Over the past three years, the US has defied worries that a slump may be imminent – most notably during 2022 and 2023 as the Federal Reserve (Fed) aggressively tightened the monetary screws to curb surging inflation. However, US President Donald Trump’s erratic on-again-off-again approach to anti-growth trade tariffs, combined with a sudden weakening of economic data, has markets asking - is the US economy merely slowing or heading into recession? The worries have badly jarred market confidence and triggered a bout of selling in US equities.
Versus its peak on 19 February, the NASDAQ has fallen by c.13% while the S&P 500 and Dow Jones Industrial Average are down c.9% and c.7%, respectively, over the same period. When markets pull back suddenly, it can create a sense of anxiety and fear about the future that can occasionally become self-fulfilling. But market corrections are normal and healthy. Most are not a precursor to recessions. Because the US economy has been growing at well above its longer-run potential for almost two years (Figure 1), some eventual moderation was inevitable. At the start of the year, we projected a slowdown in US momentum in 2025 and warned that a recession was a risk to watch. We stick by these calls. As our base case, we look for real GDP growth to slow from 2.8% YoY last year to 1.9% in 2025. Risks are tilted to the downside.
Healthcheck – what do the latest data show?
After a long period of outperformance, it is not unusual for expectations to get ahead of fundamentals and for data to eventually surprise to the downside. For now, the downside surprises remain modest – Figure 2. The Conference Board consumer confidence index in February declined to 98.2 from 105.3 in January – Bloomberg consensus had expected 102.5. Real personal spending in January declined by 0.5% MoM, wiping out the 0.5% December rise and exceeding the 0.1% dip expected by consensus. ADP employment gains slowed from 186k in January to 77k in February – well below the 104k expected. The disappointment on the non-farm payrolls data in February (151k versus 160k) was less bad than for the ADP report, but the January number was revised down to 125k from 143k. Other surveys show weakening small business confidence and rising inflation expectations.
Perhaps the more worrying signal has come by way of the Atlanta Fed GDPNow estimate. The model provides a running estimate of current quarter GDP growth based on currently available data. The estimate for Q1 has plunged from a little above 2% annualised a month ago to a 2.4% decline in its latest estimate. But the estimate includes a large one-off factor. The nowcast estimates that real personal consumption expenditures and real gross private domestic investment will grow by 0.4% and 4.8%, respectively, which is consistent with steady growth – but that net exports will strip 3.84 percentage points from the growth rate. What is going on? The answer is that producers are likely ramping up their purchases of foreign inputs in order to front-run tariffs. If this assessment is correct, this effect should unwind over the course of the year after an immediate negative hit.
Still, even with this oddity, the narrative around the US is changing. Whereas the US enjoyed less inflation and more growth in 2023 and 2024, the outlook for this year looks to be more inflation and less growth in response to tariff measures. After growing ultra-positive on the US outlook, markets now have to adjust to the less positive news flow.
Textbook fiscal expansion
Over the past few years, the US has enjoyed almost textbook government debtfuelled expansion. While growth was strong and investors were making outsized returns, few asked whether the underlying dynamics were sustainable. This kind of behaviour can go hand in hand with malinvestment and a distorted view of the balance of risks. My own impression is that, following the Trump election victory, market participants placed much too much emphasis on the pro-growth aspects of his agenda – deregulation and tax cuts – and insufficient weight on the antigrowth tariff measures and plans for spending cuts. Part of what we see in markets now is a more even-handed assessment of risks.
US federal government borrowing reached close to 7% of GDP last year as the unemployment rate hovered around 4%. Never in the US’s post-WW2 history has there been such a large gap between government borrowing and unemployment. But recessionary levels of borrowing at full employment have helped to pump up domestic economic activity and fuel the bubble in stocks. Underpinned by the exceptional performance of top tech stocks, US market capitalisation grew from 150% of GDP in 2019 to 210% late last year. As surging stocks pushed US household net worth to an all-time high, consumers’ inclination to save for a rainy day diminished. Over the course of 2024, the household savings rate slipped from 5.5% to 3.8% - well below the 2010-2019 average of 6.1% (Figure 3).
A self-reinforcing cycle of massive government borrowing, rising stock prices, and consumers spending almost every dollar they earned kept growth well above potential – which the Federal Reserve (Fed) puts at 1.9%. From 4Q19 to 4Q24, personal consumption surged 15%, government spending rose 9% and intellectual property investment leapt 38%. In contrast, exports of goods and services rose by a meagre 6%, housing investment edged up 3% while industry largely moved sideways. Where the US economy looks soft, the situation is comparable to anaemic Europe.
Transitory 2.0 – mind the warning signs
Over the weekend, Trump said that the US economy would go through ‘a period of transition’ in response to his policy measures. Where have we heard that before? ‘Transition’ sounds a lot like ‘transitory’ - which is the description central bankers gave to the initial uptick in inflation in late 2021. As we all know, ‘transitory’ inflation turned out to be structural after all. That mistake badly hurt policymakers’ credibility - and inflation is still not yet fully stable at 2%.
If slowing momentum starts to turn into a genuine slump, Trump may be forced to eat his words too. But he is an economic wildcard. If the equity market rout worsens, it may act as a check and balance on his tariff push.
Besides tariffs, we also need to watch the risk that the US unemployment rate begins to rise suddenly in response to measures to cut the size of the US public sector. Because rising unemployment tends to coincide with weakening household spending and demand, it remains one of the best early indicators that the US could be tipping into recession – Figure 4. Rising unemployment would also add to another amber warning sign that the US economy could be rolling over. Note that the 10-year 3-month Treasuries spread (Figure 5) has turned positive after a period of inversion.
Recession basics
Despite the warning signals, US economic data remain consistent with a moderation in growth, which would be a benign scenario, rather than a genuine hard landing. Market participants will be scrutinising every incoming US data print over the coming weeks – and surprises in either direction could lead to shifts in sentiment and revaluations within and across markets. And against a backdrop of US economic and policy uncertainty, we need to watch out for abrupt losses of confidence.
But in times of uncertainty, it is worth remembering the basics. While growth slowdowns are normal (and inevitable) after a period above-potential growth, it need not follow that a growth slump automatically turns into a recession, even if data turn choppy and negative for a couple of months.
Recessions tend to come after a long period during which an economy has built up excesses that need cleansing. By and large, we do not see such excesses in the US. There are no piles of inventory or too many houses, and measures of private debt and credit are in the safe zone. This suggests that, even if the engines of growth slow or even stall for a while, a recession need not follow. And, if it did, the absence of excesses can help to limit the damage.
What should the Fed do?
Amid slowing US momentum, the likely impact of tariffs on US prices will be a one-off jump in the price level but no persistent inflationary effect. However, because US inflation is not yet fully under control (Figure 6) and tariffs have caused a spike in inflation expectations (Figure 7), the Fed will be cautious of stepping in too quickly with any precautionary rate cuts. After all, if the worries about growth turn out to be overdone, the Fed could risk amplifying longer-run price pressures – setting up for an even bigger hangover down the road.
Last Friday, Fed Chair Jerome Powell said that “despite elevated levels of uncertainty, the US economy continues to be in a good place”, that “sentiment readings have not been a good predictor of consumption growth in recent years”, and that “we do not need to be in a hurry and are well positioned to wait for greater clarity”.
Over the past month, Fed futures markets have added 50 basis points to their expectations for rate cuts in 2025 – market participants now expect 100 basis points of cuts to take the upper limit of the Funds Rate corridor to 3.5% by yearend, with the next cut coming in May. The market does not expect a cut to come at next week’s (19 March) meeting. However, the March meeting will give the Fed an opportunity to provide an updated assessment of the economic and inflation outlook and the balance of risks. Open mouth operations can be highly effective. A strong signal that the Fed is prepared to lean hard against any undue softening in economic activity could encourage an increase in lending and bolster risk-taking in financial markets.
