Understanding Economic Scenarios
The economy is constantly changing, and it’s essential to understand the different scenarios that can affect its growth. In this article, we’ll explore three possible scenarios: baseline, trade tensions ease, and trade deals fall apart.
Baseline Scenario
The baseline scenario is the most likely outcome based on current assumptions. It assumes that the average tariff rate will remain around 15% throughout the forecast period. However, the tariff rates on imports from Canada and Mexico are expected to decrease to about 3% by next year due to the United States-Mexico-Canada Agreement (USMCA). The average tariff rate on China is expected to be around 50%, while the European Union will face a 20% tariff rate.
Assumptions and Expectations
In this scenario, the Tax Cuts and Jobs Act (TCJA) provisions that are set to expire will be extended, preventing a tax increase in 2026. The 10-year treasury yield is expected to hover around 4.5% for the remainder of the year, despite a softening in economic data. The Federal Reserve (Fed) will cut rates slowly throughout 2026, bringing the federal funds rate to a range between 3% and 3.25% by the first quarter of 2027.
Economic Impact
The higher tariff costs and elevated interest rates will cause businesses to slow their pace of investment and hiring. This may lead to an increase in the unemployment rate to 4.6% in 2026. Real GDP growth is expected to be 1.4% in 2025 and 1.5% in 2026, with a steady-state growth rate of about 1.8% in 2029.
Trade Tensions Ease Scenario
In this scenario, more trade agreements are finalized, allowing the average tariff rate to decrease substantially. The average tariff rate falls to about 7.5% by the end of 2025. Imports from Canada and Mexico become compliant with the USMCA, reducing the effective tariff rate.
Economic Impact
The lower tariffs allow for inflation to fall more quickly, giving consumers additional purchasing power. The Fed takes a more dovish approach to monetary policy, cutting rates by 25 basis points in each quarter starting with the third quarter of 2025. Business investment increases due to lower tariffs, lower interest rates, and improved productivity growth.
Trade Deals Fall Apart Scenario
In this scenario, negotiations for new trade agreements stall, and existing agreements fall apart. The average tariff rate rises to about 25%, with the tariff rate on imports from China increasing to 75%. The bond market reacts to the higher tariffs, sending the yield on the 10-year treasury above 5% in the fourth quarter of 2025.
Economic Impact
The US enters a recession in the fourth quarter of 2025, with real GDP falling 1.7% in 2026. All sectors of the economy face sizable declines, and the unemployment rate rises to 6% in the middle of 2026. The Fed is stuck between its inflation and full employment mandates, initially cutting rates by just 50 basis points in the fourth quarter of 2025.
Conclusion
Understanding the different economic scenarios is crucial for making informed decisions. The baseline scenario provides a foundation for understanding the economy’s growth, while the trade tensions ease and trade deals fall apart scenarios highlight the potential risks and opportunities. By analyzing these scenarios, we can better prepare for the future and make more informed decisions about our economic lives.
