Macro Consensus Is Inconsistent

Summary

• The macro consensus assumes benign inflation and unemployment, which seems inconsistent with the large tariffs supply shock.
• The consensus seems overoptimistic on trade and fiscal policies, which carry downside growth risks.
• Weak growth will limit second-round effects from the tariffs, allowing the Fed to focus on employment weakness.
• The unemployment trajectory I expect suggests a July Fed cut as risk management.

Market Implications

• I still expect two-three 2025 Fed cuts against markets pricing 2.2.

Inconsistent Consensus Forecast

Here, I argue the consensus soft landing forecast is inconsistent with the large tariff shock the US is experiencing. Either consensus growth is too high, or consensus inflation is too low. I believe the former is more likely because consensus underestimates growth risks from tariffs and fiscal policies.

Economists as well as betting and financial markets have converged on the following soft-landing scenario. Here, inflation would peak around 3% and unemployment around 4.5% at end-2025, declining thereafter (Table 1). Betting and financial markets see risk of a 2025 recession around 30%. This scenario includes two ‘goods news’ Fed cuts and is based on expectations of no further large increases in tariffs and expansionary fiscal policy.

Table 1: 1/FFR OIS-based; CPI inflation swap based; growth from SPX forward sales expectations; recession risks from yield curve model.

I think the market is too optimistic about tariff and fiscal policy.

Tariff Policy Normalisation Could Take Up to a Year

The consensus on tariff policy is that it is more likely to improve than worsen. For instance, betting markets expect President Trump to extend the suspension of reciprocal tariffs before it expires.

I agree but think it will take time to happen. I also think consensus could be too focused on the level of tariffs and not focused enough on their volatility and unpredictability, which remain high (Chart 1).

How tariffs have been implemented has lifted policy uncertainty to levels consistent with a recession (Chart 2). Despite the recent US-China deal, uncertainty remains high and has triggered a collapse in private confidence (Chart 3). This has raised savings, already apparent in weaker business and consumer spending.

The Trump administration’s policy discretion must be constrained to make tariff policy more predictable. The Court of International Trade’s striking down of the administration’s reliance on the IEEPA is a step in this direction.

The IEEPA afforded full discretion to Trump. If the Court of International Trade ruling is confirmed, the administration must rely on other legal provisions like the 1974 Trade Act or the 1962 Trade Expansion Act. Both laws are slower to implement and can cap the size and duration of tariff increases.

The administration has appealed but the appeals process could take up to a year. The circuit appeals court is likely to rule by end-June (Table 2). If it confirms the International Trade Court’s decision, the administration will appeal to the Supreme Court. The Supreme Court 2024-25 session is almost over; it will not hear arguments until October and tends to make its decisions at the end of its term in June. So the appeals process could take up to a year.

Meanwhile, the Court of International Trade’s ruling is likely to remain stayed. Tariff policy could remain unconstrained for an additional year with negative consequences for growth.

Fiscal policy is also less benign than consensus assumes.

Fiscal Policy: FY2025 Consolidation, FY2026 Expansion

The budget recently passed by the House makes for limited fiscal consolidation in FY2025 and fiscal expansion in FY2026 (Table 3). The Senate has yet to vote on the budget and both chambers have yet to agree a common version. This is unlikely to happen by the administration’s initial target date of 4 July. By end-July is more realistic, before the start of Congress’ summer recess (Table 4).

End-July is also a hard deadline to raise the debt ceiling, a provision included in the budget bill. This is because the US Treasury estimates the x-date (when it runs out of cash) will be in August (Chart 4). And while Trump and Senator Warren have called for a bipartisan bill to abolish the debt ceiling, this is likely unfeasible before the summer recess.

However, signs exist of fiscal consolidation even before the formal budget implementation. The deficit has been increasing more slowly for the past two months (Chart 5). The administration is reviewing external contracts, which have already seen contractors layoff several employees. Also, federal employees laid off or bought out will leave the government’s payroll by autumn. In April, federal employment was down 13k to 2989k from 3002k in February. This compares with an expected reduction in the federal workforce of about 280k. As a result, the 28 July QRS could surprise on the downside (Table 4).

The bottom line is that fiscal policy could detract from growth in 2025, even if it turns expansionary in FY2026.

With high policy uncertainty and fiscal consolidation, 2025 growth is likely to slow further. The consensus forecast is for Q4 GDP growth around 1.5% Q4/Q4. But I see it well below 1%.

Consumption growth slowed to 0.3% QoQ in Q1 and to 0.1% MoM in April. I expect consumption to slow further due to a rising savings rate and slower wage income growth, aligning with labour market softening. Other final demand components, fixed investment and government spending appear unlikely to contribute much to growth either. The residential market is weakening while businesses are postponing investment decisions. And the government is retrenching.

Yet softer demand would support the consensus’ benign inflation view.

Second-Round Effects From Tariffs Unlikely

The swap market expects CPI to peak around 3.3% YoY in Q4 2025-Q1 2026 and decrease thereafter (Chart 6). I see similar for core PCE (roughly 20bp above headline CPI) using a simple model with the following assumptions (Chart 7):

• Baseline inflation of 21bp MoM, the past year’s average.
• Average effective tariff (AET = the ratio of customs duties to goods imports), which was 5.7% in April, rises to 18% (the administration’s current target) over May-July and remains at 18% thereafter.
• Businesses pass on higher tariffs to consumers immediately.
• Consumers absorb only 60% of the tariff increase.
• No second-round effects from the tariff increases (i.e., no increase in non-tariffed goods or services) and no continued increase in tariffed goods prices once the tariffs are implemented.

No second-round effects is the most important since it implies that once tariffs are implemented, inflation returns to its pre-tariff dynamics. On 1 June, Governor Waller convincingly argued why this might be the case. There are five reasons:

• First and foremost, long-term inflation expectations (represented by long-term Bes) remain well-anchored. The rise in survey-based expectations to 6.6% has not impacted wages, which are slowing and below 4%. Meanwhile, survey-based expectations de-anchoring appears to have limited macroeconomic consequences.
• Labour market is softening, and wage inflation is slowing.
• No disruptions to global supply chains and no goods shortages.
• No fiscal impulse.
• Monetary policy is restrictive.

The last four sharply contrast with the pandemic, suggesting limited risk of a repeat of the 2021-22 inflation acceleration.

Waller’s views do not represent FOMC consensus. For instance, many participants are concerned about survey-based expectations de-anchoring. However, the FOMC (and market participants) can ascertain in real time whether Waller’s views are correct. Based on this analysis, I expect he will be vindicated.

With stable long-term expectations and in the absence of second-round effects, the Fed can focus on employment. The growth slowdown I expect is likely to translate into higher unemployment.

Fed to React to Higher Unemployment

In his last presser, Chair Powell stated the Fed would react to unemployment increases and to the speed of the increase. Powell was referring to perhaps the most reliable coincidental recession signal, the nonlinearity in unemployment increases. Most recessions see unemployment increase slowly and then fast (Chart 8). However, the 2023-24 unemployment increase was a benign normalisation of the labour market rather than a prelude to a recession, as I argued at the time.

Nevertheless, an unemployment increase relative to the baseline indicates higher recession risk, the essence of Sahm’s rule. Based on previous patterns, I believe an unemployment increase of about 50bp over the next six months could signal the US is near a fast unemployment increase and recession.

How proactively the Fed would respond to higher unemployment depends on its assessment of inflation risks. For instance, continued low inflation prints, no signs of second-round effects, together with an (e.g.) 20bp increase in unemployment, could see the Fed ease at the 30 July FOMC. A 25bp cut would be for risk management, in response to data showing the balance of risks has shifted towards employment and away from inflation. This analysis suggests such a scenario is plausible.

I expect two-three hikes in 2025. I will update this forecast based on unemployment and inflation developments.

Market Consequences

I still expect a cut at July’s FOMC against markets pricing only a 25% chance. I also expect two-three cuts in 2025 against markets pricing 2.2.

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