In part I of the note (here), we have shown the new baseline through 2024:Q1. In this note, we show the updated baseline, given the incoming data, the stochastic simulations around the baseline, and we simulate 8 scenarios going forward. The scenarios include (i) a recession, (ii) a stronger-than-expected GDP growth, (iii) a term premium shock, (iv) an equity premium shock, (v) stronger-than-expected foreign growth, (vi) a shock to the Dollar, (vii) a higher R* scenario, (viii) and a shock to the population growth rate. We let the reader assign a probability to each scenario.
If the reader has questions, please direct them to our FRB-US specialist: Tilda Horvath (tilda.horvath@underlyinginflation.com). Tilda has programmed FRB-US at the Board and managed the model for almost 20 years. We remind the reader that we run ad-hoc scenarios using FRB-US free of charge. Do not be shy.
The updated baseline and the stochastic simulations
The incoming data since our previous note have not modified the baseline. FRB-US expects the FF rate at 5.1% in 2024:Q4, 4.5% in 2025:Q4, and 3.7% in 2026:Q4. Figure 1 shows the updated baseline, while Figure 2 shows the stochastic simulations around the baseline. Following standard procedures of the Fed staff we draw randomly from historical errors (1970q1 to 2017q4) for 54 variables and 5,000 replications. The takeaway is the same of recent quarters. According to FRB-US, it is pretty unlikely to have a recession, and the probability of returning to target in core PCE space is quite low.
Figure 1. SEP forecast (blue line) and FRB-US forecast (red line)
Note: Real GDP growth and core inflation are expressed as YoY. Core inflation is core PCE price inflation. The blue lines show the latest SEP. The red lines show the “inconsistent FRB-US” forecast (the current baseline), that is the model-based forecast removing the “add-factors” put by the Fed staff to match the latest SEP, updated as specified in the text.
Figure 2. Stochastic simulations around the baseline.
Note: Real GDP growth and core inflation are expressed as YoY. Core inflation is core PCE price inflation.
Scenarios
We have run a large set of scenarios. We present the results of 8 of them. We remind the reader that we can simulate any scenario on-demand. The reader can also see the impulse response functions to a set of shocks here (“PING” program in FRB-US). As usual, we can provide via email the data of each scenario, as well as a PDF containing the path of the financial variables (i.e. 10y yield) implied by each scenario.
- Scenario #1: a recession. In this scenario we forced the YoY of real GDP growth to be negative at some point in 2025. As mentioned above, in order to achieve this goal, we had to fold-in a (very unlikely) path for private consumption and investment starting from the current quarter assuming exogenous shocks. Even so, the resulting recession is very mild. The reader can see the path of real GDP growth (red line is the baseline, grey line is the scenario). In this scenario the unemployment rate increases to 5¾ in 2026.
- Scenario #2: a stronger-than-expected real GDP growth. As in scenario #1, we simulated an exogenous shock to private consumption and investment that keeps real GDP growth above potential. In this case, the unemployment rate peaks at the end of 2024 at 4.0% and then gradually moves down in 2025 and 2026, while core PCE remains above target at the end of the medium-term. Overall, this scenario is more hawkish (“for longer”) than the baseline, according to the Taylor rule of FRB-US.
- Scenario #3: a term premium shock. In this scenario we simulated a one-time 100bps shock to the 10y yield (75bps to the 5y yield, and 35bps to the 30y yield). According to the model, this shock helps the Fed and lowers growth (but again, no recession). Core inflation is a bit lower and the unemployment rate increases to 4.6% in 2026.
- Scenario #4: an equity premium shock. In this scenario we assumed an exogenous one-time 100bps shock to the equity premium. As expected, this shock lowers real GDP growth a bit and results in a more dovish path of the FF rate. In any case, real GDP growth remains well above 1% in 2025 and quickly returns around potential in 2026. For the record, we simulated also a combined term-premium and equity premium shock and even in this scenario there is no recession, according to FRB-US.
- Scenario #5: stronger-than-expected foreign growth. In this case, we assumed that foreign growth is stronger and that the level of US real exports will be 10% higher by the end of 2026:Q4. Needless to say, the result is a more hawkish path of the FF rate, both because the unemployment rate peaks at 4% (before declining a bit), and core PCE price inflation remains above target.
- Scenario #6: a 10% depreciation of the dollar. A lower Dollar is stimulative for the US economy: real GDP growth is higher than in the baseline, the unemployment rate peaks around 4%, but core PCE price inflation is higher than the baseline (and remains around 2¾ percent at the end of 2026). Consequently, the path of the FF rate is well more hawkish than the baseline.
- Scenario #7: a higher R*. In the baseline, we have assumed R*=0.8%, in anticipation of future upward revisions in the SEP. In this scenario, we pushed R* to 1.2%, the double of the March SEP, and close to Loretta Mester’s view. As expected, the path of the FF rate is above the baseline. The interesting feature, already signaled in previous communication, is that a higher R* does not translate in additional hikes but in a “for longer” message (at the end of 2026 the difference between the red line and the grey line in the chart below is basically equivalent to the gap between the assumed R*s).
- Scenario #8: lower population growth. Given the recent shock to the size of the US population, we simulated a shock that gradually shaves off about 1% of (working age) population growth by the end of the forecast horizon (1% is about 3mln people). This negative supply shock results in lower growth (and lower potential), a higher unemployment rate, and a slightly more dovish FF rate.
