Can The Fed Celebrate? Not Really.
The March CPI was a bit weaker than expected, although core inflation remained very solid. Both headline and core CPI came in a bit below our expectations (here our preview); the downward surprise with respect to our own forecast is 6bps for core. In our view, the report is a mixed bag. On one side, we are finally starting the long-waited rent/OER disinflation. However, core is still running close to 5% (ar) despite the improvement in rents/OER. Not only, but signs of improvements across items in the last few months are very limited (see Kernels below). Overall, it seems that the US economy is facing a 4%-5% core inflation process and that going back to target continues to require a protracted period of restrictive monetary policy.
Today’s CPI implies a marginally lower core CPI forecast in the near-term but we continue to expect a 0.4% MoM in the next 2 reports. Today’s CPI implies no revision to the medium-term model-based (core) PCE price inflation forecast. We expect the Fed to hike 25bps at the next meeting. We do not expect the Fed to cut rates in 2023.
Evidence from the distributions
Distribution implies (core) inflation is very persistent, possibly more than generally perceived. This month, there is no clear signal from the percentiles (not shown) as some (at the bottom of the distribution) moved up but other (at the top) moved down. Rather, by looking at the Kernel across months, the conclusion is pretty clear: the distribution of the last 3 months is nearly identical compared to the one of 6-9 months ago and marginally worse than 3-6 months ago. Also, the median ticked down in March (from 4.4% ar to 4.0%) but remains within the range of values recorded since mid-2021.
Bottom line: can we really celebrate this CPI report? The answer is “not really”.
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 March remained intact. 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 March the common component increased by 27bps, a touch higher than in February. The Covid effect is estimated at 13bps (in line with previous months excluding February), and the idiosyncratic shock is negative (-1bps).
The behavior of the common component in recent months (Figure 4) confirms that disinflation is not so easy and that going back to the 2% target will take a lot of time: if anything, the common component seems to have re-accelerated in recent months, not decelerated.
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 is unchanged. Today’s data has no material implications for the medium-term model-based forecast because our nowcast of Q1 (the starting point of the model) is unchanged to rounding. The “main” model forecast is: 4.3% in 2023, 3.9% in 2024, and 3.6% in 2025 (Figure below).
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
March SEP is the most likely outcome for the FF rate going forward. In the latest SEP, the FOMC expected core PCE price inflation at 3.6% in 2023. Today’s CPI report is roughly in line with the implicit forecast of the FOMC. Having said so, the FOMC forecast remains a pretty high bar in our view because it implies a string of 0.2% readings in the second half of the year. Therefore, we continue to think that the risks around the Fed staff and FOMC forecasts are skewed to the upside. Not only, but even conditional on the FOMC forecast, the Fed does not cut rates in 2023. For this reason, we continue to think that the most likely outcome is that the Fed will deliver the path of the FF rates it has signaled at the March meeting: going a bit above 5% and remain there until we have evidence inflation can return to 2% in a reasonable amount of time (that is, possibly for the rest of the year).