Fed macro projections hint at higher GDP, but higher rates too

22 Sep 2023 , 04:25 PM

The first outcome was the Fed statement holding status quo on rates. Another equally important outcome of the meeting was the quarterly projections issued by the members of the Fed on key macro parameters. Typically, the Fed members offer projections on the consumer inflation, PCE inflation, core PCE inflation, GDP and jobs or employment data. Fed members offer their projections based on the past data flows and their own well-honed assessments on each of these parameters. 

The quarterly data projections are put out by the Fed each quarter and offer estimates for the next 4 calendar years as well as the long term. These data projections are then juxtaposed with the new projections every quarter to assess the colour and direction of the macro data. The September 2023 projections are presented in the form of median projections of the various members to provide a consensus view. Such projections are also compared with the June 2023 projections to get an idea which way the macro winds are blowing in the US economy. Here is a quick review of the key data points and the projections put out by the FOMC for the September 2023 quarter.

Let us start with a recap of key data point actuals

Here is a quick recap of the data points of the last 5 years. These are actuals and based on actual data flows. The key data points are captured in the table below.

Variable	CY-2018	CY-2019	CY-2020	CY-2021	CY-2022
Real GDP Growth	2.3%	2.6%	-1.5%	5.7%	0.9%
Unemployment Rate	3.8%	3.6%	6.8%	4.2%	3.6%
PCE Inflation	2.0%	1.5%	1.2%	5.7%	5.7%
Core PCE Inflation	2.0%	1.6%	1.4%	4.7%	4.8%

Data Source: US Federal Reserve (CY refers to calendar year)

What do we read from the table of historic variables. Let us start with the real GDP first. GDP had been consistent under 3% till 2019. However, COVID led to the real GDP growth slipping to the negative zone of -1.5%. Now, the 5.7% GDP growth in 2021 may be slightly misleading as it comes on a negative base. However, the real data point to watch is the 2022 real GDP growth, which fell sharply to 0.9%. The impact did not come as much from slowing of nominal GDP, but it came from higher levels of inflation. To an extent, growth pressures also came from the start of hawkishness and the Russia war, that created supply chain disruptions to a large extent.

Let us turn to the unemployment rate. Interestingly, the unemployment rate has been the big beneficiary of the pandemic. The surge in liquidity has seen heavy demand for workers and that has been the story even as other macros like inflation and GDP growth were going through cycles. The spike in the rate of unemployment in 2020 is misleading as it came under the severe stress imposed by the COVID pandemic. In 2023, the unemployment rate has dipped even lower as the demand for jobs has continued to outpace supply.

Finally, let us look back at inflation, which has been the real talking point in the last couple of years. The Fed looks at PCE (private consumption expenditure) based inflation and not the regular consumer inflation. While the consumer inflation is reported in the middle of next month, the PCE inflation is reported towards the end of the next month. The combination of supply chain constraints and a surge in demand led to a spike in inflation to 5.7% for 2021 and 2022. It was this spike that added to the urgency of the rate hikes announced by the US Fed. Inflation for 2023 is expected to be lower, but still far from the low levels of 2018 and 2019. Core PCE inflation (net of food and fuel inflation) has continued to rise, largely an outcome of supply chain constraints.

What the FOMC members are projecting for coming years

The table below has 4 parts. The first part is the projections of these key macro variables for the next 4 calendar years i.e., CY2023, CY2024, CY2025 and CY2026. In addition, the second part is the long term sustainable projection for each variable, which is the median rate that is expected to sustain in the long run. The third part of this table is the comparison with the June projection of each variable for each of the years. Finally, the table below also comprises of the outcome of all these data points. That is how the interplay of these data points would eventually impact the Fed rates over the years.

Variable	CY-2023	CY-2024	CY-2025	CY-2026	Longer run
Change in real GDP (Sep-23)	2.10	1.50	1.80	1.80	1.80
June projection	1.00	1.10	1.80		1.80
Unemployment rate (Sep-23)	3.80	4.10	4.10	4.00	4.00
June projection	4.10	4.50	4.50		4.00
PCE inflation (Sep-23)	3.30	2.50	2.20	2.00	2.00
June projection	3.20	2.50	2.10		2.00
Core PCE inflation (Sep-23)	3.70	2.60	2.30	2.00
June projection	3.90	2.60	2.20
Federal funds rate (Sep-23)	5.60	5.10	3.90	2.90	2.50
June projection	5.60	4.60	3.40		2.50

 

Data Source: US Federal Reserve (CY refers to calendar year)

That is a rather comprehensive projection of key data points for the next 4 years as well as the long term projections. Here are the key takeaways from an analytical perspective.

1. Let us first talk about the GDP growth projected for the coming years. For the current year CY2023, the real GDP is expected to grow by 2.1%. This is likely to be largely helped by the sharp fall in retail inflation. However, the real GDP growth is likely to taper to 1.50% in 2024, but bounce back to 1.80% for 2025 and 2026, which will also be the long term equilibrium GDP growth rate that the FOMC members are looking at.

    

2. Let us quickly turn to how the GDP growth projections for the next few years compares with the projections made in June 2023. There is a clearly buoyancy visible. For example, for 2023, the June GDP growth projection was just 1%, which has been upped to 2.1% in September 2023. Similarly, the GDP projections for 2024 is also upped sharply from 1.1% to 1.5% compared to the June 2023 projections. GDP growth is likely to stabilize at 1.80% after that, as projected in June. This is a clear indication that the fears of recession may be largely misplaced and the Fed should be able to control inflation, even while it manages a soft landing of the US economy.

    

3. Let us turn to the unemployment projections for the coming years. For the current year CY2023, the unemployment rate is expected at 3.8%. This is likely to be largely helped by demand for jobs still exceeding the supply of jobs in the US market. However, the unemployment rate is likely to increase to 4.1% in 2024, but taper back to 4.0% for 2025 and 2026, which will also be the long term equilibrium unemployment rate that the FOMC members are projecting.

    

4. Let us quickly turn to how the unemployment rate for the next few years compares with the projections made in June 2023. In line with the strong GDP data, even the jobs situation is seen as robust. For example, for 2023, the June unemployment rate projection was 4.1%, which has now bene cut to 3.8% in September 2023. Similarly, the GDP projections for 2024 and 2025 is also cut from 4.5% to 4.1% compared to the June 2023 projections. The projections for the unemployment rate for 2026 and beyond are seen at 4.0%. This is once again a clear indication that the fears of recession may be largely misplaced as that is not in sync with such strong labour data. As said previously, the Fed could just about manage to tame inflation, without a hard landing risk.

    

5. Let us turn to the PCE inflation and the core PCE inflation projections for the coming years. For the current year CY2023, the PCE inflation at 3.3% with core PCE inflation higher at 3.7%. However, PCE headline inflation is expected to taper to 2.5% in 2024 and to 2.2% in 2025. For years 2026 and beyond, the inflation is likely to be at the target of 2%, although many economists still have their doubts about such lofty projections. Core PCE inflation is likely to come down more gradually to 2.6% and 2.3% before tapering and settling at 2% for the long term. This is one factor which the Fed has been really struggling to contain.

    

6. How do the inflation projections compare with the story in June 2023? The inflation has clearly proved to be tougher than imagined and in most cases, there is an uptick in inflation compared to June 2023 projections. For example, September projection of headline inflation is 3.3% compared to 3.2% in June while the projection for core PCE inflation is 3.7%, which is lower than the 3.9% projected in June 2023. While the projections for inflation and core PCE inflation have bene static for 2024, they have been again upped by 10 bps in 2025. This is a clear signal that the challenge of inflation is going to be a lot more complex to handle. As one quick goes on Wall Street, soft landing now looks a lot easier than containing inflation.

What does this mean for interest rate projections

One of the major outcomes of these projections, as is evident from the dot plot charts, is that Fed rates are likely to remain at higher levels for much longer. They are not going to come down in a hurry. Even the cuts in rates projected for next year would be more calibrated. The interest rate projections for 2023 at 5.6% are at the same level as June 2023. However, the rate projections for 2024 and 2025 are up by 50 bps each at 5.10% and 3.90% respectively. Even in 2026, the rates are likely to be at 2.9%, which his well above the neutral rate of 2.5% (When rates are above neutral rates, it is likely to impair GDP growth). That is the major takeaway from the September projections. Rates are likely to stay at elevated for much longer than originally anticipated. Hawkishness is here to stay.