Goldman Sachs: June inflation has eliminated the possibility of a Fed rate hike in July; Waller needs to explain the response mechanism in detail to avoid financial volatility.

Goldman Sachs: June inflation has eliminated the possibility of a Fed rate hike in July; Waller needs to explain the response mechanism in detail to avoid financial volatility.

The unexpected cooling in June’s inflation data has completely eliminated the possibility of a Federal Reserve rate hike in July. Goldman Sachs Chief Economist Jan Hatzius stated in a new report released on July 19 that the improvement in inflation has essentially locked in an outcome where the FOMC remains on hold this month. However, the real test for Fed Chair Walsh is how to effectively manage market expectations during a policy shift and prevent excessive moves in financial conditions.

According to Wind Chaser Trading Desk, Goldman Sachs estimates that core PCE in June rose moderately by 0.18% month-on-month, up 3.3% year-on-year; core CPI rose just 2.6% year-on-year, and the trimmed mean PCE was even lower at 2.3% year-on-year. Hatzius believes this set of data has "effectively eliminated" any chance of a rate hike at the FOMC meeting on July 28-29. Meanwhile, he warns, whenever policy needs to be adjusted in any direction, Walsh will have no choice but to explain the committee’s economic outlook and reaction function more thoroughly than at the first press conference or Congressional hearing, otherwise it will be difficult to control the market narrative.

Goldman Sachs’ forecast for the Fed’s rate path remains noticeably below market pricing. The baseline scenario (probability 35%) is a rate cut in June and December 2027, while the likelihood of rate hikes is only 25%. The report also notes that Goldman Sachs’ rates strategists believe current market pricing for tightening is excessive, but as long as risks of an escalation in the Middle East continue to dominate market sentiment, this deviation is unlikely to be corrected in the near term.

Inflation Cools, July Rate Hike Window Closes

Goldman Sachs estimates that core PCE in June rose 0.18% month-on-month and 3.3% year-on-year, with other inflation measures also mild: core CPI rose just 2.6% year-on-year, trimmed mean PCE rose 0.14% month-on-month and 2.3% year-on-year. Hatzius points out these data confirm substantial improvement in inflation, and the possibility of an FOMC rate hike in July has been "effectively eliminated."

The report further points out that core PCE is a clear outlier among G10 economies—core inflation in other G10 economies (whether traditional measures excluding food and energy, or trimmed mean) has now fallen to 2.1%, despite an energy price shock earlier in March-April this year. Goldman Sachs believes the higher U.S. core PCE compared to other economies is partly due to statistical issues, including unadjusted software and accessory prices, portfolio management fees measured in U.S. dollars instead of basis points, as well as tariff impacts unique to the U.S.

Looking ahead, Goldman Sachs expects adjustments in the statistical methodology for software and accessory prices in September to reduce the core PCE annual growth rate by about 0.2 percentage points, and predicts core PCE inflation will gradually fall to near 2% by 2027, driven mainly by the fading effects of software and accessories, energy transmission, and tariffs.

Walsh Must Explain Reaction Function Thoroughly to Prevent Financial Overshooting

Goldman Sachs believes that although inflation improvement rules out a July rate hike, there remains a possibility of further hikes in subsequent meetings if inflation is significantly higher than expected and unemployment significantly lower. The deeper challenge is how the FOMC can effectively guide market expectations when acting without a dot plot or at unscheduled meetings.

Hatzius clearly states that to control the market narrative and prevent financial conditions from becoming too tight or too loose, Walsh will have "no choice" but to explain the committee’s economic outlook and policy reaction function more thoroughly to the market than before. The backdrop is that Goldman Sachs rates strategists believe current market pricing for tightening is already excessive, but as long as escalation risk in the Middle East lingers, this mispricing is expected to persist.

Looking at Goldman Sachs’ scenario analysis, the baseline path (35% probability) is a 25bps rate cut in June and December 2027; rate hike scenario is 25% probability; high inflation/high growth/high terminal rate scenario 25%; recession scenario 15%. The overall probability-weighted path remains below current market pricing.

Labor Market Cools, Consumption Faces Pressure in Second Half

On the employment front, the June nonfarm payrolls report was weaker than expected, and Goldman Sachs lowered its estimate of potential employment growth from 130,000 per month to 73,000. Although the unemployment rate fell to 4.2%, Goldman Sachs believes this drop was mainly driven by an unusually sharp decline in labor force participation, which is expected to rebound in the coming months, and should not be overinterpreted.

Other labor market signals are also weak: residents’ assessment of the job market remains sluggish, job inflows and outflows are both suppressed, and Goldman Sachs’ wage tracker has slowed to 3.4%, below the 4% level needed to match the 2% inflation target (assuming a 2% productivity trend).

On the consumer side, Goldman Sachs estimates the U.S. economy expanded at a trend growth rate of about 2.25% in the first half, with the effects of tax cuts offsetting the impact of high oil prices on consumers. But the outlook for the second half is weakening: a slowdown in real disposable cash flow growth is expected to weigh on consumer spending, and if oil prices remain high, the pressure will intensify. In addition, should the AI boom lose momentum, the roughly 0.5 percentage point boost to consumption from stock wealth effects will also face downside risk, adding further uncertainty.

 

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The above content is from Wind Chaser Trading Desk.

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