The Decisive | Season 6 | Ep.8 - Resilience Tested: What's at Stake for the US Economy

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Kristen Hallam

Hello, and welcome to The Decisive podcast. I’m your usual host, Kristen Hallam. This week’s episode is taken from our client webinar with the S&P Global Market Intelligence US macroeconomic team: Ben Herzon, co-head of US economics; Michael Zdinak, director, US economics; and Lawrence Nelson, principal US economist.

Moderated by Emily Crowley, head of our Pricing & Purchasing research team, the discussion covers our base case for the US economy, how we bracket a plausible range of outcomes outside our base case, and what the Federal Reserve has in store now that Kevin Warsh is the new chair.

Without further ado, here’s Emily to kick us off.

Emily Crowley  

Can you walk us through your baseline outlook, including your key assumptions about developments surrounding the war in the Middle East?

Michael Zdinak  

Here are the current hallmarks of the U.S. forecast. As Emily noted, we expect the U.S. economy to remain resilient in '26 with growth close to potential despite the near-term drag from the war in the Middle East. Part of that story comes from the resilience we saw last year with the U.S. remaining resilient despite the swings in trade from changes in tariff policy and growth near potential, just about 2% over the 4 quarters of 2025. Surging energy prices and the slower growth of real income and wealth are expected to weigh on consumer spending and growth is expected to ease to 1.6% over the 4 quarters and then to pick up afterwards. With that, the unemployment rate is expected to rise to a peak of 4.8% by the first quarter of 2027. This puts policymakers in a tough spot. They're trying to balance their dual mandate of maximum employment against rising prices and prices in our baseline are expected to rise as tariffs and now elevated oil prices push through to finished goods. That has the Federal Reserve on pause in our forecast with easing not resuming until June of next year, 3 months later than the last month's forecast. Prior to the war, our outlook was broadly optimistic for 2026. And the reason for this was twofold. First, despite the significant uncertainty last year, the U.S. economy had remained resilient, as I said, and grew at a rate near potential. And the drivers of the uncertainty were at that time, tariff rates, swings in the GDP source data and uncertainty about the impact of so much uncertainty and the effects of things like the government shutdown. Now we're facing oil prices, and oil shock. And second, the reason why our outlook was more optimistic was along with the decline in uncertainty last year, we saw a recovery in equity prices. We're seeing something similar right now, and so that's factoring strongly into our baseline outlook for the rest of the year. And the reason for this was twofold. Markets were increasingly less concerned about the impact of tariffs and things like the historically low levels of consumer sentiment and this fear or talk of an imminent recession never really materialized. Now the outbreak of the war obviously changes that. And so what's going to matter for the U.S. economy are 3 things. First, how high oil prices will go and how long they'll remain elevated. This feeds into core inflation -- headline and core inflation in our forecast, which again weakens real income and wealth spend and softens consumer spending. The second question is how low will equity values go and how tight financial conditions will get as a result. Weak equity values again feed back negatively into consumer spending and tight financial conditions feed back negatively into business spending. And then the third thing we're watching is how will that shock unfold materially? Will it weaken consumer and business confidence sufficiently enough that there are knock-on effects to the broader economy. And that's where we start to get the risk of the recession dynamics coming into play. our baseline forecast includes the assumptions that supply conditions remain tight for months, even if today's cease fire holds. Yet the S&P 500 has remained resilient. It's over 7,000 at the end of June, though our forecast doesn't really include much more upside there this year. We're also balancing the risks from tariffs with the Supreme Court having struck down the IEEPA tariffs that we saw last year. And our expectations are that while the administration has the flexibility to put in a similar tariff regime that as we manage the difference between what we see coming in, in the data on imports and exports and the announced statutory rates, we're looking at a rate that's closer to converting to around 10%, down from our expectations of a much higher rate of 13% in the last baseline forecast. That's going to provide a little bit of cushion for our outlook for inflation. With that, we have immigration also slowing this year. Population growth has slowed markedly since the president took office, and we have population growth of immigration of 500,000 less than center baseline through the remainder of its presidency.

So where else do we stand today? And how does this all factor into our May baseline? A useful comparison that we've been using is the progression of daily oil prices and equity values compared to August 1990. Why August 1990? That's when Iraq invaded Kuwait and set in motion the first Gulf war. The result was a macro shock that combined with the underlying fragility that was occurring during the savings and loan crisis led to the ‘90-‘91 recession. Over the first 25 days of the war, oil prices fell, and they were tracking along the same path that we saw during the first Gulf wars and equity prices initially declined. But since then, oil prices have stalled and equity prices have again risen. And so we're looking at a situation that in context is quite different. And if you think that, that view seems overly optimistic, remember that history doesn't repeat itself. It merely rhymes, so we have to ask ourselves what's different. And one of the primary differences that we've been pointing to, to help us understand this conflict and how it's evolved is where the U.S. economy is today relative to where it was in 1990. Back in 1990, the economy required about 8,000 BTUs of energy usage to produce $1 of GDP. And in 2025, that number is down to 4,000 BTUs. So from this comparison, the U.S. economy is nearly twice as efficient as it was in the 1990s, which makes it much better equipped to handle an energy shock. So we're asked the question of what price in oil would be concerning to us or what level are we looking at that would cause concern. We're not talking about $150 barrel per oil like we have even in our baseline forecast peaking in May. In real terms, adjusted for the change in prices, that's no different than 2012 or 2014, which is 3 years where the economy grew at a rate of about between 2% and 2.5%, meaning that from our perspective, we will probably need to see oil around $200 a barrel for a sustained amount of time before we really got concerned about inflationary dynamics. Now regarding a recession doesn't mean the impact isn't large. This scenario is very different from where we were last year. And when the tariffs were announced and then delayed and then later reduced because what has been done in the Middle East can't be undone quickly. And our expectation is that oil supplies will remain tight through the rest of the year, and that will have real consequences for the U.S. economy. And with that, I'll kick it back to you, Emily.

Emily Crowley 

Thanks, Michael. There's a lot of uncertainty surrounding developments in the Middle East, So Ben, I want to turn to you and ask you, how would you think about bracketing a plausible range of outcomes? I guess the first place to start is what are those outcomes? And then also just as a fellow economist, are any of them a recession?

Ben Herzon

Yes, I'd be happy to talk about those. Thanks, Emily. Well, okay, so the way we think about bracketing a plausible range of outcomes is through scenario analysis. And in the current situation, we are leading on the expertise of our partners in the energy and risk groups of our company. Together, they have developed a plausible range of outcomes for oil prices that are conditioned on developments in the Middle East. We take those projections for oil prices and supplement them with other macroeconomic inputs that we believe would accompany them. For example, when we look at an oil price projection that's conditioned on developments in the Middle East, we ask ourselves, okay, what kind of pullback from risk would we expect to see in financial markets that went along with this scenario. Moreover, how would the Fed respond in such a setting? Once we've assembled all of the macroeconomic inputs that we view are relevant, we enter them into our macro model and produce a simulation. The macro model then tells us how the U.S. economy would fare under these alternative circumstances. So in a plausible yet pessimistic scenario, the spot price of Brent rises to about $140 per barrel and remains elevated above our baseline projection and risk appetite in financial markets sours enough to produce a moderately weaker projection for equity prices. On the other side, in a plausible yet optimistic scenario, the spot price of Brent tracks below our baseline projection, while risk appetite is stronger than in our baseline. In the pessimistic scenario, weaker equity values reduce household wealth and higher oil prices pushed through to higher finished goods prices, raising the rate of inflation and weakening measures of real household income and wealth. The full model response to these inputs is a weaker growth outlook and a higher peak in the unemployment rate, but no recession. GDP growth remains positive. The optimistic scenario is essentially a mirror image of this pessimistic scenario. So you asked about a recession. So what would it take to produce a recession? Well, what our macro model tells us is that $140 oil and a modest pullback of risk would not be sufficient to cause a recession. It would take a much larger shock. So this is how we approach bracketing a range of plausible outcomes. The last piece in this exercise is assigning probabilities to these outcomes. Well, this is a tricky business. We do this judgmentally. Currently, we are assigning 50% to our baseline forecast, 25% to our pessimistic alternative and 25% to our optimistic alternative.

Emily Crowley 

You’ve got inflation, and we've touched on unemployment. So those are the 2 mandates of the Fed. Lawrence, let's bring you in to discuss the Fed call. Michael noted that you don't expect the Fed to ease until the middle of next year. You also don't expect a hike. Can you walk us through the thinking behind that call?

Lawrence Nelson

That's right. Thank you, Emily. So after cutting by 25 basis points at each of the final 3 meetings of last year, the Fed signaled with its December policy statement that a pause was likely to start the new year as we turn the calendar over. In the first 2 months of this year, we saw already that the Fed was facing increased pressure on the inflation side of its mandate. Inflation was looking sticky through January and February as we continue to deal with the effects of last year's price shock. As a result of this, with our March baseline, we had already pushed back our expectation for the next rate cut from June to July. That's notable because the March baseline was finalized before the war started. So we had already started pushing back our expectations for the next rate cut based on pre-war developments. This reflected an upward revision to our inflation forecast in our March forecast as well as a downward revision to the unemployment rate. Now of course, the war has compounded the risks on both sides of the mandate. Both baselines we've issued since we incorporated more effects into our forecast have shown positives for all of this year on further rate cuts. With our May forecast, as Michael noted, we now show the next rate cut occurring in June of next year. This reflects our expectation that core PCE inflation will firm to 3.6% this year. The forecasts do show higher unemployment rate than our pre-war baselines, but it's not enough to countermand the extent of the upward revision on the inflation side of the ledger. The last summary of economic projections we got from the FOMC was published in mid-March, a few weeks after the war started. In the post-meeting press conference in March, Chair Powell noted that policymakers generally felt at the time it was too soon to know what the ultimate effects of the war would be. So they didn't incorporate much of those effects into their forecast at the time. Now our May forecast looks quite different than what we and the FOMC had back in March. We have higher core inflation, higher unemployment, weaker near-term growth. Notably, in March, 7 of the 19 policymakers on the FOMC indicated that they felt no rate cuts, no change in the policy rate would be appropriate this year. 7 also indicated that they felt only one rate cut would be appropriate this year. So when we get the next set of projections following the meeting next month, it would be interesting to see, one, how many people have moved from the one or more cuts to no cuts this year. And critically, if any are indicating that they expect that possibly rate hikes might be appropriate this year or beyond.

Traditional thinking around monetary policy holds that policy should look through the effects of energy price shocks, such as the one we're currently living through. But when making this point, policymakers have tended to emphasize that, yes, while it is true that the effects of those shocks tend to be short-lived, monetary policy famously operates with long and variable lags, but they can only apply that thinking so long as inflation expectations remain well anchored. In the months since the war started, we have seen some upward drift in inflation expectations, but not yet enough to suggest that expectations have become unanchored. However, with inflation now over 5 years above target, this is not an outcome that policymakers can take for granted. So it is something we and they will surely be watching closely as we go forward through this conflict. Our processing of the consumer and producer prices for April suggests that April PCE will come in at 0.5% for headline inflation and 0.3% for core. These readings would bring the 12-month changes to 3.8% and 3.3% for headline and core, respectively. Based on our current oil price assumptions, the 12-month change is expected to drift higher through this year as energy prices diffuse through the economy. And leaving the nominal policy rate unchanged against this backdrop of rising inflation is a passive loosening of policy in real interest rate terms. As the real interest rate gets closer to 0, this suggests a change in forward guidance is likely forthcoming from the Fed. With 3 dissents in the April meeting from 3 presidents already signaled that they were inclined to favor more neutral forward guidance. They wanted to drop that implicit easing bias from the policy statement. Dropping that bias and making the forward guidance more neutral would not necessarily signal that a hike is forthcoming. Rather, it would illustrate that the Fed remains steadfastly committed to restoring inflation to its 2% target and that all options are on the table to achieve that. So whether or not that extent and timing of further adjustment language is dropped or changed in the June statement is one of the first things we will be looking for following the release of the policy statement at the June meeting, which will, of course, be Kevin Warsh's first meeting as the new Fed chair.

Emily Crowley  

So I have to ask, how do you think a transition to a Warsh Fed will affect the conduct of monetary policy, if at all? Has there been any indication of how Warsh might do things differently once he is leaving the FOMC?

Lawrence Nelson

Yes. So Warsh was officially confirmed by a Senate vote last week. As of right now, he has yet to be sworn in at the Fed. So currently, Jerome Powell is serving as Chair Protem as part of the arrangement he outlined following the April meeting. Once Warsh is sworn in, Powell will cede the title of chair to him, but continue to serve as a governor. Powell indicated that he intends to serve as a low-profile sort of governor, not trying to stir up too much dissent or cause any trouble as Warsh takes over the leadership role and seeks to implement his agenda. Warsh has outlined a pretty sweeping agenda of changes he would like to pursue as Fed Chair. First and foremost among them, he believes that AI-driven productivity gains support lowering the policy rate in the near term. He's also advocated changing the inflation framework. He has attributed much of the -- what he called the fatal policy error of 2021 to 2022 to the way the Fed measures and gauges inflation and inflation trends. During his congressional testimony, he emphasized a preference for considering alternative means of inflation, particularly highlighting trimmed mean measures of core inflation. Warsh has also long been an advocate of reducing the size of the balance sheet. His stance on that has been publicly well stated since his first term as a governor back in 2006 to 2011. He's also advocated scaling back on communication from policymakers. He believes the practice of forward guidance has kind of forced the Fed to precommit to policy paths that subsequent developments may not warrant as being appropriate. Throughout his congressional testimony, Warsh did affirm his intent to maintain the Federal Reserve's institutional independence and monetary policy, but he added that independence needs to be earned by achieving its dual mandates of maximum employment and stable prices while focusing solely on these core issues. Taking a step back and weighing his whole agenda, it's fair to say that this is the first time since Paul Volcker took over in the late '70s that an incoming Chair has not emphasized continuity with their predecessor. We do believe that Warsh's background, particularly his experience at the Fed, should set him up well to succeed as Chair. Nevertheless, the extent to which he can actually deliver on this ambitious agenda is somewhat limited by the structure of the Fed. There is very little that the chair can do unilaterally. Of course, the chair holds outsized influence. They set the agenda for the meetings. But ultimately, they are just one vote on policy outcome. So it's really through his ability to forge a consensus among his colleagues that Warsh will actually be able to achieve these changes once he takes over as Chair. So given all the uncertainty we've highlighted so far, I think it's certainly fair to expect some pushback on the support for lower rates, at least in the short term. Scrutinizing Warsh's preference for trimmed mean and alternative measures of core inflation, while it is true that today, and looking strictly at core mean inflation would be more supportive of lowering the policy rate than looking at core, trimmed mean measures are trending closer to 2% than core. But it is less clear that that emphasis would have avoided what he called the fatal policy error of 2021 to 2022. Most measures have trimmed mean inflation did not breach 4% until about 6 months later than core inflation. So again, it's not clear that this change in focus would have prompted policymakers to act any sooner than they otherwise did. On the balance sheet, we're not going back to precrisis levels of reserves that would not be compatible with the Fed's current operating framework. But we have heard some support from other members of the committee that there is some support for reducing the size of the balance sheet, but we expect changes here to be slow, deliberate, fairly marginal and well signaled. As a result, we have not yet made any explicit adjustment to our assumptions for the balance sheet, pending clarity on what the broader committee is likely to support, similar to the approach we've taken on interest rate policy.