‘Yellow flags’: The cracks forming in the U.S. economy that we’re watching

The U.S. administration has described a compelling future U.S. economy—one that’s deleveraged from the public sector, recalibrated global trade to benefit U.S. households, and implemented new tax policies designed at least in theory to support broad based growth. But the challenge is, of course, getting there. And perhaps, what is weighing most on these goals is the growing recognition that the bridge from now to that desired outcome isn’t seamless or guaranteed.

We’ve long been believers of the U.S. “soft landing” theme. Strong household balance sheets, a structurally tight labor market, reduced interest rate sensitivity, government spending and solid corporate profits have fuelled a relatively resilient aggregate economy. Broadly speaking, we continue to believe the U.S will avert a recession and produce moderate, albeit sub-trend, growth in 2025.

However, over the past month, some “yellow flags” have popped up in the data that are worth monitoring closely—some more concerning than others. Of course, one month of data isn’t enough to shift an entire base case forecast for the world’s most resilient economy.

Notably, we surmise it is uncertainty itself weighing on much of these indicators—an uncertainty that could reverse or change—but also risks bleeding into the real economy in more tangible ways if left unchecked. Indeed, early signals of lower growth and higher inflation are consistent enough across several sectors to merit analysis. Here are some yellow flags that are worth paying close attention to in the coming months for the U.S. economy.

Sentiment data has deteriorated but it will matter most if high income households pull back

An array of consumer and business survey data has been showing signs of growing economic discomfort. The University of Michigan measure of consumer sentiment fell in January after rising for five consecutive months, and the Conference Board consumer confidence declined in both December and January following a near record jump in October. Meanwhile, the NFIB Survey of Small Business optimism retraced more of its post-election burst in February with only a net 15% of businesses planning to create new jobs in the next three months.

We’re noticing this shift. And yet, putting too much emphasis on soft data has led many economists astray in the past year as they have done a poor job of leading with “hard” data or aggregate data on which markets move and policy is largely based. Much of this divide between soft and hard data, from our perspective, has been driven by a growing spread between lower- and middle-income Americans, who are struggling under the weight of higher interest rates and a worse inflation hit compared to higher-income Americans, who are in much stronger economic shape and account for the larger share of aggregate spending, which is what we see in the hard data.

Acknowledging the “K-shaped” nature of the U.S. economy doesn’t discount lower- and middle-income Americans, but it does mean that survey data won’t necessarily help us forecast the aggregated, total spending ahead. In this current downtrend in sentiment, there are two particular implications. First, we remain cautious about using soft data to forecast hard data as the “K-shaped” nature of the economy persists. Second, and perhaps more importantly, we are monitoring for developments that will weigh, in particular, on high-income Americans such as the recent retracement in the stock market. A pullback among high-income consumers would merit a shift in our U.S. consumer outlook.

RBC Capital Markets Chief Equity Strategist Lori Calvasina has noted, “Net bulls on the weekly [American Association of Individual Investors] survey came in at -37.8% last week, taking the four-week average to -27.3%. This indicator is now more than two standard deviations below the long-term average, a level associated with major stock market drawdowns (1990, 2009, 2022).”

This development could create a negative wealth effect for higher-income consumers that shows up more meaningfully in macro data in the months ahead, producing a circuitous feedback where corporate earnings are revised lower, stock portfolios lose value, and high-income consumers pull back further on spending.

Inflation expectations are popping higher in an environment when it was already a concern

At the same time, some surveys are seeing an uptick in inflation expectations even as energy prices are lower—an atypical combination.

Importantly, these are appearing in consumer sentiment surveys as well as in business surveys such as the ISM Manufacturing and Services indices. Added to this, the Federal Reserve’s February 2025 Beige Book said prices had climbed “moderately,” but also that firms “expected potential tariffs on inputs would lead them to raise prices with isolated reports of firms raising prices preemptively.”

Our general view is that inflation will moderate but remain sticky above 2% off the back of rising goods prices, stall out in the improvements in shelter inflation, and resilient wage gains in a tight labor market. While we have yet to see one month of increased inflation expectations in survey data translate into broader market-based expectations or material behavioural changes, the risk of this occurring on the horizon is worth watching for. Close monitoring of month-over-month changes in inflation data will become more important.

Government job cuts are already showing up in labor data

These yellow flags are not solely isolated to sentiment. Government layoffs are showing up in jobs data, and potentially bleeding into other sectors.

The U.S. added 151,000 jobs in February, which is far from problematic, but the federal government cut 10,000 jobs, which is likely to accelerate. Meanwhile, Challenger Job Cuts jumped 103% year-over-year. Initial jobless claims suggest the federal job cuts are modest so far, but the number of initial claims filed by federal workers more than doubled in the week of Feb. 22, and will likely continue to rise.

U.S. Secretary Treasury Scott Bessent highlighted in his speech at the Economic Club of New York that one of the administration’s goals is to de-lever the public sector in order to support the private sector and government job losses could be transitioned to private sector hiring. We’ve covered how that process could be tricky and lagged.

But what is also becoming clear is the indirect ways that government cuts may filter through the economy via contractors and uncertainty around future funding. For example, news that some universities are freezing hiring is another example of potential bleed through. We continue to develop methods of measuring the (negative) multiplier effects of government job cuts and will produce more updates ahead.

Growing evidence higher rates are weighing on economy via consumer debt and housing activity

Consumers added over US$56 billion to their non-real estate personal debt loads in December and January with much of the increase coming from credit card spending. As a result, they are now spending 2.5% of their monthly disposable income on non-mortgage monthly interest payments—a share that is at risk of rising with the Fed on pause amid rising credit card bills, already high auto payments, and the burden of student loan repayments. This dynamic is weighing disproportionately on younger households more reliant on debt and credit to finance major purchases. This growing debt burden is also beginning to show up in the hard data with real personal spending declining by more than 5% at an annualized rate in January.

One sector, in particular, that continues to see anemic activity is the housing market. Affordability measures are near record highs, meaning home ownership will remain out of reach for many young households. What’s worse is the primary mechanism to lower mortgage rates (i.e., the Fed lowering interest rates) is unlikely to improve affordability, because of the well-documented lock-in effect wherein existing homeowners have little incentive to leave favourable mortgage rates.

Trade shock is in play creating distortions but larger drags on growth are ahead

Tariff trade distortions are already in play. As we highlighted in How to measure a tariff shock, we expect two things to occur before a tariff is even applied.

First, an uncertainty shock that weighs on activity—plenty evidence of that above. Second, a front-loading of trading activity that creates a surge in imports in anticipation of future price increases. We witnessed this in January’s trade data, even though, there were some nuances to the reporting related to gold bar imports. Still, it has mechanically pushed the Atlanta Fed’s GDPNow forecast for Q1 gross domestic product into negative territory. We qualify this more as a distortion rather than a representation of a cyclical slowdown—recessions don’t start with surges in import activity. But, combined with the yellow flags above, it won’t help optimism for growth and will likely continue to distort a range of variables.

Frances Donald is the Chief Economist at RBC and oversees a team of leading professionals, who deliver economic analyses and insights to inform RBC clients around the globe. Frances is a key expert on economic issues and is highly sought after by clients, government leaders, policy makers, and media in the U.S. and Canada.

Mike Reid is a Senior U.S. Economist at RBC. He is responsible for generating RBC’s U.S. economic outlook, providing commentary on macro indicators, and producing written analysis around the economic backdrop.

Disclaimer