The Case Against Rate Cuts

Wrong Medicine for the Wrong Policies

A year ago, we had a labor market scare in early August, which led to a huge VAR event in the markets. I spent that entire weekend digging into the labor market to get a full understanding of what was going on, and published The State of Labor. This report helped readers of Macro Musings understand the full dynamics, and we were able to generate significant alpha by fading 2025 rate cut pricing (110 bps gain) and the 10y (100 bps gain). Let’s see if this report can help provide a similar level of clarity on the the state of the U.S. economy. I will make this report public, so feel free to share it widely.

There is widespread concern that aggregate demand is slowing to stall speed, and that the next risk is that it tips over into contraction. The latest non-farm payrolls has brought this concern to the forefront of discussion in macro circles and is leading to calls for rate cuts at the September FOMC meeting. As of this writing, a cut at that meeting is about 90% priced. This note is going to explain why Trump’s policies affect both the supply and demand side of the economy. While everyone is understandably focused on the demand side, they are missing the bigger story on the supply side.

I think rate cuts are the wrong medicine for what ails the U.S. economy.

Employment, real consumption and GDP growth have all slowed to start the year. The concern is that private payrolls, ex healthcare, are at stall speed.

The other concern is that consumer expectations for the economy remain depressed and thus their consumption will roll over shortly.

I think these are valid concerns and questions, so this note is not meant to dismiss them. However, I think we need to get to the bottom of what is driving these concerns in order to prescribe the right medicine.

What ails the U.S. economy?

Below I have collected a number of the most recent business and consumer surveys. Read through each of them and see if there is a pattern.

There is widespread concern from both businesses and consumers about tariffs raising prices. Tariffs, prices and inflation remain the overwhelming concern among all actors in the economy and it is not even close. In terms of voter priorities, reforming trade is very low on the list of priorities, so the trade policy does not suggest it has upside relative to its downside politically.

There are two key aspects of the Trump agenda hitting the economy at the same time in a big way: Immigration reform and trade policy.

Both of these policies are contractionary for the supply side of the economy, reducing potential growth, and are also hitting aggregate demand. Thus, there is no other possibility other than a slower growth profile relative to before these policies were enacted. However, we must analyze the supply side and demand side separately.

Immigration.

Trump campaigned on stopping the flow of illegal immigration that began in 2022. By all accounts, he has succeeded in delivering on this as we can see below, with border encounters falling to basically 0.

Labor force growth in recent decades has averaged ~0.5% per year. However, as we can see below, for 4 years we grew substantially above this level. In an economy as big as the U.S., an increase from a 0.5% trend rate to 1.5% is a lot of bodies, and it raises the potential growth rate of the economy. Thus, for 2021-2024, the potential growth rate of the economy rose quite sharply. We can see that by course correcting the flow of immigrants as he campaigned for, the growth rate is tracking at a very slow rate for 2025. As such, potential GDP for this year cannot be anywhere near what it was the last few years. In other words, the U.S. economy cannot grow on its own at the rate it was growing the last few years unless we stimulate it via either fiscal or monetary policy.

We can illustrate this in terms of workers. We can see the foreign born workforce has grown steadily over the years post GFC starting in 2011, but accelerated sharply beginning in 2021. We can see the sharp fall over the last few months as the border policies have been enacted, shrinking the foreign born labor force by 1.65MM workers, on par with 2020.

As we dig more into the foreign share of employment, the issue becomes more apparent. Foreigners have become an increasingly large share of the labor force over the last few decades, growing from 11% to 19% by the end of 2024.

More importantly, we need to count what share of labor force growth has been foreign born. In other words, how much of job growth has come from foreigners over the years. Prior to COVID, the share was around 30% of labor force growth. In the years after COVID in the Biden administration, it surged to a high of 70%. 70% of all the growth in the labor force in 2022 were foreign workers. This slowed to still very high levels over 2023 at 60% of the total. By the middle of 2024, we started to see the share fall sharply as immigration became an important political issue for the election. However, we can see the very sharp fall since Trump took office in 2025, and it has even fallen below the levels of 2019.

The conclusion is that the supply of labor has collapsed. This means, we simply do not have the capacity to generate jobs at the same rate as we used to, which is defined as the breakeven job level, which has fallen below 2016 levels.

What about demand? Although certainly less robust than 2022, demand still outstrips supply.

The prime age labor force participation rate remains at the highest level in history and has been flat for 3 years.

So in spite of the stall speed in private sector job growth (outside of healthcare, which is dictated by demographic forces), the unemployment rate remains very low and around the level of full employment.

In fact, we had a very large upside impulses to the unemployment rate this most recent NFP, and yet the unemployment rate still didn’t budge.

New entrants unemployment surged by 275k in this most recent report, and the second chart below shows how historically large this was. Without this surge, we would have been at a 4% unemployment rate in the most recent report.

Permanently unemployed, the longer term unemployed worker series, actually declined on the month and is at November 2024 levels.

In fact, if we look at the flows of layoffs, hires and quits we can see the story clearly. Layoffs have not increased since January 2023 for 2.5 years. Everyone is in a rush to declare that they are about to surge, and maybe that will be true, but that is still an assumption and not a fact. What has slowed is clearly the hiring and quit rates.

To summarize, the immigration story has impacted both the supply and demand side of the labor equation. The supply of available workers has fallen sharply due to immigration, and naturally this is leading to lower job gains. The labor market simply cannot grow at the pace of the last few years because we do not have the bodies. Demand has slowed, both as a natural consequence of the immigration story but also due to the immense shock we had to start the year.

I am not dismissing the possibility that employment growth slows further, or even contracts ahead. However, I do not think we should dismiss the possibility either that it improves ahead from the very low levels as that shock has passed.

Keep this in mind: even with the miniscule stalling job growth of the last 3 months, even with the largest surge in history of new entrants unemployed last month, the unemployment rate stayed at 4.2%. On top of it, wages re-accelerated from a 3.2% annualized pace to 4%. Aggregate incomes, including hours worked, grew by 5% annualized in the most recent report. That is a sign of a tightening labor market, which very well may happen if the worst of the uncertainty shock is behind us and labor demand, while not at sexy levels, outstrips the anemic supply. Something to consider.

Tariffs and Aggregate Demand.

Trade barriers are impediments to trade and impact both the supply and demand side of the economy. We do not know yet which side will have a larger impact, but that is important before deciding on any type of stimulus necessary. Trade barriers have the following impacts on the supply side of the economy:

Similar to the labor story, tariffs create manufacturing inefficiencies and bottlenecks, reduce productivity and increase pricing power for existing manufacturers due to reduced competition. Thus, trade barriers reduce potential GDP but raise prices in a persistent manner. The Budget Lab at Yale has been doing excellent work on modelling the dynamic effects from the trade policy and their latest update is here State of U.S. Tariffs: August 1, 2025. They estimate the long run impact on the economy, or the reduction in potential GDP, as -0.4%.

The impact on the demand side would come from reduced investment by the business sector and consumption. The Budget Lab provides their dynamic estimates of the 2025 impacts.

Intuitively, tariffs negatively impact the demand side of the economy by raising prices without providing additional dollars to pay for them. In simple terms, if I spend more on goods, I have less money to spend elsewhere on discretionary services.

There are ways the consumer may respond to mitigate these higher prices: they can demand higher wages (which we are possibly seeing due to the collapse in labor supply, as shown above), or given very low debt servicing costs and household debt, they can borrow to cover their added expenses.

So far, we are not seeing it reduce business investment, which looks healthy but not spectacular. This is mostly being driven by the enormous AI CAPEX. We do know that labor demand has weakened, as shown above by lower hiring and quits rates.

What about consumption? Below is the 3-month moving average of YoY growth in nominal vs. real consumption. Nominal consumption has actually risen of late, while real has not. Here we can see the impact from rising prices quite clearly. In layman’s terms, we are not consuming more things, we are just paying more for them. The consumer is fine because they have not lost jobs. If that changes, it will change the consumption trajectory, or it’s entirely possible that as more and more tariffs bite, it will naturally as well.

One area where demand is struggling is real estate. While not collapsing, it is not thriving either and seems stuck in a stasis with conflicting impulses: supportive demographics, reduced volumes due to the lock in effect and unaffordable prices. I covered this in detail in The State of Housing if you wish to read more.

Let’s put this all together.

What ails the U.S. Economy?

The Trump’s policies have substantially hurt the supply side of the economy and reduced potential growth. The hit from immigration policies is ~1% and the hit from tariffs (using Budget Lab’s distributional effects) is 0.4%. That means potential GDP has fallen from 3% real growth of the last few years to 1.6%. This is an enormous curtailment of the potential growth of the economy. It should also put into context the 1.25% average pace of real GDP over the first 2 quarters of the year. Given the reduced supply side, it is slightly below potential GDP and not deeply below as many are loudly proclaiming, and it only may be below potential due to the huge shock we observed in this period.

On the demand side, we can go through every business and consumer survey (as shown earlier) and clearly identify the issue: higher prices. As shown earlier, inflation remains by far the biggest concern and tariffs are adding a new anxiety about higher prices. The issue on the demand side is quite clearly the higher prices from tariffs.

How will the U.S. Economy evolve from here?

As longtime readers of my work know, I never express certainty on outlooks. I assess the situation, then outline scenarios.

Scenario 1: Downturn. Tariffs are biting sooner and earlier than anticipated. With stagnant labor demand that is only at the breakeven level of employment, and real consumption that continues to flatline, the clock is ticking and we will likely tip over before long. This will manifest with the consumer retrenching in nominal terms as well soon, and businesses will face the prospects of reducing margins and profitability, or will struggle to pass tariffs through to consumers and will soon revert to layoffs. This is the consensus view, and what is priced into the bond market, but not the stock market.

Scenario 2: Uncertainty Shock. The tariffs enacted thus far are too small to tip the economy over. Labor has slowed but has not broken with any meaningful rise in layoffs. We have not had a credit event or a bank failure. Thus far, nothing has broken. The demand side of the economy, besides from being impacted by the reduced potential growth, was hit with an enormously large policy uncertainty shock. This began in mid February, and peaked in April and has since declined back to where it was in December. In this scenario, it is consistent with an FCI shock. FCI tightened sharply from mid February to mid April (21% equity correction with extreme volatility), which has been reflected with weaker economic data since then. On this basis, the stagnant NFP reports for May and June are far more representative of the stasis that businesses found themselves in due to the uncertainty over supply chains, the overall business climate and whether the U.S. was proceeding with an embargo on its largest trading partner China.

In this scenario, the worst has passed us. Just as FCI tightened rapidly, it has since loosened to not only recover the entire tightening, but has loosened further. Since the low in stocks on April 7th, S&P 500 has rallied by 23%, more than reversing any hit to household wealth. The trade weighted dollar is weaker by 8% this year. 10yr yields are lower by 60 bps to start the year. As a result, my FCI model’s impulse for growth is supportive for the next few quarters. For details on my new FCI framework, please check out my note Financial Conditions Reborn.

To be clear, I have always maintained that the impulses from FCI are most impactful in a steady state of the economy. Effectively, if labor and/or the credit markets have not broken to a level that needs repair, then the impulses from FCI dynamics feed through to the economy with a strong efficacy. If we are in scenario 1, then these forces will be less impactful and the economy will need repair.

Is there any evidence that the worst is passed us? Yes, a few data points do suggest it to be the case. Even though July NFP numbers were unimpressive at 73k, that is an improvement from the prior two months of below breakeven, stagnant growth. Perhaps it is the start of an acceleration, but we will have to wait until the next NFP report to confirm. There are other pieces of evidence as well.

The services PMI fell to stagnant levels of growth in April around liberation day, but has since bounced to over 55, with sector improvements in business conditions, new orders and employment.

Auto sales, one of the most cyclical sectors in the economy, fell sharply by 14% from the March frontrunning peak to June, but jumped by 6.5% in July to nearly the highest level since mid 2021.

Policy Prescriptions.

What we have shown in this report is that the supply side of the economy has been substantially curtailed by the Trump economic agenda, reducing potential GDP by a massive 1.4%. At the same time, the demand side of the economy has been hit not only by the reduced growth profile but a substantial price shock generated by the tariffs. Both businesses and consumers are signaling anxiety about higher prices.

As usual, with any growth scare, the natural inclination is to call on the Fed to cut rates in response to stimulate the economy. I do not think this is the correct medicine for what ails the U.S. economy at all.

Rate cuts are not magic. They cannot fix everything, even though we have long been accustomed to them being the solution for nearly every economic problem out there. Rate cuts stimulate the economy by making the cost of credit cheaper to induce borrowing by the private sector. Credit expansion has a strong multiplier effect across the economy as more borrowing leads to business expansion, hiring and consumption. They also loosen financial conditions and stimulate by the feedback mechanism from higher household wealth to consumption.

Is the correct response to a price shock to entice the economy to borrow more to pay for these higher prices? This will stimulate the economy but also inevitably lead to a new price shock via monetary induced inflation. This is the absolute worst policy choice in response to what ails the economy!

Rate cuts cannot fix the contraction in the supply side and potential growth in the economy. What is needed there are positive supply side policies that only the White House can enact. My prescriptions are as follows:

1. Drop Trade Wars. It is not working. Manufacturing is not increasing, nor is employment or consumption. I understand admitting failure is not something politicians do, especially Trump, but agreeing with trade partners to now reduce all tariffs to 0 on both sides would lead to an enormous boom in trade and growth ahead.

2. Develop new immigration policies. As shown at the onset of this report, clearly foreign born labor has been an enormous and growing source of labor over the last few decades. However, the type of immigration seen the last few years was clearly the wrong kind as it was predominantly illegal immigration. The U.S. economy has the best economic prospects and has always attracted the best immigrants to its top universities and its workforce. However, the U.S. immigration policy is extremely strict and rigid. The U.S. has the best prospects for high quality immigrants and the demand to move to the U.S. is very high, so loosening immigration policies for high quality immigrants would raise potential GDP and benefit everyone in the economy.

   

   

   On the demand side, are rate cuts appropriate? The question comes down to which economic scenario we are in. If it is scenario 2, then rate cuts will be extremely dangerous, loosening credit and FCI just as the economy is recovering from the uncertainty shock! We already have extremely large impulses from FCI to inflation that will hit over multiple quarters on top of the expected rises in prices from tariffs. We would be adding fuel to the fire at the wrong time in scenario 2.

   

   

If we are in scenario 1, then we will see rate cuts because the Federal Reserve is not going to sit and wait for new supply side policies to be enacted if the labor market is tipping over. My argument is that the Fed should wait! The reason they should wait is that monetary policy has been completely ineffective in slowing the economy and, more importantly, slowing inflation. Core PCE has been stagnant for 16 months.

Let’s say we are in the midst of scenario 1 and the Fed cuts in September. This will support demand as it always does and prevent weakness from cascading further. It will achieve the goal of stimulating labor demand, but at the cost of ingraining inflation at above target levels for even longer. It will also further loosen FCI and ingrain the mentality that is prevalent in the equity market that nothing bad happens because the Fed will always be quick on the draw to save it. The equity market will go parabolic when they cut and become an even bigger problem down the line.

If we are in scenario 1, the correct policy prescription is to let it play out awhile longer. Let the unemployment rate rise to ~4.8% or so for actual economic weakness, and let the markets reduce froth and speculation. Basically, let tariffs do the demand destruction that monetary policy has never been able to deliver all cycle, then come in and save the day with a proper cutting cycle without the fear of it instantly reigniting inflation pressures. Cutting immediately will upend this demand destruction process and keep us on the unhealthy path we have been on for years.

In conclusion, there are multiple shocks hitting the economy at the same time as a result of Trump’s policies. These policies have cratered the supply side and potential growth by ~40% from where it stood last year. Demand is being impacted by another price shock just as the potential of the economy is falling. I remain open minded as to how the demand side plays out in terms of the two scenarios I presented and it will take time to come to a final conclusion.

My advice would be for the White House to either cancel trade wars or begin working on policies that grow the supply side of the economy.

My advice for the Fed would be to wait for actual economic weakness, if that is the scenario that unfolds, before beginning a rate cut cycle.

I hope this report helps with understanding the myriad forces at play in the economy. Feel free to share it widely with anyone who would benefit, and check out my work for detailed notes such as this one.