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One question dominates the outlook for stock markets in 2023.

The question is this: How fast and how far will inflation fall?

If inflation fades away quickly in coming months, then happy days are here again.

Falling inflation will allow central banks to let up on interest rates. Policy makers won’t need to drive the economy into deep recession to put a lid on inflation. Stock prices may briefly waver, and the economy may experience a mild recession, but, barring some new shock, business and markets should be back to normal in short order.

On the other hand, if high inflation proves to be persistent, watch out below.

Central banks will keep on hammering us with interest-rate hikes until inflation finally succumbs. A deeper recession is all but inevitable. So, too, are lower stock prices.

So which scenario is more likely? Market indicators mostly favour the benign scenario that says inflation has peaked and is now on the verge of rolling over as supply pressures ease.

If the energy sector is any guide, this benign viewpoint seems entirely plausible. Oil prices have tumbled by at least US$40 a barrel from their peaks this summer.

Used-car prices are also falling. So are lumber prices. Meanwhile, global supply chains have largely unclogged, according to an index maintained by the Federal Reserve Bank of New York. While some supply stresses remain, they are only a fraction of what they were a year ago.

The bond market has turned positively cheery. Consider breakeven rates, which measure expected inflation by looking at the difference between yields on inflation-protected bonds and yields on conventional bonds that don’t have any inflation protection.

Earlier this year, breakeven rates indicated that investors feared the Federal Reserve was losing its battle to keep inflation in check. In recent weeks, the market’s frown lines have disappeared. Breakeven rates now show that the market is expecting annual average inflation between now and 2027 to come in pretty much right in line with the Federal Reserve’s 2-per-cent target.

In Canada, the path of the Consumer Price Index over the past year shows why markets are growing more confident that inflation has peaked.

During the six months from November, 2021, to April, 2022, consumer prices rocketed upward at an 8.2-per-cent annualized clip. Over the next half-year, from May to November, 2022, prices continued to rise, but at a much more modest 5.6-per-cent annualized rate. If the downward trend that has prevailed since May continues, inflation will fall substantially in 2023.

Given all this, why are central bankers and grumpy newspaper columnists still so worried about inflation? Because we are still a light-year removed from anything that would pass for normality.

Inflation may be on the decline, but it continues to run at more than double the annual pace the Bank of Canada is supposed to target. Forcing wage gains and price increases back to levels consistent with the bank’s goal of 1-per-cent to 3-per-cent-a-year inflation looks like it will be a mighty challenge.

The problem is labour shortages. Unemployment levels in both Canada and the United States have tumbled to near half-century lows. Employees are wielding as much or more bargaining power than they have in decades.

They are using that power to demand higher wages – which makes perfect sense given the extent to which inflation has gouged their purchasing power over the past couple of years. In Canada, average hourly earnings were 5.6 per cent higher in November than they were a year earlier. In the U.S., the employment cost index for private-industry wages and salaries rose at an annualized pace of 5.3 per cent in the third quarter.

If wages continue to grow at that clip, the market’s current optimism about inflation is likely to be wrong. And that raises interesting questions about how far central banks will go to wrestle inflation to the ground.

Federal Reserve chairman Jerome Powell sounded unexpectedly hawkish at the Fed meeting on Dec. 14. He suggested interest rates could go higher and stay there longer than markets are expecting.

Bank of Canada governor Tiff Macklem is also talking tough. He recently rejected suggestions that the bank consider raising its inflation target to, say, 3.5 per cent. He reiterated his belief that inflation will start to subside rapidly come spring.

To sum all of this up, the big question of the next few months will be whether easing supply pressures in areas such as oil and used cars will be enough to offset the impact of rapidly rising wages. If they are, and inflation falls back relatively painlessly, central banks could be pivoting toward rate cuts by the third quarter of 2023 – and that would be great news for both economy and stocks.

If not? Then it will be a tough year ahead. Investors who don’t want to be ambushed should follow the Consumer Price Index as closely as they follow the stock index.

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