Change of Call: Fed to Cut 150bp Due to Recession

Summary

• A 2025 recession is likely due to the extraordinary increase in tariffs and policy uncertainty, with the pause in tariffs implementation likely to move the onset to Q2 from Q1.
• The recession is likely to last about three quarters with unemployment increasing by about 2.5ppts.
• I expect the Fed to cut as the recession will contain the second-round effects from the tariffs.
• Because of higher inflation, this time the Fed is unlikely to hit the zero bound on the policy rate. It could still expand its balance sheet, but this would be in response to financial market instability rather than providing stimulus to the real US economy.

Market Implications

• I am changing my Fed call to about six cuts, most of them in 2025, from previously one 2025 cut.

First Ever Policy Uncertainty-Driven Recession

For the first time since the pandemic, I am calling for a recession. The reasons are twofold.

First and foremost, markets are experiencing a systemic breakdown, with the dissolution of the global rules-based order. So far, the breakdown has been in the goods markets, but the global services and capital markets are likely next.

The US and world trade policies are now based on President Trump’s personal decisions rather than on a globally agreed upon set of rules. This has introduced unprecedented uncertainty that will be difficult to reverse (Chart 1). The compact between government and markets has been broken and restoring confidence will take time. This is a bigger loss of confidence than I initially assessed and that is why my base case is now a recession.

Uncertainty has a negative impact on HH and businesses spending and this time is likely high enough to trigger a recession (Chart 2).

The ongoing consumption slowdown shows this, largely due to an uncertainty-driven increase in the savings rate (Chart 3). By contrast, up to now, real income growth has remained close to trend. Similarly, business surveys indicate higher uncertainty that is likely cause a slowdown in investment and hiring.

The second recession driver is the tariff increase. The US average effective tariff rate has increased to about 22%, from 2% in 2024. This increase is about three times as large as the Smoot-Hawley tariff increase of 1930. It is likely to hit growth through two channels, a decline in real wages and a manufacturing recession.

The first round effect of the tariff increase is likely to lift inflation by about 1ppt, based on a 10% share of imports in consumption and on importers, retailers and wholesalers ‘eating’ about half of the tariff increase. Also, risk exists of second round effects with US-based producers taking advantage of the higher prices of imported goods to raise their own, and/or wages rising to offset the loss of purchasing power. However, wages adjust more slowly than prices, and the initial impact of tariffs will be to lower real wages, which will weaken consumption further (Chart 4).

Additionally, given the massive increase in the costs of imported inputs, a manufacturing recession is likely since manufacturing is the economy’s most import intensive sector and is currently set to bear the brunt of US trading partners’ retaliation. Furthermore, the complex nature of the new tariff schedule and the repeated policy turnarounds are likely to cause goods shortages, a further hit to the manufacturing sector.

Trump’s announcement of a three-month pause on reciprocal tariffs does not change my view as:

1. The announcement adds to policy uncertainty.
2. It is a tactical pause rather than a change of strategy.
3. Any surge in goods purchases ahead of the tariffs is likely to be offset by a corresponding decrease in purchases once the tariffs are implemented.

However, the impact of the reprieve could move the onset of the recession to Q2 from Q1.

If my prediction is correct, this will be the first US recession triggered by policy uncertainty. Either policy tightening or private balance sheets weaknesses have previously triggered recessions.

Recession of Median Severity

My base case scenario for the forthcoming recession is nearer the median of US recessions during 1960-2020 rather than the protracted recessions of the early 1980s or to the GFC (Table 1 and Chart 5). This is because the Fed has much more credibility than in the early 1980s and because private sector balance sheets are stronger than before the GFC (I am defining a recession as two consecutive quarters of negative final sales growth, where final sales is GDP excluding net exports and inventories changes. This is to sidestep the large negative net exports contribution to growth caused by tariff frontrunning in Q1 that is likely to reverse in Q2).

Also, because manufacturing is likely to get hit harder than services, I am assuming a deeper contraction in capex (= non-residential investment) that comes mainly from the manufacturing sector, than in the typical recession.

Regarding the Fed’s reaction, I provide two alternative scenarios, worse and better. The better scenario is based on Trump committing credibly to a gradual and predictable tariff implementation. In such an instance, the hit to the economy would be limited to the manufacturing sector and the economy would contract for only one quarter. This is unlikely but is illustrative.

In the worse scenario, the downturn is deeper and lasts longer due to worse policies, as well as to bond market instability. While the private sector has continued to deleverage, the government sector is re-leveraging (Chart 6). Together with Trump unpredictability undermining market confidence, this creates upside risks for yields and downside risks for the economy, especially for interest rate sensitive demand components, such as residential investment.

Fed to Ease in Response to Recession

As Chair Powell made clear in his latest speech, the Fed’s overarching objective is to preserve its credibility. The Fed could still ease more than currently priced in.

FOMC speakers have made clear they can tolerate a rise in inflation expectations but do not want long-term inflation expectations to de-anchor. Therefore, their key indicator is the 5y5y BE rate (Chart 7).

Furthermore, the Fed is prepared to look through the first-round inflation impact of the tariffs, but not the second-round impact. This likely reflects inflation being above target for four years. A persistent further increase would risk de-anchoring long-term expectations.

However, the magnitude of the second-round effects depends on businesses pricing power, which in turn depends on growth and resource pressures. In the better scenario for instance, the second-round impact of the tariffs would be substantial and the Fed would likely not ease, or at most once, symbolically (Table 2).

By contrast, in the worse scenario, the deep recession would limit businesses pricing power, and second round effects would likely be small. Here, the Fed could look through the tariffs and focus entirely on unemployment. In this scenario, the Fed could cut about 300 bp. This is based on the 2000s, when unemployment of around 8% led to the Fed establishing a real FFR around -150bp (Chart 8). With the Fed looking through the tariff impact, this would translate in a nominal FFR of 1.3% (i.e., 300bp lower than currently).

However, by contrast with the 2000s, and due to higher inflation, the Fed would not hit the zero bound on the policy rate and therefore would not have to rely on quantitative easing (QE).

It does not mean the Fed would not expand its balance sheet. For instance, risk of Treasury market instability is substantial and may require the Fed to provide substantial liquidity injections. But these would be aimed at stabilizing financial markets, rather than providing policy support to the real economy. Overall, this makes for a recovery less supportive of financial assets than under QE.

In practice, the economy is likely to be in between these two scenarios, hence my expectation of a 150bp cut. Since the recession would last three quarters, most of the Fed cuts would happen in 2025 rather than 2026.

What to Watch for?

How do we know which scenario the economy is in?

The more reliable quantitative indicators, the OECD and the Conference Board indicators show the current cycle is peaking (Chart 9).

Key macro variables likely to signal a recession:

• Weak business and consumer confidence.
• Labour market signals growing slack. Initial jobless claims above 400k; sharp pick up in unemployment (the non-linearity identified by Sahm’s rule).
• Consumption indicators are likely to be biased over the next few months by tariffs frontrunning. Therefore, services consumption could be a more reliable indicator of underlying demand strength than goods consumption (Chart 10).
• Lack of second round inflation effects would also signal a weak economy.
• Job losses outside the manufacturing sector.

Market Consequences

My base case scenario is for a recession starting in Q2 and lasting about three quarters, with the Fed cutting interests rate by about 150bp, mostly in 2025. This compares with markets pricing three 2025 cuts and one 2026 cut.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs. You are not permitted to publish, transmit, or otherwise reproduce this information, in whole or in part, in any format to any third party without the express written consent of Macro Hive. This includes providing or reproducing this information, in whole or in part, as a prompt.)