The X Factor

Investing is challenging because, like many disciplines, it requires predictions and analysis of myriad variables. However, today’s environment is unusual in that the path forward for the economy and financial markets is likely to be dictated by a single factor: the trajectory of inflation. Of course, other data points, such as labor market statistics, manufacturing data, and consumer activity, require attention. However, with the economy essentially at full employment, the purpose of these indicators is principally to gain clues about future inflation and, in turn, monetary policy.

What makes today’s environment challenging is handicapping a wide range of potential inflationary scenarios that could result in a similarly wide range of financial market outcomes. As evidence, the Bloomberg inflation forecast survey of 51 Wall Street economists—as measured by Consumer Price Index year over year (CPI y/y)— for the fourth quarter of 2022 ranges from 1.7% to 5.4%. On one end of the spectrum, inflation could decline precipitously, providing the Federal Reserve considerable breathing room in tightening policy and extending the economic cycle well beyond 2023. At the other extreme, the Fed might need to tighten policy so aggressively that it induces a recession by late this year. In this letter, we detail our expected forecast—for inflation to decline to around 3% on the CPI y/y by end 2022—as well as identify where we could be wrong to the upside and, yes, even to the downside. (The January CPI data will be released the day after this issue is published; while the numbers could move in either direction, they will likely not change our assessment of the trajectory for the year.)

Please see important disclosures at the end of the article.