Tariff-fied

Horror movies are an improbable success: they terrify audiences, but viewers can’t resist the urge to watch. Economists don’t need to seek out scary films; our list of worries is sufficiently frightening. The horror of a looming global trade war is the latest specter keeping us up at night.

The U.S. administration continues to ratchet up tariff talk. The timeline and scope for many of these actions remain uncertain, making the potential economic ramifications difficult to estimate. That said, some of those threats are likely to materialize in the coming weeks. We continue to expect gradual U.S. tariff hikes that would leave room for negotiations. A more modest start will manage the risk of reflation but will still be enough to put a dent on growth in some markets.

Our expectation for the year ahead is for positive but unspectacular growth in major economies. Inflation is encountering a last mile problem in many western centers, so central banks are not committing to a pre-determined path of policy. A trade war could complicate their already-difficult jobs.

Following are our thoughts on how top areas are faring.

United States

The U.S. economy grew 2.3% at an annualized rate in the fourth quarter, for a full-year increase of 2.5%. Gains in consumption and residential investment offset weakness in business investment and inventory accumulation. Unemployment has ticked down to 4.0%; as long as the labor market holds its strength, consumers will continue to underpin growth. But this also means the progress on disinflation will require more patience. We believe the Federal Reserve will wait until September to continue easing interest rates.
A series of significant policy changes from Washington across a number of fronts, from trade to immigration, is starting to sour sentiment among businesses and consumers. The Services Purchasing Managers’ Index fell into contraction for the first time in more than two years in February. Fiscal anxiety is high, with the debt ceiling back in force and funding for government operations approaching expiration in the middle of March. Combined with expiring tax cuts, the legislative work facing Congress is daunting.

Canada

Temporary fiscal stimulus in the form of the federal Goods and Services Tax holiday and looser financial conditions are underpinning activity. But trade policy uncertainty will be a drag on growth from the middle of the year. A tariff battle with the U.S. would essentially mean the end of the United States-Mexico-Canada Agreement and will come down hard on the Canadian economy. The domestic political environment is volatile as the country could go to the polls as early as the spring and the likelihood of a hung parliament is rising.
After cutting rates aggressively last year, the Bank of Canada (BoC) returned to a more gradual pace of easing in January. Given the lack of guidance from last meeting’s statement and the fact that rates are already within its estimated neutral range of 2.25%-3.25%, the BoC is likely remain on hold in the near term. A maximal tariff action by the U.S. could compel the BoC to cut sooner and more deeply.

Eurozone

Eurozone real gross domestic product (GDP) grew 0.1% in the fourth quarter of 2024. Momentum remains weak: Consumption is barely growing, industry is still mired in recession, and the job market is showing signs of loosening. Coupled with the prospect of American tariffs, consumer caution could offset the benefit of easier monetary conditions. We continue to expect sequential cuts from the European Central Bank to 1.75% by mid-summer.
Fiscal issues will remain front and center in Europe, amid pressure on states to ramp up military and economic defenses. Additional spending in these areas will impact public deficits and interest rates. Washington has recently turned its trade policy attention to Europe; as we have written, the potential harm of reciprocal tariffs would be significant.

United Kingdom

The U.K barely avoided a technical recession in the fourth quarter, with real GDP growing 0.1%. Government consumption and inventories provided just enough to overcome stagnation in household consumption and a decline in business investment. Given the risks of large spending cuts and rising external uncertainties, we expect Britain to be stuck in a low-growth rut.
The Bank of England (BoE) cut its policy rate by 25 basis points to 4.5% in February. While two members of the Committee voted in favor of a larger 50 basis point reduction, positive labor market conditions are adding to the central bank’s dilemma. Wage growth remains much higher than the rate that would be consistent with their 2% inflation target. A rise in employers' National Insurance contributions could also add to inflation. We continue to expect the BoE to cut by another 75 basis points this year, leaving the Bank Rate at 3.75% at the end of 2025.

Japan

The Japanese economy ended the year on much stronger footing than expected. Real GDP grew 0.7% in the fourth quarter, with the gains mainly driven by external demand. Even though consumption growth slowed considerably to 0.1% from 0.8% in the prior quarter, the virtuous cycle between income and spending remains in place. Japan is not high on the list of the U.S. administration’s trade concerns, but threats of reciprocal tariffs and a 25% levy on car imports present downside risks.
The prospects of achieving the inflation target and the case for continued policy normalization have risen. We expect the Bank of Japan to hike again this summer, as Shunto wage negotiations are likely to deliver another year of solid income growth. The threat of renewed market turmoil amid a volatile external backdrop could impact the yen, a development which will also factor into plans for rate increases.

China

Though reported fourth quarter 2024 output allowed China to officially hit its “around 5%” growth target exactly, momentum is likely to fade after the first quarter of 2025. The real estate market is already starting to lose steam; home sales and prices fell in January. Local governments are hurting under debt burdens. The economy is highly vulnerable to U.S. trade policies, owing to the size of the bilateral trade deficit and the strategic nature of the nations’ competition.

The tone from Beijing is becoming more supportive for the private sector, but business sentiment is unlikely to rebound anytime soon amid a host of lingering domestic and international challenges. Recent excitement around artificial intelligence is unlikely to deliver a large uplift to growth, given that a large share of workers in China are in occupations that are not easily automatable. We expect growth to decelerate to below 4% by the end of the year.
Consumer price inflation in China improved in January, but was distorted by the timing of the Lunar New Year holiday. The GDP deflator has been in negative territory for seven quarters in a row. Deflationary pressures are likely to persist, given weak domestic demand and excess capacity in some industries. Policymakers are likely to roll out more easing in March’s Two Sessions meeting, but it may underwhelm.

Australia

The Australian economy has been afflicted with a mild form of stagflation. Consumption growth is constrained by stagnant real wages, high interest rates and high consumer debt ratios. But performance is likely to improve in 2025, led by rising real household incomes and a rebounding housing market. Given its bilateral trade deficit, Australia is well down the list of potential U.S. tariff targets. (The looming steel and aluminum tariffs will have a minor effect.) But as a trade-reliant economy, it may be affected indirectly by global trade frictions. The upcoming election is unlikely to have a major bearing on Australia’s near-term economic outlook.
The Reserve Bank of Australia (RBA) has finally joined its central bank peers in lowering interest rates amid moderating inflation. The 25 basis point cut was accompanied by hawkish messaging, pushing back on expectations of further easing in the near term. The expiration of consumption subsidies later this year, coupled with a still-tight labor market, could aggravate inflation. As a result, we expect only one more reduction by the RBA this year.

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