Over the past year stubbornly high inflation has been a major bugaboo for the consuming public, policymakers and of course for investors.

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At the same time, there is a strong consensus among economists that US inflation has already peaked, and that slow economic growth or even a recession in 2023 will bring inflation down much more rapidly. 
 

 US Inflation Is Cooling

Of course, the comfortable assumption is that recessions or slow economic growth will reduce the pace of price inflation. 

Nonetheless, the continuation of the Russia-Ukraine war, and high food and fuel prices, are outside shocks that could still offset the trend towards lower inflation.   

The inflation projections that I am focusing are in the latest economic projections set out by Federal Reserve policymakers and the inflation projections that are imbedded in the US Treasury bond market. 

In December the Fed’s Open Market Committee (the FOMC) published a set of forecasts by their own officials on real GDP growth, the unemployment rate, price inflation, and the Fed’s own policy interest rates. The projections were for each year from 2022 to 2025 and over the longer run. 

These official’s projections are important for they reflect the thinking and priorities of the Fed, as well as the Fed’s outlook on the future direction of interest rates.

My own observations will focus on the median set of projections made by the Fed officials. 

Note that the GDP growth projections are for the fourth quarter (Q4) of the year compared to the same quarter in the previous year. The inflations, unemployment and federal funds rate projections are also for the same fourth quarter of the year. 

Several obvious observations clearly leap out from the Fed projections. 

In December policy makers were generally more pessimistic on inflation, unemployment and economic growth than they were in their September meeting. 

At the December meeting, the FOMC raised the federal funds interest rate 50 basis points to 4.25% to 4.50%. It was the seventh consecutive policy rate hike, following four straight 75 basis point increases. 

As well, Fed officials currently expect the federal funds rate to peak substantially higher at 5.1% in 2023 than was projected earlier on (4.6%). The Fed also expects interest rates to decelerate to 4.1% in 2024, and 3.1% in 2025.  

While the economic growth projections for the US were revised slightly higher for this year to 0.5%, the economy is still expected to post a similar dismal 0.5% growth rate in 2023. The 0.5% economic growth rate could easily incorporate several negative quarters of GDP growth in 2023. 

The good news in the Fed outlook is that price inflation is projected to be on a significant downward track over the next couple of years. 

Consumer inflation is expected to be 5.6% in the fourth quarter of this year and is projected to decelerate to 3.1% in 2023 and 2.5% in 2024. 

Longer run inflation is also expected to converge to the 2% target that the Fed hopes to achieve.
 

Fed Officials Median Economic Projections, December 2022

Turning to the financial markets, the US Treasury bond market is an alternate predictor of inflation and the direction of the economy. 

Bond yields are clearly expecting a slow growing economy in 2023 also combined with a slower pace of inflation.  

One can roughly estimate the rate of inflation expected in the bond market by comparing the difference between nominal yields on U.S. Treasury bonds and the real bond yields on the same maturity available on Treasury Inflation-Protected Securities (or TIPS). 

The recent five-year break-even inflation rate for the US was 2.14%, and the ten-year break-even rate implied a 2.1% rate of inflation.
 

The Five-Year Break-Even Inflation Rate -A Proxy For Inflation Expectations

It follows that the bond market expectations for inflation are still very well anchored close to 2% over the next five to ten years, which is similar to the longer run inflation projections set out by Fed officials. 

Nonetheless, there is still much to be worried about in the short term about these two somewhat rosy inflation views. 

Fed officials seem to believe in a soft landing for the economy in 2023 and that the coming phase of slow growth and rising unemployment will decelerate inflation towards its 2% target.

We will have to keep our fingers crossed that the soft landing and the decelerating inflation outlook is actually realized. 

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