Economy: A post-cycle economy faces greater policy uncertainty

This year, the economy saw surprisingly robust growth with real GDP on track to expand at a 1.8% annualized rate in the fourth quarter, closing 2024 with 2.3% annual growth, by our estimates. The biggest driver of this strength has been consumer spending, which contributed an average 78% of real GDP growth in the first three quarters. Despite pushing back on high retail prices, a thriftier consumer managed to stretch their budget and still expand their shopping cart. Inflation-adjusted consumer spending grew 3.0% year-over-year in 3Q, accelerating from 2.7% in 2Q, fueled by strong gains in real after-tax income. Consumption has been dominated by highincome households, which have enjoyed enormous gains in household wealth, along with strong interest, dividend and property income. Elsewhere, consumers have been more cautious but continue to spend. In the year ahead, continued progress in real wage growth should broadly support consumers, but consumption is likely to contribute less to growth going forward as the tailwind of pent-up savings and debt has largely faded.

Interest rate-sensitive sectors continued to face challenges but began to stabilize as interest rates peaked. The scope of its acceleration will depend on how much long-end yields move lower next year. Residential investment contracted in 2Q and 3Q as homebuilder sentiment struggled under elevated long-term interest rates, which may persist even as the Fed lowers the federal funds rate. The manufacturing sector, grappling with slow global demand, has also experienced weak job growth and new order activity. However, potential rate cuts could stimulate activity in these sectors, thereby broadening support for GDP growth.

Despite high borrowing costs, business investment has been buoyed by strong corporate balance sheets and fiscal support from legislation such as the CHIPS Act and the Inflation Reduction Act. Tech companies, in particular, have accelerated investment amidst an AI-arms race, and lower rates could facilitate similar investments across other sectors.

The labor market, while facing challenges such as recent hurricanes and strikes, is expected to remain healthy, with continued job gains and a stable unemployment rate at close to 4%. Employment growth has moderated and may stabilize at a monthly pace of 100,000 to 150,000, consistent with moderate employment growth and a down-shift in immigration. As the labor market normalizes, so too should the inflation rate. We anticipate headline PCE inflation to close the year at 2.3%, and then average 2.0% next year. Altogether, we expect real GDP to expand 2.1% year-over-year in 2025, marking its fifth consecutive year of expansion.

Policy shifts cast a fog of uncertainty on the outlook

The re-election of Donald Trump and the Republican sweep of Congress could lead to significant policy changes, casting a fog on the economic outlook. While the specifics and timing of potential policy shifts remain unclear, we anticipate tax cuts, higher tariffs, reduced immigration and deregulation of various sectors.

On the tax front, a full extension of the Tax Cuts and Jobs Act and the potential for a lower corporate tax rate for U.S.-based production seem most likely. Slim majorities in the Senate and House may limit a full implementation of proposed tax measures, but there could still be some items folded in on business tax provisions, tip income and the cap on SALT deductions. Regardless of any tariff budgetary offsets the administration may propose, these policies are likely to increase the deficit without significantly stimulating economic activity, adding to the nation’s long-term fiscal challenges.

An area of potential economic concern is the incoming Trump administration’s stance on tariffs. President-elect Trump has proposed a 10% tariff on all imports and a 60% tariff on all Chinese goods, which could be interpreted as a bargaining tool in trade negotiations. If these tariffs were enacted as stated, they could lead to higher inflation and reduce overall demand, as well as higher interest rates and a stronger U.S. dollar. According to a recent estimate by the Budget Lab at Yale, these tariffs would raise consumer prices by 1.4% to 5.1% before substitution, equivalent to the cost of $1,900 to $7,600 in disposable income for the average household.¹

Additionally, severely curtailed immigration could decrease real economic growth by limiting the growth of the labor force and may cause higher inflation through higher wages.

Lastly, it remains to be seen what the countervailing effect of lower regulations across various sectors is, especially the perspective for higher capital investment and hiring.

If we incorporate a rough expectation of these policy changes into our economic forecasts, the outlook shifts accordingly²:

• Real GDP would be largely unaffected next year, but tax cut stimulus kicking in at the start of 2026 could boost real GDP growth to 2.8% by the end of 2026.
• Job growth would be relatively unaffected in 2025 but labor markets would tighten. Lower labor force growth from less immigration would cut the unemployment rate to 3.9% by the end of 2025.
• Inflation, in terms of headline PCE, could rise to 2.7% by the end of 2025 in a one-time boost from tariffs then drift down to 2.1% by the end of 2026.
• The Fed could put a premature end to its easing cycle with just three more cuts, bringing the funds rate to 3.75%-4.00% by next summer and holding it there.

Policy forecasts at this stage are still highly speculative, but they don’t seem to spell disaster for the economy or markets in the short run. In the coming months, investors will look for greater clarity on the new administration’s agenda, which will help refine the economic outlook. Until then, the economy remains on stable footing as we enter the new year, with a gradual return to normal across many fronts. However, investors should remain vigilant, considering the fragility of the economic expansion that underpins a bullish fervor in markets.

¹ Yale Budget Lab, “Fiscal, Macroeconomic, and Price Estimates of Tariffs Under Both Non-Retaliation and Retaliation Scenarios,” October 16, 2024.

² See “Policy Changes and the Macro Outlook” by Dr. David Kelly for further details on these policy scenarios.

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