Jan Hatzius and his team at Goldman Sachs propose the five most important questions for investors in 2017.
1. Will growth remain above trend?
Yes. Admittedly, the expansion is quite advanced. It has already lasted about 18 months longer than the median completed expansion since the mid-1800s. And while expansions do not die of old age, history shows that they are at greater risk when spare capacity is exhausted, as it probably is now. So it is especially important to monitor whether growth may be running out of steam.
Exhibit 1: US Recession Risk Below Historical Average
Source: Goldman Sachs Global Investment Research
Second, financial conditions have turned from a growth headwind into a growth tailwind over the past year, as shown in Exhibit 2. Admittedly, financial conditions have tightened modestly in recent months as the increase in bond yields and the appreciation of the US dollar have outweighed the rally in the equity market. But our analysis shows that, in practice, the growth impulse depends on the year-to-year change in our financial conditions index, at least to a first approximation. Barring a big tightening in coming months, the impulse should therefore remain quite supportive, at least in the first half of 2017.
Exhibit 2: FCI Impulse Likely to Remain Positive for Much of 2017Source: Goldman Sachs Global Investment Research
2. Will US wage growth hit our 3.0%-3.5% estimate of its full employment level?
Yes. Wage growth has accelerated meaningfully in recent years as the labor market has tightened (Exhibit 3). The firming has been most pronounced at the bottom end of the wage distribution, aided by minimum wage hikes at the state and city level that are likely to continue in coming years—even if an increase at the federal level now appears very unlikely. While aggregate wage growth remains somewhat below both the pre-recession rate and the equilibrium rate that we would expect in a full employment economy, we do not see this as a sign that hidden slack remains. Rather, a combination of the impact of past slack earlier in the year, negative composition effects on aggregate wage growth, and an environment of weak productivity growth and soft inflation appear to account for most of that gap. As the labor market tightens further wage growth should continue to firm.
Exhibit 3: Wage Growth Continues to Accelerate
Source: Goldman Sachs Global Investment Research
3. Will inflation reach the Fed’s 2% target?
Yes. Headline PCE inflation has picked up from a low of 0.2% year-over-year in September 2015 to 1.4% as of last month. If energy prices hold around the current level, PCE inflation should reach the Fed’s 2% target by February or March. Core PCE inflation has also firmed over the last year, rising from a low of 1.3% to 1.6% as of November. We expect core inflation to continue accelerating—reaching 2% by Q4—as the labor market tightens further and the lagged effects of past dollar appreciation fade.
We will be keeping a particularly close eye on medical care inflation next year, which has been the main factor behind the divergence between core CPI and core PCE inflation recently. Only about half of the gap between the two measures can be explained by differences in scope. The remaining difference between the two series largely reflects measurement error, in our view, with the CPI overstating reimbursement rate inflation and the PCE index understating it. We therefore expect the two series to converge over time, giving a lift to core PCE inflation while holding core CPI inflation roughly steady in 2017.
4. Will the Fed hike faster than implied by market pricing?
Yes. At present markets are discounting an end-2017 federal funds rate of about 1.2%—54 basis points (bp) above the current effective funds rate, and implying just over two 25bp rate hikes for the year. We continue to expect the FOMC to raise rates three times, with the first hike coming in June. At the end of October markets were pricing in about 30bp of rate increases for 2017—slightly more than one 25bp rate hike—so the gap between market pricing and our forecast has already narrowed quite a bit, but we still think market pricing looks too low. Much will depend on the incoming data early in the year and the evolving prospects for fiscal stimulus. If growth momentum continues to look solid and fiscal stimulus appears likely, we would expect most FOMC members to support picking up the pace of hiking.
5. Will the Fed start to shrink its balance sheet?
No. Fed officials have said that the size of the central bank’s balance sheet will likely remain unchanged until funds rate increases are “well under way”. We have interpreted this guidance to mean that full reinvestments in the Fed’s securities portfolio would continue until mid-2018, when we expect the funds rate to be around 2% (Exhibit 4). After that we forecast that policymakers would begin a slow, tapered runoff of the balance sheet that would last for several years.
Exhibit 4: We Expect the Fed’s Balance Sheet to Remain at Current Size in 2017
Source: Federal Reserve. Goldman Sachs Global Investment Research.
Some of the economic advisers to President-elect Trump appear to favor a smaller Fed balance sheet with a shorter duration, and this issue could come up in any nomination hearings for the two open Board positions. However, we do not think the election result meaningfully affects the outlook for the balance sheet for 2017. First, Chair Yellen will remain at the helm until early 2018, and will likely continue to execute the committee’s current plans—even with the addition of a few President-elect Trump appointees to the Board. Second, in our view, the ideal size of the central bank’s balance sheet is not really a macroeconomic issue—rather, most of the key determinants are institutional and regulatory matters. As a result, the views of the new administration may evolve as it begins to tackle regulatory reform and debt management concerns.