- 2024-08-13
- News
U.S. Economy in 2025: High Inflation, Slow Growth
A series of policy propositions have cast a thick fog over the U.S. economy. Morgan Stanley believes that the global market may usher in an America with slower economic growth and more stubborn inflation next year.
Morgan Stanley economists, led by Seth B Carpenter, warned in a recently published forward-looking report that if the promises to tighten immigration policy and impose higher tariffs are fulfilled, the U.S. labor market and trade will both be impacted, putting pressure on U.S. GDP growth over the next two years and making the path to lower inflation more bumpy.
Considering the initial inflationary pressures and policy uncertainties, Morgan Stanley expects the Federal Reserve to remain cautious about the future interest rate path and to pause rate cuts starting in the second quarter of next year. As the economy slows down, job growth is expected to almost stagnate in the second half of 2026, at which point the Federal Reserve is expected to resume rate cuts.
Economic pressures are immense.
Given the significant economic pressures from stricter immigration policies and high tariffs, Morgan Stanley expects U.S. GDP growth to slow down from 2.4% in 2024 to 1.9% in 2025, and further drop to 1.3% in 2026.
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Morgan Stanley believes that the new government's expulsion and exclusion of illegal immigrants will lead to a decrease in net immigration from 3.3 million in 2023 to 500,000 in 2026. The reduction in immigration is expected to keep the labor market tight in 2025, but as economic growth falls below potential, the unemployment rate will rise in 2026.
Estimates suggest that the unemployment rate will be 4.3% by the end of 2024, 4.1% in 2025, and 4.5% in 2026. The reduction in immigration means a significant decrease in the number of employed people in 2025 and 2026.
Although the consumer base remains solid, consumption growth is expected to slow down significantly in 2025 and 2026 due to a cooling labor market, rising tariffs, and reduced immigration.
It is projected that real consumption growth will be 2.6% in 2024, dropping to 2.0% in 2025, and 1.3% in 2026. Compared to service consumption, the decline in goods consumption is smaller, as lower interest rates support durable goods consumption.
In terms of fiscal policy, Morgan Stanley believes that the momentum of fiscal spending will weaken in 2025. Although the new government will pass tax legislation, it will mainly maintain existing tax cuts rather than stimulate economic growth.
Business investment is expected to maintain steady growth next year, with AI investment potentially contributing more to GDP.
In recent years, business investment has been limited to specific industries, such as the manufacturing investment boom in 2023 and the AI investment wave in 2024.
In particular, AI-related investments have significantly accelerated in the past year, and Morgan Stanley expects this trend to continue in 2025 and 2026. The growth of AI investments is expected to have a positive impact on investments in data centers, power structures, and related technical equipment, directly contributing to GDP growth.
Morgan Stanley expects real business fixed investment to grow by 4.0% in 2024, 3.9% in 2025, and 3.2% in 2026; structural investments will grow by 1.6% and 5.4% in the next two years (half contributed by AI).
AI has already driven structural investments in data warehouses and power-related structures. Morgan Stanley expects further acceleration in investments related to data warehouses and power.
We expect AI's strong performance to contribute about half of the structural investment growth in 2025. For 2026, we expect growth to slow down to 4%.
Compared to 2025, AI-related structural expenditures will contribute roughly the same in 2026 (3.5 percentage points). However, the negative factors related to tariffs reduce growth by three-quarters of a percentage point.
Morgan Stanley expects AI investments to raise the U.S. GDP by 0.1 percentage point in 2024.
The report points out that at the beginning of 2023, investments in data center structures showed an upward trend, and power construction and computer investments also increased in mid-2023. These three types of business investments may indicate the effect of accelerated investment. Additional investments in power-related structures and data centers directly drive GDP growth. However, AI-related equipment investments mainly rely on imports, with 75% of domestic computer expenditures used for imports, and additional battery storage almost entirely dependent. Therefore, the positive impact of AI equipment expenditure on GDP is largely offset by imports at present.
It is expected that by 2025, AI investments will have a greater impetus on economic growth, expected to increase by 0.25 percentage points. Expenditures on data warehouses and power structures will contribute 3.5 percentage points to structural investments and one-tenth to GDP. Despite faster import growth, expenditures on computers and related equipment will also make a similar contribution.
By 2026, due to the slowdown in data center construction, the contribution of AI investments to GDP growth may drop to 0.15 percentage points.
Under high import tariffs, trade is under pressure.
In the next two years, the policy of high import tariffs is expected to put pressure on imports, and the prospect of slower growth in Mexico and a stronger dollar is expected to lead to slower exports.
Morgan Stanley expects trade to slightly drag on GDP growth in 2025 (-0.2 percentage points), but the impact will decrease in 2026 (-0.1 percentage points) as import growth slows down.
Despite the pressure on imports from tariffs, the continued growth of AI investments is expected to support imports, especially in 2025 and 2026. Morgan Stanley says that U.S. companies will continue to seek specialized hardware, advanced electronic devices, and other technical components for AI research, development, and infrastructure.
More stubborn inflation.
Morgan Stanley expects inflation to continue to decelerate before the first quarter of 2025, but become more stubborn afterward.
Specifically, the U.S. core PCE inflation rate will drop to 2.8% in 2024, but due to tight labor markets and high tariff policies, this figure will remain at higher levels of 2.5% and 2.4% in 2025 and 2026, respectively, still above the Federal Reserve's target level.
The imposition of tariffs is expected to have a more noticeable impact on inflation in the second half of 2025, and the tight labor market may drive wage growth in 2025, thus putting pressure on service industry inflation.
A more cautious path of rate cuts.
Loving monetary easing, one might inadvertently ignite inflation, and the Federal Reserve must be very cautious about the future interest rate path.
Morgan Stanley expects the Federal Reserve to continue cutting rates in the first half of 2025, with each cut of 25 basis points, until the federal funds rate drops to 3.625%. However, with the tight labor market and pressure on service industry inflation, as well as residual seasonal factors, the Federal Reserve may pause rate cuts after May 2025. At the same time, the Federal Reserve will end quantitative tightening (QT) in the first quarter of next year.
Only when inflation stabilizes and begins to decline, and economic growth significantly slows down due to tariffs, may the Federal Reserve resume rate cuts in the second half of 2026.
Morgan Stanley expects the federal funds rate to drop to 2.375% by the end of 2026. Morgan Stanley made assumptions about the U.S. interest rate outlook for 2025:
Scenario 1: U.S. hard landing - The neutral interest rate is lower than expected, and the Federal Reserve over-tightens. Monetary policy lags, only affecting the economy from the first quarter of 2025, leading to a sharp economic slowdown, inflation below target, and a hard landing.
In this case, it is expected that the Federal Reserve will quickly cut interest rates to 1% in the first half of 2025 and maintain it until the second half of 2026. The forecast for GDP growth in 2025 is -0.3% (quarter-on-quarter year-on-year), and 1.8% in 2026.
Scenario 2: U.S. re-acceleration - The economy rebounds in 2025 due to rate cuts. The neutral interest rate is higher than expected, and the Federal Reserve cuts rates too much, causing the economy to re-accelerate and inflation to rise as a result.
In this scenario, productivity growth is stronger, and the neutral interest rate remains high. It is expected that after the policy interest rate drops to 3.625%, the Federal Reserve will raise rates again in the fourth quarter of 2025, raising the rate to 3.875% by the end of 2025, and further raising the rate to 4.875% by the end of 2026. The forecast for GDP growth in 2025 is 2.8% (quarter-on-quarter year-on-year), and 2.3% in 2026.
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