Why did US GDP fall?

News that the US economy contracted by 0.3% in the first quarter of 2025 led to a range of Donald Trump’s opponents blaming him and his tariff policies for the downturn. The US president blamed predecessor, Joe Biden, who was still in charge for the first few weeks and denied that the downturn was anything to do with him or with tariffs. So, what does the data say?

The two main reasons for a decline in gross domestic product (GDP) were the surge in imports to get ahead of the tariff increases which had been threatened, and a reduction in Federal government spending. Both these were Trump policies. It is also true, as the president says, that there was a sharp rise in investment spending, a further increase in consumer spending at a slower rate, and a good rise in personal disposable income.

Some of the investment was the rise in stocks ahead of the tariffs. Given the sharp changes of trade policy in recent weeks and the difficulties facing business in knowing how to adjust output and imports to big potential variations in costs it would be unwise to see the first quarter figures as representative of what happens next. In the second quarter, imports are likely to plunge.

What is US tariff policy?

We have explained before that there are two rather different policies struggling for predominance in the administration and in President Trump’s mind. There is the deal-making option, where the president uses the threat or short-term reality of high tariffs to do a series of tariff and barrier-lowering deals with major trade partners. Following a bit more turbulence during the negotiations it would create a backdrop for more growth and market reassurance.

There is also the high tariff option, where the president opts for trade-crushing barriers with China and a higher average tariff elsewhere as a source of revenue. He would be doubling down on the idea that this will onshore much more manufacturing investment into the US. This would be more negative for markets, as in the next couple of years demand would be hit by the higher taxes whilst the US would still be short of capacity to replace more expensive imports. The US and the world would be worse off.

It seems likely that we must live with uncertainty for longer, as the two options are argued through and as the administration experiments. It does not seem likely that the conflict will be resolved with a wide-ranging set of tariff and barrier lowering deals with most of the main trade partners. It also seems less likely the president will persevere with very high tariffs on a wide range of partners given the likely damage to growth, confidence and markets.

We expect a compromise to emerge, leaving the world with higher tariffs on average, with some countries more seriously hit and with the US suffering some increase in the price level and some diminution of growth.

The likely economic consequences

The US imports a little over a tenth of its GDP. If an average tariff of 20% is placed on all imports, some say this will mean a 2% plus rise in the overall price level as those imports will cost 20% more. This will be accompanied by a reduction in demand from the higher prices squeezing real incomes and will keep interest rates a bit higher for a bit longer.

In practice, the price level is likely to rise by less as exporters in a weak market position will absorb some, or all, of the tariff costs to maintain sales volumes. Let us say half the average tariff is passed on resulting in a price rise of 1%. This should not be sufficient to tip the US economy into recession but could slow the growth rate appreciably. It is unlikely the Fed would move early to offset the deflationary longer-term impacts of removing consumer spending power with an effective US sales tax on foreign goods. There is unlikely to be a second-round inflationary impact at current levels of money and credit growth. The medium-term impact is more deflationary than inflationary.

The higher the average tariffs settle, the more risk of recession as the bigger the hit to demand and confidence. There is also the issue of disrupted supply chains. If the trade war with China is prolonged and intense, the absence of Chinese products will be disruptive to US business who need Chinese raw materials and components and to US retailers and service suppliers who rely on Chinese goods. This leaves more scope for stronger upwards price movements to acquire the missing goods from elsewhere, and difficulties for local producers in maintaining consistent supply.

Is this the end of US exceptionalism?

Some say that this will be a bigger blow to the US than to other countries. It could prove to be a bigger blow to countries that export much more than 10% of their GDP as they lose sales to the US and need to seek sales elsewhere, probably by cutting margins and prices. Countries such as Ireland, South Korea, Canada and Mexico are exposed to a sudden loss of volumes into the US.

The US is the economy that faces the consumer tax, deflating growth. There are however two main underpinnings of the US exceptionalism of recent years that are less affected. They are the success of US digital companies, and the drive to extract more cheap oil and gas at home.

The energy industry may continue to lose a bit of revenue and profit from lower energy prices worldwide as demand slows. The digital industry is flourishing, as recent figures from the leading US companies have indicated. Amazon, Meta, Alphabet, and Microsoft are achieving double digit growth rates in turnover and are sustaining high margins and cash generation.

Apple delivered reasonable growth but is incurring more cost to move supply from China to India to avoid the worst penal tariffs. Amazon faces issues in its retail business over how to source alternative product to Chinese all the time the ultra-high Chinese tariffs remain.

The US retains a dominant position outside China in digital services. It is using the world demand for ever more storage and computing power in the Cloud, and the interest in Artificial Intelligence aids, to power further growth. Whilst growth rates for the majors have slowed, they remain above the market average – whilst several of the companies are now rated more like the rest of the market following the sell-off in the first quarter of 2025.

Conclusions

We expect President Trump to back down from the extreme use of high tariffs as they will destabilise markets and slow the economy too much. We do not expect him to produce a convincing range of freer trade deals with leading partners to turn the trade issue into a positive. We expect US retail prices to have a one-off modest rise on the back of the tariffs, for supply chains to be disrupted, and for growth to slow.

We do not expect on base case a recession. The Federal Reserve can always cut rates faster. Congress might be persuaded to cut taxes more if need arose. US exceptionalism will be dialled down a bit, but two of its core ingredients, digital and energy, remain in place. In due course, the US should have more onshore manufacturing, but factories take time to build and need plenty of money and builders to do so.