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March 11, 2025

Uncertain situations prompt us to err on the side of caution. It is a base instinct that can be tempered by trust. Those who trust those around them tend to weather the tides of uncertainty better. An erosion of trust can amplify the consequences of uncertainty, causing people to behave even more cautiously.

Economists have taken note of these base human emotions and investigated how they affect decision-making and by extension, shifts in the economy. A surge in uncertainty tends to act as a tax on economic activity; it causes us to delay big spending decisions.

Trust is the oil of a market economy. With it, the economy moves forward unencumbered. Without it, the engine of the economy can literally seize and stop functioning. Some of the most extreme examples we have seen are when financial markets have seized and trades could not clear.

That is why economists are alarmed by the one-two punch of a surge in uncertainty amidst an erosion of trust. The experience five years ago with the onset of the pandemic provides a cautionary tale.

Measures of uncertainty spiked on a global scale as Wuhan went into lockdown in January 2020. Fear of contagion was so great that employment fell by a record-breaking 1.3 million jobs between February 16 and March 14, before any lockdown went into place.

This edition of Economic Compass takes a closer look at the economic consequences of a surge in economic policy uncertainty can have amidst an erosion in trust. The two together act like a broken stoplight at a busy intersection, slowing the flow of traffic to a crawl as each driver cautiously takes their turn at crossing. Some make a U-turn and opt out of moving forward, waiting until the light is fixed or the traffic has cleared.

The Federal Reserve is expected to hold off on rate cuts until early 2026. Financial markets have front-run rate cuts, which suggests a painful adjustment.

Chart 3 shows the surge in economic policy uncertainty post-election. The Global Economic Policy Uncertainty (EPU) index has already eclipsed the pandemic. The US EPU index is catching up rapidly; it reached its second highest level on record in February. Tariffs, threats of retaliation, changes to migration policies and shifting geopolitical allegiances stoked that surge.

Chart 4 shows the erosion in trust by the public in government. Those who viewed the government as doing the right thing always or most of the time moved from the majority of Americans in the late 1950s and early 1960s, to the minority in recent decades. We are not alone, as the electorate abroad has experienced an erosion in trust.

A study by reveals that the deterioration in trust is not limited to the public sector. It extends to the private sector. The pandemic accelerated that decline, especially for large firms, banks and financial institutions.

The exception is trust in small businesses. They get close to 90% favorability ratings from members of both political parties. That is no small feat in these divisive times.

Consumers hunker down

Economic research¹Ìýreveals that consumers tend to focus more on necessities over discretionary purchases during periods of high uncertainty. They shy away from big-ticket purchases, save more and swap expensive for cheaper items to hedge shocks.

Add the regressive nature of tariffs, and lower and middle-income households get hit hardest by those shifts. That will exacerbate inequality, which further erodes trust.

Surveys of consumer attitudes plummeted in January and February on concerns about job security and fears of inflation. Fear of tariffs and a surge in layoff announcements clearly played a role in that shift.

Consumers are more likely to spend with companies they trust when uncertainty spikes. They will even pay a premium for goods and services provided by companies they trust.

They are also more likely to vote with their wallets and coalesce around firms that align with their own ideologies. That is a tough landscape for firms to navigate, given the divisiveness of our politics.

Tariffs and curbs to immigration simultaneously stoke inflation and stem growth. The context in which they are occurring today is different than it was in 2018:

1. The embers of inflation are still smoldering, which ups the risk they will reignite.
2. Supply chains are longer than they were pre-pandemic and more susceptible to retaliatory disruptions.
3. The size and scope of tariffs are larger than they were in 2018-19, with a greater set of goals; they are intended to punish our trading partners, create incentives for domestic production, protect strategically important industries and generate revenues all at once.
4. Companies have already begun to raise prices of intermediate goods in the pipeline for items slated to be tariffed. Steel, aluminum and lumber prices have all spiked in recent months.
5. Labor shortages due to deportations and a change in the legal status of immigrants could reignite service sector prices, which have proven stickiest. Childcare and eldercare costs, which rely more on immigrant labor than other sectors, are already rising at twice the pace of overall inflation.
6. Work done by Moody’s Analytics suggests that the top 10% of earners account for nearly half of all consumer spending, a new record; they can better absorb the cost of tariffs and create a floor under inflation.

The largest offset to inflation is: a strong dollar (as long as it stays that way). There are some within the administration who believe they can engineer a sharp depreciation in the dollar by revaluing the nation’s assets. Color us skeptical, given the havoc such moves could trigger in financial markets.

Inflation as measured by the personal consumption expenditures (PCE) index, peaks at a 4.1% rate in the second quarter, but remains elevated well through year-end. That leaves us with a mild bout of stagflation in 2025.Ìý

The PCE index slowly cools in 2026 but does not return to the Fed’s 2% target until the second half of 2027. The deceleration in inflation is helped by a drop in the effective tariff rate late in the year and into 2026.

Downside risks: A full-blown recession with a much larger pullback in global trade could cool inflation more rapidly. The Smoot-Hawley Tariff Act of 1930 is our only reference point; it triggered trade wars with 25 countries, reduced global trade by 67% and plunged the global economy deeper into the depths of the Great Depression.

A wary Fed

The Fed is on hold pending policy shifts by the administration. Fed Chairman Jay Powell said, “We do not need to be in a hurry and are well positioned to wait for greater clarity [on the direction of policies and their impact.]�

When asked who his favorite Fed Chair was, he responded “Paul Volcker� - the man who broke the back of inflation in the early 1980s. That is why several Fed presidents have evoked the inflation nightmare of the 1970s as a cautionary tale. They are signaling that they are willing to trade a rise in unemployment - and rate hikes if necessary - to stop a more pernicious bout of inflation. The fact that the war on inflation has not yet been won only hardens that resolve.

The Fed would prefer to stop short on rate cuts and wait to see how tariffs ripple through the economy before cutting again. Our forecast suggests it will need to stay on the sidelines through 2025 before it cautiously resumes rate cuts in 2026.

Separately the Fed is getting close to announcing an end to its quantitative tightening program. That does not mean the Fed will be increasing its balance sheet anytime soon. The goal is to prevent a liquidity problem in the Treasury bond market like we saw in September 2019⁵.

Paralysis risks: The Fed finds itself in a bit of a pickle: if it cuts too soon, we could suffer a more pernicious bout of inflation; it it waits too long to cut, it could trigger a recession; or if it raises rates, it could trigger an even deeper recession and scarring bout of unemployment.

Financial markets wake up

We have begun to see volatility in financial markets pick up in response to escalating trade tensions. However, the markets have yet to fully price in the damage those shifts could mean to profits. More than 40% of the profits in the S&P 500 are derived from abroad.Ìý

Treasury bond yields fell in response to the potential weakness that trade wars and cuts to federal spending could cause. A rise in the U-6 measure of unemployment in February, a gauge of stress in labor markets, confirmed those fears.

That rally is expected to reverse. Continued federal deficits, higher inflation and a prolonged pause by the Fed are expected to put upward pressure on yields. The 10-year Treasury note is expected to move back above 4.5% by mid-2025.

Volatility risks: The bout of stagflation we have forecast is mild and nothing like that of the 1970s, but could still be very destabilizing for financial markets. Efforts to depreciate the dollar could add to market volatility.