sets off the recession and then there's usually some underlying fragility or an imbalance that propagates that shock into a recession. So I think it's instructive to look at the last few recessions with this lens to give us a context for how we're thinking about from today's situation.

So looking back to the 1990-91 recession, there was shock. So the shock included the beginning of the Persian Gulf War, a spike in oil prices, and a sharp decline in consumer sentiment. All of this happened in August of 1990. So that was a, that was the shock. That was a big one. And there was an underlying fragility.

The underlying fragility was, at the time, there was an ongoing savings loan crisis, which led to a wave of bank closures and a, and a tightening of a bank credit. So, and, and as, as it so happens, the peak of this wave in bank closures was in 1990. So at the same time we had this big shock, we had an underlying

fragility, a weakness in the banking system, tightening credit that propagated that shock into a recession.

Let's take a look at the 2001 recession. So the shock – there were two shocks. One was the bursting of the dot-com bubble, and the other was the 9/11 terrorist attacks, which happened later in the session, and sort of extended the period of weakness. Those are the shocks. Again, they were big ones. There was an underlying imbalance, and that imbalance was that, that equities were simply overvalued.

So once they, once equities started losing value, it kind of gained momentum and transmitted these shocks into recession. Let's look at the Great Recession, 2007 to 2009. The shock was the bursting of the housing bubble or the bursting of the house price bubble. The underlying fragility, which, you know, is well understood now, well documented now, was the unappreciated riskiness and ubiquity of mortgage-backed securities.

The COVID recession was, was different, but it's, you know, the COVID recession, there was, you know, a global pandemic and forced shutdown of activity. It was a short recession, two months, and there was a rapid recovery after that. But I don't think the COVID recession is really instructive for, obviously, for today's situation.

So let's fast forward to today. So we do have a shock, and it's a big one. We have an historic increase in tariff rates. And we were experiencing historically elevated levels of uncertainty, particular uncertainty about trade policy. Now we've seen, you know, the anecdotal and heard the anecdotal reports that businesses are putting investment plans on pause while this uncertainty resolves, and we've done our own research where we've identified a link between trade policy uncertainty, and in particular, the index of trade policy uncertainty and business fixed investment. And in fact, we put the weakness in investment spending implied by trade policy uncertainty into our forecast.

What we have found is, in our previous work, is that the industries that are most exposed to trade, be it on their cost side due to imported imports or on the revenue side due to exported sales, those are the industries that are most susceptible to trade policy uncertainty. Okay, so we have a shock, and this big one, a historic increase in tariff rates, elevated uncertainty.

So now the next question is, do we have some underlying fragility or imbalance? Well, it's, so as we're kind of thinking through this, and as we were putting together the April and the May forecast, we're thinking, well, especially the April forecast, when markets were at the bottom, we were thinking, you know, okay, this is a big shock.

But is there, is there some, is there some imbalance? Is there some fragility that's going to propagate this into a recession? And it was really hard. It's really hard to point to point to a fundamental fragility or imbalance at this time. In the wake of the Great Recession, the Federal Reserve began conducting annual stress tests for large banks.

And those stress tests were designed to ensure that large banks and the banking sector in general are sufficiently capitalized so that they could continue to lend in a severe situation. So it, you know, if there is, if there is some fragility or some imbalance is probably not on the banking sector.

The banking sector looks like it's in pretty good shape. So that's where we stand now. So we've got a shock. We don't think we're out of the woods, but we, it, it's really hard to point to, an imbalance or a fragility that would propagate get the shock into a recession.

Alyssa Grzelak:

What would lead you to change your recession call and what indicators are you, are you watching at the moment?

Ben Herzon:

Right. So what we're watching, we're, we're certainly looking for signs of renewed financial stress. So the, the, the type of financial stress that we saw in early April. We'll be watching the next few readings on, on consumer expectations and business expectations. The Michigan Index of Consumer Expectations has fallen pretty sharply over the last couple of months.

Now, you know, we know that the link between consumer expectations and consumer spending recently has softened. But you know, I would think that at some point if expectations were hit hard enough that it would eventually translate into weakness in consumer spending. So we're watching consumer expectations. We're also watching business expectations.

One indicator we look at is the composite PMI for future output. This is a, this is a survey question that asks businesses, do you expect your output to be higher or lower than current levels on 12 months from now? And if businesses start telling us they expect their output to be lower, which would be indicated by this indicator falling below 50.

That would be a sign and we would, we would probably take that seriously. We'll also be watching the developments on trade talks we saw in early April

that markets don't have much of an appetite for the reciprocal tariff policy that was introduced then. So, we've got a couple of 90 day pauses for the reciprocal tariffs broadly.

And the tariffs on China in particular, in particular, at the end of those 90 days, we'll, you know, we'll see what happens and something, there could be developments before the 90 day pause as well. So we're watching those trade talks as well. And we do expect there will be additional section 232 tariffs that will be implemented on commodities, like lumber on copper critical materials, semiconductors in pharmaceuticals. And we expect those chairs to go into place later this year. We'll be watching for, uh, market reactions to those tariffs as well.

Alyssa Grzelak:

So not our baseline expectation, but still certainly some items to watch for that could, you know, derail our outlook. Do you have a view on what a recession would look like if one were to occur this year?

Ben Herzon:

Yes, we do. As for the last two baseline forecasts – for the April forecast, May forecast – we've been preparing as our pessimistic alternative scenario. What we think a recession would look like this year were it to, were it to occur. So in that, in that scenario, in that recession scenario, there is the way, the way we're thinking about what would, what would trigger it, is that there would be a more pronounced negative reaction in financial markets to, to existing policies or to, to the policies that as they unfold over the next several months.

In such a scenario, we would expect to see a, a jump in volatility as measured by the S&P VIX. We'd expect to see weakness in equity values like weaker equity values than we have in our baseline forecast.

We would also expect to see some weakening in, in business confidence that would translate pretty quickly into cuts in production that would lead to inventory paring. And finally, we would expect in that scenario that the Fed to begin easing earlier than in our baseline forecast at sort of middle of this year and the recession that results in this pessimistic scenario, which is the, the recession that we think we would get were one to occur, is a pretty mild one. There's a two-quarter decline in GDP. It's a 0.5% decline, peak to trough. And the unemployment rate rises to a peak of 6.4%.

Alyssa Grzelak:

Thank you, Ben. So Pat, we just heard from Ben on, you know, what developments could reshape our thinking on the near-term economic outlook. The advanced economic indicators report is due next week. In March, we saw that imports and the trade deficit surged to record highs, according to both the advanced economic indicators and the trade report. Given that backdrop, what do you expect to see in this upcoming release and how might the data shape forecasts for second quarter GDP growth?

Pat Newport:

Thanks. Thanks, Alyssa. The trade report doesn't get a lot of media attention and that, that's unfortunate because it's an important report.

It's, it's comprehensive, and it's accurate. Every item that goes across the border and goes through customs is reported, so the information doesn't have a sampling error, and the data revisions are very easily, very small. So in March, imports skyrocketed to record high. That's not surprising because we were expecting companies to front load to avoid the tariffs.

But what's surprising is that imports didn't increase more. Because if you take away five of the 150 listed end use categories in the trade report, gold, computers, computer accessories, communications equipment and pharmaceuticals, you don't see any surge, hardly any surge at all. So let me talk about these briefly.

So it is, the gold surge wasn't front loading. Instead, what the tariffs did was that they created arbitrage opportunities driving a wedge between the spot and the future price of gold traded in New York. And so this brought in about $80 billion of gold between December and March, and that's about 800 tons of gold or about 150 flights from Switzerland to New York.

And it's actually from London to Switzerland where the gold bars are melted down into the right size pieces and then to New York, which shows you some of the inefficiencies that tariffs produce. And now that gold is starting to flow the other way. The pharmaceuticals accounted for about a quarter of the increase in imports in the first quarter and one little obscure category called HS 293719, defined as polypeptide proteins and glycoprotein hormones and derivatives, which I know it includes insulin and it may include weight loss drugs.

Big surge. This small category accounted for almost all of that surge in pharmaceutical imports. And moreover, almost all that surge originated in Ireland and almost all of it went to, was, was shipped to Indiana. The question is why Ireland? Because Ireland has become a hub for producing pharmaceutical

products the US imports and why Indiana Indiana's a home of the most pharmaceutical products.

So the third thing are them are the high-tech products – computers, computer accessories and telecommunications equipment. There was a surge in the first quarter, but I think we can comfortably say that about, probably about a quarter of the surge would've happened anyway.

This surge in investment in computers started to take place last year because the big companies, high tech companies, have stepped up investment in artificial intelligence. So there was a big surge in high tech, but not as much as you might think by just, there was some front loading, but not as much as you think there might've been by looking, by looking, looking at the charts.

So the question is, why didn't companies bring in more? And I think that the size and the breadth of the tariffs announced in April just caught most firms off guard. So the advanced report, advanced trade report, comes out next Tuesday, and if I'm correct, it will include a record drop in imports and a record decrease in the trade deficit.

The trade balance is going to improve for five reasons. First of all, gold will drop, gold imports will drop back to normal levels. Second, imports of pharmaceuticals will drop probably below normal levels. Third, imports of high tech will drop more closely to normal levels. Fourth, outside of computers, pharmaceuticals, and high tech, there was a surge in other categories, and those other categories are going to return back to normal levels. And fifth, we're going to see a massive drop in imports from China based on customs data from China.

We already know that China's exports to the United States plunged in April, and those are going to show up in the April, the US April and May trade report. So the question is, what does this mean for growth? And that's hard to say, but probably not very much. There's a misconception that imports are a drag on growth, and indeed the GDP release includes a table that measures the contribution to growth from the different components.

And in the first quarter, the contribution to growth from imports was negative 5%, which some of the media had come, had interpreted as had imports not dropped as much in the first quarter, the economy would've boomed, and that's simply not the case. GDP contracted in the first quarter, in my view, because of measurement errors.

And I say that because other measures of economic strength, such as employment growth, industrial production, final sales to private domestic

purchasers, personal income, disposable income, all showed healthy growth and I think that the first quarter drop of GDP is a number that eventually will be revised away.

Alyssa Grzelak:

Thank you, Pat. So the dollar's been on a volatile ride surging after the November election, but losing ground since the started the year. What are the key forces that are driving these swings and looking ahead, where do you see the dollar heading over the next 12 months, three years, 10 years?

Pat Newport:

So the Fed's dollar index for the advanced economies, and this is very similar to the created dollar index, DXY called the Dixie, it's seven currencies, and you can see it went up and then since the start of the year, it's been going down. And here I've listed some of the reasons for why it has dropped. Tariffs are a tax, they're drag on growth. They make it more likely the then like to, to lower rates.

So that, that would tend to weaken the currency. And China has kept its currency stable in 2018, 2019, and didn’t let its didn't let its currency depreciate. And Europe and Germany particularly are responding with more aggressive fiscal expansion and that's, that's tends to strengthen their currency and weaken the dollar.

But basically understanding the movements of the dollar is always a challenge because so many forces are driving it, but I think right now there, the dollar's being tugged around in opposite directions by two powerful forces. On the one hand, tariffs are reducing demand for foreign currency to purchase imports, and that's boosting the dollar.

And on the other hand, policy uncertainty has eroded confidence in the dollar, and that's put downward pressure on the dollar. And recently the drag from policy uncertainty has outweighed that up tariffs, and we're seeing a weaker dollar, but I think it's more than this. Because of our frayed alliances with our traditional allies such as Canada and Western Europe, and because countries will be trading less with the United States, and also because the United States institutionally appears incapable of bringing down its fiscal deficits.

The deficit this year is going to be 6% or more of GDP. In a country of full employment, the US full employment should be reducing its deficit. It shouldn’t be runnin

down. Because of this, the risk premium for holding US debt has increased, and this risk premium has, has a name, it's called exorbitant privilege.

Historically, when uncertainty rises, investors shipped their portfolio into the safety of long-term US government bonds, driving interest rates and the, and the exchange rate up. But this did not happen when the tariffs were made public. Instead, the yield on long-term government rates went up and the dollar loss value.

So the bottom line is that the US has lost some of its exorbitant privilege and that comes at a really bad time because long-term interest rates are high and foreigners hold a lot of debt. So our forecast is that the dollar will continue to lose ground over the next six months, over the next year and over the next 10 years, over the next 18 months, Fed easing will make us assets less favorable and that'll weaken the dollar.

But we have other fundamental forces at work. We have a big current account and a current account, large current accounts tend to weaken the dollar and we have large projected fiscal deficits and uncertainty over whether, uncertainty over the size and whether these deficits will be eventually become unmanageable will reduce confidence in the dollar, contributing to its decline.

So the bottom line is that the US dollar has probably lost some of its exorbitant privilege. And that's, that's unfortunate.

Alyssa Grzelak:

So, Mike, Pat just gave the outlook for the US dollar. This is tied to the fiscal situation of the US as a rise in the federal deficit can put downward pressure on the dollar. Mike, can you please give us an overview of what's going on right now in Congress and discuss the fiscal assumptions that are in your baseline forecast.

Mike Konidaris:

Thank you, Alyssa. Extraordinary measures by the US Treasury are still in place, while the current tax bill and the debt ceiling negotiations are still ongoing in Congress.

It's worth noting that the Joint Tax Committee expect the tax bill to add nearly $4 trillion to the federal deficit over the next decade. But not that number can change up or down depending on the final of the tax bill. So let's talk about our baseline forecast now.

We, first of all, we assume a permanent extension of a 2017 personal tax cut and some exclusion of tip and overtime pay from federal taxation. We also assume generic cuts in federal spending across the board, and that the corporate tax rate is lowered from 21% to 15% for corporations that produce domestically.

Finally, we assume that the debt ceiling is assumed raised or suspended prior to the exhaustion of these extraordinary measures now and in the future. Now to focus on the fiscal part of our baseline forecast, since my colleagues focus on other parts, so the fiscal, the baseline forecast includes parts of what's of what's in the current tax bill in Congress right now.

And we expect the federal budget deficit to increase from 6% to 7% over the next decade as no meaningful action on getting the deficit under control is taken. We also expect federal debt, a share of GDP to increase another 30 percent over the next decade as a result of that widening deficit.

Alyssa Grzelak:

So while there is still the question mark around the resolution of the tax bill and debt ceiling negotiations, do you think that this can lead to a more serious turn of events? Is this something that you've already thought about?

Mike Konidaris:

Yeah, so first of all, there are multiple risks to the fiscal outlook at any point in time, as there is a sequence of negotiations stalling in Congress from raising the debt ceiling to passing the US tax bill to approving, you know, the annual budget of any given year, but regardless of the positive outcome in any of those negotiations, the important thing is that the rising federal budget deficit is not properly addressed.

There have been episodes in the past where financial markets get spooked due to a lack of progress on negotiations regarding the debt ceiling or the budget. With a split Congress, a lack of progress on a bill that would meaningfully lead to a reduction in the deficit and a rising cost of debt relative to the last 10, 15 years, now, the risk of a debt sustainability crisis is very much existent, though we consider this a very, very low probability case.

Alyssa Grzelak:

Okay. Thank you very much. And for more analysis on the US and other global economies. Please refer to our reports and daily insights on connect.

Kristen Hallam:

Thank you for listening to the Decisive Podcast from S&P Global. Please subscribe and join us for next week's episode. Until then, stay curious and stay informed.