2012:3--2022:4 (42 quarters)

Data

The forecast is based on the national income and product accounts (NIPA) data that were released on July 27, 2012.

The Latest Version of the US Model

For purposes of this forecast the US model has been reestimated through 2012:2. These estimates and the complete specification of the model are presented in Appendix A: The US Model: July 27, 2012, which is an update of Appendix A in Fair (2004).

Beginning with the forecast dated October 31, 2005, some specification changes have been made to the US model from the version in Fair (2004). These are explained in Changes to the US Model Since 2004.

Unless otherwise noted, the flow variables in the model are presented in this memo and on the site at quarterly rates. This is a change from versions dated July 31, 2011, and back, where the flow variables were presented at annual rates. To convert quarterly rates to annual rates, just multiply by four.

Assumptions Behind the Forecast

The table below gives the growth rates that were assumed for the key exogenous variables in the model along with the actual growth rates between 1989:4 and 2007:4 (before the stimulus measures beginning in 2008).

                 Growth Rates (annual rates)

           Forecast                         Actual     
          Assumptions                   2007:4-1989:4  

TRGHQ         4.0                            3.9       
COG           3.0                            2.4       
JG            1.0                           -0.7       
TRGSQ         2.0                            5.2       
TRSHQ         8.0                            5.6       
COS           1.0                            3.7       
JS            1.0                            1.5       
EX            7.0                            6.0
PIM           2.0                            1.2

The first seven variables are the main government policy variables in the model aside from tax rates. TRGHQ is real federal government transfer payments to households, COG is real federal government purchases of goods, JG is federal government civilian employment, TRGSQ is real federal government transfer payments to state and local governments, TRSHQ is real state and local government transfer payments to households, COS is real state and local government purchases of goods, JS is state and local government employment, EX is real exports, and PIM is the import price deflator.

All tax rates were taken to remain unchanged from their 2012:1 values except for D4G, the employee social security tax rate. Because the payroll tax cut was extended through the end of 2012, D4G was taken to be unchanged from its 2011:4 value through the fourth quarter of 2012 and then to return to its value in 2010:4 for the first quarter of 2013 on.

Implicit in this treatment of the tax rates is the assumption that the Bush tax cuts remain in place throughout the forecast horizon (since tax rates are assumed to remain unchanged from current values except for the payroll tax). Also, no attempt is made to account for future fiscal policy changes that are in the debt ceiling bill. Most of any spending cuts or tax increases are not likely to begin until 2014, and as of now (July 27, 2012) it is unclear what will be done. The present forecast is thus a forecast conditional on no future spending cuts and tax increases. It is a base forecast from which experiments can be run regarding spending cuts and tax increases.

The above assumptions regarding the state and local government variables result in roughly balanced budgets over time in the forecast.

No assumption is needed about monetary policy for the forecast because monetary policy is endogenous. Monetary policy is determined by equation 30, an estimated interest rate reaction function or rule.

The Forecast

Forecasts of selected variables are presented in the following: Forecasts of selected variables---html, Forecasts of selected variables---pdf file. If you want more detail, click "Solve current version" after "US Model," create a data set, and then go immediately to "Examine the results without solving the model." You can then examine any variable in the model.

Real GDP Growth and the Unemployment Rate: The forecast has real GDP growing at 3.4, 4.8, 4.8, and 4.6 percent in the next four quarters, respectively, and then at about 4.5 percent for the year after that. (All growth rates in this memo are at annual rates.) The unemployment rate falls to 7.3 percent by the end of 2013. The jobs variable, JF, shows jobs rising by 2.46 million in the next four quarters, an average of about 200 thousand per month.

Inflation: Inflation as measured by the growth of the GDP deflator (GDPD) rises to 3.2 percent by the end of 2013.

Monetary Policy: The estimated interest rate rule (equation 30) is predicting that the three month bill rate (RS) will begin gradually rising by the end of 2012. At the end of 2013 it is 1.0 percent.

Federal Government Budget: The nominal federal government budget deficit on a NIPA basis, variable -SGP, is predicted to be about a trillion dollars at an annual rate for the next three years and then to rise thereafter. It rises to $1.8 trillion by 2022. The federal government debt, variable -AG, is $24.7 trillion at the end of 2022, which is 76.9 percent of nominal GDP (variable AGZGDP in the model). This is up from 35.4 percent in 2007:1. Interest payments of the federal government, variable INTG, rise from an annual rate of $322.4 billion in 2012:1 to $1.427 trillion in 2022:4 as a result of the increasing debt and rising interest rates. At the end of 2022 the ratio of INTG to GDP (variable INTGZGDP) is 4.4 percent.

U.S. Current Account: The deficit in the U.S. current account, variable -SR, falls for the next four quarters and then is fairly constant throughout the rest of the forecast period.

Comments on the Forecast and Possible Experiments to Run

The main message from the current forecast is that if there are no bad shocks, the economy grows well in the near future. By the end of 2013 the unemployment rate is down to 7.3 percent. This is more optimistic than the current consensus view about the future course of the economy. However, the strong growth forecast is not surprising given the model. Monetary and fiscal policy are expansionary, and physical stocks that were drawn down during the recession are predicted to be built up. Without any bad shocks assumed, it is thus not surprising that the model predicts a moderately strong recovery. Also, as mentioned above, no government spending cuts or tax increases are assumed for the forecast.

The assumption of no bad shocks, which is used for the forecast, means that stock prices, housing prices, and import prices grow at historically normal rates. There are no negative wealth shocks through falling stock prices and housing prices and no positive price shocks through rapidly rising import prices (due, say, to a depreciating dollar and/or rising dollar oil prices). Asset prices like stock prices, housing prices, exchange rates, and oil prices are essentially unpredictable. One can use the US model to analyize the effects of asset price shocks, but the shocks themselves cannot be predicted. The best one can do in a forecast is to assume some historically average behavior of asset prices, which has been done here.

To examine the effects of asset price shocks, experiments can be run using the model in which stock prices (variable CG), housing prices (variable PSI14), and import prices (variable PIM) are changed. This allows one to examine the sensitivity of the forecast to changes in these values. It may be, for example, that the growing federal government debt triggers a large depreciation of the dollar and possible fall in U.S. equity prices, and this can be analyzed by changing CG and PIM.

To review, oil price shocks and exchange rate shocks are handled through changes in PIM. Housing price changes are handled through changes in PSI14. Changes in PSI14 change PKH relative to PD and thus change housing wealth, PIH*KH. This affects consumption through the wealth variable AA (equation 89 and equations 1, 2, and 3). Regarding the stock market, each change in the S&P 500 index of 10 points is a change in CG, the capital gains variable in the model, of about $100 billion. If you think that the S&P index will fall, say, 100 points, you should drop the equation for CG and change CG by about -$1,000 billion. See the discussion in Section 7.2 of The US Model Workbook, July 27, 2012. This will have a negative effect on real output growth because of a negative wealth effect.

Regarding the federal government spending variables, the key variables are TRGHQ and COG. The key personal income tax rate is D1G. The employee payroll tax rate is D4G.