U.S. Price growth has notably cooled since its peak in 2022. The core Personal Consumption Expenditures (PCE) deflator, the Federal Open Market Committee's (FOMC) favored measure of inflation trends, has declined from a high of 5.6% to 2.7% year-over-year. Several key sources of inflationary pressure, particularly an overheated labor market, are beginning to dissipate. Employment costs have only risen by 3.9% over the past year, especially as productivity growth has improved to an average annualized rate of 1.8% this cycle, slightly up from 1.5% during the 2007-2019 period. A further slowdown in shelter inflation is also anticipated, driven by softening market conditions and the delayed impact these conditions have on official housing inflation measures.
Trade Policy Implications
The American president wields significant unilateral power over trade policy changes. During his presidential campaign, Donald Trump pledged to impose a 10% across-the-board tariff on U.S. trading partners, with a staggering 60% tariff on China. Economic research indicates that the majority of the cost of tariffs—a tax on imports—falls on U.S. businesses and consumers. Consequently, the likelihood of higher tariffs makes a return to the Fed's 2% inflation target increasingly improbable over the next year. We project that tariffs will elevate the Q4 rate of core PCE inflation in 2025 by 0.25 to 0.40 percentage points. While the year-over-year rate of core PCE inflation is expected to decrease from 2.8% in the fourth quarter of this year to approximately 2.5% in the spring, we foresee a rebound to 2.6% in the fourth quarter of 2025 due to rising goods prices.
The anticipated inflation surge driven by tariffs in late 2025 will pose challenges for real consumer spending growth, as income gains will not stretch as far. Spending has been bolstered by a resilient labor market that continues to add jobs and where wages and salaries outpace inflation. Although tax relief is expected to be legislated by Congress next year, it may not offset the immediate impact of higher tariffs, as changes to the tax code are unlikely to take effect before 2026. Thus, we predict a slowdown in both real income and real spending growth in 2025, with ongoing economic expansion increasingly reliant on a stable job market. Real income growth is expected to strengthen in 2026 due to the anticipated tax relief.
Higher import duties are likely to cut into company profits, and the risk of retaliatory measures from trading partners could further dampen real GDP growth. We estimate that the U.S. economy will expand by only about 2% in 2025, with some of this moderation attributed to the lingering effects of monetary policy.
Monetary Policy and Economic Growth
The FOMC has reduced the federal funds rate by 100 basis points from its peak, yet it remains above our estimate of the neutral rate—the real interest rate that neither restricts nor stimulates economic activity—as well as the estimates from all FOMC members regarding neutral rates. Furthermore, monetary policy effects are famously delayed. The elevated interest rate environment of the past couple of years has created a thinner pipeline for capital spending projects, which is expected to reduce non-residential expenditures in the coming year.
A rush to import goods ahead of higher tariffs is likely to widen the trade deficit and accelerate inventory accumulation early in the year. Subsequently, we expect real GDP growth to weaken in the second half of 2025 as both export activity and consumer spending growth diminish, resulting in real GDP growth of only 1.3% on a Q4 basis.
Global Economic Interconnections
Chinese authorities have a range of policy responses available to mitigate the effects of new tariffs. These responses may include depreciation of the renminbi by the People's Bank of China to maintain trade competitiveness and rerouting exports through proxy nations to avoid tariffs. However, the effectiveness of these measures could be hampered by a global tariff scenario. In addition, the ongoing challenges within China’s real estate sector and subdued domestic consumption undermine our optimistic view of China’s growth trajectory. Recent policy support from Chinese authorities has lacked substance, leading to a deterioration in financial market sentiment toward China. As sentiment toward China declines, the U.S. dollar may benefit as investors seek safe-haven currencies. A less dovish Federal Reserve, coupled with escalating challenges in China, typically results in depreciation and underperformance of emerging market currencies.
Given its extensive trade ties with the United States, Canada will likely experience a slowdown in economic growth due to tariffs. However, Canada has shifted over the past two decades from a manufacturing-based economy to a more service-oriented one. This diversification may help the Canadian economy maintain a respectable growth rate in 2025. In the United Kingdom, moderate trade connections with the U.S. and expansionary fiscal policies should sustain the growth recovery narrative. Conversely, economies like Australia and New Zealand may face quicker slowdowns due to their ties to China, but the spillover effects on the global economy are expected to be minimal.
Commodity Market Outlook
2024 has proven to be a remarkable year for gold, which has risen by 26% year-to-date, outperforming the S&P 500. Geopolitical events in 2024 have largely stemmed from domestic factors, such as the declaration of martial law in South Korea. However, next year may introduce more significant global risks. Gold hit a record high at the end of October but has wavered since, failing to rally in tandem with other asset classes after Trump's election. Moving into 2025, we maintain a bullish outlook for gold prices, as President-elect Trump's economic policies may trigger inflationary pressures. We predict that gold could surge to $3,000 per ounce at some point next year.
OPEC has revised its oil demand forecast for 2025 downwards for the fifth consecutive month, with the latest adjustment being the most substantial. The organization indicated that downward revisions were made regarding demand from non-OECD countries, including China, India, and other regions in Asia, the Middle East, and Africa. We are not surprised by the downward revision for China, as we have consistently highlighted the structural challenges facing its economy. In the Middle East, while ceasefire negotiations between Hamas and Israel appear to be progressing, we remain cautious about any claims of lasting stability. Current conditions seem relatively stable, which may alleviate concerns about oil supply disruptions in the region. However, renewed tensions could positively impact oil prices. We expect global oil demand to decrease, which could exert downward pressure on oil prices in the long run.
Consumer Spending and Future Projections
Overall, in 2024, inflation is no longer being pulled down by the unwinding of food and energy commodity price spikes that followed Russia’s invasion of Ukraine. Supply chain pressures show no signs of worsening or improvement, resulting in a slower pace of core goods deflation. We do not foresee a significant contraction in real consumer spending next year, but a more moderate growth pace is likely. The inflationary impact of tariff hikes will erode real income growth, particularly affecting lower- and middle-income households that have a higher propensity to spend. With the Federal Reserve expected to ease monetary policy gradually after Trump's return to the White House, the contrast between the slower easing in the U.S. and faster easing from G10 central banks will likely drive our outlook for U.S. dollar strength.
Gold is expected to remain a valuable tool for combating inflation, while our outlook for oil prices may lean bearish. As we transition into 2025, the economic landscape will be shaped by these intricate dynamics, requiring close monitoring of inflation trends, trade policies, and global market conditions.
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