Will Fiscal Headwinds Derail the Fed’s Economic Forecasts?

Source: http://www.flickr.com/photos/s4intly/

Source: http://www.flickr.com/photos/s4intly/

The U.S. Federal Reserve surprised markets on September 18 when it announced that it was not, in fact, tapering asset purchases, despite months of consensus speculation to the contrary. The Federal Open Market Committee voted to continue purchasing $40 billion worth of agency mortgage-backed securities and $45 billion worth of longer-term securities per month, signaling that economic conditions — particularly within the labor market — were not yet up to snuff.

The minutes from its September 17-18 policy meeting were released on Wednesday, and the document reveals that mixed data such as “inflation readings that remained below the Committee’s longer-run objective, and the concerns over near-term fiscal uncertainties” ultimately swayed policymakers to wait. Only one member argued in favor of the taper, suggesting that labor market conditions had sufficiently improved and that further delay would hurt the Fed’s credibility.

The Fed was very much aware of the fact that the financial markets were expecting a taper. The minutes reveal that “concerns were raised about the effectiveness of FOMC communications,” and that the various considerations involved in acting against market expectations “made the decision to maintain an unchanged pace of asset purchases at this meeting a relatively close call.”

As far as the economic situation is concerned, both Fed staffers and policymakers appeared generally optimistic: “meeting participants regarded the information received during the intermeeting period as indicating that economic activity had continued to expand at a moderate pace, albeit somewhat more slowly than earlier anticipated, and they generally indicated that the broad contours of the outlook further out had not changed materially since their July meeting.”

Fed policymakers cite the fiscal situation in the U.S. as a headwind throughout the report and it’s still unclear what impact the ongoing partial shutdown of the U.S. government will have on its projections. Projections included in the report were made in September, before the budget impasse, and were likely made under the assumption that the government would not shutdown and that the debt ceiling would be raised. At a glance, the September projections show that overall growth projections have been reduced, employment expectations have improved modestly in the long-run, and inflation expectations have narrowed slightly. Here’s a breakdown.

Gross Domestic Product

Projections for real GDP growth were reduced for 2013 and 2014, while the central tendency for growth in 2015 narrowed slightly. In 2016, the Fed is looking at real GDP growth in a range between 2.5 and 3.3 percent.

Change in real GDP

Central Tendency

2013

2014

2015

2016

Longer run

June projection

2.3 to 2.6

3.0 to 3.5

2.9 to 3.6

n/a

2.3 to 2.5

September projection

2.0 to 2.3

2.9 to 3.1

3.0 to 3.5

2.5 to 3.3

2.2 to 2.5

Real GDP increased at an annual rate of 2.5 percent in the second quarter, according to the Bureau of Economic Analysis. This compares to the 1.1 percent rate of growth recorded in the first quarter and a 0.1 percent growth rate in the fourth quarter of 2012. Alongside consumer spending, rising exports, and real estate spending helped boost the second-quarter numbers even as lower government spending acted as a drag.

The ongoing partial shutdown the of federal government is likely to have a negative impact on fourth-quarter growth, but it’s still not clear exactly how much. The Pentagon has called a large number of furloughed civilian employees back to work, which will reduce the economic drag of the impasse, but with no clear end in sight it appears as if we can expect some meaningful reduction to overall economic activity as a result.

FOMC Projection GDP

Source: U.S. Federal Reserve

Unemployment

Unemployment projections were little changed, but somewhat encouraging is that the lower limit of the central tendency was lowered in both 2013 and 2014. Headline unemployment declined to 7.3 percent in August, already at the upper limit of the Fed’s projection. Data for September has been delayed because of the shutdown, but economists project that the headline rate declined further to 7.2 percent.

Unemployment rate

Central Tendency

2013

2014

2015

2016

Longer run

June projection

7.2 to 7.3

6.5 to 6.8

5.8 to 6.2

n/a

5.2 to 6.0

September projection

7.1 to 7.3

6.4 to 6.8

5.9 to 6.2

5.4 to 5.9

5.2 to 5.8

During the press conference, Bernanke was asked about the impact that a reduction in the labor force participation rate has had on the headline unemployment rate. The labor force participation rate in August was 63.2 percent, down from about 66 percent in the pre-crisis period. While this reduction has had an impact on the headline rate, Bernanke suggested that payroll growth — +169,000 in August — has accounted for most of the decline. Payrolls are estimated to have grown by

FOMC Projection Unemployment

Source: U.S. Federal Reserve

Inflation

Inflation expectations narrowed in 2013 and 2014 and remained unchanged in the longer run. The Fed’s prefers to measure inflation using personal consumption expenditures.

Headline PCE inflation

Central Tendency

2013

2014

2015

2016

Longer run

June projection 0.8 to 1.2 1.4 to 2.0 1.6 to 2.0 n/a 2.0
September projection 1.1 to 1.2 1.3 to 1.8 1.6 to 2.0 1.7 to 2.0 2.0

Staff calculations from the Fed minutes reveal that total U.S. inflation through July averaged about 1.5 percent, below the Fed’s 2 percent target rate. Expectations for longer-term inflation rates remained stable, if still subdued.

FOMC Projection Inflation

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