Markets in 2023: It’s All About Inflation

Peter Donisanu
11 min readDec 30, 2022

To say that 2022 was a disappointing year for investors is an understatement. US stocks gave up more gains to close the year than they have since the height of the Global Financial Crisis. And even bonds, which tend to move higher when stocks fall, saw their worst declines in decades in 2022. And while some investors sought out cash as a haven of sorts, double-digit inflation and a rising cost of living ate into the purchasing power of most savers. Ultimately, investors had no safe place to hide from this year’s economic and market carnage, and it’s arguably all the Fed’s fault.

Understandably, after this year’s market volatility, many investors are ready to throw in the towel and move to the sidelines as there appears to be no end to the ongoing economic and market uncertainty. Even so, as we look ahead to the coming year, there are some early signs that we may finally receive the long-awaited relief rally sought by so many investors. And that’s why getting out of the markets now could mean potentially missing out on the start of the next bull market rally. To get to that rally, however, we’ll likely need to move through more uncomfortable periods of market ups and downs.

While it feels like the floor is coming out from under the markets, the unwinding that we’re seeing across the financial system today is arguably not primarily driven by bubbles bursting as they did in 2000 or 2008. Instead, what’s different about this selloff is that policymakers, namely the Federal Reserve (Fed) and central banks globally, are purposefully engineering an economic and market decline by raising interest rates in a bid to combat out-of-control inflation.

What this means for many investors out there is that, once policymakers are sufficiently convinced that inflationary pressures are under control, their next likely move could be a pause in interest rate hikes before lowering them once again. Now, this outcome is essential for financial markets because, typically, in a bear market, risk assets tend to find their footing and rally higher when economic conditions are prime (like when inflation is falling and the economy is stalling) for the Fed to cut interest rates.

And as you’ll likely recall, this expectation led to fits-and-starts in 2022 as many market participants prematurely held out hopes for a “Fed Pivot.”

So, if the Fed is engineering an economic slowdown that led to the recent market selloff, what needs to happen before the central bank finally starts cutting interest rates to give the markets a chance to rally once again? In our latest article, we discuss the three conditions that likely need to play out before the Fed changes its policy stance that could pave the way for markets to close on a higher footing in the year ahead. Continue reading here.

So, if the Fed is engineering an economic slowdown that led to the recent market selloff, what needs to happen in the coming months before the central bank finally starts cutting interest rates again and giving the markets a chance to rally higher?

Well, policymakers likely will need to see three economic conditions play out before changing their approach, including 1) a drop off in consumer spending, 2) a reset of inflation expectations, and 3) persistent declines in services inflation. As these conditions are met, we likely will see a bottom formation in the current market selloff, which, holding all else equal, paves the way for a higher market close in the year ahead. As we move towards these conditions, we will likely face increased market and economic volatility in the first half of 2023.

Condition #1: Household Spending Needs to Slow

Now, one question you may be asking yourself is, “why would the Fed care about curbing household spending when its key concern is inflation?” Well, if you think back to your college Economics 101 courses, then you’ll likely recall that high inflation tends to happen when there are either too few goods to purchase (or a supply side inflation) or too much money chasing too few goods (demand side inflation).

And following the pandemic in 2020, we did experience the effects of supply-side inflation as global supply chains came to a screeching halt, and prices for some goods on store shelves moved higher. But you’ll also recall that the Federal Reserve and US government as a whole injected trillions of dollars into the financial system and economy to stave off what could have been an economic downturn worse than the Great Depression.

Now, while money printing helped to stave off what could have been a devastating recession, all of that extra money, combined with global supply chain bottlenecks, ultimately led to more money chasing too few goods. Adding insult to injury, as supply chain issues were resolved, households continued to spend at historically high rates while businesses further raised prices on goods and services sold.

One reason for this is that the pandemic led millions of individuals to retire early or quit the labor force altogether. And a lack of qualified workers in several key economic sectors ultimately led employers to raise wages to entice individuals to come back to work. So, combine extra cash available from higher savings (stimulus checks) coupled with higher incomes, and now you have a recipe for higher household spending.

Now, policymakers can’t directly determine how you or I spend our money. Still, they can influence our spending decisions by introducing economic uncertainties that prompt questions like, “should I save more money because I could lose my job” or by ultimately making it more expensive to purchase big-ticket items like a home or automobile. This point, arguably, was likely one of the reasons why Fed Chair Jay Powell alluded to the central bank’s need to inflict “economic pain” during his comments at the Jackson Hole Symposium back in August.

So far, the economic data suggest that one indicator of consumer spending, retail sales, remains robust. Even broader gauges of spending, like the government’s measure of personal consumption expenditures, show that while slowing recently, spending continues to grow at a steady clip with little sign of abating.

Now, with all that said, there is hope that the Fed’s policies are beginning to have an effect. That’s because the data show that households, after spending through pandemic-era stimulus cash, are seeing their personal savings rates fall to their lowest levels in recent history. This low level of savings suggests that some individuals are finally achieving the limits of their spending ability.

Another sign that households are becoming financially tapped out is what’s happening in the lending market. For example, outstanding revolving debt balances, including credit cards, are now back to their highest levels in history. In fact, in less than two years following the pandemic, consumers charged up nearly $200 billion worth of spending to their credit cards and other revolving lines of credit. To put this figure into perspective, it took households seven and a half years to charge up the same amount of money to their credit cards in the years following the Great Recession!

Taken together, what the data likely means is that while households are earning more today, their savings are being depleted, leading some individuals to use credit cards to pay for non-essentials as prices rise and, in some cases, to spend beyond their means. And as the Fed continues to raise rates, higher interest charges will likely make it more difficult for individuals to live off borrowed money, potentially putting a damper on economic consumption in the months ahead.

Condition #2: Expectations Need to Fall

Another factor that Fed officials closely watch is expectations. That’s because your and my expectation of where we think inflation is headed often shapes how inflation plays out in the months and years ahead. Indeed, what we believe about inflation often turns it into a self-fulfilling prophecy.

For example, suppose you expect the costs of maintaining your household to rise with no end in sight. In that case, you and your coworkers will demand your employer to give you a raise to cover your cost of living adjustment, or you’ll likely seek a new job that pays you more to cover your rising expenses.

So, how do we measure this sentiment? Well, several outfits conduct their own surveys to gauge household inflation expectations. And one of the most prominent surveys comes to us from the University of Michigan, whose latest reading shows that household inflation expectations remain among their highest levels in decades.

Similarly, if businesses expect costs to continue rising in the years ahead, they’ll likely raise their prices now to compensate their workers and pad their margins. This expectation of higher inflation among business leaders is evident in the Richmond Fed’s recent CFO survey.

For example, in its latest print, business leaders indicated that they expect unit costs to rise 9.2% in 2022 and a further 6.7% in 2023. Adding insult to injury, executives surveyed also predict wage growth to rise another 6.9% in 2023!

Now, if we measure inflation as the realized price consumers expect pay for goods or services, it’s hard not to see how these rising expectations flow through to inflation. That’s why policymakers are keen to make economic conditions so unbearable for individuals and businesses alike, that workers remain grateful for having a job during an economic downturn and business leaders are willing to put their goods and services on sale to entice the next marginal buyer so they can, at the very least, cover their operating expenses.

Condition #3: Inflation Trends Need to Confirm

Finally, in terms of conditions that policymakers likely will be watching before changing their policy stance in the coming months is actual incoming inflation data. These data include the headline CPI (consumer price index) and the Fed’s preferred measure of inflation, PCE (personal consumption expenditures price index).

Now, the trouble with using price indices as inputs to direct policy is that they tend to lag behind the mechanisms that drive inflation in the first place. That’s why measures of inflation, like the consumer price index, are best viewed as confirmation that policies have taken effect rather than leading indicators of future household or business activity.

So, what’s the data telling us? Well, incoming data suggest that Fed policies are having their desired effects on inflation to a certain extent. Indeed, recent data shows that headline inflation in November fell to 7.1% from its peak of 9.0% earlier in the year. To put this number into context, however, the current inflation reading is still five percentage points above average and remains well outside the Fed’s 2% inflation target. This current trend means that the Fed still has work to do to get inflation under control.

And while we’ve seen food and energy prices begin to ebb to a certain degree, one of the most significant components of inflation is shelter prices, which remain stubbornly high. In fact, shelter accounts for a full third of CPI. But, there’s hope among some policymakers that the Fed’s restrictive policies could take the air out of the overheated housing market and bring overall inflation back down to ground.

Indeed, recent data show that home prices are now falling but remain elevated from where they were a year ago. Even so, lender Freddie Mac projects that home price growth will decline on a year-over-year basis next year, and many other economists predict a decline of between 3–4% by year end 2023. Such price declines could be a welcome development for price inflation overall, but that likely won’t be enough to curb the current effects of inflation.

Another critical factor influencing current price levels is what’s happening in services inflation. What is services inflation, you ask? Services inflation includes the prices we pay for housing (rent), health care, eating out, transportation, and online subscriptions. While headline CPI has fallen from record levels this year, services inflation in November, on the other hand, marked one of its fastest periods of growth in over three decades.

And why is this important? Because as a share of overall consumption, households today spend more on services over goods than they had over forty years ago. So, while falling headline inflation likely will be perceived by some market participants as a hopeful sign that the Fed could eventually begin easing back on its rate hike policy, what happens with housing and services inflation likely will play a more prominent role in Fed policy decision making in the months ahead.

It’s All About Inflation in 2023

At this point you may be wondering, “what does all this talk about inflation have to do with my financial independence savings?” Well, the simple answer is that the Fed cares about inflation, and the markets care about what the Fed will do next. Until the Fed stops raising interest rates, investors will likely be challenged to find a direction in this uncertain market, especially as an economic and earnings recession looms large on the horizon. That’s why, for the markets, it’s all about inflation in 2023.

To be sure, how and when the Fed ultimately decides to exit this latest rate hike cycle is anyone’s guess. However, there are some guideposts that investors are watching to help provide some indication of the market’s next potential move. And these include household spending, price expectations, and headline inflation reports.

So far, none of these indicators have fallen to levels that would prompt policymakers to shift gears, which is why market hopes of a “Fed Pivot” in 2022 have fallen flat. This means that market volatility will likely remain elevated for the foreseeable future. Indeed, for the first few months of the year, we expect market direction to be biased to the downside until we see evidence that inflation has sharply decelerated or a shock event (like a sudden economic downturn) takes the wind out of inflation’s sails.

Until then, our guidance remains unchanged from where it has been in 2022: stay the course. But as we head into another period of heightened market volatility, here are three things you can do to ensure that your goals stay on the right track.

First, keep enough cash on hand to help you sleep well at night when the markets go south. This approach could help you avoid selling securities at inopportune times in the markets.

Second, stay committed to your disciplined investment strategy and avoid trying to time your way into and out of the markets. History has shown that the best days in the markets typically happen towards the end of a bear market selloff and missing out on those days could cost you.

Finally, and most importantly, stay focused on the long-term purpose of your money and make grounded financial decisions. We’re more prone to make emotionally based decisions when the future appears uncertain.

When it comes down to it, there’s little we can do to control inflation, the Fed’s next move, or how the markets will respond. Ultimately, you can rest assured that your financial plan exists to help you navigate your path to financial independence no matter what’s going on in the world around you.



Peter Donisanu

I help first-gen tech professionals get their financial house in order so they can live their legacy.