Last Monday, the Congressional Budget Office released The Budget and Economic Outlook: 2018 to 2028, the latest installment of an annual report explaining the agency’s budget and economic projections. This week, CBO is publishing daily blog posts to share key excerpts from the report, and today’s post is about the agency’s economic projections. (CBO has also posted a series of slides about those projections.)
In CBO’s projections for 2018 through 2028, the economy follows a marked cyclical path: Economic growth rises notably this year, slows during the next few years, and then rises to match the growth of potential output—the maximum sustainable output of the economy—in the last years of the projection period. Over the next few years, the demand for output exceeds the sustainable supply of output (that is, there is excess demand in the economy). That excess demand pushes up inflation and interest rates and exerts downward pressure on the unemployment rate, which was already below CBO’s estimate of the natural rate of unemployment (the rate arising from all sources other than fluctuations in the economy) at the end of last year. Higher interest rates slow the growth of output, and the excess demand begins to diminish after 2019. By 2022, the excess demand disappears, easing the pressure on inflation, interest rates, and the labor market.
The cyclical path in CBO’s economic forecast reflects recent economic developments; the changes to federal tax policies made by Public Law 115-97, referred to here as the 2017 tax act; recent legislation that increased projected discretionary spending; and the assumption that fiscal policy will generally unfold as scheduled under current law. At the end of last year, the growth rate of the U.S. economy was trending upward, and the slack in the economy—that is, underused productive resources, such as unemployed workers—was almost gone.
The recent tax cuts will, in CBO’s view, increase the supply of labor and capital in the economy, thereby raising potential output throughout the projection period. Nevertheless, because the tax cuts boost after-tax incomes, they, along with the increases in federal spending, are expected to add excess demand in the next few years. Near the end of the projection period, the scheduled expiration of the reduction in tax rates on personal income temporarily and slightly reduces demand in the economy.
CBO’s current projections suggest a stronger economic outlook than those that the agency published in June 2017; in particular, the amount of output is higher throughout the projection period. CBO’s current outlook also is stronger than the consensus outlook of about 50 private-sector forecasters. Although all forecasts involve some degree of uncertainty, CBO’s current projections are particularly uncertain because they incorporate estimates of the likely economic impact of the recent changes in fiscal policy that, although based on past experience, are themselves uncertain.
The Overall Pattern of CBO’s Economic Projections
In CBO’s current projections, both real gross domestic product (or GDP, the total output of goods and services adjusted to remove the effects of inflation) and real potential GDP grow at an average annual rate of 1.9 percent over the 2018–2028 period. Projected growth of real GDP over the next two years is faster than it is during the rest of the projection period. The growth of real potential GDP also is faster over the next few years than it is in later years.
Potential Output. In CBO’s analysis, potential GDP represents the agency’s estimate of the trend around which actual GDP fluctuates over business cycles. Given the state of the economy, the average growth of real potential GDP is the key determinant of CBO’s projection of the average growth of real GDP over the next 11 years.
In CBO’s forecast, real potential GDP grows faster, on average, over the projection period than it has over the past decade. That occurs mainly because the growth in productivity per unit of combined labor and capital services is projected to rise to nearly its average over the past 25 years. But in addition, the agency projects that reductions in marginal income tax rates will boost incentives to work and invest and thereby raise potential output.
At the same time, in CBO’s forecast, the larger federal deficits projected under current law lower national saving and increase the nation’s borrowing from abroad, raising interest rates and thus tending to slow potential output growth by reducing—or crowding out—some capital investment. Finally, the expiration of the cuts in individual income taxes that will, under current law, take effect at the end of 2025, reduces the incentive to work, modestly slowing the growth of hours worked and potential output.
The Outlook for the Next Two Years. CBO projects that recent legislation—the 2017 tax act and the legislation affecting discretionary spending—will strengthen the momentum in household and business spending, adding to the excess demand in the economy. In percentage terms, the resulting gap between real GDP and real potential GDP would be the largest it has been since 2000. Correspondingly, in CBO’s projections, employment picks up considerably this year, and during this year and next, the unemployment rate falls significantly below the agency’s estimate of the natural rate of unemployment, and inflation and interest rates rise.
The Outlook for the Rest of the Projection Period. Rising interest rates and prices, along with the slower growth in federal outlays after 2019 projected under current law, restrain demand and thus keep the growth of actual GDP below the growth of potential GDP from 2020 to 2026, in CBO’s projections. (The excess demand in the economy is eliminated by 2022, and actual GDP returns to a level slightly below potential GDP—the historical relationship between the two measures—by 2024.) The higher marginal tax rates on personal income that follow from the expiration of temporary provisions of the 2017 tax act at the end of calendar year 2025 also contribute to the slower growth in actual GDP in 2025 and 2026 because the reduction in disposable personal income restrains consumer spending (and some consumers change their behavior in anticipation of the rise in taxes). That slower growth, in turn, raises the unemployment rate slightly and somewhat lowers short-term interest rates in those years.
CBO anticipates an end to that episode of slightly slower growth by 2027. In the agency’s projections, the growth of output rises slightly in 2027, once again returning output to its historical level relative to potential output in 2027 and 2028. Also in 2027, the unemployment rate falls and returns to its historical level relative to the natural rate, interest rates rise, and the rate of inflation is 2 percent.
Uncertainty Surrounding the Projections
CBO’s current economic projection is particularly uncertain. The recent changes in fiscal policy add uncertainty to those projections throughout the forecast period. CBO’s estimates of the responses of households and businesses to changes in incentives to work and invest are based on the effects of similar policies in the past, but none of those previous episodes is a perfect guide to the future. Moreover, because many of the recent tax provisions are scheduled to change during the projection period, CBO estimated how individuals and businesses might react to the scheduled shifts in policy. The forecast for economic growth could be understated if capital investment and the labor supply increase more than CBO anticipates in response to changes in the tax code. Conversely, economic growth could be overstated if the incentive effects of the tax changes are smaller than the agency expects.
In the long term, key determinants of long-run growth, such as the labor force, the capital stock (equipment, structures, intellectual property products, and inventories), and productivity, could evolve much differently than expected. In the near term, many developments, including changes in consumer or business confidence or in international conditions and trade agreements, could make economic outcomes differ significantly from CBO’s projections. Although inflation has been low for a long time, it might rise more than CBO expects in response to excess demand over the next few years, causing the Federal Reserve to raise its policy interest rate more than CBO anticipates. History suggests that the risks of recession may increase when the economy’s growth begins to slow over the next few years, especially if, for example, households or businesses take on too much debt during the current upturn.
Comparisons With Other Projections
CBO’s current economic projections differ from those that it published in June 2017. In large part, those differences reflect recent enactment of the 2017 tax act and legislation that increased projected discretionary spending. In particular, CBO now anticipates a more pronounced cyclical pattern of faster growth followed by slower growth over the first half of the projection period, as the current expansion is fortified by a fiscal policy that expands overall demand by significantly more than it expands overall supply in the first few years.
CBO’s estimate of potential output has risen because the 2017 tax act’s changes to incentives increase potential GDP in the early years of the forecast period above the levels that CBO projected in June. That difference diminishes in later years as some of the incentive effects of the tax changes are reversed, but potential output remains higher throughout the period than it was in the agency’s June projections. As economic output returns over the projection period to its average historical level relative to potential output, those higher estimates of potential output translate into projections of actual output that are also higher than the agency projected last summer.
The economic projections in CBO’s report differ somewhat from those of most other forecasters. The agency’s projections for 2018 and 2019 suggest a stronger economic outlook than does the Blue Chip consensus (the average of the roughly 50 forecasts by private-sector economists published in the March 2018 Blue Chip Economic Indicators) or the latest forecasts by Federal Reserve officials.
Kim Kowalewski is a senior adviser and Christopher Williams is an analyst in CBO’s Macroeconomic Analysis Division. The economic forecast was the work of about 20 people at CBO.