To help you navigate the economic year ahead, the Kenan Institute kicks off 2025 with a rundown of five issues that will be top of mind for business leaders and policymakers, along with our analysis. While this annual exercise is never easy, significant uncertainty about federal policy and its impacts on the economy make forecasting for the next 12 months a particular challenge.
How Will Federal Policies Impact the Economy?
The US economy begins 2025 on solid footing with healthy job creation and gross domestic product growth. Meanwhile, inflation has been coming down, although public concern and recent readings illustrate how difficult it is to get inflation all the way to the Fed’s target of 2%. We believe that the biggest risk to the nation’s economic outlook comes from new federal policies – the potential mix of immigration, tariffs, and tax and regulatory policy that could on net slow growth and raise inflation in 2025.
First, the stimulatory. The 2017 Tax Cuts and Jobs Act expires at the end of 2025, so its likely extension is more a story for 2026. However, expectations that the 2017 tax cuts will be extended along with any additional tax cuts and a generally more lax regulatory environment could increase business and consumer confidence, and thus spending and investment, in some sectors in 2025.
The two biggest concerns are whether stringent immigration policy will slow job creation and whether new tariffs will raise inflation. Job creation is a key factor in economic growth (the other is productivity, which we discuss below). With current labor market dynamics, the most effective way to fill jobs is by increasing the size of the labor force. As the chart below shows, potential labor force growth – a Congressional Budget Office estimate of the number of people available to work – had, until recently, been largely in decline since the early 1970s. In the 10 years ending 2021, the potential labor force grew by a mere half a percent per year. In the past two years, however, the labor force increased at roughly a 0.9% annual rate, primarily because of immigration, and under current policies its growth rate is expected to increase to 1% in 2025. Closing the border or large-scale deportations could shrink that number significantly. One analysis presents a scenario in line with incoming administration policy statements, with a resulting 1.2 million loss in job creation and a significant cut in GDP growth. To put that into perspective, in the past year, 2.3 million jobs were created and GDP grew by 2.7%.
At present, customs duties collect $85 billion in revenue for the federal government from $4.2 trillion of imports – an effective tariff rate of 2%. In the 10 years ending 2016, the effective rate was 1.2% and the Trump presidency high was 2.8%. During the Smoot-Hawley era, coinciding with the Great Depression, the tariff rate peaked at 15%. At that time, imports made up just 3% of the economy, down from 5% prior to the implementation of the Smoot-Hawley tariffs. Today, imports represent 14% of US GDP. Given that import share, a significant increase in tariffs in the US would pass through a meaningful rise in inflation. The extent of the passthrough will be determined by many factors, such as the competitive landscape and the response of the dollar.
What Will the Federal Reserve Do in Response?
The Fed usually looks past price shocks that lead to softer demand – think geopolitically driven energy price surges. But as Federal Open Market Committee members hinted at when they slowed the pace of expected rate cuts, the story is a more complicated this time around. Given its slow reaction to the recent inflationary cycle, the Fed is wary of any hints of higher inflation, including recent data suggesting that inflation remains stubbornly above target. The Fed’s preferred price measure is up 2.4% over the past year, with the less volatile “core” measure up 2.8%. Furthermore, a series of escalating tariffs and retaliation would more resemble an inflationary trend than one-off price increases. The Fed will closely monitor consumer and market-based inflation expectations for hints of any upward shift or unanchoring of inflation expectations.
Stringent immigration policies could exacerbate inflation in several ways. As we discussed above, these policies would lower potential growth by reducing the labor supply, which is itself inflationary, especially if tax and regulatory policy spurs growth. Given the large share of immigrant workers in construction, new immigration policies could also put upward pressure on housing prices, which have been a source of persistent inflationary pressures. Housing inflation is up 4.8% over the last year, a slowdown from the 8.3% peak in early 2023. The current reading is still well above the 2.7% rate experienced in the 10 years ending 2019. While the passthrough of higher construction costs is hard to measure, it is likely to keep housing inflation elevated.
Will Productivity Save the Day?
Treasury secretary nominee Scott Bessent envisions a 3-3-3 economy – 3% GDP growth and budget deficits and a 3 million barrel per day increase in US oil production. Given the aging of the workforce and potential for reduced immigration, the only way to generate 3% GDP growth is to have productivity growth of more than 2.5%. This would also make the budget deficit target easier to hit as faster growth generates higher tax revenue and lowers spending on income support programs. Yet, since 2004, we have been in an era of low productivity growth, which has risen at a mere 1.6% annual rate for the past two decades. By comparison, from1995 to 2004, productivity grew at a 3.1% annual pace.
The cautiously optimistic news is that in the past few years we have seen some evidence of a productivity revival. Over the past five years, productivity has grown at a 2.5% pace, after a dismal 2010s, when it was up just 1.3% a year. This rise in productivity is one reason why the US has achieved strong growth and falling inflation in recent years. Strong productivity goes hand in hand with low inflation, so the Fed is cheering this trend. We may be seeing the benefits of technological innovations that began in the early 2000s – think mobile technologies and other digital applications, renewable energy and electric cars.
It is likely too early to see the impact of artificial intelligence in productivity numbers. In fact, AI is probably deleterious to productivity as of now, as businesses are spending heavily on the technology without yet seeing significant benefits. The challenge with productivity data is that the signal-to-noise ratio is low, so it is difficult to discern whether the observed recent strengthening is volatility resulting from COVID-19, hybrid working and demographic trends or if it signals the dawn of a new era of high productivity.
Do Local Economies Differ?
Given the high uncertainty regarding new federal policies and their potential to exacerbate inflation and drag economic growth, all 150 Extended Metropolitan Areas (EMAs) that we model as part of the American Growth Project are expected to experience slower yet still positive growth in 2025. The continued economic expansion will be experienced unevenly across EMAs. Areas experiencing the fastest recent growth – often beneficiaries of innovation and domestic in-migration – will likely continue to outpace the rest of the country. Many of these EMAs have built up reserves of capital in the form of skilled labor, technological infrastructure and other investments, which will limit the slowdown and policy risks. Meanwhile, areas that are more dependent on immigration, housing trends and international trade face the greatest downside risk. The map below illustrates a base case, which incorporates a moderate version of the policy changes laid out in the new administration’s economic platform. This scenario is a less desirable path, yet it reflects a largely benign outlook for 2025.
Why Is Skills Development So Important?
Skills matter a lot, and there seems to be a persistent “skills gap” in the American economy, meaning that the skills that employees possess are falling short of employer needs. This is a troubling trend, and what we wrote in May 2023 still holds true: “[Skill level] is directly linked to economic productivity; not only do you need skills to foster innovation, but the impact of any innovation or technological progress will be severely limited if the workforce lacks the skills to properly use them.” Since that was written, the pace of change and demand for skills looks to have accelerated.
Skill measurement is a contentious exercise, and there is some debate about the breadth of the skills gap and the factors underlying it, yet more executives and hiring professionals are citing skills gaps as a key challenge. In Wiley’s 2023 survey of 600 human resources professionals, nearly 70% reported a skills gap in their organization, up from 55% reported in a 2021 survey. As technological advancement, innovation and uptake continue at a rapid clip, workforce training will struggle to keep pace, and the skills gap will expand in the near term. The Kenan Institute’s 2025 Grand Challenge will focus on skills gaps and developing solutions to close these shortfalls.
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