Where will the US economy be at year end?

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Good morning. China’s services PMI fell to a 7-month low yesterday, adding to evidence that the country is being hammered by waning US demand. Other indices and sub-indices also came in cooler than anticipated in April: construction, manufacturing and, notably, employment. China is in a better political position than the US to withstand the pain tariffs will cause. But its economic position appears to be weakening. Email us: robert.armstrong@ft.com and aiden.reiter@ft.com.  

The economic outlook revisited

A few months ago we made the following matrix of potential year-end outcomes for the US economy and asked readers to place their bets on which quadrant was most likely:

The most popular answer was B, “too hot”, followed closely by D, “stagflation”. But the picture since then has undoubtedly changed. Inflation has come down some, and the extent and severity of Trump’s tariff policies have surprised markets. While earlier this year investors were betting on lower taxes and deregulation powering US growth, fears of a slowdown, or worse, now predominate.

So let’s revise our expectations. Here are the arguments for each of the options, as we see them now:

A: Just right

This seems a bit farfetched as we stare down a trade war with China and the possibility of high global tariffs in two months when Donald Trump’s “reciprocal” tariff pause ends. But inflation has been moving in the right direction, and the Fed appears to have room to keep rates high. The jobs data has been solid, even with plunging sentiment. The US president may well chicken out on tariffs (because Taco!), or cut reasonable trade deals. And tax cuts and deregulation could keep growth rolling and unemployment low.

B: Too hot

This one also seems less likely than it was in February, but it is still possible. If Trump pushes ahead on tariffs, even at the current levels, that will probably push prices higher. That we have not seen a pick-up in inflation yet appears to be a matter of timing; inventories of pulled-ahead imports will diminish in time, and companies might raise prices preemptively. Omair Sharif at Inflation Insights thinks we will see higher prices in next week’s CPI report, starting with household furnishings.

Tariffs at current levels may cause a slowdown in domestic activity and higher unemployment, but that is not guaranteed. The economy could stay hot if domestic production increases quickly. Clearer and more decisive policy from the White House, even if it includes higher tariffs, could boost business investment and consumption, too — for markets and many businesses, the uncertainty is the killer. But, even if we remain in the dark, there does not have to be a slowdown. “As the April employment report perhaps demonstrated, firms are unlikely to freeze investment and hiring plans entirely just because of uncertainty about future trade policy,” says Stephen Brown at Capital Economics.

And, for somewhat technical reasons, unemployment could stay low even if the economy slowed down. As both Sharif and Brown note to Unhedged, immigration flows are low and set to get lower still. That means the labour force will grow more slowly and the US will need to add fewer jobs each month to keep unemployment from rising sharply.

C: Too cold

This option appears more likely than it did in February. Consumers, analysts and economists have started betting that the US economy will slow down this year. Tariffs or uncertainty could bog down consumption by so much that the price impacts of tariffs are minimal. 

There are obstacles, however. If Trump keeps backing down on tariffs, there will probably not be too big a hit to US consumers — who have continued to spend heavily. And if he ratchets up, there will probably be an even bigger price flow-through. Also, if prices remain restrained and the economy slows down considerably, the Fed will have room to cut, which can boost domestic activity and potentially put us back in the “just right” camp. 

As Manoj Pradhan at Talking Heads Macro points out to us, there is also the possibility that a slowdown combined with low migration pushes prices higher, not lower:

If labour supply and demand net out, though that could keep the unemployment rate steady, that implies higher wage growth, which translates to higher services inflation . . . [Combining that with] lower capex implies that potential growth will be subdued, which would mean a less negative output gap — keeping inflation from falling too much. 

D: Stagflation

Every analyst we asked thinks this is the most likely outcome. We agree. Tariffs at the current levels will slow growth and raise prices. US consumers — particularly rich ones, who account for the majority of consumption — still have a decent financial cushion, so a slowdown might not kill inflation. Indeed, higher prices may be coming.

A slowdown is looking increasingly likely, too. While a big increase in the unemployment rate could be prevented by slower growth in the labour force, most of the analysts we spoke to still expect that unemployment will go as high as 4.8 per cent. And, though the economy has remained solid, there are worrying storm clouds on the horizon: durables purchases have bottomed out, manufacturers and service providers are seeing price rises and trade with China is already slowing, according to shipping data. 

One of the worst features of stagflation is it puts the Fed in a dilemma: if inflation remains too high, they can’t cut rates to protect employment. That leaves fiscal policy as the final wild card, and the last potential solution besides walking back the tariffs. As of now, it looks like Trump’s budget will increase the deficit, but will do so by less than its predecessors; the level of fiscal stimulus will be somewhat diminished. But that might change, should a pronounced slowdown make the bond market and Republican budget hawks more accommodating.

In the comments or by email, please write to us with your prediction (A, B, C or D), how sure you are, and why.

One good read

Sonora, Mexico, is a root beer town. 

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