If overall inflation continues to trend down and the labor market rebalances, that likely would be a green light for the Fed to stop raising rates—that is, after the rate hikes that are already anticipated for February and March. After March, the Fed would hold rates near 5% for much of the year. On the downside, this labor market rebalancing means that the unemployment rate would rise, but that rise is part of the Fed’s purposeful slowing of the economy in order to combat inflation. On the upside, not only would prices be coming down in this scenario, the country’s gross domestic product (GDP) growth in the quarter would be positive—at least somewhat, at below 1%. This scenario would also mean an above-average year for bond investments and a fine outcome for stocks, too, although they still might have a below-average year.

This “good news” scenario is slightly the more likely option of the two for several reasons. First, November’s CPI headline rate marked the fifth-straight monthly decline, so inflation does seem to be moving in the right direction. Goods prices in particular are coming down, and even rent prices, which have been persistently high, are moving down some.

In summary, in order for this scenario to happen, the U.S. economy needs to slow enough to bring down demand and, in turn, prices. We’re starting to see signs of slowdown in the manufacturing sector already. For instance, ISM Manufacturing PMI declined to 49 in November; less than 50 is considered a contraction—that is, a period when economic output declines. The Chicago Purchasing Managers Index, the Dallas Fed Manufacturing Index and the Philly Fed Manufacturing index are all at their lowest levels since 2020, reflecting a slowdown in manufacturing in multiple geographic regions of the U.S.

However, the services side of the economy, which makes up the lion’s share of it, continues to expand. That’s largely due to the strong labor market, which needs to cool in order for this “good news” scenario to take place.

If inflation doesn’t trend down significantly in the first quarter, that would force the Fed to hike rates even more than the 5% range they are currently guiding toward. These additional rate hikes would cement the odds for a recession in the mid-year. Although this scenario is less likely to happen than the first, the difference in probability is marginal.

If this “bad news” option does occur, it would impact both your stock and bond investments. The “harder” the economic landing, or recession, the more the Fed would have to reverse course and actually cut rates, which would be good for bonds, especially longer-term bonds with high credit quality. However, it would be bad for equities, which could be down double digits again.

I can’t say it enough: it all comes down to inflation. Inflation will determine the Fed’s actions, which will determine what happens for the U.S. economy.

But amidst this uncertainty, there are still some economic upsides. Consumers still have an estimated $1.2 trillion in excess savings that they accumulated during the pandemic. Those savings can fuel increased spending and economic growth. In fact, they’re part of the reason the U.S. economy hung on as well as it did in 2022, despite decades-high inflation levels.

Yet not everyone has had the ability to hang on this well in the face of high prices at the grocery store and gas pump, as well as high bills at home. Rather, these excess savings are likely being held by wealthy consumers—not middle- and lower-income consumers, who have been struggling and accumulating more and more credit card debt to make ends meet.

That’s why it’s so important for the Fed to slow the economy to bring inflation down.

Brian Henderson, BOK Financial Chief Investment Strategist Steve Wyett and Cavanal Hill Investment Management President Matt Stephani share their outlook on the latest US and global economic conditions.