In this part of the note, we present a set of seven scenarios around the baseline, including (i) a recession scenario, (ii) a stronger than expected economy, (iii) a term premium shock, (iv) an equity premium shock, (v) a weaker-than-expected foreign growth, (vi) an appreciation of the Dollar, and (vii) a higher R* scenario. In part IV of this note, we will discuss the Trump tariff scenario (conditional on Trump being elected). Part I and II of this note are here and here. As usual, we offer a set of scenarios and let the reader assign a probability to each of them.
In the charts below, the red dashed line shows the current model baseline, while the gray solid line shows the constructed scenario.
Note: we have also updated the baseline following the Q3 GDP release. The baseline is not materially different than the previous run, as our Q3 nowcast turned out to be correct.
Scenario#1: Recession scenario
In this scenario, we simulated an exogenous shock (via add factors) that results in a recession. As in previous simulations, the add factors needed to generate a recession are quite large (that is, according to the model, this scenario remains unlikely right now) and in the end we could generate only a mild technical recession (GDP growth (QoQ ar) is -0.4 pct in 2025q2; -0.7 pct in 2025q3 and -0.8 pct in 2025q4). In this scenario, the FF rate falls substantially in 2025 and 2026, the unemployment rate reaches 6% and core inflation undershoots target (even in 2027). See here and here for a full set of results.
Note: the red dashed line shows the current model baseline, while the solid gray line shows the constructed scenario.
Scenario #2: Stronger growth
In this scenario, we assumed a persistently higher growth rate that results in real GDP growth a bit below 3% going forward (again via add factors but similar results are obtained assuming a persistently higher productivity growth). In this scenario, the unemployment rate remains around the current level before falling in 2025 and thereafter. Core inflation reaccelerates at the end of the medium-term and the Fed hikes in 2027. See here and here for a full set of results.
Note: the red dashed line shows the current model baseline, while the solid gray line shows the constructed scenario.
Scenario #3. Term premium shocks
In this scenario, we simulate a one-time 100bps shock to the 10-year premium, 0.75 to the 5-year premium and 0.35 to the 30-year premium. Real GDP growth takes a hit in 2025 (and partially in 2026), before recovering in 2027. The unemployment rate peaks at 4.6% and core inflation approaches target in 2027. Consequently, the FF rate falls more quickly than in the baseline and reaches 2.5% in 2027. See here and here for a full set of results.
Note: the red dashed line shows the current model baseline, while the solid gray line shows the constructed scenario.
Scenario #4: Equity premium shock
In this scenario, we simulate a one-time 100bps shock to the equity premium resulting in a one-time 24pct drop in stock market wealth before gradually returning to the baseline by the end of 2027q4. In this scenario, growth is lower than the baseline, although the impact is overall limited, as the marginal propensity to consume out of wealth stock is very low. See here and here for a full set of results.
Note: the red dashed line shows the current model baseline, while the solid gray line shows the constructed scenario.
Scenario #5: Weaker than expected foreign growth
We simulate a lower-than-expected foreign growth assuming that the level of export is gradually lower than the baseline (13 percentage points lower by the end of 2027q4). Obviously, growth is lower and recovers only at the end of the medium-term. The FF rate is more dovish than in the baseline. See here and here for a full set of results.
Note: the red dashed line shows the current model baseline, while the solid gray line shows the constructed scenario.
Scenario #6. Appreciation of the dollar
In this scenario, we simulate a one-time shock to the level of the broad dollar (10 percent higher than baseline by 2027q4). The appreciation of the dollar lowers growth and put downward pressure on inflation. The unemployment rate peaks at 4.6% and the FF rate is a bit lower than in the baseline. See here and here for a full set of results.
Note: the red dashed line shows the current model baseline, while the solid gray line shows the constructed scenario.
Scenario #7: Higher R*
In this scenario, we raised R* to 1.5%. As a reminder, the model needs an exogenous assumption for R*, which we generally match with the SEP. A higher R* mechanically translates into a higher FF rate at the end of the medium-term. The impact on growth is visible, although limited. The unemployment rate moves sideways. See here and here for a full set of results.
Note: the red dashed line shows the current model baseline, while the solid gray line shows the constructed scenario.
Conclusion. As mentioned at the beginning, we let the reader assign a probability to each scenario. We are happy to discuss each scenario in detail privately or via email. We also remind the reader that we run scenarios on-demand (in case, please get in touch).