LAST WEEK MIGHT HAVE been the moment we flipped from inflation worries to recession risks. On Tuesday, November’s inflation report turned out to be cooler than economists expected. Stocks initially soared, only to sell off toward the end of the day in anticipation of Wednesday’s news. Sure enough, the next day, Federal Reserve Chair Jerome Powell delivered not only a 0.5-percentage-point interest rate increase, but also a stern message in his press conference afterward.
While the Fed’s words move markets, I like to look at what traders expect future inflation to be. According to the interest rate market, disinflation is clearly priced in. The 12-month inflation rate is expected to fall from its current 7.1% to below 3% by June 2023. That’s not necessarily good news—because weaker future economic growth is the probable culprit. There are growing signs, such as lower commodity prices, that a mild recession could strike next year.
It’s turning into a battle of who will be correct—the bond market or the Fed. Trading markets expect 1.3 percentage points of policy rate cuts starting in the middle of next year through the first half of 2024, as the Fed moves to counteract a recession. That bearish economic outlook contrasts with the Fed’s so-called dot plot, which projects a higher federal funds rate through 2025. Many pundits believe the Fed’s hand will be forced, and that short-term interest rates will need to be slashed because of a weak economy.
Indeed, recent economic data have been dicey, with manufacturing activity suggesting a recession could already be underway. November’s retail sales, released last week, were also disappointing, notching the slowest annual growth rate since December 2020. We’ll get a fresh look at the employment situation early in 2023, just before the corporate earnings reporting season kicks off in mid-January.