Apr 16, 2024, 10:58 AM ETInterview, Fireside Chat

Are inflation fears overblown? The outlook for inflation, US growth, and long-term rates

Current Inflation Trajectory: While Year-to-Date inflation has been higher than expected, the primary drivers are idiosyncratic "catch-up" inflation (specifically in car insurance and shelter rents) rather than overheating; the core PC inflation trend remains downward.
- Forecasts: Core PC inflation is projected to decline from 2.9% at the end of last year to 2.5% by year-end 2024.
- Disinflation Drivers: Future disinflation is expected to be driven by the reversal of the lag in official shelter data (which reflects market rents from two years prior) and the unwinding of pandemic-era supply shortages.
Labor Market Balance: The labor market is no longer in a "re-tightening" phase; it has returned to a pre-pandemic balance that supports strong job creation without generating sustained wage-price spirals.
- Supply Factors: Recent job growth is largely attributed to increased labor force participation and a surge in immigration, which expanded labor supply rather than indicating excess demand.
- Metrics: Composite measures of labor tightness (including job vacancies and survey data) indicate the market is balanced, contrasting with the extreme tightness of 2022.

Above-Consensus Growth: Goldman Sachs forecasts U.S. real GDP growth of 2.5% on a Q4-Q4 basis for 2024, which is approximately one percentage point above consensus expectations.
- Rationale: Strong growth is not expected to spur inflation because faster population growth (via immigration) is increasing the economy's supply-side potential, keeping the supply-demand balance intact.
- Phillips Curve Sensitivity: Even if the unemployment rate falls to 2.7%, the quantitative impact on core inflation is estimated to be negligible (approx. 5 basis points) compared to the disinflationary impact of catching down rent indicators.
Financial Conditions: Despite higher nominal interest rates, broad financial conditions remain as easy as they were during the 2017–2019 period.
- Offsetting Factors: Optimism in risky asset markets and strong equity prices have offset the drag from higher policy rates.
- Fiscal Support: Large federal budget deficits are currently acting as a non-monetary stimulus, allowing the economy to operate at full employment despite higher interest rates.

Higher Neutral Rate Thesis: Goldman Sachs argues the long-run "neutral" interest rate ($r^*$) is structurally higher than the pre-pandemic consensus suggested, estimating it to be in the 3.0%–3.5% range (nominal).
- Evidence: The economy has sustained full employment and 2% inflation targets at higher policy rates, challenging the previous view that near-zero real rates were necessary for equilibrium.
- Structural Drivers: The current neutral rate is supported by sustained fiscal deficits and resilient financial conditions, though these factors may not be permanent.
Fed Policy Outlook:
- Rate Cut Expectations: The first Fed rate cut is now projected for July 2024, with a total of two cuts anticipated for the year.
- Stopping Point: While the Fed is expected to eventually lower rates to "normalize" policy, it is unlikely to return to the ~2.5% terminal rate seen in the previous cycle; the ultimate neutral rate is uncertain but likely higher.
- Risk Warning: There is a risk that markets are currently over-adjusting to a "higher for longer" rate environment, potentially extrapolating temporary fiscal deficits as permanent structural forces.

Market Pricing: The market has already priced in significant shifts regarding the terminal rate and the duration of high rates; further changes in the timing of cuts (e.g., July vs. November) are unlikely to materially impact the broader economic outlook.
Forward-Looking View: Disinflation is expected to be more straightforward to forecast this year due to the mechanical nature of the remaining catch-up adjustments, reducing the uncertainty compared to typical economic cycles.