Alarms Went Off (Again) – Will the Fed Listen?
The January core CPI figure was just a touch higher than our forecast (41bps vs 36bps). However, under the surface inflationary pressures are very persistent (and possibly increasing again). Last month (see here) the CPI report and the models sent very mixed signals. This month several alarms went off: the median jumped to 6.1% (MoM, ar), the common component of our CI-C model is the strongest of the last 3 years (excluding Jan 2022), and all percentiles of the distribution of price changes moved up. Never take too much signal from a single report, but there is really not a single good news for the Fed (staff) and the FOMC today.
Evidence from the distributions
Distribution shifting to the right (!) again. Take it seriously. This month, all percentiles of the distribution (not shown for brevity) moved up again after increasing last month. For instance, the 10th pct increased from -22.1% (ar) in November to -7.7% in January, the 25th from -10.2% to 0.0%, and the 90th from 20.9% to 35.4%. Consequently, the distribution of the last 3 months (black line in Figure 1) shows a right shift compared to the one of 3-6 months ago (yellow line). Even more significantly, the January report shows a jump in the median to 6.1% (MoM, ar), which was at 0.9% just two months ago (Figure 2). More in general, the distribution remains far from its pre-Covid shape because the price dispersion continues to be much higher now.
Bottom line: huge red flags from the distributions. Alarms went off again today.
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 January increased significantly. 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 January the common component increased by 27.8bps, the second highest reading of the last 3 years (the highest is January 2022 at 28.1bps). The Covid effect is estimated at 16bps, and the idiosyncratic shock is a small negative (-3bps). Even considering the January re-pricing effect, there is a sense that price increases are diffuse and that the Covid effect is very persistent. Translated: according to our CI-C model, the January figure is not driven by “unlucky” item-specific shocks: the wave is going up again for all items.
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.
A technical note
We often get questions and see comments about “services excluding shelter”. This paragraph is to remind that there is a difference between “services excluding shelter” (1) and “core services excluding rents and OER” (2). The difference is that (1) excludes shelter as a whole but includes energy services (and households operations), while (2) includes core items only. In our view, when Chair Powell refers to “services excluding housing”, he means (2) not (1).
Implications for the medium-term forecast of core PCE price inflation
The medium-term forecast of core PCE is little changed. We are working under the assumption that core PCE prices grew 3.9% (QoQ, ar) in Q4 and with a nowcast of 4.0% for Q1. Conditional on this, our “main” model-based forecast is just a touch lower than last run, as the incoming data are a touch softer than expected by the model. The Q4/Q4 forecast of the model is the following: 3.9% in 2023, 3.5% in 2024, and 3.1% 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
Time for the Fed staff and Chair Powell to come back for the second half of the game.
Last month we got a warning. This month alarms went off. While core CPI printed roughly as expected, under the surface inflationary pressures are building up again. Not only, but the medium-term forecast remains very unfavorable to the Fed. Our “main” model has been delivering a 2023 Q4/Q4 forecast for core PCE in the neighborhood of 4% for few months. What seemed to be an upwardly biased forecast just few weeks ago, it is now very much possible because the January report seems a confirmation that the inflationary process the Fed is facing is very persistent. In our view and estimates, there is now some room for the FOMC (and possibly the Fed staff) to revise up marginally its 2023 forecast (with a slightly higher terminal rate). But there is no room for policy errors again. The Fed can be saved by a sharp deceleration in rents/OER, and the models suggest it might come at the end of Q2. Until then, no room for relaxing FCIs, otherwise we are at risk of landing on a permanently higher inflation rate.