The quandary faced by the Federal Reserve amid contradictory inflation and economic data has left economists and market observers pondering the appropriate course of actionWhile there is potential for the Fed to slow the pace of interest rate hikes, market expectations suggest that the terminal rate could indeed be set higher than anticipatedThe persistent gap between supply and demand in the labor market implies that the Fed may have to bear a heavier economic cost than in previous cycles to rein in inflation.

Over the last month, there has been a buoyant surge in market speculation surrounding a slower rate of increase from the FedThis optimism has spilled over into global financial markets, resulting in a significant rebound in U.Sequities from their recent lows, a drop in U.STreasury yields, and a weakening of the dollar.

The S&P 500 index has witnessed a remarkable recovery, bouncing back from a mid-October low of 3,490 points to above 4,000—an increase of approximately 15%. Meanwhile, yields on 10-year U.S

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Treasury bonds have retreated nearly 75 basis points from a high of 4.25% to around 3.5%. The U.Sdollar index has also seen a decline from a high of 114.8 to approximately 104, indicating a notable appreciation of the offshore renminbi, which has pushed the dollar to renminbi exchange rate down below 7 from 7.37 earlier this year.

This global market recovery can be interpreted as a correction to the previous excessive expectations regarding the Fed's rate hikes, but this path to recovery seems anything but linearRecent conflicting economic indicators from the U.Smay contribute to short-term market volatility.

From an inflationary perspective, the U.Scontinues to grapple with a significant actual inflation rate of 7.7%. While some leading indicators, such as commodity price declines and falling new rental rates, suggest potential easing, components that significantly affect the Consumer Price Index (CPI), such as old rent prices and wage growth, remain elevated.

Conversely, several indicators of the U.S

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economy hint at an impending recessionThe Purchasing Managers' Index (PMI) has dipped below the neutral line, revealing a cooling real estate market and decreasing export figures to various countriesYet, third-quarter GDP growth still stood at a robust 2.9%, while low unemployment rates linger at 3.7%, suggesting an economy that still shows signs of resilience.

The ql-multiple conflicting economic indicators raises pertinent questions about which data the Fed should prioritize when devising future policyDiscrepancies in commentary from Fed officials further illuminate the uncertainty surrounding forthcoming policy adjustments.

In a speech on November 30, Fed Chairman Jerome Powell exhibited a somewhat dovish tone, stating that slowing the pace of interest rate increases makes sense when nearing a level that could sufficiently curb inflation

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Meanwhile, New York Fed President John Williams adopted a more hawkish stance, suggesting that while some external pressures on inflation are easing, underlying price pressures may persist, indicating that a distance to lower rates remains considerable.

The upcoming Fed meeting in December may adopt a compromise approach: slowing the rate hike to 50 basis points while pushing the terminal rate for 2023 beyond 5%. This ‘short-dove long-hawk’ strategy appears to reflect an optimal response to the current contradictory data.

CPI data for October revealed a year-on-year increase of 7.7%, although a decline from the mid-year peak of 9.1% indicates a potential turning pointHow then can markets begin to factor in a future decrease in inflation?

One potential explanation lies in the nature of CPI as a lagging indicator

• Contradictory Data Poses Challenge for the Fed
• Liquidity Risks in the U.S. Treasury Market
• Outlook on Interest Rate Trends in China and the U.S.
• Profit Pressures on Financial Payment Institutions
• The Peak of U.S. Inflation: An Ongoing Trade

A number of leading indicators seem to predict a downward trajectory for U.SinflationMoreover, the Fed's tightening policies may take time to influence the real economy and subsequently, inflationary pressuresThese effects, stemming from 375 basis points cumulative rate hikes since 2022, are expected to gradually materialize, leading to easing inflation rates.

To better evaluate the intricacies of U.Sinflation, one could invoke Williams' onion metaphor, peeling away layers to uncover divisive details within the inflation landscape.

Williams posits that the outer layer of the inflation onion comprises commodity and trade prices, including essential goods like oil, iron, and timberThe mid-layer consists of finished product prices, particularly the price of durable goods such as automobiles and household appliances

The innermost layer encapsulates crucial underlying inflationary pressure, reflecting the general imbalances within the economy and labor market, with important indicators being costs associated with services, housing, and labor.

Let’s first examine the external drivers of inflationAs the world's largest oil consumer, fluctuations in oil prices heavily influence CPISince the beginning of the year, oil prices have dropped from around $130 per barrel to approximately $80, contributing to a year-on-year increase in energy prices, which fell from 41.6% in June to 17.6% by October.

What about the performance of durable goods prices? The demand for durable goods has markedly decreased in response to consecutive interest rate hikes by the FedIn the third quarter, durable goods consumer spending showed a shrinkage of 0.3%. The CPI indicated that in October, durable goods prices had increased year-on-year by 4.8%, a considerable 14-percentage point retreat from the year's peak.

This evidence points to a clear decline in inflationary pressures concerning the outer and mid-layers of the onion

However, the overarching inflation level remains persistently high, largely attributed to elevated prices at the innermost layer.

Among the critical elements of the inner layer of inflation is the ongoing increase in rental pricesAs of October, rental prices grew by 7.1% year-on-year, continuing to climb despite decreases in property values and shifts in certain rental indicesThis discrepancy arises from the nature of long-term lease agreements, which remain static and do not adjust in tandem with market fluctuations immediately after a rental agreement is established.

As Powell analyzed, housing-related inflation is typically sluggish in responding to wider price changes due to the slow pace of lease renewals"As long as the inflation rate for new leases keeps dipping, we anticipate housing service inflation to decline at some point in 2023,” he remarked, with this part of inflationary decrease being fundamental to most inflation reduction predictions

Yet, why has the Fed not fully embraced market expectations? The answer lies in another vital component within the inner layer—labor costs remain stubbornly elevated.

Prices associated with a host of services—including healthcare and education—constitute over half of the core Personal Consumption Expenditures (PCE), marking them as a crucial factor influencing U.Sinflation trendsUnderstanding labor market dynamics is essential for resolving the enigma of U.Sinflation.

As of November, average hourly earnings across the private sector have risen by 5.1% year-on-year, reflecting a rebound from previous months' declines, an unsettling departure from pre-pandemic growth levels of around 3%. Powell emphasizes, “Nominal wage growth outstrips levels consistent with a 2% inflation target significantly, indicating a long road ahead to restore price stability.”

The pandemic and other influences have resulted in a decline in labor supply, creating a considerable gap in labor demand that remains unfilled

The objective of the Fed’s tightening policies is to reduce labor demand, restoring equilibrium to the labor market to facilitate sustainable wage growth.

In this precarious balancing act, the Fed aspires to simultaneously combat inflation without stifling economic growthHowever, the reality is often more unforgiving, as curbing inflation inevitably dampens demand, leading to economic decline that manifests itself in tangible indicators.

Various forward-looking indicators signal an impending recession for the U.SISM's PMI index fell to 49% in November, marking the first time it dipped below the neutral line in the post-pandemic era, sending a cautionary signal regarding U.Seconomic healthHistorically, while a PMI dip below 50 does not automatically invoke recession, crossing the 45% threshold has typically signaled an impending economic downturn.

Interest rates have a pronounced impact on the real estate market, with the Fed's rapid hikes contributing to a perceptible cooling in housing activity

The 30-year fixed mortgage rate has surged over 7%, surpassing pre-financial crisis levels of 2008 and reflecting an increase of approximately 4 percentage points since the start of the year.

The National Association of Home Builders’ market index has plummeted to levels seen during the pandemic, with home sales dwindling significantlyBy October, existing home sales were recorded at 4.43 million units—below the average rates from prior to the pandemic and plunging 30% from their peak early this yearResidential investment has slumped for two consecutive quarters, contracting at an annualized rate of 26.4% in the third quarter, representing a 1.4% negative pull on GDP growth.

Given the protracted nature of real estate cycles, the downturn witnessed in the housing market may herald the conclusion of a long-term bull market that began in 2012, with ramifications extending well into the future.

Simultaneously, the declining exports to the U.S

from other nations indicate that the slowdown in the American economy is already spilling over into the broader landscape of global tradeNovember saw South Korea’s exports decline by 14% year-on-year for two consecutive months, and China’s exports to the U.Sfell by 12.6%, marking a third month of negative growth.

Historical trends show that for the Fed to stabilize inflation around the 2% level, it typically requires maintaining a slight labor demand gap, where demand is marginally less than supplyHowever, unlike prior economic cycles, the reduction in labor supply post-pandemic necessitates a more aggressive dampening of demand to achieve this balance, potentially demanding greater economic sacrifices from the Fed during this inflationary combat.

Currently, the Fed's outlook on the economy remains relatively optimistic, with projections suggesting growth could maintain around 1.8% in 2023. The prevailing market sentiment mirrors this ideal mix of economic stability and managed inflation, leading to high hopes even in the face of impending recession declarations

This optimism largely underpins the recent rally in equities.

In the event the Fed fails to rein in inflation effectively, the economy may slip into a deeper recession, necessitating a revision of stock market expectationsWhether the economy can withstand a prolonged elevated interest rate environment around 4% to 5% remains uncertain; it is worth noting that the U.Seconomy has not experienced such high rates in over two decades.

The uncertainty in economic forecasts is reflected in the Fed's veiled signals regarding policy adjustmentsOn one hand, there are concerns about recurrent inflation rates, accentuated by past missteps that have prompted tighter decision-making based on current indicators rather than forecastsSimultaneously, fears of a rapid economic decline loom, with underlying concerns about financial stability

The upcoming December Fed meeting is anticipated to shift to a pace of 50 basis points for rate increases, serving as a "concession" to the markets

Powell has indicated that the timing for slowing hikes might come as early as this next meeting.

However, slowing the rate of increases doesn’t necessarily imply a rapid pivot in policy; the Fed is likely to raise expectations about terminal rates further while maintaining high base rates for an extended duration until inflation is adequately addressed.

Fed officials such as StLouis Fed President James Bullard assert that financial markets may underestimate the probability of aggressive rate hikes in 2023, advocating that policy rates may need to reach a minimum of 5% to 7% to sufficiently constrain inflation.

Echoing this sentiment, Powell reiterated, "Terminal rates may need to exceed numbers from September's meeting and economic projections." Stressing the significance of raising rates further to control inflation, he highlights the importance of maintaining those rates at restrictive levels for a sustained period compared to the timing of rate increases.

Journalist Nick Timiraos, often regarded as a mouthpiece for the Fed, recently suggested that during the December meeting, the Fed will likely present forecasts indicating a peak rate around 4.75% to 5.25%.

Previously, in September, projections for peak rates hovered between 4.5% to 5%. The implications here suggest the likelihood of an upward adjustment of expected rate limits.

Some analysts posit that the current market expectations appear somewhat premature