Looking Through Weak Q1, Awaiting Effects of Fiscal Stimulus

The most important macro developments since the last forecast are that inflation now appears to be closing in on the FOMC’s 2% objective; that Q1 growth continues to appear to be modest, and that trade policy remains an important source of volatility in financial markets and a principle downside risk to global economic activity. Notwithstanding these developments, there has been very little change in the headline numbers in the forecast and the broad contours of the outlook remain intact. 

▪ We now project lower growth in the first half of the year and higher growth in the second half. We still project 2.8% growth in 2018, a pace well above potential, followed by a steady slowing that brings growth in line with potential in 2020. 

▪ In response to the continued stability in the unemployment rate, we slightly slowed the projected decline. But we still expect strong projected GDP growth to bring the unemployment rate down to 3.5%  by 2019, a full percentage point below the estimated NAIRU. 

▪ Core inflation has been somewhat firmer than anticipated and we also marked up the near-term path very slightly. That raised our projection of core PCE inflation in 2018 a tenth to 2.1%. We continue to expect the overshoot to build to about ¼ percentage point in 2019 and 2020. 

▪ Financial markets have been volatile, sensitive to the trade policy proposals from the Trump administration and to the promises of retaliation from China. This is still only a risk factor in our forecast.  

▪ Our monetary policy call is unchanged: Four hikes this year, four hikes in 2019, and another hike in  2020, as the FOMC moves more quickly to neutral and then rises above the estimated neutral rate. 

The March CPI report stands out, not so much because it was surprising, but because it confirmed our expectation that the earlier slowing in core inflation would be temporary. 

▪ The inflation story for the past year has been that the decline in core consumer prices in March 2017 was a one-time shock that would lower the 12-month inflation rate until that reading passed out of the  12-month window, in March 2018. 

▪ We got a rise in the core CPI in March in line with expectations and validating that story. We expect a  corresponding rise in the core PCE measure in March, bring the 12-month rate to within a tenth of 2%. ▪ From the FOMC’s perspective, the inflation story is no longer about how much confidence the FOMC  has that inflation will get to 2% within a year or two, but rather by how much inflation will overshoot the FOMC’s 2% objective. 

Key questions about real GDP growth include what the underlying rate is, how much of a signal, if any, to take from the slowdown in Q1, and how to translate the details and size of the fiscal stimulus into GDP  growth over the next few years. 

▪ Fiscal stimulus is the big macro event this year. Even with a slightly faster pace of rate hikes than otherwise, that stimulus is expected to contribute substantially to growth. 

▪ However, private demand in Q1 has been marked down further, as consumer spending was softer than anticipated. That weakness gives us a little pause, but we remain confident of a rebound in Q2.  ▪ We see the labor market as a better indicator of the economy’s momentum than GDP, and it continues to look very strong. As such, we see the Q1 slowdown as transitory and see the underlying trend in consumer spending as likely around 2½%—the pace at which it grew over the last two quarters. 

▪ We view the underlying fundamentals—including strong growth in employment and income, high levels of consumer confidence and business sentiment, still-accommodative financial conditions,  stronger growth abroad, and, of course, the large fiscal stimulus—as sustaining continued momentum and yielding strong growth this year. 

Our expectations about FOMC decisions through 2020 are unchanged since our last forecast. ▪ The FOMC raised rates 25 basis points in March, and we continue to expect three more hikes this year and four in 2019. One further hike, in 2020, would bring the fund’s rate ½ percentage point above its neutral rate. 

▪ The minutes for the March FOMC meeting suggest the Committee now has greater confidence in achieving the 2% objective and is becoming more focused on the increasing likelihood that inflation will overshoot the 2% objective over the forecast horizon. 

▪ We see that shift in focus as consistent with our projected pace of rate hikes, which is still somewhat faster than the FOMC’s median projected path. We expect that shift to continue, and for the FOMC’s projections to converge to our own. 

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 

▪ We marked down Q1 growth a tenth, to 1.9%, the biggest change being a ½-percentage-point downward revision to growth in consumer spending, to a tepid 1.1%. That was partially offset by stronger business fixed investment in structures and equipment. 

▪ After several consecutive weaker-than-expected readings, however, sales in the retail control group— which includes only those categories of retail sales that are direct inputs into the PCE data—posted a solid 0.4% gain in March. 

▪ That sets the stage for a rebound to 2½% growth in consumer spending in Q2, its average growth rate over Q4 and Q1. 

▪ Inventory investment is estimated to have added over ½ percentage point to growth in Q1. The strength of the rebound in real GDP growth in Q2 may hang on whether this was unanticipated inventory accumulation because of weaker-than-expected demand in Q1, or intended inventory building following a rundown in Q4 and ahead of an expected acceleration in demand. We expect the inventory building in Q1 to be partially reversed in Q2. 

▪ The trade deficit widened in Q1, likely subtracting ½ percentage point from real GDP growth. We expect continued, though much more modest, drag from net exports in coming quarters. 

▪ A solid gain in the core CPI in March suggests that 12-month core PCE inflation will jump to within a tenth of the 2% objective in March. Recent core inflation readings have been slightly firmer than anticipated, so we marked up our near-term forecast marginally. We now expect core PCE inflation to be a tenth higher in 2018 and reach 2.1%. 

▪ The labor market continues to look tight. We had no trouble looking through a slowdown in payroll gains in March, given that gains have averaged roughly 200K over the last three, six, and 12 months. ▪ The unemployment rate remained at 4.1% for a sixth consecutive month in March. The stability of the unemployment rate has been a surprise, and in response, we slowed its projected decline in the near term. ▪ Inputting together this forecast, we’d seen changes in financial conditions as little changed, on balance—low longer-term rates and a lower dollar roughly offsetting somewhat lower equity prices and higher oil prices. Recently, the 10-year yield surged above 3% for the first time, while equity prices fell further and the dollar appreciated somewhat. These changes, if sustained, would constitute some moderate tightening. 

Fundamentals and Fiscal Stimulus Point to Strong Growth 

The story remains that fiscal stimulus—through the recent tax and spending bills—is expected to drive the outlook for growth. We expect that fiscal stimulus to begin showing up in stronger growth over the next couple of quarters. An economy that grew faster than potential in 2017 will now receive a further jolt, keeping growth well above potential in 2018. We expect a slowing in growth thereafter, by about ½ percentage point per year in 2019 and 2020. That leaves growth still somewhat above trend in 2019 and back at the potential in 2020. This forecast of well-above-trend growth is being tested once again by the apparent slowing of growth in Q1 to around a 2% rate. We mostly look through that, focusing on the strong underlying fundamentals: strong growth in employment and income, high consumer confidence and business sentiment, the fiscal stimulus still to come, still-supportive financial conditions, and the strength of growth abroad.


Strong Growth to Push Unemployment Rate Lower 

It is easy to look through the disappointing and well-below consensus gain in payrolls in March. After all, gains have averaged roughly 200K per month over the last three, six, and twelve months. So the trajectory was strong, even before the boost to growth and employment from fiscal stimulus. But the stability of the unemployment rate over the last six months has been a surprise. Over that period, household employment gains weren’t as strong as payroll gains, and the labor force expanded more rapidly as the participation rate increased. In response, we again delayed the expected decline in the participation rate. We expect a flat participation rate though this year, as a cyclical rise is offset by the ongoing secular decline, but we still project a gradual decline in the participation rate to resume. With strong momentum in job gains, and fiscal stimulus expected to boost growth over the remainder of the year, we expect a renewed decline, to 3.5% in 2019, about a percentage point below the NAIRU. With growth at the potential in 2020, we expect the unemployment rate to stabilize. 

Inflation: Heading for an Overshoot 

The inflation story for most of last year was to what extent the sharp slowing in 12-month core PCE inflation reflected transitory factors—including, perhaps, a price level shock in March 2017, when core prices declined—and whether there was a signal of a more fundamental slowing in inflation. That story began changing toward the end of 2017, as firmer monthly readings accumulated and gave policymakers more confidence that the slowdown was mostly transitory. The recent March CPI release marks an important point in this narrative. Another solid gain in the core CPI suggests that 12-month core PCE inflation will rise to within a tenth of the 2% objective when it is reported just ahead of next week’s FOMC meeting. So no more looking back at the softer-than-expected inflation. Now it’s time for policymakers to look forward and think about what to do to limit the overshoot. Given the flatness of the Phillips curve, there is not much concern about a substantial overshoot. But 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. 

Funds Rate to Move Into Restrictive Territory, Raising Prospect of Yield Curve Inversion 

To this point, raising the fund’s rate has been about gradually removing accommodation, while leaving sufficient accommodation to support growth and raise inflation. Now it’s about limiting the extent of the overshoot of the inflation objective, and the question is how fast to get to neutral and how far past neutral to go. Moving to a moderately restrictive posture will assure markets that the FOMC is focused on its 2% objective, first containing inflation in the 2%-to-2½% range, and then bringing it back to 2%. We expect the FOMC to raise rates three more times this year, four times next year, and once more in 2020, leaving the funds rate about ½ percentage point above its neutral level. Without a substantial rise in the term premium, such an overshooting of the neutral rate would likely result in a slight inversion of the yield curve. There has been a lot of talks, including by some FOMC members, about an inverted yield curve is a harbinger of recessions. The yield curve can signal a recession because it tells something about how aggressive the tightening has been and is expected to be. But a move to somewhat restrictive policy will be warranted, given projected very low unemployment and inflation gradually further above 2%, so it doesn’t seem likely that a slight inversion alone would stop the FOMC. So the theme for monetary policy is faster and further, but appreciating the challenging balancing act it is attempting: Go fast enough to limit the overshoot, but not so fast as to endanger the expansion. 

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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