U.S. Quarterly Economic Forecast

Dramatic policy shifts in Washington continue to drive the narrative underlying the global economic outlook. It has been a wild ride since our March forecast, with the Liberation Day tariffs initially proving to be far higher than expected, only to be delayed. It remains highly uncertain what path U.S. tariff policy will take, the biggest wildcard in our forecast. Our global outlook is based on an assumed path for U.S. tariffs that balances the likelihood for tariff deals, with the administration’s desire to raise revenue and encourage onshoring of manufacturing in key industries. 

Since March, we have learned that even when a country like the UK gets a trade “deal” (see report), the 10% “reciprocal” tariff was not lifted. Combine that with additional sectoral tariffs coming down the pipeline via section 232 investigations, leaving the effective U.S. tariff rate higher than our last forecast (Chart 1). This has led to a downgrade to our U.S. growth outlook to 1.7% this year, before improving to a 2.1% pace next year, boosted by tax cuts. 

The world economy continues to soften, downshifting from 3.2% in 2024 to 3% this year and 2.8% in 2026 as the natural cyclical slowing coincides with the impact of tariffs. Underneath these figures, the markdown in North American growth is largely offset by a stronger start to the year in Europe and Asia. China’s economy is set to cool from 5% last year to 4.6% this year, unaltered from our prior forecast. We continue to expect that the negative impact from U.S. tariffs on Chinese activity will be offset by fiscal or monetary stimulus. 

U.S. Resilience to Be Put to the Test

The U.S. economy has remained remarkably resilient so far, despite the back-and-forth uncertainty on tariff policy. However, in many cases it can be difficult to separate the signals from the noise as tariff policy shifts have contributed to extreme data volatility. Economic growth in the first quarter is a case in point. A very slight contraction was due to a 43% surge in imports, as businesses rushed to ship ahead of tariffs. Growth in final domestic demand, which strips away the impact of trade and inventory building and is thus a truer representation of domestic output, was resilient at 2%. That pace was still a step down from the 3% clip seen last year, but not as bad as the headline suggested. 

That said, caution has crept into consumer behaviour. After a flurry of purchases on vehicles to get ahead of tariff-driven price hikes, auto sales fell back to earth in May. Activity in the housing market is soft, as higher borrowing costs and uncertainty sap demand. Broader consumer spending cooled in April, even though income gains remained healthy. That lifted the personal savings rate to its highest level in a year, suggesting the consumer has more capacity to spend, if the uncertainty cloud lifts. 

Resilient personal income growth has been supported by a job market that has held up better than we expected in our March forecast. Monthly job gains have slowed versus a few months ago, but the unemployment rate has held steady at 4.2% for basically a year now. Wage growth has cooled a bit, but remains above the rate of inflation, keeping consumer purchasing power intact.

Unfortunately, inflation is likely to head higher in the months ahead as tariffs filter through to consumer prices. We expect that sector-specific tariffs will be implemented on pharmaceuticals, semiconductors, lumber, and copper adding to those on autos and steel & aluminum. By the end of the year, we assume that deals will be reached with many of the U.S.’s larger trading partners. China, however, is likely to continue to face a 30% levy, which when combined with sectoral tariffs would leave the U.S. ‘s overall effective rate at 10%. 

The U.S. economy’s resilience is expected to wear a little thin in the second half of this year, when growth slips to a sub-trend pace, and the unemployment rate rises. This will provide the impetus needed for the Fed to finally return to cutting interest rates. By the September FOMC meeting, central bank officials should have greater confidence that the inflationary lift from tariffs is temporary, setting the stage for three quarter-point cuts by year end, and further reductions in 2026 before reaching our estimate of the neutral rate. That should help take longer-term bond yields, and related borrowing costs lower towards the end of the year. That, in turn, would provide a much needed shot in the arm for the housing market, which is expected to be a key contributor to growth next year. 

A factor that is likely to limit the downside in Treasury yields is a higher term premium. Longer-term Treasury yields have risen since March as U.S. plans for deficit-expanding tax cuts have led investors to require more compensation to lend to the U.S. government (Chart 2). The U.S. dollar has also taken a hit, as investors diversify to other parts  of the globe. We don’t think this process is finished, and expect the U.S. dollar to weaken further, particularly against its G7 peers. The final shape of the tax cut bill currently making its way through Congress is another uncertainty in the forecast. Our forecast assumes the TCJA tax cuts are extended, with some additional tax cuts added in. This is unchanged from our view in March and adds between 0.1-0.2 percentage points to U.S. growth next year.