Inflation rose by 6% in February year-over-year, down from a 6.4% annual rise in January, according to the U.S. Labor Department’s monthly consumer price index (CPI) released Tuesday. That’s still well above the Fed’s inflation target of 2%, but the numbers are trending in the right direction (down from an annual rise of 9.1% in June 2022). Other recent data points that show inflation is softening could add further impetus to the Fed altering course, either by slowing the pace of rate hikes or pausing them altogether.

Morgan Stanley in a research note Tuesday highlighted that home prices declined for six consecutive months, as of Dec. 2022, according to the Case-Shiller national home price index. On an annual basis, Morgan Stanley analysts expect price appreciation to decelerate in the coming months, predicting a 3.6% annual increase in January, down from the 5.8% rise in December 2022. Homes, though, still aren’t becoming more affordable for most buyers because borrowing rates have risen so high, resulting in waning of demand. This is exactly the kind of scenario the Fed has been trying to engineer. Existing home sales are actually falling faster now than during the Great Recession. And perhaps even more telling, Morgan Stanley highlighted a 38% decline in mortgage applications in February compared with a year ago.

At the same time, the fall of SVB suggests other banks will need to raise deposit costs to stem outflows due to the increased competition offered by higher-yielding Treasuries. That, in turn, could squeeze many banks’ net interest margins —  the difference between the money a bank makes on loans and what it pays customers for their deposits — and further restrict lending activity, according to Morgan Stanley. The analysts argue such a development could weigh on corporate earnings and growth, leave fewer dollars circulating in the economy — and ultimately relieve inflationary pressures.

Consumer spending also shows further signs of slowing, Morgan Stanley said, as U.S. shoppers are relying less on excess savings accumulated during the Covid-19 pandemic and more on income, credit cards and other types of loans. The bank predicts consumer spending will bottom out in the second quarter of this year, before slowly rebounding in late 2023. Given that spending activity accounts for nearly 70% of U.S. gross domestic product (GDP), a more cautious consumer would certainly help the Fed in stamping out inflation.

The bottom line, inflation appears set to decline in the coming months. That would be a major positive, as it would allow the Fed to take a more moderate approach to interest rate hikes at a time when the financial sector has come under unexpected strain. However, deflation does not mean the coast is clear, go buy everything on the market. Deflation only comes as a result of the economy slowing (weakening of consumer spending, cooling of economic activities), which likely means corporate earnings are at risk. With the consensus being the economy will substantially cool and potentially heading into a recession, we want to stay defensive and be overweight the healthcare sector like we have been for the past year.