Economy Has Plenty of Momentum Even Before Effects of Fiscal Stimulus

First things first: We’ve changed our fund’s rate call, and in this forecast, we now assume three hikes, rather than four, in 2019. Our assumption is now four hikes in 2018, three hikes in 2019, and one more hike in  2020. That slight adjustment in our call was not about any change in the macroeconomic outlook, however.  Rather, it was about rebalancing the risks around our call in light of FOMC participants’ willingness to tolerate inflation somewhat above 2% and their cautiousness about proceeding past neutral. Indeed, the economic outlook has strengthened. 

▪ Growth in the first half of 2018 is looking much stronger than in our last forecast. We now have real  GDP growth at 3.0% in 2018, up two-tenths from our last forecast. Not only have the incoming data validated the view that the slowdown in Q1 would prove transitory, it now looks like real GDP will advance at a pace above 3½% in Q2. 

▪ Most importantly, consumer spending looks strong, and we expect it to accelerate to 3½% in Q2, from  1.0% in Q1. 

▪ Net exports have also surprised to the upside. In our previous forecast, we’d expected moderate drag from net exports in the first half of 2018, but instead, we now have a positive contribution, including four-tenths in Q2. 

▪ All of this strength is before the effect of the recent fiscal stimulus. We expect that to be delayed somewhat, relative to our last forecast, but still expect a sizable boost. 

▪ While the economy has more momentum this year, financial conditions have also tightened somewhat,  with the dollar stronger and oil prices higher. As such, our forecast for real GDP growth remains 2.3%  in 2019 and 1.8% in 2020. 

There is very strong momentum in the labor market, with payrolls continuing at a robust pace. One of the biggest developments since our last forecast is the three-tenths decline in the unemployment rate over April and May, to 3.8%. 

▪ This relatively sharp decline followed six months of an unemployment rate stable at 4.1%. However,  we had long expected the unemployment rate to resume declining, and this recent decline doesn’t change the broad story with respect to the labor market. 

▪ We marked down the projected unemployment rate path a tenth for the fourth quarters of 2018, 2019,  and 2020. We now expect it to fall to 3.6% by 2018:Q4, then falling to 3.4% in 2019 and 2020. ▪ Some FOMC participants have questioned why wages haven’t risen more given the pace of job gains and the level of the unemployment rate, but the recent ECI data may help to alleviate some of those concerns. That measure, the one preferred by the Fed, showed a strong increase in the first quarter that brought the year-over-year rate up to 2.8%. 

The core inflation forecast is very little changed, and we continue to expect a modest overshoot of the  2% objective. 

▪ Core PCE prices increased 0.16% in April, as anticipated, but the readings for January through March were slightly softer than in our last forecast. 

▪ That left the 12-month core PCE inflation rate in April, at 1.8%, a tenth lower than in our last  forecast. 

▪ Still, if core PCE prices increase at their recent pace for the remainder of the year, as expected, core  PCE inflation will be 2.1% in 2018, as in our last forecast. 

▪ While the projected path of the unemployment rate is a tenth slower in this forecast, that wasn’t enough for us to raise our inflation forecast in 2019 and 2020 because the Phillips curve is so flat. 

Such a strong outlook—lots of momentum in growth, fiscal stimulus on the horizon, a strong labor market, and inflation near its objective—strengthens the case for the FOMC to first get to a neutral policy stance and then become slightly restrictive. 

▪ But while the case for getting to a neutral stance is clear, FOMC participants are uneasy about proceeding past neutral into restrictive territory, which raises the prospect of a recession. They’ve also appeared more willing to tolerate core inflation around 2¼%. 

▪ As such, we now expect them to pause in 2019, when they reach neutral, raising rates three times  rather than four that year. 

▪ We expect the FOMC to raise the fund’s rate target by 25 basis points at every other meeting (those with press conferences and projections) until June 2019, when they reach the estimated neutral fund’s rate, which FOMC participants put at 2¾%-3%. 

▪ By that point, we expect it to be apparent that growth is moderating and the unemployment rate is stabilizing, giving them some space to pause and proceed cautiously with further tightening. ▪ However, even with longer-term inflation expectations remaining anchored, inflation above its objective, and an unemployment rate well below the NAIRU will clearly call for moving monetary policy into restrictive territory. 

▪ Thus, after that pause in mid-2019, we expect the FOMC to hike a couple more times, once in late  2019 and once in 2020, bringing the funds rate about 50 basis points above its neutral 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 

▪ BEA estimates that real GDP advanced at a 2.2% pace in Q1, three tenths higher than initially reported. ▪ Consumer spending slowed to 1.0% in Q1, but the recent monthly data have shown a stronger-than-expected upturn, so we marked up Q2 real PCE eight tenths to 3.4%. 

▪ The trade data have been significantly stronger, relative to our last forecast. Rather than subtracting six tenths from Q1 growth, net exports contributed a tenth. And now we expect a four-tenths contribution to real GDP growth in Q2. 

▪ The outlook for business fixed investment looks healthy, though we expect growth to moderate from its robust 9.2% pace in Q1 to 4½%-5%. 

▪ The housing data have continued to be lackluster and point to only modest growth in residential investment over the remainder of 2018 after a slight decline in Q1. 

▪ The market has focused on several key downside risks, including those related to trade restrictions, fiscal sustainability and political risks in the euro area, and vulnerabilities in emerging markets. But at this point, these remain risks to an economic outlook that is very strong. 

▪ While financial conditions remain accommodative overall, they’ve tightened somewhat since our last forecast. Oil prices are up and, most importantly, the dollar is somewhat stronger. 

▪ The unemployment rate declined three-tenths over April and May after it had been at 4.1% for six consecutive months. We had long expected the unemployment rate to resume its decline, though the sharpness of the recent decline came as a surprise and led us to mark down its path by a tenth. 

▪ Payroll gains, though uneven month to month, have remained strong, showing slightly more momentum than we’d anticipated. 

▪ There was also some good news on the wage front. The ECI for private compensation advanced at a robust 4% pace in Q1, which raised the year-over-year rate to 2.8% 

▪ The 12-month core PCE inflation rate was 1.8% in April, a tenth slower than anticipated because of slightly softer readings for January through March. But the trend remains solid, and continued gains at the recent pace are expected to bring that rate to just above 2% late this year. 

▪ We now assume one fewer hike in 2019, though not because of a change in the macro outlook. Rather, FOMC participants have signaled that they are comfortable with core inflation ¼ percentage point above its 2% objective, so we expect they might pause in mid-2019, once they reach the estimated neutral fund’s rate, before proceeding cautiously into restrictive territory. 

Strong Momentum, and Fiscal Stimulus Still to Come 

The recent incoming data have validated the decision to look through the slowdown in real GDP growth in Q1. Growth appears to be rebounding strongly in Q2, indeed, significantly more than expected. We now expect real GDP to advance at a 3% pace in the first half of this year, a well-above-trend pace. One of the surprises since our last forecast has been a smaller-than-expected trade deficit. Net exports are now expected to have added about ¼ pp to the annualized rate of real GDP growth in the first half of the year. The upside surprise to growth since our last forecast would have encouraged us to revise up our forecast but for somewhat tighter financial conditions in the form of higher oil prices and a stronger dollar. We expect net exports to revert to a modest drag in 2018:H2 and 2019, in part because of the stronger dollar in this forecast. Overall, however, financial conditions remain very supportive of growth. The economy has lots of momentum, and we expect it to get another boost later this year in the form of fiscal stimulus from the tax and spending bills, to which we do not attribute the economy’s recent strength. With the aid of that stimulus, we expect real GDP growth to average about 3% in the second half of the year, as in the first half. After that, with the FOMC continuing to tighten policy, we expect growth to moderate to 2.3% in 2019, still faster than the growth rate of potential and enough to lower the unemployment rate a couple of tenths further. Further moderation in 2020, to 1.8%, is projected to bring real GDP growth in line with potential and result in a stable unemployment rate. 

Labor Market Tight, Getting Tighter 

For our last forecast, in April, it was easy to look through a disappointing payroll print for March. The labor market was clearly strong, and the picture has only improved since then, with payroll gains surprising to the upside and the six- and 12-month averages remaining near 200K. Other indicators also point to a tight labor market. For example, job openings are at a record high. And, after six months at 4.1%, the unemployment declined three tenths over April and May, to 3.8%. That earlier stability had surprised us, and we had long expected the unemployment rate to eventually resume declining. However, the recent decline was sharper than we’d anticipated in our last forecast. The lower jumpoff, as well as slightly stronger growth this year, led us to mark down the path of the unemployment rate so that it now bottoms out a tenth lower than in our previous forecast. Given the strong momentum in job gains and the fiscal stimulus expected to boost growth over the remainder of the year, we expect the unemployment rate to decline to 3.6% by the end of 2018. With growth moderating, but still above potential, in 2019, we expect job gains to moderate but be sufficient for the unemployment rate to edge down a couple of tenths further, to 3.4%. With growth at the potential in 2020, we expect the unemployment rate to stabilize. 

Inflation: Heading for a (Limited) Overshoot 

The inflation outlook is little changed in this forecast. Oil prices have risen, and we now expect energy prices to result in slightly higher headline inflation relative to core inflation. The core PCE data came in close to expectations, but downward revisions to readings in Q1 left the 12-month rate at 1.8% in April, a tenth lower than anticipated in our last forecast. In our forecast, we assume that over the remainder of the year core PCE prices increase at about their average pace over the last six months, bringing the 12-month rate to 2.0% in July and to 2.1% later in the year. The slowdown in core inflation that began in March 2017 is now firmly in the rearview mirror, and now the task for monetary policymakers is to look forward and balance limiting the overshoot of the 2% objective with a desire to sustain the economic expansion. However, given the flatness of the Phillips curve, there is not much concern about a substantial overshoot. The decline in the unemployment rate relative to the NAIRU is quite large, leading us to project an overshoot to about 2¼% in 2019 and 2020. FOMC participants have generally indicated that they would be quite comfortable with such a modest overshoot. Indeed, there have been concerns that inflation expectations may have fallen, and some FOMC participants have suggested that firmer inflation could help stabilize inflation expectations at levels consistent with the inflation objective. 

Steady Hikes Until Neutral, then A Pause and Cautious Overshoot 

We have adjusted our Fed call, and now our baseline is three hikes in 2019, rather than four. All told, our modal call is now four hikes in 2018, three hikes in 2019, and one hike in 2020. We made this adjustment, not because of any change in the macroeconomic outlook. Rather, the adjustment reflects a reassessment of the FOMC’s reaction function in light of recent remarks and an accompanying rebalancing of the risks around our call, which we had already seen as tilted toward a slower pace of hikes next year. We still expect the FOMC to raise rates at every other meeting, those with press conferences and updated projections until the funds rate is near estimates of its neutral level. With inflation near the objective already, the unemployment rate already well below the estimated NAIRU, and the outlook for growth strong, getting the funds rate to neutral is the priority, and there is a high bar for deviating from this pace. What has changed is our thinking about how the FOMC will behave next year as inflation rises modestly above its objective and the funds rate nears estimates of the neutral rate. FOMC participants appear to be comfortable with inflation modestly above 2%. Participants have noted that such a modest overshoot would be consistent with the asymmetric inflation objective following a period when inflation has been persistently below 2%. Rather than expressing concern that inflation expectations might rise above 2%, a number of participants see overshooting 2% as helpful in raising inflation expectations that may be below 2% today. There has been increasing discussion of a desire to pause around neutral, especially given the uncertainty around estimates of the neutral rate, the increased risk of recession when the funds rate moves beyond its neutral level, and the lags with which monetary policy affects the economy. For these reasons, we now expect the FOMC to hold the fund’s rate steady in September 2019, then proceed very cautiously with further rate hikes into restrictive territory, with a hike in December 2019 and once more in 2020.

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.

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