Careful, Do Not Celebrate (Yet)
The December report confirms there are signs of disinflation but the models suggest that under the surface the evidence is less convincing. Our models suggest that in today’s report all percentiles of the distribution shifted up (up, not down) including the median, and that the “common” component increased compared to last few months. Not only, but some of the forces that helped in the last 4 months (declining energy and used car prices) are expected to take a break in January and February. Translated: we are really not done. For this reason, we continue to expect the Fed (staff) to deliver the same message, something like: “there are encouraging signs, but we need much more”.
Evidence from the distributions
A “lucky” month for the Fed, given that all percentiles of the distribution moved up. This month, all percentiles of the distribution (not shown for brevity, available upon request) moved up (again, up not down). For instance, the 25th pct increased from -11.3% (ar) to -2.9% (ar), and the 95th pct from 27.3% to 41.2%. The median (Figure 3) also increased to 2.7% a.r. (from 1.2% a.r.). Therefore, we invite to take today’s reading for what the distribution suggests: a “lucky” reading for the Fed influenced by the relative weights more than a genuine broad-based disinflation process.
The Kernels of the last 3 months (black line in Figure 1) show that we can have strong MoMs down the road until the right tail will be much thinner (see next paragraph about the risks in the next 2 months).
The next two months might be worse than December
Careful, do not celebrate yet: the next two months might be worse than December for both, core and headline. The last 4 CPI prints have been influenced by two main factors: dropping energy prices and used car prices. Both factors are set to take a break in the next 2/3 months. Conditional on this, we expect the MoM of core CPI and headline CPI to average 33bps and 38bps in the next couple of months, respectively (with the MoM of headline expected at 44bps sa or 64bps nsa in January at the moment). In other words, the next couple of CPI reports can show the persistence of the process and we can easily see the 3m/3m of core CPI at 3.5-3.7% (which would imply a hawkish Fed, of course).
Evidence from our CI-C model
Our CI-C model estimates that net of Covid and idiosyncratic shocks, the strength of the data in December increased. Figure 4 shows the decomposition of the MoM of core CPI in the “common” component, the “idiosyncratic” component, and the “Covid” effect. The model estimates that in December the common component increased by 22bps, higher than the previous 2 months (16bps and 21bps, respectively). The Covid effect is estimated at 11bps, and the idiosyncratic shock is a small negative (-3bps). This is another sign that we are not done yet, we are still dealing with a persistent process.
Implications for the medium-term forecast of core PCE price inflation
The medium-term forecast of core PCE is unrevised as the implications for core PCE from today’s CPI report are negligible. Compared to the latest forecast (Jan 4th, post minutes), our “main” model-based forecast is unchanged, as our nowcast for Q4 is unrevised. Our “main” Phillips curve model continues to deliver the following Q4/Q4 forecast: 3.3% in 2023, 3.2% in 2024, and 3.0% in 2025 (Figure below)
Note: the figure shows the latest run of our “main” Phillips curve model. The confidence intervals (C.I.) are estimated using quasi-out-of-sample methods (estimate the model over a sub-sample, forecast, and calculate the root mean squared forecast errors). First quarter of forecast: 2023:Q1.
Implications for the Fed Board staff
Today’s PCE reading is a mixed bag. We expect the Fed to continue delivering the message of the December 2022 FOMC meeting.
If we put everything together, we are left with a mixed bag of signals after today’s report. The Fed staff can certainly celebrate the market-based core PCE reading (1% ar), which confirms we are on the right trajectory. But the behavior of the median (stable) and the entire distribution (similar to the previous months) is not good news for the staff/FOMC. In our experience, in the pre-Covid world, the Fed staff would have taken signal from the market-based reading and the evidence of the CI-C model. But the recent experience caution against jumping to strong conclusions, especially because the distribution is more stable than (we) expected.
The data are saying “good news but be careful!”. In our view, the Fed is listening and act accordingly.
Figures – monthly distributions
Figure 1. Kernel of CPI excluding food and energy items changes (%, a.r.)
Note: the Figure shows the fitted Kernel (Epanechnikov) distribution of MoM percent changes at annual rate of CPI prices excluding food and energy items.
Figure 2. Percentiles and Standard Deviation of the distribution of MoM changes (CPI prices excluding food and energy items, % a.r.)
Note: the Figure shows the distribution percentiles of CPI prices changes excluding food and energy items (left panel), and the cross-sectional standard deviation (right panel).
Figure 3. Median CPI price increase
Note: the Figure shows the median (MoM %, a.r.) of the distribution of CPI prices changes excluding food and energy items (left panel) and the YoY (right panel).
Figures – CI-C model
Figure 4. Contributions to MoM changes of CPI excluding food and energy items (CI-C model)
Note: the Figure shows the decomposition of the MoM percent changes of CPI prices excluding food and energy items. The contributions are estimated using our CI-C model, a 2-stage OLS-LASSO regression model. The “Covid” effect is identified with price variations outside the 10th-90th percentiles of each item pre-Covid price change distribution.
Figure 5. Estimated “Common” component: YoY, 3m/3m a.r. and 6m/6m a.r.
Note: the Figure shows the 3m/3m at annual rate (green line), the 6m/6m at annual rate (red line), and the YoY (blue line) of the “common component” estimated using our CI-C model.