and Firming Inflation Point to Four Hikes in 2018
We made a number of changes in this forecast round, and they affected our forecasts of growth, the unemployment rate, and inflation. The stronger outlook led us to add a fourth funds rate hike in 2018 and a hike in 2020.
▪ Once again, the data have indicated more momentum in economic activity than anticipated. Growth in the second half of 2017 is now expected to average 3%, ¼ pp more than in our last forecast. ▪ In addition, financial conditions remain highly accommodative, with higher equity prices and lower dollar and Treasury yields since our last forecast.
▪ The labor market continues to look strong, and the unemployment rate has again declined faster than we’d expected. In addition, we now see a bit more evidence of a firming in wage inflation, with the ECI for total private compensation increasing much more than anticipated in Q3.
▪ The last few readings on core inflation have been firmer, and we expect a jump in Q4 core PCE inflation. This led us to edge up our 2018 forecast for core PCE inflation a tenth, back to 1.9%. We expect a slight overshoot of the objective in line with our empirical Phillips curve, to 2.1% in 2019 and 2.2% in 2020, as the unemployment rate falls (and remains) well below the NAIRU.
With stronger growth momentum, still-tighter labor markets, firmer wage growth, and a pick-up in core inflation, the focus will shift in 2018 toward greater concern about falling behind the curve. ▪ That translates into a faster pace of rate hikes than earlier anticipated, beginning with four hikes rather than three in 2018.
▪ The further easing in broader financial conditions adds to the case for a fourth rate hike next year. In addition, we are seeing more concern with emerging (or already emerged) financial stability risks and growing support for reflecting this in monetary policy decisions.
▪ We also added another rate hike in 2020, leaving the fund’s rate 50 basis points above the median estimate of the neutral rate by 2020. This fairly modest overshoot is consistent with inflation slightly above its objective and the unemployment rate so far below the NAIRU.
▪ Our assumption of a faster pace of rate hikes essentially offsets the changes we would otherwise have made in our forecast for the unemployment rate and real GDP growth in the medium term.
In short, 2018 is looking like a watershed year. The conundrum of a disconnect between wage and price inflation and a tighter and tighter labor market is going to diminish, if not disappear. This will be a game-changer for monetary policy.
▪ Most important, the Phillips curve reasserts itself! The unemployment rate will fall nearly a full percentage point below FOMC participants’ median estimate of the NAIRU.
▪ There will be more definitive evidence of an upturn in wage gains and core inflation will be heading back to 2%, and ultimately overshooting the 2% objective.
▪ In short, we expect the incoming data will begin to line up with the predictions from the Phillips curve. ▪ We expect to get fiscal stimulus in 2018, compounding the challenge for monetary policymakers. ▪ The faster pace of rate hikes might a precipitate correction in the bond market, given that markets a much slower pace of rate hikes than we anticipate.
▪ And monetary policymakers will be challenged to execute a tightening to a funds rate above neutral without precipitating a recession.
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.
▪ Since our last forecast, financial conditions became even more accommodative. Equity prices reached new highs on improved prospects for tax legislation, and the 10-year Treasury yield and the dollar declined somewhat.
▪ Oil prices rose about $5/bbl since our last forecast, and OPEC extended production cuts through the end of 2018. We have WTI being sustained in the mid-50s on the belief that the market is tighter than generally appreciated (greater demand and higher stocks unavailable because of new infrastructure).
▪ The House and Senate have each passed their own tax cut bills, and it seems likely that they will be able to agree and pass a reconciliation bill by the end of the year. For this forecast, we’ve maintained our previously assumed fiscal package, composed mostly of tax cuts, which seems likely to provide an amount of stimulus broadly in line with the tax legislation that is likely to be passed.
▪ Job gains rebounded in October after being depressed by the hurricanes in September, and the unemployment rate fell yet again, to 4.1%.
▪ The ECI (total private compensation) advanced at a 3.1% pace in Q3, well above expectations. We took some signal from the firmer data and marked up our forecast slightly, so that ECI reaches 3.2% in 2020, a tenth more than before.
▪ While underlying inflation still appears to be moderately below 2%, the last few readings on core inflation have been a bit firmer and led us to mark up our forecast slightly. We now have core PCE inflation at 1.9% in 2018, 2.1% in 2019, and 2.2% in 2020.
▪ There appears to be greater economic momentum than we’d expected. Real GDP growth was 3.3% in Q3, boosted by inventories and net exports even as consumer spending moderated. ▪ Growth looks set to continue at an above-trend pace in Q4 even as inventories and net exports take about ½ percentage point off. Equipment spending has been the brightest spot, advancing at a 10.4% pace in Q3 and with the core capital goods data pointing to another quarter of elevated growth in Q4. ▪ Consumer spending looks a touch weaker than we’d anticipated, but still quite healthy. The recent housing data have pointed to moderate growth in Q4 after two consecutive quarterly declines. ▪ With financial conditions accommodative, the data suggesting more momentum, the unemployment rate continuing to fall faster than expected, and some slightly firmer wage and price inflation data, we adjusted our monetary policy call, adding a hike in 2018 and in 2020. We now expect four in 2018, three in 2019, and one in 2020, leading to a moderate overshoot of the estimated neutral rate.
More Momentum Before Fiscal Stimulus Even Hits
There is clearly more growth momentum than we anticipated in our last forecast. We now estimate that real GDP will advance at a 3% pace in the second half of 2017, a ¼ percentage point faster than in our last forecast. Equipment spending will likely expand at an even more robust pace in Q4 after two-quarters of roughly 10% growth. The data for residential investment have firmed somewhat, suggesting a return to moderate growth in Q4. And consumer spending looks set to continue advancing at a healthy pace, supported by high consumer sentiment, solid employment gains, maybe some signs of firmer wage growth, and further strengthening of household wealth. We now project 2.7% growth in Q4 and 2.6% for 2017 as a whole. To put this into perspective, the 2.6% growth anticipated in 2017 is a full percentage point above CBO’s estimate of potential growth. We expect growth close to that in 2018 (2.4%), as the economy receives a bit of a boost from fiscal stimulus. After that, we expect growth much closer to the trend—2.1 % in 2019 and 1.9% in 2020.
We have retained our assumption that a fiscal stimulus package will be passed and signed. With both the House and Senate have passed tax bills, it looks likely that a substantial tax cut will be passed by the end of the year. The prospect of a government shutdown looms, but we continue to assume that this outcome is avoided. Our forecast assumes that modest spending increases, weighted heavily toward defense spending, will be implemented in the second half of next year. While our tax cut assumptions do not correspond exactly to what is likely to be passed by Congress, and the path of spending is highly uncertain, the degree of stimulus provided by our assumed package strikes us as broadly reasonable.
Labor Markets and Inflation: Toward Resolving the Conundrum
The FOMC has been struggling with the disconnect between surprisingly lower core inflation and a still falling unemployment rate. Next year we expect the labor market and inflation to become better connected. Since our last forecast, the unemployment rate again fell more than anticipated, and we lowered the path in the near term. However, because we assume a slightly faster pace of rate hikes, we left the low point for the unemployment rate unchanged at 3.7%, still almost a percentage point below the estimated NAIRU. The recent firmer reading on wage inflation (ECI total private compensation) was promising, leading us to revise up slightly our path of the ECI for the first time in many forecast rounds, two tenths this year to 2.7% and a tenth in subsequent years, ending at 3.2%. The last couple of readings on core PCE inflation also look somewhat promising, pointing to materially higher inflation in Q4. That leaves core inflation a tenth higher this year, at 1.5%, and reinforced our expectation that the Phillips curve will assert itself and core inflation will move closer to 2% in 2018. We marked up our forecast for core PCE inflation slightly, to 1.9% in 2018, 2.1% in 2019, and 2.2% in 2020.
Four Hikes in 2018; Overshoot of Neutral; and an Inverted Yield Curve
Stronger growth momentum, an unemployment rate projected to fall about a percentage point below the estimated NAIRU, firmer wage inflation, and firming core PCE inflation will lead to more concern about falling behind the curve. We expect that will encourage the FOMC to hike four times in 2018, rather than three times, as in our last forecast. In addition, we added a hike in 2020, which leaves our projected funds rate about 50 basis points above the longer-run neutral fund’s rate in 2020. Tighter monetary policy partially offsets the changes in our forecast, so that the revisions are relatively minor several years out. The higher path of the fund’s rate trims growth slightly more than otherwise in 2019 and 2020 and lessens downward pressure on the unemployment rate, so that the unemployment rate bottoms out at 3.7%, as in our previous forecast. In our forecast, longer-term yields are only slightly higher because of the faster pace of rate hikes, but there is a risk of a correction in the fixed income markets given that the market is pricing at a much slower pace of hikes. The modest overshoot in the fund’s rate that we project in 2020 contributes to an inverted yield curve in this forecast. We don’t believe that this means a recession will necessarily follow; with the 10-year term premium remaining depressed, the yield curve can much more easily become inverted than in previous years.
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.