Inflation Likely To Decline During 2023

Market sentiment has done an about turn on inflation in recent weeks, following stronger than expected Consumer Price Index and Producer Price Index figures for January 2023. The ongoing strength in the jobs market and the solid jobs report for January 2023 added further support to concerns of inflation. The January Personal Consumption and Expenditure figures, the Fed's preferred gauge of inflation, due for release later this week also are likely to show similar strength.

While inflation data for January 2023 showed strength, one month of strengthening data does not make a trend. The current reactions in the markets to the January inflation reports are essentially a correction of the excessive optimism about cooling inflation that was observed over the past few months. Inflation has been showing signs of cooling over the past several months and inflation should be expected to soften over the course of 2023. The decline in inflation will be gradual and volatile, however.

The expectation of softening inflation is based on the Fed maintaining a restrictive monetary policy, tighter financial conditions as the markets aligning their interest rate expectations with that of the Fed, an easing of supply chain bottlenecks, and some softness or concerns of softness in labor markets as the year progresses.

While reduced compared to before, there still are risks to inflation arising from the Russia-Ukraine war and or Covid, both of which are factors that played an important role in boosting inflation in recent years and could come back in some shape or form to derail progress made on inflation so far.

Monetary policy takes several quarters to fully filter through the economy. The full impact of the sharp tightening of monetary policy put in place since last year still needs to work through the economic system. Additionally, and more importantly, as the divergence between market expectations of monetary policy and the Fed's projections of monetary policy narrows the more effective monetary policy will be in bringing inflation down. Earlier this year, before the release of the January inflation and jobs data, there was a wide divergence between the Fed's projections for interest rates and the market's expectations for interest rates. While the Fed was projecting no reversal in interest rates for this year, the markets were factoring in up to a 50 basis points (bps) reduction in rates during the fourth quarter of 2023. The consequent loosening of financial conditions was exactly the opposite of what the Fed was looking to accomplish with the raising of its Federal Funds rates.

That gap between the Fed's projections and market's expectations of monetary policy in 2023 has narrowed in the weeks following the stronger than expected January inflation and employment data. A gap still remains, however. The market now anticipates a 20 bps to 25 bps reduction in rates during the fourth quarter of 2023, which is about half its expectation compared to earlier this year. The Fed meanwhile, has not announced any plans to reverse rates in 2023. Markets also are pricing in an additional 25 bps increase in 2023 for a total increase of 100 bps during the first half of 2023. This is a stronger increase in rates than any official announcement by the Fed and the Fed may choose to stick to its original plan of only a 75-bps increase, unless there is a meaningful and consistent increase in inflation.

While inflation is expected to soften over the course of the year, the path is expected to be bumpy, with stronger than expected inflation figures being reported from time to time. This should help to further reduce market expectations of an interest rate cut later this year.

Supply chain bottlenecks were an important contributor to the recent surge in inflation. These chokepoints have been showing signs of easing. The end of China's zero-Covid policy and transition of demand away from goods toward services are both expected to help lower inflation. Inflation has been transitioning away from goods inflation to services inflation but the latter typically has a tendency to be stickier in nature. As mentioned before, the path to lower inflation will be slow and bumpy.

Employment has been strong and is likely to remain so at least the near term, that said, there are some initial cracks that seem to be developing in the labor market, especially in white collar jobs. Concerns of job losses could dampen demand and weigh on inflation.

While there are various factors that are expected to bring inflation down over the course of the year, there are other risks that will make lowering inflation challenging in coming quarters.

The transition in demand from goods toward services has helped to deflate goods' inflation, which has been an important contributor to lowering inflation. The benefits of this transition could fade over time. generally healthy labor markets and high costs of housing, due to persistent housing supply issues, are likely to keep services inflation elevated. There also is the potential risk from Covid mutations and the Russia-Ukraine war that could disrupt progress made on reducing inflation.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.