CBO Cuts 2018 GDP Outlook, Sees Fewer Fed Rate Hikes

Four months after the CBO surprised US economy watchers by releasing an especially strong outlook for 2018 US GDP, which it said would hit 3.3%, on Monday afternoon in its latest projections, the CBO unexpectedly trimmed its 2018 real GDP forecast to 3.1% citing concerns over rising trade war coupled with higher inflation. The Congressional Budget Office kept its 2019 GDP growth forecast unchanged at 2.4%, and also trimmed its 2020 outlook to 1.7% from 1.8% in April.

While the 2018 cut will come as a disappointment to the Trump administration, it was still 0.6% points faster than the pace of its growth in 2017. The pickup in growth is largely the result of increases in government spending, reductions in taxes, and faster growth in private investment it said.

The catalyst for the cut is the risk of escalating trade war: the CBO admits that "higher tariffs on more imported products could add to inflationary pressure, which in turn would not only reduce the purchasing power of domestic income but also increase the costs of domestic production."

A sizable uncertainty in the U.S. trade and inflation forecast stems from recent changes to U.S. import tariffs and the retaliation of the country’s key trading partners. The renegotiation of the North American Free Trade Agreement (NAFTA) similarly presents the risk that trade and inflation may differ from CBO’s projections.

Meanwhile, “retaliatory tariffs on U.S. exports are likely to reduce the profitability of U.S. businesses whose products are targeted by those tariffs."

The CBO also echoed the Fed's recent warnings noting that the "heightened uncertainty about trade policy could discourage businesses from making capital investments that they might otherwise have made."

It also cautioned that "recent volatility in equity markets might indicate that such uncertainty is already taking a toll on the value of U.S. businesses."

For the second half of the year, CBO expects real GDP to grow at roughly the same average pace as it grew in the first half of the year, which would represent a moderation following the 4.1% annualized growth of GDP reported in the second quarter. Such moderation occurs because several factors that boosted second-quarter growth— including a rebound in the growth of consumer spending from a weak first quarter and a surge in agricultural exports—are expected to either fade or reverse. In 2019, the pace of GDP growth slows to 2.4 percent in the agency’s forecast as growth in business investment and government purchases slows.

The CBO also forecast a continued rise in inflation, noting that gGrowth of actual output is expected to outpace the growth of its maximum sustainable amount through the rest of 2018 and 2019, creating excess demand in the economy. Excess demand will put upward pressure on prices, wages, and interest rates over the next few years. In CBO’s forecast, the growth of actual output slows markedly after 2019 because higher interest rates, along with the slower growth of federal outlays projected under current law, restrain demand. As the excess demand dissipates, the unemployment rate rises and inflation and interest rates fall. By 2022, the CBO sees the excess demand in the economy disappearing altogether.

The CBO also revised down its projections of interest rates over the 2018–2023 period since April in order "to incorporate the current path for discretionary spending as well as to account for new data on financial markets and information from other forecasters." Incorporating the baseline spending path resulted in slower output growth in the near term and a slightly smaller output gap.

The outcome - fewer rate hikes: On the basis of that smaller output gap, CBO projects that the Federal Reserve would raise interest rates fewer times and that short-term interest rates would be lower. Projections of long-term rates, which are based in part on the expected path of short-term rates, were revised down as well.