Fire & ice in 2025

February 20, 2026

Real GDP growth for the year came in at a 2.2% annual pace in 2025, a slight deceleration over the 2.8% pace of 2024:

• Consumer spending slowed slightly. The weakness was front-loaded into the first quarter of the year, as uncertainty about changes to trade policy spiked and consumers held off on their purchases. The wealth effects generated by the AI boom, efforts to front-run tariffs and an end to electric vehicle tax credits fueled spending midyear. Gains were more moderate in the fourth quarter. Low-income consumers started to spend more but at a cost: high credit delinquencies. 

• Housing contracted, despite an end-of-year spurt on construction. Home buying and building entered a third year of moribund performance as affordability remained a hurdle. Three of the last four years showed a contraction in overall activity. The share of those holding a mortgage over 6% exceeded the share below 3%, which spurred refinancing each time the mortgage rate fell. High home values, escalating insurance and real estate costs strained existing homeowners and prompted a rise in subprime defaults.

• Investment accelerated on the heels of the AI boom. Gains undercount the total investment in AI-related infrastructure. The real GDP data understates AI investment as it fails to count the semiconductor and circuit purchases that go into their construction. There were little to no inventories 

• Inventories were drained for three of the fourth quarters, after a surge ahead of tariffs in the first quarter.

• Government spending slowed. A drop in federal spending was partially offset by slower but still positive gains in state and local spending. Federal spending took a hit due to the continuing resolution, which held spending at fiscal 2024 levels through July, and the six-week government shutdown. Losses due to the government shutdown will be largely recouped in the first quarter.

• The trade deficit expanded for the year. (Yes, you read that correctly.) Exports slowed more rapidly than imports.  Stocking up on imports ahead of tariffs helped blunt the blow for the total year. Late in the year, we saw a change in the composition of imports. Imports to feed the AI boom were largely exempted from tariffs, while imports shifted to lower tariffed nations. 

The GDP deflator, which is a measure of inflation, accelerated in 2025. That further tempered overall gains, after adjusting for inflation.

Employment rose by a negligible 181,000 jobs in 2025 versus 1.45 million in 2024. When the economy does more with fewer workers, the reason is productivity growth. Productivity growth looks like it fell a bit short of the 2.8% pace of 2024.  

Recent research by the Kansas City Federal Reserve Bank suggests the diffusion of AI was not broad enough to account for the economy-wide boost to productivity we have seen in recent years, specifically in 2025. The broad adoption needed to move the national needle on productivity growth is too concentrated in too few firms to account for the economy- wide jump in productivity growth post-pandemic. Other factors such as remote work, hybrid work arrangements, experience and the reshuffling of workers to more productive firms during the hiring frenzy played a larger role to date. 

Fourth quarter dealt a blow by government shutdown

Real GDP expanded at a 1.4% annualized pace in the fourth quarter, a fraction of the 4.4% pace of the third quarter. The six-week government shutdown shaved more than one full percentage point from growth during the quarter. Those losses will be largely recouped in the first quarter. The estimates of the government shutdown from the Bureau of Economic Analysis include government services lost during the shutdown.

Consumer spending slowed from the red-hot pace of the third quarter. Consumers bought ahead of the lapse in electric vehicle tax credits on October 1, which borrowed from spending on vehicles in the fourth quarter. Holiday spending in December came in weak. Affluent consumers continue to carry spending gains, although work by the New York Federal Reserve Bank reveals that low-income households are picking up their pace of spending. The problem is how they are doing that. Credit delinquencies soared to the highest level since 2017 in the fourth quarter.

Subprime borrowers and those with student debt were hardest hit. Borrowers 40 and over are struggling the most with student debt. The problem is so severe that the administration has decided to delay garnishing wages of those who default on student loans. 

Separately, spending on services remained buoyant, largely due to spending on medical services. In the third quarter, that sector grew at its fastest pace since the height of the Omicron wave of COVID and remained a major source of spending in the fourth quarter. Aging demographics, a surge in hospitalizations due to the flu among older people, a jump in measles and mumps outbreaks among children and the rise in GLP-1 drugs were all contributors.

Residential investment contracted for the fourth consecutive quarter. That is despite an end-of-the-year spurt in new home construction, which helped buoy housing starts in November and December. Existing home sales remained weak.

Efforts to lower mortgage rates via increased purchases of mortgage-backed securities narrowed the spread between mortgage rates and Treasury bond yields. That does not solve the affordability problem but has fueled mortgage refinancing. The share of homeowners who have a mortgage above 6% is now greater than those below 3%, which opens the door to more refis. Mortgage defaults are at their highest level in nearly a decade, but still well below the peaks hit during the subprime crisis. 

Business investment picked up, fueled by the ongoing boom in data centers. Nonresidential construction continued to contract, with data center construction accounting for a growing share of commercial construction activity.

Inventories were further drained. Retail inventories remain lower than wholesale and manufacturing inventories. That has left retailers with low inventory following the holiday season. They are not expected to rebuild rapidly. Inventory management is one way to mitigate the cost of tariffs and elevated interest rates. The freight industry remained in recession. Consolidation has lifted spot rates but not volumes.

Government spending contracted. Large losses at the federal level offset gains at the state and local levels. Federal spending was dealt a blow by the six-week government shutdown. We are still on track to see federal debt eclipse the size of the overall economy for the first time since WWII. 

The trade deficit moved sideways. Exports fell less rapidly than imports. The weakness in exports was due to weakness abroad and soft boycotts of US products by consumers in other countries. Imports fell, except for high-tech goods, many of which go into data center construction and are exempted from tariffs. 

Inflation still too hot 

The personal consumption expenditure (PCE) index, the Federal Reserve’s favored index, rose by 0.4% in December from November. The year-over-year increase in the PCE index was 2.9%, up a tick from the 2.8% we saw last month. That is the hottest pace for PCE since March 2024. The three-month annualized pace went up to 3.1% from 2.7% in November. Those figures better capture momentum; all are in the wrong direction for the Fed. 

That is despite the data lapses due to the six-week full government shutdown, which are artificially holding year-over-year measures of inflation down. We need to see much cooler monthly prints on the PCE (0.2% or less) to bring index back to the Fed’s 2% target and stay there.

Core PCE, which strips out the volatile energy and food components of the index, rose by 0.4% in December. That translates to a 3% increase from a year ago, its fastest pace since early 2025. The three-month moving average jumped to 3.1% in December from 2.4% in November. Core goods and services inflation are both running too high. 

Core goods inflation picked up in December and January except for vehicle prices. The dispersion of price increases rose, which is more disturbing. That is despite a drop in the effective tariff rate in December. Much of what we imported was either lower or non-tariffed goods. 

The super core services, which strip out energy services and shelter, rose 0.3%. That translates to a 3.3% increase from a year ago, close to where it has been for much of the year. That is still more than a full percentage point above where it was pre-pandemic and appears sticky. That is a problem for the Fed, as it is harder to get inflation down to its 2% target, without service sector inflation cooling. 

Recreation services increased at their fastest pace on record in December, rising 2.3% in the month alone. Much of that was due to video streaming and rentals, which posted a 20% increase in December and a whopping 29% from a year ago in December. There was likely a quality adjustment, as many streaming services have cut back and charged more for special events, including sports.

Employment faltered

Those gains came despite a loss of 51,000 jobs during the quarter. A loss in federal workers who had taken earlier buyouts rolled off federal payrolls on October 1. Private sector employment increased at its fastest pace all year, but gains were tepid; wage gains continued to cool after adjusting for composition of the labor force. Worse yet, the increase in the private payrolls was due to hiring in just one sector: healthcare and social assistance, which is fueled by aging demographics. 

IEEPA overturned

Separately, the Supreme Court ruled that the emergency powers that the president used to levy over half of tariffs in 2025 were illegal. The justices left the door open for refunds. However, that will likely be litigated. The logistics of refunds are expected to be a nightmare and require an enormous amount of documentation. 

The Supreme Court noted that refunds could be a “mess.” Small firms are not likely to fare as well as large firms due to the paperwork, time and potential for additional legal challenges by the administration on refunds.  

More importantly, the White House has been bracing for a negative outcome. Tariffs ruled illegal can be rapidly reinstated via other levers. It has been preparing for this. Expect another round of executive orders regarding tariffs. Financial markets rallied on the news, but that is premature given ongoing investigations into statutory tariffs.