This is an excerpt from the complete Economic Outlook feature published earlier. To access the full report, please click here.

Soft data (surveys) and a smattering of hard data are fueling a sense that the economy gained momentum late in 2016 and into early 2017. Nevertheless, a preponderance of hard data indicate growth is softening in the first quarter.

It’s likely that residual seasonality is causing reported first quarter growth to be roughly eight-tenths of a point weaker than its true pace. Meanwhile, equity markets have rallied more than we had expected, juiced by expectations of regulatory relief and fiscal stimulus.

That sense of improved momentum, and firming in inflation of late, encouraged the Fed to move up the first tightening of 2017 to March, as we suggested they would on March. This month we raised our forecast of GDP growth over 2017 one-tenth to 2.4%, up from 2.1% as recently as the forecast we published in early December.

Trump’s tax and spending proposals would have us lean in the direction of more stimulus, but we will continue to wait for more clarity before introducing new fiscal assumptions into the forecast. In this forecast, we expect 2.1% growth, on average, through 2019, a continued downward drift in the unemployment rate to 4.1% by mid-2018 and a gradual rise in core inflation to the Fed’s target for overall PCE inflation of 2% by late 2017.

A gradual removal of accommodation sets short- and long-term rates on a moderate upward trajectory, while the tug of war between rising yields and declining risk premia leave the broad equity market eking out small gains.

Solid momentum, but a soft Q1

• Fourth quarter GDP growth was reported at 1.9%, but the mix of growth showed a large nine-tenths of a point contribution to GDP growth from inventory building. That is not expected to be repeated in Q1, contributing to the softer GDP growth then of just 1.6%.
• PCE growth, which averaged 3.0% over the second half of last year, is projected at 1.9% in the first quarter, a slowing we view as the “pause that refreshes,” rather than the start of a sustained slowing.

“Two plus” growth through 2019 

• GDP is expected to grow 2.1%, averaged over 2017-2019, identical to last month’s forecast.
• Recent strong gains in equities and to a lesser extent home prices, as well as declines in risk spreads reflecting improved risk appetite, are important factors powering consumer spending and business fixed investment. 
• Over the next two years, growth of business fixed investment is expected to be roughly 5%, PCE growth is expected near 2½%, and declining net exports are expected to subtract roughly ½ point per year from growth.

Inflation to reach Fed’s 2% target by 2018

• Core PCE inflation was 1.7% last year, but we are projecting it to rise to 1.9% in 2017, 2.0% in 2018 and 2.1% in 2019. 
• The trend in core inflation is expected to drift higher, as the effects of the recent rise in the dollar and fall in oil prices wane and as inflation expectations pull inflation higher.

Fed policy: Start earlier, but proceed cautiously

• The Fed is on tap for three rate hikes this year, with a reasonable chance that we could see a fourth hike.
• Policy asymmetry, uncertainty about the level of the neutral rate and its forward path, and lagging inflation argue for caution.  With inflation having firmed somewhat ahead of schedule, improved financial conditions and greater growth momentum, there is room for somewhat less caution.
• We view the “terminal” neutral funds rate to be 2¾%.

In this forecast, the 10-yr yield ends 2017 at 2.67% and 2018 at 3.11%

• The S&P 500 rose 9½% last year, and we expect it to increase only about 7% cumulatively over 2017 - 2019.
• Rising risk-free rates pose a formidable headwind, offset by a declining equity risk premium.

This is an excerpt from the complete Economic Outlook feature published earlier. To access the full report, please click here.