GettyImages 1446279820 e1670857685118

All eyes are on tomorrow’s crucial inflation report. Here’s how the Fed, the economy and the markets might respond

Year-on-year inflation, as measured by the consumer price index (CPI), has reached a four-decade high 9.1% in June. But by October it had dropped to 7.7%.

Investment bankers and economists expect the slowing trend in inflation to continue, but that prediction will be tested this week with the release of November CPI data and the Federal Reserve’s latest interest rate decision .

Jefferies chief financial economist Aneta Markowska said so Fortune which expects Tuesday’s CPI report to show year-on-year inflation falling to 7.2% in November. Inflation will continue to fall next year as well, he said, but warns it may not hit the Federal Reserve’s 2% target without some “pain.”

“I think inflation will slow down, very linearly and then level off,” Markowska said, arguing that some of the inflation is already in the labor market, as evidenced by hourly wages growing at a rate Annual rate of 7.8%. last month.

The Fed faces a “trade-off” between persistent inflation and recession after it failed to raise interest rates last year when rising consumer prices first became an issue, he explained.

“Avoiding pain is not an option here. That’s just not on the menu,” she said. “What’s on the menu is, ‘We want some pain real quick. [a recession]? Or potentially we wait and then deal with more pain along the way [persistent inflation]?’”

Markowska has the company in warning that the decline in inflation may be insufficient to keep the US economy from a recession. Here’s what other major investment banks, economists and analysts expect from this week’s CPI report, the Fed and the US economy.

What to expect from the CPI report: A cooler November

Inflation has hit consumer wallets hard this year, but 2023 will likely offer some relief.

Morgan Stanley U.S. chief economist Ellen Zentner said in a research note on Friday that lowering used and new car prices, as well as transportation, medical and housing costs, should reduce year-on-year CPI inflation to 7, 3% in November.

With Americans shifting their spending from goods to services like travel as pandemic restrictions fade worldwide, Bank of America US chief economist Michael Gapen also forecast that year-on-year inflation fell to 7.3% last month. However, in a research note on Thursday, he said shelter inflation, which is based on rental prices and how much homeowners would pay to rent their homes, could “remain sticky into next year.” .

That safe-haven inflation is measured with a lag, so despite falling house prices, that component of the CPI could remain elevated. And the prices of food, which have gone up 10.9% compared to October a year ago, it will also remain high, according to the economist, in part due to high logistics, storage and wage costs.

Goldman Sachs chief economist Jan Hatzius said in a research note on Sunday that he expects year-over-year CPI inflation of 7.2% in November, driven largely by lower gasoline prices. The average price for a gallon of gas peaked at $5.01 in June, but plunged 34% to just $3.26 in subsequent months, according to the American Automobile Association.

Hatzius forecast a 3% drop in used car prices, a 1% drop in clothing prices and a 1% drop in hotel prices in November inflation data. However, it also anticipated a 2% rebound in airline ticket prices.

The future of the Fed’s inflation fight

While most investment banks are cautiously optimistic about Tuesday’s CPI report, all eyes will be on the Federal Reserve and Chairman Jerome Powell on Wednesday. Powell to raise interest rates this week and next year, even if CPI data reveals inflation is down, experts said Fortune.

“The Federal Reserve will hike interest rates again, for the seventh straight meeting, but appears poised to raise rates by half a percentage point rather than three-quarters of a percentage point at each of the past four meetings,” the chief financial analyst said at, Greg McBride “Although the Fed will move at a more typical pace, it will continue to raise interest rates now and into 2023…at a more usual pace.”

Danielle DiMartino Booth, CEO and chief strategist at economic research firm Quill Intelligence, also expects the Fed to hike rates by 50 basis points on Wednesday.

“It’s still a sizable increase that will continue to wreak havoc on interest-rate-sensitive sectors like housing and autos,” he said. “A half-point rate hike is double the pace markets were accustomed to before Jerome Powell brandished his wrecking ball earlier this year in an effort to slow runaway inflation.”

DiMartino Booth, who spent nine years at the Federal Reserve Bank of Dallas, believes investors shouldn’t focus too much on rate decisions. Instead, they should keep an eye on Powell’s Wednesday press conference and his tone, which is critical in assessing what happens next in the markets.

It all boils down to “which Jerome Powell comes across,” DiMartino said: “A gentle, gentle, scripted dove ready to pivot or a hawkish Powell who isn’t afraid to rock the markets.”

If Powell is viewed by investors as dovish, then the stock could go higher. But if he’s seen as a hawk, that’s another story.

For now, the money is on Powell for being more hawkish, or as Jefferies’ Markowska put it, “less accommodating” than in recent meetings. DiMartino also warned that Fed officials are ready to “squeeze the excess” out of markets with interest rate hikes, despite the recent drop in inflation.

Too little too late

Markowska and DiMartino Booth both fear the Fed can no longer achieve a “soft landing,” where inflation is tamed without triggering a recession.

“Hopes for a soft landing have been dashed,” DiMartino Booth said, arguing the job market is starting to show cracks, with initials unemployment claims And layoffs increasing. “The Fed’s efforts have already pushed the US economy into a recession.”

DiMartino Booth also argued that “sticky housing inflation” will keep inflation high next year, meaning the Fed will be forced to keep raising rates, raising the odds of a “global financial crisis.”

Markowska didn’t go that far in predicting a “global financial crisis,” but she expects the Fed will likely “do quite a bit of damage to the economy.” Some investors have been lulled into a “false sense of security” as inflation has fallen since June, she said, warning that a recession was likely.

“The problem is, even if they [the Fed] they have no intention of sending the economy into a recession…the desire to avoid something does not mean that they will actually avoid it successfully,” he said.

Markowska added that “at some point” the Fed will be forced to recognize the need to push the unemployment rate substantially above the current 4.4% Year-end goal 2023. Doing so through further interest rate hikes would help the Fed slow the economy and bring inflation down to its 2% target, but it would come at a steep cost.

“It’s going to be a very difficult political environment for Powell,” Markowska said. “He’s going to get a lot of pushback.”