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For The First Time, Goldman Warns Fed's Aggressive Tightening May Lead To "Hard Landing"

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by Tyler Durden
Tuesday, Feb 08, 2022 - 08:25 PM

One month ago, we quoted a fragment from a recent Goldman research report, which carried two potential meanings, neither of which was especially good. Specifically, when discussing the Fed's dramatic hawkish pivot, the vampire squid's economists said that "inflation risks—rather than improving growth expectations—have driven the recent hawkish pivot," which we translated as follows: "the Fed is i) either hiking into a stagflation or ii) hiking with hopes of creating a recession."

Today, Goldman's chief economist Jan Hatzius published a follow up report in which he hinted at the answer.

In the note suggestively titled suggestively enough "The Slowdown That We Need", Hatzius writes that the "most important number in the US employment report for January was not the surprising 467k increase in nonfarm payrolls, but the 0.7% increase in average hourly earnings."

He also notes that this number reinforces the message from Goldman's composition-adjusted wage tracker, "which has accelerated to a 6% annualized rate over the past 2-3 quarters" and adds that "with core PCE inflation running at about a 5% rate over the past 3, 6 and 12 months, this raises the question whether we are already in the middle of a wage-price spiral that will need to be broken by aggressive Fed rate hikes and a large tightening in financial conditions."

But wait: does this mean that Goldman's note from just one month ago which said that there was "little sign of a wage-price spiral"...

... was wrong? Apparently yes, just as Goldman was dead wrong throughout all of 2021 when month after month, the bank dismissed the surge in inflation as transitory, even as we warned repeatedly that inflation was permanent and would force the Fed to tighten aggressive.

So what is Goldman saying now? Well, having conceded that a wage-price spiral is very much a possibility, and that inflation expectations are close to becoming unanchored, the bank writes that it "even if wage growth comes down from 6% to 5%, as we expect, this would imply unit labor cost inflation of at least 3% assuming productivity rises no more than 2%. If it persists, such a pace would be too high for achieving the Fed’s 2% PCE inflation target. This raises the risk that Fed officials would want to see an even bigger slowdown in output and employment growth than we are currently forecasting, to a pace no faster than the long-term trend."

Putting it all together, Hatzius notes that - just as we said - the Fed is "hiking with hopes of creating a recession", only of course the Goldman economist doesn't use those words, and instead says that "the broadening of wage and price pressures across the advanced economies implies that growth needs to slow and financial conditions need to tighten at an earlier stage of the recovery than previously expected."

In terms of what this means for markets, Hatzius explains that his "core market views are an increase in riskless yields, a widening of IG and HY credit spreads, and a combination of lower expected returns and bigger potential drawdowns in the major DM equity markets relative to the post-covid recovery so far."

Of course, all of that assumes that the Fed will somehow pull off a soft landing. The problem is that the Fed has never been able to pull off a soft landing and every tightening cycle has ended in a crisis.

Worse, this time around the Fed is hoping to not only lift the short-end of the curve through rate hikes, but to also force a steepening of the yield curve by shrinking the balance sheet actively so that the long end sells off more than the short-end. The alternatively is, of course, a curve inversion which would telegraph an early start to the recession, and which the forward curve is already pricing in.

How Powell can do all this and land "softly" is a mystery. What is far more likely is that within a  year or so, the US economy will crash and burn. Hard. And while not Goldman's base case, Hatzius hints at just this outcome in his last sentence:

At this point, our baseline remains that this will be sufficient to slow growth and bring inflation back toward central bank targets over the next 1-2 years. But the risk of a harder landing will rise if US growth stays significantly above our below-consensus forecast.

Spoiler alert: there will be no soft landing.

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