I was running along the roads of our neighborhood last weekend when I came upon a small herd of deer. I often see these beautiful but dopey creatures at dawn as they wander aimlessly in the middle of the road. When a car or truck bears down on them, they stop and stare. Perhaps they are pondering whether it would be more fun to hop into the woods to their right or gambol off into the field to their left. But, of course, the only important decision is to get out of the road. A “wait and see” attitude could be fatal.
“Wait and see” are also the three most dangerous words in economics. When everyone waits to see, what they eventually see is not good. However, in the midst of heightened policy uncertainty, many consumers, businesses and state and local governments may now be hesitating to spend and invest and hire. This hesitation, along with the actual impacts of tariffs, government spending cuts and lower immigration, is applying the brakes to economic growth.
So far, this appears to be a slowdown, not a recession. However, it is clear that the economy has slipped a gear since the start of the year and more extreme policies on tariffs, immigration and federal cutbacks might well tip the economy into outright recession, even as tariffs threaten to elevate inflation this year and Congress prepares to deliver a fresh round of tax cuts for 2026.
All of this should impact the Federal Reserve’s thinking on the economy, which will be revealed this Wednesday in its dot plot and its summary of economic projections, although likely not in an actual rate move. It’s also impacting markets, with the S&P500 dipping into correction territory, (that is to say down more than 10% from its peak), last Thursday, before bouncing higher on Friday. For investors, the evolving financial environment points to the need for broader and more sophisticated diversification, including international and alternative assets. It's too soon to say recession – it’s not too soon to be prepared.
Sizing Up the Slowdown
The latest projection from the Atlanta Fed’s GDPNow model is for a 2.4% annualized contraction in real GDP in the first quarter. This forecast is very likely too low, since a big part of the downdraft comes from a mechanical extrapolation of anomalous January international trade data.
Still, even correcting for this, growth looks weak and possibly negative for the first quarter. To see this, we need to go through the sectors of demand one by one.
The obvious place to start is with consumer spending which accounted for 69% of GDP in 2024.
After growing at nearly a 4% pace in the second half of 2024, real consumer spending is now tracking less than a 1% gain for the first quarter of 2025. Part of the problem has been a decline in light vehicle sales to 15.7 million units annualized in January and February compared to a 16.5 million unit pace in the fourth quarter. Other areas of consumer spending are also soft, with ex-auto retail sales falling by 0.4% in January, although data due out this week should show a February bounce back. Recent numbers from the travel industry also point to first-quarter weakness.
Survey data are troubling, with consumer confidence, as measured by both the Conference Board and the University of Michigan, falling in both January and February and the Michigan index plunging to its lowest level in three years in early March. Commentary from consumer companies during the earnings season also suggest that consumers are spending more cautiously.
For the moment, however, the drivers of consumer spending remain relatively strong. The economy added a respectable 151,000 jobs in February and real wages have risen on a year-over-year basis for 22 straight months. Year-to-date income tax refunds are running 2.5% ahead of last year’s pace. Moreover, despite a rocky start to 2025, stock prices have risen sharply over the past two and a half years, bolstering spending on luxury goods and services.
All of this being said, consumers could retrench further in the spring, in the face of layoff announcements and tariff-induced price increases. Real consumer spending has grown in every quarter since the pandemic and our baseline forecasts don’t have a decline in the first or second quarters of this year either. However, the pace of growth should be subdued, leaving the economy vulnerable to weakness elsewhere.
Homebuilding accounted for just 3% of GDP in 2024 so, despite its high profile, it has limited impact on overall GDP growth. That being said, recent data on home-building have been downbeat, with existing home sales, new home sales and housing starts all falling in January. However, mortgage rates have fallen in recent weeks and the actual pace of housing starts, at 1.37 million units in 2024, is at its lowest annual pace since 2019, suggesting some room for revival. Right now, we expect a small decline in home-building in the first quarter to evolve into a small gain in the second. However, a sudden plunge in immigration could impede housing demand, as well as the supply of construction workers, going forward.
Business fixed investment spending generally occurs many months, if not years, after the decision is made to invest. Consequently, even if business confidence falls, most capital spending should be unaffected for a while. Moreover, there is little evidence, in published data so far, of a decline in business confidence. Small business confidence, as measured by the National Federation of Independent Business, surged after last November’s elections and remains relatively strong, although it fell for a second consecutive month in February. CEO confidence, as measured by the Conference Board, was up strongly in the first quarter based on data collected between January 27th and February 10th.
Nevertheless, capital spending is still feeling the lagged impact of higher interest rates and unoccupied offices. Consequently, we estimate that real business fixed investment spending will fall by 1.8% annualized in the first quarter, following a fourth-quarter decline of 3.7%.
Inventories should boost GDP growth in the first quarter, both because of relatively slow stockpiling in the fourth quarter and attempts by companies to frontload imports ahead of tariffs. Conversely, trade should be a drag on first-quarter growth because of this front-loading. Finally, while federal government spending will likely decline throughout 2025, state and local government spending should continue to grow, albeit at a slower pace, as federal government transfers decline.
As of right now, we expect real GDP to fall by between 0% and 1% annualized in the first quarter and rise by a similar small amount in the second. Payroll employment growth should also slow, although stay positive, while a sharp decline in immigration and, consequently, labor supply should limit any rise in the unemployment rate. Growth could pick up a little in the second half of the year and should be boosted in 2026 by some degree of fiscal stimulus.
The Potential for More Extreme Policies
It must be admitted, however, that all of this is clouded by a great deal of uncertainty. Even if there were no further changes in tariffs or immigration policies or government cutbacks, it would take a few months to discern the true impact of these policies on economic growth and inflation. Moreover, these policy actions may become more extreme.
On tariffs, we estimate that policies enacted to this point have raised the average tariff rate on goods coming into the United States to 6.4% - its highest level since the 1960s. However, the president has threatened to implement delayed tariffs on Canada and Mexico, new tariffs on the European Union and general reciprocal tariffs in early April. All of these moves would increase the impact of tariffs on both economic growth and inflation.
On immigration, illegal border crossings have plunged in the last two months, with fewer than 12,000 encounters with border patrol agents in February, compared to an average of roughly 100,000 per month in the fourth quarter of 2024 and over 250,000 per month in the fourth quarter of 2023. Conversely, however, traditional immigrant visas issued at foreign embassies were up year-over-year in January and deportations continue to run at less than 1,000 per day. However, if more federal resources are devoted to expelling unauthorized immigrants and if the flow of traditional visas being issued slows, the labor supply crunch could worsen as the year goes on. It is worth noting that, in a zero-net-immigration scenario, the population aged 18-64 would fall by about 800,000 people per year over each of the next five years.
And government cutbacks could intensify. Apart from the roughly 75,000 federal workers who accepted the initial buyout offer from the new administration and numerous layoffs at individual departments, media reports suggest the administration plans to cut roughly 45,000 IRS jobs, 55,000 Department of Defense civilian positions and 80,000 Veteran’s Affairs jobs. Other cutbacks or pauses in federal grants and spending have occurred and the House budget resolution allowing for up to $4.5 trillion in additional tax cuts over the next decade, envisions up to $2.0 trillion in cuts to federal government spending.
All of this could slow the economy further in 2025. Conversely, however, the tax bill that is beginning to wind its way through Congress could boost growth.
In theory, the fiscal 2025 budget resolution that passed the House in late February, authorizes up to $4.5 trillion in tax cuts which would only extend the 2017 tax cuts that were set to expire at the end of this year. However, this could be boosted by allowing tax cuts to expire within a few years while assuming spending cuts hold for a full decade. Alternatively, Congress could decide to calculate further tax cuts relative to “current policy” rather than “current law”, thereby assuming no need to pay for an extension of the 2017 tax cuts and leaving more money available to cut taxes in other areas in 2026. Any economic weakness in the next few months would likely bolster the political argument for further fiscal stimulus, and higher deficits, in 2026.
The Fed’s Dilemma
All of this adds to the complexity of the Fed’s job this week.
In their December 2024 Summary of Economic Projections, they forecast 2.1% real GDP growth in 2025 with PCE inflation running at 2.5% year-over-year. We expect that this week’s forecast will project somewhat slower growth and hotter inflation. In December, they prophesied two rate cuts in 2025. This week, they may follow the market in projecting three.
However, in their statement and in Chairman Powell’s press conference, they will likely highlight increased uncertainty about the direction of the economy. They will, no doubt, try to steer clear of any judgement on political decisions. But they will want to wait and see the probable end game on all of these major changes being made elsewhere in Washington before adjusting monetary policy. Consequently, we are very unlikely to see any rate move at this week’s meeting.
Investment Implications
Investors will also be tempted to wait and see. This is a perfectly rational choice rather than trying to time market swings based on some insight into potential policy decisions or the direction of the economy. Sometimes, there is a level of uncertainty that cannot be much reduced even by the brightest of analysis.
However, investors should recognize that volatility in Washington policy and U.S. equity markets does carry an important implication. If the economy does tip into recession and if a market correction worsens into something much uglier, the pain would likely be most concentrated in areas such as mega-cap U.S. equities and cryptocurrencies which have seen such strong gains in recent years. This being the case, it is important that investors rebalance and diversify to make sure they own sufficient fixed income as well as equities, value stocks as well as growth, small as well as large, international as well as domestic, and alternative assets as well as those traded on public markets.
As with the deer, the danger for investors is not so much that they wait and see – it is where they are positioned when they do so.