An Economy at an Inflection Point

The economy is at an inflection point, facing a significant fiscal stimulus at a time when growth was already above trend, the unemployment rate was already below the NAIRU, and inflation was already moving to 2%. A higher path of federal spending following the passage of the Bipartisan Budget Act of  2018 was the principal adjustment in this forecast round, calling for a significant reconsideration of the outlook.  

▪ We raised projected GDP growth in 2018 two tenths to 2.8%, about a percentage point above the estimated growth rate of potential GDP. 

▪ We further lowered our path of the unemployment rate two tenths, to 3.5% in 2020, more than a  percentage point below the estimated NAIRU. 

▪ We slightly raised our forecast for core PCE inflation, by a tenth each year for 2018, 2019, and 2020.  We had previously projected that inflation would overshoot 2%, but not the overshoot is about ¼  percentage point in 2019 and 2020. 

▪ The revisions to projected growth would have been larger but for somewhat tighter financial conditions and weaker-than-anticipated spending data for Q1.  

It appears that the momentum in spending that had built in the second half of 2017 and was expected to carry into 2018 has been interrupted in Q1, but we expect this to be transitory. 

▪ Tracking estimates of growth have fallen from near 3% to 2% or even slightly lower today, but the softer recent spending data likely understate the underlying strength of economic activity. ▪ Most significant is that employment growth has remained strong. Indeed, it’s surprised to the upside since our last forecast. In cases of diverging signals from the data, we put more weight on employment growth as an indicator of underlying strength than a single quarter’s GDP number. 

▪ Sharply weaker consumer spending accounts for much of the downward revision to Q1. Perhaps the slowdown in consumer spending in Q1, to 1½%, reflects in part payback for 3.8% growth in Q4.  Consumer spending in recent quarters has also been impacted by last year’s hurricanes. 

▪ Whatever the case, we are not concerned about the prospects for consumer spending. Equity prices are elevated, consumer sentiment is high, and consumers have yet to really feel the benefits of the recent income tax cuts. 

Inflation continues to be one of the biggest question marks in the outlook, and there remains a division within the Committee, with some more skeptical of the Phillips-curve-based forecast that inflation will head to 2%. But that division is now less pronounced. 

▪ Participants have been unwavering in projecting that inflation would rise to 2% within a couple of years. But the significant slowing in core inflation last year—12-month core PCE inflation fell from 1.9% to 1.3%– raised questions and increased uncertainty surrounding that forecast. 

▪ Firmer monthly readings on core inflation later in 2017 were consistent with the underlying rate not being as far below 2% as the 12-month rate would imply, but month-to-month inflation readings are volatile, so more confirmation was needed. 

▪ Recent readings have provided that confirmation: Core inflation is firming, and we, as well as FOMC  participants, can have more confidence in that forecast. 

▪ Perhaps the most important question in the outlook and for monetary policymakers now is whether and by how much inflation will overshoot the 2% objective. 

The labor market remains strong, and we have revised upward our projected pace of job gains this year. ▪ Payroll gains have averaged 190K per month over the last six months, and the 313K increase in  February was eye-popping. 

▪ Despite a robust pace of job gains, however, the unemployment rate remained at 4.1% as the participation rate increased three-tenths in February. 

▪ We revised up payroll growth in this forecast, reflecting the stronger growth outlook as well as a higher initial pace, though we still expect a gradual slowing. We also delayed until 2019 the point at which we expect the participation rate to begin edging down gradually in line with its secular trend. This delay blunts somewhat the decline in the unemployment rate. 

▪ The biggest question in the labor market is whether we will finally see the clear upturn in wage inflation that have we have expected and continue to project. 

All of this leaves monetary policy at an inflection point. These developments push monetary policy toward a faster pace of rate hikes and higher endpoint, which brings risks. 

▪ For now, that leaves a tension between the evolution of the outlook and the rate projections. We expect that tension to remain after the March meeting, as we expect the median dots to still indicate three hikes in 2018. 

▪ But if the outlook evolves as participants likely now expect, the Committee will have to pick up the pace—to four hikes in both 2018 and 2019, in our view. 

▪ In addition, with the unemployment declining even further below the NAIRU and core inflation set to reach 2% later this year, the prospect of an inflation overshoot will warrant raising the fund’s rate above r* eventually. 

▪ Policymakers will also have to contend with a likely increase in r* as a result of the expected sustained increase in the deficit-to-income ratio following a long period of downward revisions to estimates of r*

Faster and further rate hikes raise the risk of recession. 

▪ Recessions are typically preceded by increases in the fund’s rate above the prevailing estimate of r*. ▪ The FOMC has been balancing going gradually enough to ensure that inflation rises to 2% but fast enough to avoid getting behind the curve. 

▪ The prospect of significant fiscal stimulus on top of an already strengthening economy has left them behind the curve if they were not already. 

▪ Now they will have to balance containing the overshoot of the 2% inflation objective with raising rates too fast and too far, which would threaten the expansion. 

Forecast Overview 

General Note: Unless otherwise indicated, quarterly growth rates are expressed as compound annual rates, expenditure components of GDP are chained in 2009 dollars, and annual growth rates refer to growth from the fourth quarter of the previous year to the fourth quarter of the year indicated. 

What’s New 

▪ The biggest development since our late-January forecast was the passage of a spending deal that raises base discretionary spending about $300 billion above the caps in fiscal years 2018 and 2019 and also includes additional spending primarily related to disaster relief. President Trump also recently announced steel tariffs, but the prospects for trade restrictions are uncertain, and we made no assumptions regarding either U.S. tariffs or retaliatory tariffs from trading partners. 

▪ As a result of the spending deal, we expect an additional rate hike in 2019. We also raised our estimate of the neutral real fund’s rate 25 basis points, to 1%, because of the higher deficits resulting from the tax and spending bills. 

▪ Financial conditions are somewhat tighter than at the time of our last forecast. Equity prices fell substantially following the January jobs report, which showed stronger wage growth, but subsequently reversed most of those losses and are now down about 3% since our last forecast. Longer-term rates are higher and the dollar also rose slightly, while oil prices declined slightly. 

▪ The changes in our fiscal and monetary policy assumptions alone would have suggested revising up our growth forecast by a total of about four-tenths through 2020. However, somewhat tighter financial conditions, as well as data pointing to weaker Q1 growth, led us to revise up real GDP growth only two tenths over that period. 

▪ Soft retail sales point to a slowdown in consumer spending in Q1. Weaker consumer spending, a wider trade deficit, and poor housing data led to a downward revision in Q1 growth from 3.0% to 2.0%. ▪ The unambiguous strength of the labor market is the most significant indicator that the economy has strong underlying momentum. Payroll gains have surprised to the upside, increasing an average of 205K per month over the last six months. The unemployment rate has remained at 4.1%, however, and the participation rate has increased. 

▪ Recent monthly core inflation readings have been somewhat firmer than expected, reinforcing our view that underlying inflation is not far below 2%. The recent data, as well as a lower projected path of the unemployment rate, led us to mark up core PCE inflation a tenth each year so that it reaches 2.3% in 2020.

Fiscal Stimulus Added to An Already-Strong Economy 

The story of 2018 is badly timed pro-cyclical fiscal stimulus—more stimulus than we had anticipated. Momentum in the economy was building in the second half of last year, and we had begun to revise our growth forecast for 2017 and 2018 upward. While the scale of the tax legislation ultimately passed in December was roughly the same as the package we’d long assumed in our forecast, the recent spending legislation was much larger than we’d anticipated. Now real GDP appears likely to grow close to a percentage point faster than potential. Whereas in mid-2017 we’d expected growth in 2018 to be near 2%, we now project growth closer to 3%. The incoming spending data since our last forecast motivated a downward revision to Q1 growth, but sustained robust employment growth gives us confidence in the stronger growth we now project. Financial conditions—even after some turbulence in equity markets– remain accommodative and support growth, despite the rise in the fund’s rate to date and projected further rise. 

Fiscal Policy in the Forecast 

Fiscal stimulus, which plays an important role in our forecast, has two parts: tax cuts passed in December 2017, which we had previously incorporated into our forecast, and spending associated with the recent passage of the Bipartisan Budget Act of 2018 (BBA 2018), which required an upward revision relative to our previous forecast. BBA 2018 raised base discretionary spending by about $150 billion above caps in fiscal years 2018 and 2019, and also included $85 billion in additional spending for disaster relief. We assume that base discretionary spending is held at its FY19 level in FY20. Previously, we’d assumed spending in fiscal years 2018 through 2020 would be raised by $40 billion per year over the caps, with those increases beginning in the second half of 2018. Our simulations with FRB-US suggest that, without any monetary policy response, this legislation would increase the level of real GDP by one percent by the end of 2020 relative to a no-legislation baseline and by seven-tenths relative to our previous assumed spending levels. Taking into account the additional hike in 2019 relative to the previous forecast that we now assume, the simulations would suggest real GDP would be about four-tenths higher by the end of 2020. 

Labor Market: Tighter and Tighter 

The unemployment rate has been stable at 4.1% for several months, but we expect it to resume a decline over the coming quarters given the momentum in payroll gains and the stronger pace projected for GDP growth. In line with the upward revision to GDP growth, we revised the path of the unemployment rate down so that it reaches 3.5% at the end of 2019, two tenths slower than in our previous forecast. That would leave the unemployment rate about a full percentage point below the estimated NAIRU. The participation rate has moved sideways for some time now despite demographic factors implying a gradual secular decline and actually jumped three-tenths in February. This suggests that the tight labor market may be pulling people back into the labor force, in line with what the FOMC expected or at least hoped for. We pushed back the expected decline in the participation rate from mid-year into 2019, blunting somewhat the downward revision to the unemployment rate in this forecast. We see wage growth on an upward trend, albeit a very modest one. 

Inflation: Heading for an Overshoot 

Inflation remains the biggest question mark in the outlook. A decline in core PCE prices in March 2017 was followed by soft readings for several months that raised doubts about the expectation that core inflation was on a gradual path to the 2% objective. But the more recent incoming data suggest that inflation is firming, confirming expectations that the earlier slowing would prove transitory. Indeed, the monthly data are consistent with underlying inflation already moving close to 2%, and the balance of risks is shifting from a slower rise to 2% to the likelihood that core inflation will overshoot the 2% objective. We have previously projected an overshoot in 2019 and 2020. In this forecast round, in response to the still-lower path of the unemployment rate, we raised slightly the degree of overshoot, to about ¼ percentage point in 2018 and 2019.

Faster Pace of Rate Hikes, Overshoot of Slightly Higher Neutral Rate 

Adding fiscal stimulus to an already strong economy calls for a response of monetary policy: a faster pace of rate hikes to a level further above the neutral rate. In this forecast, with higher discretionary spending leading to higher growth, we added an additional rate hike in 2019; we now assume four hikes in 2018 and 2019 and an additional hike in 2020. In addition, the sustained increase in the deficit-to-income ratio points to a higher neutral funds rate—in our forecast, ¼ percentage point higher, to 1%. In our forecast, the fund’s rate ends up 50 basis points above the upward-revised estimate of the neutral rate in 2020. On the one hand, this puts monetary policy in a danger zone, as overshoots of the neutral rate have typically preceded recessions. On the other hand, we raised the fund’s rate more modestly than suggested by FRB US simulations using what Yellen called the “balanced approach” rule. This reflects our view of the FOMC’s strategy, an attempt to balance the desire to limit the overshoot of the 2% inflation objective with the desire to sustain the expansion. It is also consistent with the asymmetric inflation objective in practice. Asymmetric objective, after all, is consistent with a modest and presumably temporary overshoot of the 2% objective late in the cycle, especially given the degree and duration of the undershoot over the last several years. 

Financial Conditions Remain Accommodative 

The ten-year Treasury yield rose more than we anticipated since our last forecast. The higher jumpoff, as well as our expectation that there will be four hikes in 2019, up from three, contributed to a higher path of longer-term yields in our forecast. The recent sharp rise in the ten-year yield appears to reflect more a rise in the term premium than a higher expected path of short-term rates. Perhaps the emerging prospect that inflation might overshoot 2% has put upward pressure on the term premium. While the market expectations of the path of the fund’s rate have risen, that path is still well below the FOMC’s projected path of rate hikes, as well as our own. This suggests the potential for a correction if the data come inconsistent with our forecast and the FOMC raises rates four times this year, as we expect. On balance, financial conditions tightened modestly since our last forecast, as equity prices have mostly reversed a sharp decline that followed the January employment report. Still, the important theme with respect to overall financial conditions is that they remain very accommodative and have tightened little if at all in response to the rate hikes so far and the prospect of further hikes ahead. Still-accommodative financial conditions support a forecast of well-above-trend growth and push in the direction of a faster pace of hikes than otherwise. 

Major Economic Indicators 

By default, values represent seasonally-adjusted, annualized growth rates (%) for the series indicated in the leftmost column. 

Note on Units and Transformations 

“Quarterly” values are q/q rates; “Annual” values are q4/q4 rates. For series followed by units in parentheses, “Quarterly” values are quarterly averages, and “Annual” values are q4 averages. 

* “Quarterly” values are not compounded to annual rates. 

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