With all the changes in Washington, airing of diametrically opposed ideas, reflecting suits and countersuits that change on a daily basis, an observer almost needs an event program to keep it all straight. Needless to say, this type of environment complicates planning for both businesses and individuals. But as with all things, in time a concept of the future will gel. The key is to not be overly distracted by events and continue to keep your eye on how to best deal with the evolution, pay attention to what is changing and what is not, what things that you can control and what you cannot, and being prepared to take one step at a time toward your goals.

The Economy

The most recent official GDP reading measured a .5% contraction in the economy during the first quarter. This however appears to have been due to increases in imports to beat tariffs. Competing real-time Fed estimates are 3% and 1.7% for the second quarter, and 1.4% for all of 2025. Fed regions reported that economic activity was down slightly and that the outlook was slightly pessimistic and uncertain. Those observations have not shown up in the labor numbers however. Unemployment is steady at 4.2%. Consumer confidence remains poor, likely due to the overall political uncertainty, and leading indicators continue to fall. The last time that there was a decline this large and long started in 2006 and lasted through the “Great Financial Crisis” (GFC) of 2008. Home prices increased 1.3% nationally, which is less than inflation, and the inventory of homes for sale is increasing. The northeast saw a 7.5% advance.

The Markets

The markets continue to hang on every word from members of the Fed Open Market Committee to divine the course of interest rates. The average prediction of the Fed Funds Rate for the end of 2025 is 3.9%, while futures contracts suggest a little lower at 3.75%. Short-term bonds and money market accounts are likely to drift toward these yields over the year. Longer term yields have resumed their usual position above the short-term as the “yield curve” continues to normalize.

Stocks ended their tariff-induced selloff in early April and spent the rest of the quarter recovering their prior loss. As usual, large company stocks are leading the recovery, leaving small and mid-sized company stocks in a loss position so far this year. Seasonal expectations would be for a good third quarter initially followed by a slump toward September, but this year has been atypical to say the least, so normal patterns may be suspect.

The Current Cunundrum

After famously predicting that the post-pandemic bout of inflation would be "transitory", the Fed has been resolutely following a program of holding interest rates above inflation. This reflects a change to the policy of the previous decade years where rates remained at historically low levels, which were very close to zero. They are currently comfortable with their position of keeping rates mildly restrictive, while still providing the necessary liquidity required to grease the gears of the country's financial mechanisms. Furthermore, they have not yet seen whether there will be additional price pressures from the administration's new tariff policy. Nor have they seen any significant economic slowdown materialize yet.

The Fed is a student of history and is well aware of the policy mistakes that were committed in the 1970’s that caused and extended inflationary forces during that decade. It was standard policy before that time to keep a generally balanced Federal budget, engaging in a little deficit spending during recessionary periods and maintaining balanced or surplus position during expansions. This conservative approach worked well when the country was not engaged in wars or depressions. The deficit spending would sometimes overshoot though and last longer than the recession, causing some inflationary effects. The tradition of restoring the government's budget to a surplus ended around 1970, about the same time as Nixon announced that the dollar would no longer be convertible into gold. Those policy changes would have the effect of removing constraints on spending and creating constant deficits for the next thirty years and beyond. Instead of promoting a contained expansion in the non-recessionary times, the 1970 decade economy developed several severe post-recession inflationary periods, which could only be brought under control by increasing interest rates.

Because interest rates continued to drop from the early 1980s through 2000, recessions were mild and far between. This pleasant change from the frequent recessions of the previous period ended abruptly with the GFC of 2008. That trend ran into a wall though, because interest rates could not drop further on their own accord to below zero. The Fed's response to this was to develop experimental measures keep rates low and the economy growing. When the GFC and pandemic contractions hit, the only other available policy response was to incur even greater record deficits. The policies used between the two recessions did not show up in the consumer price index, but rather created a major inflation in financial and real estate asset values, which was just fine for some as investors and home owners saw their wealth grow well beyond their expectation. The policies adopted with the pandemic, being essentially deficit spending hand-outs to people and companies, showed up as inflation in goods and services. That inflation is now falling as the bulge moves through the system. The Fed appears to have contained self-fulfilling expectations of continued inflation, which they do not want to see re-kindled.

The administration would like the Fed to change its policy, however, and reduce interest rates to 1-2%, which would be below current inflation and provide pre-emptive economic stimulus. Such a decrease would also be helpful to reduce the government's interest burden. A danger is if the currently debated “Big Beautiful Bill”, permanently kicks the spending can down the inflationary road any further, additional stimulatory spending could create a situation just like the 1970's that ping-ponged between recession and inflation that was dubbed "stagflation". The administration may not be as concerned about inflation as the Fed, because it provides the additional benefit of making the government's debt burden easier to pay back.

Economic worrywarts are not only concerned about stagflation. They are also concerned about how we will continue to finance the country and about losing the status as a world financial leader. If the dollar loses its status as a medium of global exchange, it will be less attractive to hold. Lower perceived worth of the dollar increases US prices for international goods. If high inflation, either from domestic or global causes makes government bonds worth less, who will buy them? Will they demand higher interest rates, which will compound the problem?

To the extent this type of environment comes to pass, the worriers suggest protecting investment portfolios by avoiding long-term bonds, adding exposure to non-financial assets like real estate, commodities (gold) and defensive stocks. We would add to this recipe avoiding investments with excessive valuation.

For our readers who are concerned about the currently unsettled financial environment, our advice is to maintain composure, consider your options, plan as best you can for the future, take one step at a time, and continuously re-evaluate as you go.