The Fed facing stagflation risks, the five stages of (tariff) grief, and the climate cost of defense spending

With inflation still stubbornly above target (+2.8% y/y in February), the Fed is likely to remain on pause next week, even as steep tariff hikes, soaring policy uncertainty and deteriorating consumer sentiment are raising risks for US economic growth. We do not expect US GDP to grow at all in the first half of 2025. With tariffs set to push inflation further above target for most of the year (peaking at 3.5% in Q3), we expect the Fed to prioritize bringing inflation back under control over supporting economic growth, with one 25bps cut likely in November, followed by back-to-back 25bps cuts in Q1 2026. However, it could be forced to act earlier if trade tensions do not wane by mid-year as recession risks intensify. Markets are positioned for three rate cuts by the end of this year, discounting inflation risks for now.

The US global tariff rate is expected to land at around 8% – the highest since the 1940s. Markets and policymakers are going from denial and anger to acceptance and adapting to the new economic reality. However, the cost of uncertainty is already extremely high and retaliations create escalation risks. US businesses are also in the acceptance stage and frontloading: US imports jumped by an impressive +11.9% in January, increasing for the third consecutive month, and we expect this trend to continue as long as tariff talks worsen. Beyond tariffs, currency markets are also under unprecedented risks from the US administration’s unorthodox ideas to depreciate the USD in exchange for security guarantees (the “Mar-a-Lago” Accord). Other governments may resort to bargaining by purchasing more US goods (e.g. agrifood, natural gas, military products, transport equipment), lowering trade barriers, negotiating deals on critical topics (e.g. minerals, sustainability regulation or data). Europe could leverage services trade as a bargaining chips as the US has sizable trade surplus in services.