Another Step in the Right Direction
The May CPI report was in line with expectations. The report in our view should be neutral for the upcoming FOMC (hawkish pause still the baseline). Headline CPI came in as expected (12bps vs 13bps), while core CPI was a bit stronger than expected by our judgmental forecast (44bps vs 37bps), although almost identical to what our models suggested (42bps – our preview here).
The good news come from our models. Despite the 44bps of core, this month we got a downward shift of all percentiles, the median is now in line with pre-Covid, and the common component is the lowest since June 2021. This suggests that in the coming months we should move toward lower readings in core space (~0.3% MoM sa). The downside is that nothing says we can easily go back to 2% soon.
Evidence from the distributions
Distribution implies (core) inflation is very persistent. This month all percentiles (not shown) moved down. Also, the median ticked down to 1.7% (MoM saar from 4.0% two months ago). We are very careful in declaring victory or claiming that 2% is around the corner; it cannot be done right now because the distribution remains very different than pre-Covid (Figure 1). In our estimates, disinflating the US economy will require time, and probably more than what most people expect. But the good news is that there is hope of moving to softer readings (say from 0.4% MoM sa to 0.3% MoM sa).
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 May was lower than in recent months. 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 May the common component increased by 18bps, the lowest reading in about 2 years. The Covid effect is estimated around null, and the idiosyncratic shock is large and positive (28bps), possibly driven by used cars prices.
Th evidence from our CI-C model this month is significant because it implies that the inflationary process is losing steam (reminder: the result of our CI-C model anticipates well 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 is little changed. Because the data came in largely as expected, the implications for the medium-term model-based forecast of core PCE price inflation are trivial. Please refer to our Pre-June 2023 FOMC meeting package (here) for details. Latest run of the model is shown 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:Q4.
Implications for the Fed Board staff
Hold your fire. Implications for the Fed staff and the FOMC are straightforward. The Fed needs to sound hawkish tomorrow (and possibly signal a higher terminal rate in the dots) because one way or the other we are still at 5.4% MoM saar in core CPI, a level that almost nobody expected only a few months ago. Having said so, as mentioned, it is very much possible to have a 0.3% MoM sa in core CPI in the next prints, on average. There is little discussion (in our view) about the fact that the Fed must keep the rates high for long. But we are not sure whether it is a good idea to keep pushing the FF higher just for the sake of disinflating faster (see our latest FRB-US note). The Fed can just take time in this environment, in our view.