Softer Inflation, Slightly Less Momentum

The real side of the economy looks solid, though there are some signs that momentum may be slowing. ▪ Growth appears to have rebounded in Q2, although a bit less strongly than had been earlier anticipated. ▪ Recent readings on core retail sales suggest less momentum in real PCE heading into Q3, and auto sales have continued to soften. 

▪ Payroll employment growth remains strong, with an average of 180K jobs added per month over the  last six months. 

▪ While the unemployment rate ticked up a tenth in June, at 4.4% it is below FOMC participants’ median estimate of the NAIRU, and it is expected to fall further. 

Inflation, on the other hand, is lower than expected. The 12-month core PCE inflation rate fell to 1.4% in  May, well off the recent high of 1.8%, reached as recently as February, and the lowest it’s been since  December 2015. 

▪ Since our last forecast, CPI again came in below expectations, with the June reading suggesting that  12-month core PCE inflation will remain at or below 1.4% in June. 

▪ The dominant view among FOMC participants, and one we share, is that the lower core inflation to a  significant extent reflects outsized one-time declines in the prices of certain components of the core  PCE index. If so, the slowdown will be temporary, though calculated 12-month inflation rates will be depressed as long as they include the affected months. 

▪ On the other hand, for those more skeptical of forecasts based on the Phillips curve, this appears to be yet another instance of an ongoing persistent overprediction of inflation.  

In this forecast, we left our path of GDP growth unchanged: 2% this year and 2.2% the following two years. ▪ The dollar has fallen, leading us to boost net exports a bit. Oil prices have dropped as well, and we expect this decline to boost disposable incomes and consumer spending. There will be a partial offset in nonresidential structure investment from an accompanying decline in drilling. We estimate that these  

developments would have added perhaps a tenth of a percentage point to growth in 2018 and 2019. ▪ While these factors will be supportive, activity in Q2 has been weaker than we had expected, and less momentum is being carried into Q3, largely reflecting disappointing readings on consumer spending. 

While we believe the slowing in inflation principally reflects one-time declines in certain categories of prices,  we are disinclined to attribute the slowdown entirely to these factors. This inclination was reinforced by the release of June core CPI, which remained soft and did little to offset previous months’ weak readings. ▪ A downward revision to our forecast of core inflation in 2017 was clearly called for. We revised it down two-tenths to 1.5%. 

▪ In addition, we took a tenth off of core PCE inflation in 2018 and 2019, revising to 1.8% and 2.0%,  respectively. We believe that the recent string of low inflation readings should be read as giving some small signal about the underlying pace of price inflation. 

Our forecast continues to assume a fiscal package of about 1% of GDP per year, heavily weighted toward corporate tax breaks. However, the prospects of such a fiscal stimulus have continued to diminish. ▪ Our assumed fiscal stimulus, with unchanged financial conditions, would add perhaps four to five-tenths to growth in 2018 and 2019. 

▪ However, the aggregate effects of fiscal stimulus would likely be cushioned by some tightening of financial conditions. 

▪ In the absence of fiscal stimulus, growth would be closer to the trend in 2018 and 2019, rather than somewhat above, and with the lower projected inflation rate in 2017 and 2018, we would expect two hikes instead of three next year. 

We expect the FOMC to announce the beginning of the phasing out of reinvestment at its September meeting, and to raise rates for the third time this year in December. 

▪ The hurdle for announcing the end of reinvestment is lower than that for another rate hike. In any case,  the slowdown in core inflation will not lead the Committee to delay the announcement of a change in reinvestment policy in September. 

▪ On the other hand, the Committee would be very reluctant to raise rates in September, given that it would not be necessary in order for them to implement three hikes this year. 

▪ A wait-and-see posture appears appropriate given the incoming data, and a contingent on the FOMC  had long preferred a pause at the time of the balance sheet announcement. 

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 Q1 real GDP growth two tenths on stronger final private demand and a bit stronger contribution from net exports. PCE was revised up ½ pp to 1.1%. 

▪ While consumer spending appears to have accelerated substantially in Q2, the trend in the recent retail sales data suggests less momentum and bodes poorly for consumer spending in Q3. Vehicle sales also disappointed. 

▪ Measures of consumer sentiment, which surged following the election, remain at solid levels but have eased in the last couple of months. 

▪ Other data on private demand have also been weaker than expected, on balance. We now expect final private demand growth of only 2.2% in 2017:Q3, down ½ pp from our last forecast. ▪ The broad trade-weighted dollar has fallen roughly 2% since our last forecast even as the ten-year treasury yield is somewhat higher, on the net. U.S. equity prices remain at high levels. ▪ Oil prices are down substantially since our last forecast, though they’ve rebounded from their recent lows. 

▪ Nonfarm payrolls increased 222K in June and upward revisions to previous months totaled 47K; total hours worked also posted a solid gain. Average hourly earnings advanced a modest 0.2% in June and the 12-month change remained at 2.5%. 

▪ In the household survey, the unemployment rate ticked up a tenth, to 4.4%, as the participation rate also ticked up. The U-6 rate edged up two tenths. 

▪ The 12-month core PCE inflation rate fell further, to 1.4% in May, its lowest rate since late 2015. Core CPI advanced 0.12% in June, and the details suggest core PCE prices advanced somewhat less in June than we assumed in our previous forecast. 

Growth: Still 2% in 2017, a Bit Higher in 2018 and 2019 

We estimate that Q2 growth was 2.4%, about ¼ pp lower than in our last forecast, and there appears to be less momentum in private demand, with recent consumer spending data particularly disappointing. On the other hand, oil prices fell, which we see as stimulative, on the net, as did the dollar in response to a brightening outlook for foreign economies since our last forecast. On balance, we saw these effects as offsetting and maintained our forecast for growth over the next couple of years: 2% in 2017 and 2.2% in 2018 and 2019. The pickup in growth in 2018 and 2019 owes to the fiscal package we continue to assume is implemented—about 1% of GDP per year—though the probability of a stimulus has been diminishing. In the absence of the fiscal stimulus, growth would be slowing in 2018 and 2019 toward its trend rate. 

Labor Market Continues to Improve 

While the unemployment rate rose a tenth since our last forecast, the story remains that the unemployment rate has continued to decline, almost ½ pp since late 2016. And with growth projected to remain above trend, it is expected to continue to decline, reaching 3.9% by the end of 2019, unchanged from our last forecast. On the other hand, the estimated NAIRU also has continued to decline and where it will be at the end of 2019 is an open question, likely depending on whether inflation comes in lower than expected. Payroll gains continue to be strong, averaging 194K over the last three months. Still, we see the underlying pace of monthly job gains as slowing to about 160K over the remainder of 2017, on its way to close to 125K by the end of 2019. The lack of an acceleration in wage growth is a notable feature of the recent labor market data: the 12-month change in average hourly earnings remains only 2.5%. 

What to Make of the Slowdown in Inflation 

Core PCE inflation has slowed this year, from 1.8% on a 12-month basis in February to just 1.4% in May, even as the underlying fundamentals do not appear to have changed significantly. Indeed, the expectation that inflation is still headed to 2%, as early as next year, continues to be consistent with projections from empirical Phillips curve models. Significant declines in prices for certain components, notably wireless communications services, have contributed significantly to the decline in 12-month core inflation—we estimate by several tenths. As Chair Yellen has stressed, even if these declines are temporary, as expected, they will still depress the calculated 12-month core inflation rate for a while. However, there has been softness in core inflation outside of these components as well, which we do see as providing some signal of lower underlying inflation. While core CPI did increase in June, it was still yet another soft reading: Given the recent readings, we lowered our forecast for core PCE inflation another two tenths in 2017, to only 1.5%. We also thought recent developments warranted a slight downward revision in 2018 and 2019, to 1.8% and 2.0%, respectively. 

Phasing Out Reinvestment in September, Third Rate Hike in December 

The lower inflation readings will not delay the announcement of the phasing out of reinvestment at the September meeting. There is much less flexibility for the timing of the announcement of the change in reinvestment policy than there is for the next rate hike. The communication in advance of the change in reinvestment policy has been excellent, and there should be a little market reaction. A contingent on the FOMC preferred to pause rate hikes at the time of the announcement in any case, and with the slowdown in inflation, there is no support for doing both a rate hike and a balance sheet announcement at the same meeting. We still expect the third hike this year, in December, but that is conditional on the incoming data confirming some rebound in inflation readings after May, as well as continued momentum on the real side. 

Financial Conditions Remain Accommodative 

Financial conditions have remained quite accommodative even though the FOMC has been raising the fund’s rate, the market expects further rate hikes to come, though fewer than implied by the June dots, and the phasing out of reinvestment appears imminent. The 10-year Treasury yield, at about 2.25%, is up less than 10 basis points since our last forecast, and the trade-weighted dollar has fallen roughly 2%. Equities have continued to march higher, even as prospects for the passage of a substantial fiscal package appear to have diminished. We expect longer-term rates to rise gradually as markets appreciate that a gradual move toward a neutral funds rate will continue, and at a faster pace than now built into market pricing. Two major questions are where neutral is and will be by 2019, specifically whether the real equilibrium funds rate (r*) will converge toward its longer-term level by then, and the degree to which balance sheet developments, before and following the phasing out of reinvestment, substitute for some rate hikes that otherwise would have been warranted. 

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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