Goldman: Economy growing at 'twice our estimate' of its potential

Key Points
  • Goldman Sachs says the underlying economic growth is running at 3.5 percent, or double its estimated potential.
  • While there are headwinds, Goldman economist Jan Hatzius says one of the most oft-cited, the trade war, poses little danger.
  • Citigroup economists, on the other hand, warn that slowing growth in 2019 and 2020 pose a substantial danger to markets.
Trump's economy: Here’s where he gets credit, and what could go wrong
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Recent data is pointing to an economy growing at an even more rapid pace that will overcome various headwinds including the intensifying trade war, according to Goldman Sachs.

Friday's nonfarm payrolls report that showed 201,000 new jobs combined with manufacturing surveys to indicate underlying growth at 3.5 percent, "twice our estimate of the economy's potential and consistent with a rapid pace of labor market tightening," Jan Hatzius, Goldman's chief economist, said in a note Monday.

The result is a Fed that will increase interest rates six more times through the end of 2019, he said. That forecast is slightly above the five hikes that central bank officials have indicated during the period and considerably above the implied three moves being priced in by futures markets.

Hatzius acknowledged that various headwinds could change the Fed's trajectory, but said that he is "comfortable" with the current forecast, which he said might even be conservative.

"Although it is certainly possible that trade policy and emerging market spillbacks will result in a shallower path, on net we think the risks are tilted to the upside of our baseline forecast given the impressive growth momentum, the upward trends in wage and price inflation, and the very limited impact of the hikes on financial conditions so far," he wrote.

The Fed's current target range for its benchmark funds rate is 1.75 percent to 2 percent. Markets expect the policymaking Federal Open Markets Committee to approve another quarter-point increase at the Sept. 25-26 meeting and again in December. The September hike has a 98 percent chance of happening, while the December move carries a 79 percent probability, according to the CME's FedWatch tracker.

From there, though, the outlook becomes less clear.

Fed Chairman Jerome Powell, at his closely watched Jackson Hole, Wyoming, speech in August, pledged a "whatever it takes" approach to controlling inflation but said for now he is comfortable with the FOMC's gradual approach. Goldman's economists have maintained that the market misinterpreted Powell's remarks as being dovish.

An economy that is showing strong signs of heating up likely will continue to get the chairman's attention.

Goldman is forecasting inflation, by the Fed's preferred gauge, to hit 2.3 percent by the end of 2019, above its 2 percent symmetric target. If the bank is correct, Hatzius said that's not too much above where the Fed would feel comfortable "but it could nevertheless be important for the monetary policy outlook. After all, if we do go higher from here, it will become harder for Fed officials to maintain their emphasis on the lack of inflation pressure as an offset to the overheating in the labor market."

Hatzius also said he does not see the escalating trade tensions, particularly with China, as posing a major threat. In fact, he said the immediate impacts "are not as clearly negative as widely believed." President Donald Trump is expected to implement another 10 percent to 25 percent round of tariffs on $200 billion worth of Chinese goods, which in turn are expected to prompt a $60 billion retaliation.

"The 'secondary' effects — greater business uncertainty, potentially tighter financial conditions, a hit to supply chains, and non-tariff retaliation — are negative and ultimately probably bigger, but our best estimate remains only a modest net impact," Hatzius wrote.

One area that could give the Fed pause in its rate-hiking cycle would be weaker global growth.

Citigroup has a less buoyant outlook on the global economy, which had been benefiting from synchronized growth but recently has shown pockets of weakness, particularly in emerging markets and even China.

At least for investors, that could be an issue no matter how fast the U.S. is speeding ahead.

"We would characterize global growth as riding on the back of fading tailwinds, while facing increasingly strong headwinds. This raises the risk of an inflexion point some time in 2019 or early 2020," Citigroup economist Mark Schofield said in a note. "We fear that the investment backdrop is becoming more likely to support extended down-trades."

In fact, Citi cites higher interest rates as one of four obstacles for the recovery after this year, the others being a China slowdown, an intensifying trade war and tighter financial conditions, which would be a byproduct of higher rates.

"A great deal will depend on investor behavior as and when markets correct," Schofield said. "With that in mind, the increasing signs of volatility in asset prices, the increasingly narrow stock market leadership (the US equity market, ex the FAANGs would actually be down on the year) makes us fearful that a quite sharp correction is possible once markets do turn."