A significant shift in the Federal Reserve's monetary policy framework may be on the horizon. Analysts at BCA Research, led by Dhaval Joshi, predict that under the potential leadership of a future Fed Chair, the central bank might de facto accept inflation rising to a range of 2.5% to 3.5%. The objective would be to support the US economy operating at a higher temperature. The core driver of this strategy is the US labor market reaching a rare equilibrium point where contraction on either the supply or demand side could trigger a recession. Data indicates that both labor demand and supply in the US currently stand at 172 million people, with job openings and non-temporary unemployment figures stable at 6.6 million each, placing the market in a theoretical state of "perfect balance."

Joshi notes that at this critical juncture, tightening immigration enforcement leading to a contraction in labor supply would directly threaten economic expansion. Consequently, the Fed might increase its inflation tolerance to stimulate aggregate demand while using an "overheated" environment to boost labor force participation, thereby offsetting potential supply-side shrinkage. This policy shift would profoundly reshape asset pricing logic. The report anticipates that even if the inflation center rises to the 2.5%-3.5% range, the Fed would continue to cut interest rates, accelerating the decline in short-term real interest rates. The US dollar is expected to weaken persistently due to narrowing real interest rate differentials, while the US Treasury yield curve faces "bear steepening" pressure, where rising long-end yields cause long-term bonds to underperform cash and other sovereign bonds.

Within this macroeconomic context, equity assets are expected to continue outperforming bonds. BCA Research recommends a tactical overweight position in the MSCI World Consumer Discretionary sector relative to the Industrial sector. The consumer discretionary sector has underperformed significantly by nearly 20% over the past 65 trading sessions, indicating substantial room for recovery.

The labor market balance introduces a "dual risk" scenario. The US labor market is entering a rare "balanced moment," marking the first time since the pandemic began that supply and demand have reached numerical parity. By definition, labor supply encompasses employed and unemployed individuals, while labor demand includes employed individuals, job openings, and temporarily laid-off workers. The market achieves strict equilibrium when the number of "workers looking for jobs" equals "jobs looking for workers."

This balance is rare due to a fundamental shift in the underlying economic logic. For decades prior to the pandemic, the US economy operated in a state of insufficient demand, with labor demand consistently below supply. Post-pandemic, this relationship reversed, with labor supply becoming the growth bottleneck, transitioning the economy into a "supply-constrained" operational mode. In this mode, a slowdown in demand does not directly cause a GDP recession, explaining why the US economy maintained positive growth during 2023-2024 despite weak demand-side performance.

However, the current balance also means the market has entered a "dual risk" zone: contraction in either demand or supply will directly lead to output decline. Therefore, policy must promote simultaneous expansion on both fronts. This implies the Fed needs to keep the economy running "hot": stimulating aggregate demand through accommodative conditions while expanding supply by increasing labor force participation to counter potential labor outflow pressures from stricter immigration enforcement.

Structural increases in wage inflation appear difficult to reverse. Although the US labor market has returned to its pre-pandemic supply-demand balance, wage inflation remains significantly higher. In the last quarter, the US Employment Cost Index rose 3.4% year-over-year, exceeding the 3% threshold consistent with a 2% core PCE inflation target. This deviation is not a short-term fluctuation. Historical patterns show a stable 1 percentage point gap between ECI and core PCE inflation, meaning ECI growth must fall to 3% to achieve the 2% core inflation target. While this implied assumption corresponds to productivity growth of just 1%, seemingly low, it reflects a long-established statistical relationship between the two macroeconomic datasets.

Markets widely hope that AI technology can drive a productivity leap, creating buffer space for higher wage growth. However, to date, this gap has not shown signs of widening, cautioning investors against betting on an AI-driven productivity surge as a baseline scenario. The deeper reason for structurally higher wage inflation lies in lasting changes in labor force composition. Compared to pre-pandemic levels, the US labor supply has nearly 3 million fewer older workers. Due to clear functional complementarity between age groups in the labor market—older workers being less suited for physically intensive roles and younger workers unable to replace roles requiring decades of experience—the absence of older workers creates additional structural tension beyond the overall job gap. Models indicate that incorporating this structural factor almost perfectly explains the trajectory of US wage inflation.

Equities are expected to outperform bonds. Faced with the dual risk of contraction in both labor supply and demand, the Fed may choose to tolerate structurally elevated wage inflation, effectively raising the inflation target range to 2.5%-3.5%. This shift in policy stance will trigger a series of ripple effects across major asset classes.

Firstly, short-term real interest rates are expected to decline further. Even with inflation running in the higher 2.5%-3.5% range, the Fed may continue to implement rate cuts to support economic growth. Secondly, the US dollar is likely to remain under pressure and enter a weakening trend due to narrowing real interest rate differentials. The US Treasury market faces "bear steepening" pressure: as inflation expectations gradually rise, long-end yields tend to increase, causing long-term bonds to underperform cash and other major sovereign bonds.

Within this macroeconomic backdrop, equity assets are poised to continue leading fixed income products. Based on this outlook, BCA Research proposes a new tactical trading recommendation: overweight the MSCI World Consumer Discretionary sector relative to the Industrial sector. Data shows the consumer discretionary sector has underperformed the industrial sector by nearly 20% over the past 65 trading sessions—a near-vertical decline whose magnitude and speed suggest an oversold condition. Market sentiment may be approaching a recovery window. Considering the ultra-low real interest rate environment, potential fiscal stimulus support, and the still-resilient labor market, market pricing for the US consumer could turn optimistic again.