Wall Street boldly predicts: in order to hedge the labor shortage, the Fed may tolerate inflation of 2.5% to 3.5%!

The monetary policy framework of the Federal Reserve may undergo a major shift. BCA Research analyst Dhaval Joshi predicts that under the leadership of future Federal Reserve Chair Volcker, the Fed may effectively tolerate inflation rates rising to the range of 2.5% to 3.5% to support the US economy operating at a higher temperature. The core motivation of this strategy is that the US labor market has reached a rare balance between supply and demand, and any contraction from either side could lead to an economic recession. Data shows that the current US labor demand and supply are both at 172 million people, with job vacancies and non-temporary unemployment stable at 6.6 million, putting the market in a theoretically "perfect balance" state. Joshi points out that at this crucial juncture, if tightening immigration enforcement leads to a contraction in labor supply, it will directly threaten economic expansion. Therefore, the Fed may increase inflation tolerance to stimulate total demand while boosting labor participation in an "overheated" environment to hedge against supply side shrinkage. This policy shift will reshape asset pricing logic significantly. The report forecasts that even if inflation rises to the range of 2.5% to 3.5%, the Fed will continue cutting interest rates to accelerate the decline in short-term real interest rates. The US dollar will continue to weaken due to the narrowing of the real interest rate differential, while the US bond yield curve will face pressure from the "steepening bear market," where rising long-term yields lead to underperformance of long-term government bonds compared to cash and other sovereign bonds. Against this macro backdrop, stocks are expected to continue outperforming bonds. BCA Research recommends tactically over-allocating to the MSCI Global Consumer Discretionary sector relative to the Industrial sector. The sector has significantly underperformed the Industrial sector in the past 65 trading days, presenting a significant opportunity for recovery. Labor market balance brings "dual risks" The US labor market is entering a rare "balance moment," marking the first time since the outbreak of the pandemic that both supply and demand sides have achieved numerical parity. By definition, labor supply includes employed and unemployed individuals; labor demand includes employed individuals, job vacancies, and temporarily unemployed workers. When the number of "jobs looking for workers" is equal to the number of "workers looking for jobs," the market is in a strict sense of balance. This rare balance state is due to a fundamental shift in economic logic underlying it. For decades before the pandemic, the US economy was in a state of chronic undersupply, with labor demand persistently lower than supply. Post-pandemic, the supply-demand relationship has reversed, with labor supply becoming a growth bottleneck, leading the economy into a "supply-constrained" operating mode. In this mode, a slowdown in demand does not directly trigger GDP recession, explaining why despite weak demand performance between 2023 and 2024, the US economy continues to grow positively. However, the current balance state also means that the market has entered a "dual risk" zone: any contraction in either demand or supply will directly lead to output decline. Therefore, policy must drive simultaneous expansion on both sides of supply and demand. This means that the Fed needs to keep the economy operating at a "high-temperature" state: by stimulating total demand through an accommodative environment and increasing labor participation to expand supply, in order to offset potential outflow pressures on labor due to stricter immigration enforcement. Structural rise in wage inflation is difficult to reverse Although the US labor market has returned to pre-pandemic supply-demand balance, wage inflation remains significantly higher than pre-pandemic levels. In the fourth quarter of last year, the US Employment Cost Index (ECI) rose by 3.4% year-on-year, exceeding the 3% threshold that corresponds to the 2% core PCE inflation target. This deviation is not a short-term fluctuation. Historical experience shows that there is a stable 1 percentage point gap between ECI and core PCE inflation, meaning that for the core inflation target of 2% to be achieved, ECI year-on-year growth must fall back to 3%. Despite this implied assumption corresponding to a productivity growth of only 1%, seemingly low, it reflects a statistically established long-term relationship between the two macro data sets. The market generally relies on artificial intelligence technology to drive a leap in productivity, thereby providing a buffer space for higher wage growth. However, as of now, the gap has not shown an expanding trend, warning investors against betting on a scenario of AI-driven productivity surge as a benchmark. The deep underlying reasons for the structural rise in wage inflation lie in persistent changes in the composition of the labor force. Compared to pre-pandemic, the US labor supply has decreased by nearly 3 million older workers. As different age groups exist in the labor market with evident functional complementarity, older workers are unable to engage in physically intensive roles, while younger workers cannot replace professional roles that require decades of experience. The absence of older workers, beyond the overall job gap, creates additional structural tension. Models show that by factoring in this structural factor, the evolution trajectory of US wage inflation can be almost perfectly explained. Stocks outperform bonds Faced with the dual risk of supply and demand contraction in the labor market, the Fed may choose to tolerate the structural rise in wage inflation, effectively raising the inflation target range to 2.5% to 3.5%. This shift in policy stance will trigger a series of chain reactions at the asset class level. Firstly, short-term real interest rates are expected to further decline. Even if inflation runs in a higher range of 2.5% to 3.5%, the Fed may continue to push for rate cuts to support economic growth. Secondly, the US dollar will remain under pressure due to the narrowing of the real interest rate differential, entering a period of weakness. The US bond market faces pressure from the "steepening bear market": as inflation expectations gradually heat up, long-term yields tend to rise, leading to long-term government bonds underperforming cash and other major sovereign bonds. In this macro context, equity assets are expected to continue outperforming fixed-income products. Based on the above analysis, BCA Research proposes a new tactical trading recommendation: over-allocating to the MSCI Global Consumer Discretionary sector relative to the Industrial sector. Data shows that the Consumer Discretionary sector has significantly underperformed the Industrial sector in the past 65 trading days, with its vertical decline being in an excessive range in terms of magnitude and speed. Market sentiment may usher in a window of recovery. Considering the ultra-low real interest rate environment, potential fiscal stimulus support, and the resilient labor market, market pricing of US consumers may return to a more optimistic outlook. This article is reproduced from "Wall Street Insight," GMTEight Editor: Jiang Yuanhua.