The Federal Reserve's monetary policy framework may be on the verge of a significant shift. BCA Research analyst Dhaval Joshi predicts that under the leadership of future Fed Chair Waller, the Federal Reserve may effectively tolerate an inflation rate rising to the range of 2.5% to 3.5% to support the U.S. economy operating at a higher temperature. The core motivation behind this strategy is that the U.S. labor market has reached a rare balance point between supply and demand, and any contraction on either side could lead to an economic recession.
Data shows that the current labor demand and supply in the U.S. are both at 172 million people, with job vacancies and non-temporary unemployment numbers stabilizing at 6.6 million, placing the market in a theoretically &#34;perfect balance&#34; state. Joshi points out that at this critical juncture, if tightening 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 overall demand while enhancing labor participation rates in a &#34;hot&#34; environment, thereby offsetting supply-side shrinkage.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/5169d7de-cd29-4c28-842c-b0fa9f50a55d.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/5169d7de-cd29-4c28-842c-b0fa9f50a55d.png"/>
This policy shift will profoundly reshape asset pricing logic. The report anticipates that even if the inflation center rises to the 2.5%-3.5% range, the Federal Reserve will continue to cut interest rates, accelerating the decline of short-term real interest rates. The U.S. dollar will continue to weaken due to the narrowing of the real interest rate differential, while the U.S. Treasury yield curve will face &#34;bear steepening&#34; pressure, meaning that rising long-end yields will cause long-term government bonds to underperform cash and other sovereign bonds.
In this macro context, equity assets are expected to continue leading over bonds. BCA Research recommends tactically overweighting the MSCI Global Consumer Discretionary sector relative to the industrial sector. This sector has significantly underperformed by nearly 20% over the past 65 trading days, indicating substantial room for recovery.
<h2>Labor Market Balance Brings &#34;Dual Risks&#34;</h2>
The U.S. labor market is entering a rare &#34;balance moment,&#34; marking the first time since the outbreak of the pandemic that supply and demand have achieved parity.
By definition, labor supply includes both employed and unemployed individuals; labor demand encompasses employed individuals, job vacancies, and temporarily unemployed workers. When the number of &#34;jobs seeking workers&#34; equals the number of &#34;workers seeking jobs,&#34; the market is in a strictly defined equilibrium state.
This equilibrium state is rare due to the fundamental shift in the underlying economic logic. For decades before the pandemic, the U.S. economy was in a state of chronic demand deficiency, with labor demand consistently falling short of supply. However, post-pandemic, the supply-demand relationship has reversed, with labor supply becoming a growth bottleneck, leading the economy into a &#34;supply-constrained&#34; operating mode. In this mode, a slowdown in demand does not directly trigger a GDP recession, which explains why the U.S. economy has maintained positive growth despite weak demand from 2023 to 2024.
However, the current balance state also means the market has entered a &#34;dual risk&#34; zone: any contraction in either demand or supply will directly lead to a decline in output. Therefore, policies must promote simultaneous expansion on both the supply and demand sides. This means the Federal Reserve needs to keep the economy operating in a &#34;high-temperature&#34; state: stimulating overall demand through a loose environment while expanding supply by enhancing labor participation rates
To hedge against the potential outflow of labor pressure due to stricter immigration enforcement.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/5d22656a-ecbe-4aae-9359-55b0e6cd64aa.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/5d22656a-ecbe-4aae-9359-55b0e6cd64aa.png"/><img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/e563be38-900e-480c-b3c7-d72018bdf722.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/e563be38-900e-480c-b3c7-d72018bdf722.png"/>
<h2>Structural Rise in Wage Inflation Difficult to Reverse</h2>
Although the U.S. labor market has returned to a supply-demand balance before the pandemic, wage inflation remains significantly higher than pre-pandemic levels. In the fourth quarter of last year, the U.S. Employment Cost Index (ECI) rose 3.4% year-on-year, exceeding the 3% threshold that aligns with the 2% core PCE inflation target. <img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/bca7603d-1e92-46c2-990f-418a8876d414.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/bca7603d-1e92-46c2-990f-418a8876d414.png"/>
This deviation is not a short-term fluctuation. Historical experience shows a stable 1 percentage point gap 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 implied assumption corresponds to a productivity growth of only 1%, which seems low, it reflects a long-established statistical relationship between the two macro data sets.
The market generally hopes that artificial intelligence technology can drive a leap in productivity, thereby providing a buffer for higher wage growth. However, to date, the aforementioned gap has not shown a trend of widening, which warns investors against betting on an AI-driven surge in productivity as the baseline scenario.
The deep-rooted reason for the structural rise in wage inflation lies in the persistent changes in the labor force composition. Compared to pre-pandemic levels, the U.S. labor supply has decreased by nearly 3 million older workers. Due to the significant functional complementarity among different age groups in the labor market, older workers find it difficult to engage in physically demanding jobs, while younger workers cannot replace specialized roles that require decades of experience. The absence of older workers creates additional structural tension beyond the overall job gap. Models show that when this structural factor is taken into account, it can almost perfectly explain the evolution of U.S. wage inflation.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/3c59b9fa-8dad-4567-afb1-5849a8ecd1b8.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/3c59b9fa-8dad-4567-afb1-5849a8ecd1b8.png"/>
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/93cf1e44-3b7d-4b51-a346-4acf39620c1b.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/93cf1e44-3b7d-4b51-a346-4acf39620c1b.png"/>
<h2>Stocks Outperform Bonds</h2>
Faced with the dual risk of contraction on both the supply and demand sides of the labor market, the Federal Reserve may choose to tolerate the structurally elevated 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
First, short-term real interest rates are expected to decline further. Even if inflation runs in the higher range of 2.5% to 3.5%, the Federal Reserve may continue to push for interest rate cuts to support economic growth. Secondly, the U.S. dollar will remain under pressure due to the narrowing of the real interest rate differential, entering a weak channel. The U.S. Treasury market faces the pressure of &#34;bear steepening&#34;: as inflation expectations gradually warm up, long-term yields tend to rise, causing long-term government bonds to underperform cash and other major sovereign bonds. In this macroeconomic context, equity assets are expected to continue to lead fixed income products.
Based on the above judgment, BCA Research has proposed a new tactical trading recommendation: overweight the MSCI Global 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, and this nearly vertical decline is excessive in both magnitude and speed. <img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/1abe545a-5588-4419-b5ee-9ddfdb8bc5ff.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/1abe545a-5588-4419-b5ee-9ddfdb8bc5ff.png"/>
Market sentiment may welcome a repair window. Considering the ultra-low real interest rate environment, potential fiscal stimulus support, and a still resilient labor market, market pricing for U.S. consumers may become optimistic again

.DJUS

.SPX

ONEQ

BCA Research expects that to hedge against the recession risks caused by a contraction in labor supply, the Federal Reserve may, under the leadership of incoming Chairman Waller, tacitly raise the inflation target to a range of 2.5%-3.5%. Although wage inflation is structurally rising due to a shortage of older workers, policy will still focus on maintaining a "high-temperature" economy. Against this backdrop, real interest rates and the dollar are likely to trend downward, and equity assets will continue to outperform bonds

- The Federal Reserve's monetary policy may shift under Chairman Waller, potentially allowing inflation to rise to 2.5%-3.5% to support a stronger economy.  
- Current labor market data shows a rare equilibrium, with both demand and supply at 172 million workers, indicating a significant risk if immigration enforcement tightens.  
- BCA Research suggests tactical over-allocation to MSCI global consumer discretionary stocks over industrials, as these stocks have lagged significantly, presenting a potential rebound opportunity.

Bold predictions from Wall Street: To hedge against the labor shortage, Waller may tolerate inflation of 2.5%-3.5%!