Timing Is Everything
The June CPI report was softer than expected, more good news to come. Can the Fed hike? Core CPI was softer than expected (16bps vs 25bps – our preview here) with broad-based signs of disinflation.
Two weeks ago, when commenting the May PCE prices report (our note here) we wrote: “Time to Bet Against the Hawkish Fed”. In the note, we explained why in our estimates the evidence had changed. Based on that, we wrote that we did not see the Fed hiking twice again this year (and we were not even sure about a hike in July). Today’s CPI report is a confirmation of that call given the dovish signals from our models. Crucially, we now expect the FOMC to revise down its 2023 projection for core PCE prices (Q4/Q4) in 2023 at the September meeting (say from 3.9% to 3.6%-3.7%). Conditional on that, there is no way the FOMC can hike in September. And again, we remain unsure (in fact, skeptical) it will hike this month.
Evidence from the distributions
Distribution trying to re-gain the pre-Covid shape. This month almost all percentiles (not shown) moved down again, especially in the right tail of the distribution. 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 because the shape of the distribution remains very different than pre-Covid (Figure 1). But we cannot even ignore the progresses and a “data-dependent” Fed should neither, especially because the median of the distribution (Figure 2) has dropped to a level comparable to pre-Covid.
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 strength of the data in June decreased again. 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 June the common component increased by 13bps, the lowest reading in about 2 years. The Covid effect is estimated around null, and the idiosyncratic shock is also small (3bps).
Th evidence from our CI-C model this month is significant because it implies that the inflationary process is losing steam and that the low reading is NOT driven by large negative idiosyncratic shocks (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 revised down. The model revised down again the medium-term forecast as the incoming data were softer than expected. The model Q4/Q4 forecast is: 3.7% in 2023, 2.9% in 2024, and 2.6% in 2025. The most significant news is that, according to the model, the probability of hitting the 2% target at the end of the medium-term has increased.
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
On what basis can the Fed hike? Conditional on the models’ results and our judgmental MoM forecast for the next months, there is a close-to-zero chance the Fed will hike in September. Not only, but when we think about the coming (July) FOMC, we are unsure about the outcome. The reality is that there are clear signs of disinflation and the models are cooperating as they never did so far.
Powell and the FOMC can hike at the end of this month, but to us it would be a very weird press conference. Can Chair Powell really justify a hike after such a CPI report rather than taking time? The logical answer, to us, is very clear. Again, the FOMC can hike but at this point the most logical thing should be another skip.