Every December, economists are asked for their projections for the coming year. What’s GDP growth going to be? How many jobs will be added? What’s the Fed going to do? How will the financial markets react? We build models of the economy – models that we know are not precise. There are simply too many variables. Those who have studied forecasting in any detail know that a forecast is composed of a point estimate (a value at a certain point in time) and a level of uncertainty around that estimate. In economics, that uncertainty is usually very large, making the point estimate seem almost meaningless. For financial market participants, one should look at point estimates as a base-case scenario and focus on the risks surrounding that outlook. Some uncertainties are known, but there are others, currently unknown, that are sure to come up.
The Federal Reserve employs a lot of very smart people with considerable knowledge of forecasting. However, the Fed’s GDP projections of the last few years have been humbling. Growth estimates for 2011, 2012, and 2013 started out near 4%, only to be whittled down to more disappointing levels. Part of that reflects the nature of the recession. GDP growth projections for the next few years are more moderate.
Looking ahead to 2015, there are a number of key uncertainties. Oil prices are perhaps the most significant. After a sharp drop in the final months of 2014, most expect a new equilibrium in the months ahead – but where exactly? The answer matters a lot. The impact of lower oil prices on the consumer depends on how far prices decline and how long they stay low. The drop is a function of increased supply and decreased demand. However, lower prices will discourage new supply and encourage consumption, a combination which should (eventually) lead prices back up. The path of oil prices will have a significant impact on the economic outlook in 2015.
For Fed policymakers, the impact of lower oil prices on growth and inflation is seen as “transitory.” Overall inflation will be lower in the near term and we could see some small feed-through to core inflation. However, oil prices cannot fall forever. The impact will decrease over time. Lower gasoline prices are expected to help boost consumer spending growth, but that impact is also transitory, showing up mostly in the first half of 2015. Spending patterns will adjust to the new level of oil prices. We’ll need to see a pickup in average wages in the second half of the year to sustain strong growth in consumer spending. That may happen, but it’s hard to predict exactly.
Job growth was strong in 2014, but we didn’t see accompanying strength in areas that are normally associated with job gains, such as consumer spending and housing. Lackluster growth in average wages appears to be the most likely explanation. Average wages have barely kept pace with inflation. Wage growth should pick up as the job market tightens, but while slack is being taken up, a lot remains.
The job market outlook is a key uncertainty for Fed policymakers. While the December 19 monetary policy statement indicated that the Fed can “be patient”in beginning to normalize monetary policy, some Fed officials are more patient than others. Monetary policy affects the economy with a long and variable lag. The Fed sets policy with respect to where it thinks the economy will be 12 to 18 months from now. So, tightening does have to start at some point. However, the risks around the timing of tightening are not symmetric. If the Fed tightens too soon and growth is slower than expected, it will be harder for policymakers to change course. Short-term interest rates will still be low (even after the first couple of rate hikes) and nobody at the Fed wants another round of quantitative easing. If the Fed waits too long and inflation picks up more than intended, officials can then raise short-term rates more rapidly to get back on course. This is a strong argument for being patient and waiting longer to start tightening.
The Fed is focused primarily on the U.S., but it also has to pay attention to what’s going on in the rest of the world. That means anticipating the impact of overseas developments on the U.S. economy and financial markets. At this point, global growth is expected to be a bit soft in 2015, but the risks have been weighted to the downside. Yet, the amount of leverage in the global system is nowhere near where it was at the start of the financial crisis. That suggests that the downside risk to the financial system may be limited. Lower oil prices should have a mixed, but mostly positive impact on the rest of the world.
The 2015 economic outlook will evolve over time as the key issues, oil prices, the job market, and the global economy, become clearer. Best Wishes for a Prosperous New Year!