Overshooting, Undershooting, and Trump

Our macro forecast is little changed from early December, and the broad themes remain firmly in place.  ▪ We remain in a 2%-growth economy. Growth has averaged about 2% over the course of the recovery,  and we expect it to remain near that level through 2019. 

▪ That is the case even with an assumed fiscal package contributing to growth in 2018 and 2019. ▪ The economy is at or very close to full employment, with projected above-trend growth expected to lead to a modest undershoot of FOMC participants’ median estimate of the NAIRU. ▪ Core PCE inflation will end 2016 near 1¾%, closing in on the FOMC’s 2% inflation objective. ▪ The outlook remains especially uncertain as we await more clarity on various Trump initiatives. 

With 2016:Q3 growth revised up to 3½% and our estimate of 2016:Q4 growth marked down somewhat,  we still see 2016 real GDP growth at, yes, 2%. 

▪ The slowdown in Q4 is not a cause for concern; it largely reflects a sharp swing in net exports as the  Q3 surge in food exports was reversed in Q4. 

▪ The final private domestic demand looks solid. We estimate that it advanced at a 2.4% rate in 2016, and we expect continued growth of around 2½% over the next few years. 

▪ Given the recent appreciation in the dollar and our expectation of some further appreciation, we anticipate net exports will subtract several tenths from growth per year through 2019. ▪ This combination of solid private demand growth and drag from net exports underpins our expectation  that growth will be near 2% through 2019, in line with recent forecasts. 

Core PCE inflation remains below its objective and was soft late in 2016. But we still see core PCE inflation on a modestly rising trend, nearly reaching 2% in 2017. 

▪ Core PCE was softer in the fourth quarter than we had anticipated, but this doesn’t give us much pause because monthly readings have been soft late in the year for the last few years. 

▪ A further tightening of the labor market and long-term inflation expectations reasonably anchored at 2%  will promote a further rise in 12-month core PCE inflation, to 1.9% this year. 

▪ Even before the prospect of fiscal stimulus, we saw the asymmetric risk of overshooting the 2% inflation objective. Given the fiscal stimulus we expect, we project a slight overshooting in 2018 and 2019. 

FOMC participants have made clear that the pace of hikes will quicken in response to fiscal stimulus, but we wouldn’t expect monetary policy to respond until legislation actually passes.  

▪ The FOMC raised the target range for the fund’s rate by 25 bps in December, and the median dots for  2017 implied three hikes, up from two at the September meeting. 

▪ What we see as a solid consensus among participants for three hikes in 2017, conditional on a forecast much like ours, led us to assume three hikes this year, up from two hikes in our last forecast. ▪ But, at the same time, we reduced the number of projected hikes in 2018 from four to three. This gives the FOMC space to end the current reinvestment policy somewhat earlier, in mid-2018, compared to early 2019 in our last forecast. 

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 

▪ Growth was revised up a few tenths to 3.5% in the final report for Q3 GDP. We revised down our estimate of Q4 growth by six-tenths to 2.1%, which leaves 2016 growth unchanged at 2.0%. ▪ The downward revision in Q4 growth reflects a higher estimate of drag from net exports in Q4 following a very sharp rise in Q3 when goods exports surged. It was all about soybeans! 

▪ We moved one hike from 2018 to 2017, leaving three hikes in each of those years, and we also moved up our assumed date of the end of the reinvestment program to 2018. 

▪ We estimate that final private domestic demand grew at a 2.9% rate in Q4, as residential investment rebounded following a weak couple of quarters and consumer spending moderated to a 2½% pace. ▪ A variety of indicators of consumer and business sentiment have moved up since the election to or near multi-year highs. 

▪ Post-election moves in financial markets have largely persisted. The dollar has pared some of its rises but remains up over 3%. 

▪ 12-month core PCE inflation edged down to 1.6% in November. The Michigan survey measure of longer-term inflation expectations fell to a new low of 2.3% in December but rebounded to a (still-low) level of  2.5% in January. Market-based measures of inflation compensation remain sharply higher following the election. 

▪ The December jobs report continued a run of strong releases. The 12-month change in average hourly earnings rose to 2.9% in December, up from 2.5% in the previous month. Minimum wage increases in  19 states will likely give a slight one-time boost to average hourly earnings in January. 

Still a 2% Economy 

We did not change our fiscal policy assumptions and still project a fiscal stimulus that ramps up to $165  billion in 2019, a program much smaller in scale than the proposals floated by Trump and Republican leaders. Taking into account the negative feedback from a quicker pace of tightening and less accommodative financial conditions, the fiscal stimulus adds only a couple of tenths to projected growth in  2018 and 2019. While we still project near-2% growth this year and the following two, there is an upside risk from a possibly larger and earlier fiscal stimulus. On the other hand, there are downside risks from trade and immigration policy and geopolitical developments. Moves in some indicators, such as equity prices and indicators of consumer and business sentiment, suggest the possibility of a shift in “animal spirits”  following the election. We are open to the possibility of such a dynamic taking hold, but it’s much too early to assume any fundamental change has taken place. 

We expect final private domestic demand to grow at a 2½% pace over the next couple of years. That will help to overcome the expected drag on GDP growth from net exports of a few tenths. 

Percentage points 

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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