Mid Year Outlook

July 1, 2025

An Economy On "Pause"

Talk about sitting on a hot seat! With inflation alternatively showing signs of heating and cooling, forecasts for GDP growth this year and next to be negligible, and consumer sentiment in the dumpster, Fed Chair Jerome Powell is under unprecedented pressure to cut interest rates and, better yet, simply leave town.

Because you know the rest of that story, let’s instead focus on the merits of each side’s argument for cutting rates versus the Fed’s current policy "pause." Let’s also talk about earnings and valuations, which may wind up mattering more to investors in the second half than Washington’s conflicting monetary and fiscal policies.

While uncertainty is inherent to predicting anything, making an economic call is especially daunting when tariffs and trade policies are unresolved, and more so when the One Big Beautiful Bill Act is also unresolved.

To that point, rarely is a budget so contentious as this one. Sidestepping the bill’s minutia, if passed in its present form, the Congressional Budget Office and some budget think tanks appear to agree that over the next decade, the federal deficit may grow $3 to $4 trillion to almost $320 trillion. While deficit spending tends to support GDP growth (thus the rationale for Covid-era deficits), an additional $550 billion in annual interest payments is inflationary.

While Chairman Powell has been quick to note that Washington’s fiscal (and tariff) policies are outside the Fed’s monetary purview, rest assured, great consideration is being given to this spending bill and its possible impact on inflation. As for President Trump, he’s also watching, fully appreciating that lower interest rates benefit the consumer as well as the world’s largest debtor: the U.S. government.

In the short term, meaning the remainder of 2025, few see inflation cooling to the Fed’s long-term target of 2%. At the same time, the Fed (and the White House) are cautiously watching the economy’s overall health.

While the economy is enjoying "full employment," recently displaced workers are needing more time to find a job. Other metrics paint a less clear picture: recurring jobless claims are up slightly, although initial claims have dipped. And with stocks in flux and investors perhaps hyper-sensitive to inflation, consumer spending was up a modest 0.5% in May, down from an anticipated rise of 1.2%. Perhaps most significantly, revised first-quarter GDP indicates the economy grew at an annualized rate of only 0.5%, and that was before the trade imbroglio was in full force. In other words, irrespective of trade battles, spending bills and widely publicized government firings, the economy has been showing signs of distress.

That there is something of a disconnect between weakening consumer sentiment at a time when stocks have roared back and even set a new record or two, is not without precedence. In fact, that the correlation between "Wall Street" and "Main Street’s" optimism has diminished appears to have become more prevalent in this post-Covid era.

While some may dismiss that as either a temporary phenomenon or a curiosity for economists to ponder, misses an important point: The U.S. is a consumer-driven economy. That the University of Michigan’s index of consumer sentiment recently fell to its second-lowest lowest level since its inception 70 years ago, is very much worth understanding why. After all, about two-thirds of America’s GDP is directly tied to our GDP.

Given all that’s riding on the consumer and the fact that the coming budget may lead to further uncertainty as it’s still unclear as to who actually "wins" and "loses," the Fed’s conditional promise to cut rates this year may come sooner than later. Second only to receiving a stimulus check from Uncle Sam, few things boost consumer confidence quite like borrowing money for less. That will most assuredly help to sustain share prices, even though their valuations (price-to-earnings) are most assuredly elevated. But alas, there may be help on that score, too.

Businesses also like lower interest rates because they help to improve balance sheets (especially for small, more leveraged companies) and drive top-line growth. Unfortunately, FactSet is calling for a slowdown in second-quarter earnings growth. If correct, that and elevated valuations may combine to rattle markets this quarter. On the other hand, if shaky earnings, low consumer confidence and a weakening labor market are all in the cards this quarter, the Fed will have little choice but to cut. That would help support share prices and perhaps extend Mr. Powell’s career.

— John Bonnanzio