Policy Uncertainty Clouds the U.S. Economic Outlook 

Projecting the economy’s direction is always tricky, but today’s volatile sweeping policy changes make it nearly impossible. Higher tariffs and reduced immigration continue to threaten the health of the U.S. economy; these policies increase prices, reduce output, and decrease employment. But no one knows how significant these changes will ultimately be, or how long they’ll last. 

We do know what the President and Congress plan for the federal budget in the fiscal year beginning in October. Details still need to be worked out, but it will likely cause deficits and debt to increase by some $3 to $5.5 trillion over the next decade, depending on how fast the economy grows, what happens to interest rates, and other factors. It should provide only modest stimulus to the economy, however, because most of the tax cuts are merely extensions of the 2017 personal income tax reductions that were due to expire at the end of the year. The new budget is expected to modestly boost the economy next year, as the tax cuts are front-loaded and the spending cuts are mostly back-loaded.

The U.S. Economy Is Slowing, but There Are Helpful Supports 

As for where the U.S. economy stands right now, it is holding up but slowing. Real GDP growth averaged nearly 3% in 2023 and 2024 but has slowed to 1.25% in the first half of this year. While output accelerated to a 3% annual rate in the second quarter, following a 0.5% drop in the first, demand slowed, signaling weak economic activity going forward. Imports surged in the first quarter in anticipation of higher tariffs, but then plummeted in the second as the tariffs began to take effect. Aggregate private demand—that is, consumer and business spending—decelerated in the second quarter to a pace of 1.2%, following growth of 1.9% in the first quarter. 

Job growth is also slowing. It averaged 35,000 per month in the three months ending in July, down from an average of 127,000 during the previous three months. The unemployment rate has remained in the 4.0 to 4.2% range for over a year, but this obscures the weakening in the labor market. With diminished immigration having slowed labor force growth down to a trickle, the economy now requires significantly less job growth to maintain a steady unemployment rate.

With the economy already slowing and the tariff and immigration policies likely to depress economic activity in the second half of the year, it is reasonable to worry about the possibility of recession. Fortunately, there are underpinnings of resilience, and the best guess at this point is that the economy will bend but not break. Corporate profit margins remain high, and spending on artificial intelligence is boosting investment, even in the face of the uncertainty created by a constantly changing tariff regime. Meanwhile, the debt burden on households and businesses is not ringing alarm bells, and risk-taking and speculation in financial markets do not seem excessive enough to create a systemic blow-up. 

With Prices and Output Moving in Opposite Directions, the Fed Is on Hold

The prospect of higher prices and reduced output in the second half of this year puts the Fed in a bind. Most economic shocks are on the demand side, which shifts prices and economic activity in the same direction, making monetary policy decisions straightforward. Increases in aggregate demand put upward pressure on both prices and activity, suggesting some tightening is in order. Adverse demand shocks reduce both inflation and economic growth, prompting the Fed to lower rates. Tariffs are a negative supply shock because they increase business costs, which in turn raise prices and lower output. Core inflation has been running above the Fed’s target of 2% by nearly a full percentage point. With most of the effect of higher tariffs on prices expected to show up in the second half of the year, this makes the Fed reluctant to lower its policy rate. Reduced immigration amounts to a negative supply shock to the labor market, implying slower job growth and higher wages, some of which will likely be passed through to higher prices. 

The Fed is not confident about the relative size of these shifts that push policy in opposite directions. As a result, monetary policy is likely to remain on hold for the time being as officials observe how the changes in inflation and economic activity play out. One or two quarter-point rate cuts by year-end would not be a surprise, however, since the current policy rate of over 4.25% is modestly restrictive, and economic growth is likely to be weak. 

Why Are Financial Markets Performing so Well?

The stock market has been performing well despite the uncertainty surrounding U.S. economic policy and the potential for a weaker economy due to higher tariffs and reduced immigration. There are several explanations:

1. The adverse effects of tariffs and immigration on the economy are just beginning to show up. The Liberation Day reciprocal tariffs were announced just this past April and were subsequently paused, resulting in an average U.S. tariff rate of approximately 9 to 10% in May. That is well above the 2.5% rate at the beginning of the year, but well below the 20 to 30% rate that was expected before the pause. Moreover, goods imports rose at a rate of more than 50% annually in the first quarter as the prospect of tariffs induced a massive front-loading. This boosted inventories of imported goods to unusually high levels, preventing prices from rising. As these inventories wind down, prices are expected to rise, assuming the tariffs remain in place. Meanwhile, job growth due to immigration has become minimal at a time when the non-immigrant labor force is experiencing little to no growth, primarily due to historically low birth rates and the aging of the large baby boom generation, which is retiring. Immigration accounted for nearly 90% of U.S. labor force growth over the past five years and has played a crucial role in boosting U.S. employment and economic activity. A stagnant labor force will create significant headwinds for GDP growth going forward, but it has just begun to show up in the data.
2. Investors seem inclined to believe that the President will back off on tariffs over time, given the experience after Liberation Day. Coincident drops in stock and bond prices, as well as the U.S. dollar, induced the Administration to pause the tariffs, and the pause was subsequently extended for an additional month. Tariffs on China were hiked to a staggering 145% just after Liberation Day—amounting to a virtual embargo—and then reversed back down to 30% a month later after markets crashed.
3. Investment is being boosted by spending on artificial intelligence. AI promises to be a significant innovation that should enhance productivity—much as the internet did in the late 90s and early 2000s—and businesses in industries across the country don’t want to be left behind. The internet turned out to be the game-changer everyone thought it would be, but that didn’t prevent a bubble that took stock prices to record levels before it eventually burst. 

Higher Bond Yields Are a Reflection of Higher Inflation and Growing U.S. debt.

Bond yields are significantly higher than they were before the COVID-19 pandemic. The 10-year U.S. Treasury yield has been trending in a 4 to 5% range, well above the unusually low 1.5 to 3% that persisted for a decade before the pandemic. The “Big, Beautiful Budget Bill” will likely continue the trend of rising U.S. debt and deficits, and the expected increase in government borrowing is putting upward pressure on bond yields.

The U.S. budget deficit has been running around 6% of GDP the past few years—the highest non-recessionary deficits since WWII—and the current budget plan should take them to about 7%. The U.S. spent $1.1 trillion on debt interest payments in fiscal year 2024, more than double what was paid as recently as five years ago. It accounted for 16% of federal spending and is now the second-largest expenditure of the U.S. government, after Social Security. The government now spends more on interest payments than on either defense or Medicare. 

U.S. Federal Debt Is Sustainable, at Least for Now

The failure of the recent budget plan to address ballooning U.S. debt and deficits is raising concerns about debt sustainability. Publicly held government debt has already surged to close to $30 trillion, up from around $5 trillion before the financial crisis. This has increased the debt-to-GDP ratio from 35% in 2007 to 97% by early 2025. The proposed budget is projected to bring that ratio to over 120% by 2034. 

No one knows for sure what the maximum sustainable ratio is, but we do know that the reserve currency status of the dollar–reflecting the dominant role that the U.S. plays in international finance–provides it with much more leeway than what is afforded to other countries. With the largest, safest, and most liquid financial markets in the world, the U.S. remains an attractive destination for investment capital, including foreign purchases of U.S. Treasury securities. 

It is widely agreed that a debt-to-GDP ratio of 200% or higher would be a disaster, and we are far from that. But the recent trend is alarming. The Penn-Wharton model suggested that the U.S. could not sustain more than 20 years of accumulated deficits under what was current law in 2023, and the recent budget proposal implies an even shorter time horizon. The bottom line is that U.S. federal debt and deficits are sustainable for now, but at some point, a future President will have to bite the bullet, much as Presidents HW Bush and Clinton did in the early 90s.