The December Consumer Price Index (CPI) report, set for release on January 12th, has the potential to shift the market’s outlook on interest rates and the pace of disinflation. Economists are expecting a 0.1% month-over-month rise in headline CPI and a 0.3% increase in core CPI, which excludes volatile food and energy prices. This could challenge hopes for rapid rate cuts by the Federal Reserve in 2023.
Headline Inflation Seen Ticking Up, Core Slowing
Forecasts point to headline CPI acceleration after a flat November reading, while core inflation may continue to moderate from its peak of 6.6% last September.
CPI Forecasts for December 2022:
| Measure | Month-Over-Month | Year-Over-Year |
|-|-|-|
| Headline CPI | 0.1% | 6.5% |
| Core CPI | 0.3% | 5.7% |
Higher gasoline prices are expected to put upward pressure on overall inflation, along with increases in shelter and medical care costs. Core goods disinflation could accelerate however, helped by improving supply chains and retailer discounting.
The inflation report comes on the heels of a stunning jobs report showing wage growth remaining stubbornly high even as broader labor market conditions start to cool. This presents a tricky balancing act for the Fed between tamping down still elevated inflation and avoiding an economic downturn.
Markets Pricing in Rapid 2023 Easing
Markets have rallied in recent months on hopes that subsiding inflation will allow the Fed to rapidly cut interest rates in the second half of 2023. Fed funds futures imply a terminal rate around 5% in May, before 100 basis points of easing to 4% by December.
However, officials have been pushing back against expectations for swift rate reductions. An upside surprise on inflation could bolster the case for rates to remain higher for longer to ensure disinflation is sustainable. This could pressure risky assets like stocks that have rebounded strongly amid expectations for Fed pivots.
Dollar Rebound Hinges on Strong Inflation Data
The US dollar index has pulled back over 8% from its September highs as markets reduced the odds of continued aggressive Fed tightening. Confirmation of sticky inflation could provide fuel for the greenback to extend its January rebound.
In particular, further divergence between a resilient US economy and deteriorating outlooks in Europe and China could send capital flowing back into dollar-denominated assets. The Bloomberg Dollar Index is up 1.3% so far this year, snapping a five-month slump.
Global Central Bank Messaging Shifts Hawkish
Signs of spreading price pressures have prompted a number of major central banks to send hawkish signals in recent weeks. Both the ECB and BOE raised rates by 50 basis points in December and look poised for further large hikes to curb inflation running at multi-decade highs.
Even the Bank of Japan, which has kept rates pinned near zero, shocked markets in December by widening the band it allows 10-year yields to fluctuate in. This represents a incremental step away from yield curve control as inflation rises outside the central bank’s target.
Robust global demand combined with supply shortfalls and the lagged effects of loose pandemic-era monetary policies suggest inflation may take longer than expected to fall back to target levels. This could force central banks to keep policy restrictive for an extended period to avoid unanchoring inflation expectations.
Recession Fears Mount Heading Into 2023
While the near-term economic data remains strong, analysts see gathering clouds on the horizon. Surging interest rates through 2022 have sharply slowed demand for interest-rate sensitive sectors like housing and autos. Businesses have also reined in hiring plans and curbed capital expenditures amid elevated uncertainty.
2023 GDP Growth Forecasts:
| Region | 2023 Forecast |
|-|-|
| United States | 0.2% |
| Euro Area | -0.1% |
| China | 4.9% |
Most Wall Street forecasters expect a US recession this year as the full brunt of Fed tightening ripples through the economy. However, the timing and severity remain highly uncertain.
Upcoming high-frequency data on retail sales, industrial production and regional business activity could provide clues on how quickly demand is cooling. So far, outside of housing, economic momentum has proven surprisingly resilient.
Path Ahead Murky for Fed Policy and Markets
Decembers’ inflation report is a crucial mile marker, but unlikely to conclusively shift the policy or market outlook. The path of inflation, growth, Fed policy and risk assets hangs in a delicate balance, making surprises in either direction destabilizing.
If price pressures show signs of subsiding faster than expected, markets could gain confidence in the disinflation narrative and bond yields may decline further. However, if core inflation remains sticky near multi-decade highs, fears of a wage-price spiral could intensify.
The Fed faces an unenviable task in engineering a soft landing amid tremendous uncertainty over the transmission lags from policy to the real economy. Miss-steps risk plunging the US into a severe downturn and financial crisis, while premature policy easing could de-anchor inflation expectations.
The next few CPI and employment reports will be critical guideposts, but unlikely to provide definitive answers any time soon. Markets should brace for turbulence over the first half of 2023 as the Fed feels its way forward and economic risks crystallize.
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