I will be on Bloomberg TV today at 7:30 am to preview the December CPI data, and the key question for the Fed and markets is if a recession is needed to get inflation all the way back to the FOMC’s 2% inflation target. Economic models, such as the Phillips curve, would say that a much higher unemployment rate is needed to get inflation down to 2%. But maybe economists are too wedded to their models? What if inflation is mainly driven by supply shocks that are going to sort themselves out over time without any need for additional demand destruction (as suggested by Fed papers here, here, and here).
So far, inflation has been trending lower without any increase in the unemployment rate, suggesting that we are in the soft landing scenario. A continued solid economy with falling inflation and steady corporate earnings is good news for both IG and HY credit. But with inflation at 7.1%, the Fed will continue to be hawkish, and as a result, markets will likely remain volatile as we go through 2023.
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