Monetary Policy & Inflation | US
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Summary
- Last week’s US-China deal has lowered tariffs but only dented policy uncertainty, which remains exceptional. As a result, I have lowered my probabilities of recession.
- There are early signs the tariff impact could be more benign than I expected. April CPI was below expectations largely due to still low tariffs, implementation lags, intermediaries absorbing the tariffs, low energy prices and demand weaknesses.
- Going forward, confidence is unlikely to get restored, which will keep spending weak and dampen any second-round effects from the tariffs while low energy prices will contain inflation expectations.
Market Implications
- I now expect two-three 2025 Fed cuts, against markets pricing two.
China-US Deal Lowers Recession and Inflation Risks
Following the US-China deal, I have raised the probability of the good macro scenario (i.e., self-correcting demand weaknesses) and lowered that of a recession (Table 1).
The US and China agreed to lower tariffs on each other by 115ppt for 90 days effective 14 May. This lowers tariffs on imports from China from 145%, a de facto embargo, to 30% (still very high). As a result, the US average effective tariff (AET) is now about 18% from previously about 28%.
This reduces recession risks as it:
1. Lowers the hit to inflation and household real incomes.
2. Lowers the risk of a manufacturing recession.
What the deal did not do is fundamentally change policy uncertainty (Chart 1). The unilateral imposition of tariffs on 2 April has shown the US no longer feels bound by international rules but rather rules that can be changed largely based on President Trump’s personal wishes.
The unprecedented surge in uncertainty has seen private sector confidence collapse, which is likely to cause lower business and consumer spending (Chart 2). Hard data showing this is not yet available. Q1 GDP covered the pre-2-April period. Furthermore, April’s NFP survey was run during 12-16 April, which did not give enough time to employers to react to policy uncertainty. Today’s retail sales will likely represent the first sign of spending weaknesses.
The US-China deal only marginally lowers the risk of a Treasury funding crisis, which reflects a loss of safe haven status by the Treasury market and uncertainty on fiscal consolidation.
I have also changed my view on inflation risks under the good scenario.
Limited Tariff Passthrough So Far
April was the first month of significant tariff increases. Yet CPI surprised on the downside (Inflation Monitor Charts 3 and 4).
I think this reflects four factors:
First, even though April AET nearly doubled to about 4.5%, they remain much lower than the Trump administration goal of 18%, which reflects implementation lags.
Second, exporters, importers, wholesalers and retailers have been absorbing the tariffs through margin compression. This can be seen, for instance, in the slowdown in import prices and the flattening of the goods inflation uptrend (Chart 5).
Third, demand weaknesses are helping contain prices. For instance, supercore inflation has slowed markedly since end-2024, which largely reflects steep cuts in airfares. In April, those were down 11% relative to December (Chart 6). By contrast, passenger numbers have remained at the same level as a year ago (Chart 7). This suggests airlines have had to cut airfares to maintain traffic.
Fourth, nominal wage growth has been slowing, which has been facilitated by falling energy prices and slowing headline inflation (Chart 8). This has allowed real wage growth to accelerate despite nominal wage disinflation.
Market Consequences
The Fed is concerned by potential second-round effects from the tariffs and de-anchoring of long-term inflation expectations. However, persistent policy uncertainty is likely to keep business and consumer spending weak. This will limit businesses’ pricing power and ensure the tariff-induced increase in the price levels does not become a persistent inflation increase.
Furthermore, long-term market-based expectations have been stable so far (Chart 9). By contrast, survey-based expectations have risen (Chart 10). But energy prices tend to drive the latter, suggesting continued low energy prices would see survey-based inflation expectations follow market-based expectations lower.
Overall, the tariffs’ inflation impact is likely to be less pronounced than I expected. This is largely because of the extreme uncertainty caused by their implementation, which is dampening demand. As a result, I expect the Fed to cut two-three times in 2025, even if the good scenario materialises. The Fed could start cutting in July based on continued spending weaknesses. By contrast, markets are pricing two 2025 cuts and only 30% chance of a cut by July.
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