Taking out the December Hike, Lowering the Path of Longer-term Rates

We made many changes in this forecast round, affecting growth, inflation, longer-term rates, and our monetary policy call. 

▪ We took out the December hike, though we still see this as a close call: Core inflation came in soft again in July, and we lowered our assumptions for August through October. 

▪ However, we didn’t adjust the subsequent pace of rate hikes because we also lowered our estimate of the nominal equilibrium funds rate, from 3% to 2¾%. 

▪ We assume that Harvey will take seven-tenths off Q3 growth but that that will be largely made up over the following two quarters, with a bit more of a rebound over the remainder of 2018. ▪ We slowed the rise in the ten-year term premium, and it is now projected to reach zero at the end of  2020. 

▪ In addition to our downward revision to rates, the dollar has weakened further, contributing to more accommodative financial conditions in this forecast. 

▪ There is slightly less fiscal stimulus in this forecast. We removed our assumption of an infrastructure package that had ramped up to $20 billion per year, and we also delayed an assumed increase in discretionary spending (mostly defense) into the second half of 2018. We continue to assume that a  substantial package of tax cuts is passed in the spring, retroactive to January. 

▪ All in all, the outlook is a bit stronger in this forecast as more favorable financial conditions and somewhat more momentum outweigh the change in our fiscal assumptions. 

From the perspective of monetary policymakers, it is the view of underlying inflation heading into the  December meeting that will mostly determine the outcome. 

▪ Since our last forecast, core PCE readings came in below expectation in June and July, leaving the 12- month rate at only 1.45%. 

▪ On a year-over-year basis, the Dallas Fed’s trimmed mean PCE inflation rate and core PCE inflation had been tracking very closely for some time and were both 1.9% in February. While core PCE inflation has certainly declined more, the trimmed mean measure has steadily declined to 1.6%, which we take to be closer to the current underlying inflation rate. 

▪ We adjusted downward, but only slightly, projected monthly increases in core prices through the  remainder of 2017. 

▪ Those adjustments plus the softer data lowered our projection for core PCE inflation in 2017 to a tenth to  1.4%. They also lowered our expectation of the compound annual rate of core PCE inflation from March to October from 1.6% to 1.5%; we expect this figure will be given special weight in the rate decision at the December FOMC meeting. 

▪ We still expect core PCE inflation to rise to 1.8% in 2018 and then reach 2% in 2019. We expect a  modest overshoot to 2.1% in 2020. 

▪ The slight overshoot reflects that the unemployment rate is now a ¾ percentage point below our downwardly revised estimate of the NAIRU by 2020. That is worth at least a tenth on core inflation by  2020. 

We raised the growth forecast for 2017 and 2018 by three tenths and a tenth, respectively, to 2.3%. We project a slowing thereafter, to 1.8% in 2020. 

▪ Q2 was revised up significantly, by six tenths, to 3%. And we revised up projected Q3 growth a couple of tenths, to 2.2%, even after assuming a seven-tenths hit from Hurricane Harvey. 

▪ We expect that hit from Harvey to be made up in subsequent quarters, including four-tenths in Q4,  bringing growth temporarily up to 2.7%. 

▪ The boost to growth in 2018 from the rebound from Harvey, greater apparent momentum, and a lower path of the dollar more than offsets the assumed delay in the increase in discretionary spending to the second half of 2018, leaving growth in 2018 up a tenth relative to our last forecast. 

We expect the unemployment rate to continue declining through 2019, then stabilize in 2020. ▪ While growth is somewhat stronger in this forecast, we still expect the unemployment rate to bottom out at 3.9%, the reason being that we’ve further tempered our projected decline in the participation rate because it’s continued to move sideways. 

▪ With growth projected to be a trend in 2020, we expect unemployment to stabilize. ▪ We also lowered our estimate of the NAIRU to a tenth to 4.5% reflecting continued downside surprises to the path of inflation. 

▪ Notwithstanding a weaker print on payrolls for August, the trend remains very strong. We expect gains averaging 175K per month over the remainder of the year–though recent weather events will result in substantial month-to-month volatility. 

▪ After that, we expect a gradual decline to a pace of gains below 100K per month at the end of 2020. 

Our projected path of the ten-year yield is substantially lower in this forecast.  

▪ We lowered our estimate of the longer-run neutral fund’s rate by 25 basis points to 2¾%, and we also assumed the neutral rate rises more slowly to its longer-run level.  

▪ We also assume a slower rise in the term premium toward its steady-state level, two or three basis points per quarter. The term premium is still about -7 basis points in 2019, about 16 basis points lower than in our last forecast. 

▪ The downward revision to our estimate of the neutral fund’s rate and a downward revision to our path of the term premium left the 10-year yield at 2.74% at the end of 2019 and only slightly higher in  2020, about 45 basis points lower than in our last forecast. 

Forecast Overview  

Major Economic Indicators 

Note on Units and Transformations 

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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