United States Economic Forecast

Scenarios

Baseline:

Our baseline forecast is closest to how we expect the economy will grow based on a set of assumptions made at the time of analysis. Despite recent court rulings, we expect that the average tariff rate remains around 15% throughout the forecast period, though the country- and product-specific rates are expected to change. For example, we expect the average tariff rate on imports from Canada and Mexico to steadily fall to about 3% by next year. This happens because exporters in those countries will increasingly be able to comply with requirements of the United States-Mexico-Canada Agreement (UMSCA),³ bringing the average tariff rate down over time. In addition, we anticipate a 50% average tariff on China, which is about where they were as of May 14, 20% on the European Union, and 10% on most other countries.

We also assume that the provisions of the Tax Cuts and Jobs Act (TCJA) that are set to expire at the end of this year are ultimately extended, preventing a tax increase in 2026, and that additional tax cuts are also included in the final budget bill. Although the overall bill is expansionary relative to what would happen if the provisions were allowed to expire, it offers only limited upside next year relative to the government’s tax and fiscal stance this year. Part of this is due to the assumption that there is a more modest increase in the deficit as a result of the final legislation relative to what the US House of Representatives passed initially.

Longer-term interest rates have increased recently, as bond investors demand higher yields to lend to the US government. We expect the 10-year treasury yield to hover near 4.5% for the remainder of this year, despite a softening in economic data and a 50-basis-point cut from the Fed in the fourth quarter of 2025. The 10-year treasury yield begins to decline slowly in 2026, falling to 4.1% by 2027 and remaining there through the end of 2029. The Fed’s hesitance to cut rates quickly is due to the inflationary impulse of tariffs, which bring the core PCE price deflator up to 3.6% on a year-over-year basis by the fourth quarter of 2025. The inflationary impulse proves to be temporary, allowing the Fed to cut rates slowly throughout 2026, bringing the federal funds rate to a range between 3% and 3.25% by the first quarter of 2027.

In this scenario, the higher tariff costs coupled with elevated interest rates cause businesses to slow their pace of investment and hiring throughout the remainder of 2025 and into 2026. This may lead to the unemployment rate to rise to 4.6% in 2026. Elevated trade barriers on US imports as well as exports slow the pace of international trade, with real imports of goods and services falling by 7.1% in 2026, and real exports falling 1.8%. As a result, real GDP growth is expected to be 1.4% in 2025 and 1.5% in 2026. Real GDP accelerates in 2027 and 2028 before settling into its steady-state growth rate of about 1.8% in 2029.

Trade tensions ease (upside):

Our upside scenario assumes that more trade agreements are finalized, allowing the average tariff rate to move substantially lower. The average tariff rate falls to about 7.5% by the end of 2025. Imports from Canada and Mexico quickly become compliant with the USMCA, rapidly reducing the effective tariff rate from both countries even ahead of the updated USMCA agreement we expect to be reached in 2026. The average tariff on China comes down to about 30%, while the European Union faces a tariff of just 5%.

Despite much lower tariffs, the US economy is still expected to grow at a slower rate in 2025 compared with the previous two years. In particular, consumer spending had been growing at a much faster rate than income, suggesting that consumption would slow this year. However, lower tariffs allow for inflation to fall more quickly, which gives consumers additional purchasing power.

As inflation subsides, the Fed is able take a more dovish approach to monetary policy. We assume the Fed cuts rates by 25 basis points in each quarter starting with the third quarter of 2025 and ending with the fourth quarter of 2026. The final budget bill extends current tax provisions but is projected to add significantly less to the federal deficit than previously expected. This prevents a rise in taxes while also calming bond markets. The yield on the 10-year treasury is expected to fall to 4.25% by the fourth quarter of 2024.

More trade deals and lower tariffs unleash business investment, which had been subdued due to economic policy uncertainty. Lower interest rates and inflation also help to support business investment. Additionally, we assume that deregulation and gains from artificial intelligence improve, leading to a rise in productivity growth over the forecast period.

Trade deals fall apart (downside):

Our downside scenario includes a bigger rise in tariffs in the United States and abroad relative to our baseline. We assume that the average tariff rate rises to about 25% as negotiations for new trade agreements stall and existing agreements fall apart. Notably, the tariff rate on imports from China rises to 75%, while imports from Canada, Mexico, and the European Union all face 25% tariffs. The rest of the world generally faces 10% tariffs. We also assume that the bond market reacts to the higher tariffs and the passage of the budget bill, sending the yield on the 10-year treasury above 5% in the fourth quarter of 2025. This forces the US government into an austerity trap where cuts to spending and higher tax rates are required to bring the interest rate on government bonds back down.

As a result of the bond market turmoil and austere fiscal policy, the US enters a recession in the fourth quarter of 2025 and does not return to its prerecession level of real GDP until early 2027. All sectors of the economy face sizable declines in 2026. Real GDP falls 1.7% with consumer spending, government spending, business investment, imports, and exports all declining on a year-over-year basis. The 10-year treasury yield falls gradually, remaining above 4.5% until the end of 2026.

Given the bond market reaction to fiscal policy, real federal spending declines in 2026 and 2027, creating a substantial drag on economic growth. Federal spending remains weak in 2028 and 2029 as policymakers are hesitant to introduce stronger spending out of fear that the bond market will react negatively. With the public and private sectors shedding jobs, the unemployment rate rises to 6% in the middle of 2026 and remains at 4.5% in 2028.

With both inflation and the unemployment rate rising quickly, the Fed is stuck choosing between its inflation and full employment mandates. As a result, it remains on hold until the fourth quarter of 2025. It initially cuts by just 50 basis points in the fourth quarter as inflation continues to accelerate. However, once there is turmoil in bond markets and there is evidence that inflation may be turning the corner, the Fed cuts rates more aggressively. In the first quarter of 2026, it cuts rates by 100 basis points, followed by further 50-basis-point cuts in each of the next three quarters. Only in 2027 is the Fed able to slowly raise rates back toward neutral.

Housing

Long-term interest rates have been rising, with the 30-year treasury yield rising above 5% at the end of May. The 30-year fixed mortgage rate has been slightly more subdued but remains just shy of 7% as of this writing. Elevated rates have restrained residential investment, and housing starts were 4.7% lower in May compared with a year earlier. Similarly, building permits were down 6.4% over the same period. Housing starts never returned to their peak levels from before the global financial crisis of 2008 to 2009. The long-term failure to build enough homes has contributed to the lack of inventory and elevated prices we see today in some parts of the country. We may have to wait for rates to drop to see a significant uptick in housing construction.

We expect housing starts to continue falling through the first half of 2026, before rising again in the latter half of the year. Overall, we expect housing starts to fall to 1.29 million in 2025 and to 1.27 million in 2026. Thereafter, we anticipate housing starts to rise for the remainder of the forecast period once the Federal Open Market Committee (FOMC) lowers rates once again. After 2026, we expect the housing stock to rise more rapidly than total population, helped in part by the slower population growth.

With housing construction expected to fall over the next year, home price appreciation is expected to rise more quickly in the near term. We expect the benchmark home price index will rise by 3.8% in 2025, with a further 4.7% growth in 2026. In the outer years of the forecast, the house price index is expected to moderate to about 4%.

Business investment 

Investment is spending that helps grow the long-term productive capacity of the economy, and as such, is one of the most important indicators of an economy’s future potential. Investment often follows a cyclical pattern, driven by commodity price booms and economic cycles. It can also be incentivized by policies like lower taxes or subsidies for investments.

Business confidence is a crucial determinant of the level of investment growth, as businesses need to feel positive about their future potential to justify spending money to grow their operations. Unfortunately, business confidence is weakening in the face of uncertainty. The National Federation of Independent Business’ small business optimism index had been falling since December 2024, though it recovered slightly in May.⁶ Plans to make capital expenditures had fallen to the lowest since 2020 in April and remained weak in May. In addition, several regional Federal Reserve Bank surveys⁷ indicate a relatively weak outlook for business conditions.⁸

Interest rates also influence investment. Corporate borrowing rates increased along with inflation into 2023. Since then, rates have come down slightly but remain high relative to pre-pandemic levels, particularly for longer-term borrowing. However, many firms still have more cash on hand than they did before the pandemic, and they can consequently avoid borrowing at elevated rates.

After posting a 1.5% decline in the first quarter of 2025, we predict investment in structures will continue to fall into the first quarter of 2026. Overall, we predict investment in structures to fall 1.6% in 2025 and 0.9% in 2026. The decline in structures investment in 2026 obscures a rebound that occurs in the second quarter of 2026.

Besides structures construction, other types of business investment include spending on machinery and equipment (M&E), such as on computers or industrial equipment, and on intellectual property, such as software or AI. Businesses accelerated their purchases of equipment in the first quarter of 2025 to avoid tariffs. Real spending on equipment grew by 24.7% (at annual rates) in the first quarter of 2025 compared with the previous quarter. We expect growth to drop substantially as tariff costs begin to bite. Investment in intellectual property products is expected to remain stronger as it is far less exposed to tariffs. Our forecast shows M&E investments rising just 0.1% in 2025 and declining 2.5% in 2026. We see intellectual property spending rising 2.4% in 2025 and 3.7% in 2026.

The resumption of bonus depreciation that has been gradually phased out under the TCJA is expected to support investment spending beginning next year. However, higher tariffs and interest rates restrain growth in the near term. Overall, in 2025, we predict business investment to rise just 0.7%, slowing from the 3.7% recorded in 2024. As interest rates come down and policy uncertainty wanes, business investment will grow 1.1% in 2026 and 4.6% in 2027.

Foreign trade

Foreign trade remains the sector with the biggest question marks surrounding it. Tariff details are being changed frequently. Two federal courts ruled against President Trump’s use of the International Emergency Economic Powers Act (IEEPA) to impose tariffs on trading partners. On May 28, the Court of International Trade invalidated the tariffs on a nationwide basis, while a separate court invalidated the application of tariffs more narrowly on the two plaintiffs in the lawsuit. Both rulings have been temporarily stayed and the cases are in the process of appeal,⁹ which has made the future path of tariffs and trade policy even more uncertain. Further, the rulings do not apply to tariffs imposed under other statutes.

In our baseline scenario, we raise the average tariff rate on goods imports by 12 percentage points, from approximately 2.5% to 14.5%. This level is equivalent to having a 50% tariff on China, 20% on the European Union, 3% on Mexico and Canada, and 10% on the rest of the world. However, we assume that the average effective tariff rate on Canada and Mexico declines steadily to 3% as more goods from those countries are deemed USMCA compliant. Readers can also refer to our downside scenario, which contains a 22-percentage-point increase in the average tariff rate, for an indication of what might happen if tariffs rise even higher. That downside scenario would be roughly equivalent to a 75% tariff on China, a 25% tariff on the European Union, Mexico, and Canada, and 10% tariffs on the rest of the world.

The imposition of these tariffs is likely to turn into a complicated process involving individuals and businesses trying to make substitution and supply chain decisions based on new relative prices. As elevated tariffs remain in place, we expect growth in exports and imports to rise by 0.4% and 2.9% in 2025, respectively. Import growth this year is flattered by a surge in imports at the start of the year as importers sought to avoid looming tariffs. Trade growth slows more dramatically by the end of 2025. In 2026, exports will fall by 1.8%, while imports plummet by 7.1%.

It may be surprising to see that exports may suffer by the imposition of tariffs. There are a few reasons why this may be the case in the short term, and why these tariffs may not have their desired impact in the long run. First, about half of imports are currently used as intermediate inputs by US businesses. It is likely to take some time for US producers to find local alternatives to the goods they are currently importing, and in the meantime, their cost of doing business will rise. This dynamic could reduce the money available to firms to invest and may drive some US producers out of business if the costs are not passed on to consumers. It may also make their exports costlier and less competitive. Tariffs may shield US producers from the import competition required to make globally competitive products. So, while they may dominate the US economy, they are also likely to lose export sales, which could potentially lead to limited net gain for American manufacturing.

There are potential benefits of tariffs, though they would take much longer than four years to be realized, and so do not occur within our forecast horizon. In most industries, there is not a large pool of American manufacturing production currently staffed up but sitting idle. Factories will need to be built, and workers hired and trained, both of which will take time. During this transition period, when there are no US alternative goods, the cost of tariffs is likely to be borne by American households and businesses. In many cases, the reason for offshoring can have as much to do with the availability of certain skills as it does cost, and reshoring all this production will require major skills-training programs to ensure an adequate supply of workers.

Government policy

As of this writing, the House of Representatives passed its version of the One Big Beautiful Bill, which includes changes to federal tax and spending priorities. We recognize that the final legislation may look different from this bill but use it as a guide for our baseline forecast. The Congressional Budget Office (CBO) expects that the bill, as passed by the House of Representatives, would add about $2.4 trillion to the federal deficit over the next 10 years excluding debt service and macroeconomic effects.¹⁰ Most of that rise in the deficit will occur earlier in CBO’s 10-year forecast window. For example, just over $1 trillion would be added to the deficit in 2026 and 2027 alone.

Some of the largest tax cuts in the bill include an extension of the tax provisions in the TCJA that were set to expire, an elimination of taxes on overtime and tipped income, and an increase of the cap on deductible state and local income tax. To offset these tax reductions in the budget window, savings are found by repealing and modifying tax credits that were previously part of the Inflation Reduction Act and cutting expenditures on Medicaid and food assistance.¹¹

Although the increase to the deficit is expected to be substantial, the economic effects are more limited. Much of the cost of the budget bill is spent extending tax provisions that are already in place. Extending those provisions creates neither a stimulative nor contractionary effect. After removing those provisions, we find that the direct effect of the bill would raise economic growth by 0.2 to 0.3 percentage point in 2026 and then subtract a roughly equivalent amount by 2029. In addition, we assume that the final legislation adds slightly less to the deficit and is therefore slightly less stimulative than the bill that the House of Representatives initially passed.

In addition to the budget bill, trade policy will also generate revenues. Using our baseline assumptions for tariffs, we estimate that tariffs would create about $2.5 trillion over the next decade. On the spending side, federal government employment has been declining since January 2025, a trend we expect to continue through the end of 2028.

Incorporating all these factors plus debt service costs and economic effects, we find that the federal budget deficit will rise to 6.4% of GDP in 2025 from 6.2% in 2024. The deficit will rise slightly to 6.5% in 2026 before narrowing for the rest of the forecast.

Labor market

At the time of writing, labor markets continue to look relatively healthy. The unemployment rate remained at 4.2% in May, the same rate as April and March, while the average monthly nonfarm payroll gains were 124,000 during the first five months of this year, lower than the average gain of 168,000 observed in 2024.

Although the labor market has held up so far this year, there are a few very early signs that cracks are emerging. For one, the number of people claiming unemployment insurance has started to rise, though it remains low by historical levels. Employment in the federal government has also been declining since the start of this year. Job cut announcements have grown this year. Much of the increase has been in the public sector, but even after excluding those workers, job cut announcements were still elevated compared with a year earlier.

In the long term, demographics are the most important determinant for labor markets. A surge in immigration over the last three years has caused stronger than anticipated labor force growth. Given the current administration’s more hawkish immigration policy stance and the sharp drop in reported border crossings,¹² we expect the labor force will grow slightly slower than what had been expected prior to these developments. However, the total effect on immigration remains highly uncertain. We therefore made only modest changes to demographics for the next four quarters. We will likely need to adjust this part of the forecast in the future as more data becomes available.

We expect job growth to slow this year as economic growth weakens due to tariffs and elevated interest rates. The sharpest drop in employment growth is likely to be in federal government, but employment growth in the private sector is also expected to moderate into next year. We expect the unemployment rate to rise from 4.2% to an average of 4.6% in 2026 before declining toward 4.1% in 2029.

Financial markets

Stock markets have shown considerable volatility this year as they react to rapid changes in economic policy. Equity prices plummeted when “reciprocal tariffs” were announced on April 2. The announced country-specific tariff rates were evidently much higher than investors had anticipated. Once the 90-day pause in those higher reciprocal tariffs was announced, stock prices rebounded. As of this writing, the S&P 500 stock price index has yet to return to the high reached in February.

While equity markets plunged and mostly recovered in April, bond markets have been acting unusually. During financial market stress, the yield on US treasury bonds increased and the value of the dollar fell. In the past, the exact opposite usually occurs during times of financial stress. Since then, yields on longer-term treasury bonds have remained elevated and the dollar has remained weak. In addition, the dollar had been expected to appreciate as tariffs were implemented, making the recent downturn in the dollar particularly unusual.

In our baseline forecast, we maintain a relatively high 10-year treasury yield. However, we assume it remains around 4.5% through the end of this year, roughly where it was in May on average. In our downside scenario, we explore what would happen if bond yields jumped significantly higher should bond investors become uneasy about the sustainability of US government debt.

Since the FOMC began its rate-cutting cycle, it cut rates worth 100 basis points, bringing the Fed’s target range to between 4.25% and 4.5%. However, policymakers are now entering a period of harder choices on interest rates.

In our baseline scenario, we think the Fed remains on hold until the fourth quarter of this year. Stubborn inflation, elevated inflation expectations, and the threat of an inflationary impulse from tariffs will slow the speed at which interest rates can be brought back down. We now expect the federal funds rate to settle at 3.125% by the fourth quarter of 2026. In all scenarios, we expect that the FOMC will maintain its independence, with its mandate remaining unchanged.

Prices

Headline inflation has come down modestly, with year-on-year consumer price index (CPI) inflation in May coming down to 2.4%, tied for the second-lowest reading since February 2021. Similarly, the Fed’s preferred measure of inflation—the personal consumption expenditures deflator—came in at 2.1% year over year in May, just slightly above the Fed’s 2% inflation target. However, core inflation, which excludes food and energy prices, has been more persistent. For example, core CPI inflation was 2.8% in May. Still, the Fed is seeing steady, if modest, progress on its inflation mandate.

While the inflationary environment has improved a bit, the outlook remains more worrying. So far, there has been little evidence of tariffs in the consumer inflation data. However, we expect inflation to pick up a little this year. With an acceleration in prices due to tariffs, we expect CPI growth to average 2.9% in 2025 and accelerate  to 3.2% in 2026. Thereafter, inflation is expected to moderate to about 2.3% in 2029.

In addition to the inflationary impulse from tariffs, we expect inflation expectations to drive some of this acceleration. In May, the New York Fed’s survey of consumer expectations revealed a one-year ahead median point prediction for inflation to be 4.3%.¹³ That was up from just 3% in November 2024. Other measures have shown more extreme increases in inflation expectations. For example, in the University of Michigan’s June survey, forward inflation expectations rose to 5.1% from 3.3% in January. Because inflation expectations tend to influence actual inflation, the Fed’s role involves controlling not only real prices but also market expectations. These data points, as well as the potential inflationary effects of tariffs, will give the FOMC a pause when considering if further interest rate cuts are appropriate.