Which policies will impact the U.S. economy in 2025?
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Hello and welcome to Strategic Alternatives, the RBC Capital Markets podcast, where we uncover new ways to raise capital, drive growth, and create value in an ever-changing world. I'm your host for this episode, Vito Sperduto, head of RBC Capital Markets U.S., and today we'll delve into the U.S. economic themes shaping our outlook for 2025 with RBC's new chief economist, Francis Donald, and our U.S. economist, Mike Reed.

In this episode, they will unpack the key dynamics and risks that could influence their base case and broader forecast and highlight the indicators they're monitoring closely, sharing insights that may impact strategies for our clients in the year ahead.

We'll also explore how the U.S. fits into a global context, considering themes of U.S. exceptionalism, rates divergence, and demographic shifts, as well as uncertainty around monetary policy for the U.S. in 2025, inflation, and more. And most importantly, we'll talk about some of the things that we're conveying to our clients on a daily basis in what is a fast-changing environment. So with that setup, Mike, Francis, welcome to the podcast.

Mike, why don't we start with you? And I know we just published our US outlook for 2025 recently, which everybody should take advantage of in terms of our research. But what do you see as the most important themes for the US in 2025? Yeah, you know, our general positive outlook for the US economy remains unchanged. So what that means is we see a lot of the momentum

in 2024 carrying over into this new year. Throughout 2024, we viewed the labor market dynamics as being in the state of normalization rather than entering a hard landing. That was really confirmed this fall when we saw the untriggering of the SOM rule and other labor market indicators that have failed to show signs of meaningful slowing.

So looking ahead to 2025, we see more headwinds than tailwinds, at least in the first half. And that includes things like the prospects of rising consumer optimism, resilient consumption, favorable tax policies, deregulation, and stricter immigration policies. All of this kind of contributing to a tighter labor market that tips the balance of risks around our growth and inflation forecast to the upside.

In 2025, our base case is that the economy continues to normalize with GDP growth getting back towards 2%, and we expect consumption will continue to drive GDP growth despite a drag from lower and middle income consumers who are bearing the brunt of higher price levels and higher interest rates.

I'm in complete agreement with Mike that the general U.S. economy is probably going to continue to look pretty good on the surface. And at the same time, there's a lot of things that are happening underneath the surface that are telling some broader stories.

And especially as I travel across North America, but then also globally, there are things that you don't see in the headline data, which is most relevant to markets that maybe could be relevant for a lot of our clients who are thinking about the economy from a different, more segmented perspective. And one of those issues is that we expect, and Mike and I have talked a lot about this, that the U.S. economy, while looking strong on the surface, is probably also going to continue to have this

K-shaped dynamics.

And by that, we mean that a lot of the support that comes through in the headline data that is market moving, that the Fed is responding to, is coming from large corporations and higher income households. These are groups that have felt the interest rate shock somewhat less. They're benefiting from wealth impacts, from those really strong stock markets, much more so than lower income households and smaller businesses. And the confidence level for small businesses is really much

much closer to what we saw in 2008 than we have in very strong economies. Now, that doesn't mean that one of these groups is wrong and one of these groups is right, but it does speak to this bifurcation that exists under the surface. So if we're thinking about what does the economy look like in total, it's going to continue to be driven by large companies and high-income households, but there's also some pockets of weakness underneath that we think are also relevant.

It's also interesting to point out here that the US and our resilient view of the United States economy is very different from our view of what's happening globally. So US exceptionalism, which drove a lot of trades last year, is going to continue to be a huge theme in 2025 and maybe one that we increasingly consider not just cyclical but structural in nature.

Some of this U.S. exceptionalism is fundamentally driven and sustainable. For example, productivity and the AI boom is really accruing mostly in the United States.

Some of it also has to do with extraordinary amounts of government spending in the United States that is just not matched elsewhere in other developed market economies. And that extent of government spending continues to lift growth, which is a good thing. But also, I got to tell you, Vito, keeps economists up at night too. So Congressional Budget Office sees the U.S. federal budget deficit rising from $1.9 trillion currently all the way up to $2.9 trillion by 2035.

That's creating distortions in the data. It's making the Federal Reserve's job harder. It's increasing the share of government spending within the economy. And yeah, it's putting a floor under growth, but it also means that the type of growth that's being fueled right now is not all private sector driven, and it's not all the traditional types of growth that we've seen before.

So those aren't themes that you would necessarily see in our GDP forecast, but I think they're going to continue to be relevant. And particularly if you're just looking a little below the surface on more of a sector by sector call, we're trying to get a sense of what consumer segments look like over the course of the next 12 months.

Francis and Mike, we were talking immediately post-election on how to guide our clients. And Francis, you highlighted the quote unquote two U.S. economies and that bifurcation in terms of how different segments are feeling the economy. I'd be curious as you've watched some of these policies.

announced and some of these individuals that have been selected for various positions in the cabinet and in the government. What are you watching post that U.S. election? And what are some of the key items that you think are going to drive the economy going forward?

It's a great question, Vito. And I try to remind myself every day when I come in and I see potential stories that our job as economists and as we put together proper and defensible base case outlooks is to look for policies, not politics. So we're looking for things that are generally announced or good base cases that come through.

And the truth for economists, just like most American households and businesses, is that we don't actually know the size, the magnitude, the timeline, the scope of a great deal of the policies that will probably come through. We do, however, know their directions.

So we have to go with what we know now. Now, in the meantime, as we await more information, the U.S. economy and the global economy are still experiencing what we tend to call an uncertainty shock. So most measures of uncertainty, the small business index of uncertainty is at record highs. Even though we know the outcome of the election, a lot of companies are still trying to figure out what does that mean for them, just as much as we're trying to figure out what does that mean for a GDP forecast.

And from my point of view, and I think Mike can walk through some of the more technical elements of this, he really is one of the best in the world at that. What I keep thinking about is actually the sequencing of what we're going to see next. So we have some policies that we know will probably lift growth, things like deregulation, potential tax cuts. And then we know there will be policies that historically have been more challenging for growth. Tariffs, of course, but also immigration policies that may reduce the amount of labor force available in

These how these are implemented and what comes first is going to matter a lot more, I think, in 2025 and the early part of 2026 than just outright putting a number on a GDP outlook.

At the same time, Vito, I got to tell you, tariffs are complicated. But generally, the way that we think about this is that tariffs hit an economy in four parts. There's kind of four stages. The first one we may start to see earlier rather than later, and that is a front loading of activity. We got some examples from this 2018 steel and aluminum tariffs on Canada, for example, tariffs on a washing machine.

What we tend to see is that people will say, okay, those are going to get more expensive, so we'll bring them in earlier. That can push up things like inventories and actually goose growth in the beginning. Then we tend to see the price shock, that one-time, one-off price shock where prices rise in level terms, not in persistent one-time shock. Central bankers look through that.

Third step, a demand shock to the downside. So we've seen examples where growth can actually deteriorate as that price shock comes through. That makes the job of central bankers real tough, right? Because they see prices go up, but they know there could be actually a demand shock afterwards.

And the fourth and something we're still trying to get our hand around all economists globally is, do you then see some reshoring of activity that happens structurally? So as we assess things like tariffs, it's a little bit more in-depth than simply saying a tariff increases a price and that's all we have going through it. The sequencing, the timelines are going to matter in a really significant way. And anytime someone says, what's the impact of a tariff? My first question to them is, well,

What horizon are you talking about? You want to know the impact in the next three months or in the next three years? But Mike, I know you've been really deep on this in the spreadsheets. How are you thinking about tariffs right now? Yeah, you made some really good points, Frances. And, you know, the order matters, the magnitude matters. And importantly, I think for the Fed in 2025, what matters is where this shows up in terms of how we measure inflation.

And what I mean by that is when we look at things like the consumer price index, that measures what consumers are paying for goods and services in the economy. We also have a measure called the producer price index or PPI that looks at what businesses are paying for their inputs. So in terms of what we saw in Trump's first term, you mentioned some aluminum and steel as great examples. A lot of his tariffs targeted those intermediate inputs.

So what we're thinking about, and in terms of how that shows up in the inflation data, really shows up first in that PPI index. And so the extent to which

those higher prices are passed on and show up in the CPI is really what matters for the Fed. Right now, we have corporate profits near an all-time high. We also know that Trump is playing with the idea of lowering the corporate tax rate. And that's something that could help offset some of the potential threat of a pass-through of those input prices onto the CPI. So the full extent of consumers feeling higher prices as a result

of these tariffs remains to be seen. Yeah, Mike, that's pretty interesting. I had asked our RBC Elements team to kind of pull some information in terms of the topics that were most mentioned pre and post election. And as you might imagine, tariffs

which was kind of generally up there, kind of number five or six in terms of mentioned categories when you compare it to sort of inflation or interest rates or other issues on voters' minds.

popped up pretty dramatically post-election, and especially in recent weeks, as there have been more items mentioned by the incoming president in the U.S., and Trump has tweeted around tariffs with regards to Canada and Mexico and also to the BRIC countries. And it starts to become a question as to how they're going to be used, or are they just a negotiating ploy?

which I think some people are still falling back on. So it'll be interesting to watch that happen. But as we think about that, whether it's tariffs or other spending programs that they're going to be implementing, and you mentioned inflation briefly, but maybe let's take a deeper dive into that. What are some of the key factors that are driving your inflation outlook for next year?

You know, one thing that's really interesting, and you touched on this, Vito, is kind of how Trump is going about this. Under his first term, he used trade policy and threats of tariffs as a tool to address issues like immigration.

Ultimately, those tariffs were never implemented, especially for countries like Canada and Mexico. We know we had the NAFTA renegotiations back in its first term. There's a period where that comes up in 2026. So our base case right now assumes a relatively limited implementation of tariffs in 2025. More importantly, the massive immigration inflows that were a key factor of loosening the labor market conditions in 2024 are starting to reverse right now.

And what that means is we could see potential wage pressures start to increase again.

When you look at things like job openings, those are already starting to creep back up. If you think about the dynamics of slowing immigration inflows and then potentially adding on things like deportations, actually removing people who are here in the country working, that's going to add to the number of job openings we're seeing. That's going to potentially see a reacceleration in wage growth.

perhaps closer resembling the tightness of 2021 and 2022, rather than the continued normalization that we saw in 2024.

I think what's really interesting, Vito, is that historically in 2019 or earlier, if you'd asked Mike or I to talk about inflation, we might have given you this breakdown. Oh, here's what's happening in goods and services. And this is what we're seeing in core CPI and CPI. But actually, we're spending a lot more time thinking about different drivers of inflation now than we were just a few years ago.

Now, historically, if you wanted to estimate inflation, you'd be thinking about demand side. So what is the willingness and ability of people like you and I to go out and spend at a restaurant or buy our kids something nice for Christmas or a company that wanted to expand?

But these factors that Mike's speaking to actually indicate that a lot of the drivers of inflation are not just about whether you or I are interested and capable of going to a restaurant. Is that restaurant even open? Did they have enough people to open that day and actually operate? Were they capable of having their various inputs brought in? Was there a port strike that kept it open?

That's dramatically changing the way that we forecast inflation, but it also means it's going to put pressure on central banks to think differently about inflation as well. A lot of these new types of inflation are far less interest rate sensitive. So you can hike or cut interest rates all you want. It's not likely going to change a deportation policy, for example. You can hike interest rates all you want. It's not going to make it rain in Brazil when we have droughts that impact our food supply and raise prices.

Interest rate policy doesn't impact geopolitical events anymore. It doesn't change more frequent and severe weather, which has been very disruptive to our data and inflationary. So you'll notice both Mike and I, but also just the economics profession more broadly is

changing the way it talks about inflation. And I'm not sure markets have entirely caught on to the idea yet that there will be a, in our view, larger wedge between the inflation story and the interest rate story than there has been historically. So maybe a different way to think about it, but certainly something that I think everybody needs to acknowledge is a new type of inflation and how we're going to incorporate that into our own market views, but also how companies are run and households make decisions.

Another big factor, and this gets back to some of the tariffs that everyone's thinking about, is the deflationary pressure of goods that we've seen through much of 2024. And even without tariffs, that is likely to go away at some point. We don't expect to see goods prices decline on a sustained basis over a two-year period. So if you take away the goods deflation,

You look at what we're seeing in terms of the labor market and how that impacts the wage pressure we've been talking about. We think that really keeps the services component of inflation rather sticky. Also, another component we've been talking a lot about is housing, both its impact on inflation in particular as being one of the largest components and how the interest rate environment is impacting the trajectory of housing prices right now.

Mike, that's an interesting comment, because when I looked at the 2025 economic outlook that was published by you and the team, you know, there was certainly a bit of a focus on, hey, we're heading into 25 on really strong footing.

But that's the initial period as you're talking about it. And Francis, you were talking about what time period are we looking at? And so I know that the team and especially our rate strategist, Blake Wynn, have been ahead of the curve in terms of calling for specific levels of rates and kind of where we're going to get to and at what point does a pause begin? Because I think that's become even more part of the conversation in the past month.

I think we were, you know, prior to a month ago, before the election, we were talking about clearly we're in a rate cutting cycle. Now, I think as we're trying to get our arms around what policies are going to be put in place, there's a clearer view or more people talking about the fact that at some point we're going to see a pause in 25. How does all of this factor in terms of the rate forecast and the like factor into your economic forecast and how do they play together?

You mentioned housing. Maybe you can expand on that. Yeah, this is a really interesting one because, you know, housing passes through to inflation with a very large lag. And so some of what some of what's going on right now in the inflation front is coming from what we were seeing the housing market do, you know, roughly 20 months ago.

So we know about 20 months ago, the housing market started to slow. Prices were falling a little bit. But right now, prices have seen a sustained rise. This is largely due to a structural shortage of supply of homes for sale.

So really what that means is by the start of 2025, we think the Fed is going to go on a pause after the January meeting. That's also when we think housing prices bottom out and start to add inflationary pressure in that CPI measure we were talking about earlier. So in thinking about what that means in 2025 for the Fed, you're going to see upward inflationary pressure with a potential hiking bias by the end of 2025.

And that's going to leave mortgage rates quite high relative to where they were back in 2021. And that's part of the story here. We all know that one of the reasons where you're seeing a very low supply of homes for sale is you have existing homeowners who locked in very favorable mortgage rates back in 2021. And there's little incentive for them to move, even if the Fed were to continue cut, say, 100 basis points.

So we see this dynamic of limited supply playing out in 2025. One, because existing homeowners just aren't going to move. You're not going to see the wage increases needed to offset a higher cost of a mortgage, say closer to six or 7% even.

And on top of that, this higher rate environment is also weighing on new home builders. So that's another area where when you adjust for household formation, the new supply is still really recovering from the great financial crisis. So ultimately, we think housing will continue to be a problem and something that is really not easy

easily addressed by the Fed and their interest rate policy. Another example, Mike, of this economy maybe becoming less interest rate sensitive and how challenging that is for central bankers. You know, you mentioned this concept of a pause in 2025. And really what that pause comes down to is our expectation that the Federal Reserve, like Microsoft,

market participants and forecasters and policymakers is going to be feeling around to figure out what neutral rate is, at least the short-term neutral rate. So neutral rate's a concept that gets thrown around all the time. I tend to think of it as, you know, what is the rate that is neither tightening nor easing on the economy? We know there's no technical way to estimate this. And generally what people say is, well, you kind of know when you get there.

And the challenge as we look in this post-COVID economy is there is a growing belief, and this has certainly been held by our fantastic great strategy, Blake Quinn, and supported by Mike Reed's work, is that that neutral rate is probably higher than it has been historically. And it may be as high as 4%.

Now, the Federal Reserve is still in the camp that it's probably closer to three. So our expectation is that they figure out probably pretty quickly that that's too low in this type of economy and that they actually just need something around four to keep things in equilibrium.

What's interesting to me is that the Federal Reserve is effectively alone in this search for higher neutral rate because several other developed markets and central banks like the ECB or the Bank of Canada have been pretty vocal that they don't actually think the neutral rate outside of the United States has changed very much at all. And that's why the U.S. forecast, while interesting, is most interesting to me because we have

a very expected large spread between the U.S. rate story and the rest of the world, particularly across that gets a lot of attention, the U.S.-Canadian story. We're expecting some of the largest divergence of rates that we've seen between the two countries' histories, not the largest, but consistent with that. And it's being driven by this concept of U.S. exceptionalism

And a fiscal story, a productivity story, an AI story that's lifting the U.S. in a structural stance as well as a cyclical. So when I think about 2025, my expectation is that a lot of these stories that we thought were one-offs, that were distortions of the post-COVID economy, that were about this cycle specifically being different, are going to transform into a realization that these could be 10-plus year themes.

And, you know, it's often hard to talk to market participants about 10 plus year themes. They don't seem like trades. But you could just take a look at AI. AI is a 10 plus year theme that got priced in real darn quick into this story. So I think being aware of what's actually sticky and long term in the rate story might be the most interesting part of this year out of all of the themes that we look at. Yeah.

I've always been interested in the concept of looking at consumer debt and the level of exposure consumers have and how much availability they have. And as I've seen debt levels rise relative to sort of the amount of available credit that they could go out there and get, that's been the times where I've gotten concerned.

When I think of the concept of neutral rate, if I have it correct, it seems like that's where the Fed and others are trying to get to an equilibrium to maintain rates at a level that doesn't harm the consumer that much, but also controls inflation going forward. You mentioned that the Fed was targeting more at 3% level. I think our rate strategist, as you said, is more in the four, four and a quarter level.

What does that one percentage point difference do? Is that something that is an issue if we don't get down to the 3% or how do you think about that?

Something Mike and I have been talking about a lot in the past couple of weeks is what is the risk that the Fed is either too hawkish or ultimately too dovish? And how do we weigh those risks? And it's not a cop out to say that the tails around the outlook are very fat. A lot of times people want economists to have high conviction and say this is exactly what's going to happen. But sometimes the role is to say that there is some uncertainty. And that's because the neutral rate is ultimately unobservable.

So, one of our concerns, particularly as we continue to see data that comes in relatively strong on the labor front, is that the Fed doesn't actually find neutral and stays too high for too long. That's a risk, and that could create a more aggressive slowing in the economy than our forecast currently exists.

But there's two-sided risk, and the central banks have been clear about this too. And there is also risk that inflation comes out too hot if they don't or if they go too loose. That's always a central bank's problem, but in an environment in which the economy is less interest rate sensitive, and we have been through these this time as different shocks, finding that level of neutral is going to be very difficult, and it's going to happen in 2025.

we will know whether they hit it or miss it. I'd be interested to hear Mike's thoughts on this one as well, because it's so critical to the U.S. outlook and how the U.S. economy behaves. Yeah, you know, I think this really plays into that K shape that we're talking about earlier. When you think about the Fed leaving rates too high, that impacts a certain segment of the population that relies on credit

for their consumption. So thinking about folks who take out auto loans, that 1% veto would be very meaningful. Another one that I think has kind of gone by the wayside, but still is something I've been thinking a lot about is student loan repayments. That was a big story in 2023. We had the resumption of student loans.

start back up in October. And so far, the impact on consumption has been limited in 2024. That's in large part because of the Biden administration. They have worked hard to find ways to forgive that and create income-based repayment programs. But I think if some of those policies go

go by the wayside, or if some of those programs are cut, you risk a growing burden of student loan debt on those lower income consumers. And that's where that 1% that you mentioned earlier can really make a big difference when you're talking about tens, if not hundreds of thousands of dollars of student loan debt for anyone who has graduated in recent times.

So, Mike, you brought up some of the concepts of some of the things you're focused on. And maybe as we go to the tail end of this podcast, let's take a look at maybe what are you most concerned about? What is it that could go wrong with the forecast? And what are the items out there? And maybe I'll start off with the following. I think geopolitical risks are very top of mind.

And when I think about that, it's some of the obvious ones in terms of the global conflicts that are going on. But you could probably layer in the trade wars and potential trade wars and tariffs and the like into that, just given what it might cause in terms of disruption.

That'll lead to disruption in the supply chain. Those are some of the topics I'm always looking at to try to figure out how it impacts things, but maybe for each of you, and let's start with you, Mike, what is something that could be a risk to our outlook? - Yeah, I'll offer two. I think one is something we can measure and model, and that would be the rate of retirements.

And if you see something like a stock market correction and you see people start to delay retirement, that could have a very real impact on the unemployment rate. So right now we're forecasting that the unemployment rate ends the year under four and a half percent. But if you see delayed retirements start to tick up, meaning that we don't see job openings, we don't see opportunities for new entrants, we run the risk of the unemployment rate running closer to five percent by year end.

Another one that we've talked a lot about, and this is more of an unknown unknown, is Buy Now, Pay Later. It's a relatively new development, a new program that we've seen consumers take on in recent times.

And, you know, the issue there is that we don't have a lot of good quality data on that. And what I mean by that is we don't see that show up in your traditional credit statistics. We don't have very good demographic information. So that is to say, we don't know who's using it. We don't know if it's the high or low income folks who are using it. We don't know what they're using it for, whether it be.

high cost goods or something like day-to-day groceries. And so that's a worry in our mind because we may not know how big that issue is until it's too late. And that's something, you know, kind of going back to this K-shaped economy, that's something that could cause this

What we're saying, a lowercase K economy could turn into a capital K economy. I'm in complete agreement with Mike on all of these. And it just stresses that we are a little bit more in the dark than we are heading into a lot of years because we have not just some data visibility issues, but we have an economy that is very policy sensitive.

If we have a Fed that doesn't quite sniff out that neutral rate and is too hawkish, that could spell some trouble for small businesses who employ 80% of Americans. If we have trade conflicts that come in earlier in 2025 than our current base case, that could knock our more resilient aggregate economy off of its feet.

And one of the challenges with that veto is that policy, you know, Mike spoke about what's measurable. Policy is driven by human beings. And most of us are not sitting in those rooms with those policymakers having some clear-eyed understanding of exactly what will happen next.

And anytime we have a higher degree of human decision making in the outlook, it adds a lot more risk to the outlook that spells volatility and forecasts and it probably means some volatility in market moves as well that go along with that.

With that said, I think we're pretty confident in our base case that the cyclical normalization is happening in conjunction with a lot of structural change. And while we might not know the direction, the scope, the size, the timing, we do have a general good sense of the direction. And to my clients, I tend to say, you know, nail the direction first, and then we can get the magnitude down when we have a better sense of exactly what these policies will look like.

Look, I think that's a great point to end on. And, you know, I would just highlight that, you know, overall, I think we're optimistic about the trajectory, at least for the start of 25 as we're going into it. And, you know, the fundamentals are strong. I think we're being very cautious in terms of keeping an eye on all the key measures that we talked about to make sure that we can properly understand when there's going to be pivots or pauses and the like.

And so, you know, look, I think it's it's very important to make sure that we're listening to the experts here. And so it's been really helpful to have Francis and Mike provide their insights to our audience here. So, Francis, Mike, thank you for joining the podcast today. It's a pleasure. Thanks for having us. Yeah, thanks for having us on here, Vito. So to our listeners, that's all for this episode and thank you for tuning in. Please remember to subscribe to get more great content and be alerted about future episodes.

You have been listening to Strategic Alternatives, the RBC Capital Markets Podcast. This episode was recorded on December 6th, 2024. Listen and subscribe to Strategic Alternatives on Apple Podcasts, Spotify, or wherever you get your podcasts. If you enjoyed the podcast, please consider leaving us a review and share the podcast with others. See you next time.

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