Inflation and the Unemployment Rate Surprise to the Downside

Since our last forecast, inflation, the unemployment rate, and job gains have all surprised us to the downside.  ▪ We expect the Committee will view the slower inflation as largely temporary and the fundamentals as consistent with their expectation of 2% inflation by 2019. 

▪ Similarly, the FOMC is unlikely to see the recent slowdown in payroll gains as a reason to reconsider its medium-term forecast. 

▪ On the other hand, they will view the decline in the unemployment rate as more enduring.  

The slowdown in core PCE inflation in March and April left the 12-month rate at just 1.5%, the lowest rate since late 2015 and down from its recent high of 1.8%, where it was in February. ▪ Taking some signal from the softer data, we lowered our projections for core PCE inflation in 2017 and  2018 a tenth each year, to 1.7% and 1.9%, respectively. 

▪ However, the underlying fundamentals still support a firming in core inflation to 2% over the next  couple years. 

▪ Indeed. the recent further decline in the unemployment rate reinforced our expectation that there might be at least a slight overshoot of the inflation objective, so we retained our forecast of 2.1% core PCE  inflation in 2019. 

The most important development with respect to the labor market since our last forecast was the further decline in the unemployment rate, which is now three-tenths lower than we had anticipated. ▪ Rather than edge back up a tenth, as we’d expected, the unemployment rate fell two tenths further. ▪ The recent decline in the unemployment rate appears likely to persist; accordingly, we releveled down the path of the unemployment rate throughout the forecast. 

▪ Payroll gains have slowed in the last few months, but the six-month average increase is still a very solid  161K and there appears to be plenty of momentum in the labor market. 

▪ With growth above trend, we expect sufficient employment growth for a further decline in the unemployment rate through 2019, when we project it will reach 3.9%.  

▪ Give the substantial inflation surprise, we expect that FOMC participants may revise down their estimates of the NAIRU, perhaps as early as the June meeting. 

As growth continues at an above-trend pace and labor markets tighten further, we expect some additional acceleration of wages over the forecast period. 

▪ Our favorite measure for wage inflation, and the one followed most closely at the Fed, is the ECI for private compensation, which rose at a 3.2% annual rate in Q1, well faster than we’d anticipated. ▪ However, the year-over-year rate for that measure is still a modest 2.3%, and we’re not inclined to put too much weight on one reading. We revised up our forecast for ECI this year a tenth, to 2.6%. ▪ We expect ECI to pick up a bit further after that, to 2.7% in 2018 and 2.9% in 2019. Those increases in compensation would be sufficient for real wages to rise, which in turn would support consumer spending and overall real GDP growth. 

Unemployment Rate to Fall Even Further Below the NAIRU

Progress Toward the 2% Inflation Objective Interrupted 

Major Economic Indicators 

By default, values represent seasonally-adjusted, annualized growth rates (%) for the series indicated n 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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