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Goldman Sachs says the Federal Reserve is likely to let inflation run higher than its 2 percent target.
The central bank has begun a monthslong review of its policy framework to consider alternative approaches to targeting inflation. Goldman believes the Fed will decide to allow overshoots of its inflation goal next year, which would take rate hike off the table.
"Our economists believe it is leaning toward adopting an average inflation targeting approach. If implemented, they believe this change would decrease the likelihood of further near-term policy tightening and lead to a small and gradual increase in both expected and realized price inflation," Goldman equity strategist Ben Snider said in a note.
Since 2012, the Fed has always been attempting to hit a 2 percent inflation target, but the rate of price rises has fallen short through much of the recovery from the recession. The alternative approach that Goldman expects the Fed to adopt calls for targeting 2 percent on average over the business cycle, which encourages higher prices during expansions to balance weak inflation during recessions. New York Fed President John Williams is a supporter of this framework.
Fed chief Jerome Powell during his February testimony before the House Financial Services Committee said the central bank is examining alternatives to "more credibly achieve" its target, adding that it's not looking at a higher inflation target.
Such an accommodative policy change would make risk assets like stocks more appealing, Goldman said.
"Decreased odds of incremental Fed tightening would increase investor confidence in future discount rates as well as reduce the probability investors assign to recession occurring in the near term, supporting higher risk appetites," Snider said.
History has shown that slightly higher inflation would lift stock valuations as funds tend to flow from cash to equities as inflation expectations rise. In addition, there's a strong correlation between the S&P 500 forward price-to-earnings ratio and the breakeven inflation over the past 15 years, Goldman pointed out.
As higher inflation will cause higher wages that could add to pressure on corporate profit margins, companies with high pricing power and low exposure to labor costs should outperform as inflation expectations rebound, the bank said.