Goldman sees a ‘viable but hard way’ for the Fed to beat inflation without recession

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

Kent Nishimura | Los Angeles Times | Getty Images

According to Goldman Sachs, the way for the Federal Reserve to keep the economy from slipping into a major recession is still open, but it is getting narrower.

As the central bank continues to raise interest rates, the economy is met with mixed signals: rapidly rising payroll figures against rapidly declining housing numbers, falling gasoline prices versus rising costs of shelter and food, and stagnant spending numbers. Low consumer sentiment against.

In the midst of all this, the Fed is trying to strike a balance between slowing things down, but not by too much.

On that score, Goldman economists think there are clear wins, few losses and a scenario ahead that presents substantial challenges.

“Our broad conclusion is that there is a viable but difficult path to a soft landing, although a number of factors beyond the Fed’s control can make that path easy or complicated,” Goldman economist David Merkel said in a client note. can increase or decrease the probability.” sunday.

slow growth, high inflation

One of the biggest inflation drivers has been increased growth that has created an imbalance between supply and demand. The Fed is using interest rate hikes to try to dampen demand so that supply can hold, and supply chain pressure, as measured by the New York Fed Index, is at its lowest since January 2021.

So on that score, Merkel said the Fed’s efforts “have gone well.” He said the rate hike – a total of 2.25 percentage points since March – has achieved a “much needed slowdown” with respect to growth and demand in particular.

In fact, Goldman expects GDP to grow at a pace of only 1% over the next four quarters, and that’s coming from a steady decline of 1.6% and 0.9%. Although most economists expect the National Bureau of Economic Research not to declare the US in recession for the first half of the year, the slow growth path makes the Fed’s balancing act more difficult.

On a similar count, Merkel said the Fed’s moves have helped bridge the supply-demand gap in the labor market, where there are still about two job opportunities for every available worker. “That effort has a long way to go,” he wrote.

The biggest problem, however, remains stubbornly high inflation.

The Consumer Price Index was flat in July but is still up 8.5% from a year ago. Wages are rising at a strong clip, with average hourly earnings up 5.2% from a year ago. As a result, the Fed’s efforts to halt a spiral in which higher prices feed higher wages and keep inflation in check have “shown little concrete progress so far,” Merrick said.

“The bad news is that high inflation is broad-based, the underlying trend measures are high, and business inflation expectations and pricing intentions remain high,” he said.

Doubts about the Fed’s policy path

Fighting inflation may require higher rate hikes than the market currently expects.

Goldman anticipates the Fed raises benchmark rates by another percentage point before the end of the year, but Merkel acknowledged that “reverse easing risks to the upside” due to “recent easing of financial conditions, strong hiring momentum and signs of stickiness”. ” Is. in wage growth and inflation.”

Indeed, former New York Fed chairman William Dudley said on Monday that he thinks markets are underestimating the future course of rate hikes and, as a result, risks of a hard landing or recession.

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

In Dudley’s view, the Fed will continue hiking until it is sure that inflation is going back to the central bank’s 2% target. Even by the most lenient inflation measure, the main personal consumption spending price index followed by the Fed, inflation is still running at 4.8%.

“The labor market is much tighter than the Fed. Wage inflation is too high, not in line with 2% inflation,” he said.

Dudley expects rates to continue to rise until employment mobility has shifted enough to get the unemployment rate “above 4%” compared to its current level of 3.5%.

“Whenever the unemployment rate has increased by half a percentage point or more, it results in a complete recession,” he said.

One measure of the relationship between unemployment and recession is called the Sahm rule, which states that a recession follows when the three-month average of unemployment exceeds half a percentage point from its lowest level in the previous 12 months.

So it would require a rate of only 4% under the Sahm rule. In their most recent economic projections, members of the rate-setting Federal Open Market Committee do not see jobless levels breaking that rate until 2024.

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