2025: A Tale of Two Outlooks

• We expect another year of solid growth for the US economy. A healthy labor market and high levels of household net worth will support consumer spending. The AI boom, along with ongoing fiscal incentives for public and private investment, will also serve as tailwinds..

• The economic policies of the incoming administration inject a high level of uncertainty into the outlook. In our base case, changes to trade, immigration and fiscal policies will be much more limited than former President Trump’s campaign promises. However, if policies turn out to be closer to those discussed during the campaign, the outcome would be stagflationary – lower growth and higher inflation.

The U.S. economy continues to display remarkable resilience, emerging from the period of peak monetary policy rates with considerable growth momentum. This trend is set to continue, as some additional monetary policy easing should leave financial conditions supportive of growth. In addition, with the labor market showing signs of stabilizing, real wage growth and gains in overall household net worth should support robust household spending. The AI investment boom, along with investment incentives from landmark legislation such as the CHIPS Act and Inflation Reduction Act, continues to catalyze innovation and private-sector investment, reinforcing a robust growth outlook.

Figure 1: Real Investment Spending in Categories Related to CHIPS ACT, IIJA , IRA and AI as Percent of GDP

Source: Includes private investment in computing and peripheral equipment, communications equipment, electrical transmission equipment, construction equipment, alternative electrical energy structures, manufacturing structures and office structures, software; and state and local government investment in structures and equipment. Data centers included in office structures.

CHIPS: 2022 Creating Helpful Incentives to Produce Semiconductors Act; IIJA: 2021 Infrastructure Investment and Jobs Act; IRA: 2022 Inflation Reduction Act.    

The economic policies of the incoming administration inject a high degree of uncertainty into this outlook. Assessing the impact of former President Trump’s policies is challenging because (1) they will be implemented at different points in time over the next few years; (2) some policies have an immediate impact following implementation while others impact the economy more gradually, and (3) there could be substantial differences between the scale of implementation and what Trump promised or proposed during the presidential campaign. 

In practice, we anticipate a more measured implementation of Trump’s campaign pledges, with tariff rhetoric primarily serving as leverage for trade negotiations or aimed at winning other concessions from major trade partners. The more recent threat of immediate 25 percent tariffs against Canadian and Mexican imports fits into this category, in our view, with Trump seeking to pressure both countries into stricter border enforcement. We would expect this issue to be resolved within the first few months of Trump’s term. Similarly, mass deportations are very unlikely given how disruptive they would be to the economy, and the potential difficulties in securing the necessary funding from a fractious Republican-controlled Congress that commands only a slight House majority. Finally, although Trump promised a host of new tax breaks during the presidential campaign, in reality simply extending the expiring provisions of the 2017 tax cuts will add significantly to deficits. Pushback from Republican Senators and from the bond market will ultimately constrain the amount of fiscal loosening. Trump’s December failure to secure a two-year debt ceiling suspension from Congress during passage of a Continuing Resolution portends the challenges he will face in seeking additional tax cuts.

A scaled-down version of economic policy implementation may look more like the following:

• Higher tariff rates against many Chinese goods, but no sustained tariffs against other trading partners;
• Some restrictions on legal immigration, heightened border security and expedited removal procedures for new asylum seekers. Some long-standing programs that allow for asylum on humanitarian grounds could be phased out; and
• Little fiscal easing beyond extension of expiring provisions of the 2017 Tax Cuts and Jobs Act and increases in defense spending.

The net impact of these policies would be a slight drag on the economy in 2025; as such, we see real GDP growth in the year ahead moderating to a 2.25 percent pace, which is modestly above our estimate of the economy’s potential. 

Meanwhile, the inflation outlook is somewhat less encouraging. After moderating significantly in 2023, core inflation has turned somewhat sticky lately. In fact, with one more month of price data to go in 2024, core PCE inflation looks set to finish this year just a few tenths below where it ended 2023, and notably above the Committee’s two percent objective.

Figure 2: In 2023, Services Inflation Excluding Housing Proved Sticky

Source: Bureau of Economic Analysis, MacKay Shields. 

2024 inflation is through November and annualized.

The rebalancing that has occurred in the labor market suggests that inflation should continue to moderate. But the journey back to the Fed’s two percent inflation objective will continue to be bumpy, in our view; above-trend growth, strong real income gains and high levels of household net worth, and the economic policies of the incoming administration suggest that core inflation will end 2025 around 2.5 percent.

With solid economic activity and somewhat sticky inflation, we believe that the FOMC will feel less urgency to cut the policy rate over coming quarters. As a result, we expect just 50 basis points of easing between now and the end of 2025. The risks to this policy outlook are generally balanced, though fiscal policy bears close monitoring. If Congress moves forward with meaningful fiscal expansion in 2025, any additional rate cuts could be entirely off the table.

Figure 3: Monetary Policy Rules Indicate Limited Scope for Further Easing

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Board of Governors of the Federal Reserve System, MacKay Shields. MacKay end-2025 forecasts: core PCE inflation - 2.4 percent; unemployment rate – 3.9 percent; median longer-run federal funds rate from the FOMC’s Summary of Economic Projections – 3.25 percent.

Economic Policy Risks

Despite our constructive outlook, we are highly attuned to the risk that the policies of the incoming administration may be closer to Trump’s campaign promises and proposals than we currently envision. Such an outcome would be stagflationary: growth and employment would suffer, and inflation and interest rate volatility would increase.  Most importantly, broad-based and high tariff barriers and retaliation, along with immigration restrictions and significant deportations, would serve as a drag on growth that would only be partially offset by additional fiscal easing and deregulation. Meanwhile, all four policy thrusts – tariffs, immigration restrictions and deportations, deregulation and fiscal expansion - would boost inflation. All told, we estimate that these policies would lower the level of GDP by approximately one percentage point relative to our baseline, with that growth drag peaking in early 2026. Inflation would be close to a full percentage point higher by Q4 2025, mainly due to tariffs, though the inflationary impact would fade over the course of 2026. And most importantly for investors, this stagflationary outcome would likely dent risk-taking in financial markets, especially against the backdrop of tight credit spreads and exceptionally strong equity gains over the past two years.