FOMC Forecasts Justify More Hawkish Dots, but May Be Too Optimistic
Bottom Line: The FOMC’s more hawkish dots can be seen as a response to economic forecasts being revised upwards while inflation forecasts saw little net change. We and the Fed continue to see one more 25bps tightening in 2023. The Fed has switched to seeing 50bps of easing in 2024 rather than 100bps. We stick with 75bps of easing in 2024, on a view that the economy may underperform the Fed’s upwardly revised projection.
Fed’s updated economic view justified more hawkish dots
Since the FOMC dots were last updated in June, GDP has exceeded expectations, with Q1 revised up, Q2 exceeding expectations and early signals for Q3, particularly from consumers, as stressed by Chairman Jerome Powell in the press conference, looking positive. However, since June’s meeting we have also seen a significant improvement in the tone of the core inflation data, with the June, July and August outcomes significantly slower than the months that preceded them.
The FOMC’s economic forecasts saw 2023 GDP revised up significantly, to 2.1% Q4/Q4 from 1.0%, but core PCE prices were revised down only marginally, to 3.7% from 3.9%, with overall PCE prices revised up, to 3.3% from 3.2%, presumably on recent gains in oil. However the forecasts that caught our eye most were those for unemployment, with Q4 2023 seen at 3.8% rather than 4.1% and 2024 and 2025 seen at 4.1% rather than 4.5%. The Fed now sees unemployment ending 2023 at August’s level and no significant labor market slack emerging in 2024 and 2025, with the long term unemployment rate still seen at 4.0%.
The Fed’s soft landing forecast may be too good to be true
2024 Q4 GDP is seen at 1.5% Q4/Q4, revised up from 1.1% and no more below the 1.8% long run potential than 2023 is seen above it, and GDP is seen growing by this long run rate in 2025 and 2026. The Fed is therefore forecasting a very soft landing, with the economy stabilizing near full employment while inflation slows to the 2.0% target by 2026, with 2024 unrevised at 2.6% and 2025 now seen at 2.3% rather than 2.2%. We have to ask whether this economic forecast is a bit too good to be true, with growth just slow enough to bring inflation back to target, albeit gradually, but not slow enough to move the economy significantly off full employment.
It probably is too good to be true, but whether the disappointment will come from persistently strong inflation or a steeper than expected slowing in the economy is uncertain. We expect the economy to underperform the Fed’s expectation in 2024, with GDP growth positive but below 1.0%. Downside risks are the feed through of past rate hikes, recent gains in oil prices and mortgage rates, the cancellation of student debt relief, and in the near term strikes in the auto industry and an increasing risk of a government shutdown. Given that our GDP forecasts are now weaker than the Fed’s, we maintain a view that 2024 will see 75bps of easing.
Getting inflation back to target will be tough
We expect a little more progress than the Fed on core PCE prices, seeing Q4 2023 at 3.5% rather than the Fed’s view of 3.7% and Q4 2024 at 2.5% rather than the 2.6% seen by the Fed. However we are less convinced that progress in reducing inflation will continue all the way to the 2.0% target in a less globalized environment. The neutral rate may be higher than the 2.5% seen by the Fed, and indeed the dot plot shows an upward skew in the respondents’ view on the neutral rate,
Before then however the skew on the dots is marginally downwards. For 2023 12 see one more 25bps tightening and 7 see no change, meaning that the final 2023 move, to 5.5-5.75%, that we and the Fed both project, is far from a done deal. For both 2024 and 2025 the number of participants below the respective medians exceeds the number above the medians by 3. The 2026 skew is close to balanced. This hints at some downside risk to the Fed's median view that 2024 will see only 50bps of easing. The Fed continues to see 125bps of easing in 2025, though the year end level of 3.75-4.0% is, like the 2024 view, 50bps higher than seen in June. 100bps of easing are seen in 2026, the year-end rate of 2.75-3.0% still above the neutral 2.5%.