The economy is grappling with multiple shocks, prompting economists to revise their outlook on growth, inflation, unemployment, monetary policy, and financial markets. The silver lining is that the economy was in robust shape before these shocks, with low unemployment, retreating inflation, and stock markets retaining most of the substantial gains achieved in recent years. This resilience provides a cushion to absorb the impact of these shocks. However, resistance is wearing thin, and the longer these shocks persist, the higher the likelihood of the economy slipping into a recession.
The first shock stems from higher tariffs—and consequently, higher prices—on U.S. imports. These tariffs will cut into disposable income, creating a demand shock. Although tariffs did not significantly affect consumer prices in March, their impact will soon become evident. There is typically a lag between tariff adjustments and their reflection in consumer prices.
The second shock is surging policy uncertainty, which is already negatively affecting business investment in both equipment and structures. While consumers are still spending—evidenced by stronger-than-expected March retail sales, much of this strength is attributed to the front-loading of purchases ahead of anticipated tariff-induced price hikes. Household sentiment has plummeted to recessionary levels and buying plans have been scaled back. Policy uncertainty is unlikely to dissipate soon, as tariffs can change rapidly and unpredictably, as demonstrated in the first few weeks of April.
The third shock involves disruptions in global supply chains. Unlike the tariffs implemented during Trump’s first term, the scope and scale of the new tariffs are significantly broader. These measures could usher in an era of fractured global trade, placing immense pressure on supply chains.
The final shock arises from tighter financial market conditions. Stock prices have dropped noticeably, long-term interest rates have risen, the trade-weighted dollar has depreciated, and corporate bond spreads have widened. These tightening financial conditions are eroding wealth and increasing borrowing costs, which will inevitably hurt consumer and business spending. The shockwaves continue to reverberate through the economy and financial markets, posing complex challenges for the Federal Reserve as it navigates their disruptive effects on inflation and growth.
Phantom Wealth
A significant tailwind cushioning the impact of trade and tariff shocks is the strong balance sheets of American households, bolstered by surging stock portfolios and housing equity in recent years. So far this year, stocks have pulled back modestly amid heightened volatility, but most of the previous gains remain intact. This increased wealth, in turn, incentivizes households to save less from their incomes than they otherwise would, freeing up more funds for spending. However, households now hold a record share of stocks in their portfolios, making them much more vulnerable to a bear market—an event that could occur suddenly and reduce their wealth.
For most Americans, housing remains their biggest asset, and, like stocks, home values have skyrocketed in recent years. Compared to stocks, home values are less volatile, providing a more stable source of wealth. By the end of 2024, households had accumulated $35.0 trillion in housing equity, up from $19.5 trillion in less than five years. That pace far exceeded the growth in total financial assets, including stocks and bonds. Yet, unlike financial assets, housing equity cannot be easily converted into cash, as selling a home is a lengthy process, and market conditions are not always conducive to a quick sale.
Moreover, appreciating property values come with costs that may deter spending. Homeowners may face higher property taxes, their increased equity may disqualify them from receiving college financial aid for their children, and selling a home could result in a significant capital gains tax burden that would erode much of their profit. While homeowners could borrow against their home equity for immediate cash needs, the cost of a home equity loan may be prohibitive if interest rates are high, and banks are tightening access to such loans. Indeed, lenders are rejecting refinancing applications at record rates. Simply put, the wealth effect that has fueled economic growth over the past three years is unlikely to be as potent in 2025.
How Inflationary are Tariffs?
The tariff shock will inevitably trigger a one-time increase in the prices of U.S. goods and, in some cases, services. However, this price uptick may unfold over several months rather than occurring instantaneously. The critical question—especially for the Federal Reserve—is whether this sharp and visible price surge will set off a broader wave of price and wage increases as firms and households attempt to shield themselves from the shock. The risk of these so-called second-round effects increases the larger the initial spike in prices. In this regard, some analysts are forecasting tariffs to push the inflation rate to a peak of around 5.0% by midyear, up from the current 3.1%, according to the Fed’s preferred inflation gauge, the Personal Consumption Expenditures Index. While this represents a significant jump, it remains well below the post-pandemic peak of 7.9% recorded in June 2022. Three key factors explain why this inflationary increase is expected to remain below prior highs.
First, imported products pass through multiple intermediate stops along the supply chain before reaching consumers. At each stage, part of the tariff cost is absorbed, meaning that by the time the product reaches the end consumer, the final price increase will be only a fraction of the initial tariff. Second, while certain goods will be disproportionately affected, tariffs apply to only about 10% of the total basket of goods and services that consumers purchase. As a result, the overall impact on headline inflation will be far smaller than the tariff increase itself. Finally, the sharp decline in oil prices this year will partially offset the tariff-related price shock. This relief comes from two sources: lower oil prices reduce the cost of shipping goods from overseas, and cheaper fuel at the pump mitigates the impact of tariff-induced price increases on other consumer goods, as consumers save from spending less at gas stations.
Background Will Not Sustain Higher Inflation
The announcements are unfolding in a chaotic manner, with much of the anticipated “liberation day” blitz on April 2 postponed for 90 days. With so much uncertainty, it is nearly impossible to predict the tariff landscape a few months from now. However, the market anticipates that the universal 10% tariff imposed earlier this year will remain in effect, the 145% tariffs on China will become permanent (despite President Trump hinting at a reduction on April 23), and the pause on tariffs for other trading partners will be extended indefinitely. The situation could worsen if tensions with trading partners escalate, leading to reciprocal tariffs and a tit-for-tat trade war. As it stands, the effective tariff rate is set to reach its highest level since the 1930s.
Tariffs have the potential to create lasting inflationary effects if they coincide with a strong economic backdrop that allows firms to raise prices and encourages workers to demand higher wages. However, this is not the case currently. The tariff hikes are occurring in a much weaker economic environment compared to the period when the U.S. and other economies reopened after the pandemic. Consumers are no longer sitting on a surplus of savings from stimulus payments that previously enabled them to absorb steep price hikes and sustain consumption. Similarly, the labor market, which once faced worker shortages that drove significant wage increases, is now balanced, with wage growth slowing.
Analysts expect the inflation spike to fade shortly after reaching a peak in the coming months. The front-loading of consumer spending to avoid tariffs has nearly run its course. Purchases that would typically occur during the spring and summer have already been made, leading to a payback period of weaker spending in the months ahead. Similarly, firms have accelerated their orders from domestic and international suppliers to build up inventories before tariffs take effect. Imports at the Port of Long Beach surged by 26% in March. While these accumulated inventories will boost growth in the first quarter, they will likely drag GDP as they are drawn down in the second quarter. Simply put, the current economic backdrop is not robust enough to sustain a prolonged inflationary surge.
A Fork in the Road
Yogi Berra once famously quipped, “When you get to a fork in the road, take it.” Such is the dilemma now confronting the Federal Reserve. The aggressive tariff hikes currently underway are simultaneously stifling growth and fueling inflation. The Fed, tasked with a dual mandate to achieve maximum employment and stable prices, faces a challenging balancing act when these two goals come into conflict. While today’s conditions do not mirror the extreme stagflation of the 1970s, the choices before the Fed are strikingly similar, and the risk of miscalculation remains high.
Unsurprisingly, economists are divided on the appropriate course of action. Some argue that the almost inevitable economic slowdown caused by tariffs necessitates immediate rate cuts to preempt a recession. This view aligns with President Trump’s stance, as he has criticized the Fed chairman for acting too slowly and appears poised to assign blame if a recession materializes. Others contend that inflation poses the more pressing threat, warning that near-term tariff-induced price hikes could ignite inflationary expectations, potentially leading to a more persistent inflationary spiral.
From our perspective, the Fed is adopting a measured and rational approach to this dilemma. In recent remarks, Chair Powell emphasized that the decision will hinge on which objective—employment or inflation—is further from being achieved. With the unemployment rate at 4.2%, close to a level consistent with maximum employment, and inflation significantly exceeding the Fed’s 2% target, the likely course of action is to maintain interest rates at their current mildly restrictive levels. The Fed is expected to delay rate cuts until clear signs of weakening labor market conditions emerge. However, this strategy could shift abruptly if trade tensions escalate, delivering a severe economic shock.
If you are a Legacy client and have questions, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or connect@lptrust.com.
This newsletter is provided for informational purposes only.
It is not intended as legal, accounting, or financial planning advice.
