Forecasters Eye Uncertainties When Sizing Up U.S. Economic Outlook

The first of the year is a natural time for forecasters to take stock of where the economy has been and where it might be going over the next year or so. But peering over the horizon becomes more difficult during times of heightened uncertainty, which has been a key part of the economic landscape during the past several years. And now another source of uncertainty has been added: the COVID-19 (coronavirus) outbreak. With that setup, it’s important to take stock of the things we know and the things we don’t know very well—if at all.

What Do We Know?

By most metrics, the economy continues to expand at a modest pace. In 2019, real gross domestic product (GDP) increased 2.3%, which was modestly slower than growth in 2017 (2.8%) and in 2018 (2.5%). The unemployment rate continues to drift lower: It averaged 3.5% in the fourth quarter of 2019, the lowest rate in more than 50 years. Despite solid growth and a falling unemployment rate, the Federal Open Market Committee’s preferred inflation rate—the headline personal consumption expenditures price index—rose only 1.5% in 2019, a modest step-down from 2018’s inflation rate (1.9%).

Will these good times persist in 2020? One of the first things forecasters do is to assess the economy’s momentum. If the data are uniformly good or have consistently been better than expected, that would be a signal of forward momentum. While never routine nor easy, gauging economic momentum is chiefly done by monitoring the incoming data flows and financial market developments.

First, consumer spending remains a source of strength for the economy, though it was not as strong at the end of 2019 as it was in the middle of the year. The second thing we know is that the labor market remains strong. Job gains were stronger than expected in January—rising by 225,000. Moreover, the strong labor market is continuing to draw in workers from the sidelines. Both the labor force participation rate and the employment-to-population ratio rose to multiyear highs in January 2020. A healthy labor market lifts all boats.

Two other developments are key to the outlook—one signaling optimism and the other registering a note of caution. Regarding the former, housing—which has struggled in recent years—appears to have turned the corner. Both new-home sales and new housing construction (starts) in 2019 were the strongest in a dozen years. Regarding the latter development, manufacturing and business capital spending (fixed investment) have been weak parts of the economy. Importantly, though, the industrial sector’s weakness has yet to derail growth in the services sector. There were signs of a manufacturing rebound in December and January, perhaps because the recent trade agreement with China raised expectations of reduced uncertainty and faster export growth.

The final thing we know is that financial conditions and the stance of monetary policy are supportive of further growth. Federal Reserve Chair Jerome Powell and other Fed officials have emphasized that the “insurance” rate cuts in 2019 helped to put the economy on a more sustainable footing after last year’s recession scare.

Going forward, the consensus of Fed policymakers for the next couple of years is for continued modest real GDP growth (around 2%), a low unemployment rate (below 4%) and an inflation rate at or near the Fed’s 2% target. The consensus of private sector forecasters is generally aligned with the view of Fed policymakers. (See accompanying table.) A reduction in trade tensions with China that lowers uncertainty could provide a boost to the U.S. and global economies. This presents an upside risk to the forecast.

The Unknowns and the Unknowables

But there are also downside risks to the consensus forecast. Some of these risks are known but difficult to accurately quantify. One key risk is the possibility of a recession in 2020. Last year’s yield curve inversion suggests that it might be too early to signal the all-clear. The reason is that historically inversions tend to accurately predict that an economy will eventually go into a recession. However, they are much less accurate at predicting when this will occur. Currently, model-based recession probabilities are elevated, but they are below the levels seen during last fall’s recession scare.

One can envision other risks. These include the risk of another debilitating financial crisis or a marked acceleration in federal debt that leads to higher interest rates or inflation. These risks are real but probably small at present. Still, estimating the probability of their occurrence at any point in time is next to impossible. In this vein, one risk that has unexpectedly cropped up is the threat of a worldwide viral pandemic stemming from the COVID-19 outbreak in China.

From an economic standpoint, this is worrisome because China is the world’s second-largest economy. Moreover, with the highly integrated supply chains that U.S. and foreign manufacturers have developed in China, it is possible that a prolonged outbreak—or worse, if the outbreak turns into a pandemic—could have a nonnegligible effect on the U.S. and other major economies. Thus far, though, the baseline case is that, like recent epidemics, the outbreak will be contained during the first quarter of 2020. If so, the economic effects of the virus on the U.S. economy will probably be quite modest.

Kathryn Bokun, a research associate at the Bank, provided research assistance.