U.S. Policy Uncertainty Spikes

U.S. policy moves are dominating the macro narrative. The new Trump administration (Trump 2.0) has come out aggressively with a vow to "move fast and break things." We've seen this most clearly in tariff policy. Trump 1.0 focused tariff--and sanctions--policy mainly on China related to allegedly unfair trade practices and security concerns, which the Biden administration continued.

In contrast, Trump 2.0 started with threats of steep tariffs on Canada and Mexico related to immigration and illegal drug flows. Importantly, policy pronouncements, reversals, and revisions have come on almost a daily basis (see "Economic Research: Macro Effects Of Proposed U.S. Tariffs Are Negative All-Around," published Feb. 6, 2025). Unorthodox policy moves on government employment and immigration, plus geopolitical and security developments, have added to a hyperactive mix.

As a result, the normally unexciting U.S. Policy Uncertainty Index has spiked to near-record territory. Indeed, the index level stands near or above the previous peaks associated with the Global Financial Crisis and the COVID-19 pandemic (chart 1). While those peaks related to the worst economic downturn since the Great Depression and the first pandemic in a century, the current peak stemmed from deliberate policy choices.

Chart 1

Trans-Atlantic Split: U.S. Markets Go South, But Europe Picks Up

Markets have been volatile the first quarter of 2025, digesting changes in U.S. policy and differing global growth prospects. A broad theme has been U.S. (and Japan) lower and Germany (and China) higher. This holds across equities, government bonds, and currencies. Our reading is that markets are pricing slowing U.S. growth and a pickup in Europe, which we flesh out in our revised forecasts (see table 1).

Chart 2

The U-turn in U.S. markets since late January has been a surprise. Up to and following the U.S. election in November, markets were expecting higher inflation pressures resulting from tariffs, lower labor supply due to deportations, and looser fiscal policy featuring tax cuts. This manifested in higher rates along the risk-free yield curve (including few policy rate cuts at the short end) and a stronger currency. Higher equity valuations reflected the perception of a more business friendly administration.

However, shortly after the new administration took office, the spike in policy uncertainty reversed these trends. U.S. equity markets are down, bond yields have fallen, the dollar has weakened.

There remains unresolved tension between the hard data and the soft data. Activity data looks stronger than sentiment and survey data, which have generally fallen sharply across most economies in recent months. While U.S. GDP in the first quarter is likely to come in much lower than in recent years, some of this is one-off due to a severe winter, and the there is still a gap. This is particularly apparent at the global level. If anything, investment appears to be strengthening not just modestly as in the U.S. and China, but strongly in Germany and Japan (see chart 3). Moreover, employment remains high almost everywhere, perhaps with the caveat that youth unemployment in China has risen significantly. The question is whether the soft data is going to revert, or whether it signals a deterioration in the activity data. The latter would be a sharp slowdown or possible recession.

Labor markets remain the bright spot among most economies, underscoring general macro resilience. Unemployment rates remain near multidecade lows, and job creation has slowed but is still healthy. Most labor markets have come into better balance with both vacancies and quit rates back to historically normal ranges, following pandemic-induced dislocations. (China is an exception here, with slack labor demand, particularly for college graduates.) Heightened uncertainties around U.S. policy and global growth have yet to dent labor demand.

Chart 3

The U.S dollar has weakened modestly so far this year, retracing most of its gains since the election. But major currency divergence following the pandemic remains wide (see chart 4). In our view, U.S. dollar depreciation reflects market expectations of relatively lower U.S. growth prospects and a narrower interest rate gap vis-à-vis U.S. government bonds of major trading partners (see chart 2). Measured in real effective terms (that is, adjusted for trade weights and relative inflation), the main counterparts of U.S. dollar strength have been a weak Japanese yen and Chinese renminbi, not the euro.

Chart 4

The policy rate-cutting cycle continues among major central banks, with widening divergence. The Bank of Canada and the European Central Bank (ECB) have been cutting most aggressively since mid-2024. These moves reflect slower demand and GDP growth and lower inflation pressures relative to the peer group. Canada has the additional downside pressure of U.S. tariffs. Australia and the U.K. face lingering inflation pressures and have been the slowest to cut rates.

The U.S. Federal Reserve is in the middle of the pack and has taken a wait-and-see approach as the effects of heightened U.S. policy uncertainty on growth, inflation, and employment play out. As we have forecast, almost all policy rate cuts have been 25 basis points, and we expect this to continue as long as demand and price changes remain moderate.

Chart 5

Our Updated Forecasts: Global Growth Rotation Ahead

We have a material change in our global growth narrative this quarter, stemming from the fallout from U.S. policy uncertainty. This includes slower growth this year, as well as some modest growth rotation away from the U.S. in the following years (see table 1).

Our tariff assumptions for goods for this forecasting round are the following:

• For Canada and Mexico, U.S. import tariffs are 10% during 2025 until a new United States-Mexico-Canada Agreement is negotiated.
• For China, additional U.S. tariffs of 20% stay in place indefinitely.
• For all trading partners, U.S. tariffs of 25% on all steel and aluminum imports stay in place indefinitely.
• For all trading partners, U.S. imposes tariffs of 10% on automobiles, pharmaceutical products, and semiconductors
• For all trading partners, reciprocal U.S. tariffs equalizing effective rates will be announced in April.

Table 1

U.S. GDP growth will decline faster than our previous baseline throughout 2025, although this is masked by the annual average number. The starting point this year was growth of about 2.5%, following a solid final quarter of 2024. We forecast growth falling to about 1.5% in the final quarter of 2025. The kicking-in of tax cuts and some supply-side reforms should move growth back up toward its 2% speed limit thereafter.

European growth prospects have improved since our previous forecasts. While tariffs and related uncertainties will slow the pace of activity in 2025, higher investment, including for defense spending, will drive growth higher in 2026-2027. It will also rebalance eurozone growth toward Germany.

China's growth is broadly unchanged. We continue to see some near-term weakness from the property sector. The recently completed National People's Congress signaled more aggressive stimulus measures ahead, which should boost headline GDP growth.

The knock-on effects of U.S. tariff policy have dragged many emerging markets (EMs) lower, with Mexico in the spotlight. We maintain our view that the larger, more domestically focused EMs are better placed for growth. We can now add that running a trade surplus with the U.S. is negative for growth since reciprocal tariffs are on the horizon.

We have updated our detailed regional narrative as follows:

U.S.

The Trump administration's shifting policy mix is leading to a faster decline in growth in 2025 compared with our previous forecast. While our full-year growth rate is unchanged at 1.9% (due mainly to a higher base effects from a strong end to 2024), we see a downshift in growth to 1.6% by the fourth quarter. In turn, we forecast unemployment will drift higher, peaking at 4.6% by midyear 2026, with the public sector likely limiting payroll expansion. This contrasts with significant contributions to jobs growth in the past two years.

We project inflation will remain closer to 3.0% in 2025 as tariffs increase prices along the domestic supply chain and for end consumers. As a result, we now expect one 25-basis-point federal funds rate cut for 2025, ending the year at 4.00%-4.25%. The balance of near-term risks to our profile is on the downside, with sustained policy uncertainty raising the prospect of material declines in output and employment. Supply-side reforms and the implementation of AI pose longer-term upside risks to growth.

(For details, see "Economic Outlook U.S. Q2 2025: Losing Steam Amid Shifting Policies," March 24, 2025.)

EMEA

We revised our eurozone GDP growth forecast for 2025 downward to 0.9%, from 1.2% previously, due to uncertainty and U.S. tariffs. However, we expect a substantial recovery from 2026, thanks to fiscal stimulus measures in Germany and the EU in the areas of infrastructure and defense. For 2026, we now forecast GDP growth of 1.4%. The ECB could deliver its final rate cut of the year by June, taking interest rates to 2.25%.

Reflecting the investment-led boost to spending, we expect policy rate hikes as early as the second half of 2026 because fiscal stimulus programs will push growth beyond its potential. Trade uncertainty, potential failure to execute fiscal plans, and spillovers from the U.S. economy dominate the downward biased balance of risks. However, positive factors could tip the balance if the effects from fiscal stimulus programs exceed our expectations or confidence improves rapidly.

(For details, see "Economic Outlook Eurozone Q2 2025: A World In Limbo," March 24, 2025.)

Asia-Pacific

While U.S. tariff hikes will hit China's economy, offsetting factors keep our 2025 growth forecast unchanged at 4.1%. Better growth at the end of 2024 will lift China's 2025 GDP gains. Moreover, this year's growth target and fiscal stimulus are more ambitious than we had expected. While U.S.-led trade friction will weigh on the Asia-Pacific economies, excluding China, we expect domestic demand momentum to mostly remain solid, generally leading to only modest downward revisions to GDP forecasts. Still, as the growth outlook softens and inflation is likely to stay moderate, central bankers will increasingly be willing to risk some currency depreciation and cut policy rates.

(For details, see "Economic Outlook Asia-Pacific Q2 2025: U.S. Tariffs Will Squeeze, Not Choke, Growth," March 24, 2025.)

Emerging markets

Lack of clarity over U.S. trade policy is likely to delay investment decisions, with negative implications for GDP in most EMs this year. The direct impact of tariffs will be modest in most major EMs outside of Asia and Mexico. However, if tariffs lead to slower growth in the U.S., other major advanced economies, and China, the knock-on effects in EMs could be substantial. As we learn more about the specifics of U.S. trade policy, we will also better understand their impact on EMs, but we believe the risks to our growth outlook are mostly to the downside.

(For details, see "Economic Outlook Emerging Markets Q2 2025: Trade Policy Unknowns Dampen Investment," March 24, 2025.)

Global Risks: Macro And Geopolitics Sharply Lower, Tempered By AI

The spread of the impact of U.S. policy uncertainty to the hard data is our key downside risk. U.S. policy uncertainty has pushed confidence and sentiment indicators sharply lower, but it is not clear to what extent the real economy or hard data will follow. This depends on the continued resilience of investment and consumer spending, and the associated links to labor demand. This consumption-labor market nexus has been remarkably resilient in the post-pandemic era. Should it crack, then U.S. growth will decline materially and take down economies that rely on U.S. consumer spending for growth. (For details on our rising U.S. recession risk, see "U.S. Business Cycle Barometer: Increasing Likelihood Of A Slowdown," March 13, 2025.)

Supply-side reforms have the potential to boost growth--for instance, tax policy and improving the ease of doing business, including permitting reform. But these will take time and risk being overwhelmed by policy uncertainty in other areas in the short term.

Geopolitical risks to macro outcomes have also risen, with mixed effect. On the downside, consumption and investment spending are likely to be more cautious amid heighted security risks, and these will put downward pressure on demand and growth. On the upside, higher defense spending in response to geopolitical risks will lift growth as governments spend on infrastructure, materiel and workers/labor to boost security. Europe is seeing the beginning of these effects.

AI-related technology risks will provide medium-term tailwinds to growth. The adoption of AI is still in its early days, but we agree that its impact will be transformational. Electricity in the late 19th and early 20th century strikes us as an appropriate comparative. Many companies are already exploring the applicability of AI across their operations and countries--particularly the U.S. and China--are engaged in a virtual AI arms race. All of this will need enormous amounts of electricity and infrastructure. Tech firms are leading these efforts, and at breakneck speed. At the GDP level, the positive benefits of the AI revolution on growth are clear, although estimates vary widely.

Forecasting Struggles As The Washington Consensus Fades

Geopolitical and policy uncertainty, and a changing global order complicate our macro forecasting. The state of the world is such that our forecasts will have wider confidence bands, and our narratives will have lower conviction (and shorter shelf life).

The exit from the Washington Consensus has accelerated with the new U.S. administration. Rules around trade and government employment (in the U.S) seem to be rewritten in real time. The trust in markets to efficiently allocate resources has waned, and the state is playing a larger role across the economy, including to achieve non-economic outcomes. Long-standing norms are being refashioned. Also, changes to geopolitics and security are moving the macro needle in ways not seen in decades.

In such an environment, traditional forecasting methods become compromised. Using regression analysis to populate our models with coefficients is no longer dependable because the world we live is no longer stationary. That is, we are not playing the same game year after year. Policy rules of thumb have also broken down. We are left to rely more on slimmed down desktop models aimed at capturing key relationships constrained by our accounting identities (which of course still hold).

Where we ultimately land in the journey is unknown. While the Washington Consensus train has left the station, we have not yet arrived at a new stable, global macro configuration. What does that ultimately look like? What is the role of the market versus the state? What is the role of tariff policy and trade? Is the U.S. dollar still dominant? How does geopolitics affect macro policy and outcomes? Until we get clarity, we must deal with a more challenging forecasting environment.