Surprises of 2023 Volume 1: From Inflation to Deflation

The money supply is contracting, and at this rate will go negative year-on-year in four months. That points to at-target inflation rates by summer, continuing to fall until they reach outright deflation in early 2024. A 25 bp hike is locked in for February, but with two more CPI reports before the March FOMC, February is likely to be the final hike, in which case recession will not be inevitable. In March the Fed will take credit for the disinflation baked in the cake a year ago before they even lifted off, and will warn markets of a long plateau at a restrictive level. But as inflation continues to fall, the first cut will likely come at the June FOMC. This is significantly out of consensus, and will be very bullish for both stocks and bonds. There will be uncertainty when deflation appears, and much will depend on how the Fed reacts to it. Rate cuts are likely to accelerate, and QT is likely to end. If the Fed fails to react, there would be a different recession than the one now feared – one based not on tightening, but on failing to ease.