Fed Rate Hike Probability Within Year at 45%. Why Goldman Sachs Bets Against the Market on Two 2026 Rate Cuts

TradingKey - Market data shows that the current probability of the Federal Reserve raising interest rates in 2026 is approximately 45%, significantly higher than the 12% recorded before the outbreak of the war in Iran. However, Goldman Sachs (GS) takes a different view, contending that market expectations for rate hikes are unreasonable, as the firm's baseline forecast still includes two rate cuts in 2026.

Goldman Sachs stated that current inflation and rate-hike risks are far below the levels of the 1970s or 2021-2022, and it is uncommon for the Federal Reserve to raise rates solely due to an oil shock.

Why soaring oil prices are nothing to fear

Since the onset of the US-Iran conflict, international crude oil has experienced an epic rally, with prices climbing to their highest levels since 2022. However, Goldman Sachs economist Manuel Abecasis noted in a research report that even under a "severe adverse scenario," the magnitude of this oil price shock is smaller than that of the 1970s, and its duration is shorter than the Russia-Ukraine conflict period of 2021-2022.

Another factor worth considering is that the US economy's current dependence on oil has significantly decreased, which is reflected in economic data by the energy intensity of GDP and the share of gasoline in Personal Consumption Expenditures (PCE), both of which have declined substantially from the 1970s.

While rising oil prices do push up headline inflation, their impact on core inflation is relatively limited and tends to fade over time, as oil prices do not sustain a continuous climb. Consequently, a mainstream view holds that central banks should even look past transitory energy shocks. On the contrary, if central banks tighten monetary policy, it would exacerbate damage to the labor market rather than helping to control inflation.

Goldman Sachs also pointed out another historical observation: no meaningful correlation has been found between oil shocks and monetary policy tightening in the speeches of Federal Reserve officials. In other words, instances of the Fed tightening interest rates solely due to an oil shock are virtually non-existent.

Low probability of a second-round inflation spread.

Goldman Sachs raised another point, suggesting that the current macroeconomic environment makes large-scale second-round inflation effects unlikely. Historically, during the 1970s and the Russia-Ukraine war, tight labor markets and accelerating wage growth created the conditions for inflation to spread broadly.

In contrast, in the U.S. today, the labor market is cooling, with market fears of a potential recession, and wage growth is below levels consistent with the Federal Reserve's target inflation rate. Consequently, the probability of supply-side shocks driving persistently high core inflation has significantly diminished. In other words, although surging prices have stimulated inflation, the lack of disposable income among consumers has effectively offset this, making it difficult for inflation to become widespread.

Currently Above the Neutral Rate; Further Rate Hikes More Difficult

Currently, the federal funds rate is 50-75 basis points above the median estimate for the neutral rate in the Federal Reserve's Summary of Economic Projections (SEP). Goldman Sachs stated that the current interest rate is broadly in line with levels suggested by standard policy rules.

This also differs from the 1970s and the Russia-Ukraine war period: in 2021 and early 2022, the federal funds rate was at the zero lower bound, significantly below the neutral rate, as was also the case in the 1970s. While low rates set the stage for hikes, current high rates have raised the threshold for further increases. Furthermore, financial conditions have tightened by approximately 80 basis points since the outbreak of the U.S.-Iran conflict, further reducing the necessity for proactive monetary policy tightening.

Goldman Sachs Warns of Recession Risk

Currently, Goldman Sachs has raised the probability of a recession over the next 12 months by 10 percentage points to 30% and expects the Federal Reserve to initiate interest rate cuts should a recession materialize.

In addition, while the inflationary pressure from rising oil prices is overestimated, Goldman Sachs noted that it will suppress real disposable income and drag on economic growth and employment. Goldman Sachs expects the unemployment rate to rise to 4.6% by 2026, and under conditions of further oil price increases, the rise in the unemployment rate would be even more pronounced, which is one of the criteria for identifying a recession.