Why Goldman Thinks The Fed May Hike Past February

Notwithstanding an inevitable “step-down” in the pace, Jerome Powell’s Fed may find itself compelled to keep raising rates for longer than anyone would ideally like.

As regular readers are well apprised, I view the concept of “stochastic inflation” as one of the biggest tail risks on the board. Forecasting macro outcomes is everywhere and always a fool’s errand, but economists have enjoyed three decades of structural disinflationary tailwinds, which made it seem as though independent central banks and inflation-targeting were a recipe for predictably benign price growth dynamics.

I, for one, doubt it’s a coincidence that the very moment those structural disinflationary forces began to wane (as the pandemic and then the war in Ukraine changed the game), central banks lost control of inflation. The implication is that they never had control in the first place. Tom Barkin suggested as much himself over the summer.

But even if the stochastic inflation tail risk doesn’t materialize (i.e., even if inflation outcomes eventually normalize and inflation uncertainty as measured by, for example, the interquartile range in sentiment surveys, abates), there are good reasons to believe we’re not in Kansas anymore, and thereby the Fed may find itself hiking longer than it and the market current project.

“We see three possible reasons why the FOMC could end up hiking past the February meeting, as we now expect,” Goldman wrote, in a new note adding a hike to their official Fed call.

If you ask Goldman, inflation will probably stay “uncomfortably high for a while,” which would make incremental hikes (likely 25bps) “the path of least resistance” for “a bit longer” after February. Shelter and health care inflation will probably linger next year, which means most measures of the underlying inflation trend will stay elevated, the bank’s David Mericle wrote.

The figure (above) shows projections for core price growth, with FOMC meetings identified for context. Core services inflation is seen staying elevated for the entirety of the forecast horizon.

But there’s more to it than that. Mericle went on to note that the fiscal impulse doesn’t have much further to fade. “With few fiscal transfers left to lose, the household sector should experience solidly positive real disposable income growth over the next year, which could lead to an unhelpful reacceleration of consumer spending,” Goldman said.

In that scenario, the Fed might be compelled to hike further in order to guard against a spending impulse that pushes growth “too” high to be consistent with a sustainable trek lower for inflation. More simply: The Fed won’t want to see any demand destruction they manage to engineer reconstructed too quickly.

Finally, Mericle specifically addressed the prospect of easier financial conditions predicated on an eventual pivot.

“The FOMC might need to do more if a future pivot caused a premature easing of financial conditions,” Goldman said. “While there is no reason to expect a major change in financial conditions if the Fed delivers on what is already priced, there is some risk that the equity market could rally on a Fed pivot — even one that is in principle already expected,” Mericle continued, adding that “this would be unwelcome if it comes before inflation is clearly on its way back to target, and the FOMC might have to hike a bit more to counteract it.”

As I put it over the weekend, in a response to reader comments, “a Fed that delivers a dovish hike and accidentally sparks a decline in real yields, a weaker dollar, tighter CDX and an equity rally is a Fed that eases financial conditions” at cross purposes with the inflation fight.

Summing up, Goldman wrote that although it’s not easy to discern “which of these three possible routes might eventually lead the FOMC to tighten by more than it currently plans,” the bank’s view is that “it is more likely than not that one of them will.”