Economic Forecast Update, May 2025: A Short Rocky Road

The economy contracted by 0.3% in the first quarter, according to the official report on Gross Domestic Product. Widespread worry about consumers and businesses postponing purchases and hiring decisions has led economists to raise their estimated risk of recession, the Wall Street Journal reported in April. Yet the economic outlook is not bad if decisions on tariffs are concluded this summer. That’s true even if the tariffs end up significantly above last year’s rates.

The key elements of the economic forecast include the solid growth we achieved in 2024, which provided a good foundation for this year. Most policy changes other than tariffs will have small impacts on the short-run economic forecast, some positive and some negative but the sum total very small. And the Federal Reserve has good plans for tariff-induced price hikes. The U.S. economy simply needs to get through the tariff uncertainty without major damage.

GDP Decline In Q1

The GDP report does not mark the start of a recession, in all probability. The first GDP report is labeled “Advance Estimate,” which the Bureau of Economic Analysis says is “based on source data that are incomplete or subject to further revision.” The average revision, ignoring whether it’s upward or downward, is 0.7%. Thus, the -.3% Advance Estimate may well be revised significantly.

The details of the report do suggest revisions. Imports rose significantly in Q1, as people and businesses bought in anticipation of tariffs. This data is pretty accurate by a month after the end of the quarter, when the Advance Estimate is released. Imports are subtracted in the GDP calculation, to remove them from figures for spending as well as inventory increases. But inventory increases are not so accurate, and with a surge of imports, it is quite possible that some goods were in transit from the port to the buyer and not counted in anyone’s inventory. The spending figures are also estimates based on surveys of businesses. A large upward revision at the end of May is quite possible, concentrated in inventory change with also some spending increases. Thus, the negative GDP change should not be taken as a portent of looming disaster.

Most Policy Changes Minor

Before considering tariffs, three other policy areas should be addressed. Immigration control will limit population growth, as it did in the first Trump administration. This will lower job growth in low-skilled occupations, hitting farming, food processing, construction, housekeeping and restaurant cooking. The border control will not weaken the economy, but it will remove a small positive increment to the growth rate.

Federal government layoffs have shown up in the April employment report, which overall was solid. The job cuts will have negligible impact on the overall economy, though they will certainly affect the people involved. Payroll is a minor part of the total federal budget, and even though people have been laid off, the money for the departments has been appropriated and current law requires the president to spend it. The labor market is fairly tight, so most government workers will be absorbed into other parts of the economy.

Deregulation is the other policy change that will impact the economy. Although some action can be taken through executive orders, most require a multi-year rule-making process. Deregulation will enable more construction projects, but very little in the next two years.

Tariffs And Uncertainty

Nobody is certain, as of this writing, where tariffs will settle. For this forecast, I assume that we will have a much clearer picture by July, the deadline set by the president for tariff policy. The contrary assumption will be discussed below.

Tariffs themselves, though condemned by the overwhelming majority of economists, will not trigger a recession. They will reduce the purchasing power of consumers and require businesses to change their operations. In the long run, they will lower the growth rate of the economy by a small amount, as tariffs limit our ability to get products from the best locations. The effect is very small in the short run, but compounds like interest to be significant by our grandchildren’s era.

Uncertainty about tariff policy constitutes our greatest economic risk in 2025. Businesses hesitate to hire more workers or buy more equipment until they are sure about tariffs that we charge as well as retaliatory tariffs imposed by foreign countries. Consumers, too, are not sure if this is a good time to buy a car or go out to dinner. So spending is delayed, which is likely to lower GDP relative to a no-uncertainty world. The impact should be limited to the second quarter of 2025. If the tariff changes are completed this summer, then we’ll see a bounce-back in spending, which will show up as a rebound in GDP in the third or fourth quarter.

Interest Rates And Tariffs

The Federal Reserve will ignore price increases triggered by tariffs. They may not like the price increases, but they know that tighter monetary policy isn’t the right response. However, the data may be hard to interpret. Tariffs often vary by commodity and by country of origin. Some product prices will respond fully right away, while others will adjust more gradually. But the Fed will try to identify how much non-tariff inflation occurs. If that is stable, then they will not hike interest rates.

If tariffs do get settled in the next few months, then the economy will need neither stimulus nor tightening. Interest will remain at about current levels.

The Risk Of Recession

Unfortunately, the tariff issue may not be resolved soon. If not, then a recession becomes likely. It would be triggered by too many businesses and consumers delaying purchase and hiring decisions. Businesses that sell industrial equipment or consumer discretionary goods would have to lay off workers due to slack orders. That would trigger further consumer spending cutbacks and more layoffs.

The economy would recover, with faster recovery the sooner that tariff uncertainty is eliminated. We will not enter a death spiral, just a setback.

Business Strategy For Tariff Uncertainty

Business owners and executives need to assess their risks from possible tariff changes, as described in a previous article. Key elements for successful contingency plans include, first, specificity about where the risk comes from. Second, consider general economic slowdown and how sensitive the particular business would be to a recession. Third, sketch out contingency plans for the downside risks.

Finally, don’t forget the upside possibility. Some companies will emerge from the rocky road with more opportunities, more potential for increased volume and margins. But sometimes capturing the upside requires more resources—financial, physical or human—and thinking about those potential resource needs ahead of time will speed up a company’s ability to grasp the opportunity.