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.
