Goldman sees a ‘doable but difficult path’ for the Fed to beat inflation without a recession

Construction workers outside the Marriner S. Eccles Federal Reserve Building, photographed Wednesday, July 27, 2022 in Washington, DC.

Kent Nishimura | Los Angeles Times | Getty Images

The path for the Federal Reserve to reduce runaway inflation while preventing the economy from sliding into a major downturn is still open but narrowing, according to Goldman Sachs.

As the central bank seeks to continue raising interest rates, the economy is rife with mixed signals: rapidly rising payroll figures versus a sharp drop in housing numbers, falling gasoline prices versus rising housing and food costs, and weak consumer sentiment against flat spending figures.

Amid all of this, the Fed is trying to find a balance between slowing things down, but not too much.

On this point, Goldman economists believe there have been clear gains, losses and a landscape ahead that poses significant challenges.

“Our overall conclusion is that there is a possible but difficult path to a soft landing, although several factors beyond the Fed’s control can facilitate or complicate this path and increase or decrease the chances of success,” the statement said. Goldman economist David Mericle in a client note. Sunday.

Slow growth, high inflation

One of the main drivers of inflation has been excessive growth which has created imbalances between supply and demand. The Fed is using interest rate hikes to try to dampen demand so supply can catch up, and supply chain pressures, as measured by a New York Fed index, are to their lowest since January 2021.

So on that point, Mericle said the Fed’s efforts “went well.” He said the rate increases – totaling 2.25 percentage points since March – have “achieved a much-needed deceleration” on growth and specifically demand.

In fact, Goldman expects GDP to grow at just 1% over the next four quarters, after back-to-back declines of 1.6% and 0.9%. Although most economists expect the National Bureau of Economic Research not to declare the United States a recession in the first half of the year, slow growth makes it more difficult to exercise Fed balance.

Along the same lines, Mericle said the Fed’s actions have helped narrow the gap between supply and demand in the labor market, where there are still nearly two job openings for every worker available. This effort “has a long way to go,” he wrote.

However, the biggest problem remains stubbornly high inflation.

The consumer price index was flat in July, but still rose 8.5% from a year ago. Wages are rising at a steady pace, with average hourly earnings up 5.2% from a year ago. Consequently, Fed efforts to halt a spiral in which higher prices fuel higher wages and perpetuate inflation have “shown little convincing progress so far,” Mericle said.

“The bad news is that high inflation is widespread, measures of the underlying trend are elevated, and corporate inflation expectations and pricing intentions remain elevated,” he added.

Doubts over the Fed’s policy trajectory

Fighting inflation may require bigger rate hikes than the market is currently anticipating.

Goldman’s projection is that the Fed will raise benchmark rates another percentage point before the end of the year, but Mericle acknowledged that there is “upside risk” due to “the easing financial conditions, the sustained pace of hiring and signs of rigidity”. wage growth and inflation.

Indeed, former New York Fed President William Dudley said on Monday that he thinks the market is underestimating the future path of rate hikes and, therefore, the risks of a hard landing or of a recession.

“The market misunderstands what the Fed is doing,” he told CNBC’s “Squawk Box” in a live interview. “I think the Fed is going to be higher for longer than market participants understand at this point.”

According to Dudley, the Fed will continue to climb until it is confident that inflation will return to the central bank’s 2% target. Even according to the most generous measure of inflation, the core personal consumption expenditure price index tracked by the Fed, inflation is still at 4.8%.

“The labor market is much tighter than the Fed wants. The wage inflation rate is too high, not compatible with 2% inflation,” he added.

Dudley expects rates to continue to rise until employment dynamics have changed enough to bring the unemployment rate “well above 4%”, from its current level. by 3.5%.

“Any time the unemployment rate has increased by half a percentage point or more, the result has been a full recession,” he said.

One measure of the relationship between unemployment and a recession is called Sahm’s rule, which states that recessions occur when the three-month average of unemployment rises half a percentage point above its 12-year low. previous months.

This would therefore only require a rate of 4% under the Sahm rule. In their most recent economic projections, members of the Federal Open Market Committee responsible for setting rates don’t see the level of unemployment breaking that rate until 2024.

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