Dhaval Joshi, an analyst at BCA Research, predicted that under the future leadership of Kevin Warsh as Fed Chair, the Federal Reserve might de facto tolerate an inflation rate rising to between 2.5% and 3.5% to support the U.S. economy operating at a higher temperature.
The Federal Reserve's monetary policy framework may be on the verge of a significant shift. Dhaval Joshi, an analyst at BCA Research, predicted that under the future leadership of Kevin Warsh as Fed Chair, the Federal Reserve might de facto tolerate an inflation rate rising to between 2.5% and 3.5% to support the U.S. economy operating at a higher temperature. The core motivation behind this strategy lies in the fact that the U.S. labor market has reached a rare state of supply-demand equilibrium, where contraction on either side could trigger an economic recession.
Data shows that the current demand and supply of labor in the United States both stand at 172 million people, with job vacancies and non-temporary unemployment numbers stabilizing at 6.6 million, placing the market in a theoretically 'perfect balance.' Joshi pointed out that at this critical juncture, if tighter immigration enforcement leads to a contraction in labor supply, it will directly threaten economic expansion. Therefore, the Federal Reserve may increase its tolerance for inflation to stimulate aggregate demand while fostering labor participation rates through an 'overheated' environment to offset potential contractions on the supply side.
This policy shift will profoundly reshape the logic of asset pricing. The report anticipates that even if the inflation midpoint rises to the 2.5%-3.5% range, the Federal Reserve will continue cutting interest rates, driving short-term real interest rates to decline more rapidly. The U.S. dollar will continue weakening due to narrowing real interest rate differentials, while the yield curve of U.S. Treasuries faces 'bear steepening' pressure, meaning long-term yields rise, causing long-term government bonds to underperform cash and other sovereign bonds.
Against this macroeconomic backdrop, equities are expected to continue outperforming bonds. BCA Research recommends tactically overweighting the MSCI World Consumer Discretionary sector relative to the industrial sector. This sector has significantly underperformed by nearly 20% over the past 65 trading days, presenting substantial recovery potential.
Labor Market Balance Brings 'Dual Risks'
The U.S. labor market is entering a rare 'moment of balance,' marking the first time since the outbreak of the pandemic that supply and demand have achieved numerical parity.
By definition, labor supply encompasses employed and unemployed individuals; labor demand includes employed workers, job vacancies, and temporarily unemployed workers. When the number of 'positions seeking workers' equals the number of 'workers seeking positions,' the market is in strict equilibrium.
The rarity of this balanced state stems from a fundamental shift in its underlying economic logic. For decades prior to the pandemic, the U.S. economy was characterized by persistent demand shortages, with labor demand consistently lagging behind supply. Post-pandemic, the relationship reversed, and labor supply became a bottleneck to growth, shifting the economy into a 'supply-constrained' operational mode. In this mode, a slowdown in demand does not directly lead to GDP contraction, explaining why the U.S. economy maintained positive growth during 2023-2024 despite weak demand-side performance.
However, the current state of balance also implies that the market has entered a 'dual risk' zone: any contraction in either demand or supply will directly result in output declines. Consequently, policies must drive simultaneous expansion on both sides of supply and demand. This means the Federal Reserve needs to keep the economy running in a 'high-temperature' state—stimulating aggregate demand through accommodative conditions while expanding supply by boosting labor participation rates to counterbalance potential labor outflows caused by stricter immigration enforcement.
The structural rise in wage inflation is difficult to reverse.
Although the U.S. labor market has returned to its pre-pandemic supply and demand balance, wage inflation remains significantly higher than pre-pandemic levels. In the fourth quarter of last year, the Employment Cost Index (ECI) in the United States increased by 3.4% year-on-year, surpassing the 3% threshold consistent with the target of 2% core PCE inflation.
This deviation is not a short-term fluctuation. Historical experience shows that there is a stable gap of one percentage point between the ECI and core PCE inflation, which means that to achieve the 2% core inflation target, the year-on-year growth rate of the ECI must fall back to 3%. Although this implicit assumption corresponds to a productivity growth rate of only 1%, which seems low, it reflects the long-established statistical relationship between the two macroeconomic datasets.
The market generally hopes that artificial intelligence technology will drive a leap in productivity, thereby providing room for higher wage growth. However, so far, the aforementioned gap has not shown an expanding trend, warning investors against betting on an AI-driven surge in productivity as a baseline scenario.
The deep-seated reason for the structural rise in wage inflation lies in the persistent changes in the composition of the labor force. Compared to pre-pandemic levels, nearly three million older workers have exited the U.S. labor supply. Due to the significant functional complementarity across age groups in the labor market—where older workers are unable to take on physically intensive roles and younger workers cannot replace specialized positions requiring decades of experience—the absence of older workers creates additional structural tensions beyond the overall job vacancy. Models show that incorporating this structural factor can nearly perfectly explain the trajectory of wage inflation in the United States.
Equities outperform bonds.
Faced with the dual risks of contraction on both the supply and demand sides of the labor market, the Federal Reserve may choose to tolerate structurally elevated wage inflation, effectively raising the inflation target range to between 2.5% and 3.5%. This shift in policy stance will trigger a series of chain reactions across major asset classes.
First, short-term real interest rates are expected to decline further. Even if inflation runs within the higher range of 2.5%-3.5%, the Fed may continue to cut interest rates to support economic growth. Second, the U.S. dollar will remain under pressure due to narrowing real interest rate differentials, entering a weak channel. The U.S. Treasury bond market faces 'bear steepening' pressure: as inflation expectations gradually rise, long-term yields tend to increase, causing long-term Treasuries to underperform cash and other major sovereign bonds. Against this macroeconomic backdrop, equity assets are expected to continue outperforming fixed-income products.
Based on the above analysis, BCA Research has proposed a new tactical trading recommendation: overweight the MSCI World Consumer Discretionary sector relative to the industrial sector. Data shows that the consumer discretionary sector has significantly underperformed the industrial sector by nearly 20% over the past 65 trading days, with this near-vertical decline reaching excessive levels in both magnitude and speed.
Market sentiment may see a window for recovery. Considering the ultra-low real interest rate environment, potential fiscal stimulus support, and the still-resilient labor market, market pricing for U.S. consumers may turn optimistic again.
This article is reprinted from “Wall Street News,” edited by Jiang Yuanhua of Zhitong Finance.
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