Ok, so basically Goldman thinks the labor market is going to overheat materially in 2018, inflation pressures are going to materialize, and growth is going to be above-trend thanks to hurricane reconstruction activity (ahem, broken windows) and Republicans cramming through tax cuts in some form or another.
That, Jan Hatzius and company figure, will prompt the Fed to deliver four hikes in 2018, in addition to the December hike. That’s above the median in the September dots and above market forwards as well.
On Goldman’s read, the Fed has been trying to “tap lightly on the brakes” with a series of hikes, but this has turned out to be one of those situations where someone apparently cut the brake line. “Although this path of tightening came as a significant hawkish surprise to financial markets, it proved too little to achieve the desired tightening in broader financial conditions,” Goldman writes, adding that “instead, our financial conditions index (FCI) has eased meaningfully over the last year.”
And so, unable to stop the train, the unemployment rate continued to dive to even more unsustainable levels while the economy picked up still more steam. “This is not how Fed officials envisioned 2017 drawing to a close,” Goldman goes on to write.
With the economy rolling along and growing at a rate that’s ahead of GS’s estimate of the long-term potential growth rate and well ahead of its short-term potential rate, the bank figures that between rebuilding shit that hurricanes destroyed and former employee Gary Cohn coming through on tax reform (and then, if media reports are any indication, hightailing it the fuck out of dodge before the administration crashes and burns), there’s more upside from here. Here’s Goldman’s take on the boost from tax reform:
The economic impact of tax reform is likely to be moderate, reflecting both the size of the net cut and the likelihood of a gradual phase-in of at least some components. Updating our analysis using the Fed’s macroeconomic model, we estimate that the total package we expect would boost GDP growth by about 0.2pp in each of 2018 and 2019 and lower the unemployment rate by an additional 0.2pp. The combination of the tax cuts and increases in federal government spending should produce a noticeable uptick in the fiscal impulse to growth in 2018, as shown in Exhibit 4.
And it’s not just specialty items (if you will) driving the economy onward and upward. Goldman also says “the fundamental picture” should “remain encouraging” with healthy consumption growth and job creation, etc. etc. The bottom line: Goldman sees GDP growth of 2.5% in 2018 Y/Y, or 2.3% on a Q4/Q4 basis.
They’ve revised their forecast for the unemployment rate even lower, noting that “a rate in the mid-3’s would complete an evolution over the current cycle from the weakest labor market in postwar US history to one of the tightest [and] in fact, such a scenario would take the US labor market into territory almost never seen outside of a major wartime mobilization.”
As for inflation, suffice to say that Goldman isn’t ready throw in the towel in favor of a Bezos-based world view, which shouldn’t exactly come as a surprise because as you’ll recall, Goldman found earlier this year that the “Amazon effect” is actually less pronounced in terms of its deflationary impact than the “Walmart effect” of yesteryear. Ultimately, GS sees inflation picking back up and doesn’t necessarily think an “obsession” with “the mundane effects of idiosyncratic, acyclical, and ultimately transitory influences on core prices” is warranted. To wit:
We expect inflation to accelerate meaningfully in 2018, but for a broader set of reasons than in the case of wage growth. Specifically, we forecast a roughly 0.5pp acceleration to 1.8% by end-2018, driven by the dropping out of past one-off declines, rising labor costs, higher energy prices and a weaker dollar, and the fading drag from healthcare policy. We emphasize two points about our forecast. First, we expect 0.3pp of this nearly 0.5pp acceleration to come in March as the weakest base effects fall out of the year-on-year calculation. Second, only about 0.1pp of the acceleration is driven by Phillips curve effects.
Putting this altogether in terms of what it portends for the Fed – and thereby coming full circle to what we said here at the outset – Goldman sees a hike in December and four more in 2018, which would take funds to 2.25-2.5%. Here’s where Goldman thinks the market has it wrong:
Despite the hawkish surprise this year, a forecast of quarterly tightening next year still appears just as improbable to many investors as it did around this time last year. Our disagreement with market pricing springs from three sources, corresponding to the three inputs into a standard reaction. First, we disagree that the recent inflation softness reflects deeper structural forces that are likely to persist next year. Second, we think markets underestimate the Fed’s desire to limit labor market overheating, even in the absence of excessive inflationary pressures. Third, while many investors appear to view roughly 2% as the economy’s neutral nominal rate and therefore a high hurdle if not a cap for further rate hikes, we see little to suggest that the US economy is just three hikes away from a sustainable equilibrium.
So that’s all fine and good, but needless to say, if all of those pieces don’t fall into place and the Fed actually does decide to go with four hikes, it’s conceivable that they will hike us right into a recession and/or prompt a disorderly unwind of trades that are to a certain extent psychologically dependent on the Fed not surprising anyone.