The evolving landscape of inflation and economic data in the United States presents a complicated challenge for the Federal ReserveDespite the likelihood of a slowed pace in interest rate hikes, the terminal interest rate in the future could exceed market expectationsThe persistent gap between supply and demand in the labor market suggests that the Federal Reserve may face higher economic costs than in previous cycles to rein in inflation.

Over the past month, speculative trading regarding the Fed’s potential deceleration in interest rate increases has surged, leading to a rise in global risk appetiteThis resulted in a significant rebound in the U.Sstock market from its recent lows, along with a sharp decline in U.STreasury yields and the dollar.

The S&P 500 index has risen 15% from its mid-October low of 3,490 points, surging past the 4,000 mark

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Meanwhile, U.S10-year Treasury yields dropped nearly 75 basis points from a high of 4.25% to around 3.5%. The dollar index fell from a previous high of 114.8 to about 104, leading to a notable appreciation of the offshore RMB, which strengthened against the dollar from 7.37 to below 7.

This global market recovery can be seen as a recalibration of the excessive expectations surrounding future Fed rate increasesHowever, this journey towards recovery may not be straightforwardRecent contradictory economic indicators from the U.Shave resulted in increased volatility in the markets.

When analyzing inflation in the U.S., it’s evident that the actual inflation rate remains high at 7.7%. Some leading indicators of inflation are beginning to decline, such as falling commodity prices and decreasing new rental prices

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Nonetheless, older rental rates and wage growth, both of which heavily impact the Consumer Price Index (CPI), are still elevated.

On the economic front, various leading indicators suggest that the U.Seconomy may be heading towards a recessionThe PMI index has dipped below the growth threshold, the housing market is cooling off, and exports to the U.Sfrom several countries have started to recedeHowever, Q3 GDP growth in the U.Sstill registered at 2.9%, and employment data, which the Federal Reserve closely monitors, remains robust, with an unemployment rate holding steady at a low 3.7%.

Faced with such conflicting data, the Fed must determine which indicator to trustRecent comments from Federal Reserve officials reveal differing opinions regarding future policy directions.

In a speech on November 30, Fed Chair Jerome Powell signaled a more dovish tone, mentioning that slowing rate hikes might be prudent as they approach a level that could curb inflation

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He suggested that this slowdown could occur as soon as the December meetingIn contrast, New York Fed President John Williams adopted a more hawkish stance, indicating that while external and intermediate inflationary pressures are decreasing, core price pressures are likely to persist for some timeThis implies that rate cuts are still a considerable distance away.

The upcoming December Federal Reserve meeting may strike a compromise approach: on one hand, reducing the pace of rate hikes to 50 basis points; on the other hand, raising the endpoint for rate increases in 2023 to above 5%. This "dovish short-term, hawkish long-term" approach might be the optimal strategy to address the current contradictory signals.

Peeling the Onion: Inconsistent Indicators

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CPI rose by 7.7% year-on-year in OctoberAlthough this figure is down 1.4 percentage points from the peak in June, it remains significantly above the Federal Reserve’s targetAt a glance, it seems puzzling that the market is already banking on a decline in inflation given the remaining elevated CPI.

One fundamental reason is that CPI is typically a lagging indicatorMeanwhile, many leading indicators hint that inflation may decline in the futureMoreover, the Fed's tightening policies may take time to percolate through the real economy and impact inflation; in other words, inflation data has yet to fully reflect the effect of the 375 basis points of rate hikes accumulated since 2022. The repercussions of these hikes could unfold gradually, leading to a downturn in inflation.

To better understand the complexities of U.S

inflation, we can employ a model analogous to that of an onion, as suggested by Williams, which allows us to dissect some of the contradictory indicators.

Williams contends that the outer layer of the onion consists of commodity and trade prices, such as those for oil, iron, and timberThe middle layer comprises prices for manufactured goods, particularly durable goods like cars, appliances, and furnitureThe innermost layer reflects potential inflation, indicating imbalances in the economy and labor market through service industry costs, housing prices, and labor costs.

Firstly, let's examine the external factors driving inflationAs the world’s largest consumer of oil, fluctuations in oil prices have a direct bearing on CPIFor instance, oil prices have plummeted from around $130 per barrel at the start of the year to about $80 currently

Consequently, energy price growth within the CPI has decreased significantly, from 41.6% in June to 17.6% in October.

Next, what about the performance of durable goods prices? Demand for durable goods is showing a clear decline, with current spending on these goods falling by 0.3% in Q3, marking two consecutive quarters of negative growthIn terms of CPI, October saw a 4.8% increase in durable goods prices year-on-year—down roughly 14 percentage points from the peak earlier in the year.

These observations point towards a notable reduction in inflation pressure indicated by the outer and middle layers of the onionHowever, the overall inflation level in the U.Scontinues to remain highThe core reason lies in the elevated prices indicated by the innermost layer of the onion.

A significant component of the innermost layer is rent prices

The CPI revealed a 7.1% year-on-year increase in rental prices for October, which continues to riseDespite the fact that U.Shousing prices have decreased and some rent indices have started to show downturns, why does the rental growth in the CPI still display an upward trend? The explanation rests in the long-term nature of rental contracts, which tend to remain fixed once established, thus not immediately reflecting changes in the housing market.

As Powell has analyzed, housing inflation lags behind changes in other prices, particularly when it comes to the slower pace of rent adjustments“As long as the inflation rate of new leases continues to decline, we expect housing service inflation to begin decreasing at some point in 2023. In fact, this reduction will likely underpin most forecasts of declining inflation.” The Federal Reserve is well aware of recent market trading logic and the basis of these predictions

However, they refrain from fully endorsing market expectations due to the persistent strength in labor prices within the innermost layer.

Prices for services encompassing healthcare and education make up more than half of core PCE, which plays a critical role in shaping the trajectory of U.SinflationSince wages constitute the largest expense in providing these services, understanding the labor market is essential to unlocking the key to U.Sinflation.

In November, U.Sprivate sector hourly wages grew by 5.1% year-on-year, rebounding slightly and breaking the downward trend observed in prior monthsMoreover, the growth rate remains significantly above the pre-pandemic level of about 3%, which is a major concern for the Federal ReservePowell remarked, “The growth rate of nominal wages far exceeds the level consistent with a 2% inflation rate

We still have a long journey ahead to restore price stability.”

The pandemic, along with other factors, has led to a decline in labor supply in the U.S., creating a significant mismatch between labor supply and demand, with demand exceeding supply under unchanged demand conditionsThe goal of the Federal Reserve's tightening policy is to temper labor demand, moving the labor market back to equilibrium in order to foster sustainable wage growth.

Compromises and Realities

The Federal Reserve faces the harsh truth that it cannot have its cake and eat it tooControlling inflation necessitates reducing demand, and the prospect of an economic slowdown is becoming a reality.

Several of the leading indicators within the U.S

economy signal that a recession is increasingly likelyAs of November, the ISM PMI index slipped to 49%, marking its first fall below the growth threshold since the post-pandemic period, raising concerns about the economic health of the U.SHistorically, while a PMI drop below 50 does not always anticipate a recession—2019 saw a brief dip without precipitating one—if it falls below 45%, a recession has nearly always followed.

The housing market, which is particularly sensitive to interest rates, has shown clear signs of cooling due to the Fed’s rapid rate hikesThe 30-year fixed mortgage rate has surged above 7%—higher than levels seen before the 2008 financial crisis—and has risen by roughly 4 percentage points since the beginning of the year.

The National Association of Home Builders housing market index has plummeted to pandemic lows, with home sales cooling significantly

In October, the number of existing home sales fell to 4.43 million, dipping below the pre-pandemic average in 2019 and representing a 30% decline from the peak earlier in the yearResidential investment has seen two consecutive quarters of steep declines, with Q3 residential investment contracting at an annualized rate of -26.4%, dragging down GDP growth by 1.4% alone.

Given the prolonged cycles in the real estate market, the current downturn in U.Shousing may signal an end to a long property bull market that began in 2012, with lasting implications for the U.Seconomy.

Export declines from other countries are also evident, suggesting that the slowdown in the U.Seconomy is starting to impact global tradeFor example, South Korea's exports fell by 14% year-on-year in November, marking two consecutive months of decline; while China's exports to the U.S

dipped by 12.6% in October and experienced three months of negative growth in a row.

From a labor market perspective, historical data indicates that to achieve an inflation target near 2%, the Federal Reserve must maintain a slight labor demand gap, wherein demand slightly undershoots supplyHowever, differing from previous economic cycles, due to a permanent reduction in labor supply relative to pre-pandemic levels, the Fed may need to suppress labor demand more forcefully to attain this targeted gapThis could entail greater economic sacrifices than in previous cycles to effectively combat inflation.

As of now, the Federal Reserve’s outlook on the economy remains relatively optimistic, maintaining that a “soft landing” is plausibleIn fact, their economic forecasts released in September indicate that Fed officials widely expect the U.S

economy to sustain a growth rate of 1.8% in 2023.

Market sentiment is currently aligned with an ideal combination of economic growth and inflation expectations, factoring in the belief that even if a recession occurs, it will be mildThis optimism underpins the recent significant rebounds in U.SstocksConversely, if the Federal Reserve fails to effectively control rates and the economy slides into a more severe recession, then market expectations would require swift adjustmentsThe sustainability of the economy under sustained high benchmark rates between 4%-5% remains uncertain, especially considering that the U.Seconomy has not navigated such high rates over the past two decades.

Ambiguous Expectations

In light of conflicting economic data, the Federal Reserve's policy expectations seem rather ambiguous

On one side, there’s concern that inflation may continue to fluctuate, especially considering past forecasts have repeatedly proven incorrect, prompting the Fed to increasingly rely on current indicators for decision-making rather than predictionsOn the flip side, there is a fear of an overly rapid economic decline alongside concerns regarding financial stability.

During the December Federal Reserve meeting, a probable adjustment to the pace of rate hikes to 50 basis points appears likely, which would serve as a "sweetener" to the marketPowell has previously signaled that a slowing of rate hikes may be possible as soon as the December meeting.

However, slowing the pace of increases does not imply that policy will pivot quicklyThe Fed is likely to further elevate expectations for the terminal rate, maintaining baseline interest rates at restrictive levels for an extended period until actual inflation shows significant reductions.

St

Louis Fed President James Bullard expressed that financial markets may be underestimating the likelihood of the Fed adopting a more aggressive rate hike path in 2023 to temper inflationHe believes the Fed needs to align policy rates with the lower end of the 5%-7% range to achieve sufficiently restraining levels.

Powell reiterated that the terminal interest rate is likely to go higher than previously projected at the September meetings, emphasizing the importance of increasing interest rates to control inflation and the necessity of maintaining the policy's restrictive nature.

Recently, journalist Nick Timiraos, considered to be the “Fed Whisperer”, noted that in the upcoming December Federal Reserve meeting, officials may forecast a peak in rates rising to the range of 4.75%-5.25%.

Previously, the September Federal Reserve forecasted a peak range of 4.5%-5%. This suggests that the Fed will likely adjust the terminal rate upward.

Chinese Financial Company has suggested that current market expectations may be somewhat ahead of themselves