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July 19, 2021 | GSAM Connect

US Inflation Reverting to the Mean

US inflation has reached its highest level over the last two decades. While a spike above 3% for the core personal consumption expenditure (PCE) may be unusual in today’s low inflation regime, the Federal Reserve has largely attributed the strength in prices to temporary factors such as supply bottlenecks, generous fiscal responses, and resurging consumer demands, which we expect will fade. To date, the year-over-year inflation gains observed—most notably in durable goods—have been driven predominantly by low base effects where current prices appear significantly stronger compared to weaker prints from the COVID-19 pandemic a year ago. We ultimately believe that elevated prices have likely reached their peak and therefore expect inflation to moderate toward the Fed’s target level over the medium term. Importantly, past periods of low and stable inflation have coincided with short-term inflationary episodes (as shown in exhibit 1 below), leading us to believe that this, too, shall pass.


Exhibit 1: Inflation – Past, Present, and Future

Source: US Bureau of Economic Analysis, Goldman Sachs Global Investment Research, and Goldman Sachs Asset Management. As of July 9, 2021.


Goldman Sachs Global Investment Research forecasts inflation to peak in the coming months before normalizing to 3.0% by year-end, 2.0% in 2022, 2.15% in 2023, and 2.2% in 2024. While prices have moved higher, they have also been concentrated in specific categories, namely medical services, used cars, hotels, nonprofits, and furnishings. We believe that in order to achieve sustainable inflation, it would require stoking higher prices from a broader set of categories beyond the ones most sensitive to reopening. Importantly, once manufacturing capacity comes back online and pent-up demand levels off, prices should start converging onto a more normal path of inflation.


An even greater hurdle exists to realizing hyperinflation, in our view. About 63% of annual inflation comes from acyclical categories—goods and services with stable demand—such as transportation, healthcare, and financial services. Acyclical inflation has averaged only 1% over the last 10 years.[1] Meanwhile, cyclical categories, comprising recreational services, housing, and food services, have realized significant price inflation. Still, we believe it would take either a significant pick-up in acyclical inflation or persistent price increases of cyclical components for inflation to hold at current levels or higher. Both conditions will be difficult to achieve, as the path to realizing above-4% inflation would require a consistent 2% inflation from acyclical categories and at least 7% inflation from cyclical categories.[2]


Despite our outlook, tail risks on both sides should be considered. On the one hand, the abundance of labor market slack, fading policy impulses, aging demographics, and digitization/globalization may generate more disinflationary effects. On the other hand, faster-than-expected full employment, pent-up household consumption, and high fiscal multipliers from infrastructure spending may push inflation above target. Realistically, we think the greatest upside risk is a more patient Federal Reserve. First, the adoption of flexible average inflation targeting (FAIT) policies will likely result in the Fed being more comfortable with slightly higher inflation in an effort to achieve the broadest measures of full unemployment. Therefore, we believe the risk of preemptive tightening appears much lower today. Second, policymakers’ appetites for higher inflation also come from the reality that disinflationary or deflationary pressures pose a greater concern today. In the last decade, US core PCE has trended below target at 1.6%.


As investors, we primarily worry about inflation dynamics in the context of monetary policy. And despite the Fed’s unchanged inflation forecasts, the latest hawkish FOMC commentary suggests that policy easing may come to an end. In our view, there is still plenty of time between now and the time the first policy hike occurs. We forecast tapering to begin in 2022 with the first rate hike likely scheduled for 2H 2023. Our expectation is for monetary policy to remain accommodative in the near future.


Ultimately, we are reminded that higher inflation and rates driven by a stronger macro backdrop are typical features of expansionary cycles and can still support risk asset performance, as shown in exhibit 2 below. What may matter more to risk assets are the pace of policy change and how forward guidance will be telegraphed. We remain watchful on both of these as monetary policy shifts in the coming quarters.


Exhibit 2: Real Returns Under Different US Inflation Regimes

Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. Monthly data from September 1929 to December 2019. A “60/40” portfolio comprises of 60% allocation to S&P 500 and 40% allocation to 10-year US Treasuries. These examples are for illustrative purposes only and are not actual results.  If any assumptions used do not prove to be true, results may vary substantially. Past performance does not guarantee future results, which may vary.

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Candice Tse

Candice Tse

Global Head of Strategic Advisory Solutions, Goldman Sachs Asset Management

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