In recent weeks, with the erratic announcements and implementation of the first Trumponomics 2.0 measures, a less favorable wind has been blowing across the US economy, whether it be Main Street or Wall Street. Between rising fears about inflation and growth, how long can the Fed extend the status quo on its policy rates?
The signs of the reversal in financial markets and the negative economic signals have been well documented in our recent publications, and we will not revisit them here. One complementary point, however, is the sudden reappearance of the ‘R’ word – for recession –, even though the negative economic signals are still few and limited. At present, a US recession is only a risk, and it is still a low one. But it marks a dramatic change in mood after many quarters dominated by the outperformance of the US economy.
Much of this is in the hands of American consumers. Most of today’s negative economic signals lie on their side. And while Donald Trump has downplayed the recent correction in equity markets, highlighting that what matters is what is happening on Main Street, the two are closely linked however, in particular through wealth effects. But if household consumption were to be lacking, US growth would lose its main and powerful engine.
Could such a deterioration in Main Street act as a guardrail, instead of Wall Street, and cause Donald Trump to backtrack on his economic policy? This is not clear either based on another statement by the US President, dismissing recession concerns and preparing minds for short-term pain against the supposed long-term gains of his economic policy. It remains to be seen, however, to what extent this statement, like the one on Wall Street, would withstand a more pronounced worsening in the US economic situation and/or stock market indices, should it occur.
At present, there is considerable uncertainty about the US economic outlook. In our view, a stagflation-lite scenario is most likely. It combines, according to our forecasts, a fairly sharp rise in inflation (around 4% by the end of 2025 compared with just under 3% today), a near-stability in the unemployment rate (4.2% at the end of 2025 compared with 4.1% today), but a marked slowdown in real GDP growth (1.2% year-on-year in Q4 2025 compared with 2.5% in Q4 2024).
Under such a scenario, the Fed maintains its policy rates unchanged throughout the year, with downside risks to growth and upside risks to inflation balancing each other. Even if the additional inflation caused by tariff increases remains transitory, inflation will stop moving towards the 2% target. The Fed can hardly look through this development as well as the concomitant risk of a de-anchoring of inflation expectations. And on the growth side, as long as its slowdown remains contained, it does not call for rate cuts. On the other hand, if the risk of recession becomes more tangible, the status quo would likely leave room for new rate cuts. For now, the Fed is defending the status quo, perhaps not as long as we contemplate it (until late 2025), but at least for quite some time. A clear view in an environment that is not. Thank you for your attention today and for watching this new issue of EcoTV.
