December 2022 / VIDEO
The 2023 Inflation Outlook
Easing inflation may slow or pause Fed hikes, but we believe a rate cut is unlikely if inflation settles above the Fed’s 2% target.
- Inflationary pressures have been a headwind for financial markets, so recent reports showing a declining trend in prices have been encouraging to investors.
- Moderating inflation may slow—or even pause—Fed hikes in the near term, but we believe a rate cut is unlikely if inflation settles above the Fed’s 2% target.
U.S. inflation remains a key variable for investors, given the strong equity market rally that followed an encouraging CPI report for the month of October.
The report was received favorably because inflation fell for the fourth consecutive month and also moved below 8% for the first time since February. But a more subtle and important reason for optimism is that services inflation showed signs of leveling out. This is important because services inflation remains the most ominous part of inflation, and therefore the biggest enemy of the Federal Reserve.
Goods inflation—the portion of inflation that includes food, energy, and other commodities (but not services)—is already well on the mend. Thus far, we have seen the goods portion of CPI collectively fall in every single month of 2022, and forward-looking indicators point to this trend continuing.
Most notably, supply chains have rapidly improved since April and are now close to returning to pre-pandemic levels. Also supportive is that the S&P GSCI Index, a broad measure of global commodity prices, remains well below the levels it reached earlier in the year. This bodes well for a continued decrease in year-over-year comparisons for at least the next eight months.
Looking ahead, it is likely that commodity prices will remain somewhat anchored at current levels as global commodity demand fades due to weakening economic activity. It is also reassuring that U.S. oil production has been rising steadily while natural gas storage levels in Europe have been surprisingly strong due to a mild winter—meaning that some of the most significant supply constraints are easing as well.
What about core services? As noted earlier, services is the most important part of inflation from the Fed’s perspective. There are two reasons why this is the case:
- The tools that the Fed uses to curb inflation are the most effective against services inflation, so this is their fight to fight.
- Services inflation tends to be much stickier than goods inflation—meaning that once it becomes elevated, it takes longer for it to recede back to normal levels.
Again, there is positive news on this front. This is because shelter inflation, which is a very large part of services inflation, is poised to fall considerably over the next 12 months. While most people may not consider shelter to be a service, it is considered to be one in the CPI calculation and currently accounts for 57% of the CPI services component.
Due to the mechanics of the CPI calculation, changes in rent and housing prices are reflected in CPI on a lagged basis. This means we can look at real-time data on rent and house prices and get a fairly reliable estimate of where shelter CPI will be over the next 12 months. Using the Zillow Observed Rent Index, we can estimate that rent CPI may increase for a few more months but should begin to pull back sharply after that. Using the S&P CoreLogic Case-Shiller Home Price Index, we can estimate that owner’s equivalent rent CPI is also likely to decrease in 2023.
Unfortunately, the outlook for the remaining components of services is less encouraging. This is because wage inflation remains elevated and there is little reason to believe this will ease in the near term with the U.S. labor market remaining extremely tight. As of the end of November, there were 1.7 job openings in the U.S. for every unemployed worker. As a result, employers will likely be forced to pay elevated wages to attract new job applicants over the foreseeable future.
In conclusion, there is good reason to believe that inflation will likely continue to fade throughout 2023. Both goods and services inflation are on course to fall considerably by the middle of next year. Unfortunately, this may not be enough to get inflation close to the Fed’s target of 2%, especially if labor markets remain extremely tight.
As a result, it is reasonable to expect the Fed to be slowing its pace of rate hikes as we enter 2023 and perhaps reaching a pause in rate hikes by June. However, if wage inflation remains elevated and CPI is still well above the Fed’s target level, the Fed will be reticent to begin cutting rates at any time during 2023.
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