The December inflation report will make the Fed realize it'll be more costly to plunge the US into recession than dial back on interest rate hikes, Fundstrat says

• December CPI will make the Fed realize a recession is more costly than pivoting on rate hikes, Fundstrat said. 
• Fundstrat's Tom Lee has predicted the Fed will soon ease up on rates hikes.  
• The S&P 500 could jump 20% this year as the Fed narrative changes, Lee said. 

The December inflation report will make the Federal Reserve realize it'll be more costly to plunge the US into a recession than to shift its interest rate policy, according to Fundstrat's head of research Tom Lee. 

Lee pointed to the upcoming December Consumer Price Index report to be released on Thursday, which central bankers will be considering when delivering their next policy decision on February 1. Consensus expectations peg the monthly increase in core inflation to a quarter-percentage point increase – a "very good number" Lee said, since it implies annualized core inflation of 3%. 

That would be the third straight month of falling inflation – which could alter the Fed's hawkish view on monetary policy. Already, officials have raised interest rates 425-basis-points to tackle rising inflation, with plans to raise rates past 5% in order to successfully rein in prices. 

But rates that high risk overtightening the economy into a recession, and officials could be overestimating how high inflation actually is, Lee noted. Previously, he pointed to the CPI's lag behind actual conditions in the economy, which means that the Fed may not need to raise rates as high as it's signaled. And while the labor market is still hot – a reason central bankers have vowed to keep rates high – the Atlanta Fed wage tracker shows three-month annualized wages are softening.

"In our view, we think the December CPI has potential to 'leg down' how the Fed and consensus see inflationary trajectory," Lee said in a note on Wednesday. "We think one of the changes in the coming months is the Fed will soon realize it is cheaper to change the inflation narrative than reverse a recession leading to millions of lost jobs," he later added. 

Signs of stress are already showing in the economy. The Treasury yield curve on the 2 and 10 year notes – a notorious predictor of a recession – is now at its most inverted level in over 40 years, and a statistical analysis from Bloomberg found a 100% chance the US would tip into recession by late this year. 

Other analysts have also predicted the Fed will ease up on rates once more signs of economic damage appear. UBS predicted central bankers would start cutting interest rates as soon as this summer.

And any pivot on rate hikes could drive a new rally in stocks, which have been weighed heavily by rate hikes last year. Lee has predicted a 20% gain in the S&P 500 in 2023. That bullishness run contrary to what other Wall Street analysts expect, with many forecasting a 20%-25% decline in the stock index in the first half of the year and relatively flat returns through year end.