Stronger Growth Takes Unemployment Rate Even Lower

While our forecast remains broadly intact, we made three modest adjustments that together shift upward somewhat the balance of risks to inflation and the path of the fund’s rate. 

▪ We revised up projected real GDP growth in response to improved momentum as well as easier financial  conditions. 

▪ Stronger projected growth led us to lower our path of the unemployment rate. 

▪ The even-greater undershoot of the NAIRU in turn led us to revise up our forecast of core PCE inflation in 2019, so that there’s a slight overshoot of the objective, to 2.1%. 

▪ We assume the FOMC raises the fund’s rate target in December. After that, our baseline forecast assumes three hikes in 2018 and three more in 2019, taking the target range to 2.75%-3.00%. That is slightly above our estimate of 2¾% for the neutral rate, reflecting the projected significant undershoot of the NAIRU and slight overshoot of the inflation objective. 

▪ Our baseline forecast continues to assume a fiscal package of $1.2 trillion in tax cuts and $400 billion in spending increases over 10 years. 

The economy appears to be carrying a bit more momentum than we envisioned in our last forecast, and financial conditions continue to be very accommodative. 

▪ The greater momentum is concentrated in consumer spending and net exports and is only partially offset by weaker residential investment and business fixed investment. 

▪ The ten-year Treasury yield rose, but only somewhat more than expected, and credit spreads narrowed. ▪ The dollar rose since our last forecast, but by less than projected, and equity prices have continued to reach new all-time highs. 

▪ FRB/US simulations suggest that easier financial conditions, particularly higher equity prices, would raise the level of real GDP by four-tenths by the end of 2020. 

We retained our assumption that a fiscal package amounting to $1.6 trillion over ten years is passed in mid 2018. 

▪ We assume that tax cuts amount to $120 billion per year, heavily weighted toward the corporate side,  and are passed retroactively to the beginning of 2018. We assume an increase in discretionary spending of $40 billion per year beginning in the second half of 2018. 

▪ This is a close call so we also discuss what the outlook would be like without the fiscal package. ▪ Our simulations using FRB/US indicate that fiscal stimulus would raise the level of GDP by 0.6  percentage points by the end of 2020, with the policy rule prescribing a 50-basis-point higher funds rate than otherwise. 

The labor market continues to be strong, and with GDP growth revised up, we lowered the path of the unemployment rate by two tenths by the end of 2020, to 3.7%. 

▪ We suspect the recent hurricanes accounted for the sharp slowing in payroll employment gains in  September, and continue to project a robust pace of payroll gains in the near term. ▪ The unemployment rate fell two-tenths to 4.2% despite an increase in the participation rate and is now already almost ½ percentage point below participants’ median estimate of the NAIRU. ▪ While we expect the unemployment rate to edge back up to 4.3% in October, we revised down its projected path over the medium term because of stronger projected growth. 

▪ The projected further decline in the unemployment rate of ½ percentage point would put it almost a  full percentage point below today’s estimated NAIRU.  

Based on participants’ September projection for core PCE inflation in 2018 and their subsequent discussions, it is clear that the consensus on the FOMC is that underlying inflation is close to 1¾% and that most of the slowdown in core inflation from a cyclical peak of 1.9% in February to 1.3% in  September will prove transitory. 

▪ One source of the slowdown was a one-off decline in core prices in March that will depress year-over-year inflation until it falls out of the 12-month calculation period. 

▪ Nevertheless, there is anxiety on the Committee about this, which is understandable. Some take a  signal from the slowdown that the underlying inflation rate may have fallen. 

▪ Indeed, core PCE prices have advanced at only a 1.4% annual pace after the March reading. We are not prepared to interpret this slowing as entire noise, but we still expect the pace to pick up to  1.8% in 2018. 

▪ We’d previously projected a slight overshoot, to 2.1%, in 2020. In this forecast, we still project only one-tenth overshoot despite the lower projected unemployment rate because the Phillips curve is so flat. But we now project a somewhat earlier overshoot, in 2019. 

▪ The message here is that the balance of risks later in the forecast period has shifted and is weighted toward higher inflation. 

The FOMC appears ready to hike the fund’s rate by another 25 basis points in December, bringing the target range to 1¼% to 1½%. The strong consensus to hike in December despite the substantial slowing in core inflation reflects two considerations. 

▪ First, the consensus view is that the decline in core inflation will prove transitory and that inflation will be close to 2% next year and reach 2% in 2019 and 2020. So look through the softness. ▪ Second, there is concern about how low the unemployment rate might go and the possibility that a  faster rise in rates will be necessary to avoid substantially overshooting the 2% objective. ▪ The three hikes per year we expect in 2018 and 2019 would bring the upper end of the target range to 3%, just above our estimate of r-star of 2¾%. This reflects that we have core inflation slightly over 2% and the unemployment rate still well below the NAIRU at the end of 2019. 

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 

▪ Once again there appears to be more momentum than we’d expected. We revised up Q3 growth five-tenths to 2¾%, with net exports and inventory investment contributing significantly more to growth. ▪ As for final private demand, consumer spending is also stronger, estimated to have advanced at a 2½% pace despite the hurricanes in Q3. 

▪ On the other hand, residential investment has disappointed again. Business fixed investment has also come in softer than we’d expected but still appears to be advancing moderately, with equipment spending a bright spot. 

▪ The ten-year yield has risen substantially since our last forecast, roughly 30 basis points, and the trade-weighted dollar has risen about 2¾%. Private rates rose a smaller amount, as spreads declined. ▪ The rise in Treasury yields and the dollar might be seen as weighing on demand, but our forecast had already been conditioned on a rise in both. In fact, financial conditions are more accommodative in this forecast, particularly because of a further rise in equity prices. 

▪ The strength in the data for trade and consumer spending, as well as the changes in financial conditions, led us to add a tenth to growth in each year through 2020. 

▪ 12-month core PCE inflation edged down since our last forecast, to 1.3% in August, and in September core CPI was also soft. There is a strong consensus on the FOMC, as indicated by FOMC participants’ September projections and recent remarks, that the underlying rate of core inflation is only somewhat below 2%, however. 

▪ We’d expected the recent hurricanes to significantly impact September payrolls, but the 33K decline was worse than expected. We expect that to be made up in the coming months, however. ▪ The unemployment rate declined two-tenths to 4.2% in September even as the participation rate rose. We expect the unemployment rate to edge up a tenth in the next report. 

▪ Average hourly earnings posted a strong gain in September, which we are looking through because these data were affected by the hurricanes. The data for July and August were revised up, but are not enough to convince us that wages are on a substantially different trajectory.

Effects of Fiscal Stimulus in Our Forecast 

Our baseline forecast assumes a fiscal package amounting to $1.6 trillion over ten years. • We assume a package is passed in mid-2018, with the tax cuts retroactive to the beginning of the year. • We assume that tax cuts amount to $120 billion per year, with $100 billion per year in corporate tax cuts and $20 billion per year in personal income tax cuts. 

• We assume an increase in discretionary spending of $40 billion per year beginning in the second half of  2018, with most of that increase in defense spending. 

• This is a close call, so we discuss what the outlook would look like without this fiscal stimulus. • We present the results of FRB/US simulations assuming monetary policy follows what Yellen has called the “balanced approach” rule: Fiscal stimulus would raise the level of GDP by 0.6 percentage point by the end of 2020, with the funds rate ending 50 basis points higher than otherwise. 

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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