Every three months, the 19 members of the Federal Reserve’s Federal Open Market Committee, of FOMC for short, aided, no doubt, by an army of econometric minions, work up new forecasts for key economic variables and their assessment of appropriate monetary policy. In recent days, as they have huddled in their offices engaged on this task, they’ve had much to be thankful for. The economic roller coaster triggered by the pandemic and the policy response, which manifested itself in wild swings in output, unemployment and inflation, has subsided. Moreover, the very narrow road by which they thought inflation could be subdued without triggering a recession, turned out to be not so narrow after all. The U.S. economy has maintained solid economic growth and a very tight labor market even as inflation has fallen towards their 2% objective.
However, the outlook is, to say the least, foggy. Geopolitical risks abound even as an approaching U.S. election carries the potential for significant policy changes with regard to taxes, immigration and trade. Moreover, government data are becoming less reliable, with wide gaps emerging between estimates of output and income and numbers produced by the two main employment surveys. On such a foggy road, while the members of the FOMC will, as usual, provide their best guesses as to the direction of the economy, they will be reluctant to change the current stance of monetary policy.
The Summary of Economic Projections
The week ahead will be a busy one for markets, with fresh data on inflation and continuing questions about the sustainability of both the economic soft-landing and a still very concentrated rally in U.S. stocks. However, the highlight of the week will be communications from the Fed on Wednesday. They are very unlikely to change either short-term interest rates or their current pace of quantitative tightening. However, they will release a new Summary of Economic Projections, or SEP, and a new “dot plot”, showing their expectations for key economic variables and short-term interest rates. They will also have the opportunity to add nuance to these forecasts through the FOMC statement and Chairman Powell’s press conference. So what changes are they likely to make to their forecasts and how could these changes impact markets?
The SEP includes forecasts for only four economic variables: year-over-year real GDP growth, headline PCE inflation, core PCE inflation and the unemployment rate. These forecasts are provided for the fourth quarters of 2024, 2025 and 2026.
Growth
In their March projections, the FOMC forecast real GDP growth for 2024 of 2.1%. Three months later, this forecast appears to be on track. Consumer spending on health care, travel and entertainment continues to grow strongly. However, spending on non-durable goods, such as food and clothing, was lower in April than in December, suggesting that lower and middle-income households are having to retrench. In addition, investment spending on structures and equipment appears to be slowing, presumably in a lagged reaction to higher interest rates. Notwithstanding a payroll job surge in May, we expect year-over-year real GDP growth to slide from 2.9% in the first quarter to 2.0% by the fourth – essentially in line with the Fed’s numbers.
Thereafter, the Fed projected real GDP growth of 2.0% in both 2025 and 2026, with growth falling to 1.8% in the long run. This continues to seem plausible, as both job growth and GDP growth are currently getting a temporary boost from immigration that is likely to fade in the years ahead.
Unemployment
In March, the SEP showed the unemployment rate rising from 3.9% in February to an average of 4.0% by the fourth quarter. Last Friday’s jobs report showed an unemployment rate of 4.0% in May, or 3.96% taken out to two decimals. It is quite possible that the Fed will boost its unemployment rate forecast to 4.1% or even 4.2% for the fourth quarter to reflect the lagged impact of slower economic growth. Alternatively, they could boost their unemployment rate estimates on the theory that the latest entrants drawn into the labor market may be more prone to bouts of unemployment than those who have been employed throughout the last few years. Either way, it is worth noting that the Fed’s long-run forecast of the unemployment rate is 4.1%. Like economic growth, the Fed’s forecasts show the labor market very close to where they want and expect it to be.
Inflation
Which brings us to inflation. In March, FOMC participants projected headline PCE deflator inflation of 2.4% by the fourth quarter and 2.6% for core inflation. We now expect, based on data through April, that these numbers will be a little stronger than those projections, at 2.5% at the headline level and 2.8% at the core.
One reason for this slightly hotter-than-expected inflation is stubbornly strong shelter inflation. After declining by 2 percentage points from 8.2% year-over-year in March of last year to 6.2% in December, it only fell a further 0.7% by April of this year, to 5.5%. We do expect it to keep easing, based on newly negotiated rents. However, if this decline mirrors the slower pace of recent months, it will limit the potential for shelter to erode measured inflation.
A second reason is auto insurance. Many, including myself, assumed that with auto insurance rates up by 20.3% year-over-year in December, rates would have to grow more slowly in 2024. So far this hasn’t transpired, with auto insurance up an astonishing 22.6% year-over-year in April.
These are, to some extent, special and temporary factors. However, Fed communications will likely express dissatisfaction with the slow pace at which inflation is traveling this last leg of its journey back to 2.0%. We expect the summary of economic projections to add 0.1% to participants’ forecasts for both headline and core inflation in both 2024 and 2025 with the economy only attaining the nirvana of 2.0% inflation by the end of 2026.
Mixed Messages
Given this slightly revised view of the economy, what messages will the Fed likely send about the future path of monetary policy?
There are likely to be only very minor changes in the FOMC statement or in Jay Powell’s opening statement at his press conference. The text could allude to recent data showing a slightly higher inflation and slightly higher unemployment – factors that would be offsetting from the perspective of financial markets.
However, the “dot plot” will very likely show an adjustment in expectations for Fed policy. In March, of the 19 FOMC participants, 10 forecast three or more rate cuts in 2024 while 9 forecast two or fewer. It is very likely that the new dot plot will show a majority expecting two or one, with markets potentially reacting favorably to the first of these possible outcomes and unfavorably to the second. On balance, the Fed’s communications may sound slightly more hawkish than in recent meetings. However, they are also likely to stress the uncertainty of the present moment.
They will have noticed, as economists generally have noticed, that the two major employment surveys are saying radically different things about the U.S. economy. According to the payroll survey, the economy gained a booming 2.8 million new jobs over the past year. However, according to the household survey, it only added a paltry 376,000 workers over the same period.
And this is not the only glaring discrepancy. Nominal GDP, adding up the components of output in the economy, grew by 5.4% in the year ended in the first quarter. However, adding up all the income received in the economy and making appropriate accounting adjustments shows only a 4.3% gain on the other side of the ledger. The statistical discrepancy – the amount by which the income and output accounts of our national income statements disagree - has now swelled to $621 billion, or more than 2% of GDP.
The economy appears to be on a good road – but it is a foggy one for both policy makers and investors. The confusion in the data only makes it more likely that the Fed will resist calls either to cut rates soon or to tighten further. It is also an argument for investors to be well diversified despite a continued strong bull market in large-cap U.S. stocks.