The market seems to be of the view that if inflation quickly declines to the Fed’s 2% target, then everything will be fine and stocks will continue to go up, and credit spreads will continue to narrow.
There are two problems with this logic.
1) If inflation comes down faster than the Fed expects, it is because the economy is slowing faster than the Fed expects. For example, if wholesale car prices decline more quickly than expected, then it is driven by a sharper-than-expected drop-off in demand for cars.
2) The Fed and academics agree that it takes 12 to 18 months before monetary policy impacts the economy, and this is true both when the Fed is raising rates and when they are cutting rates. So if inflation quickly declines to 2%, we would still have 12 to 18 months of slowing growth ahead of us.
The bottom line is that no matter what happens to inflation, the lagged effects of Fed hikes will continue to drag the economy down over the coming 12 to 18 months, and that is why a recession is a more likely outcome than a soft landing, see chart below.
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