Real GDP stays near potential

The Bush administration, through the Council of Economic Advisers (CEA), released revisions last week to its economic forecast. The administration releases economic forecasts twice a year and the forecasts play a significant role in the administration’s budget proposals. The forecast released by the CEA is a joint effort of the CEA, the Department of the Treasury, and the Office of Management and Budget.

There were no dramatic changes in the forecast numbers from the prior forecast released in November 2006.  According to Edward Lazear, chairman of the CEA, the biggest change was incorporating the nearly flat first quarter GDP number into the forecast.

“The forecast revises the projection of real gross domestic product (GDP) down from 2.9 percent growth to 2.3 percent during the four quarters of 2007. This revision incorporates the slower growth that occurred in the first quarter of the year with the expectation that solid growth will resume for the rest of 2007.”

Given that first quarter real GDP came in at 0.6 percent annualized, and the CEA projects 2.3 percent growth for 2007 overall, this backs out to growth for the remaining three quarters coming in at 2.9 percent annualized. The CEA anticipates that real GDP growth will be 3.1 percent in both 2008 and 2009. Basically, the CEA sees the economy growing right at potential over the forecast horizon. Many economists view potential GDP at 3.0 percent and the Fed is counting on somewhat below potential economic growth to help ease inflation.

Inflation expected to ease

The CEA’s forecast for overall CPI inflation calls for a notable drop in 2008 from a spike in 2007 and then a gradually easing over the next two years. Higher energy prices this year have boosted the CPI forecast for 2007 to 3.2 percent from the November estimate of 2.6 percent. An unwinding of some of these energy increases is expected to bring the CPI down to 2.5 percent in 2008. By 2010, the CPI is seen being in line with the core CPI (not published) and edging down to 2.3 percent. Given that the CPI tends to run about a quarter percentage point higher than the PCE price index, such a rate would be at the top of the Fed’s inflation target of 1 to 2 percent for the core PCE price index.

Labor markets remain tight

The CEA’s forecast for nonfarm payroll employment is 131,000 per month in 2007, 130,000 per month in 2008, and 122,000 per month in 2009. These figures are only slightly lower than in the November 2006 forecast. How do these job growth numbers compare to trends with unemployment?

While nonfarm payroll employment is not the same as employment in the household employment survey (which includes the unemployment rate), the two are usually treated as the same or very similarly for forecasting purposes. One can infer the relative strength of labor force growth to employment growth from changes in the unemployment rate. For example, the unemployment rate jumps from 4.5 percent in 2007 to 4.7 percent in 2008 even though employment growth is steady in 2008. As such, the unemployment rate is boosted by an implied jump in labor force growth. This may or may not be a contrived outcome so that there is healthy employment growth but some modest loosening in labor market tightness. Essentially, the CEA is simply asserting that the unemployment rate will rise in 2008 even though real GDP growth picks up in 2008 and employment growth is steady.  The only way for the unemployment rate to go up is to forecast a spurt in labor force growth so that it outpaces employment growth. The slightly higher unemployment rate may be intended as a justification for the easing in inflation.

Short rates ease while long rates firm

The Administration sees only a modest decline in the 3-month T-bill – from 4.8 percent in 2007 to 4.6 percent in 2008. This likely would be consistent with only one cut in the fed funds target in early 2008 or possibly late 2007. However, based on recent actions by central banks in New Zealand and by the European Central Bank, short rates may be headed higher instead of down.

While short rates are easing over the forecast horizon, long rates are headed in the other direction. The 10-year Treasury note is forecast to rise 10 basis points in each of the next three years. This is not a huge firming and likely reflects continued healthy consumer demand for loanable funds and moderately strong business investment.

The higher long-term rates are consistent with a strong economy. Apparently, the CEA does not believe there is a rising inflation premium in the 10-year T-note since the CEA is forecasting an easing in inflation over this same period.

Bottom Line

The CEA’s latest economic forecast is not dramatically different from many private forecasts.  However, around the edges there are some question marks. The combined nudging of various forecast components may not stick together further out in the forecast range. Is it realistic to expect trend economic growth over the forecast horizon, a still tight labor market, and for inflation to ease? With foreign central banks in a tightening mood, the forecast for lower short-term rates next year may miss significantly. The CEA probably has the rest of 2007 about right. But if real growth is as forecast, then the Fed will likely have to nudge rates up a bit late this year or early in 2008.