Tariffs Put Global Economy at Risk of Recession
As announced, the new US tariffs are not sustainable. We expect the new tariffs to be scaled back, but whether that will be done in time to prevent the economy from sliding into recession remains an open question. The strong starting point provides a buffer, but it won’t be for long.
Weekly Highlights
One of the highest in a century
Beat expectations
Has barely rounded up to this
Complex negotiations ahead
Lowest common denominator
As a bloc, largest source
Growth at risk. BoJ unlikely to hike till more clarity emerges; likely done hiking if tariffs stay
Disinflation is intact
On hold as expected; we see the cash rate gradually lower to 3.10% by December.
Tariffs Are an Active Threat to Both Sides of Dual Mandate
New tariffs announced on April 2 leave the average US tariff rate at the highest level in a century (18.8% based on Tax Foundation estimates). The market reaction has been powerful but orderly so far, with risk assets globally sharply lower and bond yield falling. An extended period of negotiations lies ahead, with the trade war likely intensifying short-term through retaliation before agreements are eventually reached. But a 10% US universal tariff may have become the best case final outcome, save for Canada and Mexico, where closer integration is still our ultimate expectation.
The market response suggests this is, on net, viewed as a negative demand shock. Risk assets sold off sharply in the aftermath of the initial announcement and subsequent retaliatory action by China. US stocks experienced the worst two-day plunge since 2020, WTI oil prices dropped nearly $10 a barrel, and the yield on 10-year US Treasuries slipped to 4.0%, the lowest since mid-October. More Fed rate are being priced in, with a June cut fully priced, more that two cuts priced by July and four by year end.
In contrast to a recent surge in consumers inflation expectations, market-based medium-term inflation expectations have been well behaved. Notably, they actually declined following the tariff announcement, suggesting investors see the inflationary impact of tariffs as short lived. This seems reasonable for two reasons:
a) Given that consumer wallets do not expand, higher tariffs cause a negative demand shock that eventually neutralizes the initial inflation effect.
b) On a longer term basis, the US policy of reshoring/friendshoring (which tariffs mean to accelerate) leads to additional productive capacity globally, without a commensurate increase in demand. Longer-tern, this is disinflationary.
No-Recession Call Is Hanging by a Thread
Since the start of the year, we have repeatedly argued that risks to both sides of the Fed’s dual mandate had increased. In our March forecasts (Little To See, Much To Worry About) we maintained a baseline macro call of slowdown but no recession, with real GDP growth moderating from 2.8% last year to 2.0% in 2025, driven primarily by softer consumer spending (2.8% to 2.2%, respectively).
The April 2 tariffs raise those risks to an “active threat” level. Relative to the March baseline forecast (which already incorporated tariff assumptions amounting to a roughly 0.4-0.5 hit to core PCE in H2 2025), we make further adjustments to those forecasts as follows: we raise end-2025 core-PCE inflation forecast by s further 0.3 ppt to 2.9% y/y, we lower Q4 2025 real GDP forecast by 0.2 ppt to 1.5% y/y, and we raise the end-2025 unemployment rate forecast by two tenths to 4.7%. We maintain the call for three rate cuts this year, although the rationale behind them has turned more ominous: no longer primarily a story of “cut because you can” but rather “cut because you have to”. While we do not have an outright recession in the forecast, we put the odds thereof at about 40%.
We retain the June-September-December timing despite risks of a later start.
Importantly, these forecast changes do not assume that these tariffs are permanent in their current form.
What Next?
Despite the detailed April 2 announcement, there is plenty we do not know. There will be retaliation (China has already made its move) but how intense? Most importantly, how long will US tariffs stay in place and what will their ultimate level be? It is impossible to know. But what we do know is that as they stand, these tariffs are too onerous to be sustainable without tipping the economy in recession. If in three month’s time these tariffs are still in place in their current form, the economy will be entering a recession. If they are scaled back (our baseline expectation), the no recession call might just survive by the barest of margins thanks partly to a decent starting point.
In that vein, the better than expected March employment report offered some reassurance, but not much since it reflects the past, rather than what is coming down the line. The economy added 228k jobs in March, much better than expected, although this was offset but a 48k downward revision to the prior two months. Gains were fairly well represented across sectors, although federal government employment and temporary help continued to shrink. The unemployment rate nudged up to 4.2% but this was primarily a rounding move and occurred alongside a one-tenth rise in the participation rate, so the dynamic was healthier than it appears at first glance. Hours worked were steady overall (up marginally in manufacturing) and wages well behaved. Average hourly earnings (AHE) inflation slowed to an eight-month low of 3.8% y/y while growth in average weekly earnings slowed to 3.2%. The latter is very important in constraining the extent of tariff passthrough. Given the consumer wallets are not expanding and job security is deteriorating, businesses may have difficulty passing through higher costs onto consumers, capping the ultimate inflation effect.
Eurozone: Negotiation First, Then Retaliation
While China has already announced broad retaliatory actions, the European Union has so far not done so. While vowing to protect their business interests, European leaders have signaled a willingness to give negotiations a change. EU Commission President Ursula Von der Leyen ventured on Friday that “It is not too late to address concerns through negotiations.” Doing so would be beneficial for all involved. The negative market reaction to the rollout may incentivize the US to engage.
The US tariff announcement did not appear to differentiate much between friend and foe, although Mexico, Canda, and the UK have all come through with minimal damage relatively speaking. The European Union was more aggressively targeted with 20% tariffs. As a block, it is the single largest source of US imports (Figure 3). That trade relationship runs deep in an of itself, but the historical relationship runs deeper still. In myriad ways, the US and Europe are natural allies. We hope that as (undoubtedly tense) discussions unfold, that reality is not forgotten.
For more on potential EU retaliation see our recent blog: More Storms Brewing: Are Tariffs on Europe Next?
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Australia: No Guidance, But Brace for Dovish Pivot
The Reserve Bank of Australia (RBA) met this week and left the cash rate unchanged at 4.10% as widely expected. The statement acknowledged that the progress made on inflation was ‘welcome’, and featured minor changes. During the press-conference, Governor Michele Bullock did not take the bait on whether a soft Q1 CPI print would result in a rate cut in May. The statement recognized higher global uncertainty but noted that monetary policy is “well placed to respond”.
The showstopper of the week, however, was the imposition of reciprocal tariffs by US President Trump. Australian exports to the US will now face a 10% tariff, a huge reprieve compared with other countries, which are subject to much higher rates. Hefty tariffs are imposed on other Asian countries, which account for 80% Australia’s exports. This is especially true in the case of Australia’s largest trading partner, China. Australia will be impacted indirectly through two channels:
- Lower aggregate demand globally and
- Sharply slowing demand from China
The tariffs pose modest direct downside risks to growth, assuming a minor fall in export volumes to the US. What is unclear if how this might affect export volumes elsewhere, especially to China. As such China announced a matching 34% retaliatory tariffs on Friday, which took the AUD sharply down 2.2%, an immediate market safeguard for Australian exports. Still, the escalating trade war poses further downside risks and can nip the nascent recovery in the bud unless some exceptions are made in the following weeks. As such, the reciprocal tariffs may have taken effect by the time you are reading this report.
This makes a dovish pivot and material easing from the RBA a more plausible option to safeguard Australia’s economy. Although revising forecasts between our quarterly cadence is not our preference, the rapidly evolving macro landscape led us to relook our Australia numbers. We still expect a rate cut in May, and see a 10% chance for a 50 bps cut, should US growth disappoint materially in Q1 (data out on April 30). Furthermore, we think the RBA may eventually cut rates to take the cash rate to 3.10% by December, as opposed to 3.60% previously.
In the prior week the Federal Budget delivered a surprise tax cut reduction to Australians earning A$18k-A$45k (from 16% to 14% over the next two years). This measure lowers receipts by A$17 billion and lets the overall fiscal deficit in FY 2026 rise to A$42.1 billion. The government now expects the net debt to rise a few tenths more than the MYEFO projected and will peak at 23.1% of GDP in FY 2029. As such, the deficit rose nearly A$35 billion over the next four years since the MYEFO projections in December, most of which is due to the tax cuts, whose impact will be felt from FY 2027. Otherwise, the budget aimed to address a wide ranging issues and allocated more to capex programs (A$ 15 billion over 10 years), Medicare (around A$8 billion over four years) and an expected extension of electricity subsidies (A$2 billion).
All these spending plans mean that the government’s contribution to growth will remain substantial in the next few years, another positive factor for growth in the wake of tariffs. All this may lower growth by a couple tenths this year and next but, we are inclined to leave the forecasts to factor more information in the weeks ahead.
However, an important aspect is that these bold spending plans are announced only weeks before the Federal elections, slated to take place on May 03 as called by Prime Minister Anthony Albanese. The campaign is heating up between the ruling Australian Labor Party and the opposing coalition led by the Liberal/National Coalition Party.