So And So
In our estimates, the March PCE price report can be another “false positive disinflation signal”. Admittedly, the evidence from the models is encouraging but we invite to take it carefully. The reason is that March (as February in real-time) is influenced by a contraction in non-market (a.k.a. “other than market-based”) prices. Not only, and unsurprisingly so, January and February have been subject to upward revisions (1 tenth in total).* Non-market prices are extremely volatile, they carry no signal for future readings of core PCE itself and they are subject to large revisions. On the other hand, market-based prices (figure 5 below) are going sideways and show no signs of improvement whatsoever. In our experience, the Fed staff will take no signal from non-market prices.
Put it simply: until market-based will disinflate, it is hard to be optimistic because we are very much at risk of getting upward suprises/revisions from non-market prices in the next few months.
*The size of the upward revisions in January and February is non-negligible this time. In our pre-FOMC meeting package we estimated that the Fed staff got downward surprised by the incoming data by about 2 tenths. Today’s revisions imply that half of that downward surprise is gone.
Evidence from the distributions
Some hope? This month, most percentiles of the distribution (not shown for brevity, available upon request) moved down. Admittedly, this is good news, although the suspect is that this result might be driven by non-market prices which might be revised in future months. The Kernel of the last three months (Figure 1) is sending mixed signals: the distribution is trying to regain its pre-Covid mean but the right shoulder of the last three months is thicker than the previous 3 (or 6). Therefore, it is very difficult to take some signal from the distributions now. We need much more convincing evidence to conclude that the real disinflation has begun. The median of the distribution has ticked down this month (Figure 2). Should this happen in a month in which non-market prices are roughly stable, we would take signal. Right now, we interpret it as some hope.
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 March is a bit lower than in recent months. 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 March the common component increased by 17bps, a bit less than the previous 2 months (24bps and 20bps, respectively), although in line with the readings at the end of last year. The Covid effect is estimated at 6bps, and the idiosyncratic shock is also positive (5bps). Overall, the common component has been going roughly sideways for about 1 year and a half.
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 unchanged. Compared to the time of the May Pre-FOMC Meeting Package (here the slides) the model delivers a forecast which is nearly identical. The model (Q4/Q4) forecast is: 4.2% in 2023, 3.7% in 2024, and 3.5% in 2025 (Figure below).
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 carries some bad news for the Fed staff as well as some hope. If we put everything together, we are left with zero progress where it matters (market-based core PCE) and some hope. The issue is that in our estimates core CPI in April is expected very strong (0.4%-0.5%) and non-market prices are unlikely to post another large contraction in April. As usual, we think the Fed staff will take signal only from market-based and will deliver accordingly.
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).