US inflation falls below 2%? Goldman Sachs: Yes, in 2024

After the unexpected cooling of US inflation, Goldman Sachs predicts that the core PCE may drop to 2.0% in May next year.

On December 22nd, Goldman Sachs' team led by Chief Economist Jan Hatzius released a report titled "Will Inflation Fall Below 2%?" Hatzius believes that based on the inflation report for November, they believe that by the end of 2024, prices in the consumer goods and services industry will decline, and US inflation may drop below 2%.

The latest data shows that the US core PCE increased by 3.2% YoY in November, the lowest since April 2021, and lower than market expectations.

Hatzius believes that the rapid decline in US inflation is not a temporary trend, and the Federal Reserve has no difficulty in completing the "last mile". It is expected that the core PCE will decrease from 3.2% to 2.2% by Q4 2024, which is 0.3 percentage points lower than the general expectation. If consumer goods profit margins normalize and core service inflation no longer accelerates, it is expected that the YoY growth rate of core PCE inflation will drop to 2.0% in May and 1.9% in December:

We expect car prices to continue to decline, and the prices of other consumer goods to basically return to pre-pandemic levels. Based on corporate profit margin data, we expect a further 0.6% decline in consumer goods prices excluding cars. This will further decrease the overall core inflation rate by 0.15 percentage points.

The second source driving inflation downward is the labor-dependent service consumption sector, where the inflation growth rate has already declined significantly. If core service prices, excluding housing, healthcare, and finance, no longer accelerate, then the core PCE inflation rate in 2024 will be 0.15 percentage points lower than our benchmark forecast.

Goldman Sachs believes that if core inflation is below its target level next year, the FOMC is expected to cut interest rates by 25 basis points at multiple meetings until the federal funds rate approaches its estimated neutral rate.

Further decline in consumer goods prices

Goldman Sachs analysts pointed out that they recently lowered their core PCE inflation forecast for December 2024 to 2.2%. Currently, they believe that with the further slowdown in consumer goods prices and the slowdown in service inflation, the core PCE inflation in 2024 may be below 2%.

Firstly, the prices of goods with limited supply are still higher than pre-pandemic levels. According to Goldman Sachs' calculations, consumer goods prices excluding cars have a 0.6% downward space, which will further decrease the overall core inflation rate by 0.15% next year: In the past, different situations have shown that the ways and degrees of price recovery vary. For example, during the real estate bubble in the 2000s, although appliance prices dropped after the bubble burst, they did not fully return to pre-bubble levels.

Compared with the unit production costs of the Bureau of Economic Analysis (BEA) in the United States, the prices of certain goods (except for automobiles) are still relatively high. If the prices of these goods can trend in line with the inflation trend of production costs, it is expected that core consumer goods prices can be reduced by 0.6% in 2024 and 2025, thereby reducing the core PCE inflation rate by 0.3%.

Goldman Sachs bluntly stated that there is a limit to the extent of inflation decline, and their assumption is that these industries return to the profit margin of 2019. Under the same conditions, this will reduce the overall core inflation rate by 0.1-0.15 percentage points:

"We supplement the previous analysis results by analyzing the profit margins of the consumer goods industry. Re-weighted to reflect the share of consumer spending in the national accounts, based on this method, even after the normalization that occurred in 2022, the after-tax profit margin is still 0.5 percentage points higher."

Further Decline in Core Service Inflation

Goldman Sachs pointed out in the report that the decline in labor-intensive core service consumption is the second source of inflation decline. In this area, inflation has returned to the level consistent with the target. Specifically, core service prices, excluding housing, healthcare, and financial services, rose by 2.8% YoY in the third quarter, which is lower than the 3.5% rate in Goldman Sachs' base model:

"There are two reasons for the significant decline in core service inflation: first, the reversal of the relative overshoot compared to the model during the period of 2021-22; second, a significant rebound in productivity in the service sector (2.5% YoY growth in the third quarter)."

"For whatever reason, if the prices of these services no longer accelerate, it will further reduce the overall core PCE inflation by 0.2-0.25 percentage points relative to our baseline scenario."

Goldman Sachs also pointed out that healthcare service prices are another factor they expect inflation to decline, accounting for 18% of the core PCE basket. Currently, their baseline assumption is that healthcare service prices will rise from the current 2.6% to 3.1% in 2024, but the recent price increases may slow down or continue to be under pressure next year:

"Our basic assumption for healthcare service prices is due to a higher cost environment. Medicare data shows that the cost of healthcare services has grown faster than price growth, with prices being nearly 6% higher, leading to the government setting higher price growth rates (4.3% in 2023, +3.1% in 2024)."

"However, in the past six months, healthcare PCE prices have risen by 2.3% YoY. If this growth rate continues in 2024, it will further reduce core PCE inflation by 0.15 percentage points."