There are signs that inflation has peaked

Inflation should remain the key economic factor in 2023. Encouragingly, we have already begun to see signs that inflation has peaked. On a year-over-year basis, the headline consumer price index (CPI) likely hit a high watermark in June 2022 and has decelerated every month since. The core CPI has also showed tentative signs of peaking in recent months. However, both are still uncomfortably near four-decade highs. Nonetheless, further slowing seems likely. Moreover, the global supply chain, significantly disrupted over the last few years, continues to recover, and will continue to improve in 2023. This will help to alleviate supply-side inflationary pressures. 

Demand-side pressures on inflation show signs of stabilizing. While consumer spending has remained resilient, demand-side pressures on inflation should also ease in 2023. Wage growth is slowing, outsized fiscal stimulus from the last couple of years continues to fade, and excess savings are burning off relatively quickly under the weight of higher prices and a desire to spend. Consequently, we anticipate a more pronounced slowdown in inflation during 2023, likely heading toward 3% to 4%. Even so, this means inflation will stay above the Fed’s target level for the year. We envisage additional slowing in inflation in 2024 and 2025 as it falls to near the Fed’s flexible target rate of 2%.

No rate cuts expected until end of 2023 at the earliest

With inflation running at four-decade highs, the Fed took bold steps in 2022 to tamp down inflation. After beginning the year with the Fed Funds rate in a target range of 0% to 0.25%, the Fed embarked on its most aggressive tightening policy in four decades. After hiking by 50 basis points (bps) in March, the Fed then began a run of 75bps hikes that brought the target Fed Funds rate to a range of 3.75% to 4.0%. 

However, it appears that the Fed is not yet done. With inflation anticipated to remain above target in 2023, we expect the Fed to continue tightening into the first half of 2023, but at a less aggressive pace. The Fed Funds rates should peak around 5%. After that, the path will continue to be incredibly uncertain. The Fed will undoubtedly need to see clear evidence that inflation is headed toward target before easing. This raises questions about how long the Fed will stay at the terminal rate before cutting. At best, it likely means no rate cuts until the latter half of 2023, but it could mean no rate cuts until 2024. By 2024 we anticipate the Fed will cut rates in order to restabilize the economy and get growth moving in the right direction again amid lower inflation. 

Government policy set to turn even tighter in 2023

After a period of incredibly stimulative fiscal policy, with trillions in government spending, the situation seems likely to shift in 2023. The appetite for very stimulative fiscal policy diminished in 2022 across the political spectrum with high inflation prevailing. But the situation now looks set to turn even more cautious. With the Republicans retaking control of the House of Representatives, government spending is expected to become more contentious and challenging. Practically, this means for the first time in decades the U.S. economy should head into a period of slowing without the benefit of fiscal stimulus to help soften the blow. 

Slowing growth will therefore not likely be supported by any meaningful government safety net. Yet this also means that some of the government spending supporting demand-side inflation will also wane in 2023. Together with higher interest rates, overall government policy seems set to be even tighter in 2023. While some government spending, such as infrastructure, will occur over the next decade, the prospect of purely stimulative fiscal measures appears low in the near to medium term.