U.S. Outlook: Fed Easing to Prevent Recession, but May Also Keep Inflation Above Target

Economy resilient, but labor market slowdown will restrain consumers  

The U.S. economy has slowed, and with employment growth now minimal looks set to slow further. However it does not appear to be on the cusp of recession. A strong 3.3% annualized rise in Q2 GDP needs to be seen alongside a 0.5% decline in Q1, leaving an average of 1.4%, but final sales to private domestic buyers increased by 1.9% in each quarter, suggesting a near potential underlying pace outside tariff-induced volatility in net exports and cuts in government. Business investment has been strong, particularly intellectual property which has been lifted by the spread of artificial intelligence. Consumer spending has lagged behind real disposable income, which grew by 2.5% in Q1 and 3.0% in Q2, albeit supported by some one-time factors. Historical revisions to GDP data due on September 25 do however need to be watched. 

Employment growth through March 2025 has been revised down by 911k, suggesting trend had already fallen below 100k per month by then, and appears to be slowing further with August’s three month average only 29k. However, slowing labor force growth means that the unemployment rate is edging only marginally higher, with the August 2025 rate of 4.3% only marginally above 4.2% seen 12 months before. Initial claims, while having increased recently, remain consistent with limited layoffs. Still, minimal employment growth will restrain consumer spending, particularly if tariffs boost inflation to contain real wage growth. We expect growth in consumer spending to fall to 0.5% annualized in Q4 2025 and Q1 2026, underperforming GDP which we expect to rise by 1.0% in each of those quarters. Fed easing is likely to help growth pick up into the second half of 2026, but a return to 2.0% will be difficult to achieve with limited increases expected in the labor force. We expect GDP to rise by 1.7% in 2025 and 1.4% in 2026 by calendar year, with the Q4/Q4 gains being 1.2% in 2025 and 1.5% in 2026.  

Tariffs to continue a gradual pass through to inflation 

Tariff rates are a little higher than we anticipated in June, though retaliation on US exporters has been mostly modest. The tariff impact on inflation so far has been modest, but visible in goods inflation. Uncertainty remains high with the Supreme Court set to consider an appeals court ruling against Trump’s reciprocal and fentanyl tariffs. While Trump’s claim that trade deficits represented an emergency is a dubious one, we expect the Supreme Court will rule in favor of these tariffs, though we would not rule out the possibility of them seeking some middle ground. If the Supreme Court does rule against these tariffs, Trump has legal means that he could pursue to impose other tariffs, and deals made with various trading partners are likely to stick. Still, one reason tariffs have not been fully passed on to consumers yet is likely to be uncertainty over their eventual magnitude. Continued uncertainty is likely to keep the feed through from tariffs to inflation gradual, though ultimately a substantial pass through will be difficult to avoid. 

We expect annualized growth in core PCE prices above 3.0% in Q3 and Q4 of 2025 and Q1 of 2026. Some slowing is likely after that but we expect the rate to remain above 2.0% even in the second half of 2026, and with the economy likely to be regaining momentum by then the rate may settle slightly above the Fed’s 2.0% target. This will be the consequence of a less globalized world and tighter immigration controls restricting growth in the labor force. We expect yr/yr growth in core PCE prices of 3.1% in Q4 of 2025 and Q1 and Q2 of 2026, before a slowing to 2.6% in Q4 2026. We expect core PCE prices to average 2.9% in both 2025 and 2026, while CPI rises to 3.0% in 2026 from 2.8% in 2025, though we see CPI at 2.8% yr/yr in Q4 2026, down from 3.2% in Q4 2025.  

Tariffs are providing the government with revenue, which is likely to see budget deficits edging slightly below 6.0% of GDP in 2026 rather than rising to 7.0% of GDP as would have been the case without tariffs under the “Big Beautiful Bill”. That bill will provide support to consumers from tax cuts and most of its spending cuts will be delayed until after the 2026 midterm elections. That tariff revenues look set to be substantial means the eventual pass through to consumer prices will also be, even if it takes time to fully arrive.

Fed policy and political risk

The Fed is weighing upside risks to inflation and downside risks to employment, in an increasingly politically changed environment. Slowing in the labor market has seen easing start, and the pace of future moves will be data-dependent. Should non-farm payrolls turn significantly negative and unemployment rises quickly above 4.5%, the Fed could move aggressively below the neutral 3.0%. However under our soft landing view, in which payroll growth is near flat and unemployment gains limited, the Fed is likely to move gradually, particularly if inflation is lifted by tariffs, as the neutral rate gets closer. The latest Fed dots suggest two more 25bps moves this year, in October and December,  but if inflation remains firm with payrolls near neutral a pause may be seen in Q1 2026. We expect two  moves in 2026, in Q2 and Q3, once inflation moves off its highs. That would take the Fed Funds target range to 3.0-3.25%, close to where the Fed currently sees neutral. This may be a little lower than appropriate if the Fed fails to return inflation to the 2.0% target. 

Jerome Powell’s term as Fed Chairman, though not as Governor, ends in May 2026 and Trump is certain to replace him with someone more dovish. If Trump selects a Fed insider, with Governor Christopher Waller the most likely choice, we doubt easing as rapid as Trump would wish would be seen in the absence of recession. However should Trump select a less known figure, and that individual is confirmed by the Senate, markets would be right to worry. Still, it will be difficult for Trump to achieve a FOMC voting line up in which the majority follow the President’s wishes rather than their own assessment of what appropriate monetary policy will be. Policy slightly more dovish than appropriate is our expectation. A complete loss of Fed credibility is not. 

Midterm elections in November 2026  look likely to see Democrats regaining control of the House, which will require only a small swing and the election is likely to be seen as a referendum on the Trump administration. However it is unlikely the Democrats will be able take control of the Senate unless the economy falls into recession. The economic consequences of the elections will be moderate, with the Trump economic agenda already in place, and unlikely to be dramatically altered before the elections of 2028 even if Republicans maintain control of Congress in 2026. The elections will however be significant in many other aspects of policy, some of which, notably immigration, would have indirect economic implications. Recession is a significant risk, we estimate at 30%, if weakness in employment leads to a sharp consumer pullback, generating the start of a vicious circle of declining consumption and employment. However, the Fed has the ability to respond to an emerging recession, and it appears likely that the Fed will do at least as much as it needs to keep any recession brief and moderate, potentially cutting the Fed Funds target to 2.0-2.5%. The risk of the Fed doing too much, and sustaining both economic growth and above target inflation is also a significant risk even if the Fed is able to largely sustain its independence.