Goldman with the note. Not sounding so bullish suddenly:
1. The most important number in the US employment report for January was not the surprising 467k increase in nonfarm payrolls, but the 0.7% increase in average hourly earnings. It reinforces the message from our composition-adjusted wage tracker, which has accelerated to a 6% annualized rate over the past 2-3 quarters. With core PCE inflation running at about a 5% rate over the past 3, 6 and 12 months, this raises the question whether we are already in the middle of a wage-price spiral that will need to be broken by aggressive Fed rate hikes and a large tightening in financial conditions.
2. So far, we don’t see a spiral where wage and price inflation feed on each other while expectations become unanchored to the high side. Our wage survey leading indicator remains consistent with just under 4% growth, as does a narrower set of business surveys that ask specifically about compensation budgets for 2022. And while short-term inflation expectations have surged, longer-term forward inflation expectations—whether measured via bond yields, forecaster surveys, or household surveys—remain well anchored. Taken together, these observations suggest that firms, households, and market participants still expect the current wage and price surge to level off as the economy emerges more fully from the pandemic.
3. There are also reasons to expect the supply-demand balance in the labor market to improve. On the supply side, labor force participation has begun to pick up in recent months, and we expect further gains as health concerns recede on the back of improving case counts and better treatments. On the demand side, GDP and employment growth should slow this year—at least once the near-term rebound from Omicron has run its course—because fiscal policy is turning more restrictive, the Q4 inventory boost is now behind us, and the financial conditions impulse will go from sharply positive in 2021 to (at least) modestly negative in 2022. For these reasons, our 2022 GDP forecast of 2¼% on a Q4/Q4 basis is 0.8pp below the latest Bloomberg consensus and 1.8pp below the FOMC’s last published forecast (as of the December meeting).
4. Even if wage growth comes down from 6% to 5%, as we expect, this would imply unit labor cost inflation of at least 3% assuming productivity rises no more than 2%. If it persists, such a pace would be too high for achieving the Fed’s 2% PCE inflation target. This raises the risk that Fed officials would want to see an even bigger slowdown in output and employment growth than we are currently forecasting, to a pace no faster than the long-term trend.
5. How much additional monetary policy tightening would be needed? To obtain an illustrative answer, let’s assume that the Fed wants to slow GDP growth by an incremental ½-1pp. (The bottom end of that range closes the gap between our own forecast of actual and potential growth, while the top end does approximately the same for the consensus.) Based on our estimated rules of thumb, this would require an incremental 50-100bp of FCI tightening, which in turn could be brought about by an incremental 50-100bp of Fed rate hikes. Importantly, the added Fed tightening would need to come on top of the amount that is currently discounted in the yield curve, and thus in our FCI. All else equal, this suggests that markets will have to revise up their estimate of the terminal funds rate from the current 1.7% to roughly our own 2½-2¾% forecast, or else the Fed may need to deliver more than the five 25bp hikes that are currently priced for 2022 (and included in our own forecast). If it is the latter, we think an even longer series of up to seven 25bp moves this year is more likely than a turn to 50bp moves.
6. We have made significant hawkish changes to some of our non-US monetary policy forecasts in recent weeks. We now expect the European Central Bank to deliver two 25bp hikes in late 2022, as the labor market is making rapid progress, inflation has surprised materially on the upside, and President Lagarde signaled less willingness to look through these surprises than we had expected. We expect the Bank of England to deliver back-to-back 25bp hikes at the next two meetings, followed by asset sales and one additional 25bp hike in H2; as in the US, however, the risks to our forecast are tilted to the high side. Lastly, we now expect the Reserve Bank of Australia to deliver a first 25bp hike at the November meeting, despite the still-dovish guidance from Governor Lowe.
7. While the PMIs declined in January and the property market continues to soften, China has seen a decline in covid case numbers on the back of increased restrictions. That said, keeping Omicron at bay is likely to continue to require a higher level of restrictions than were in place for most of 2021. Another Chinese city is in lockdown, and Hong Kong, Taiwan, and New Zealand—the other zero-Covid economies—have all tightened restrictions in recent weeks. We continue to expect a below-consensus growth outcome of 4½% this year, although we note that this is consistent with a moderate sequential acceleration in the course of 2022 on the back of further policy easing.
8. The broadening of wage and price pressures across the advanced economies implies that growth needs to slow and financial conditions need to tighten at an earlier stage of the recovery than previously expected. Consistent with this, our core market views are an increase in riskless yields, a widening of IG and HY credit spreads, and a combination of lower expected returns and bigger potential drawdowns in the major DM equity markets relative to the post-covid recovery so far. At this point, our baseline remains that this will be sufficient to slow growth and bring inflation back toward central bank targets over the next 1-2 years. But the risk of a harder landing will rise if US growth stays significantly above our below-consensus forecast.