When it comes to the inflation debate looming over the US economy, Goldman Sachs is on the side of the Federal Reserve and the Biden administration.
Gauges of nationwide price growth are surging at their fastest rate in more than a decade, sparking concerns of an overheating economy ending the recovery early. Republicans and some moderate Democrats have blamed the Fed’s ultra-easy policy stance and unprecedented fiscal stimulus for the inflation overshoot. The Biden administration and the central bank have instead argued the stronger price growth is temporary and fade starting next year.
Goldman economists led by Jan Hatzius reiterated their stance on the Biden side on Monday, citing the latest jobs numbers as supporting evidence. The US added 559,000 nonfarm payrolls in May, missing the median estimate but still a sharp rebound from the dismal April report. Wages shot higher for a second straight month, signaling inflation was picking up in pay and pricing.
The combination of soaring wages and stronger inflation amplified Republicans’ claims of an overheating economy. Yet both pressures should cool in the coming months, Goldman said. For one, the economy is still down roughly 8 million payrolls, and May’s pace of job creation still places a full recovery more than a year into the future. Labor supply, which has been slowing hiring in recent months, should also “increase dramatically” as virus fears dim and enhanced unemployment insurance lapses. As more Americans return to work, wage growth is expected to slow.
Inflation should also cool on the pricing side, according to the bank. Goldman’s trimmed core Personal Consumption Expenditures (PCE) index – which excludes the 30% largest month-over-month price changes – has only risen 1.6% from the year-ago level. By comparison, standard PCE – among the most popular US inflation gauges – notched a 3.6% year-over-year gain in April. Core PCE strips out volatile food and energy prices and is generally viewed as a more reliable measure of long-term inflation.
The disparity reveals the “unprecedented role of outliers” in driving inflation higher, and such an effect should “have only limited effects on longer-term inflation expectations,” the economists said in a note to clients.
“Ultimately, the biggest question in the overheating debate remains whether US output and employment will rise sharply above potential in the next few years,” the team added. “If the answer is yes, then inflation could indeed climb to undesirable levels on a more permanent basis. But our answer continues to be no.”
The forecasts echo sentiments shared recently by central bank officials. Fed Governor Lael Brainard said last week that, as schools reopen and vaccinations continue, it’s likely that the labor shortage will unravel. Job openings sat at record highs by the end of March, and a matching of such huge demand with bolstered supply should drive “further progress on employment,” she added.
More broadly, Goldman expects GDP growth to slow after peaking in the second quarter and normalize as stimulus support lapses. The massive jobs shortfall makes for “significant slack” in the labor market, the bank said, adding that unemployment-based output should reach its maximum potential in late 2023.
The debate around passing President Joe Biden’s $1.9 trillion aid proposal is a simple one.
Democrats argue the hole in the economy is so big that it warrants spending nearly $2 trillion, on top of the $3 trillion spent last March and the $900 billion spent late in Trump’s term. Republicans point to all the relief the government has already provided, and say the economy can recover with a much smaller boost. If you overdo it, they say, spending so much could take inflation to worrisome levels.
But there’s a third player in the debate: the Wall Street investment banks that are crunching the math. And they are increasingly saying the concerns about runaway inflation are misplaced.
For weeks, economists at major banks had sat on the sidelines, vaguely saying another package would achieve its intended goal of accelerating growth. Now that Democrats are charging forward with Biden’s large-scale plan and likely to pass the bill by mid-March, Wall Street’s take probably won’t make Republicans too happy.
Every big bank has its own forecast, models, and team of experienced economists, and many are arriving at the same conclusion: the benefits of the Biden plan overshadow the risks. After a decade of weak inflation and a currently stagnant economic recovery, Wall Street is cheering on efforts to supercharge the economy with a massive shot in the arm.
Here’s what four banks have to say about new stimulus and what inflation may come of it.
(Spoiler: not very much)
Bank of America: ‘A difficult balance, but so far highly successful’
Investors haven’t been thrown by the inflationary concerns surrounding stimulus. Stocks – which have historically sold off when consumer prices have overheated – sit near record highs. Investors are also continuing to rotate into downtrodden companies set to bounce back as the economy reopens, signaling they’re more focused on profit-growth upside than potential inflation headwinds.
Michelle Meyer, the head of US economics at Bank of America, puts its succinctly, saying the market is “painting a story of optimism.”
“Market participants are looking for stronger economic growth to push up inflation but not trigger Fed tightening too quickly,” the team said in a Friday note. “It is a difficult balance, but so far highly successful.”
The firm forecasts gross domestic product growth of 6% in 2021 and another 4.5% next year. This kind of expansion would fill the hole in the economy by the end of 2022, and additional stimulus would further accelerate growth, the economists said.
The question isn’t whether the economy will overheat, but by how much, they added. The output gap – the difference between actual GDP and maximum potential GDP – is projected to reach its greatest surplus since 1973 if Biden passes his proposal, according to the bank.
Still, with the Federal Reserve actively pursuing above-2% inflation for a period of time, the hole in the economy likely needs to be overfilled before there’s a return to stable growth, the note said.
UBS: ‘Rising only gradually’
The White House’s package might exceed what’s necessary but the effect on inflation “likely will be small,” UBS economists led by Alan Detmeister said in a Wednesday note to clients.
The bank’s rough estimate sees the proposal prompting about 0.5 points more inflation compared to a scenario where no additional aid is approved.
Price growth is expected to rise “only gradually” after “modest” inflation in the first half of 2021, the team said. Core personal consumption expenditures – the Fed’s preferred gauge of inflation – will rise to 1.8% in 2022 and to 1.9% the following year, still trending below the central bank’s goal. Inflation is likely to overshoot 2% beyond 2023 if the economy can strengthen further, UBS said.
The forecast doesn’t yet account for the currently proposed stimulus measure, but the package “poses a small upside risk” and probably won’t lead inflation to reach 2% any sooner, the economists added.
Goldman Sachs: ‘Models currently understate slack’
Economists led by Jan Hatzius took a different approach, focusing on models measuring the output gap instead of inflation expectations. The metric hinges on maximum potential GDP estimates published by the Congressional Budget Office, but those estimates change over time as the US economy evolves.
History suggests the CBO’s calculations are flawed and “currently understate slack” in the US economy, Goldman’s economists said Wednesday. The team alleged the office’s model suffers from endpoint bias, meaning it interprets short-term changes as a reversal of a long-term trend.
Economists don’t need to look too far back to find other examples of this, according to the bank. The CBO’s estimate of potential GDP was consistently revised lower from 2009 to 2017 when actual GDP lagged the maximum potential. Revisions then turned positive in 2018, when actual GDP exceeded the estimated maximum. The CBO reinterpreted what first seemed to be an overheating to later be a catching-up toward full potential, the economists said.
“Both on the way down and on the way up, actual GDP was therefore a leading indicator for estimated potential GDP, indicative of endpoint bias,” they added.
Overall, Goldman projects the output gap to currently be more than twice the size of the CBO’s estimate, backing the bank’s view that “inflation risk remains limited,” even with its above-consensus growth estimates. The CBO’s model is also hard to square with inflation over the past decade, Goldman said, as price growth has steadily fallen short of the Fed’s target even as the budgetkeeper saw the economy overheating.
Deutsche Bank: ‘An unusual moment in macro history’
A special report on Friday by Deutsche Bank’s Chief International Strategist Alan Ruskin sought to strike a balance. Essentially, he wrote, this coming year will be too soon to tell.
Noting that inflation usually tends to lag growth by as much as two years, Ruskin wrote that inflation fears likely won’t be easily proven wright or wrong in 2021.
“A few soft US inflation numbers will not sound the all clear. A few strong US inflation numbers will however elevate concerns,” he wrote. “There is then some inherent asymmetric skew to how the markets will think about inflation risks going forward.”
Ruskin foresaw building inflation fears for this reason, as his “all clear” on inflation risk will not be reachable. Over the medium term, he added, the “market consequences of a meaningful US inflation acceleration are far greater than if inflation fails to accelerate.”
Zooming out somewhat, Ruskin noted this is “an unusual moment in macro history” where “the ‘stars’ as they relate to inflation fears have aligned” because economists of various traditions, ranging from neo-Keynesians to Monetarists to the Austrian school, all have growing evidence showing more rather than less inflation risk.
These elements include the strongest money supply growth in history; the strongest expected real growth in 70 years; the closing of a large negative output gap, and some of the most accommodative financial conditions on record.
Ruskin wrote: “There is a certain sense of ‘if not now, then when?'”