We have updated the FRB-US baseline through Q1. Higher-than-expected long-term yields are beginning to exert downward pressure on growth. Inflation remains persistent, while the unemployment rate is projected to rise starting in Q2 2025. Overall, the trajectory of the federal funds rate closely aligns with the most recent Summary of Economic Projections (SEP), albeit slightly more dovish toward the end of the forecast horizon. Great summary: Fed is on hold for the time being.
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 new dataset and our assumptions
The Federal Reserve Board has (finally) released a new FRB-US dataset, available here. The dataset was created in December, right after the FOMC. Our baseline assumes that real GDP will grow at an annualized rate of 2.5% quarter-over-quarter in Q1, with the unemployment rate averaging 4% and core PCE prices increasing by 2.8% QoQ saar. We have also updated long-term yields to reflect current levels and incorporated a modest shock to core import prices. Lastly, we assume an equilibrium real interest rate (R*) of 1.0%. From Q2 onward, the model evolves endogenously.
The new baseline
Higher yields, lower growth. Figure 1 compares the updated FRB-US baseline (red dashed line) with the January SEP (blue line). Relative to the previous run (see here), real GDP growth has been revised downward and is now projected to remain below potential in 2025 and 2026 (real GDP growth Q4/Q4 is projected at 1.7% in both, 2025 and 2026). This revision primarily reflects the impact of higher yields (discussed in detail later). Consequently, the model has adjusted the unemployment rate forecast upward, now anticipating a gradual increase beginning in the second half of 2025.
At the same time, core PCE price inflation remains persistently above target through the medium term. Taken together, the implied trajectory of the federal funds rate closely mirrors the SEP, albeit with a slightly more dovish tilt toward the end of the forecast horizon.
Figure 1. SEP forecast (blue solid line) and FRB-US forecast (red dashed line)
Note: Real GDP growth and core inflation are expressed on a year-over-year basis. Core inflation refers to core PCE price inflation. The blue lines represent the latest SEP projections, while the red dashed lines depict the “inconsistent FRB-US” forecast—i.e., the model-based baseline without the Fed staff’s add-factors used to align with the latest SEP. This forecast has been updated as outlined in the text.
Figure 2. Path for the 5y, 10y, 30y yield, and real expected return on equity.
Note: SEP forecast (blue solid line) and FRB-US forecast (red dashed line)
Why is real GDP growth now lower than the previous run and the SEP?
Higher long-term yields, lower growth. Long-term yields are a key driver of both model dynamics and real-world economic estimates. As a reference, we estimate that a 100bps increase in the term premium (10-year yield) reduces the output gap by approximately 0.7 percentage points (see FRB-US Ping simulations, page 3 here). Compared to the SEP-consistent database, long-term yields are now about 60bps higher (see Figure 2). As a result, the model has revised down real GDP growth projections for 2025 and 2026. As a reference, the reader can see the FRB-US baseline prior to the inclusion of higher yields here. Without higher yields, the new FRB-US baseline would be in line with the recent SEP for real GDP growth.
Part II
Can DOGE trigger a recession in this environment? Are the fiscal simulations different now? What are the implications of a shock to the level of population? Etc.. We will answer these questions in part II of this note.