Is the U.S. economy headed for a recession? Our chief economist says it’s likely.

Simultaneous shocks to consumer sentiment, corporate confidence, trade and financial markets as well as to prices, new orders and the labor market will tip the economy into recession in the current quarter.

We have increased our recession probability to 55% over the next 12 months.

While we think there is still time for the executive branch to limit the damage from the new tariff regime, it is too late to prevent the economy from slowing to a crawl. After all, a 25% effective tariff rate and the new 10% minimum tax on imported goods are tantamount to a $410 billion per year consumption tax on businesses and households.

It is important to note that further tariffs, implementation challenges or actions that result in further tightening of financial conditions will cause a much deeper downturn.

The economic story taking place is a classic one. A policy shock involving a significant increase in tariffs is causing an increase in costs for businesses. The inability to quickly adjust will result in firms accepting thinner profit margins, reducing outlays on capital expenditures and hiring fewer workers.

In turn, a contraction in capital expenditures, rising unemployment and falling real wages will curtail spending. The increase in inflation will cause personal disposable income growth to turn negative in the current quarter and remain there into next year.

In addition, because of the recent plunge in equity prices, the negative wealth effect will cause higher-income households to reduce their spending. This dynamic provides downside risk to our forecast and could result in a deeper and longer recession than presented in our core baseline scenario.

With manufacturers now contending with elevated inventory-sales ratios, the coming downturn will look like a garden-variety, inventory-led recession that will require the Federal Reserve to cut interest rates and Congress to approve tax cuts to put a floor under the economy.

Inventory-sales ratios for motor vehicles and parts, machinery, equipment, and lumber and construction equipment are significantly higher than normal and are where policymakers should look for signs of stress in the real economy, amid the compression of profit margins and rising unemployment.

Baseline scenario

The imposition of global tariffs on April 9 is the point of no return, marking the shift from a slow-growth economy to an outright end to the business cycle. The imposition of tariffs on U.S. trade partners is the policy tipping point at which we now expect a recession that should last approximately nine months. 

Recession is our base case for this year, in which we expect the economy to contract by 0.8% in the first quarter, 1.2% in the second and 0.5% in the third.

We are updating our call on the 10-year Treasury and expect it to average 3.75% in the current quarter and 3% in the second half of the year.

While falling rates will spur a refinancing boom in the housing sector, they will not be sufficient to offset falling real wages.

Until risk aversion abates and banks increase lending, the real economy will not benefit from lower real and nominal rates until later this year or early next year.

Our forecast implies an increase in the unemployment rate to 5.5% by the end of the year. We also expect the personal consumption expenditures price index, the Fed’s preferred gauge of inflation, to reach 4% and the PCE core index, which excludes the more volatile food and energy components, to hit 4.5% over the next 60 to 90 days.

Stabilization policy

The playbook for asymmetric trade shocks calls for aggressive action by the central bank. Our core baseline scenario anticipates inflation and unemployment simultaneously rising in a way that places pressure on the Fed to fulfill its dual mandate of maximum sustainable employment and price stability.

Under such conditions, we anticipate the Fed will lean in the direction of price stability and will not cut rates in May or June save a disruption to financial markets or real cracks in the domestic labor market.

Absent such casus belli, the Fed will not be able to mitigate the decline in economic activity and will most likely be late with its accommodation. At this point, we do not see an opportunity to cut rates until the second half of the year.

Once rate cuts begin, we expect the Fed to bring its policy rate down from the current range between 4.25% and 4.5% to, eventually, a cyclical low of 3% to 3.25%.

At this time, we would expect 25 basis-point rate cuts at every meeting of the Federal Open Market Committee until the policy rate reaches that target.

Should financial markets face further dysfunction or an unemployment surge, we anticipate the Fed would cut rates by 50 basis points at the first available opportunity.

Despite the recent market gyrations, the Fed is unlikely to intervene to restore the capital markets’ smooth functioning.

When the American economy goes into recession, it tends to fall off a cliff rather than slowly drift into contraction. It is typically an inventory correction, oil shock or other kind of shock that causes a recession.

The proximate cause for a recession this year is a new trade regime that has been rapidly implemented without time for adequate preparation of U.S. business and households.

 For the first time since Federal Reserve Chairman Paul Volcker jacked up interest rates to near 20% more than 40 years ago, the U.S. economy faces a policy-induced recession.

We expect that by the end of the year, the National Bureau of Economic Research will identify the trade shock as the origin of the contraction that will start in the current quarter.

Alternative to the baseline: ‘Vibecession’ returns

In our alternative scenario, the economy experiences more of a slowdown in growth and avoids an outright recession. Call it a vibecession, when things just seem off. Under this scenario:

• The impact of tariffs causes inflation to peak at 3% in the second quarter, with growth negative in the second quarter.
• The economy experiences two consecutive quarters of negative growth but no recession because it should bounce back as the Fed cuts rates.
• The economy remains at risk of a recession into the first half of next year.
• The Fed remains cautious because of elevated inflation, and consumers feel as if the economy is in recession.
• Labor slack develops by the end of the year.
• Potential tax cuts and Fed rate cuts push the economy back on growing track by the end of the year. 

The takeaway

The new administration’s objective to rework the global trading system has resulted in a trade and financial shock that is causing a pullback in new orders and loss of consumer and corporate confidence.

The price shock that will show up in the hard data in the current quarter should keep the Fed from reducing rates until it is convinced that the tariffs led to a one-time spike in prices that is easing.

Should the new trade regime result in an escalating trade war and rising inflation expectations, the Fed will be put in an impossible position of having to remain on the sidelines and even consider the possibility of hiking rates to restore price stability.

That would result in a deeper recession than we are currently forecasting. We will have a clearer picture before the end of the summer.