Currently, the U.S. Economy is in a 'Sweet Spot'. However, Goldman Sachs Believes That Markets Are Getting One Thing Wrong

The U.S. economy is currently in a favorable position, with steady growth and gradual disinflation, and the market may be overly pessimistic about the Federal Reserve’s trajectory for interest rate cuts. This perspective comes from Jan Hatzius, Goldman Sachs' chief economist, who recently emphasized the impact of the Trump administration's tariff policies on future monetary policy.

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“On Inauguration Day 2025, the U.S. economy is in the sweet spot of healthy growth and gradual disinflation,” Hatzius wrote in a report published Monday. Goldman Sachs estimates that real GDP grew by 2.6% in the final quarter of 2024, and similar growth is expected in 2025. This outlook is supported by a labor market that appears more resilient than initially feared.

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“The labor market signal has caught up with the GDP signal,” Hatzius explained, noting that December payroll growth reached 256,000, with three- and six-month trends surpassing the estimated breakeven rate of 150,000 jobs needed to maintain stable unemployment.

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This “low-hiring/low-firing” labor market is characterized by wage inflation hovering between 3.5% and 4%. Combined with a 1.5%-2% productivity growth trend observed over the past five years, this wage trend aligns with 2% price inflation targets. “There’s a Goldilocks flavor to it,” Hatzius remarked, “as the strength does not point to a renewed risk of labor market overheating.”

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However, despite promising labor market signals, Hatzius cautioned that recent volatility in consumer price inflation reports has unsettled markets. December’s inflation data came in below expectations, indicating a modest 0.16% increase in personal consumption expenditures. While encouraging, this disinflationary trend has been obscured by short-term fluctuations that can skew market narratives and provoke outsized reactions in bond markets.

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“[T]he underlying trend has changed much less than one might think from the volatility in the market narrative, as well as the outsized bond market impact of month-to-month inflation surprises,” Hatzius noted.

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Goldman Sachs predicts that inflation will remain sufficiently subdued for the Federal Reserve to continue lowering borrowing costs, though the firm anticipates no rate cut in January. Importantly, Hatzius sees minimal risk of a rate hike in the near term, despite earlier concerns from some investors.

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Looking ahead, Goldman forecasts two 25-basis-point rate cuts by the Federal Reserve in 2025, likely in June and December, followed by one additional cut in 2026. This would bring the central bank’s easing cycle to an endpoint with rates between 3.5% and 3.75%.

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“Nevertheless, we have a strong view that market pricing is too hawkish on a probability-weighted basis,” Hatzius stated. However, he acknowledged risks to this outlook, suggesting that the Federal Open Market Committee (FOMC) might choose to cut rates earlier than June, even if the economy remains stable. Additionally, any sharp deterioration in economic data or risk sentiment could prompt more aggressive rate cuts.

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The biggest wildcard in these projections, according to Hatzius, is the Trump administration’s tariff agenda. Goldman Sachs expects the new administration to impose tariff hikes averaging 20% on Chinese imports over the coming months. Aggressive tariffs on European automobiles and Mexican electric vehicles are also anticipated. While the likelihood of sweeping, across-the-board tariffs has decreased, the prospect of targeted tariffs on “critical goods” has grown.

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Hatzius warned that tariff developments are likely to generate financial market volatility, though their influence on Federal Reserve policy may be more complex than investors assume. “In 2018-2019, after all, the intensifying trade war set the stage for three 25bp rate cuts,” Hatzius pointed out. While inflation was below target during that period (in contrast to today’s above-target inflation), other factors—such as the current funds rate being above neutral and lower labor market utilization—could still lead to similar outcomes.

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In conclusion, Hatzius highlighted the delicate balance between economic resilience and potential shocks from tariff policies. While the U.S. economy is currently in a “sweet spot,” the path forward will depend heavily on how these factors interact. The ongoing evolution of tariffs and their broader implications will likely remain a key source of uncertainty in financial markets and monetary policy.

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