Tariff Ruling Highlights Delicate Economic Balance

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Our framing and outlook for the U.S. economy and markets in recent months can be summarized by what I like to call the “three Bs”: Bifurcation and Broadening, all within the context of a delicate economic Balance.

The past three years have been defined by a bifurcated, or “K-shaped,” economy in which the gap between the companies and consumers benefitting from high interest rates and those that are punished by them has continued to widen. This bifurcation—ignited by the Federal Reserve’s decision to raise its benchmark interest rate from 0.25 percent in March of 2022 to as high as 5.5 percent in July 2023—was only compounded by the rapid rise of artificial intelligence (AI) as massive investment into the sector pushed the “Magnificent Seven” and other technology winners to new heights.

More recently, however, the historically narrow economy and markets have begun to exhibit gradual signs of broadening as the U.S. central bank has moved to cut rates by a total of 1.75 percent since 2024. Small-Cap and Mid-Cap stocks have significantly outperformed the broader market over the past several months, marking a sharp reversal from their performance over the past several years, as investors have increasingly rotated out of mega-cap technology stocks and into more economically sensitive companies.

Nevertheless, we continue to note that much of this optimism remains in a delicate balance amid a tug-of-war of tensions between steady economic growth, persistent labor market weakness and stubborn inflation, which remains stuck above the Fed’s 2 percent target since the end of 2023. A landmark Supreme Court ruling on Friday—which deemed the Trump administration’s use of the International Emergency Economic Powers Act (IEEPA) to impose tariffs unlawful—cast further uncertainty over the markets and economy, leaving billions of tariff revenue in limbo, according to the Budget Lab at Yale.

Factor in the ever-present geopolitical risks (with escalating tension between the U.S. and Iran the latest example), the lingering impacts of the record-setting government shutdown in the fourth quarter of 2025, and mounting worries over the sustainability of AI spending, and the long-term economic picture looks increasingly unclear.

This delicate balance was on display once again last week, as a hotter than expected December inflation reading clashed against weaker than expected U.S. gross domestic product (GDP) data. The economy grew at an annual rate of 1.4 percent in the fourth quarter of 2025, according to the latest figures, significantly lower than the 2.8 percent growth many economists had anticipated, as the historic 43-day government shutdown, decelerating consumer spending and sticky inflation weighed on overall performance.

More volatility remains on the horizon. Following the Supreme Court’s tariff ruling, U.S. President Donald Trump signaled he would not back down on his trade agenda, immediately pivoting to alternative legal authorities that the court did not invalidate, including a new 15 percent global tariff under the Trade Act of 1974. Unlike the tariffs that were recently struck down, however, these new levies are capped at 150 days unless Congress approves an extension.

Questions remain as to whether what the Penn Wharton Budget Model estimates to be roughly $175 billion in already collected tariff revenue will now be subject to potential refunds. Without IEEPA tariffs, the overall average effective tariff rate will fall to 9.1 percent, according to the Budget Lab at Yale, which remains the highest since 1946 excluding 2025. Had the IEEPA tariffs remained in place, this figure would have reached 16 percent, the highest since 1936. With the new announcement of 15 percent Section 122 tariffs, the rate is estimated to reach 13.7 percent for the next 150 days. The fates of various trade deals struck between the U.S. and its key trading partners also remain in question, as does the overall implementation of the 15 percent tariffs.

The tariff ruling initially triggered a relief rally on Friday, pushing major indices as well as Small- and Mid-Cap stocks higher in a sign of continued economic broadening. For the week, all major U.S. indices finished higher, with U.S. Mid-Cap stocks notching a new all-time high alongside the equal-weighed S&P 500, which shows a broadening well beyond the technology sector. Most importantly, Treasury markets held steady in the face of uncertainty, with the yield on the benchmark 10-year note closing the week at 4.08 percent, nearly the same rate as the prior week and over 0.7 percent lower than where it stood a little over a year ago.

This is where monetary policy has recently moved into stimulative territory given lower interest rates across the yield curve, which will likely help alleviate some of the prior pain that has been endured by more interest rate-sensitive parts of the U.S. economy. Fiscal policy has begun to shift from a headwind to economic growth, with the government shutdown in Q4 to a powerful tailwind so far this year. The Hutchins Center on Fiscal and Monetary Policy currently projects that the One Big Beautiful Bill Act and the resumption of delayed federal spending will boost U.S. GDP growth by approximately three percentage points in the first quarter of 2026.

However, we note that stubborn inflation remains a key risk to future interest rate movements throughout the remainder of the year, underscoring the delicate balance of the economy and markets. New federal data last week showed that the core Personal Consumption Expenditures (PCE) price inflation rose 3 percent year over year in December 2025, an acceleration from the 2.8 percent rate seen in November and October and unchanged from the 3 percent year-over-year rate at the end of 2024. It’s also only a hair below the 3.1 percent reached at the end of 2023, meaning that the Fed has essentially made zero progress toward reaching its 2 percent inflation target over the past two years.

We acknowledge that uncertainty remains elevated in this period of delicate balance. However, it’s also worth noting that nothing is ever 100 percent certain when it comes to investing. We continue to advocate the benefits of diversification as the tried-and-true anecdote for uncertainty and utilizing a well-balanced portfolio to navigate various economic environments.

Wall Street wrap

Stubborn inflation underscores delicate economic balance: Inflation remained hotter than many economists expected, according to the latest PCE inflation report from the Bureau of Economic Analysis (BEA), with both headline and core readings coming in above forecasts. Headline inflation rose 0.4 percent month over month in December 2025, topping the expected 0.3 percent gain, and accelerated 2.9 percent on a year-over-year basis. Core inflation, the Federal Reserve’s preferred inflation gauge (which excludes more volatile food and energy prices), also rose 0.4 percent in December and 3 percent on an annual basis, exceeding consensus expectations. As previously stated, the current 3 percent year-over-year rate on core inflation has remained relatively unchanged since 2023, reflecting almost zero progress in reaching U.S. central bank’s 2 percent run target over the past two years.

Goods inflation rose by 0.4 percent compared to 0.1 percent in December 2024, bringing year-over-year inflation to 1.7 percent. This is where tariff-related inflation has likely shown up: Besides the COVID-19-impacted years of 2021 to 2023, this marks the hottest goods inflation since March 2012.

Services inflation rose 0.3 percent in December, bringing the year-over-year figure to 3.4 percent, a notable cooling from the 4 percent year-over-year reading in December 2024. However, we note the past three months have seen a spike in a reading the Fed considers important to the path of overall service sector inflation—Supercore Services ex Shelter—which has risen at an annualized rate of 4 percent over the past three months and 3.8 percent over the past six months.

This stickier inflation reading suggests that inflation pressures aren’t cooling as quickly as the Fed may have hoped, which could reduce the odds of near-term interest rate cuts and keep interest rates higher for longer.

GDP expands modestly despite shutdown: The U.S. economy grew at an annualized rate of 1.4 percent in the fourth quarter of 2025, according to advance estimates from the BEA, marking a slowdown from the 4.4 percent growth that occurred in the third quarter and significantly below economists’ expectations of around 2.8–3.0 percent.

Non-residential fixed investment, one of the few areas that accelerated, rose 3.7 percent. This was driven by a 36.1 percent increase in information processing equipment and a 7.1 percent increase in intellectual property products, each tied to the AI infrastructure boom. Offsetting these gains were declines in government spending, largely tied to the record-long government shutdown in late 2025, and a reduction in exports, both of which subtracted from overall GDP growth.

Real final sales to private domestic purchasers, a measure that strips out volatile factors like inventory swings and the federal shutdown, grew by about 2.4 percent, indicating modest but positive underlying demand. On an annual basis, the U.S. economy expanded by about 2.2 percent in 2025, down from roughly 2.8 percent in 2024.

Purchasing momentum slows amid sticky inflation: U.S. manufacturing and services business activity has picked up modestly in February, according to preliminary data from the S&P Global Purchasing Managers’ Index (PMI), but is also exhibiting clear signs of slowing momentum. The flash Composite PMI, which combines data from both the manufacturing and services sectors, fell to 52.3 in February from 53.0 in January, the slowest pace of private-sector growth since April 2025 in a sign of slowing momentum across industries.

The report showed the delicate balance between continued inflation risks amid slower labor market growth and sales. Companies cited elevated prices, tariffs and subdued consumer confidence as key sales inhibitors, though adverse weather was often noted as an additional factor for weaker numbers. The Manufacturing PMI dropped to 51.2 from 52.4, while the Services PMI eased to 52.3 from 52.7 amid softer new orders and export demand contributing to weaker output growth.

Average input costs rose sharply again in February, linked to supplier price hikes, tariffs and higher wages, feeding through to the largest increase in average selling prices since last August. Meanwile, the report noted that average prices charged for goods and services have also increased at the steepest rate since August 2025, a pace that is well above the survey’s long-run average. While selling prices moderated in the manufacturing sector to a 14-month low, services inflation jumped to a seven-month high and at a pace that is one of the strongest rates of increase recorded over the past three and a half years.

Employment growth remained slow, with payrolls rising marginally for the third month and at pace that is the slowest since the “Liberation Day” uncertainty in April 2025. In a more positive sign, business expectations for the year ahead jumped to the highest for just over a year, signaling that the slowing economic growth seen in February so far could prove only temporary.

Manufacturing output jumps amid lower interest rates: U.S. industrial production surged by 0.7 percent in January and 2.3 percent year over year, according to the Federal Reserve’s latest Industrial Production and Capacity Utilization report, a notable increase over December’s 0.2 percent gain and significantly above consensus forecasts of around 0.3 percent, as lower interest rates have served as a tailwind for manufacturing growth.

This was predominantly driven by a sharp jump in manufacturing output of 0.6 percent in December, its strongest monthly advance in nearly a year, and 2.4 percent on an annual basis. This marks the largest year-over-year increase in this category since March 2022, the month the Fed first began raising interest rates from 0.5 percent up to 5.5 percent in July 2023, which slowed the industry overall given its rate-sensitive nature.

The week ahead

Monday: The U.S. Census Bureau will release its final estimate of manufacturers’ odds shipments, inventories and orders report for December 2025 at 10:00 a.m. EST. Originally scheduled for early February but delayed due to the late 2025 government shutdown, preliminary data showed that new orders decreased by $4.6 billion (1.4 percent) to $319.6 billion, following a revised 5.4 percent surge in November.

Tuesday: The Conference Board will release its February 2026 Consumer Confidence Index report at 10 a.m. EST, including the much watched “labor differential,” a key indicator of consumers’ employment outlooks. January’s report signaled growing anxieties about a sluggish labor market, as the percentage of respondents who found jobs plentiful fell by 3.6 percent, and those who found jobs in short supply rose by 1.7 percent. We’ll be watching to see if this divergence continues amid continued signs of a cooling labor market.

Separately, December data from the S&P CoreLogic Case-Shiller Home Price Indices will be published at 9:00 a.m. EST. Last month’s release showed that home prices in the U.S. continued to increase on an annual basis through November 2025, though the pace of growth remains modest.

Friday: The U.S. Bureau of Labor Statistics will release January Producer Price Index (PPI) inflation data at 8:30 a.m. EST. December 2025 data showed that wholesale inflation came in hotter than expected, driven primarily by a surge in services costs. We will be monitoring to see how this trend has progressed.