Goldman says the economy is doing so well the Fed will need to stop it from overheating next year

Key Points
  • Goldman Sachs turned some heads when it issued 2018 projections that see the economy growing well ahead of the post-recession trend.
  • The forecast includes a near-50-year low in the unemployment rate and rising inflation.
  • Under that scenario, Goldman thinks the Fed could raise interest rates four times, or double what the market is projecting.
Jerome Powell and President Donald Trump during a nomination announcement in the Rose Garden of the White House in Washington, D.C., U.S., on Thursday, Nov. 2, 2017.
Andrew Harrer | Bloomberg | Getty Images

Investors may get little time to enjoy the accelerated growth in an increasing number of forecasts, with one school of thought envisioning the Federal Reserve turning out the lights just as the party is getting started.

Goldman Sachs turned some heads over the weekend when it issued 2018 projections that see the economy growing well ahead of trend, the unemployment rate hitting its lowest level since 1969 — and the U.S. central bank dropping the hammer on four interest rate hikes.

The forecast comes from a belief that the Fed will get more comfortable with inflation rising towards its 2 percent target and less so with an overheating labor market that finally will begin to show signs of wage acceleration.

"With robust growth momentum and no striking imbalances in the economy, near-term recession risk still looks fairly limited," Jan Hatzius, Goldman's chief economist, said in a note. "But the strength is becoming 'too much of a good thing' and containing further overheating will become a more urgent priority in 2018 and beyond."

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Here's how that strength would look: GDP rising at a 2.5 percent rate — compared with the 2.1 percent post-recession pace — with the unemployment rate falling to 3.7 percent and wage growth rising to the 3 percent to 3.25 percent range, compared with the range around 2.5 percent currently.

Inflation is projected to rise to 1.8 percent in the Goldman scenario as temporary factors unwind and accelerating wages apply additional pressure.

Under those conditions, the Fed could feel the need to step in and make sure conditions don't get out of hand, contrary to market expectations.

"Our disagreement with market pricing springs from three sources: we see little evidence that soft inflation is structural in nature; we think markets underestimate the Fed's desire to limit labor market overheating; and we are skeptical that the neutral rate is as low as widely believed," Hatzius wrote.

That would pose a weighty dilemma for a Fed that will have a decidedly different look in 2018, starting with Jerome Powell as chairman, assuming he gets Senate approval.

"Many have packaged this with regard to Powell: Is he going to surprise us? That's not the question. Is the data going to surprise us? Is inflation going to surprise us?" said Quincy Krosby, chief market strategist at Prudential Financial. "If you're going to see more inflation, if you're going to see the economy heating up, you're going to see a more aggressive Fed."

That's not what the market is currently anticipating.

Futures contracts indicate a December hike has been fully priced in, but the year ahead points to a more cautious Fed. Anticipation right now is centered around one or two hikes — one in the spring, then perhaps another toward the end of the year, according to the CME. Fed funds futures indicate the benchmark rate to be 1.74 percent at the end of 2018, compared with the current level of 1.16 percent.

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Amid the anticipation of a slow-moving Fed has come the latest leg of the stock market rally, with the ripping 15.3 percent higher in 2017, a year that, if the Fed comes through in December, will feature three rate hikes, plus the beginning of the reduction in the $4.5 trillion balance sheet.

"Every member of the Fed and the European Central Bank want to see how the market reacts," Krosby said. "They're not going to go on a faster rate-hiking cycle without seeing how the market responds."

Since the Fed began its policy normalization campaign in December 2015 — while rates are going higher, policymakers insist conditions are still "accommodative" and not tightening — stocks have continued to rise and interest rates remain low.

However, some market participants as of late have been concerned about the narrowing in spreads between bonds of different maturities, considered a warning sign for a slower economy or recession. At the same time, Fed officials have expressed concern that financial conditions generally have gotten looser, not tighter, in the time they've been raising rates.

Should the Fed next year worry that conditions are bubbling, that could push the bank into a more aggressive pattern than the market expects. There's a school of thinking within the Fed that raising rates more aggressively actually would help inflation by raising expectations.

"How committed would the Fed to be to aggressively and purposely inverting the yield curve?" said Zachary Karabell, head of global strategy at Envestnet. "It's one thing for the yield curve to invert, it's another for the Fed to force it to happen."

Ultimately, Karabell believes the Fed probably follows the market's lead and goes slow, "but never say never to any of this."

"There's also the possibility that the Fed starts to do this and the market does what it's done all along and essentially ignore it," Karabell said. "All of these are questions that people are going to be grappling with over the next couple of years."

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