Bracing for impact

Summary

• We have updated our baseline forecasts to reflect the recent de-escalation in the tariff war between the US and China. We now expect a shallow recession starting in Q3 and the Fed to cut in September.
• However, the risks to our baseline are large, given the unpredictability of the trade war.
• In addition, there are risks from fiscal policy and monetary policy. The possible failure of the “one big beautiful bill” could cause a fiscal cliff at the end of the year that would have a negative impact on economic growth and inflation. In contrast, the conceivable loss of Fed independence would have an upward impact on growth and inflation.

Introduction

Last month, after running a range of trade war scenarios in a global macroeconometric model, we concluded that the probability of a recession in the US was larger than 50% (for details about the scenarios and the simulation outcomes, see A Tariff-Induced Recession?). In each scenario, the US economy contracted in Q3. Therefore, our recession forecast seems robust to a wide range of scenarios. The same is true for the rebound in inflation and the rise in unemployment. However, the depth and length of the recession depends on which scenario materializes.

Trade war de-escalation?

Trade negotiations are still in a state of flux, but there has been some notable de-escalation in tensions between China and the US. On May 12, this led to a 90-day delay in bilateral tariff hikes, reducing the additional US tariffs on Chinese imports from 125% to 10%. While our baseline economic forecasts were based on what we called scenario 1+ and 2+, with the plus indicating an escalation between the US and China, it now seems more likely that scenario 1 (“Negotiation”) and 2 (“Implementation”) will unfold, again with different outcomes for different countries. Our new baseline forecasts, which also incorporate more recent data and insights, are shown in table 1.

We still expect a recession, but a more shallow and shorter one than in last month’s forecasts. We think it will be shorter, because of a later start and an earlier end. This also means that we have become more optimistic about near-term data, which is also supported by the most recent data, and therefore we have also adjusted our Fed policy rate forecasts. In particular, we have moved our forecast of a rate cut of 25 bps from June to September. However, we still expect only a single rate cut, assuming that the FOMC will be torn between the two legs of its dual mandate once employment growth slows down and inflation rebounds. In contrast, markets are currently pricing in two rate cuts in 2025. Of course, trade negotiations could still re-escalate or they could lead to mutually beneficial outcomes. Next month we could have a different trade war scenario as our baseline. However, as we stressed in A Tariff-Induced Recession? all scenarios we considered led to negative GDP growth in Q3, a rebound in inflation and a rise in unemployment. So that forecast seems robust to a range of trade war outcomes. Therefore, we still think that the probability of a recession is higher than 50%.

One big beautiful bill or fiscal cliff?

While we looked at a range of trade war scenarios, to keep the analysis manageable, we kept our assumptions on fiscal and monetary policy constant. Starting with fiscal policy, the House of Representatives passed their version of what has become known as the “one big, beautiful bill” on May 22. Now it is up to the Senate to come up with their version. Once both chambers of parliament agree on the text, President Trump can sign it into law. The self-imposed deadline for the Republicans is Independence Day (July 4). Our forecasts – both the baseline and the alternative trade war scenarios – assume that a version of the One Big Beautiful Budget Act of 2025 will be adopted, in particular the extension of the income tax provisions in the Tax Cuts and Jobs Act of 2017. If the bill for some reason fails and we get a fiscal cliff at the end of the year, this would have a negative impact on our baseline forecasts for economic growth and inflation, and an upward impact on unemployment, especially in 2026.

Fed in wait-and-see mode

Turning to monetary policy, we assumed that the Fed can continue to pursue monetary policy independent from interference by President Trump. However, as we flagged a year ago in Trumping the Fed, and more recently in the International Banker magazine, we think that the Fed and Trump are on a collision course. If Trump manages to remove Powell prematurely and/or impose his will on the FOMC, we would surely see more rate cuts than we have assumed in our baseline scenario. This would have an upward impact on our forecasts for GDP growth and inflation and a negative impact on the unemployment rate.

However, for now we assume that Powell and the FOMC are free to pursue their dual mandate as they see fit. This means that they are facing a balancing act between maximum employment and stable prices. The upward impact of the tariffs on unemployment would ask for rate cuts to support economic activity. In contrast, the projected rebound in inflation could require rate hikes to slow down aggregate demand and get inflation under control. The stagflationary impact of tariffs pulls the Fed in two opposite directions. On balance, we think that the Fed will therefore be slow and modest in its reactions. For now, we expect only one rate cut in the second half of the year. The Fed has only limited room to come to the rescue of economic activity, because they also have to maintain their credibility as inflation fighters.

Conclusion

While we have updated our baseline forecasts to reflect the recent de-escalation in the tariff war between the US and China, it is important to realize that there are major risks to our new baseline. The trade war could re-escalate at any time or we may see some unexpected progress in the negotiations. At the same time, the Republicans are trying to pass one big beautiful bill through Congress with small majorities in both chambers of parliament. Meanwhile, the Fed is patiently waiting for these developments to provide some clarity about trade and fiscal policy. At the same time, President Trump is impatient about the rate cuts he wants to see from the Fed. We have summarized the economic impact of trade policy, fiscal policy and monetary policy in table 3.

Note that tariffs are our baseline, while an expiration of the TCJA income provisions and the loss
of Fed independence are risks that have opposite effects on the baseline outcomes. In these times of extreme policy uncertainty, understanding the economic impact of the key risks may be helpful.