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 future Fed Chair Wash, the central bank might de facto tolerate an inflation rate rising to a range of 2.5% to 3.5%. This strategy aims to support the US economy operating at a higher temperature. The core motivation for this approach lies in the US labor market reaching a rare equilibrium point between supply and demand, where a contraction on either side could trigger a recession.

Data indicates that current US labor demand and supply both stand at 172 million people, with job openings and non-temporary unemployed persons stabilizing at 6.6 million each. This places the market in a theoretical state of "perfect balance." Joshi points out that at this critical juncture, any tightening of immigration enforcement that causes labor supply to shrink 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 rates, thereby offsetting potential supply-side contraction.

This potential policy shift would profoundly reshape asset pricing logic. The report anticipates that even if the core inflation rate settles in the 2.5%-3.5% range, the Fed would likely 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 pressure for a "bear steepening," where rising long-end yields cause long-term Treasuries 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 Industrials sector. The discretionary sector has significantly underperformed by nearly 20% over the past 65 trading sessions, suggesting substantial room for a rebound.

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 includes employed and unemployed persons, while labor demand encompasses employed persons, job openings, and temporarily laid-off workers. The market reaches a strict equilibrium when the number of "workers seeking jobs" equals "jobs seeking workers."

This balanced state is rare due to a fundamental shift in the underlying economic logic. For decades prior to the pandemic, the US economy was characterized by 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: a contraction in either demand or supply will directly lead to a decline in output. Therefore, policy must promote synchronous expansion on both sides. This implies the Fed needs to keep the economy running "hot": stimulating aggregate demand through an accommodative environment while also 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 (ECI) rose 3.4% year-over-year, above the 3% threshold consistent with a 2% core PCE inflation target.

This deviation is not a short-term fluctuation. Historical experience shows 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 artificial intelligence technology will drive a productivity leap, creating a buffer 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 base case scenario.

The deeper reason for structurally higher wage inflation lies in lasting changes in the composition of the labor force. Compared to pre-pandemic times, the US labor supply has lost nearly 3 million 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 show that incorporating this structural factor almost perfectly explains the trajectory of US wage inflation.

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

First, short-term real interest rates could decline further. Even with inflation running in the higher 2.5%-3.5% range, the Fed might continue cutting rates to support growth. Second, the US dollar would face ongoing pressure due to narrowing real rate differentials, entering a weakening trend. The US Treasury market then confronts "bear steepening" pressure: as inflation expectations gradually rise, long-end yields tend to increase, causing long-term Treasuries to underperform cash and other major sovereign bonds. In this macro backdrop, equity assets are expected to continue leading fixed income products.

Based on this analysis, BCA Research proposes a new tactical trade recommendation: overweight the MSCI World Consumer Discretionary sector relative to the Industrials sector. Data shows the discretionary sector has underperformed the industrials sector by nearly 20% over the past 65 trading sessions—a nearly vertical decline whose magnitude and speed suggest an oversold condition.

Market sentiment may be approaching a recovery window. Given the environment of ultra-low real rates, potential fiscal stimulus support, and a still-resilient labor market, market pricing for the US consumer could tilt back towards optimism.