Viewpoint

August 08, 2025 | 14:35

Calling All Jedi

Economist

Chief U.S. Economist and Managing Director
Economics

Scott Anderson is BMO’s Chief U.S. Economist and Managing Director. He analyzes and forecasts U.S. national and ... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with BMO Capital Markets since 2006. He plays a key role... (Read more)

Scott Anderson , Ph.D.

Chief U.S. Economist and Managing Director
Economics

Scott Anderson is BMO’s Chief U.S. Economist and Managing Director. He analyzes and forecasts U.S. national and ... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with BMO Capital Markets since 2006. He plays a key role... (Read more)

Our Thoughts

Calling All Jedi

I can’t help but reach for a Star Wars metaphor at this moment. The White House’s reordering of the global trading system through higher tariffs on nearly all major trading partners is creating a disturbance in the U.S. economy much like the Jedi talk about a disturbance in the force. And, like the Jedi who seek to restore balance to the force, the Federal Reserve is struggling to restore balance to both sides of its dual mandate. Its task appears simple on the surface: set interest rates and monetary policy to maintain stable prices and full employment. But with tariffs moving higher again, the disturbance to the labor market and inflation will likely be meaningful.

With nearly all new reciprocal tariff rates now in effect, we estimate the average effective tariff rate (AETR) on U.S. imports has risen to around 18% from 16% during the tariff truce—or nearly 8 times higher than in 2024. This is still a bit lower than our estimated 26% AETR calculated in the immediate aftermath of the April 2 Liberation Day announcements, but remains a far cry from some of the most optimistic scenarios that the AETR could end up in the 12-to-15% range. Based on actual revenues, the calculated rate has only risen to about 9% so far, so the tariff shock still has a long way to travel before we reach our final destination.

Even more concerning, the tariffs may not settle at current rates for long. Negotiations with China shooting for an August 12 deadline continue. And, the President announced a new 100% sectoral tariff on semiconductor imports. More duties on pharmaceuticals and other sectors could soon follow. Finally, the President appears to reach for tariffs as his first, and sometimes only, tool in achieving his foreign policy and other political aims, punishing Brazil and India with punitive 50% tariff rates when they behave in ways he doesn’t condone. How long before other countries find themselves in the crosshairs? Just this week, Japan was surprised that its new 15% rate could stack onto existing auto tariffs. Again, the uncertainty this adds (to monetary policymakers, businesses, suppliers, and consumers) is immense, and will undoubtedly curtail consumer and businesses spending and hiring plans.

Recent labor market indicators suggest the economic expansion is losing steam. Continuing jobless claims climbed to 1.974 million in the last week of July, their highest level since early 2018 outside the pandemic (Chart 1). This points to a big shift in business hiring plans. Much handwringing has occurred over the large 258K net downward revision in payroll gains for May and June—but it’s the direction of travel (i.e., negative) of those revisions that is more concerning. The payroll revisions have been persistently negative (5 of the last 7 months) and appear to be getting larger with every new report (Chart 2)… a pattern that often precedes more serious labor market troubles ahead.

The outlook on inflation appears just as uncertain. The Cleveland Fed’s Median CPI rose 4.1% annualized in June, up from 2.5% a year ago, and we forecast July core inflation will climb back above 3.0% y/y (Chart 3) for the first time in five months. Ominously, the ISM Services prices paid index for July hit its highest level since October 2022.

The Fed will need to try and see the future and set policy deftly to balance the risks. Like a blindfolded Luke Skywalker, Powell will have to wield his monetary lightsaber as he is mostly blind to what is likely to come his way in the months ahead. The President’s potential early naming of a new Fed Chair, and frequent pressure to rapidly reduce rates, raise the degree of difficulty. Jay Powell, May the Force Be with You!

Nothing Artificial about AI

To say that 2025 is the year the machines took over might be a bit dramatic, but AI is making its mark on corporate earnings, market performance, economic growth and the job market. Let’s have a look:

We’re more than two-thirds through the 2025Q2 earnings season, and the results have been very resilient despite all the economic noise. A strong 80% of S&P 500 companies have topped expectations so far, according to LSEG’s tally. That leaves growth tracking at 11% y/y for Q2, and roughly 10% y/y for calendar 2025—both of those estimates have been revised up notably since July 1. AI is making a mark on earnings, with most of the upward estimate revisions since the start of summer coming in technology and communication services. Those two sectors are now expected to post Q2 earnings growth of 24% y/y and 19% y/y, respectively, and nearly 20% each for calendar 2025. However, eight of the remaining nine major sectors are looking at earnings growth of 3% or less (financials are also firm at 13% y/y).

Suffice it to say the AI boom and tech earnings are driving the double-digit growth in S&P 500 profits, leaving earnings ex-technology and communication services very subdued at less than 4% y/y.

The equity market has been reflecting this, with technology and communication services rallying more than 30% in the past year, while a 23% gain in large caps has dwarfed sub-7% gains among small and mid-sized businesses. The Magnificent 7 have added roughly 3 ppts alone to the 11% gain in the S&P 500 since November 1. That said, the market strength runs broader than the concentrated earnings strength, with double-digit (in many cases, greater than 20%) one-year gains now spread across 7 of 10 major S&P 500 sectors, and even into the TSX as well. AI is driving the equity market, but it has many passengers at this stage.

Back in the real economy, AI investment is punching above its weight class to support growth. While still-restrictive monetary policy is weighing on consumer spending and residential investment—combined growth of less than 1% annualized through the first half of the year—investment in tech equipment and software exploded by 25% annualized, driving its share of real GDP above 6% for the first time. Over the past year, investment in those categories added 0.6 percentage points to growth; and, that accelerated to a full percentage point through 2025H1, matching the heights seen during the 1999 tech boom.

The jury is still out on the AI job market impact, and the conclusion that jobs are being taken, and hiring is held back on a mass scale, might be a tad premature. Since AI really began to proliferate in 2022, employment across a subset of U.S. tech and software industries has indeed fallen. But, that period also coincides with tax reform that phased out the immediate expensing of R&D investment, including salaries for software engineers and developers. The OBBBA reinstates immediate expensing, so we’ll see if the negative momentum there turns. Like many major disruptors before this one, the end result is usually a reallocation of labor throughout the economy along with improved overall productivity. AI will hurt some areas of the job market, help others, and ultimately reshape the employment landscape—it’s still early days on those fronts.