Downside risks to the US economy are stirring. The job market isn’t as foolproof as it once was: The rates of people getting hired or quitting their jobs remain below where they stood before the pandemic, while layoffs have been ticking up at the margin. Beyond that, the sources of growth have narrowed, and the housing market is at a standstill. The shifting political winds in Washington have also added uncertainty to the outlook. All this adds up to a more sluggish outlook for 2025 — even if many economists and analysts are reluctant to admit it.
To stem the economy’s deterioration, the Federal Reserve would be forced to hasten its policy easing, backstopping activity by cutting interest rates more aggressively than its members or investors currently anticipate. Based on the inferred probabilities from markets, investors expect to see two cuts from the Fed in 2025. But as the true picture of the economy comes into view, I would expect a couple more than that before the year is out.
After years of warning that a crash was just around the corner, economists and Wall Street analysts have largely abandoned the idea of a recession or a meaningful growth slowdown hitting the US. But as the core parts of the engine slow and the Fed sits back and does nothing, the chances of a noticeably weaker economy are rising.
Any reasonable read of the data points to a clear cooling of the US economy. Sure, GDP growth in 2024 came in at a respectable 2.5%, but that’s down from 3% in 2023. And the way that the US arrived at that growth was not especially encouraging. Household consumption and government investment accounted for the lion’s share of growth last year, while gross private domestic investment — which tracks companies putting money into their businesses and the amount spent on building new homes, apartments, and other structures — was a modest drag. Given the narrow composition of growth, it stands to reason that if consumer spending and government investment moderate, the economy will, too. The case for a slowdown in both categories is strong.
The outlook for consumption boils down to incomes — people can spend more money only if they have more money coming in. And it’s clear that income growth is easing as the labor markets cool. The percentage of people quitting their jobs hit fresh lows at the end of 2024, and as quits decline, so too does wage growth. This makes sense: When workers are less likely to leave their jobs, employers feel less need to give them raises to keep them around, which shifts power from employees to employers. And as incomes slow, so will consumption. In fact, we’ve already seen some of this decline: Inflation-adjusted incomes net of transfer payments — a proxy for people’s paychecks with government payments like Social Security and Medicaid stripped out — was a full percentage point below the pace of consumption. At the same time, the personal savings rate (a measure of the percentage that people are setting aside) fell to 3.8% from 4.4% in 2023, suggesting that Americans were dipping into their reserves to keep the spending going. But there’s a limit to how much consumers can draw down their savings to fuel buying.
The other pillar of US growth, government spending, is also showing signs of strain — and it's not just from the DOGE cuts championed by Elon Musk. States received huge cash increases during the pandemic years, but those surpluses are rapidly fading. State and local government construction spending rose 4.4% in 2024, down from 19.7% in 2023. Hiring by state and local governments is decreasing as well. A recent report from Pew said: "State budgets are expected to shrink substantially in fiscal year 2025 as the post-pandemic era of surging revenue, record spending, and historic tax cuts comes to a close. According to new data released by the National Association of State Budget Officers (NASBO), total general fund spending is expected to decline to $1.22 trillion, a more than 6% drop from estimated levels in fiscal 2024, which ended for most states on June 30."
Even spending on new housing, one of the weaker GDP components from last year, is set up for a worse 2025. Interest rates remain elevated as incomes slow, creating an affordability problem that makes it harder for people to buy a home and puts upward pressure on the number of homes sitting on the market as it takes longer for sellers to find a buyer. Redfin recently said: "The uptick in new listings, along with slow sales, is contributing to a growing pool of supply for homebuyers to choose from. It has also led to the typical home selling for 2% under asking price, the biggest discount in two years."
This slowing of growth would have serious consequences for Americans. One clear downside is a likely rise in the number of people out of a job. Despite strong growth in both 2023 and 2024, the unemployment rate still rose 0.3 percentage points in each of those years. If growth is likely to slow in 2025, it's not a tough leap to assume that unemployment will keep rising. If there's more slack in the job market, it's not hard to see incomes slowing further and a negative feedback loop kicking in, weighing on household spending and other parts of the economy.
There are, of course, ways to blunt or even avoid some of the worst impacts of this slowing. One of the most important routes to support the economy is for the Fed to start cutting interest rates. Making debt cheaper would encourage businesses to invest or hire, while providing some cushion for household balance sheets.
After all, the Fed was already bringing down its key rate at the end of last year in an effort to get in front of a deeper slowdown in the labor market. And the reason the Fed hiked rates in the first place — inflation — is also showing continuing signs of progress back toward the central bank's goal of 2% year-over-year growth. While the most recent consumer price index inflation reading was a little hotter than expected, the Fed's preferred personal consumption expenditures inflation gauge has given us better news. Core PCE inflation, which is more reliable because it has a much larger scope than core CPI, got back on track in November and December after two discouraging months. Most of the shortfall in core inflation, relative to the Fed's target, is in housing. Given the aforementioned slowdown in price growth in the housing market, it stands to reason this will continue easing.
Instead of keeping up its rate cuts, however, the Fed has changed course, preferring a more reactive approach to the data on the chance inflation surprises us by moving up. It's already foolish to wait for permission from the data before moving rates since it raises the chance that you fall behind, but the reason for the Fed's worries about increased inflation makes even less sense because it's clear that this all comes down to speculation on what the new administration might do.
Immediately following the election, Fed Chair Jerome Powell was pretty clear when he was asked about the incoming administration's policies. "We don't guess, we don't speculate, and we don't assume," Powell told reporters. A month later, Powell seemed to have changed his tune.
"Some people did take a very preliminary step and start to incorporate highly conditional estimates of economic effects of policies into their forecast at this meeting and said so in the meeting," he said during a press conference following the Fed's December meeting. In other words, they do guess, speculate, and assume. How convenient!
Let me address the elephant in the room: Donald Trump. In recent weeks, many business economists have highlighted the uncertainty coming from his administration, citing his chaotic approach to trade policy. The on-again, off-again tariff threats are said to freeze business investment, and if implemented, they could push inflation back up. This is, I think, the source of Powell's wait-and-see pivot. But the evidence for a real effect from the president's policies is weak so far.
There is always some uncertainty when power changes hands in Washington. Consider the alternative. Had Kamala Harris won the election, there would be much more doubt about whether the 2017 tax cuts, which are set to expire at the end of the year, would be extended or whether tax rates would go up for households and businesses. If corporate taxes went up at the end of the year, a wide body of research suggests that those increased taxes would likely be passed onto consumers. Does anyone seriously think that the Fed would worry about upside risks to inflation from corporate tax pass-through? No, the Fed would likely be eyeing interest rate cuts as a way to stem any downside growth risks from the decreased spending and investment. This is exactly why it is so irresponsible to prejudge outcomes. Follow the data, as opposed to speculating over a series of policies that may not even take effect.
To me, it's clear that businesses are willing to give the new administration the benefit of the doubt. Tariffs are not the only dimension of policy. Perhaps firms are willing to tolerate some short-run uncertainty around tariffs if it implies an improved regulatory and tax backdrop down the road. Obviously, there is enthusiasm, for example, for a lighter-touch approach to financial regulation.
Trump is also not the only source of uncertainty. If Congress fumbles the ball on legislation, confidence could stall, especially if the confidence is predicated on the Tax Cuts and Jobs Act being extended at the end of the year. That would be a much bigger risk to the economic outlook than the threat of tariffs. The downside scenario here is obvious: Nothing of substance happens, at least not right away, from either Congress or Trump, but the Fed, because it is concerned about possible policies, decides to hold off doing anything as nominal growth continues to slow. This would be a passive tightening of monetary policy, which has important implications for financial market investors. I anticipate a decline in longer-term interest rates and a sell-off in equity prices as risk appetite wanes. For the economy, expect conditions to deteriorate in the job market.
The Fed will eventually come around, cutting rates to support growth, but if you are waiting for the bad news to be obvious before doing something, it usually has a way of showing up.
Neil Dutta is head of economics at Renaissance Macro Research.