The Fed's goldilocks scenario of taming inflation while avoiding a recession is more likely after October CPI report, NDR says

• The October CPI report increased the chances of a goldilocks scenario for the economy, according to Ned Davis Research.
• The Fed's main goal is to tame inflation while avoiding a recession for the economy.
• "Under the goldilocks scenario, the Fed would pivot at just the right time by just the right amount to achieve a soft landing," NDR said.

Chances of a "goldilocks" scenario in which the Federal Reserve tames inflation and avoids an economic recession just increased following the October CPI report, according to Ned Davis Research.

The CPI report showed prices continued to rise at a slower pace, with a year-over-year jump of 7.7% compared to estimates of 7.9% and the June peak of 9.1%. That's good news for the Fed, especially if the deceleration spills over into the last two months of the year.

NDR boosted the chances of a "just right" economy to 30% from 20% following the CPI report. In this scenario, the stock market's mid-October low would likely have marked the bottom. Investors should monitor investor sentiment, breadth thrusts, and medium-term breadth confirmation to gauge if it is indeed playing out.

"Under the goldilocks scenario, the Fed would pivot at just the right time by just the right amount to achieve a soft landing. Since the decline [in stocks] was already approaching the average non-recession bear in both time and price, it would mean that the lows were close to being made," NDR said in a Wednesday note.

While that would be great for investors, NDR still sees the "too cold" outcome as its base case for the Fed and the broader economy, with a 55% chance of occurring.

In this scenario, inflation rolls over, allowing the Fed to pivot away from its aggressive interest rate hikes. In response, the stock market stages a powerful rally, "but the damage would already be done" from the Fed's aggressive tightening, NDR said. "A recession would begin in 2023, and stocks would fall to new lows."

Following October's CPI report, the debate has shifted "from when inflation peaks to whether the economy falls into a recession," according to the note. And that means if the economy does get closer to a recession, "earnings estimates would need to be revised down significantly," NDR said.

Consensus views currently call for earnings growth to bottom at -7.4% in the fourth quarter of this year. But during recessions, earnings fall at an annual pace of 24% on average, NDR said.

In its "too cold" base case, NDR recommends investors monitor inflation expectations, the yield curve, and commodity prices to gauge if that prediction is likely.

"However, the door has opened a little wider for a soft landing. Mr. Market may write the last chapter of Jay Powell and the three bears," NDR concluded.