From the FOMC Minutes released today:
"To reconcile the downward revision to real GDP growth for the first half of year with an unemployment rate that was now closer to the staff's estimate of its longer-run natural rate, the staff lowered its assumed pace of potential output growth this year by more than it marked down GDP growth. As a result, resource slack in this projection was anticipated to be somewhat narrower this year than in the previous forecast and to be taken up slowly over the projection period." (emphasis is our own)
In our presentation, we noted that this recovery has had a very unique characteristic. The output gap has been narrowing due to declining potential real GDP rather than due to robust real GDP growth as is the norm in previous recoveries. The chart below from the Congressional Budget Office (CBO) identifies this characteristic.
We also highlighted other measures of spare capacity that suggest a much smaller output gap may be at hand. For example, when we look at economic utilization, which is simply the capacity utilization rate minus the unemployment rate, there seems to be less resource slack in the economy than one would otherwise conclude if they only looked at the official output gap.
We would also point out that structural factors, such as a declining participation rate which according to the CBO is set to decline for many decades aheads, is putting downward pressure on labor force growth and is limiting potential GDP growth. If the unemployment rate continues to fall because there is less slack in the labor market than wages could quickly accelerate and push inflation above the Fed's 2% target. It wouldn't take much to bump core CPI above the 2% trendline as it has been tracking just below that rate for the past four years. Thus, a rate hike that is earlier than is generally expected wouldn't surprise us.