Economic and financial risk insights: the US faces recession from tariff hit

• Growth: high US recession likelihood increases the risk of adverse scenarios that could cut up to 50bps or potentially even more off global growth in 2025.
• Inflation: the global trade war raises substantial risk of inflation re-acceleration in the US, in contrast to Europe and China.
• Interest rates: the Fed is likely to remain patient before cutting rates, likely until recession materialises through job losses. Other central banks to cut interest rates more.

Growth: despite a pause, US tariffs are an asymmetric stagflation shock. We now anticipate a high likelihood of US recession in 2025, with annual growth of about 1%. This is based on a likely 20% effective tariff rate (after some expected negotiation), sharp tightening in financial conditions (Figure 1) and potential growth contraction in Q125. We focus on scenario ranges for our forecasting (Table 1) given the unprecedented policy uncertainty (Figure 2).

Figure 1: US financial conditions (index)

In an upside scenario, we envisage US GDP growth would still slow to 1.8%, as growth drags already weigh on the economy in H125. However, greater downside is more likely. A worse negative scenario emerges if blanket 10% tariffs and severe tariff rates over 100% on China go into effect durably with minimal negotiations. If the effective tariff rate rises above 30% and trust in US financial markets erodes further, a more severe US recession could occur as soon as this quarter, with spillover to the rest of the world.

Figure 2: US trade policy uncertainty (index)
 

Inflation: the US will bear the brunt of price pressures. Our alternative scenarios see US CPI inflation rising as high as 5% yoy (Figure 3). Outside the US, however, tariffs are net disinflationary in our view and pose downside to our original euro area and China CPI forecasts. We expect the tariff hit to GDP growth (by up to 90bps in the euro area and 60bps in China in 2025) to be greater than the inflation impact of latest announced retaliations from the EU and China. This is as the uncertainty shock weighs on growth too beyond the direct tariff impact. Moreover, for the euro area, for example, the US accounts for a small share of goods trade (Figure 4), limiting the impact of EU retaliations to broader euro area inflation. 

Table 1: Key SRI forecasts and scenarios (%)

Interest rates: the tariff shock presents major challenges to the Fed. Stagflation risk is problematic for the Federal Reserve to address through monetary policy. Markets now expect four interest rate cuts in 2025 (Figure 5); we forecast 50-100bps of cuts. The FOMC will likely delay cuts for as long as possible to keep inflation contained until the labour market begins to weaken sharply. A deeper recession, as in a prolonged trade war scenario, would see as much as 150bps of cuts or more. For the ECB, growth concerns will dominate inflation risks and we expect further rate reductions toward the lower bound of neutral, at least. Risks are skewed to more rate cuts than originally forecast, if an adverse scenario emerges. Sovereign bond yields (Figure 6) face near-term downside risk if our recession scenarios materialise in the near-term. But we expect a floor beneath the 10-year yield for both the US (stubborn inflation and rising expectations) and Europe (particularly greater German fiscal spending).

Baseline view: our baseline forecasts are under review, with downward revisions to growth and upward revisions to inflation