US economic data have cooled sharply due to a decline in sentiment amid elevated policy uncertainty. Indeed, ‘nowcasts’ for first-quarter (Q1) growth indicate a significant contraction, while recession risk probability models are also increasing.

However, sentiment surveys have been an unreliable guide to the US cycle, and technical factors appear to be overstating the extent of the underlying slowdown. The labor market is cooling but is not consistent with a downturn. Although we expect a softer Q1, we do not forecast a recession (Chart 1).

Nonetheless, US tariff uncertainty is significantly elevated, and we expect the average tariff rate to rise from about 3% at the start of President Donald Trump’s term to around 9%. This increase is more significant than we previously factored in and includes further tariff increases on China, various sector-specific tariffs, and a partial reciprocal tariff regime.

Meanwhile, federal agencies are facing significant disruptions due to reforms driven by the Department of Government Efficiency (DOGE). Federal job losses are starting to be reflected in the employment data, with the full extent of job reductions likely to be in the range of 200,000 to 500,000, and an average drag on monthly payrolls of around 10,000 to 15,000 over the next year.

Waiting on pro-business Trump

Progress on the market-friendly aspects of Trump’s policy mix, such as tax cuts and deregulation, has been more limited. We still expect modest fiscal stimulus, worth around 0.5% of GDP. Meanwhile, the energy and financial sectors are likely to continue benefiting from deregulation. However, the administration’s seemingly relaxed attitude to recent equity market weakness highlights that downside growth and upside inflation risks have increased.

We’ve lowered our US GDP forecasts to 1.8% (-0.2 percentage points) for 2025 and 1.8% (-0.4 percentage points) for 2026, respectively, while increasing our CPI inflation forecasts to 2.9% (+0.5 percentage points) for this year.

All this creates a challenging environment for the Federal Reserve (Fed), primarily due to an ongoing debate about the relative impact of tariff increases on growth vs. inflation. We believe the Fed will remain focused on the inflationary effect of higher tariffs and expect just one rate cut this year, likely in September. However, risks are skewed towards more easing.

Is the US economy losing momentum?

Activity

The US economy looks to be losing momentum. Activity data have been weak in early 2025, and business and consumer sentiment have deteriorated sharply in response to tariff threats. Uncertainty over trade policy and disruptions from higher tariffs now look set to provide a deeper drag on consumption and investment this year (Chart 2).

This is likely to lead to slower, as opposed to stalling, growth, with strong household and corporate balance sheets to provide some ballast against policy disruptions. However, the risk of a downturn has increased, especially should tariff rates rise even more than we expect.

Inflation

US inflation is set to remain higher for longer in the face of protectionist trade policy. Indeed, we now expect larger and broader increases in tariffs to drive consumer prices higher this year, absent any large offsetting currency moves or significant corporate margin compression.

There is an active debate about whether tariffs are a growth or inflation shock. We believe the upward impact on the US price level will be more significant than the negative impact on US GDP from Trump’s policy mix.

As such, the slowdown in core personal consumption expenditures inflation is expected to persist into 2025, leaving the year-over-year rate running uncomfortably hot between 2.5% and 3.0%. Risks are tilted towards even higher inflation should tariffs rise more than we expect or due to other aggressive policy action from the new administration, including on immigration and fiscal policy.

Policy

The Fed left interest rates unchanged at its first meeting of 2025 and signaled that it is not in a hurry to cut rates further. Renewed inflation risks from the administration’s policy agenda make the case for a more cautious easing cycle, even amid signs of slowing activity.

The nowcast likely overstates the Q1 pothole, and the front-running of tariffs may mean Q2 growth rebounds. We believe the labor market is the place to look for any underlying slowdown, which we do not think is yet flashing red (Chart 3).

Indeed, we believe the Fed will wait until September to deliver its only cut this year as it seeks to balance competing risks related to its inflation and employment mandates. However, should the central bank start to see signs of distress in the labor market, it would cut rates sooner and by more.

China's easing continues

In China, financial conditions are now the most accommodative they have been since the global financial crisis, and fiscal easing worth between 1.5 and 2.0% of GDP was announced at the Two Sessions. However, while policy rhetoric and action have been more positive, there has been very little announced to address consumption weakness or the headwinds from the property sector.

We believe this easing is enough to deliver growth of around 4.6%, which policymakers can plausibly claim is within the “around 5%” target range. However, the nominal growth environment is likely to remain very weak.

Risks are modestly skewed to the downside, and we continue to see the possibility of a China-balance-sheet-recession scenario if policy fails to respond sufficiently to the considerable headwinds facing the economy. On the other hand, a more aggressive policy stance, where China turns on the policy taps, is also possible.

Europe's spending surge

The Eurozone is on the verge of a significant shift in fiscal policy. The new German government appears likely to deliver constitutional reform, unlocking higher defense spending and public investment.

Bond yields rose sharply on this news, but the combination of higher yields, elevated equity prices, and a stronger euro suggests the market is pricing a growth shock rather than concerns about fiscal sustainability.

We believe these measures will boost GDP growth by 0.5–1.0% over the next few years. There is a scenario, however, where the combination of higher investment spending and structural reforms delivers an even more significant boost to European growth.

A ceasefire deal over Ukraine could prompt a limited resumption of Russian gas flows, also supporting European growth. However, there may be political resistance to the wholesale resumption of gas flows.

With the near-term European growth outlook remaining weak, there is still scope for further European Central Bank (ECB) easing, and we expect rates to fall to 2% this year.

Mixed picture elsewhere

UK spending cuts

In the UK, fiscal policy is set to tighten further, with the chancellor likely to announce spending cuts at the end of March. The Bank of England (BoE) is likely to continue with its quarterly rate-cutting profile. Policymakers will wait to see how the economy responds to the significant cost shock this spring before considering speeding up the pace of easing.

Japan tightening policy further

The Bank of Japan (BoJ) is likely to tighten policy further as wage pressures mount and interest rates are returned to a more neutral stance. We are expecting one further hike this year in October, but earlier tightening is possible.

Emerging markets and tariff uncertainty

Across emerging markets, the rate-cutting cycle will continue cautiously. Mexico, India, and many Southeast Asian economies could be relative beneficiaries from redirected global trade flows if US tariff increases primarily focus on China. However, if a much broader US tariff rises stick, then many of the same economies would face considerable headwinds.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

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