Tensions and tariffs: What’s next for the fragile global economy?

How significant is the risk that tensions in the Middle East could derail the fragile global recovery – and what knock-on effects might this have on inflation?

Philip: Going back to the beginning of 2025, Brent crude reached $83 a barrel – and that was with the US dollar stronger than it is today, which meant oil prices were even higher in local currency terms.

We’re confident that the global economy can survive oil prices at current levels or even somewhat higher.

In the UK, we’re actually more sensitive to gas prices, as anyone who remembers late 2022 can testify. Following recent events in the Middle East, gas prices are up: if that is sustained, then it is something we’re going to have to factor into our inflation forecast.

To provide some perspective, some of the near-term gas contracts in the UK are now at around 110p per therm from below 100p. But back in 2022-23 they were up at 800p per therm. So if we do make any changes to our Consumer Prices Index (CPI) forecasts based on rising gas prices, they are likely only to be relatively modest.

The Federal Reserve, the European Central Bank (ECB) and the Bank of England (BoE) started cutting interest rates in 2024. However, the Fed’s last reduction was in December and the ECB and BoE seem to be slowing the pace of cuts. Is there any room for further rate reductions this year?

Philip: The ECB cut its main policy rate to 2% at the start of June and we’re probably at or very close to the bottom of the Eurozone interest-rate cycle. Meanwhile, throughout the EU generally – but particularly in Germany – there is a huge amount of prospective fiscal expansion that we expect will make a material difference to medium-term economic momentum. The ECB is really in wait-and-see mode – although it’s possible we might get another cut in July.

In the UK, even if the impact of tariffs is negative, the BoE’s strategy is likely to be one of gradual and careful rate reductions: in our view, the medium-term inflation picture still looks benign and it seems likely that there will be another reduction in UK interest rates in August.

In the US, the picture is very different, and that is because the Federal Open Market Committee (FOMC) is worried about the inflationary impact of tariffs – especially if, as well as raising price levels, it feeds into higher wages and thereby entrenches inflation into the medium term. Our base scenario is that, by the end of the year, the FOMC concludes that any increase in inflation is likely to temporary and begins to loosen monetary policy again.

But that will depend on what happens to tariffs and also whether the US can avoid a sharp economic slowdown. If there are signs of a downturn, this could actually encourage the FOMC to ease monetary policy earlier.

Our central view is that the Fed will cut rates at the end of the year once it is reasonably satisfied that the medium-term inflation picture does not pose a major threat.

We are fast approaching 9 July, which will mark the end of the 90-day pause on the Trump tariffs. How has the global economy reacted to the tariff threat so far?

Philip: The picture has largely been one of uncertainty and halting spending because the economic outlook is simply not very clear. Our baseline forecast on tariffs has President Trump extending the deadline for another three months. However, if we do see another increase, that would likely raise US domestic inflation and slow the economy down – something that President Trump would not want to see.

This is where you get the so-called Taco trade – ‘Trump always chickens out’. In a purely practical sense, if the US is negotiating with a couple of dozen countries on tariff structures and other wider trade practices, it is difficult to see how those negotiators have the bandwidth to conclude that many agreements by the 9 July deadline. I think it is therefore a justifiable assumption to say that, in many cases, the can is going to get kicked down the road.

Against this backdrop of uncertainty around interest rates, tariffs and the potential direction of the American economy, what is your currency outlook?

Philip: We see no major reason to change our view that the US dollar is going to weaken moderately this year and next as the US economy proves less resilient and investors remain wary about the economic credibility of the Trump administration.

Tariffs are certainly one factor, but another important issue is fiscal policy and the debt trajectory implied by the fiscal bill that President Trump is currently trying to drive through Congress. The prospect of a significant increase in the deficit effectively led to Moody's recent downgrade of US government debt.

Another factor to note is that the greenback has been exceptionally strong for a number of years and, under present circumstances, it is not unreasonable to expect some level of pullback.

We have recently seen some moderate GDP improvement in Europe. Are you expecting this to strengthen further?

Philip: No, not in the near term. Throughout Europe we have seen a boost to economic growth at the start of the year – but that has been because firms and economies essentially forestalled high US tariffs ahead of Trump’s ‘Liberation Day’ announcement in early April. This had the effect of artificially strengthening GDP figures for the first quarter.

In the Eurozone, for example, growth was recorded at 6% quarter on quarter; in Ireland, the rate was nearly 10%. There is no way that these figures are sustainable, and we would not be at all surprised if GDP were to contract in the second quarter in response to this exceptionally buoyant Q1.

That said, the longer-term outlook is better: fiscal policy should provide a major support to the Eurozone economy in general, in particular infrastructure in Germany. In the latter case, higher levels of government spending could actually increase productive capacity and raise medium-term growth. But we would not expect this to kick in until 2026.

What are the main critical risks facing the global economy in the near term?

Philip: Going forward, we would like to see progress made on trade deals and a reduction in US tariffs, which would give business certainty over the economic outlook. We would also like to avoid the world descending into a tit-for-tat trade war.

We would like to see a de-escalation of tensions in the Middle East, which would be positive not just with regard to economic prospects but also in human terms.