Should we be more worried about U.S. growth or inflation? Or neither?

The market narrative over the last 12 months has oscillated between worries about U.S. growth and worries about inflation. Investors often get caught up in the consensus narrative, which can quickly lead to overcrowded positioning in certain trades. This, in turn, can create sudden shifts in momentum and volatility as investors rush from one side of the boat to the other.

Consensus too complacent about inflation

The consensus economic outlook as of late June has shifted entirely away from concerns about tariffs dragging the U.S. economy into recession and toward a soft landing scenario. But this is too complacent about the negative growth effects of a historic rise in the effective tariff rate—especially for small businesses—as well as the upward inflationary pressure of the tariffs.

Beyond the second quarter, when the U.S. economy benefited from front‑loading before tariff implementation, the growth outlook becomes murky. Our chief U.S. economist, Blerina Uruci, anticipates that the U.S. fiscal package, which is likely to be enacted this summer, will provide a much‑needed boost to an underlying growth rate that has been slowing. She expects the U.S. economy to stay out of a recession, albeit with tariffs causing growth to stay below trend.

While a major increase in the unemployment rate seems unlikely, the labor market has thinner buffers against significant weakening than at any other time post‑pandemic. There are now far fewer job openings per unemployed person than in 2021–2022.

Put simply, growth outcomes seem more uncertain. But with the current evidence and the likely boost from fiscal spending, recession doesn’t seem likely.

Tariff impact on prices to be significant

Our concern about inflation is more elevated than consensus. The pass‑through to consumer prices from tariffs is likely to be higher than markets anticipate. Blerina’s calculations show that a 10% across‑the‑board tariff on U.S. imports would increase annual headline inflation by between 0.5 and 1.0 percentage point. With a 15% effective tariff rate, the inflation shock could be as high as 1.5 percentage points.

Crosscurrents from tariffs (upward inflation pressure), U.S. dollar weakness (higher inflation), and possible slowing demand (lower inflation) are buffeting the inflation outlook. But I expect the tariff effects to dominate and push inflation higher in the second half of the year despite a moderation in services inflation.

Of course, the wild card here is the geopolitical situation in the Middle East, which had a major influence on energy prices (and headline inflation) in June. It’s difficult to predict how the conflict will evolve, but it has certainly raised the lower price boundary for oil in the second half of 2025.

An uneasy equilibrium

The bottom line is that the U.S. economy is in something of an uneasy equilibrium for now. Will growth or inflation worries ultimately win out? Or will the market consensus remain the scenario of decent growth without an inflation breakout? My view is that the U.S. fiscal package currently making its way through Congress will push the consensus toward inflation concerns. Tariffs (growth negative) and fiscal (growth positive) are tugging growth in opposite directions, but both move inflation risks higher. Markets will recognize this with time.

"...the U.S. economy is in something of an uneasy equilibrium for now."

When the consensus comes around to focusing on inflation concerns, the shift is likely to be abrupt. For now, inflation protection, such as exposure to Treasury inflation protected securities (TIPS), appears relatively inexpensive and would benefit from a change in the market mindset to inflation worries.

Fed remains in a policymaking bind

How does the Federal Reserve respond? It is in a bind, to put it mildly. The Fed cannot calibrate monetary policy—in terms of rate cuts—to address both economic weakness and inflation created by the Trump administration’s ever‑changing trade policy. The central bank will remain on hold until economic data provide more clarity.

The Fed’s summary of economic projections that was released after the June Federal Open Market Committee (FOMC) meeting indicated that policymakers still anticipate a median total of 50 basis points (bps) of rate cuts in 2025. While I think two 25 bps cuts are still possible, the inflation overhang makes just one rate reduction more likely. No easing this year is also a distinct possibility from a Fed that was burned by the inflation surge in 2021 and 2022, so investors hoping for a rally in U.S. Treasuries driven by Fed cuts may be disappointed.

The final wild card is the seemingly open casting call for the next Fed chair. Any sign of politically driven dovishness in this seat could certainly set inflation expectations racing.