A quick FRB-US update following the market selloff and rebound. In short: so far, the selloff has limited implications for growth and inflation. For this reason, we think that FOMC participants are watching closely the signals but they are far from panicking. In this sense, we are not surprised by recent communication from Daly (here) and Goolsbee (here): remember, a central bank does not panic. Whether they are right or not, in their minds the increase in the unemployment rate is still benign as the model suggests, and the Fed does not need to rush an emergency meeting for a summer selloff in equities.
What is the effect of an equity selloff in FRB-US?
Figure 1 shows the impulse response function (IRF) of the output gap to a 100bps equity premium shock, equivalent to a 20% drop of the stock market level. In the model, the shock implies about 50bps lower GDP growth (not shown) and almost 4 tenths lower output gap. Therefore, the market correction happened so far (which is about half of the IRF shown in Figure 1) does have implications for growth but they are still limited.
Figure 1. Impulse response function of output gap to an equity premium shock
Updated baseline
Figure 2 shows the updated FRB-US baseline (as usual, the solid blue line is the latest SEP, while the red dashed line is the “inconsistent” model baseline). In this update, we include our nowcast for the unemployment rate and core PCE price inflation in Q3, a 10% drop in the level of stock market, as well as a cut of the FF rate in Q3. The takeaway is clear: the model forecast remains close to the previous run and close to the June SEP. The model expects below consensus GDP growth in Q3 (1.4% QoQ saar), before recovering. Growth remains solid despite the market selloff because monetary policy is more dovish than the SEP, offsetting part of the negative shock. The unemployment rate trends higher (at least in 2024) driven by a positive supply shock, and core PCE price inflation remains a bit above target at the end of the medium-term. The path of the FF rate is more dovish than in the June SEP; the model projects about 50bps of cuts in 2024, 110bps in 2025, and 80-90bps in 2026. Conditional on the model forecast for the unemployment rate and core PCE price inflation, we perceive the risks around the FF rate to be skewed to the downside.
Finally, Figure 3 shows the implied path of selected financial variables: real return on equity, 5y yield, 10y yield, and 30y yield. Please, note that the 10y yield is expected to remain above 4% throughout the entire forecast horizon.
Figure 2. SEP forecast (blue solid line) and FRB-US forecast (red dashed 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 dashed 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. The blue solid lines show the June SEP forecast.
Figure 3. Financial variables – implied by the SEP (blue solid line) and FRB-US forecast (red dashed line)
