The dollar weakened further after a broad measure of November US inflation slowed while durables orders fell more than expected. Its fate in 2023 will very depend on the US inflation outlook and Fed’s monetary policy path. In our view, dollar may face some headwind as one of the biggest factors-inflation, is about to slow down next year.

For headline and core inflation, we think it is about to fall slowly through 2023, driven by an easing of supply constraints and recessionary dynamics in 2H23. The demand-driven component will stay strong and keep inflation substantially above the Federal Reserve's 2% target. We expect headline and core CPI to end the year at 3.5% and 3.8%, respectively.

Two items set to restrain the CPI in 2023, health insurance and milder rent inflation will have less impact on Fed's preferred inflation measure, the PCE deflator due to a lower weight. The gap in year-over-year rates between the two price indexes will narrow as the CPI falls more quickly in 2023. The latest 2-percentage-point gap may narrow to about 1 ppt by March 2023, and to near zero by 3Q.

If inflation is going to slow down in 2023, how long policymakers will be able to hold interest rates at high levels is an important issue. Traders in the futures market expect the Fed to start cutting rates by the end of 2023. In its own forecast, the central bank shows rate cuts starting in 2024.

Fed will have to backtrack on higher rates at some point because of the recession, but we expect a recession could run through the end of 2024 in a period of high rates. The market clearly thinks the Fed is going to reverse course on rates as things turn down, what isn’t appreciated is the Fed needs this in order to keep their long-term credibility on inflation.

While the potential for recession has been on the horizon for a while, the Fed has so far failed to slow employment and cool the economy through the labour market. But layoff announcements are mounting, and some economists see the potential for declines in employment next year.

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Fullerton Markets Research Team
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