Reflation Risk

Overheating Debate Overview

• Former Treasury Secretary Larry Summers and former IMF Chief Economist Olivier Blanchard warn that U.S. fiscal stimulus and accommodative Fed policy may trigger inflationary pressures similar to the late 1960s and 1970s.
• Goldman Sachs Research Head Jan Hatzius argues that current U.S. economic conditions do not warrant predictions of a sustained inflationary spiral.
• The Fed's new framework, which allows for "average inflation targeting," increases tolerance for inflation to be temporarily above 2% to ensure full employment is achieved before tightening.

Output Gap and Stimulus Analysis (Jan Hatzius)

• Goldman Sachs estimates the U.S. output gap at approximately 6% below potential, significantly larger than the Congressional Budget Office's (CBO) 3% estimate.
• CBO estimates are challenged by Hatzius, noting that pre-pandemic inflation was below target (contradicting an above-potential economy) and that employment remains 6% below pre-pandemic levels.
• Total fiscal support is projected at 11% of GDP in 2021, declining to 5% in 2022, suggesting the stimulus is front-loaded and unlikely to cause sustained overheating.
• Multiplier effects are deemed less relevant as they are long-run concepts that assume permanent stimulus, whereas current U.S. stimulus is temporary.
• Specific spending categories, such as $350 billion in state and local aid, are expected to replenish rainy day funds rather than drive immediate near-term consumption.
• Global overheating risks are viewed as low in Europe and Japan due to deeper output holes and less incremental fiscal support compared to the U.S.

Fed Policy and Inflation Expectations (Jan Hatzius)

• The Fed is intentionally "behind the curve" to ensure inflation is clearly anchored before withdrawing stimulus, aiming for a symmetric 2% target.
• Inflation expectations are considered well-anchored and better measured today than in the 1960s and 1970s, reducing the risk of a sudden unanchoring.
• Goldman Sachs' base case forecasts tapering to begin in early 2022, with the first rate hike occurring in early 2024.
• Risks to the timing of rate hikes are considered even or slightly tilted toward a later date, though risks to the level of the funds rate are tilted toward a more hawkish outcome.
• If inflation rebound is stronger than forecast, the Fed could execute steeper hikes (100 basis points or more per year) starting potentially in 2023.

Bond Market Repricing Drivers (Dominic Wilson)

• Recent bond yield increases reflect the realization of growth acceleration and the arrival of significant fiscal stimulus packages, moving away from the "emergency" mindset of the prior year.
• The current market environment differs from the 2013 "taper tantrum" due to the absence of a surprise policy shock and a stronger global growth backdrop (no China slowdown).
• Investors face uncertainty regarding the Fed's reaction function, specifically whether the Fed will hike sooner than its "see the whites of the eyes" rhetoric implies.
• Bond market repricing has forced a rotation out of long-duration growth assets (e.g., NASDAQ) and into cyclical sectors (banks, commodities) and the U.S. dollar.

Asset Class Implications and Market Positioning (Dominic Wilson)

• Equity markets have struggled with rate sensitivity, with growth stocks and emerging markets underperforming cyclical sectors and developed markets.
• Market positioning is currently vulnerable in rate-sensitive areas due to decades-long overweight positions in assets that benefited from falling real rates.
• Goldman Sachs recommends exposure to cyclical equities and non-gold commodities for the next 2–3 months while avoiding bonds and rate-sensitive growth stocks.
• Non-U.S. developed markets (Japan, Europe) are viewed as having better value relative to emerging markets and the U.S. in this higher-yield environment.
• Equity market stability depends on the pace of rate increases rather than the absolute level; yields can rise without disrupting equity performance as long as the increase is gradual.
• The market may be complacent regarding the long-term risk that the terminal real rate could rise permanently, reversing the secular trend of declining real rates seen in the previous decade.