Inflation – In this article you’ll find:

• Is possible that inflation will return closer to 2%?
• Inflation – Let’s try to shape 2023 roadmap
• 3 likely scenarios may happen this year
• Inflation – Asset Performance in the 3 scenarios

Here you can find other articles:

1. Is China the big player of 2023?
2. Unemployment low (for now) and no good news in horizon about it
3. The deeper the recession, the deeper the earnings decline will be. Even in China?

ENJOY THE ARTICLE

Expect the unexpected in 2023 and keep the Fed’s path top of mind.

2023 might have in store for investors, considering what the Fed may or may not do.

Real investment advice thinks there are three potential paths the Fed might follow in 2023.

The three paths determine the level of overnight interest rates and, more importantly, liquidity for the financial markets.

Liquidity has a heavy influence on stock returns.

Consumer spending patterns are now normalizing again.

In the U.S. and Europe, goods prices have already stopped rising relative to other prices – in the U.S. they’ve started falling quite rapidly – and Blackrock expect that to continue.

That means overall core inflation will come down materially from its current highs.

The unprecedented influx of liquidity that drove asset prices higher in 2020 and 2021 is quickly leaving the market.

The lag effect of higher interest rates and fading liquidity will likely play a prominent role in determining stock prices in 2023.

It’s possible that inflation could come down closer to 2% than Blackrock expect.

Goods prices could fall faster than expected and companies might not have the pricing power to pass on higher wage costs.

While this could be better news for inflation, it would be bad news for profitability.

What does this mean for investors? Falling inflation increases conviction that central banks have regained some control and will be able to stop hiking at some point.

Falling inflation has spurred market hopes that it is already on its way to target without a recession, and yet central banks will still start an easing cycle.

But getting inflation down close to target will require higher rates and recession.

The core inflation ride could be a rollercoaster

The smoothness of the ride depends on how quickly spending patterns revert and goods prices fall.

If U.S. relative goods prices fall at a pace that would get them back to their pre-pandemic trend by the end of 2024, Blackrock estimate core goods would take 0.1-0.2 percentage points off total core inflation in the second half of 2023 versus adding 2 percentage points at their peak in 2022 – meaning core inflation dropping down towards 3%.

But if the reversal of the spending mix and drop in goods prices were to be as rapid as in recent months, they estimate core goods inflation could end up taking off 1 percentage point from overall core inflation by the end of 2023, dragging it below 3%.

Where inflation settles once the adjustment is complete depends on what happens to wages and services inflation. That remains stubbornly high (see chart above).

Unless that changes, overall core inflation is not likely to settle back at the Federal Reserve’s 2% target.

The reversal of goods prices means getting inflation down from its June 2022 peak of 9.1% to around 4% will be the easy bit.

Getting it to settle below 3% will likely be much harder.

The Road Map for 2023 – Inflation

The graph below compares the three most probable paths for Fed Funds in 2023.

The green line tracks the Federal Reserve’s guidance for the Fed Funds rate. The black line charts investor projections as implied by Fed Funds futures.

Lastly, the “something breaks” alternative in red is based on prior easing cycles.

Scenario 1 The Fed’s Expectations

The dots represent where each member expects the Fed Funds rate to be in the future.

The range of Fed Funds expectations for 2023 is between 4.875% and 5.625%.

Most FOMC members expect Fed Funds to end the year somewhere between 5.125% to 5.375%.

Based on comments from Jerome Powell, the Fed seems to think Fed Funds will increase in 25bps increments to 5.25%.

While investors place a lot of weight on the Fed projections, it’s worth reminding you they do not have a crystal ball. For evidence, we only need to look back a year ago to its 2022 projections from December 2021.

Scenario 2 Implied Market Expectations – Inflation

The market thinks the Fed will raise rates to just shy of 5% in May and hold them there through July.

After that, the market implies increasing odds of a Fed pivot. By December, the market believes the Fed will have cut interest rates by about 40bps.

Like the Fed, the Fed Funds market can also be a poor predictor of Fed Funds.

During the last three recessions, excluding the brief downturn in 2020, the Fed Funds market misjudged how far Fed Funds would fall by roughly 2.5%.

Implied Fed Funds of 4.6% today may be 2% by December if the market similarly underestimates the Fed and the economic and financial environment.

Scenario 3 Something Breaks

There is a significant lag between when the Fed raises rates and when the effect is fully felt.

Economists believe the lag can take between nine months and, at times, over a year.

In March 2022, the Fed raised rates by 25bps from zero percent. Since then, they have increased rates by an additional 4%.

If the lag is a year, the first interest rate hike will not be fully absorbed into the economy until March 2023.

The yield curve is currently inverted to a level not seen in over 40 years.

It will un-invert; the only question is when and how quickly.

Asset Performance in The Three Paths

Stock investors expect the second path with a slight pivot during the summer.

Currently, corporate earnings are expected to grow by 8% in 2023. Such implies economic growth.

Therefore, it also intones the Fed will not over-tighten and cause a recession. This goldilocks scenario may provide investors with a positive return.

The first alternative, the FOMC’s expected path, may entail more pain for stock investors as it implies rates will rise higher than market expectations with no pivot in sight.

The third “something breaks” scenario is the potential nightmare scenario.

While investors will receive the pivot, they have been desperately seeking, they will not like it.

Historically, rapidly declining economic activity and financial instability do not bode well for stocks, even if the Fed adopts a more accommodative policy stance.

The graph above shows that the yield curve steepens well before the market bottoms.

Likely, the steepening will result from the Fed quickly slashing interest rates in response to “something breaking.”

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics.

In doing so he shares with you the most interesting charts and comments.