Congress Should Be Cautious About CBO's Economic Forecasts

The Congressional Budget Office’s (CBO) Budget and Economic Outlook: 2024 to 2034 contains interesting, some might say challenging guidance on interest rates and inflation in the near and longer term.^[1] Few economic indicators play larger roles in Congress’s policy work than these price variables. From the cost of entitlements and defense material to the annual adjustment tax brackets, inflation and interest rates play pivotal financial and thus fiscal roles. That is why those who focus on policy formation should spend a moment reviewing what CBO has to say. CBO’s interest rate and inflation story unfolds in an economic forecast that has the U.S. economy cooling significantly in 2024 from its 3.1 percent annual growth rate in 2023 (See Table 1 below). That cooling stems principally from the delayed effects of interest rate hikes by the Federal Reserve. The Fed has increased the federal funds rate (its principal interest rate tool) 11 times since 2022 from a low of 0.8 percent in March of 2022 to 5.33 percent today (last changed on July 28, 2023).^[2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DFF, February 12, 2024.] These aggressive moves by the Fed were designed to lower the monthly rate of change in the main price indexes, the Consumer Price Index (CPI) and the Personal Consumption Expenditures Index (PCE). The CPI hit a high of 9.0 percent annual rate in June of 2022. It has since dropped to 3.2 percent in February of this year.^[3] Besides this pivotal assumption of slowdown in 2024, let us review some of the other key CBO’s forecasts of a slower economy, before taking a closer look at CBO’s interest rate and inflation forecasts:

• Unemployment reflects the slowing of economic activity in 2024, as CBO expect it to rise from its near-historical low of 3.7 percent in late 2023 to 4.4 percent by the fourth quarter of 2024.
• The decline in household and business purchases takes the pressure off the inflation rate, and price growth declines from 2.9 percent in 2023 to 2.1 percent in 2024.
• CBO assumes that the Federal Reserve will do little to change interest rates in 2024, though a greater-than-expected slowdown in economic activity this and next year could prompt the Fed to reduce rates. Finally, monthly change in payroll employment, is expected to slow down next year, as well.
• More details are provided in Table 1 below.

Several interesting and challenging points stand out when thinking about CBO’s interest rate and inflation forecasts. Let us start with the interesting points. First and perhaps most obviously, there is a pronounced decrease in the inflation estimates for 2024 through 2026 but not a comparably sharp decline in interest rates. The CPI and the PCE drop, respectively, 60 and 70 basis points between 2023 and 2024, and the CPI declines further through 2026. The “core” versions of each index (that is, the index minus highly volatile components like food and energy) steadily decline through 2026. If that’s the case with the price indexes, why do interest rates stay relatively rigid in 2024 before declining through 2026? The answer to that question brings us to the second interesting point: CBO’s forecast reflects a widespread view among economists that the Fed is unconvinced about the trend in inflation. That is, the Fed recognizes the gains its interest rate policy has made against inflation, but it has not yet announced victory. Thus, rates remain high in the short run. In the longer run, CBO assumes that the Fed has beaten inflation, certainly by the end of 2024, and both metrics decline thereafter. Now, let us turn to the challenging points. First, if CBO is right about a downturn in the economy in 2024, how certain should we, CBO’s readers, be about interest rates staying relatively high? There is a significant probability that a downturn in the growth rate and a rise in unemployment might prompt the Fed to stimulate the economy through lower interest rates, even if inflation has not been whipped, to use Gerald Ford’s terminology. Second, is inflation even trending down? If we subtract from the CPI all-urban series (the benchmark inflation metric) the volatile food and energy components, it is possible to see in this “core” CPI a renewal of inflation pressures. Figure 1 below shows four monthly change rates: 1-month, 3-months, 6-months, and 12-months. The first three trend lines are turning up, which implies that the 12-month (or year-over-year rate) will turn up next. So, again, is the CPI falling or rising? Third, if CPI turns up in 2024 rather than down, as CBO predicts, then key budget parameters, like the Social Security cost of living adjustment and the defense outlays will be bigger budgetary elements than CBO expects in the budget portion of the Outlook. When all this limited evidence from the Report is combined with recent data, the message for policymakers is straightforward: they need to be especially cautious in their budget work this year until there’s more clarity on these two key economic variables. Badly missing the assumptions on these key economic variables could mean even worse misses in future budgets.