Why Goldman Sees Risk Of Fed Tightening ‘At Every Meeting’

Starting in March, the Fed could “take some tightening action at every meeting until the inflation picture changes,” Goldman’s David Mericle wrote, in the bank’s FOMC preview published over the weekend.

Goldman’s economists are “more concerned” about the inflation outlook than they were previously, given still elevated wage growth and the possibility that the Omicron wave prolongs the distortions contributing to price pressures in the goods sector.

Mericle didn’t mince words. “In coming months, the inflation dashboard is likely to show lingering supply chain problems, hot wage growth, strong rent growth, very high YoY core PCE and especially core CPI inflation and very high short-term inflation expectations,” he wrote.

At the risk of stating the obvious, rate hikes and balance sheet runoff won’t do much to change any of that. You might immediately assert that a cessation of MBS purchases (sans reinvestments) will help cool home prices, but remember that shelter inflation responds on a lag. So, the die is cast on rent growth, I’m afraid (figure on the left, below).

As for wages, the still acute mismatch between labor supply and demand (figure on the right, above) means employers who want workers will have no choice but to pay up.

Officials surely understand their capacity to effectuate a change in inflation dynamics is limited by the nature of the problem, as discussed in “The Real Cause Of Inflation.” That makes the juxtaposition between policymaker rhetoric maddening. Fed officials insist they’ll do what’s necessary to tamp down inflation. But the same officials routinely admit they don’t have the right “tools” to make a difference when so many of the problems reside on the supply side.

Political expediency requires action, though. Unless and until the Fed hikes the economy into recession, inflation is a bigger liability for Joe Biden than any prospective knock-on effects to growth and stocks from policy tightening. That’s especially true given that recent tightening in financial conditions has been modest. Goldman noted as much. “We estimate that the negative growth impulse to the economy remains modest too [and] if this situation persists, it would lower the bar for hiking more than the four times that the market has already priced,” the bank said.

What would prompt the Fed to get even more aggressive, where that means announcing balance sheet rundown in May and hiking more than four times in 2022? Well, as Mericle went on to write, there are “a number of potential triggers for a shift to rate hikes at consecutive meetings,” including, but by no means limited to, additional increases in longer run inflation expectations and higher-than-expected realized inflation. Indeed, Goldman wrote that “even… just realizing the inflation path that we and the FOMC already expect could make it awkward to skip May.”

The scenario analysis visualized in the figure (below) gives you a sense of just how indeterminate things really are. “The analysis is meant as a simplification of countless possible paths the Fed could take,” Mericle remarked.

The bottom line is that the risks are skewed to the hawkish side.

And yet, that hawkish asymmetry may (ironically) mean that the medium- and longer-term risks are dovish. As Goldman put it, “the key question is whether the FOMC will decide that it needs to play a larger role in reducing demand and bringing down inflation, as opposed to playing a more limited role and mainly waiting for the effects of pandemic supply-demand imbalances and fiscal stimulus to fade.”

That’s a euphemistic way of saying that there is, in fact, one (nearly) foolproof way for the Fed to bring down inflation. They could endeavor to engineer a deep recession.