Are inflation fears overblown? The outlook for inflation, US growth, and long-term rates

Episode Summary

Executive Summary: Goldman Sachs economist David Mericle argues that the recent hotter-than-expected CPI print is not evidence of renewed inflation overheating. He says disinflation should continue as catch-up inflation in shelter and car insurance fades, labor markets remain balanced, and stronger growth can coexist with lower inflation because labor supply and immigration are boosting potential output. The bigger story is a higher neutral rate and easier financial conditions.

Main Topics: Hotter CPI print and inflation outlook (Priority: 5/5): Mericle says the latest inflation surprise does not change the broader view that inflation is still headed lower this year, though not all the way back to 2%. Recent strength came from idiosyncratic, catch-up, and lagging components rather than a broad reacceleration. Why inflation is still expected to ease (Priority: 5/5): The recent upside surprise was driven by owner’s equivalent rent and car insurance, both of which reflect lagged or catch-up dynamics. These should fade as shelter inflation follows leading indicators and pandemic-era price adjustments complete. Labor market balance, not overheating (Priority: 5/5): Despite a strong payroll report, multiple labor-market indicators suggest the job market has returned to roughly pre-pandemic balance rather than becoming tight enough to reignite inflation. Strong growth without inflation pressure (Priority: 4/5): Goldman’s above-consensus growth forecast is explained by faster labor-supply growth, especially immigration, and easier financial conditions, which can raise potential growth and offset stronger demand. Financial conditions and rate-cut timing (Priority: 4/5): Markets have pushed back expectations for the first Fed rate cut, but Mericle argues that shifting timing from June to July matters less than changes in the longer-run policy path and stopping point. Higher neutral rate debate (Priority: 5/5): Mericle says the economy’s ability to function at higher rates supports the case that the neutral rate is higher than pre-pandemic assumptions. He sees markets and the Fed gradually rethinking neutral upward.

Key Arguments: The recent CPI upside surprise mostly reflected quirky, sector-specific factors rather than a broad inflation reacceleration. Shelter inflation is likely to keep falling because official rent measures are lagging leading indicators. Car insurance inflation is an example of catch-up pricing after earlier spikes in used-car prices. The labor market has moved from historically tight conditions in 2022 back to roughly pre-pandemic balance. Stronger payroll growth does not necessarily imply tighter labor markets when labor force growth is also strong. Immigration is boosting labor supply, which allows job growth without the same inflationary pressure as in 2022. Goldman’s 2.5% growth forecast is above consensus but still plausible because potential growth has risen and financial conditions have eased. A modest labor-market retightening would have only a small effect on core inflation compared with shelter disinflation and reversal of pandemic shortages. Markets have already repriced the Fed path substantially; shifting the first cut by a month or two is less important than the eventual terminal rate. The neutral rate is likely higher than the old 2% to 2.5% framework because post-crisis assumptions overstated how low rates needed to be permanently.

Data Points: Core PCE inflation end-2023: 2.9% - Level cited as the starting point for inflation and Goldman’s forecast trajectory Core PCE inflation expected end-2024: 2.5% - Goldman’s year-end inflation forecast U.S. growth forecast (2024 Q4/Q4): 2.5% - Goldman Sachs above-consensus growth outlook Estimated potential GDP growth: ~2.1% - Mericle’s estimate based on faster labor supply growth Unemployment rate impact on core inflation: ~5 basis points - Estimated effect if unemployment falls by 0.3 percentage points First Fed cut forecast: July - Goldman moved its expected first rate cut from June to July Number of cuts expected in 2024: 2 - Goldman’s updated Fed forecast Neutral rate estimate (long-run): 3.0% to 3.5% - Mericle’s long-run neutral rate range Earlier consensus neutral rate: 2.0% to 2.5% nominal - Old conventional view described as too low Current Fed funds rate: 5 3/8% - Rate level the Fed has held and that the economy is weathering well Budget deficit effect on short-run neutral rate: +1.0 to +1.5 percentage points - Estimated support to the neutral rate from unusually large deficits Financial conditions index benchmark: Similar to 2017-2019 average - Despite higher policy rates, broad financial conditions have eased via risky assets Date of episode recording: Friday, April 12, 2024 - Episode metadata

Pivotal Quotes: "What we are not seeing is a reigniting and overheating inflation." — David Mericle: Explaining why the recent inflation print does not alter the broader disinflation view "We’ve gotten to exactly where we want to be." — David Mericle: Describing the labor market’s return to balanced conditions "I think it’s a lot more likely that markets and, I suspect, the Fed will ultimately learn that long-run neutral is a good bit higher." — David Mericle: Summarizing the case for a higher neutral rate than pre-pandemic assumptions

Implications: Listeners should expect slower disinflation but not a renewed inflation surge, a still-resilient economy, and a Fed that may ultimately settle on higher-for-longer rates and a higher terminal policy level than markets once assumed.