Keep in mind
According to the June SEP, the FOMC expects the output gap to remain constant in 2022-2024 but the unemployment gap to shrink. Therefore, the June SEP forecast is inconsistent with the Okun law, which is an empirical regularity of US data. On the other hand, according to the minutes, the Fed staff is more pessimistic about real activity and expects the output gap to shrink “significantly this year and a little further next year”. Despite the more pessimistic scenario for growth, the Fed staff revised up its core PCE price inflation forecast at the June meeting (including its estimate of pi*), sent a hawkish signal to the FOMC and it is unlikely to pivot dovish soon. Consequently, in our view the FOMC is likely to revise down its GDP forecast for 2022-2024 but it is unlikely to pivot dovish during the summer given the signals it received from the Fed staff.
The Okun law
The Okun law is an empirical regularity between the change of the unemployment gap (the deviation of the unemployment rate from its natural rate), and the change of the output gap (the deviation of real output from its long-run potential). Several studies have documented the importance of the Okun law using US data (Wen and Chen (2012), Daly and Hobijn (2010), Daly et al. (2014), Knotek (2007)) and estimated the Okun law coefficient in the neighborhood of -2 (the output gap is expected to change by 2 percentage points every percentage point of unemployment gap).
The Okun law and the Fed staff forecast
As documented by public papers and past Tealbooks, the Okun law is crucial in the Fed staff forecast. For instance, Barbarino et al. (2020) write: “Among the models we consider, those that include an Okun’s law relationship, relating the unemployment rate’s deviation from its trend to the output gap, are overall quite similar to the Tealbook output gap estimate. They provide a stable and reliable estimate of the cyclical position of the economy, and are consistently among the best performers along a number of economic considerations, suggesting that they have the ability to inform policy in a meaningful way.” (Board of Governors of the Federal Reserve System, Staff Working Paper). Indeed, past Tealbook datasets (available here) reveal that the Fed staff has a tendency to forecast the path of the unemployment rate (for a given U*) following the Okun law. (The reader can look at the ”Greensheets”, Part A, table “Changes in GDP, Prices, and Unemployment” and notice that the expected changes in real GDP growth are correlated to the expected changes in the unemployment rate with a coefficient in line with the Okun law).
The June FOMC round: the SEP
At the time of the June FOMC, the Committee expected real GDP growth to be close to potential throughout the entire forecast. Specifically, the Committee expected real GDP growth to be 1.7% in 2022 and 2023, and 1.9% in 2024 (with an estimate of long-run potential growth of 1.8%). Because the FOMC does not publish the participants’ view about the level of potential GDP, we do not know its estimate of the output gap. In any case, no matter what was the assessment of the level, the June SEP implies a constant output gap over the forecast horizon (because, as mentioned, real GDP was forecasted to growth at the same rate of potential output, on average). However, at the same time the Committee projected the unemployment gap to shrink from -0.3% in 2022 to +0.1% in 2024. Therefore, the June 2022 SEP forecast is inconsistent with the Okun law: conditional on the FOMC unemployment rate forecast, real GDP growth was too optimistic. (a real GDP growth forecast Okun law-consistent would have been about 3 tenths lower in each year)
The June FOMC round: the Fed staff
The Fed staff forecast inferred from the FOMC minutes is less optimistic than the SEP. According to the staff: “Monetary policy was assumed to be less accommodative than in the previous projection, and the recent and prospective tightening of financial conditions led the staff to reduce its GDP growth forecast for the second half of 2022 and for 2023. The level of real GDP was still expected to remain well above potential over the projection period, though the gap was projected to narrow significantly this year and to narrow a little further next year.” (page 6, June 2022 FOMC Minutes). Therefore, we can deduce that the Fed staff has written a real GDP forecast well below potential for 2022 and a bit below potential for 2023 and 2024. Consequently, we can deduce that the Fed staff is forecasting the unemployment rate to increase to at least 4.0% by 2024 (and probably higher given that, in our view, the staff has revised up its estimate of U*). Reminder: the literature (Romer andRomer (2000, 2008), Sims (2002), or Faust and Wright (2009)) has pointed out that the Fed staff forecast tends to be more accurate than the SEP forecast.
Implications for the inflation forecast
Both the Fed staff and the FOMC have revised up their core inflation forecast at the June round despite the downward revision to GDP growth. The two inflation forecasts are now very similar. The upward revision of the Fed staff (1 tenth in each year) is cosmetic in 2022 but it does contain some signal in 2023 and 2024. In our view, in fact, the Fed staff has revised up marginally its estimate of pi*, which depends on recent actual inflation, long-term inflation expectations, and the behavior of wage inflation (our experience tells us that the Fed staff is very careful in revising the inflation forecast at the end of the medium-term horizon; any change is discussed in details because of the message it sends to the FOMC). In our view the Fed staff has sent the following message to the FOMC: inflation is too high and there is a risk that, if it continues, it will result in a permanently higher rate. This development is significant because the staff forecast, as mentioned, assumes a (significantly) more pessimistic trajectory for real activity than the SEP. But still, inflation does not converge back to target in 2024 in the latest Tealbook (as inferred from the minutes).
Conclusion
In our view, the latest news from the Eccles building is significant because the Fed staff is unlikely to pivot dovish soon: inflation is too high and pi* is moving higher. In our view, the FOMC is likely to revise down its GDP forecast (not only for 2022 but also for 2023 and 2024) but unlikely to revise its inflation forecast for now, unless we get a significant deceleration of observed inflation first (ad-hoc post on used cars prices coming soon). Needless to say, in this context, the risk for the Fed staff and the FOMC is to be late and over aggressive (inflation is mostly a lagging indicator). But the signal that the Fed staff is sending is clear: the risk on the inflation front is too high.
The FOMC must kill inflation, no matter what. Damned if they do it, damned if they don’t.