GDP Rebounds, but the Cracks Widen

Table of Contents

• GDP Surges Back into Positive Territory

• Employment Data Takes a Big Hit

• Inflation is Re-Accelerating

• A Tough Decision for the Fed

GDP Surges Back into Positive Territory

The U.S. economy bounced back in the second quarter, with GDP posting an initial reading of 3.0% growth in Q2 after shrinking –0.5% in Q1. On the surface, this looks like a strong recovery. But as always, the story beneath the headline matters more.

This rebound wasn’t a surprise. In fact, I pointed out in the May 5, 2025 edition of Here’s the Deal that a bounce was likely.

The negative GDP in Q1 2025 was mainly due to a massive surge in imports ahead of newly announced tariffs, which significantly subtracted from GDP calculations. Businesses rushed to import goods before the tariffs took effect, resulting in imports jumping over 40% during the quarter. Since imports are subtracted when calculating GDP, this front-loading of trade caused GDP to contract by 0.5%. A slowdown in consumer spending also contributed.

The subsequent bounce back in Q2 2025 was driven by a sharp drop in imports, which reversed the previous quarter’s import surge and provided a significant boost to the GDP calculation. However, underlying demand remained somewhat soft. Net exports made a strong positive contribution simply because imports declined drastically from their tariff-distorted Q1 highs.

In summary, tariffs and trade timing were the dominant forces behind both the Q1 contraction and Q2 rebound in U.S. GDP. The economy’s headline growth in Q2 mostly represented an accounting reversal of the Q1 import spike, with more moderate underlying domestic growth.

That explains why Q1 was weak, why Q2 looks strong, and why we shouldn’t assume this pace will continue.

You may have noticed Q1 GDP was revised from –0.3% down to –0.5%. Revisions like this are routine. Data gets updated as more complete information rolls in, and it’s nothing to panic about.

Which brings us to the next challenge: the labor market. The real concern lies not in growth, but in jobs.

Employment Data Takes a Big Hit

The real story in July’s jobs report wasn’t just the weak new numbers, it was the major downward revisions to May and June. Together, those months ended up with 258,000 fewer jobs than first reported.

Bringing the current Unemployment rate back up to 4.2%.

Then came the fallout. In a controversial move, Trump responded by firing the head of the Bureau of Labor Statistics. The politics of that decision, and the broader state of economic data deserves its own deep dive, which I’ll tackle in a future post.

Politics aside, the message is clear: job growth is faltering, and the now obvious economic slowdown continues to be unmasked.

Normally, this kind of weakening labor data would be enough to push the Federal Reserve toward cutting rates. Unfortunately, tariff-induced inflation is now complicating that playbook.

Inflation is Re-Accelerating

After months of easing, inflation is re-accelerating. July’s data confirmed it.

Consumer Price Index (CPI) – July 2025

For the third straight month, year-over-year CPI was higher than the previous month.

• Headline CPI: +0.2% month-over-month, +2.7% year-over-year

• Core CPI (ex-food and energy): +0.3% month-over-month, +3.1% year-over-year

With food prices taking the brunt of the price increases.

Producer Price Index (PPI) – July 2025

The big surprise was the significant jump in PPI, which was much higher than anticipated.

• Headline PPI: +0.9% month-over-month (biggest jump since June 2022), +3.3% year-over-year (Expectations were 0.2% MoM and 2.5% YoY)

• Core PPI (ex-food & energy): +0.9% month-over-month, 3.7% year-over-year (Expectation were 0.2% MoM and 2.9% YoY)

• Services inflation: +1.1%, driven largely by higher trade services margins

The biggest driver of the PPI surge was services inflation, especially in trade services margins which is the markup wholesalers and retailers charge. Margins spiked 2% in July. This is a clear signal that businesses are no longer fully absorbing tariff-driven costs. Instead, they’ve started passing those costs along to customers.

At first, many companies absorbed the higher costs of imports, sacrificing their margins in the process. But that approach was always temporary. The July data shows businesses beginning to raise prices and push more of the tariff burden onto customers.

This is further confirmation of the turning point. The additional costs of tariffs have moved from importer, to squeezing corporate profits, and now to fueling consumer inflation.

Goldman Sachs echoed that same conclusion, showing that as of June, 64% of the costs of tariffs were being paid by businesses while the consumer (you and I) covered 22%. Come October, they expect that division to shift dramatically to the consumer who would be on the hook for ~67% of the costs of tariffs with businesses covering only 8% of the increase in prices.

Despite the political spin, foreign producers aren’t paying much of the tariffs. US businesses and consumers are and will be, with the vast majority to be paid by the US consumer.

The next big test will be the PCE report on August 29th. Which, the same as CPI and PPI, has also been marching higher since tariffs were implemented.

This all sets up a very difficult decision for the Fed.

A Tough Decision for the Fed

The Federal Reserve finds itself in one of the most difficult positions in recent memory. Inflation has begun to re-accelerate, while the job market is clearly deteriorating. Under normal circumstances, the Fed would already be cutting rates to support employment. But tariffs, and the inflation they’re now pushing into the system, are forcing the Fed to choose between their dual mandates of maximum employment and stable prices. As those two goals are now in direct conflict.

If the Fed cuts rates at its September meeting, where markets currently assign an 86.1% probability, it risks fueling inflation further. Lower borrowing costs would boost demand, making it easier for tariff-driven price increases to stick. But if the Fed decides to hold off, waiting for this new wave of tariff-driven inflation to pass, the economy could weaken further. The end result is a greater risk of sliding into a deeper recession than we would have faced without tariffs in the first place.

This Friday at 10 a.m. EST, all eyes will be on Jerome Powell as he delivers his annual remarks at the Jackson Hole Economic Symposium. His comments should give us a clearer sense of whether the Fed is inclined to cut at the September 17th meeting or wait until October 29th for more data before acting.

This is exactly what I meant when I described the administration’s tariff strategy as a massive unforced error. The uncertainty, the chaotic messaging, and the timing - coming at the tail end of a credit cycle that had already endured pandemic-driven inflation - have all combined to box the Fed into a corner. Without tariffs, this difficult trade-off between supporting jobs and containing inflation wouldn’t exist today and they more than likely would have already continued cutting interest rates months ago as there would have been no need to worry about inflation re-accelerating without the new tariffs.

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