…But Something Is Missing Here
The July CPI report came in as expected. Both core CPI and headline CPI came in precisely as expected (16bps vs 18bps expected for core and 17bps vs 16bps expected for headline). Our CPI preview is here. Gentle disinflation continues.
(For the record, in the last 6 months, the standard error of our core CPI MoM forecast is 2bps (!) and the standard deviation is 7bps)
Switching to our models, the news today is that the ducks are still NOT in a row. On the one hand, our CI-C model suggests that the common component across core CPI items has lost steam and remains low. However, on the other hand, the distribution of price changes is still not regaining mass around its mean/median suggesting (as our medium-term “main” model) that reaching target on a sustained basis will require additional slowdown of the labor market.
Putting everything together: we started betting against the hawkish Fed back on June 30 (our note here). Even more now. As for FF cuts, we continue to think that is a completely different discussion that the FOMC will not have any time soon. But it is pretty clear now that no hikes either will be coming.
Evidence from the distributions
Distribution is still not convincing. This month virtually all percentiles (ridge plot here) moved down again. However, the shape of the distribution remains pretty different than pre-Covid. So far, disinflation has come mainly from large negative prints on the left tail rather than re-gaining mass around the mean/median. For this reason, as we wrote in previous notes, we remain careful in declaring victory or claiming that 2% is around the corner, it cannot be done right now (reminder: we do expect some rebound in Q4).
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 (core) CPI metrics
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 common component in July remained modest. 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 July the common component increased by 16bps, about the same as in June. The Covid effect and the idiosyncratic shock are both estimated close to null.
Th evidence from our CI-C model implies that the inflationary process is losing steam (that is, we expect the disinflation process to continue in the next months). (Reminder: the result of our CI-C model anticipates the “multivariate core trend” model of the NY Fed – see here and here our notes).
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 price inflation is little changed. We are assuming that core PCE prices will expand 2.65% (QoQ ar) in Q3. Conditional on that, the Q4/Q4 forecast of the model is: 3.7% in 2023, 2.9% in 2024, and 2.7% in 2025. The model continues to suggest that going back to target will take time and monetary policy will need to remain restrictive. But at least, now the confidence bands include the target at the end of the medium-term.
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:Q4.
Implications for the Fed Board staff and the FOMC
Hold for now. Good news for the Fed staff and the FOMC, although the road back to 2% is still long and we invite the reader to be careful, given the distributions. Nevertheless, it is also clear that the data received from the June meeting are better than embedded in the SEP forecast. Right now, our “main” model forecast for 2023 is already below the SEP (and the Fed staff was already below the June SEP in June). In a nutshell: we see large risks that the FOMC will revise down its 2023 core PCE price inflation forecast to 3.5%-3.6%. If so, hiking will be virtually impossible.
Figure 6. Evolution of the 2023 Q4/Q4 core PCE price inflation forecast
Note: the figure shows the evolution of the Q4/Q4 core PCE price inflation forecast. “SEP” refers to the FOMC SEP forecast, kept constant between non-SEP FOMCs. The “Fed staff” forecast is inferred from the FOMC minutes. “Main” model refers to the model shown in Figure 5.