May 9, 2025 – By popular demand, and because it’s been a while since I wrote my last such post, here are a few thoughts on the current market conditions, especially the economic and financial uncertainty. Some of the issues I like to cover:
- Is there a recession around the corner?
- What’s my inflation and Federal Reserve policy outlook?
- What are my views on the Trade War?
- With all this financial volatility, is the FIRE movement finally finished?
That’s a lot to cover, so let’s get started…
Are we in a recession already?
The most recent GDP number, released by the Bureau of Economic Analysis (BEA) on April 30, came in at -0.3%. Ouch! The street definition of a recession is “two consecutive quarters with negative growth,” so some folks pointed out that we already have half the necessary evidence to prove a recession. I’m not convinced for (at least) three reasons…
1: The street definition differs from the NBER recession definition
As I pointed out previously, the (Wall) Street recession definition differs from what is actually used by economists. The National Bureau of Economic Research (NBER) calls the business cycle turning points, considering more data series than plain old Real GDP. In the past, we’ve seen at least two wrong calls from the 2-quarter GDP definition:
- The 2001 U.S. recession never had two consecutive quarters of negative GDP growth.
- In 2022, the NBER (rightfully) didn’t call any recession, but the initial GDP releases pointed to two consecutive quarters of GDP declines. That said, Q2 of 2022 was eventually revised up to slightly positive growth.
Thus, with the Street recession definition, we’ve already experienced a type 2 error (false negative in 2001) and a type 1 error (false positive in 2022). So, don’t get your underwear in a knot over that single negative GDP growth number!
2: The underlying detail is still solid!
I always like to dig deeper into the underlying numbers in each GDP release. What caused the large drop from 2.4% growth in 2024 Q4 to -0.3% in Q1 of 2025? To that end, I always consult Table 1.1.2 published by the BEA, i.e., the contributions to GDP growth attributable to the different major subcomponents. In Q1, two components displayed unusually large swings: “Change in private inventories” with a +2.25% contribution and “Net exports of goods and services” with a -4.83% contribution. And the -4.83% is due mainly to the -5.03% in Imports, which in turn is primarily due to goods imports. Do you notice a pattern here? In preparation for the trade war, America imported massive quantities of goods before the April deadline. About half of that landed in inventories, but the net effect of those two components was -2.58%. If we add this trade war impact back into the GDP number, we will get -0.3%+2.58%=+2.28%, very close to the Q4 growth number.
In fact, GDP outside of those two volatile components is “Domestic Final Demand,” i.e., a measure of how strong actual businesses and consumers feel and how much they want to buy, which is a better indicator of economic health than overall GDP, which sometimes makes significant and noisy adjustments due to inventories and trade.
That said, not everything looks too rosy outside of the two volatile components either. Personal consumption expenditures appear a bit weak. Services only contributed 1.1% to quarterly growth. Durable goods even had a negative contribution, albeit after a blockbuster Q4, so there is a chance that this is just temporary: Americans prioritized their TEMU wishlists over buying cars and washing machines to beat the tariff deadline.
Let me dive a bit deeper into the Inventories and Net exports issue. Of course, pessimists will still accuse me of sugarcoating the GDP numbers. Net exports have detracted substantially from GDP in the past quarter, raising the question of whether a negative net export contribution has ever pushed the economy into a recession. The answer is no. Quite the opposite. Net exports usually rise (i.e., become less negative) during a recession, primarily because consumers short on cash want fewer imported goods. The chart below shows the (monthly) trade balance since 2000: The deficit narrowed in the 2001 and 2007-2009 recessions. In 2020, the recession was too short (only 2 months!) to see that effect. True, there was an eventual trade deficit expansion, but that happened after the recession ended when consumers were flush with stimulus money. So, the record trade deficit in March 2025 is the opposite of a recession indicator. It indicates economic optimism when folks still want to buy foreign goods and services.
Another way to present the data is to examine how the different GDP components and their contributions correlate with the total GDP growth number. I added another column with that correlation in the 1.1.2 table above. Note the strong negative correlation of imports with GDP. Also, notice the significant positive correlation of inventories with GDP. There is usually a substantial inventory depletion during recessions. This would put additional pressure on growth and cause GDP to decline even more because production will fall even more than final demand during a recession. The substantial inventory accumulation during Q1 would seem unusual during an economic downturn.
Also, a fun fact: federal non-defense spending negatively correlates with GDP. So, if you ever took my Introduction to Macroeconomics class, you will know what it is: economists call this effect an “automatic stabilizer,” i.e., means-tested government programs that kick in when household incomes drop, like unemployment benefits, stimulus programs, etc.
To sum up, the stereotypical mechanics of an unfolding U.S. recession are 1) a widespread(!) drop in demand in both consumption and investment, 2) an inventory decumulation, which exacerbates the GDP drop, and 3) an increase in net exports driven by a significant drop in imports, which cushions the GDP drop. In Q1 2025, we observed none of item 1 and the exact opposite of items 2 and 3. We may even see a considerable rebound in GDP in the second and/or third quarter of 2025 GDP when we likely get much lower trade deficits. So, while the headline GDP number of -0.3% may look shaky, I’m not too worried about a recession around the corner—at least not yet.
3: My favorite economic indicators still look OK
My three favorite economic and financial indicators that I’ve consistently used over the years are as follows:
- Weekly Unemployment Claims
- The ISM PMI
- Shape of the Treasury Yield Curve
First, unemployment claims are still subdued. What I like about this indicator is that it’s released weekly, so we have a faster-moving indicator than the monthly payroll employment numbers. Further, there are only modest revisions, unlike in the payroll numbers. Currently, the unemployment claims are still in the low-200k range, so none of the tariff uncertainty has caused a meaningful disruption in the US labor market. Please see the chart below. I’d need to see this figure surge to 300k+ to set off my recession alarm bells. Of course, this picture can change quickly, but the current situation still looks like an expanding economy. I would give this indicator an A- grade.
The second indicator is the ISM-PMI indicator. It tends to be a slightly leading indicator, and it has the advantage that it’s released on the first business day of the month, so the data delays are minimal. The current reading is 48.7, so it’s a bit below the 50 line, so technically, we are in the “contraction” range. But we have been in the 45-50 range for extended periods, even during solid GDP expansions. I would worry about a recession if we drop below 45. I would give this indicator a C- grade.
The third indicator is the 10y vs. 2y Treasury bond yield spread. In the past, it has been a reliable leading economic indicator, i.e., every recession saw a yield curve inversion (i.e., 10y yield below the 2y yield). This indicator gave us a bit of a headscratcher: what should we make of the 2022-2024 yield curve inversion? Some argue that the recent inversion predicts an impending recession in 2025. But it’s odd if the yield curve inversion from three years ago causes a recession now. True, the yield curve has historically been leading the business cycle, but usually not by three full years.
The more plausible explanation would be that the 2022 inversion coincided with the 2022 slowdown. That slowdown wasn’t a full-blown recession because US consumers were still high on stimulus money and post-pandemic pent-up demand. So, the yield curve inversion from three years ago is now water under the bridge, and with the renewed yield curve slope normalization, we’re out of the woods. Well, maybe not 100% because the slope is still a bit low in absolute value. To account for that residual uncertainty that my theory about the inversion causing the 2022 slowdown is wrong, I still give this indicator only a C- grade.
So, I’m not saying that the economy is particularly robust. Two of the three indicators look shaky, while only one is rock solid. But it certainly doesn’t look like the wheels are coming off the economic engine.
Inflation and Fed Policy
We just had another Fed policy meeting on May 7—no rate cut. The Federal Reserve still thinks inflation is too high, and they may have a point. CPI and PCE, both headline and core measures, are still stubbornly above the Fed target of 2%. For example, let’s look at the CPI chart below.
Y/Y inflation measures: CPI
But again, the underlying data look much better than the headline numbers. Please take a look at the chart below. If we split CPI into rental inflation (green line) and everything else (blue line), we see that CPI outside of shelter has been about 1.5% on average, ranging from around 0.8% to 2.2% since the middle of 2023. The only reason inflation is still so high is the rental component. Even though rental inflation is finally falling, it’s a slow process because rental inflation is “sticky;” both the pandemic trough and the post-pandemic inflation peak occurred with significant lags. And let’s not forget what one component in rental inflation is: the interest rate! Rental real estate is an asset, the rental rate is an asset return, and that asset competes with other investment choices, like bonds. So, if you want to lower that green line faster, lower interest rates may achieve that. The Fed’s current philosophy of “keeping interest rates high until (rental) inflation comes down” is the same logic as the classic “the beatings will continue until morale improves.”
Below is the same chart for PCE inflation. It tells the same story—rental inflation is stubbornly high but finally falling. Without that component, PCE and core PCE would already be closer to 2%.
Long story short, I think the Fed should deemphasize the inflation portion coming from housing inflation. Even peer-reviewed academic research justifies putting a low weight on housing inflation. It’s written by yours truly and my esteemed coauthor, Zheng Liu. The paper is available as an (early version) working paper at the Federal Reserve Bank of San Francisco or in the printed final version in an academic journal (Macroeconomic Dynamics). I have included the abstract here:
“Housing is an important component of the consumption basket. Because both rental prices and goods prices are sticky, the literature suggests that optimal monetary policy should stabilize both types of prices, with the optimal weight on rental inflation proportional to the housing expenditure share. In a two-sector DSGE model with sticky rental prices and goods prices, however, we find that the optimal weight on rental inflation in the Taylor rule is small—much smaller than that implied by the housing expenditure share. We show that the asymmetry in policy responses to rent inflation versus goods inflation stems from the asymmetry in factor intensity between the two sectors.” Emphasis added. From: Jeske K, Liu Z. SHOULD THE CENTRAL BANK BE CONCERNED ABOUT HOUSING PRICES? Macroeconomic Dynamics. 2013;17(1):29-53. doi:10.1017/S1365100510001021
So, I would have preferred a rate cut at this week’s meeting. But it’s not the end of the world if the Fed holds interest rates at 4.25-4.50% a little longer. You know, beat up everyone some more – maybe morale will improve this time!
So, do I agree with Donald Trump? He may be correct on substance, but certainly not on style! I’m a blogger who can criticize the Fed all day. However, a president has no business publicly criticizing the Federal Reserve. Central banks should be free of political pressure. Every historical example of inflation getting out of control comes after politicians get their hands on the proverbial monetary policy “cookie jar.” If the president has any disagreement with the Fed, he can certainly talk to the FOMC members, but privately. For example, one of the fiercest hawks at the Federal Reserve is Fed Governor Michelle Bowman, who Trump himself nominated to the Board in 2018 and reappointed in 2020. Maybe Trump should start discussing his grievances with her.
This current public discord with the Federal Reserve is extremely unhelpful. Even worse, by making this public ruckus, Trump might even hurt his case. Any FOMC voting member who might have been amenable to a rate cut at the May 7 meeting would have been hesitant because we don’t want to create the impression that Trump’s political pressure had an effect on the committee’s work. The FOMC is like a parent dealing with a terrible toddler; after the toddler throws a tantrum at the store, the parent can’t buy that toy. Even if you would have entertained the idea of purchasing the toy, you need to stay strong, put your foot down, and teach the toddler a lesson. Just like in that parenting analogy, the toddler-in-chief does not get to make monetary policy decisions!
The Trade War
I debated whether this is a good idea to discuss in a blog post because this will inevitably go into a political discussion. I like to keep things apolitical and family-friendly on the blog, so I hope this doesn’t turn into a shouting match in the comments section. This is neither an endorsement nor criticism of Trump’s trade war. I merely look at some economic theory, specifically game theory, to understand the strategic interaction in trade negotiations. Trigger warning: there could be a game-theoretic justification for Trump’s trade war. So, after I stepped on the Trump lovers’ toes in the monetary policy section above, let me now be an equal opportunity offender and, well, offend the Trump haters as well.
Let me begin by stating the obvious: I like free trade with low or zero tariffs and no other implicit or explicit trade barriers. It’s one of the cornerstones of economics, going back to David Ricardo and the benefits of specialization and comparative advantage. Nearly 100% of economists agree on this.
But we also live in a world where the US is now running trillion-dollar annual trade deficits as the worldwide consumer of last resort. Historically, we’ve had only relatively modest trade barriers. At the same time, many other countries are much more protective. This goes from explicit tariffs to other non-tariff trade barriers and even outright criminal behavior like some countries stealing intellectual property.
How do we get from the status quo to that economic Nirvana state of universally low or no tariffs and trade barriers? The approach of every single past administration has been just to be nice to other nations and try to talk them into lowering their trade barriers. That never got us anywhere.
The big question is, what’s Trump’s plan? If this is Trump’s plan, please see the diagram below, then I’d be fiercely opposed: If Trump raises tariffs and if we keep those tariffs permanently, that would be a problem. We don’t want to live in a world with permanently higher tariffs in every direction. In this scenario of worldwide protectionism and mercantilism, we’d all be worse off than the status quo.
On the other hand, if Trump’s plan is the scenario in the diagram below, then everyone should be on board: We may have higher tariffs temporarily, but penalizing other countries for their anti-competitive policies will entice them to lower their trade barriers, after which the U.S. also lowers tariffs. And everyone lives in a happy place afterward, with mostly free trade.
Americans should love this scenario! Almost every Hollywood movie follows that script, i.e., things will get worse for our hero before we reach that happy ending. You know, like (spoiler alert!) Frodo nearly got eaten by the giant spider creature in that cave. But after going through all sorts of tribulations and challenges, everything works out in the end.
I know of two examples in economics, specifically game theory, where the “it has to get worse before things get better” logic is at work. These are two examples where it is economically optimal to (temporarily!) accept dire conditions for all players (including myself) to attain better outcomes in the long run. Let’s take a look…
Example 1: A repeated Prisoner’s Dilemma game
Every economist and probably non-economist must have heard about the Prisoner’s Dilemma. It’s a dilemma because cooperation fetches the highest combined payoff for the two players. Still, each player has an incentive to defect and screw over the other player for an even higher personal gain. To put this into a trade context, both countries would benefit the most if we had zero tariffs. However, for short-term gain, a country may defect and erect trade barriers, eke out a slightly higher individual payoff (e.g., $4 instead of $3 in the numerical example below). Still, it will be suboptimal because the two countries combined now get a payoff of only $5 instead of $6.
In fact, if two players interact in a Prisoner’s Dilemma only once, “Defect” is the dominant strategy because no matter the opponent’s action, you do better by defecting. So the “A=Defect/B=Defect” with the lowest possible total payoff of $4 is the only Nash Equilibrium in that game. Bummer!
But this game gets quite interesting if we repeat it. Now, it’s indeed possible to get to that “Cooperate/Cooperate” Nirvana outcome. If we agree on cooperation, we receive the maximum combined payoff of $6. But what prevents people from shirking? It’s very simple: players punish bad behavior with, for example, Tit-for-Tat or some variation of it. Punishing my counterpart’s bad behavior, even if it temporarily hurts me, is the optimal route in this repeated game to get the “Cooperation Train” back on the rails. Appearing weak and meek is suboptimal because other players will abuse my weakness.
The second game is even more relevant for the trade negotiation debate…
Example 2: The Chain-Store Game
Another intriguing example from game theory is the so-called Chain-Store Game. Imagine an incumbent firm faces a potential entrant into a market. If the entrant stays out, the entire economic surplus of $4 goes to the incumbent, and the entrant gets nothing. If the new firm enters, the incumbent can coexist or fight the entrant. If the incumbent fights, it will get a payoff of only $1, while the new entrant will lose $1. If the incumbent does not fight, both firms share the profit opportunity equally, and they each get $2.
What should the entrant do? Well, thinking strategically, the entrant could argue that once it’s the incumbent’s turn in the game, it will choose to coexist because a payoff of 2 must be preferable to a payoff of 1 from that ruinous price war. So, entering the market seems optimal. (side note for the game theory buffs: there are two Nash Equilibria in this game: 1: Enter/Coexist and 2: Stay Out/Fight, and only equilibrium 1 is subgame-perfect. Equilibrium 2 is not subgame-perfect because the incumbent would have to commit to an action that’s not optimal after a theoretical Enter move of the first player!)
So far, so good. But what happens if we play this game sequentially, with one incumbent facing a series of small potential entrants in many different markets? That’s where the game got its name because we can think of the incumbent as a large nationwide chain store brand facing local competition from smaller players in various geographical areas. Imagine the first small competitor enters and gets whacked by the incumbent. So does the second entrant. Future competitors will eventually get the message and stay out if the incumbent builds a reputation as a tough guy (or gal). Thus, by making an example of a few recalcitrant opponents, we signal that we call the shots. Other players facing us in future iterations of this game will treat us much more respectfully. Do you think that sounds familiar? It sounds like putting 100%+ tariffs on China to signal to other countries that we have the appetite and staying power to penalize bad actors. We can take the needle pricks from a trade war with a subset of countries but then force the majority of countries to lower their tariffs. And by the way, eventually, the recalcitrant subset will also fall in line!
But to be honest, I had my doubts in early April. In the beginning, it sounded like Trump wanted to start a trade war with all global trading partners simultaneously, in which case that sequential Chain-Store Game logic wouldn’t apply so easily. Of course, everything changed on April 9, when tariffs were paused on countries that hadn’t retaliated yet. So, China walked into that trap, but almost everyone else got a reprieve from the retaliatory tariffs. That plot twist on April 9 certainly looks like the perfect replication of the incumbent player in a Chain-Store store game. You made an example of a few unlucky victims; subsequently, everybody else will comply with our wishes. The stock market certainly liked it and rallied by about 10% that day.
Of course, other countries could have blocked this plan by colluding. We had some indications that this is what China tried. For example, on April 1, Reuters reported that China had formed a united front with Japan and South Korea against US tariffs. However, Korea and Japan denied such an agreement. Duh! South Korea, Japan, and China can’t usually agree on anything (pro tip: study some Asian history). Was this an April Fool’s prank?
Chairman Xi also visited Vietnam and Malaysia to unite with them against the “evil USA.” How did that work out? Just a few days later, Vietnam bought 24 U.S.-made F16 fighter jets. Malaysia Airlines announced it wants to scoop up the Boeing 737 airplanes that China returned as “retaliation” against US tariffs. India wants the remaining 737s.
It’s obviously too early to tell if this all works out. I hope that we will get more trade and lower tariffs worldwide as a result. It’s not because I want Trump to win; as a patriotic American, I want our country to win. And with lower trade barriers worldwide, all countries will win. China could eventually be the biggest beneficiary. And I mean the Chinese people, not the Politburo thugs. If China eventually retires its mercantilism and encourages more domestic consumption, the people there can finally enjoy the fruits of their labor. Everybody will be better off!
Can you still retire in this volatile world?
If you’re a regular ERN blog reader, you might sense a bit of snark and sarcasm. And you would be 100% right. I find it amusing how even modest volatility sparks panic in the FIRE community. I suspect that the “One More Year” syndrome is often not so much about accumulating more assets for another year but rather the false hope that the markets will be calmer next year. This quest for retiring when the market is peaceful is futile. Here’s a chart of market volatility events since I retired in 2018. We had a near-bear market in Q4 of 2018 right out of the gate, followed by two actual bear markets, one in 2020 and one in 2022. Every two years, something goes sideways. After a quiet 2024, we were overdue for a correction, folks! In April 2025, the low point for the S&P 500 Total Return Index was -18.7% from the February 19 peak. So far, we have narrowly avoided a bear market. How will this current episode work out? If I had to choose between another garden-variety correction a la 2018, and a potentially retirement-ending financial crash like 1929-1932, I would still pick the former.
The talk of doom and gloom is overdone. I think the folks who talk about the impending end of the stock market are the losers who sold when the S&P 500 dipped below 5,000 in April, and they are trying to talk the market down to get a better entry point. Like these two Twitter/X experts:
If I had to pick between some guys on Twitter who breathlessly pronounce doom and gloom vs. Warren Buffett’s “Never bet against the USA,” I’d have to side with the Oracle of Omaha. I know people who got out during the pandemic at an S&P 500 level of 2,500 and never got back in. They, too, are still waiting for an entry point. Good luck, folks, but I hope you’re wrong!
Of course, the 2025 cycle could easily turn sour again. For example, the 2022 bear market had a fake recovery, only to turn into a full bear market with a trough in October 2022. But my prediction is that a sequence of trade deals will be announced over the next few months, and even some progress will be made with the worst trade offenders like China and the EU.
Conclusion
So, there you have it: it doesn’t look like a recession is around the corner. Inflation is getting better (not the price levels but the rate of increase, to be sure), and the Federal Reserve can likely lower rates later this year. The trade war may induce some temporary pain before international trade improves. And that little bit of volatility in 2025 is modest compared to the past few market cycles. Have a great and relaxing retirement, everyone!
Thanks for stopping by today! Please leave your comments and suggestions below. Please keep it civil. I will put political rants into the spam folder!
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