If we assume the likes of Bill Dudley, Larry Summers and Olivier Blanchard are correct to suggest the Fed will ultimately be compelled to engineer a meaningful increase in the US unemployment rate in order to bring inflation back to target, that raises at least two questions, and it doesn’t much matter the order in which they’re addressed.
The most obvious question for Main Street is how high the unemployment rate might “need” to go. For Wall Street, the question is what the asset price implications are from a Fed that endeavors to push the jobless rate up to levels consistent with some of the more hawkish calls emanating from economists and former officials.
As to the first question, Goldman’s Dominic Wilson and Vickie Chang constructed a “moderate” scenario in which unemployment rises to 5% and a “severe” outcome in which the jobless rate is 6%. “Using an Okun’s Law coefficient of two… this translates into GDP growth outcomes that are either 200bps or 400bps below our own forecasts on a one-year basis,” they wrote. They relied on a rule of thumb that says 100bps of FCI tightening is worth 100bps of GDP drag over a year, which means the Fed would need to engineer 200bps or 400bps of FCI tightening in the two scenarios, respectively.
Of course, economic downturns — and particularly severe recessions — do their own work. “Negative momentum,” as Goldman put it, would likely take some of the onus off policymakers. To account for that, Wilson and Chang assumed 150bps would ultimately be need in the “moderate” scenario and 300bps in the “severe” case.
As noted briefly here on Friday morning, the more benign scenario entails an additional 90bps increase in five-year US yields and another 4% rise in the dollar versus the bank’s own forecast, while the “severe” scenario would see five-year yields rise 180bps and the dollar a further 8%.
What about equities? Well, in the moderately hawkish scenario, Goldman’s approach “predicts that the S&P 500 would need to fall a little less than 15%,” while the “more severe version” predicts a 27% decline for the US benchmark, equivalent to SPX <3400 and 2900, respectively.
Those prospective outcomes, should they occur, wouldn’t count as singularly anomalous. The figure (above) gives you some context.
“The cumulative equity market declines from the highs this year of ~30% and ~40% implied by the two simple versions of this scenario would be large but firmly in the range of past experiences,” Wilson and Chang went on to remark.
Of course, all of this is extremely indeterminate, something Goldman readily conceded, calling the analysis “highly stylized” with “uncertainties at every step.” I should emphasize that this is not any sort of update to the bank’s house call. As far as I can tell, David Kostin wasn’t involved with the piece.
The point, rather, was simply to take a quick look at potential outcomes based on rough estimates for asset prices in the context of prospective increases in US unemployment under more onerous labor market conditions.
All caveats aside, Wilson and Chang said “the basic story is clear.” “If only a severe recession — and a sharper Fed response to deliver it — will tame inflation, it is likely that the downside to both equities and government bonds could still be substantial, even after the damage that we have already seen.”