Macro Update Ahead of the August FOMC Meeting:

All Signs Point to Continued Above-Trend Growth 

All in all, while trade may dominate economic headlines, and has potentially important consequences, it’s important to remember the broader economic picture underpinning the U.S. monetary policy outlook: The  U.S. economy is fundamentally strong and, despite a strong growth outlook and a low unemployment rate,  the stance of monetary policy remains accommodative. Accordingly, the FOMC is focused for now on getting to a neutral policy stance. We expect the FOMC to maintain its gradual pace of rate hikes until the fund’s rate nears its estimated neutral level, one hike at each meeting with updated projections and a press briefing. 

The broad contours of the economic outlook are essentially unchanged since our last forecast and the June  FOMC meeting. For monetary policymakers, the key features of the outlook are that there is strong momentum in real GDP growth and that the pace of job gains remains robust. Solid growth in the second half of 2018— supported by strong fundamentals, still-accommodative financial conditions, and fiscal stimulus—is likely to bring the unemployment rate down further. Growth is still expected to moderate gradually from its well-above trend pace in coming years, reaching potential in 2020. As that happens, the unemployment rate will continue declining, but at a more gradual pace, reaching 3½%. Core PCE inflation, already at its 2% objective, is expected to firm further, but only very slightly because of how flat the Phillips curve appears to be. 

BEA’s release of the Q2 real GDP data confirmed that there was a substantial acceleration in growth in Q2,  as had been anticipated. Real GDP growth came in at a robust 4.1% in Q2, a few tenths stronger than we anticipated in our previous forecast. And that was despite a decline in inventories that subtracted a full percentage point. Consumer spending and business fixed investment were strong, at 4.0% and 7.3%,  respectively. Business fixed investment was boosted by accelerations in structures investment (13.3%) and intellectual property products (8.2%), but equipment investment posted a solid gain as well (3.9%). Net exports contributed 1.1 percentage points to real GDP growth. Residential investment was, as expected, soft,  declining at a 1.1% pace. 

Our previous forecast of roughly 3% growth in the second half of 2018 is still looking pretty good, though concerns about trade policy (discussed further below) have increased. Despite those concerns, financial conditions are still accommodative, if somewhat tighter. Equity prices remain at high levels, indeed somewhat higher than they were at the time of the last FOMC meeting, and the ten-year yield is virtually unchanged.  The dollar is up about 1½%, and WTI has risen a few dollars per barrel, to about $70/bbl, which reduces real incomes. Net exports contributed more than expected to growth in Q2, likely reflecting in part some frontloading of exports to avoid tariffs. That, as well as the appreciation of the dollar, suggests a greater drag from net exports in the second half relative to our previous forecast. The recent data on residential investment have been weak, pointing to another soft quarter in Q3, but we already had low expectations for housing.  

Despite the talk of investments being delayed or nixed because of concerns about trade policy, business fixed investment has been strong and appears likely to advance at a solid pace in the second half after a strong second quarter. The big drawdown in inventories in Q2 means inventories is likely to contribute more to growth in the second half of the year. There’s likely to be a substantial moderation in consumer spending from its elevated 4.0% pace in Q2, but that is to be expected. Most important, we continue to expect the effects of fiscal stimulus to become more apparent in the second half of this year. In particular, we expect government consumption and gross investment to contribute more to growth as outlays are ramped up with a lag following the passage of the massive spending bill earlier this year. 

Consistent with the strength of real GDP growth, the labor market has continued to tighten further. The two-tenth rise in the unemployment rate in June, to 4.0%, gives us no pause, especially because it was accompanied by a two-tenth rise in the participation rate. The unemployment rate and participation rate may be slightly higher in the near term than expected in our last forecast, reflecting the higher jumpoffs, but strong real GDP growth in the second half will support continued job gains. Indeed, the pace of payroll gains has surprised the upside, and the three-month average is 211K. We still expect unemployment to gradually decline and reach around 3½%. That is expected to eventually lead to a modest overshoot of the 2%  objective, by about ¼ pp in 2019 and 2020. On a 12-month basis, core PCE inflation remains close to its  2% objective, and we continue to expect it to remain within a tenth or so of 2% into 2019. 

We, like the FOMC, are wary of downside risks from trade but remain reluctant to meaningfully adjust the baseline outlook. However, the risk of a major escalation appeared to rise substantially following the June  FOMC meeting. The Administration placed 25% tariffs on a range of Chinese imports and signaled it would impose further tariffs should China reciprocate, which it did, placing tariffs on a range of U.S. agricultural products, including soybeans and pork. There had previously been retaliatory tariffs from trading partners,  but those were much narrower than these. This marked a turning point since the Administration was willing to risk substantial damage to a key constituency. That we are sticking with our basic outlook despite all the concerns about trade does not mean that some of the measures being discussed wouldn’t alter the outlook meaningfully, if implemented. For example, Trump’s proposed 25% tariff on imported vehicles and parts would be much more disruptive than anything implemented to this point. 

As Chairman Powell emphasized in his two days of testimony last week, right now there’s little in the economic data that one can point to as evidence of the impact of the Administration’s trade disputes, though there are many anecdotal reports that business leaders are increasingly concerned about trade policy and possibly delaying investments. And at this point trade isn’t drastically affecting the outlook through the channel of tighter financial conditions. The dollar has appreciated somewhat, which will weigh on exports,  but equity prices remain high. And despite comments from Trump suggesting that he’s confident in the path  he’s on (“Tariffs are the greatest!”), there’s still good reason to believe that at least the more extreme measures will be avoided. This week’s meetings with representatives from the EU support that view. The tone was one of cooperation at Trump’s appearance with Juncker, and he emphasized that his ultimate goal was to lower barriers to trade for all. The auto tariffs appear to be off the table for now, as Trump was able to point to concessions from the EU. And it still remains to be seen what happens with China, as the farming lobby has intensified its lobbying efforts. The Administration’s announcement of $12 billion in aid to U.S.  farmers hurt by the recent tariffs shows that the Administration understands that this constituency is being harmed. But this band-aid won’t placate the farm lobby, as it doesn’t address the fundamental problem of farmers losing an important export market.

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