What’s the future of the U.S. economy?

This month, U.S. markets experienced significant declines following responses from China, Mexico, and Canada to President Donald Trump’s tariff initiatives, as they imposed tariffs on American products. Many investors are apprehensive that a prolonged trade conflict could drive the country into a recession. (The president asserts that Americans should expect a “period of transition.”) In the meantime, the University of Michigan’s consumer sentiment gauge has dropped to its lowest position since November 2022.

These trends create a context for discussions this week where the Federal Reserve will deliberate on whether to recommence interest rate reductions.

In this revised dialogue, economist Jeffrey Frankel, James W. Harpel Professor of Capital Formation and Growth at Harvard Kennedy School, explores the effects of the recent administration’s tariff policy and the overall state of the U.S. economy.

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Is there a valid reason for increasing or expanding tariffs?

Generally, they are widely regarded as detrimental — nearly all economists oppose them. Can there ever be a legitimate rationale for a tariff? I can identify three scenarios. First, a developing nation might lack an efficient means of generating revenue apart from tariffs. Second, there exists an argument for “infant industry” — if the government identifies a sector with potential for economies of scale and positive externalities, it may safeguard it against foreign competition for a few years, after which the industry can flourish, and tariffs can be lifted to enable competition in global markets. Third, Europe has what they call CBAM, Carbon Border Adjustment Mechanism, which aims to combat climate change. One could view this as a tariff, but I interpret it as potentially beneficial due to its alignment with the Paris Accord, thus fitting within the regulations of the World Trade Organization. There are possibly other instances, but none are relevant to the U.S. at this time.

Treasury Secretary Scott Bessent referred to the market downturn as a “normal” and “healthy correction” following years of excessive government expenditure, predicting that we will ultimately achieve a more robust economy. Is this a realistic assertion?

It lacks a solid foundation. Their strategy appears to be to delay, stating, “Sure, there will be some immediate negative consequences, but prosperity will arrive afterward.” However, this argument does not align with any sound economic reasoning I am aware of, much less a credible one.

One could argue that with tariff protection, our manufacturing sector may achieve increased investment and productivity growth, subsequently enhancing our competitiveness in the long run, ultimately resulting in higher incomes. Yet, Trump’s tariff strategy is detrimental to investment rather than promoting it. They typically assert that it boosts confidence, but the current policy turmoil is having the opposite effect; it is eroding confidence.

For nations facing debt crises, predominantly developing nations, a frequent pattern is excessive budget deficits leading to soaring debt levels. As part of a corrective approach, often under IMF [International Monetary Fund] oversight, they must reduce budget deficits, implement monetary discipline, and devalue their currencies. This can induce a couple of years of intense economic distress, but it enables a subsequent recovery and restoration of long-term growth. For instance, one could characterize Korea in ’98 in this manner. While the excessive debt aspect of this cycle may pertain to the U.S. currently, I don’t think the rest relates to the U.S. A debt crisis is undesirable and not what the advocates for tariffs are envisioning.

The recent University of Michigan consumer sentiment gauge indicates that economic confidence is at its lowest since November 2022. Additionally, job creation has also slowed. Do these trends signal a recession or something akin to the stagflation of the 1970s?

I believe it is sensible to be concerned about a potential recession occurring within the next year. This is significantly more probable than one would have anticipated a year prior.

I observe five factors that could logically induce or exacerbate a recession. The first is the trade conflict. The second is a crash in the stock market. The third involves substantial reductions in government expenditure, provided Musk and Trump can find meaningful cuts. The fourth factor is an impending fiscal crisis in the U.S. due to a government shutdown, inability to raise the debt ceiling, or a downgrade by Moody’s, the credit rating agency. The fifth involves an overarching increase in perceived risk. Risk is escalating as a result of Trump’s erratic actions regarding tariffs and government spending. It almost appears they are deliberately intensifying perceptions of variability, volatility, and unpredictability. This uncertainty has a detrimental impact in itself.

This instability has concerned not only investors but also industries such as real estate and healthcare, leading many businesses to adopt a “wait and see” approach. What are the ramifications for the broader economy?

If the uncertainty were brief, it wouldn’t have a significant impact, but it’s clearly going to persist well beyond that. Even if it takes months to address these issues, that could suffice to adversely affect employment and income and possibly cause a recession. In extreme cases, if hiring halts for a month or two, that alone could trigger a recession.

The Federal Reserve faces two seemingly opposing alternatives regarding interest rates: either stimulate the economy and job market with rate cuts or maintain the current rates to manage inflation and inflation expectations. What course of action is the Fed likely to take?

That’s the dilemma. In a sense, it’s always a dilemma, but it becomes significantly more pronounced during times like this, as tariffs and general turmoil act as detrimental supply shocks. These are akin to an international oil crisis or a COVID shock. Supply shocks exacerbate the trade-off between production and inflation, and they are not issues the central bank can remedy. Consequently, the Fed is concerned about both rising inflation and a deceleration in economic activity. One objective suggests maintaining higher interest rates, while another advocates for reductions. I believe they will opt to keep them steady.