Mark Vitner

The world continues to grapple with the rapid policy shifts introduced by the Trump Administration, particularly in the area of trade. From steel and aluminum tariffs to broad-based reciprocal measures against countries that impose duties on U.S. goods, the Administration’s aggressive stance threatens to disrupt global markets, reshape supply chains, and force businesses to alter the way they source and produce products. While some tariffs are intended as short-term negotiating tools, others reflect a broader strategy to reinforce existing trade agreements, such as NAFTA/USMCA, and others seek to restructure the global trading system.

One of the most significant consequences of Trump’s tariffs is their impact on inflation and consumer spending. As tariffs raise the cost of imported goods, businesses often pass these costs on to consumers, driving prices higher. While the overall effect on U.S. inflation in 2025 is expected to be modest, it remains a concern for policymakers and the Federal Reserve, particularly as inflation has already proven more resilient than anticipated. Tariffs could also contribute to inflation by fueling inflation expectations, giving businesses greater flexibility to raise prices. The primary risk is a feedback loop—firms preemptively hike prices, households adjust expectations, and wage pressures build—potentially forcing the Fed to take a more restrictive stance.

We have adjusted our inflation forecast, with tariffs now expected to add between 0.4 and 0.5 percentage points to core inflation this year. While this impact is expected to gradually diminish, the path back to the Fed’s 2% target will be longer-. Higher inflation will also weigh on consumer spending, particularly among middle- and lower-income households. Recent consumer sentiment surveys indicate rising near-term inflation expectations and weaker overall sentiment, with middle- and lower-income households feeling the greatest strain.

U.S. manufacturing is projected to experience modest growth this year as some companies relocate production to the U.S. to circumvent tariffs. The steel industry stands to gain from the 25% tariffs on all imported steel, while aluminum producers may also benefit, though the impact will be limited due to the relatively small number of operating aluminum smelters in the U.S. The broader implications of tariffs are more intricate—higher input costs could negate some of these advantages, particularly for sectors heavily dependent on steel and aluminum. Furthermore, retaliatory tariffs from other nations have the potential to hinder U.S. exports. The economic strain of U.S. trade policies is anticipated to affect Europe, Canada, and Mexico more significantly, although exemptions for essential imports such as aluminum, softwood lumber, and auto parts might alleviate some of the impacts.

We expect U.S. economic growth to slow to a 2% pace in the first half of this year. Imports are likely to exert a modest drag on GDP growth in Q1, as firms front-load shipments ahead of tariff increases. However, some of this impact will be offset by increased inventory building. Additionally, higher long-term interest rates will continue to weigh on home buying and overall spending on big-ticket items. Efforts to curb government spending will also likely lessen the tailwind from the IRA and CHIPS programs driving business fixed investment.

Inflation began the year with higher-than-expected increases in both consumer and wholesale prices for January. The Consumer Price Index (CPI) rose by 0.5%, marking its largest monthly gain since August 2023, while core CPI increased by 0.4%. The Producer Price Index (PPI) also exceeded predictions, with a headline increase of 0.4%. Additionally, annual data revisions indicated that inflation has not decreased as much as previously estimated, raising concerns that the Federal Reserve may maintain higher interest rates for an extended period.

Market expectations have adjusted accordingly, with no anticipated rate cuts through spring and summer and only a slight possibility of one by the end of the year. Some former Federal Reserve officials have even suggested the possibility of a rate hike, though this is considered unlikely. In his February congressional testimony, Fed Chair Jerome Powell confirmed that the central bank is not in a hurry to reduce rates, supporting the view that the federal funds rate will remain above its neutral level well into next year.

The market’s initial response to January’s inflation data may be exaggerated. While inflation is still on a downward trend, the final reduction from 3% to 2% is expected to take longer than the drop from 9.1% to 3%. The post-pandemic unwinding of price spikes, particularly in used cars and gasoline, amplified earlier progress. Moreover, upcoming tariff increases could apply upward pressure on prices, although consumer resistance to price hikes may mitigate the impact, affecting sales and prompting some companies to adjust their pricing strategies. Higher productivity and moderating wage growth are expected to contribute to easing inflation later in the year, creating a more stable environment for businesses and consumers.

Although the notable increases in CPI and PPI sparked concerns, they may exaggerate the potential inflation threat. Seasonal factors likely influenced the January data, as price adjustments for items with infrequent changes tend to cluster at the beginning of the year. Similar patterns have been observed in previous years, driven by one-time factors such as insurance premium resets and wage negotiations from the prior year. These seasonal distortions suggest that progress in reducing inflation is slowing but not halting or reversing. Importantly, the underlying data in the PPI report indicate that the personal consumption expenditures (PCE) deflator—the Federal Reserve’s preferred inflation measure—is unlikely to rise as sharply as CPI and PPI. Furthermore, both median and trimmed-mean CPI continue to trend downward, as do similar measures for the PCE deflator.

The financial markets were further unnerved by unexpectedly poor results from the early January University of Michigan Consumer Sentiment Survey. Consumer sentiment dipped slightly, falling to 73.2 from 74.0 in December, which was only modestly worse than expected. The decline was entirely driven by the expectations component, which fell 3.1 points to its lowest level in six months, reflecting increased concerns over future economic conditions and inflation. In contrast, the current conditions index rose 2.8 points, as low gasoline prices and solid employment conditions continued to bolster perceptions of personal finances.

The divergence between the two indices highlights consumers’ growing worries about inflation and some trepidation about the incoming Trump administration, which promises to unleash significant changes. While earlier progress in slowing inflation had brought some relief, concerns about future price increases—exacerbated by uncertainty surrounding tariffs—dampened sentiment. Year-ahead inflation expectations surged to 3.3%, up from 2.8% in December, marking the highest level since May 2024. Long-term inflation expectations also increased, climbing 0.3 percentage points to 3.3%, the largest monthly increase since May 2021 and the highest level since June 2008.

While the surprisingly large jump in inflation expectations is unnerving, it is important to note that the preliminary Consumer Sentiment data, particularly the inflation components, are often misleading. The more comprehensive data reported at end of the month often reverse early-month swings in inflation expectations entirely. That said, there are ample reasons to believe the uptick in inflation expectations is more genuine than in the past. Progress on reducing inflation has stalled in recent months, and the Fed has acknowledged that the path back to its 2% inflation target is likely to be longer and more uneven than previously anticipated.

Heightened concern about inflation likely reflects recent price hikes at grocery stores, particularly for frequently purchased items such as eggs. The UMich notes that the rise in inflation concerns is evident across various demographic groups, with particularly strong increases among lower-income households and politically Independent-leaning individuals. Combined with added inflationary risks from tariffs, inflation expectations may remain elevated in the near term, giving the Federal Reserve further reason to remain cautious. The Fed places significant emphasis on keeping inflation expectations anchored and will work to discourage consumers from accelerating purchases to stay ahead of anticipated price increases.

Retail sales experienced a significant decline in January, with the headline figure contracting by 0.9% alongside a broad-based pullback across key categories. While adverse weather and seasonal adjustment factors played a role in the reduction, the widespread weakness indicates a softer start to Q1 consumer spending. A major contributing factor was the downturn in auto sales, while discretionary categories—such as sporting goods, furniture, and building materials—witnessed the steepest declines. Additionally, non-store retail sales, primarily online, decreased, prompting questions about whether weather alone was responsible for January’s weakness.

Consumer sentiment has continued to deteriorate in early February, reflecting increasing policy uncertainty. With excess savings largely exhausted, current spending relies more on employment and income growth. Elevated grocery prices and rising insurance costs are likely significant contributors to the decline in sentiment. Consumers’ assessment of current conditions has dropped 6.4 points since December to 68.7, while expectations for future economic conditions—which have a closer link to actual spending—have fallen by 6.0 points to 67.3.

The University of Michigan’s consumer sentiment survey highlights particular weakness among lower-income households. Sentiment for the lowest income tercile has decreased to 64, matching the levels seen during the depths of the Global Financial Crisis. Middle-income households are only slightly more optimistic, with sentiment at 71.3. These figures suggest that economic uncertainty and rising costs are disproportionately affecting consumers with tighter budgets, posing a potential obstacle to discretionary spending.

Despite these concerns, underlying fundamentals support consumer spending in 2025. The unemployment rate remains low at 4%, and weekly jobless claims are near historic lows. Wage growth is robust, and household balance sheets—along with slightly lower interest rates compared to a year ago—should provide some support. Low-rate financing incentives are expected to sustain light vehicle sales and big-ticket spending.

However, financial strength is not evenly distributed across income groups. Rising costs for necessities are disproportionately impacting lower- and middle-income households, putting pressure on discretionary spending. Given these dynamics, we have slightly reduced our estimate for Q1 consumer spending and continue to anticipate a below-consensus gain of just under a 2% annual rate.

An old axiom in economic analysis advises distinguishing between what you think the Fed will do and what you think it should do. In today’s hyperpolarized political climate, this principle is just as relevant when assessing the Trump administration. It is more constructive to focus on what the administration will do rather than what one believes it should do. Another key rule to apply—take Trump seriously, but not literally—meaning the most hyperbolic rhetoric from both Trump and his opposition should be ignored or at least downplayed.

The administration’s priorities include strengthening border security, deporting undocumented migrants convicted of violent crimes, and using tariffs as a policy tool, revenue enhancement, and a means to leverage U.S. market power. DOGE also aims to reduce government waste to curb the deficit and build credibility for any potential future entitlement reform. In foreign affairs, securing strategic shipping chokepoints such as the Panama Canal and Northwest Passage is a focus, alongside recalibrating NATO to reflect post-Cold War realities. Trump has also expressed a desire to broker lasting peace in the Israel-Hamas and Russia-Ukraine conflicts.

The administration’s agenda is advancing rapidly, catching opponents off guard. Tariffs have been implemented faster and more decisively than expected. While Mexico and Canada secured an extension, comprehensive tariffs are set to take effect on March 4 and are expected to remain in place, along with a 25% tariff on steel and aluminum imports. A primary objective is curbing the transshipment of Chinese steel via Canada and Mexico.

Legal challenges against DOGE are likely to prove fleeting, as the administration has utilized the U.S. Digital Service—an agency created under Obama—to execute its plans. DOGE also remains popular with the public. Total savings from DOGE are likely to fall well short of solving the government’s spending crisis and persistent deficits, although DOGE has already proven more effective at uncovering savings than most previous efforts.

Securing peace between Israel and Hamas remains difficult. The Trump administration has resumed arms shipments to Israel, hoping to pressure Hamas into submission. In contrast, a Russia-Ukraine ceasefire appears more plausible. While Ukraine will not join NATO, an increased European military presence and US economic ties would be relied upon to deter renewed Russian aggression. A ceasefire could ease inflationary pressures in Europe and the U.S. and would support economic growth in Europe.

The weaker-than-expected January employment data, higher-than-expected inflation, and a sharp drop in retail sales align well with our below-consensus call for Q1 GDP growth. We noted last month that the Los Angeles wildfires would weigh more heavily on Q1 growth than early consensus estimates suggested. Recoveries from fires and floods tend to take longer than those from hurricanes or earthquakes, delaying any lift from rebuilding. Given the size of Los Angeles’ economy, the disruption is significant enough to impact national data on employment, income, retail sales and manufacturing.

Beyond natural disasters, the uneven distribution of economic strength remains our key concern. Upper-income households are more insulated from inflation due to rising asset prices, while lower-income, asset-light households face increasing pressure from higher costs of essentials like groceries, housing, and transportation. This divergence is contributing to weaker discretionary spending and broader economic uncertainty.

Technical factors will also restrain Q1 growth. Accounting for housing losses will weigh on consumer spending, while inventory building ahead of potential tariffs will boost imports and temporarily inflate inventory levels. Despite slower Q1 growth, the Fed is unlikely to cut rates with unemployment near 4%. However, inflation should continue to decelerate gradually this year, paving the way for a 25-basis-point cut in late spring or early summer. While we still expect two quarter-point cuts this year. The case for a second cut is now less certain.

Policy uncertainty will also restrain business investment. Concerns over tariffs, the Inflation Reduction Act, and the CHIPS Act will weigh on capital spending in the first half of the year. However, as more clarity emerges on trade, taxes, and deregulation, we expect growth to strengthen in the second half of this year.

The start of the New Year was marred by a series of tragic events, casting a pall over the nation’s hopes for a more peaceful and prosperous year. New Year festivities in New Orleans were abruptly shattered when an individual inspired by ISIS drove a vehicle into a crowd of revelers on Bourbon Street, leaving a trail of devastation in its wake. This act of violence, reminiscent of similar attacks in other parts of the world, served as a stark reminder of the ongoing threat of terrorism and raised questions about whether the world will see a revival of ISIS, particularly in the wake of the collapse of the Assad government in Syria.

Following this horrific incident, another shocking event unfolded in Las Vegas, where an explosion involving a Tesla Cybertruck at the Trump Hotel which injured several people and caused minor damage to the entry area of the hotel. While later investigations revealed the explosion to be a suicide rather than a terrorist act, the incident further heightened anxieties and underscored the fragility of safety and security in public spaces. These incidents also raise the prospect of more federal resources going toward combating terrorism at a time that the incoming Trump Administration would like to find ways to trim the federal budget and reduce the deficit.

President-elect Trump’s 2024 election victory was certified by congress without issue on January 6. Recently, Trump has garnered attention with proposals to purchase Greenland, reclaim the Panama Canal, and redefine relations with Canada. While his ambitions regarding Greenland appear grounded in strategic considerations, his positions on Panama and Canada seem aimed at enhancing negotiating leverage. These initiatives reflect a broader focus on countering the growing influence of China and Russia in the Arctic and addressing China’s dominance over key global shipping choke points.

Just as events appeared to be shifting to a more positive track, a series of devastating wildfires erupted across Los Angeles, wreaking havoc on the region. The infernos raged out of control, causing widespread destruction, displacing thousands of residents, and leaving behind a trail of devastation. The latest estimates show at least 24 people have died and more than 12,000 homes, businesses and public structures have been destroyed. Early estimates put the monetary damages at more than $90 billion, only a portion of which is insured. The impact of these fires will undoubtedly be far-reaching, affecting much more than the local economy and families impacted. Part of the runup in bond yields and selloff in the stock market is likely in anticipation of the billions of dollars insurance companies and governments will need to raise to fund recovery and rebuilding efforts.

Despite the inauspicious start to the year, the economy continues to display a great deal of resilience. Early January reports show robust service sector activity, solid holiday spending, and a strong labor market, with 256,000 jobs added in December and unemployment falling to 4.1%. The Atlanta Fed GDPNow projects 2.7% Q4 GDP growth. Our own forecast for Q4 growth is a touch softer at 2.5%.

The December jobs report appears stronger at first glance than it is beneath the surface. The data reflects a resilient but moderating labor market. While nonfarm payrolls surged by 256,000, significantly exceeding expectations, underlying trends suggest employment conditions are decelerating, albeit less sharply than anticipated. The labor market remains tight but is gradually rebalancing.

Payroll growth, though strong and technically broad-based, remains concentrated in just a few sectors. The 1-month diffusion index, measuring the share of industries adding jobs, fell 2.6 points in December to 56.4. While this still indicates broad gains, most job growth stems from health care, social services, leisure and hospitality, retail, restaurants, bars, and government. A sizable proportion of these roles, such as home health aides, staff at medical offices, hospital workers, social workers, restaurant employees, retail clerks, bus drivers, sanitation workers, and maintenance staff, are lower-paying, on-site positions. These essential roles have been difficult to fill, particularly when higher-paying jobs with more flexible work arrangements were more abundant.

The unemployment rate fell to 4.1% from 4.2%, while the underemployment rate also decreased, signaling a tightening labor market. Household employment increased by 478,000 in December, but when adjusted to the same standard as nonfarm payrolls, the rise was only 106,000. The labor force participation rate remained unchanged at 62.5%. Wage growth was modest, rising 0.3% month-over-month and just 3.9% year-over-year. These modest gains reflect compositional shifts, with bulk new jobs in lower-paying occupations, which dampened average hourly earnings. Alternative measures show slightly greater wage pressure.

The market reacted strongly to the unexpectedly robust jobs report, with the 10-Year Treasury yield surging and expectations for a Fed rate cut pushed back to September. We believe this reaction overstates the labor market’s strength. The annual payroll employment revisions will be released with January’s employment report on February 7. We expect these revisions to show about 600,000 fewer jobs added last year than currently reported, based on QCEW and state employment data. However, the revisions primarily affect data from March 2023 to March 2024 and influence estimates for the remainder of the year. Stronger immigration this past year, including the use of temporary work visas, may lead to a smaller revision than expected. If that proves to be the case, the recent tightening in immigration suggests a lower potential growth rate moving forward.

The financial markets were further unnerved by unexpectedly poor results from the early January University of Michigan Consumer Sentiment Survey. Consumer sentiment dipped slightly, falling to 73.2 from 74.0 in December, which was only modestly worse than expected. The decline was entirely driven by the expectations component, which fell 3.1 points to its lowest level in six months, reflecting increased concerns over future economic conditions and inflation. In contrast, the current conditions index rose 2.8 points, as low gasoline prices and solid employment conditions continued to bolster perceptions of personal finances.

The divergence between the two indices highlights consumers’ growing worries about inflation and some trepidation about the incoming Trump administration, which promises to unleash significant changes. While earlier progress in slowing inflation had brought some relief, concerns about future price increases—exacerbated by uncertainty surrounding tariffs—dampened sentiment. Year-ahead inflation expectations surged to 3.3%, up from 2.8% in December, marking the highest level since May 2024. Long-term inflation expectations also increased, climbing 0.3 percentage points to 3.3%, the largest monthly increase since May 2021 and the highest level since June 2008.

While the surprisingly large jump in inflation expectations is unnerving, it is important to note that the preliminary Consumer Sentiment data, particularly the inflation components, are often misleading. The more comprehensive data reported at end of the month often reverse early-month swings in inflation expectations entirely. That said, there are ample reasons to believe the uptick in inflation expectations is more genuine than in the past. Progress on reducing inflation has stalled in recent months, and the Fed has acknowledged that the path back to its 2% inflation target is likely to be longer and more uneven than previously anticipated.

Heightened concern about inflation likely reflects recent price hikes at grocery stores, particularly for frequently purchased items such as eggs. The UMich notes that the rise in inflation concerns is evident across various demographic groups, with particularly strong increases among lower-income households and politically Independent-leaning individuals. Combined with added inflationary risks from tariffs, inflation expectations may remain elevated in the near term, giving the Federal Reserve further reason to remain cautious. The Fed places significant emphasis on keeping inflation expectations anchored and will work to discourage consumers from accelerating purchases to stay ahead of anticipated price increases.

Long-term interest rates have risen steadily since the Fed began reducing its federal funds rate target last September. Initially, the Fed’s half-point rate cut signaled a pivot toward supporting economic growth, even if it meant a longer timeline for achieving its 2% inflation target. While that approach seemed appropriate at the time, stronger employment data and slightly higher-than-expected inflation since the September meeting have complicated the narrative. To address this, the Fed revised its Summary of Economic Projections (SEP), clarifying that it would proceed cautiously with future rate cuts and likely refrain from lowering rates at the January FOMC meeting.

The climb in long-term interest rate accelerated following the stronger than expected employment report, rising to 4.78% – their highest level since November 2023. The yield curve has steepened, with the spread between the 10-Year and 2-Year Treasury widening to 39 basis points. Long-term rates are rising in other developed economies as well, most notably France, the U.K. and Japan, where they threaten to produce an even greater drag on these slower growth economies. The rise in long-term rates is primarily attributed to an increase in the term premium. This premium, which is the compensation investors require for the increased risk associated with holding longer-term bonds, reflects growing concerns about persistent inflation as well as the potential for future economic volatility.

The rise in long-term interest rates has disrupted the stock market rally, particularly for high-growth tech stocks with elevated or infinite price-to-earnings ratios, a trend that became evident when the 10-year Treasury yield surpassed 4.50%. While earnings season may provide temporary support, the Nasdaq—home to many high P/E stocks—will likely remain under pressure until the yield falls below 4.50%, which we expect by spring. Sharp increases in long-term rates typically slow economic activity, prompting rates to retreat.

Higher interest rates are already significantly affecting the most rate-sensitive sector of the economy: housing. Mortgage rates above 7% have dampened demand, which was already constrained by limited inventory. However, new home inventories are rising, particularly in the South. The weakness in housing is reverberating throughout the economy, reducing demand for furniture, home furnishings, appliances, and other household-related services. We look for mortgage rates to pull back this spring as banks increase mortgage lending efforts.

The steady rise in long-term interest rates has become an early defining economic theme this year, driven by heightened uncertainty and rising term premiums. Much of this uncertainty stems from Donald Trump’s political return and his disruptive rhetoric, including post-election threats of steep tariffs on allies and competitors. His use of tariffs as leverage for trade, immigration, and security negotiations adds tension, particularly with global responses remaining unclear.

At the time of writing, there are credible reports promising negotiations involving the Biden Administration, Trump’s team, Hamas, and Israel to resolve the conflict and secure hostage releases. A successful resolution could enhance Trump’s credibility and pave the way for a Ukraine deal. However, any deal with Russia must include credible security guarantees—such as EU and NATO membership for Ukraine—to prevent future aggression. Weak agreements risk emboldening adversaries like China, Russia, Iran, and non-state actors.

Global conflicts are not the primary force behind rising bond yields. In the U.S., yields have climbed as the Fed prioritizes labor market support over a swift return to its 2% inflation target. A soft landing seems unlikely given ongoing fiscal stimulus from the IRA, CHIPS Act, and Infrastructure Bill. Rebuilding efforts in the South after this past fall’s hurricanes and in Southern California following the ongoing wildfires will further strain federal budgets, raising concerns about persistent deficits.

The prospect of new governments in Canada, the U.K., Germany, France, and Australia introduces additional global uncertainty. Policy changes in these nations are likely to mirror U.S. trends, as leaders aim to ensure workers receive a greater share of economic gains amid globalization and advancements in technologies like AI.

Long-term rates are settling into a new normal. Since 1990, the 10-year Treasury yield has averaged 4.26%, reflecting periods of quantitative easing and ultra-low rates, while the broader average since 1960 is 5.84%, influenced by past inflationary spikes. Policymakers are unlikely to repeat the mistakes of the 1970s, but rates are expected to stay within this range (4.26% to 5.84%) as long as inflation exceeds 2% and the economy maintains solid growth. Upside risks could materialize in 2025, driven by a surge in mergers and acquisitions alongside the Treasury’s need to refinance trillions in debt.

We have raised our estimate for fourth-quarter real GDP growth, reflecting stronger-than-expected economic data. Hiring accelerated in Q4, and holiday sales exceeded consensus estimates. However, higher interest rates continue to weigh on the economy, particularly in the already stretched housing market, where mortgage rates have climbed above 7%. Recent natural disasters, including Hurricane Helene in the Florida, Georgia and the Carolinas and wildfires in Southern California, will exacerbate housing pressures. Asheville, which already had one of the nation’s tightest housing markets, and Southern California are expected to see increased demand for residential rentals as displaced residents and firms seek housing. This rental pressure, especially in major markets like Los Angeles, presents another obstacle to the Fed achieving its 2% inflation target.

The disasters are also expected to dampen U.S. economic activity in the near term. Los Angeles County, home to 9.6 million people, and would rank as the 11^th most populous state. Los Angeles accounts for 25% of California’s GDP and 3.5% of national GDP. Its $800 billion economy driven by high-value industries like aerospace, pharmaceuticals, IT, and entertainment, would rank as the 5th largest U.S. state by GDP, behind California, Texas, Florida and Illinois. While hurricanes and wildfires will weigh on growth in early 2025, rebuilding efforts are projected to boost economic activity in the second half of 2025 and into 2026.

We also anticipate the economy will gradually adapt to higher interest rates. The incoming Trump Administration will likely usher in a new wave of deregulation, make prior tax cuts permanent, and ease the state and local tax deduction cap. The creation of the Department of Government Efficiency (DOGE) is expected to achieve meaningful discretionary spending cuts over the next two years. These efforts, though limited without entitlement reform, may enable broader progress at addressing the budget deficit in later years.