The U.S. economy is walking a tightrope.
A fragile balance lies beneath the surface of robust labor market performance and sustained consumer spending, where persistent inflation, frothy asset markets, a growing budget deficit, and looming uncertainties could ignite a significant disruption. Any of these risks—whether triggered by policy missteps, external shocks, or a convergence of events—can cascade into a financial crisis. With President-elect Trump poised to enact policies that could amplify these challenges, the stakes for policymakers have never been higher. They must tread carefully, act prudently, and be prepared to respond swiftly to preserve stability in this precarious moment.
Resilient Economy, Labor Market, and Inflationary Pressures
The resilience of the U.S. economy is undeniable. December’s employment report showed 256,000 jobs added, far exceeding expectations of 160,000. The unemployment rate fell to 4.1%, the lowest in 18 months, as businesses maintained strong hiring momentum. This robust job market has sustained consumer spending and driven economic activity. However, this strength has not existed in isolation. Accommodative fiscal and monetary policies have also played a critical role in sustaining the consumer, as has the wealth effect created by elevated asset prices.
The labor market remains a cornerstone of the economy’s strength, bolstered by consistent job creation and modest wage growth. Average hourly earnings rose by 0.3% in December and are up 4.4% year over year, reflecting steady income gains. However, this tight labor market risks fueling inflationary pressures as businesses compete for workers and pass higher costs onto consumers. With job openings still outpacing available workers, wage pressures could persist, adding to inflation concerns.
Inflation, despite moderating from its peak, remains persistently high. The Federal Reserve’s preferred measure, the Core Personal Consumption Expenditures (PCE) Price Index, rose 3.1% year-over-year in December 2024. The Consumer Price Index (CPI) paints a similar picture, registering 2.6% year-over-year inflation. Housing costs and service-sector prices in healthcare, travel, and dining continue to drive these numbers. While inflation has moderated from its peaks, it remains well above the Fed’s 2% target, complicating monetary policy and heightening risks.
Trump’s Policies: Uncertainty with Inflationary Risks
President-elect Trump’s incoming policies represent one of the most considerable uncertainties for the U.S. economy in 2025. Proposed tariffs and immigration reform will likely increase business costs as supply chains face disruptions and labor shortages intensify. Corporate tax cuts may provide short-term economic stimulus but could worsen fiscal deficits, while regulatory easing might encourage investment and increase systemic risks. Each of these measures, while boosting growth, carries inflationary risks that could complicate the Federal Reserve’s already difficult task of maintaining price stability.
The potential for these policies to amplify existing pressures cannot be understated. Tariffs alone could exacerbate supply chain bottlenecks and raise input costs, directly fueling inflation. Meanwhile, tighter immigration rules could reduce labor supply, increase wages, and add to cost pressures. With fiscal deficits growing, additional tax cuts may reduce fiscal flexibility, limiting the government’s ability to respond to economic shocks.
The Fed’s Premature Rate Cuts
Between September and December 2024, the Federal Reserve reduced interest rates by 100 basis points, citing initial concerns over labor market risks. These cuts were a miscalculation. Recent employment data demonstrates the labor market’s resilience, contradicting the rationale behind the Fed’s actions. Additionally, inflationary pressures remain stubborn, suggesting the cuts may have been premature.
The Federal Reserve’s actions underscore the risks of missteps in today’s environment. As we noted earlier, a misstep could ignite a crisis by exacerbating one of the many risks already present. The economy’s current balance is fragile, and any miscalculation—whether through policy or external shocks—could set off a chain reaction with far-reaching consequences.
Frothy Asset Markets Heighten the Risks
Another area of concern is the disconnect between asset valuations and economic fundamentals. The S&P 500’s price-to-earnings ratio remains at 21.8x, far above the historical average of 16x, signaling excessive optimism. Any unexpected downside information—ranging from earnings disappointments to geopolitical tensions—could trigger a sharp correction.
Cryptocurrencies add another layer of fragility. Bitcoin, Ethereum, and other digital assets experience extreme volatility, with recent daily swings exceeding 10%. While small relative to the broader economy, these speculative markets could amplify instability if a sharp downturn occurs.
A Swelling Budget Deficit Threatens Flexibility
The federal budget deficit reached $1.8 trillion in fiscal year 2024, equivalent to 6.4% of GDP. Historically, deficits of this magnitude have been rare outside of major crises. During the Great Recession, the deficit peaked at 9.8% of GDP in 2009, while during the COVID-19 pandemic, it soared to 15% of GDP in 2020. While current levels are below these extraordinary peaks, they remain alarmingly high for a non-crisis period and suggest a troubling trend.
This growing deficit is fueled by rising interest costs on the national debt and elevated post-pandemic spending levels. Without intervention, the Congressional Budget Office projects the deficit will exceed $2.8 trillion by 2034, an unsustainable trajectory. Rising deficits reduce fiscal flexibility and crowd out private investment, limiting economic growth. As interest costs consume an increasing share of federal resources, the government’s ability to respond to future crises diminishes. This lack of flexibility heightens the risks posed by other economic vulnerabilities.
Geopolitical Instability Adds to the Uncertainty
Global tensions amplify the risks facing the U.S. economy. Trade disputes with China, conflicts in Eastern Europe, and volatility in energy markets create a precarious environment. These external risks could compound domestic vulnerabilities, creating a perfect storm for financial disruption.
A Moment of Reckoning
The U.S. economy is balancing on the edge of significant disruption. Persistent inflation, frothy asset markets, commercial real estate vulnerabilities, a growing budget deficit, and geopolitical instability create an environment where the wrong move—or a confluence of unexpected shocks—could trigger a financial crisis. The Federal Reserve’s recent rate cuts have shown how policy errors amplify risks. Trump’s policy agenda adds another layer of complexity, potentially boosting growth or exacerbating inflation and fiscal imbalances.
Policymakers must act prudently and be prepared to respond nimbly to emerging challenges. The warning signs are clear, the risks are unmistakable, and the stakes could not be higher.