At Full Employment, Closing in on 2% Inflation

You may be getting tired of the repetition, but neither the data nor any other developments have required us to make any material changes to our macro outlook since our January forecast, and the broad themes underlying our outlook remain firmly in place.  

▪ We remain in a 2%-growth economy: Growth has averaged about 2% over the course of the recovery,  and we expect it to remain near that pace through 2019. 

▪ We continue to assume a modest fiscal stimulus begins in 2018 that helps maintain growth at this level, despite a tightening monetary policy that would otherwise result in a modest deceleration of activity. ▪ Based on both our and participants’ median estimate of the NAIRU, we are at, or at very least near, full employment. With growth projected to remain above trend, the unemployment rate is anticipated to fall below the NAIRU, to ½ pp below by 2019. 

▪ As in our January forecast, PCE inflation overshoots the 2% inflation target by a bit. But in our updated forecast, we get back to 2% a bit more quickly. 

Private demand is running on all cylinders. 

▪ There is a wide range of projections of Q1 GDP growth out there, with some expecting growth well below 2%, but we believe that final private domestic demand remains solid, advancing at about a 2¾%  pace in the current quarter.  

▪ Consumer spending started off in Q1 very weak, but this largely reflects the depressing effect of unusually warm weather. Assuming “normal” weather this spring, there should be a boost to spending in Q2.  Private demand is anchored over the forecast by roughly 2¼% growth in consumer spending.  

▪ Drilling has gone from a large drag to a solid plus for growth in investment. The incoming data on equipment spending look appreciably better as well. Housing continues to improve, on the net—no boom, no bust. 

▪ We expect net exports to continue to offset some of the strength in private domestic demand, and this drag is the principal reason the pace of aggregate activity remains in the neighborhood of 2%. 

We are also moving toward a 2%-inflation economy. 

▪ Core PCE inflation advanced at 1.7% last year, in line with our last forecast, but we now see it moving to 1.9% in 2017, a tenth higher than before, reflecting the slightly firmer recent data of late.  ▪ Given the projected decline in the unemployment rate to a level notably below the NAIRU, we project a  very slight overshoot of the 2% inflation objective in 2018 and 2019. But given the flat Phillips curve,  any overshoot is likely to be small. 

Thanks for telling us! A hike in March. 

▪ The next hike will almost certainly be in March, earlier than we’d expected a month or so ago. ▪ However, this earlier hike has not altered our view of the basic trajectory of monetary policy for the year as a whole. We continue to see the process of policy normalization as one of gradualism—but gradualism with a bit more spring in its step compared with the past two years. 

▪ Bottom line: We still expect three hikes this year, but whereas the risks had been weighted toward two hikes, they are now weighted toward four. 

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 

▪ Growth was 1.9% in Q4 and 1.9% over 2016, two-tenths lower in Q4 and a tenth lower in 2016 than in our last forecast. 

▪ Core PCE prices rose 0.3% in January, likely reflecting in part residual seasonality. The 12-month  increase was unchanged at 1.7%. 

▪ Financial conditions are somewhat more accommodative, on the net, since the last forecast. Equity prices continued to set records and the dollar fell slightly, but longer-term rates increased. ▪ We now assume the next rate hike is in March. In our January forecast, we had penciled in the next hike in June, and more recently we had moved up the timing to May. 

▪ Consumer and business sentiment continued to edge higher, from already elevated levels. The  Conference Board measure of consumer confidence rose to its highest level since 2001, and the  Michigan measure is also the highest it’s been in over ten years. In the business sector, the ISM reached its highest level since 2014. 

▪ Real PCE fell in January (largely due to a weather-related drop in outlays for utilities) and this led us to revise down our forecast for current-quarter consumer spending. 

▪ A rebound in oil and gas drilling is providing a considerable boost to nonresidential structures  investment. 

▪ Housing appears to be improving despite an increase in mortgage rates. In particular, the starts and permits data suggest single-family starts are on an upward trend after stalling in 2016. ▪ Construction in the state and local sector declined sharply in January, and we revised government spending lower, indeed into negative territory in Q1. 

Steady As She Goes 

We judge that the underlying pace of the expansion remains around 2%, need we say more. But, given the slow growth of potential output, 2% growth of real GDP remains cyclically good. And we expect growth in activity to remain in this vicinity over the forecast, leading to some further tightening in the labor market.  The pace of progress (or lack thereof) on a fiscal policy package has made us more comfortable with our fiscal policy assumptions: We expect some modest fiscal stimulus to boost aggregate demand beginning in  2018, with deficit-increasing actions amounting to about 1% of GDP by 2019. But our fiscal package features actions that tend to have low positive multipliers, such as corporate tax cuts and cuts in taxes for high net worth households. Furthermore, greater fiscal stimulus is anticipated to result in somewhat tighter financial conditions that further limit the aggregate effects of these fiscal actions. All told, the fiscal stimulus adds only a couple of tenths to projected growth in 2018 and 2019. However, that is enough to keep growth near 2% despite a tightening of monetary policy that would otherwise have resulted in a  slowing in growth back toward the pace of potential, which we put at around 1¾%. 

We expect final private domestic demand to grow at a 2½% pace over the next couple of years. That will help to overcome the expected drag on GDP growth from net exports of several tenths. 

Percentage points 

Private Final Demand Now Firing On All Cylinders 

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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