7.1% annual rate – Hello Phillips!
Preamble. The Fed staff made a very bad call at the January FOMC. The latest minutes have revealed that the Fed staff lowered its 2023 forecast for core PCE price inflation (to 3.2%). It turned out to be the wrong call. The downward revision was a surprise to us, especially considering the evolution of the 2023 Q4/Q4 forecast of our “main” model shown in Figure 0. For brevity, we do not discuss the details (please, get in touch if interested). The medium-term forecast remains very unfavorable and judgmental calls (as the one that the staff seems to have made in January) should be avoided in this environment because it looks like a celebration dance on the 40-yard line. We expect the Fed staff to fully revert its call at the March meeting.
Figure 0. Evolution of the Q4/Q4 2023 forecast.
Note: The figure shows the evolution of the 2023 Q4/Q4 forecast of our “main” Phillips curve model (which mimics Detmeister et al. (2014), the SEP, the Fed staff forecast, and the NY Fed DSGE model forecast). The Fed staff forecast is inferred from the FOMC minutes. The SEP (and NY Fed DSGE) forecast are kept constant for non-SEP rounds.
The January PCE price report suggests that so far, the Fed has achieved very little. Our models suggest that in today’s report all percentiles of the distribution shifted up again, and that the “common” component increased to its third largest value since Covid hit. Not only, but our “main” Phillips curve model (which mimics Detmeister et al. (2014)) revised up significantly its medium-term forecast. Translated: not a single good news for the Fed. If we zoom out, we basically made zero real progress in more than one year.
Evidence from the distributions
Distribution moving higher again. Last month (see here) we wrote “A lucky month for the Fed, given that most percentiles of the distribution moved up […] we invite to take today’s reading for what the distribution suggests: a lucky reading influenced by the other than market-based items“. This month, all percentiles of the distribution (not shown for brevity, available upon request) moved up again. Consequently, the Kernel of the last three months (Figure 1) shows another right-shift. Not only, but the median (Figure 2) jumped to 5.9% ar (from 3.6%), the second highest value since Covid hit. No need to add anything else, the evidence speaks for itself.
Figure 1. Kernel of PCE 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 PCE prices excluding food and energy items.
Figure 2. Median PCE price increase
Note: the Figure shows the median (MoM %, a.r.) of the distribution of PCE 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 as in CPI space. Figure 3 shows the decomposition of the MoM of core PCE in the “common” component, the “idiosyncratic” component, and the “Covid” effect. The model estimates that in January the common component increased by 25bps, higher than the previous 2 months (21bps and 17bps, respectively). Indeed, the increase in January of the common component is the 3rd largest one since 2019. The Covid effect is estimated at 22bps, and the idiosyncratic shock is also positive (11bps). Translated: the model is screaming “persistent”, despite all monetary efforts so far.
Figure 3. Contributions to MoM changes of PCE excluding food and energy items (CI-C model)
Note: the Figure shows the decomposition of the MoM percent changes of PCE 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 significantly higher. Compared to the latest run, our “main” model forecast is significantly higher in each year as the incoming data were stronger than the model expected. Not only but the inclusion of Q1 in sample (our nowcast: 5.2% ar) triggered a revision of the model estimated persistency (put it simply: the model is now estimating a process so persistent that it is more similar to an “unanchored” Phillips curve despite the imposed restriction). The model (Q4/Q4) forecast is: 4.5% in 2023, 4.1% in 2024, and 3.8% in 2025 (Figure below). Translated: can the Fed bring down inflation without labor market cooling off? The model has been saying “no” for a long time, now it says “definitely not”.
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
Today’s PCE reading is very bad news for the Fed staff. If we put everything together, we are left with little progress on the inflation front for a full year. Figure 5 below delivers the same message by showing the MoM (ar) of core PCE prices market-based (from which the Fed staff takes a lot of signal, in our experience). As Figure 5 shows, net of volatile items (non-market prices), we have gone sideways since the beginning of 2021. The Fed staff and the FOMC in our view and estimates should stop anticipating the events. We are still very much in the war against inflation. Will they listen to the data? Hopefully, yes, this time.
Figure 5. MoM of core PCE prices, market-based vs other than market-based.
Note: the Figure shows the MoM at annual rate of core PCE prices market-based (blue solid line) and other than market-based (light blue dashed line).