Unsurprisingly strong
The February CPI was as expected. Disinflating the US economy is not an easy task. Both headline and core CPI came in roughly as expected (here our preview); the upward surprise with respect to our own forecast is 4bps for headline and 5bps for core – today’s report implies that the standard error and standard deviation of our MoM forecast are 6bps and 17bps, respectively. Overall, the report came in as expected: the median remains elevated, the percentiles sent mixed signals, and the common component across items is very solid. Put it differently: disinflating the US economy is not so easy, and requires additional monetary actions (and hopefully fiscal as well..).
Today’s CPI implies no revision to the PCE price inflation forecast. We expect the Fed to hike 25bps next week (see last paragraph for details).
Evidence from the distributions
Distribution implies inflation is persistent. This month, all percentiles (excluding the 95th) of the distribution (not shown for brevity) moved down after increasing sharply last month. Per se, this would be a very good news for the Fed but the percentiles are, in fact, to the same levels of December (when core CPI grew 40bps). The bottom line, in our view and experience, is that there is probably not much signal from this month downward movement. Instead, the distributions (see Kernel of last 3 months in Figure 1) confirm that we are facing a persistent and dangerous process which is centered around 5% ar. The distribution continues to be radically different than pre-Covid. Indeed, in February, the median ticked down (from 6.0% ar to 4.4% ar) but remains above pre-Covid.
Bottom line: the Fed has little to celebrate.
Figure 1. Kernel of CPI excluding food and energy items changes (MoM %, 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. 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).
Evidence from our CI-C model
Our CI-C model estimates that net of Covid and idiosyncratic shocks, the strength of the data in February remained intact. Figure 3 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 February the common component increased by 25bps, just a touch lower than in January. The Covid effect is estimated at 31bps (one of highest ever), and the idiosyncratic shock is negative (-11bps). Translated: according to our CI-C model, the February figure could have been even worse (that is, it has been “saved” by some negative item-specific shocks).
The behavior of the common component in recent months (Figure 4) confirms that disinflation is a mine field and that going back to 2% will take time.
Figure 3. 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 4. 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.
Implications for the medium-term forecast of core PCE price inflation
The medium-term forecast of core PCE is unchanged. Today’s data came in broadly as expected and have no material implications for the medium-term forecast of core PCE price inflation (see here for details in our Pre-March 2023 FOMC Meeting Package). The Q4/Q4 forecast of the model is the following: 4.5% in 2023, 4.1% in 2024, and 3.8% in 2025 (Figure 5).
Figure 5. “Main” Phillips curve model forecast, core PCE price inflation (YoY, %).
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:Q2.
Implications for the Fed Board staff
We have two problems: price stability and financial stability. And we have separate tools to address them.
First rule in policy: do not over react, sit down and think. The Fed has one big problem, it is called “inflation” which did not disappear with SVB. And it has one big concern, it is called “financial stability”. In theory (and hopefully also in practice), the Fed has different tools to address them. If the Fed staff has not lost its mind (we do not think so), it is crystal clear that inflation is way higher than the staff expected in January and that it will be much more persistent than anticipated (by the staff). Therefore, we continue to expect the Fed staff to discuss a higher forecast at the FOMC table and to be concerned about price stability. We also expect the FOMC to hike 25bps (terminal rate around 5.5%) and deliver a consistent strategy to address the two separate issues the Fed is facing.
(For the record, we have been working with FRB-US and we were supposed to circulate our results over the weekend. We decided to postpone, given the circumstances. In any case, FRB-US based simulations show what markets were slowly pricing in: 6% terminal rate in Q3 and a mild but protracted recession. (Indeed, we have been a bit puzzled by markets pricing in around 100bps cuts by the end of the year at some point yesterday). We will circulate our note(s) later this week).