President Trump shocked investors last month by announcing 10% baseline tariffs on all imports into the US, additional reciprocal tariffs on dozens of foreign nations and extreme 145% tariffs on Chinese exports.

Financial markets have recovered some of this year’s losses after the US government paused reciprocal tariffs and opened negotiations with its trading partners. But Washington’s 10% baseline tariffs on all US imports and 145% tariffs on Chinese exports remain in place. We see four key implications for the economic outlook this year.

First, the shock of April’s tariff hikes will tip the US and the global economy into a recession if no deals are agreed to scale back the trade barriers. We think Washington will relent and lower US tariffs back towards its new 10% baseline for all imports but the sudden disruption to supply chains will still cause the major economies to suffer stagflation this year.

Second, the US outlook is set to deteriorate the most in 2025 as Washington’s new tariffs cover all US imports. We think the supply shock from suddenly higher import tariffs will halve US GDP growth from a strong 2.8% in 2024 to a sluggish 1.4% in 2025 as our forecast table below shows. Already, the front-loading of imports to beat tariff hikes has caused US 1Q25 GDP to surprisingly contract 0.1% Quarter-on Quarter (QoQ). At the same time, core inflation is set to increase to 3-4%. The Fed is thus unlikely to cut its fed funds rate more than once this year, leaving interest rates elevated above 4.00% to keep curbing inflation.

Third, the rest of the world, in contrast, faces a demand shock. We think monetary and fiscal stimulus in Europe and Asia will cushion the impact of tariffs on growth outside the US.

Last, the US government’s erratic policymaking is damaging faith in US assets. We see the US Dollar and US Treasuries weakening over the long term as investors turn towards Europe and Asia.

US – The Fed is likely to clash with the US government

The US outlook has deteriorated sharply since the Trump administration announced major tariff increases in April. We expect the economy will suffer stagflation as GDP growth slows sharply from a strong 2.8% last year to 1.4% this year and core inflation rises to 3-4% even as we anticipate Washington easing much of its new trade barriers.

Stagflation will challenge the Fed. We expect the Fed will leave its fed funds rate at 4.25-4.50% while assessing the risks of stagflation or a recession this year. With core inflation still above its 2% target at 2.6% and likely to end 2025 at well over 3%, we think the Fed may cut interest rates just once in 2025 unless unemployment starts to rise from its current low level of 4.2%.

Last month Chairman Powell duly warned the Fed’s twin goals of maintaining maximum employment and keeping prices stable were at risk from the US tariff increases, prompting President Trump to attack the Fed Chair.

Financial markets fear President Trump may try to fire Powell, compromising the central bank’s independence, stopping officials from setting interest rates freely and thus letting inflation soar as a weak Fed allowed in the 1970s. But the likelihood of the central bank keeping interest rates elevated above 4.00% this year will almost certainly cause another clash with the Trump administration.

Threats to Fed independence, higher inflation and the risk of future tax cuts raising the US fiscal deficit from its already high levels of 7% of GDP, keep us cautious about the long-term prospects for US Treasuries with 10Y yields set to reach 5.00% again.

China – Beijing to force Washington to concede on tariffs

The US government rather than China’s is more likely to climb down first in the two countries’ trade war, helping China’s markets rebound.

To recap, Washington has imposed two rounds of 10% tariff hikes on all Chinese exports this year and from early April reciprocal tariffs rising to an extreme 145%. In response Beijing has set 125% tariffs on US imports, curbed the exports of rare earths and started tightening regulations on US firms operating in China’s vast domestic market.

US tariffs are likely to weaken China’s GDP growth this year to 4.2% from 5.0% last year. But we expect Beijing to hold firm until Washington makes concessions and starts reducing its extreme tariffs as the Trump administration is more likely to be sensitive to the political costs of higher inflation, weaker growth and volatile markets.

We forecast China’s growth to slow significantly from the trade war this year. But activity is unlikely to buckle as officials in Beijing negotiate a truce with Washington while also providing further stimulus to the domestic economy. Thus, we anticipate the People’s Bank of China (PBoC) will cut interest rates further from current levels of 1.50% for its seven-day repo rate and the government will take advantage of China’s low levels of inflation and bond yields to increase fiscal borrowing and spending to keep supporting China’s growth this year.

Europe – The EU and UK will step up stimulus

Both the European Union and the UK are likely to experience lacklustre growth below 1% this year owing to Washington’s tariff hikes. But unlike the US which will suffer higher inflation due to the supply shock from its higher import costs, the Eurozone and the UK will see inflation ease from the demand shock of lower US purchases of Europe’s exports. We therefore expect both the European Central Bank (ECB) and the Bank of England (BoE) to keep cutting interest rates this year to 1.75% in the Eurozone and 3.75% in the UK to the benefit of Europe’s financial markets.

Japan –The BOJ cautious on further interest rate rises

In contrast to the Fed, PBOC, ECB and BOE, the Bank of Japan (BOJ) is the one major central bank that has been hiking interest rates over the past year, helping the Japanese Yen (JPY) to recover from its four-decade lows of 162 against the US Dollar reached in 2024.

We expect the BOJ will keep on gradually raising rates in 25 basis points steps roughly once every six months. Currently, the BOJ’s overnight call rate is still very low at just 0.50% while core inflation has been above its 2% target since 2022. But at its latest meeting on 1 May, the central bank gave no indication when it would next hike given the uncertain outlook for global trade. We thus expect the BOJ to keep its rate hikes paused until Japan signs a trade deal with the US. Once, the BOJ has clarity on exports, it is likely to resume its rate hikes this year to the benefit of the JPY.