Although Morgan Stanley Research is not currently forecasting a recession for the U.S. economy, the gap between the likelihood of sluggish growth outlook or an actual downturn has narrowed – even following the 90-day reprieve on reciprocal tariffs announced on April 9.
The revised forecast calls for U.S. growth of 0.6% this year and 0.5% in 2026, down from previous estimates of 0.8% and 0.7%, respectively, based on expectations for slower growth, a low unemployment rate and steady inflation.
“Given that reciprocal tariffs are delayed, but not negotiated away, we translate prolonged uncertainty into marginally softer consumer and business spending,” says Morgan Stanley Chief U.S. Economist Michal Gapen.
The forecast for inflation is for 3.5% this year, while the expectation for unemployment is an increase to 5%, but only in 2026.
“As a result, we think the right answer is for the Fed to wait in its current stance for longer,” Gapen says. “In sum, we are looking for no rate cuts from the Fed in 2025 and only expect a rate-cutting cycle to begin in March 2026, lowering the terminal rate to 2.50 to 2.75% in late 2026. However, a downturn could bring cuts forward.”
Effective Tariff Rate Is Still High
On April 9, one week after announcing a new trade policy that increased the U.S. effective tariff rate to levels not seen in over a century, the White House changed course. The administration maintained a 10% base level tariff on trading partners, but introduced a 90-day pause for the implementation of variable reciprocal tariffs for more than 50 trading partners, while raising tariffs on China to 125%.
The decision came after an unprecedented week for financial markets, with high volatility and equity markets selloff, reflecting investors’ concerns of a potential recession.
Morgan Stanley Research estimates that the increase in China tariffs plus the delay in others will lead to an average effective tariff rate of 23%, down from the 28% rate without the pause, but still in line with the 18%-to-22% range used for its forecast assumptions.
“The effective tariff rate remains exceptionally high, driven mainly by high bilateral tariffs between the U.S. and China,” Gapen says.
Alternative Scenarios
Amid the uncertainty, Morgan Stanley Research considers three alternative scenarios for the U.S. economy, depending on the outcome of tariff negotiations, immigration policy and the implications of budget plans under discussion in Congress.
Low: De-escalation. Probability: 5%.
Negotiations to reduce or eliminate reciprocal tariffs are successful, bringing the effective tariff rate to 15% by the end of the year. Immigration levels approach pre-COVID levels as the administration moves to expand legal immigration, and Congress expands the deficit by $1.5 trillion over 10 years. The economy grows in 2025 and 2026, inflation falls gradually toward the 2% target, and the unemployment rate moves broadly sideways. The Fed cuts rates to 3.25% to 3.50% in 2026.
Elevated: Mild recession. Probability: 30%.
Insufficient progress on tariff negotiations brings the effective tariff rate to 28% after the 90-day pause, leading to a sudden stop in product and asset markets. Without any relaxation of immigration restrictions or fiscal policy, growth turns lower and labor markets weaken more rapidly. Growth falls in 2025 and rebounds slightly in 2026. The Fed cuts 25 points per meeting starting in September 2025, and eases to 1.50% to 1.75% in 2026.
Medium: Trade and fiscal shock. Probability: 10%.
In addition to the return of reciprocal tariffs, the House adopts the current budget blueprint, leading to a fiscal drag in 2026. Real GDP contracts in 2025 and 2026, with consumption falling more sharply. Inflation, after rising sharply in 2025 due to tariffs, falls back to 2% as labor market slack increases. The Fed cuts rates by 100 points in 2025 and 225 points in 2026, ending at 1.0% to 1.25%.
For deeper insights and analysis, ask your Morgan Stanley Representative or Financial Advisor for the full report, “Still living on the edge,” (April 10, 2025).
