Despite the reported softening in GDP growth in the first quarter of this year, we believe growth will pick up, with GDP rising 2.3% (Q4-over-Q4) in 2017 compared to last year’s 1.9%, and continuing at 2.1% in 2018.1. The recent improvement in financial conditions, continued narrowing of risk spreads and some pre-Trump fiscal stimulus all contribute to continued above-trend growth.
This modestly above-trend pace will further tighten the labor market, with the unemployment rate expected to decline to 4.3% by the end of this year and to 4.1% by mid-2018. That will help to nudge inflation (by the core PCE measure) to 2% or a little above for the next two years.
Growth over the first half will be quite uneven with GDP expected to rise near 1% in Q1 and close to 3½% in Q2, largely due to weather effects and residual seasonality. Nevertheless, a sense of improved near-term momentum, and a firming in inflation of late encouraged the Fed to raise the fed funds target in March and coalesce around an earlier start to reducing the Fed’s balance sheet, likely later this year. Yes, it’s policy moves are still “data dependent!”
We continue to expect gradual increases in the Fed funds rate close to what the Fed’s own “dots” chart indicates, a pace of rate hikes that will keep term Treasury yields on a modestly rising track. Equities, having gotten a bit ahead of things, are expected to remain in a sideways waffle through 2019.
A soft Q1, followed by stronger growth
- GDP grew at a 2.1% rate in the fourth quarter, boosted by a full percentage-point contribution from a step-up in the pace of inventory building. We expect a partial reversal in Q1, contributing to the softer GDP growth of just 1.0%.
- Because mild weather reduced utility usage, PCE growth is projected at 1.0% in Q1, also contributing to the tepid pace of GDP growth. A return to seasonal norms in Q2 would boost PCE growth to 3.8%, and GDP growth to 3.6%.
“Two plus” growth through 2019
- We continue to expect GDP growth of 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 we expect growth of business fixed investment to average roughly 5¼%, PCE growth to average about 2½% and declining net exports 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, and likely will begin to phase in passive run-off of its balance sheet.
- Policy asymmetry, uncertainty about the neutral fed funds rate and its forward path, and inflation still below target argue for caution in removing accommodation. With inflation having firmed somewhat recently, improved financial conditions and greater growth momentum, there is room for somewhat less caution than previously.
- We view the “terminal” neutral funds rate to be 2¾%-3.0%.
- In this forecast, the 10-yr yield ends 2017 at 2.67% and 2018 at 3.06%.
The S&P 500 rose 9½% last year, and we expect it to increase only about 6½% cumulatively over 2017 - 2019.
Rising risk-free rates pose a formidable headwind, offset by a declining equity risk premium. If Trump can deliver promised tax cuts, equities could show more strength.
This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here.