More Subdued Inflation, Slower Job Gains, Sharply Lower Unemployment Rate

Growth appears to be rebounding about as we had expected, and the broad contours of the forecast remain  in place. 

▪ We still expect actual growth to remain above that of potential through 2019. 

▪ We still expect inflation to overshoot the 2% objective modestly, reaching 2.1% in 2019. ▪ And we still expect the unemployment rate to steadily decline further below the NAIRU. 

Nevertheless, we’ve made a couple of notable adjustments to our forecast in response to surprising data for core inflation and the unemployment rate. We’ve releveled our projected unemployment rate path downward, given its recent sizable decline. We view the decline in the unemployment rate this year as a  more meaningful development with respect to policy than the recent slowdown in payroll gains. 

▪ Rather than reversing some of its recent declines, the unemployment rate fell further in May and is now three-tenths lower than we’d expected in our last forecast. 

▪ In response, we have lowered the projected path of the unemployment rate throughout our forecast. We now anticipate that the unemployment rate will reach 3.9% at the end of 2019, down from 4.2% in our last forecast. 

▪ The decline in the unemployment rate this year will undoubtedly be at the center of next week’s FOMC  discussion. Many FOMC participants have noted that gradually removing accommodation now is warranted to prevent the need for a sharper tightening in the future that might put the economy at more serious risk. That possible scenario is now being brought into sharper focus. 

With respect to core PCE inflation, the soft data have come as a surprise, but the fundamentals have not  changed. 

▪ We still see core inflation gradually firming toward its objective, then overshooting very slightly,  bolstered by an unemployment rate that continues to fall further below the NAIRU, which eventually boosts labor costs, and by rising prices for non-petroleum import prices. 

▪ Indeed, with respect to the medium-term trajectory of core inflation, we believe the lower projected path for the unemployment rate will prove more of an enduring influence than the recent soft readings on inflation. 

▪ We lowered our forecast by a tenth this year and next, to 1.7% and 1.9%, respectively, but we left our forecast for 2019 unchanged at 2.1%. 

The expected rebound in Q2 growth appears to be under way. 

▪ Taken together, the incoming data on spending in Q2 is consistent with a growth of 2.7%. That leaves growth in the first half of 2017 at 2%, much as we had anticipated in our previous forecast. ▪ We still expect growth of 2% for all of 2017, as well. Financial conditions are somewhat more supportive since our last forecast, but private domestic spending has been a touch softer. ▪ We kept growth in 2018 and 2019 at 2.2% reflecting a couple of tenths of contribution from a still assumed modest fiscal stimulus. 

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 revised up both Q1 GDP growth and growth of final private demand domestic demand by five-tenths, bringing them to 1.2% and 2.7%, respectively. Growth in consumer spending, at only 0.6%, was especially weak, while inventory investment subtracted 1.1pp from Q1 growth. 

▪ The recent monthly data suggest equipment spending has slowed. We expect business fixed investment to grow at a more moderate pace following the significant acceleration in Q1. 

▪ We’ve marked down residential investment in Q2 in response to incoming data, but the slowdown appears to reflect supply constraints more than demand. 

▪ Payroll employment increased 138K in May and the three-month average is down to 121K. While this is a slower pace of payroll gains, the more significant development was that the unemployment rate fell another two tenths since our last forecast, and now is at 4.3%. 

▪ After declining in March, core PCE prices rose 0.2% in April, but the 12-month rate still edged down to 1.5%, its lowest level since late 2015. The ECI for private compensation rose at a 3.2% annual rate in Q1, much faster than expected, but the year-over-year rate is still only 2.3%. 

▪ Financial conditions eased since our last forecast, with the 10-year Treasury yield down 13 basis points, the trade-weighted dollar falling about 1¾%, and equities rising nearly 2%. 

▪ Oil prices (WTI) have fallen about $4/bbl since our last forecast as the market reevaluated the prospects of OPEC cutting supplies, inventories surged, and gasoline demand fell. 

Q2 Rebound Keeps Economy On Track for 2% in 2017 

While growth slowed substantially in Q1, final private demand advanced at a solid 2.7% pace on strength in residential investment and business fixed investment. We expect a rebound in growth to 2.7% in Q2, with consumer spending bouncing back after unusually warm weather depressed spending on utilities. We continue to expect growth of 2% in 2017 and a slight pickup in growth in 2018 and 2019. That acceleration owes to the effects of our modest projected fiscal stimulus. While we have maintained our assumed fiscal package in this forecast, the probability of such legislation being passed has been dropping. 

Major Economic Indicators 

By default, values represent seasonally-adjusted, annualized growth rates (%) for the series indicated in the leftmost column. “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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