Weak Growth in Q1, but Still a 2%-Growth Economy

The forecast round has been an interesting one: weak GDP in Q1, weak payroll employment in March, an outright decline in March core CPI, and some significant changes in financial conditions. So the key questions are: what’s noise, what’s signal, what should we look through, what should be reversed, and what should be extended. 

▪ We mostly have looked through the unexpectedly weak Q1 growth, which we now estimate to be closer to 1% than to 2%. The pattern of a weak Q1 is evident again this year, certainly exacerbated by the unusually warm winter and by a sharp falloff of inventory investment.  

▪ We are also discounting the soft payroll employment figure in March of 98K. After all, the three-month average increase is still 178K, and initial claims are running at a very low level. 

▪ Inflation presents a greater concern. The decline in core CPI in March (and our expectation that it will translate into a decline in core PCE of a similar magnitude) is expected to leave the 12-month inflation rate for the core CPE measure at 1.6% in March, interrupting the progress that was being made toward the 2% inflation objective.  

▪ Since our March forecast, interest rates and the dollar have declined, on the net. Equity prices fell after our last forecast, but have rallied in the last week and reversed that decline. 

As for fiscal policy, the outlook remains highly uncertain. Our reading of the political situation has led us to adjust a few key features of our anticipated fiscal program.  

▪ Whereas our prior fiscal package had tax cuts that were more evenly split between personal and corporate taxes, we now think the bulk of the cuts will be to corporate taxes.  

▪ We expect the marginal corporate tax rate to be reduced from 35% to 27% (perhaps to 25% if it is phased in), a far smaller cut than the Administration has indicated it will seek.  

▪ On the personal tax side, we would expect a package of small middle-class goodies, such as an increase in the child care tax credit and the like.  

▪ Along with some modest increases in federal spending, we are expecting a fiscal package of around 1%  of GDP.  

▪ And the shift in the composition of the package away from tax cuts for the wealthy and toward corporate rate reductions gives fiscal policy a bit more positive thrust. 

Bottom line: You will continue to recognize our forecast, as the message remains the same. Growth in activity is modestly above trend, the unemployment rate moves well below the NAIRU, and inflation moves to 2% and eventually overshoots that objective by a small margin. 

▪ We still have a 2% economy: Growth is projected to be 2.0% this year and 2.2% in 2018 and 2019. That is a pace above the growth of potential, and, indeed, is cyclically quite strong in 2018 and 2019. ▪ We did lower growth in 2017 by a tenth, a slight bow to the very weak Q1. We added a tenth to 2018  and 2019 owing to the somewhat lower dollar and interest rates and a slightly more supportive fiscal package. 

▪ We trimmed core PCE inflation a tenth in 2017 to 1.8% in response to the softer-than-expected March  CPI data. We still expect core PCE inflation to reach 2% in 2018, and to slightly overshoot the 2%  target in 2019. 

▪ The unemployment rate is still projected to fall ½ pp below the NAIRU by 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 

▪ The final revision to GDP for the fourth quarter of last year brought growth in 2016 up a tenth, back to—you guessed it—2%. 

▪ The incoming data suggest that growth slowed to near 1% in Q1, well below the 1.9% pace projected in our March forecast. 

▪ A slowdown in consumer spending was the principal source of the disappointing Q1 GDP growth. Equipment spending, nonresidential structures investment, and residential investment all appear to have posted solid gains. 

▪ Payroll employment rose a disappointing 98K in March. Meanwhile, the unemployment rate dropped two-tenths to 4.5%, below FOMC participants’ median estimate of the NAIRU (and below ours as well). ▪ Core CPI fell a tenth in March, which brought the 12-month rate down to 2.0% from 2.2%. ▪ Financial conditions were mixed since our last forecast, but ultimately are more accommodative, the key developments being declines in the ten-year Treasury yield and the dollar. Equity prices are little changed, on the net, as recent increases offset earlier declines. 

Looking Through the Soft Patch: It’s Still a 2% Economy 

We are mostly looking through the weakness in Q1 when we estimate growth slowed to near a 1% rate, and are projecting a rebound to near 3% in Q2. We anticipate that much of the very weak consumer spending will prove transitory. No doubt, very warm winter weather depressed spending on utilities, and real PCE should bounce back this spring. With the anticipated rebound in the second quarter, we expect growth to average nearly 2% in the first half—a pace that should be maintained in the second half. We anticipate a slight pickup in growth in 2018 and 2019 to 2.2%. That small acceleration owes to the effects of our modest projected fiscal stimulus, which offsets the otherwise restraining influence of the gradual increase expected in the federal funds rate. Putting it all together, the basic message of the forecast is that growth should remain a bit above potential, slowly pushing the unemployment rate down, and gradually lifting core inflation up. 

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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