Unfortunately, the US economy is not doing so well right now. It has become less dynamic in the past months. Overall, it still performed well, one might say surprisingly well if one considers the high uncertainty regarding tariff policies, and also actually higher tariffs. Clear signs of weakness now appear. As labor market data published on August 1 showed, net job growth was very low in the past three months. Only 106,000 new jobs were created. A sizeable part stems from the health care sector. The manufacturing sector lost 37,000 jobs. The labor market is cooling. However, one should consider that population growth has slowed due to new immigration/emigration policies. The breakeven rate of monthly payroll growth needed to keep up with the labor force has probably fallen from roughly 165,000 jobs in early 2024 to approximately 85,000 jobs in June 2025 (see Kolko, 2025). In addition to weak labor market data, purchasing manager indices did not look encouraging in July. Discussions about the independence of the Fed and statistical agencies further contribute to uncertainty and a pessimistic outlook for the US economy.
In the second quarter of 2025, the economy still expanded by 3.0 percent (annualized). A sharp drop in imports mainly drove this, while private consumption modestly increased and private investment remained approximately constant. In the first three months of 2025, imports had considerably increased before the government adopted higher tariffs.
Tariffs have dramatically increased in the past months, and there is still very high uncertainty regarding the further evolution of tariffs. The Yale Budget Lab estimates that the effective average tariff rate is now at approximately 18 percent, the highest tariff rate since the 1930s. In the coming months, inflation will be increasingly affected by these higher tariffs. Weaker demand may somewhat dampen inflationary pressures. Nevertheless, a stagflationary scenario for the US economy may be a risk to consider. This puts the Fed into a dilemma. A weaker economy calls for interest rate cuts, while inflation persistently exceeds the Fed target and may further increase again in the wake of tariffs.
We expect a stagflationary episode in that meager economic growth and somewhat elevated inflation will occur together next winter. In our baseline scenario, the economy will experience stagnation but not fall into a recession. We think inflation will gradually get lower in 2026 since the tariff shocks coincide with weak demand and still elevated interest rates. Expansionary fiscal policy and interest rate cuts will help the economy become somewhat more dynamic in 2026, mainly in the second half of 2026. We currently expect three interest rate cuts in 2025 and two more cuts in 2026.
Average annual GDP growth will be modest in 2025 and 2026 with growth rates of 1.5% and 1.1%. We expect no recession in our baseline scenario, though the economy will stagnate for approximately three quarters before becoming more dynamic in 2027, achieving 2.4% growth. The unemployment rate will moderately increase in the coming months. Inflation will stay elevated in 2025 and 2026 before approaching the 2% inflation target.
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