US growth resilient into 2025 with sticky inflation, eventual rate cuts, and tariff-driven FX effects

Why 2% Inflation Is Unlikely to Return — Case for a Higher 'New Normal'

Long-term structural forces — including deglobalization and tighter labor markets — are keeping price pressures elevated, making a sustained return to a 2% inflation target unlikely; policymakers and markets should expect a higher persistent inflation baseline with broad macroeconomic and distributional consequences.

• Deglobalization and reshoring of production have reduced the disinflationary effects of globalized supply chains, raising production costs and limiting downward pressure on prices.
• Supply-chain resilience investments and strategic stockpiling increase firms' operating costs and inventory-driven price pass-through, supporting higher core inflation.
• Tighter labor markets, stronger worker bargaining, and shifts toward higher wage floors push unit labor costs up and create more persistent wage-price dynamics.

Japan's FD‑ID Price Indexes Reveal Stronger Upstream Inflation but Still More Restrained Pass‑Through Than the U.S.

Using Final Demand‑Intermediate Demand (FD‑ID) price indexes for 2020–2025, Japan experienced larger upstream (energy and raw materials) price increases and greater cross‑stage dispersion than the United States, while downstream goods prices rose less than in the U.S.; compared with the pre‑2020 period, Japan’s goods price pass‑through to downstream stages intensified across many sectors but remained relatively muted versus the U.S.

• FD‑ID indexes reorganize producer prices by production stage, enabling stage‑by‑stage comparison of price transmission from upstream (raw materials, energy) to downstream producers and final demand.
• Cross‑stage dispersion of price increases was substantially larger in Japan than in the United States during 2020–2025.
• At upstream stages, Japan recorded larger price increases than the U.S., concentrated in energy and raw materials.

Why Chinese Current-Account Surpluses Do Not Necessarily Suppress Global Demand

Pettis's claim that China's large surpluses suppress global demand rests on a false ceteris-paribus assumption: other countries adjust policy (monetary and fiscal), and historical unemployment trends during China Shock 1.0 and after 2021 show no global demand shortfall. Even at the ZLB, several monetary tools and fiscal policy can offset external demand weakness.

• Argument under critique: China’s large trade surpluses reduce domestic consumption, which supposedly lowers global demand if other countries keep demand unchanged.
• Counterargument: The ceteris-paribus assumption fails because other countries respond—primarily via monetary policy—so suppressed Chinese demand need not translate into higher unemployment elsewhere.
• Empirical evidence: During China Shock 1.0 (2000–2008) U.S. and EU unemployment fell, and after 2021 EU unemployment fell while U.S. employment remained near full, contradicting the prediction of excess global unemployment from rising Chinese surpluses.

Firms’ Inflation Expectations Return to 2024 Levels

Despite sizable 2025 cost pressures from higher insurance, utilities, and tariffs and notable price increases—especially in manufacturing—firms’ year-ahead inflation expectations moderated to 3.0 percent and longer-term expectations remain anchored at 3 percent, suggesting limited risk of expectation-driven persistent inflation.

• In 2025 firms faced sharp cost pressures from rising employee insurance, utilities, and increased tariffs, which contributed to higher input costs.
• Firms raised prices more in 2025 after moderation in 2023–24: services averaged a 5.0% price increase (up from 4.1% in 2024) and manufacturing averaged 6.0% (up from 3.3% in 2024).
• Manufacturing price increases in 2025 slightly exceeded prior expectations (actual 6.0% vs. firms’ 5.4% expectation); service-sector realized increases were close to earlier expectations.

Cost-Based Phillips Curve Is Steep; Marginal Costs Drive Inflation Dynamics

Using firm-level price and cost microdata, the analysis finds that a Phillips curve formulated in terms of real marginal costs is substantially steeper than the conventional output-gap version and explains a large share of inflation volatility. The apparent flatness of the output-based Phillips curve reflects a weak elasticity of marginal costs with respect to output, not a weak link between costs and prices.

• Primitive (cost-based) Phillips curve links inflation to percent deviations of real marginal cost from trend; this formulation captures price-setting incentives directly and yields a much steeper slope than output- or unemployment-gap specifications.
• Firm-level microdata show substantial nominal rigidity—firms keep prices fixed on average for three to four quarters—and strong strategic complementarities, which together reduce pass-through of cost shocks but still imply a steep cost-based slope.
• Strategic interactions among firms cut cost pass-through roughly in half, but after accounting for nominal and real rigidities the estimated cost-based slope is three to ten times larger than output-based estimates.

Phillips Curve Steepens When Costs Surge

Inflation exhibits state-dependent, nonlinear dynamics: for small cost shocks pass-through to prices is roughly proportional (Calvo-like), but once shocks exceed thresholds (around 20% annual cost increases or large price gaps) pricing speeds up, pass-through strengthens and the Phillips curve steepens, as shown in firm-level Belgian data.

• Empirical evidence from Belgian manufacturing shows a nonlinear relation: small/medium cost shocks map roughly one-for-one into producer-price inflation, but beyond a threshold (~20% annual cost increase) inflation responds more than proportionally.
• State-dependent pricing explains the nonlinearity: when adjustment is costly, firms reprice mainly when price gaps are large; modest shocks leave many firms inactive while large shocks trigger widespread, larger adjustments.
• Firm-level administrative data reveal three facts: (1) adjustment probability is U-shaped in the price gap (firms far from their desired price adjust more often); (2) large aggregate shocks shift the entire distribution of price gaps rightward, substantially raising the share of firms re-pricing (e.g., a near doubling in 2022:Q2); (3) pass-through of price gaps to price changes is nonlinear—linear in a central 'Calvo region' (roughly ±10% gaps) but much steeper in the tails, producing a steeper Phillips curve during major disturbances.

U.S. manufacturing lacks a real stealth boom; tariffs and inflation negate nominal gains

Nominal increases in manufacturing shipments and output since early 2025 are largely price-driven and localized demand effects (e.g., AI-related goods); after adjusting for producer prices and examining industrial production and real output, U.S. manufacturing shows continued stagnation and tariff effects that cancel demand tailwinds.

• Nominal manufacturing metrics (shipments up 4.2%, production up 2.3% since Jan 2025) do not prove a real boom because they are not adjusted for inflation.
• Using the producer price index for manufacturing to deflate shipments removes the apparent post-2024 surge — real shipments and real output show no sustained recovery.
• Industrial production in the manufacturing sector and gross manufacturing output (price-adjusted) exhibit long-term stagnation dating back to about 2008, with no convincing breakout in 2025–2026.

U.S. manufacturing shows no hidden boom once inflation and tariffs are accounted for

Nominal increases in manufacturing shipments and output since early 2025 are largely inflation-driven and concentrated in high-demand sectors; when deflated using the producer price index, manufacturing shows no real “stealth boom” and remains in long-run stagnation, with tariffs offsetting demand tailwinds.

• Nominal rises in manufacturing shipments (4.2%) and production (2.3%) since January 2025 are misleading unless adjusted for price changes.
• Deflating shipments with the producer price index for manufacturing removes the apparent boom — real shipments and output do not show a sustained recovery.
• Industrial production and gross manufacturing output, when measured in real terms, continue a decades-long stagnation that traces back to 2008.

US Growth: Resilient Expansion, Sticky Inflation, and Policy Uncertainty

The US economy has remained resilient through the rate-hiking cycle driven by strong consumer demand, rising wages, productivity gains and tech-led business investment; growth should cool modestly in 2025 but remain above recent averages, inflation is likely to stay sticky around 2.5–3% y/y, and markets may underprice the pace of Fed easing amid tariff-driven FX and capital-flow effects.

US growth resilient into 2025 with sticky inflation, eventual rate cuts, and tariff-driven FX effects

US real and nominal GDP have been stronger than expected—driven by consumer demand, wage gains, and tech-led business investment—and are likely to cool modestly but remain above recent averages in 2025; inflation is expected to remain sticky around 2.5–3%, the Fed is likely to deliver more rate cuts than markets currently price, and tariffs show statistically significant effects on PCE and the effective exchange rate.