In a press conference dominated by financial stability concerns, a reported asked “What happened to disinflation?”. Indeed, the elephant is still in the room. Unsurprisingly, the new SEP shows a higher path of core PCE price inflation, although only marginally so. The risks around the new SEP forecast are to the upside. Powell and the FOMC took time today without giving up on the inflation front. It was probably the wisest option on the table today.
We review the main points below.
The New SEP
The March 2023 Summary of Economic Projections (SEP)
We discuss three features of the new SEP:
1. The SEP is largely unrevised. While small changes can be an indication that the previous forecast was a good one, this time it means that uncertainty is very high. FOMC is taking time.
2. As expected, the forecast of core PCE price inflation is revised up marginally (as expected means “too little”). This was an easy call (see slide 23 of our Pre-FOMC meeting package), although we expected a slightly higher forecast because the upward surprise of the incoming data since December is about 3 tenths. Having said so, as discussed in other communications, the issue remains the same: the estimated models are way above the Fed staff / FOMC forecast. Ultimately, we got around 100bps in core PCE in the first 2 reports of the year with the distribution of price changes centered around 5% MoM ar. Can the FOMC be confident to get 300-ish bps in the entire 2023? We are not.
3. Upside risks to the median FF rate. While the median dot stayed at a 5.1% peak rate (against our expectation), it is not far from a 5.4% median (7 of 18 participants are at 5.4% or higher). Ergo, a pause in the banking crisis story and we go back to a higher terminal rate. Also, please note that the FF rate is higher in 2024 in the new SEP.
All told, this new SEP is likely to set the tone of the upcoming tension between growth and the persistency of inflation. As we recently have shown (here), the models suggest that it will not be so easy for the Fed to cut rates this year, unless we are hit by a large crisis.
Q&As
Question. What happened to disinflation? Is it still occurring today?
Powell. “I think the same story is intact. So it is really three parts. Goods inflation has been coming down now for six months, it is proceeding more slowly than we would have liked but certainly proceeding. Housing services is really a matter of time passing. We continue to see the new leases being signed at much lower level of inflation. So that’s 44% of the core PCE index where you’ve got a story that’s ongoing. Where we didn’t have in February and still don’t have now is a sign of progress in the non-housing services sector. And that is just something that will have to come through some softening in demand and some softening in labor market conditions. […] The inflation data that we got really pointed to a stronger inflation.”
Comment: Indeed, not the primary focus at the press conference but yes, we still have a problem with inflation. Not only, but we disagree with Chair Powell on a very important point. The facts are not in discussion and he got them right: the only disinflation that the Fed has achieved is in core goods. The point however, is that despite the behavior of marginal rents, we really do not know: (i) *when* CPI rents/OER will turn (most forecasters have been upwardly surprised for several months in a row), and (ii) to what extent observed rents in CPI will slowdown. The reader might want to refer to this paper (Boston Fed). Our own research (that we have not circulated not to spam your inbox on a daily basis) suggests that rents/OER are probably more persistent than perceived by most. In summary: it seems we are well set for additional upward surprises on 20th and C st. in DC.
Question. You do not see more disinflation coming from the credit crunch?
Powell. “So it’s really just a question of not knowing at this point. There’s a great deal of literature on the connection between tighter credit conditions, economic activity, hiring, and inflation; very large body literature. The question is how significant will this credit tightening be. […] We don’t really see it yet. People are publishing estimates but it’s really kind of rule of thumb guess work at this point. But we think it’s potentially quite real.”
Comment: We agree. We think nobody knows at this point what will be the impact on the US economy. For the record: we are working on some simulations using FRB-US and we will circulate them when ready (in case, #AskTilda).
Question. Inflation has been sticky. Do you need help from the fiscal side?
Powell. “We don’t assume that. We don’t give advice to the fiscal authorities. […] We take fiscal policy as it comes to our front door, stick it in our model along with a million other things. We have responsibility for price stability, the Federal Reserve has responsibility for that. And nothing is going to change that. So we will get inflation down to 2% in time.”
Responding to a follow-up question:
Powell. “You know you have to look at the impulse from spending because spending was of course tremendously high during the pandemic. And then as the pandemic programs rolled off spending actually came down. So the sort of fiscal impulse is actually not what’s driving inflation right now. It was at the beginning, perhaps part of what was driving inflation. But that’s not really the story now”.
Comment: Another missed opportunity for Powell, in our view. Indeed, it is pretty clear in our view and estimates that fiscal policy has been part of the issue. As such, we think that the Chair of the Fed should be more vocal with the fiscal authority (as a reminder: there is a famous historical precedent.. right?). Not only, but Powell’s point on the fiscal impetus is quite weak in our view. Without talking about the fiscal theory of the price level (indeed, nothing should be ruled out in the current circumstances), also in a New Keynesian model the *level* of spending does matter because it determines the *level* of the gaps. What consumers inflation is telling us is that we should reduce the gaps by cutting aggregate demand (the aggregate output gap is estimated close to zero but the sectorial gaps since Covid have been very large). Therefore, in the end we are not convinced by how Powell deflected the question.