We have updated our mixed-frequency Dynamic Factor Model (DFM) of “Common Inflation Expectations” (CIE) nowcast to include new readings from Survey of Professional Forecasters, university of Michigan survey of consumers, and TIPS breakeven rates. This is our second update for 2022:Q2.
Keep in mind
The big news from this update is that long-term inflation expectations from the Survey of Professional Forecasters (SPF) are showing clear signs of deanchoring.
This is a huge development for the Fed staff and the FOMC. In our view, the Fed staff takes a lot of signal from movements in the SPF, possibly more than markets perceive.
Put it simply: so far, the Fed lost some battles. But now it is at risk of losing the entire war.
Results
Our model currently estimates that the Fed-CIE has ticked up again in 2022:Q2. The upward tick reflects the upward movement of survey-based measures of expectations, while markets-based measures of inflation compensations have -on net- remained broadly stable.
According to our model, the level of the Fed CIE is estimated at 2.10 (C.I. 2.08-2.12) in Q2. We estimate that the current level of inflation expectations is broadly consistent with a reading of core PCE price inflation of 2.2-2.3 percent.
Implications for the Fed staff
The evidence of the Fed CIE is now alarming. In the last three quarters, expectations have been trending higher and some measures are now showing signs of de-anchoring (without the recent downward tick in TIPS and with a slightly higher reading from Michigan, the CIE would be ready to breakout).
Figure 2 below show long-term inflation expectations (for both CPI and PCE) from the Survey of Professional Forecasters. In the latest release (2022:Q2), long-tem inflation expectations jumped up to 2.4% (from 2.2% in Q1) in PCE space and to 2.8% (from 2.5% in Q1) in CPI space. The reading in PCE space is the highest in history (which starts in 2007), while the reading in CPI space is the highest since 1997.
This is an important piece of evidence because in our view the Fed staff Philliips curve models are run on a sample that starts in mid-90s (see Detmeister et al. (2014)). However, the main assumption of the Phillips curve “anchored” models is that long-term expectations have remained broadly stable since 1995-ish. The latest SPF report puts the assumptions of the “anchored” model under question. There is no doubt that SPF expectations are non stable anymore and that they are trending higher.
In our view, this is a terrible news for the Fed staff and the FOMC. We also think that markets are underestimating how important the latest SPF reading can be for the Fed staff (and the FOMC). Professional forecasters are testing the Fed’s credibility. The Fed is now at serious risk of losing the entire war.
For this reason, we expect no mercy. No matter the cost (including a recession), in our view the Fed must deliver. And it will deliver. We expect the tone (and the actions) to remain extremely hawkish, possibly even more than recent communication.
Figures
Figure 1. Published Fed-CIE and our model-based nowcast
Note: the Figure shows the published Fed Common Inflation Expectations (CIE) index (the thick blue bar), and our Dynamic Factor Model (DFM) nowcasts (the black circles). Both series are displayed at quarterly frequency. The latest published quarter of the Fed-CIE is 2022:Q1. The latest circle in the Figure shows our nowcast for 2022:Q2. The dashed-blue lines are estimated confidence intervals. The Fed-CIE model is a DFM that includes 21 measures of inflation expectations. The estimated common factor (which is specified as an autoregressive process of order 4) is projected on a chosen measure of long-term inflation expectations (the SPF PCE 10 years). By construction, the level of the common factor cannot be interpreted because the underlying series are demeaned (in fact, normalized) at the beginning of estimation. Instead, the level of the common factor can be compared to its own history. Our model is run on long-term measures of inflation expectations (8 in total) included in the Fed-CIE because these are the series driving the results.
Figure 2. Original and updated Fed CIE indexes
Note: the Figure shows the SPF 10y expected PCE inflation rate.
Note: the Figure shows the SPF 10y expected CPI inflation rate.
Reminder: The Fed-CIE updates are posted at noon Eastern Time on the third Friday of the first month of each quarter (January, April, July, and October) for the previous quarter. Our model-based CIE nowcast is updated every time a new data becomes available.