Beginning the Year With Lots of Momentum

The U.S. economy is doing well and has entered 2018 with plenty of momentum. 

▪ Real GDP growth advanced at a 2.6% pace in Q4 despite net exports and inventories subtracting a  combined 1.8 percentage points, and growth in 2017 was 2.5%. 

▪ We project growth in 2018 will be about the same as in 2017, a pace well above potential. ▪ Supporting that growth outlook is financial conditions that continue to be very accommodative,  notwithstanding a recent sharp rise in Treasury yields and oil prices. Equity prices have continued to rise since our last forecast, and the dollar declined quite sharply. 

▪ The unemployment rate remains at 4.1%, a 17-year low, where it’s been for a few months. We expect above-trend growth to drive it even lower, to 3.7% by mid-2019, nearly a percentage point below our estimate of the NAIRU. 

▪ Core PCE inflation advanced at a 1.9% pace in Q4, and we expect it will firm to near 2% in 2018 after many years below the 2% objective.  

After Trump’s election, we assumed in our forecast that a tax cut would be passed, and now the House and  Senate have managed to pass a tax bill reforming the tax code and resulting in a $1.5 trillion cut over ten years. 

▪ This fiscal stimulus comes at a time when growth is already well above trend and the labor market is already at full employment. 

▪ We see the tax package as raising the level of real GDP by about ½ percentage point by the end of 2020  and resulting in a couple more funds rate hikes than otherwise—similar to the effects of the tax package we’d assumed in our forecast. 

▪ More recently, the federal government shut down for several days before Congress agreed on temporary funding while negotiations continue. Congress will also have to raise the debt ceiling soon. ▪ We don’t include any effect of a shutdown in our forecast; in any case, any reduction in GDP growth would be made up in subsequent quarters. 

▪ In light of the lack of progress in Congress, we continue to assume an increase in discretionary spending of $40 billion per year beginning in the second half, with most of that in defense spending. But there is a  risk of more fiscal stimulus than that. 

We continue to expect the FOMC’s focus to turn increasingly toward preventing overheating rather than preventing too-low inflation. 

▪ Last year the monetary policy debate centered on the disappointment of core inflation slowing substantially after having essentially reached the 2% objective early in the year. 

▪ While monthly core inflation readings are volatile, we see the pattern of readings toward the end of  2017 as consistent with an underlying pace modestly below 2%. Indeed, quarterly core PCE inflation was 1.9% in Q4. 

▪ These firmer readings increase our confidence that core inflation will rebound to near 2% this year. ▪ After that, we expect a modest—no more than a couple of tenths—overshoot of the inflation objective in  2019 and 2020, given that the unemployment rate is projected to fall a percentage point below the  NAIRU. 

Given the projected rebound in inflation and a further decline in the unemployment rate, as well as the solid growth outlook, we expect the Committee to raise rates four times this year. 

▪ The continued looseness of financial conditions and concerns about financial stability risks further  support the case for four rate hikes. 

▪ If our forecast is realized, next year the FOMC will be facing an unemployment rate well below the  NAIRU and inflation moving above its objective, albeit slowly. 

▪ Given that outlook, we project three more rate hikes in 2019 and one more in 2020, resulting in a  meaningful overshoot of the longer-run fund’s rate. 

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 

▪ Real GDP advanced at a 2.6% pace in Q4 as strong final private demand growth (4.6%) was partially offset by a significant drag from net exports (-1.1 pp) and inventory investment (-0.7 pp). ▪ Since our last forecast, and as expected, Congress passed and the President signed tax reform legislation statically scored by the Joint Committee on Taxation as reducing tax revenues by $1.5 trillion over ten years. 

▪ We see this legislation as raising the level of real GDP by about ½ pp by the end of 2020, an effect very close to that of the tax package we’d long assumed in our forecast. 

▪ After a federal government shutdown that lasted several days, Congress reached a temporary agreement to keep the government opens several more weeks while negotiations continue. 

▪ Financial conditions remain very accommodative, with equity prices continuing to reach new highs and the dollar declining sharply. On the other hand, Treasury yields increased and oil prices rose further. ▪ We marked up growth in 2018 a couple of tenths, to 2.6%, on greater momentum and also the expectation that some of the drag from net exports and inventory investment in 2017:Q4 will be reversed early in 2018. 

▪ We’ve marked up consumer spending somewhat in this forecast: The data suggest somewhat more momentum in the near term and the recent tax cuts enacted are weighted more heavily to the personal income tax side than we’d assumed. 

▪ Payroll gains moderated to 148K in December following an outsize 252K gain in November. The trend remains strong, with monthly gains averaging 166K over the second half of 2017. ▪ The unemployment rate remained at 4.1% in December. We expect the unemployment rate to decline several tenths in 2018 and a tenth further in 2019 as growth moderates toward potential. ▪ While 12-month core PCE inflation remains only 1.5%, recent readings have been somewhat firmer, suggesting the underlying rate is higher, perhaps around 1¾%. Indeed, the quarterly core PCE inflation rate was 1.9% in Q4.

Building Momentum into 2018 

The economy appears to have entered 2018 with plenty of momentum. Real GDP grew at a 2.6% pace in Q4 despite a significant drag from net exports and inventories. Final private demand advanced at a 4.6% pace, with consumer spending, equipment investment, and residential investment particularly strong. Momentum has increased even as the FOMC has been raising rates, in part because financial conditions have been becoming more accommodative. While we would otherwise have expected growth to moderate this year, we expect fiscal stimulus to contribute to the growth of about 2½% in 2018, about the same as in 2017. We expect growth to decelerate in 2019, but remain somewhat above potential, and then reach potential in 2020. 

Our simulations with FRB/US suggest the tax cuts will result in a level of real GDP 0.5% higher by the end of 2020 and an additional couple of rate hikes. While that’s similar to the effect of the hypothetical tax package we’d previously assumed in our forecast, the actual bill is somewhat larger and more heavily weighted toward the personal income tax side than we’d envisioned. As for spending, we continue to assume an increase in discretionary spending of $40 billion per year beginning in the second half, with most of that in defense spending. There is an upside risk here: Republicans want far higher defense spending, and in return Democrats want non-defense spending to be increased. But there is substantial Republican opposition to higher non-defense spending, so for now we continue to assume a smaller increase in discretionary spending.

Labor Market: Tighter and Tighter 

The unemployment rate has been stable at 4.1% for three months, but we expect it to resume declining, given the momentum in payroll gains and the strong pace projected for GDP growth. We expect it to fall a few tenths by the end of 2018, to 3.8%, a slower pace of declines than in previous years, and to 3.7% by the end of 2019. That’s almost a full percentage point below the estimated NAIRU. This is consistent with our forecast of growth slowing toward potential and the pace of payroll gains moderating as well. Indeed, the trend in payroll gains already appears to be slowing gradually, as expected, and we expect that to continue through the forecast period. The slowdown in core inflation in 2017 may have raised some questions about how tight the labor market is, but the rebound we suspect is underway should reduce that concern. We expect wage inflation to rise over the next few years as the labor market tightens further, but only modestly. 

When Will the Underlying Inflation Rate Reveal Itself? 

12-month core PCE inflation, at 1.9% in January and February of 2017, had been close to its objective before a run of weak readings brought that figure to a low of 1.3% in August. The 12-month rate has edged up to only 1.5%, still depressed by the weakness earlier in 2017. Since August, however, the monthly readings have been firmer. Indeed, core PCE inflation was 1.9% in Q4. While monthly inflation readings are volatile, we see the data as indicating that monthly core inflation readings in the near term are likely to be only somewhat below 2%. While it will take some time to be certain, we believe we have passed the brief period of much softer inflation and are on our way back to 2%. FOMC participants’ public remarks as well as the minutes of the December meeting indicate that policymakers have likewise gained confidence in the inflation outlook. Given the projected further decline in the unemployment rate to about one percentage point below the NAIRU, we expect core inflation will likely overshoot the 2% objective, though not by much. 

Four Hikes in 2018; Overshoot of Neutral; and an Inverted Yield Curve 

In December, FOMC participants’ median projection was three funds rate hikes in 2018. We, however, expect that the FOMC will raise rates four times this year, prompted by a rebound in core inflation on top of well-above-trend growth and a low and still declining unemployment rate. While those features of the outlook won’t be confirmed until later in the year, we still see a very high probability of a hike in March, as doing so would allow the FOMC to have the flexibility to hike four times comfortably. The markets are likewise pretty confident that this will be the case. Later in the year, with core inflation projected to be not far below 2% and the unemployment rate likely to have edged down further, the prospect of overshooting the 2% inflation objective will be an increasing focus. That underlies our call for four rate hikes in 2018 and, subsequently, an overshoot of the estimated nominal neutral funds rate, by about ½ percentage point. FOMC participants appear to be moving in this direction as well, with the December median dots showing an overshoot as well. While FOMC participants to this point haven’t projected an inflation overshoot, we expect “symmetric” to find its way into FOMC communications more and more, preparing markets for the possibility, indeed the likelihood, of a modest inflation overshoot as well as a funds rate overshoot.

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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