US economic outlook September 2025

Mixed signals: Inflation rising, employment slowing and consumers holding on

• US outlook:  When faced with higher costs — driven by tariffs and immigration constraints — businesses are left with two choices: absorb the costs or pass them through. Either path results in weaker employment, softer consumer spending and slower economic momentum — all with inflationary undertones. The consequences are gradual and uneven: cost absorption erodes profit margins and pressures labor market conditions, while cost passthrough delivers a real income shock.
    
  
• Notwithstanding an expected moderate real GDP gain in Q3 — driven by resilient consumer spending, the AI investment boom and wild swings in international trade — growth is projected to decelerate further. The combined drag from tariff-related cost increases, persistent policy uncertainty, reduced immigration and elevated interest rates will weigh on business investment, household consumption and housing activity. We forecast real GDP growth of 1.7% in 2025 and 1.4% in 2026, with Q4 2025 growth slowing to just 1.2% year over year (y/y). While the probability of recession over the next 12 months currently stands at 40%, the balance of risks remains skewed to the downside.
    
• Labor demand and supply under pressure: The labor market continues to downshift, with August employment data showing just 22,000 jobs added and the unemployment rate rising to 4.3% — the highest since 2021. Downward revisions to prior months and weakness in goods-producing sectors underscore the labor market’s fragility. Looking ahead, employment is set for further slowing as firms, facing renewed cost volatility from escalating trade tensions, remain focused on managing labor expenses through restrained hiring, performance-based layoffs, subdued wage growth and lower entry-level pay. We anticipate job creation will weaken further, staying below trend into 2026, with the unemployment rate likely rising toward 4.8% by early next year.
   
• Resilient consumer, but fundamentals eroding: Despite mounting pressures from tariffs and a softening labor market, retail sales rose a solid 0.6% month over month (m/m) in August, buoyed by back-to-school shopping and high-income household activity. However, real sales volumes increased only modestly, and tariff-induced price hikes are beginning to weigh on lower- to upper-middle-income consumers. While spending has thus far held up — supported by solid income gains — it now faces mounting headwinds from labor market cooling and renewed inflationary pressures. We expect real personal consumption expenditures to slow from 2.8% in 2024 to 1.9% in 2025 and 1.2% in 2026.
   
• Inflation is reaccelerating: August Consumer Price Index (CPI) data confirmed a reacceleration in inflation, with price momentum evident across both goods and services. The impact of tariffs was visible, though the passthrough remains gradual and uneven. Service prices continued to firm, driven by higher travel-related costs and a rebound in shelter. Looking ahead, inflationary pressures should continue to build as tariffs filter through, though the pace of acceleration is likely to remain measured. We expect core personal consumption expenditures (PCE) inflation — the Federal Reserve’s preferred gauge — to drift further from the 2% target, reaching about 3.2% by year-end.
   
• Fed recalibration underway: The Federal Reserve cut the federal funds rate by 25 basis points (bps) from 4.00% to 4.25%, citing rising risks to employment and renewed tariff-driven inflation pressures. The move exposed widening divisions within the Federal Open Market Committee (FOMC), with year-end rate projections spanning a 150bps range — underscoring growing uncertainty around the policy path. Chair Jerome Powell stressed a risk-management approach, signaling flexibility amid shifting data. With labor market momentum fading and inflation dynamics still fluid, we expect another rate cut in December, followed by 100bps of additional easing through 2026 as economic conditions deteriorate further. An October cut remains possible but would likely require a negative — or near-zero — September payroll print.

The views reflected in this article are the views of the author(s) and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.