The consequences of a recession are too dire, and the Fed's "curve rescue" may be the best strategy.
Last Thursday, the US Department of Labor released data showing that the US CPI rose 7.7% year-on-year in October, a sharp decline from 8.2% in the previous value and the lowest level since January; Core CPI rose 6.3% year-on-year, also better than market expectations of 6.5%, down from 6.6% in the previous month.
Weak inflation data greatly encouraged sentiment, with U.S. stock indexes posting their biggest one-day gains since April 2020. The analysis pointed out that the cornerstone of the Fed's expectations of continuing aggressive interest rate hikes is US inflation, and if inflation declines faster than expected, the Fed will have more room to slow down the pace of interest rate hikes.
However, this has led many economists to think more long-term: inflation does appear to be gradually falling in line with the Fed's target, but if the Fed insists on moving towards its 2% target, it poses significant economic risks – rising real interest rates will significantly damage the economy, worsen public finances, and challenge risk assets.
Based on this, Goldman Sachs and a number of economists believe that the Fed is very likely to adjust its inflation target to 3% or more. The good news is that Goldman Sachs also expects core PCE inflation to gradually decline from the current 5.1% to 2.9% in December.
The Fed will raise its inflation target
If the Fed insists on reducing inflation to 2%, it will pay a huge price.
Goldman Sachs pointed out in the latest research report that in the past few months, the market has been arguing about the economic outlook of the United States in 2023, in which inflation is an important reference indicator. Most agree that inflation is unlikely to fall to 2% quickly, and raising the G10's inflation target to the 3-4% range may be more desirable in terms of maintaining employment levels or public debt sustainability. If inflation remains sticky in the 6-10% range, the 2% target is impossible to achieve.
Based on the aggregate supply and aggregate demand (AD-AS) model, Goldman Sachs explained that the global supply curve has now shifted to the right due to factors such as deglobalization, underinvestment, tariffs and sanctions, moving the supply curve saddle point (tipping point) that defines the level of inflation of potential output from 2% to the range of 3.5-5%.
Goldman Sachs said that in this case, even at the expense of the economy, the 2% inflation target cannot be met. Policymakers will face a dilemma: either leave the 2% inflation target unchanged and the economy and markets will be severely damaged; Either raise your inflation target and enjoy the short "golden age" of the economy.
As for the level of real interest rates, Goldman Sachs believes that there will be significant differences in economic growth, inflation and fiscal outlook in 2023, which will depend on G10 central banks sticking to or deviating from the 2% inflation target. If real interest rates are significantly reduced (i.e. G10 central banks pause rate hikes in the first quarter of 2023), the economy will see:
rebound in real economic growth; Inflation in G10 countries slowed to the 3.5-5.0% range; Fiscal conditions have improved, and the ratio of public debt to GDP – a measure of a country's ability to service its debt has declined; The stock market rebounded, the dollar weakened; Credit spreads narrowed and capital flowed to emerging market assets.
If real interest rates continue to rise (G10 central banks continue to raise rates until core inflation falls significantly back to the 2% target), the economy will see:
Real economic growth collapsed in the first half of 2023; inflation meets, but is likely to fall below the 2% target; The fiscal situation has deteriorated, and the ratio of public debt to GDP has risen; Risk assets continue to face challenges until there is a shift in policy.
In contrast, if the Fed keeps real interest rates rising in order to curb inflation, the damage to the economy is significant.
Inflation rate 2% = unemployment rate 6.5%?
In fact, Goldman Sachs is not the first voice to shout that "the Fed needs to lower its inflation target."
In September, in an op-ed published on the media website, Jason Furman, former chairman of the White House Council of Economic Advisers, pointed out by summarizing a paper by three economists that if the unemployment rate meets the FOMC's median forecast in June, that is, the unemployment rate rises to 4.1%, then inflation will still be around 4% by the end of 2025; By then, for inflation to fall to the Fed's 2% target, the average unemployment rate in 2023 and 2024 would need to reach a high level of 6.5%.
The paper has been called "the scariest economics paper of 2022." The paper notes that the labor market remains very tight, that underlying inflation is very high and likely to continue to rise, and that it will take years of high unemployment to bring inflation under control.
The unemployment rate in the United States is currently 3.7%. Assuming a modest increase in the U.S. labor force, translated into absolute numbers, an unemployment rate of 6.5% by 2024 would mean that the number of unemployed workers would reach 10.8 million, an 80% surge from today's 6 million.
Furman believes that stable inflation at 3% may be healthier than stabilizing at 2%. So, while fighting inflation should be the Fed's top priority right now, it should at some point reassess the "meaning of victory" in this fight.
On November 4, Steven Blitz, chief strategist at TS Lombard, also pointed out in the report that the impact on employment of everything the Fed has done means that its rate hike cycle will face a huge adjustment, "I always think that the Fed will eventually raise the inflation target to 3%." Powell could not maintain high unemployment and low economic growth for a long time, as Volcker did.
U.S. inflation is expected to fall sharply next year
On the other hand, the good news is that Goldman Sachs expects US inflation to fall significantly next year.
Goldman Sachs economist Jan Hatzius and others said in a research note released on Sunday that core PCE inflation will gradually decline, from the current 5.1% to about 3.5% in the middle of next year, and then to 2.9% in December next year.
Goldman Sachs' forecast is based on three main reasons:
First, the alleviation of supply chain shortages in the commodity sector; Second, housing inflation peaked after reopening; Third, the continued rebalancing of the labor market has slowed wage growth.
First, Goldman Sachs believes supply chain disruptions and shipping congestion will ease significantly in 2022, with auto and consumer goods inventories rebounding from extremely depressed levels. The improvement in semiconductor supply has been particularly pronounced, with automotive microchip shipments now 42% higher than in 2019 – which has already contributed to a 5% decline in the used car price index, and Goldman Sachs expects another 15% decline by 2023.
In addition, Goldman Sachs believes that lower commodity prices and a stronger dollar will also push core commodity inflation lower more broadly.
Goldman Sachs expects the second reason for the decline in core inflation is that housing inflation will peak next spring. Strong demand in the U.S. rental market has triggered a supply-side response: 1 million apartments are being built or permitted, the highest level since 1974. Goldman Sachs believes that as a result, the vacancy rate of rental housing has begun to rebound and may return to pre-pandemic levels next year.
The third reason is the slowdown in wage growth. Goldman Sachs expects this to reduce upward pressure on services inflation by the end of 2023. The rebalancing of the labor market is already reducing wage growth, especially in sectors such as retail and leisure, where the employment gap has narrowed significantly. Goldman Sachs expects year-on-year wage growth to fall 1.5 to 4 percent by the end of 2023, helping to slow inflation in labor-intensive services.
It's worth noting that falling inflation doesn't mean the Fed can rest easy. Goldman Sachs believes that inflation in the core services sector will only decline modestly next year and will remain at a high of 4.4% through December. This reflects a slowdown in housing inflation later this year, but growth is still rising; At the same time, health care inflation will also rise across the board, with Medicare premiums likely to rise by the most in at least 15 years.
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