The Times They Are A-Changin’?
The May HICP report brought some good news for the second month in a row. Our models suggest that the distribution of price changes is consolidating the improvements we saw in April, including the median. There are also some progresses through the lens of our CI-C model, which estimates a “true” core HICP MoM (ar) rate below 4%. Given the noise in the data and the possible seasonal adjustment issues, we invite the reader to be extra careful. In this environment, we only need 1 bad report to unwind 3 months of progresses (see Canada, the U.K., Norway, Australia..). In the case of the Euroarea, we see risks in July and September. Having said so, we work under the assumption that “when the evidence changes, we change our minds”. The progresses presented below should be enough to roughly meet the new ECB forecast. Translated: until yesterday we were very confident about the direction of short-term rates in the Euroarea. Now we are careful.
Evidence from the distributions
The distribution: good news. Figure 1 shows that the distribution of price changes in recent months. May is the second month in a row in which all percentiles (not shown) moved to the left. While the distribution remains very different than pre-pandemic and the median well above pre-Covid, in our experience these movements are generally followed by other good news. We are not claiming we can easily go back to 2% soon (see next paragraph). But the data in the next few months should be in line with what the ECB is expecting.
Figure 1. Kernel of HICP excluding food and energy items changes (%, a.r.)
Figure 2. Median HICP price increase
Evidence from our CI-C model
Our CI-C model estimates that net of Covid and idiosyncratic shocks, the common component across items in May was in line with the previous months. Figure 3 shows the decomposition of the MoM of core HICP in the “common” component, the “idiosyncratic” component, and the “Covid” effect. The model estimates that in May the common component increased by 16bps, in line with the average of the previous months. The Covid effect is estimated at 16bps, and the idiosyncratic shock is positive (9bps). As we did in previous months, we consider as “true” core the one netting out the idiosyncratic part. Therefore, a rough estimate put the MoM (ar) of “true” core HICP at around 3.6% ar in May.
Figure 3. Contributions to MoM changes of HICP excluding food and energy items
Note: the Figure shows the decomposition of the MoM percent changes of HICP 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 HICP
The medium-term forecast of core HICP is revised down a touch. We have revised down a touch our estimate of Q2 as a re-thinking/estimate of the incoming data. The model forecast is at 5.0% (Q4/Q4) in 2023 (average of four quarters at 5.3%), 3.7% in 2024, and 3.5% in 2025. The confidence bands (calculated from the estimated parameters distributions) suggest that the risks are skewed to the upside. Overall, we continue to take this result as an evidence that monetary policy cannot turn dovish soon, given that little suggests core inflation can easily return to target.
Note: the confidence intervals (C.I.) are calculated using the estimated parameters distributions.
First quarter of forecast: 2023:Q3.
Implications for the ECB
July is on autopilot, September will be a hold in our view. Our models suggest that the likely scenario for the near-term is a moderation of core HICP, along the same lines of what we have seen in the US (disinflation in goods, more or less compensated by services, with some surprises possible in July and September). Overall, we see a “tension” between the near-term and the medium-term forecasts (again similar to the US): some good news from the incoming data but not enough to make a difference for a dovish turn in Frankfurt, at least until the end of the year. To sum up: in the last 6 months we have been very aggressive in our Euroarea calls because we saw a big opportunity. Now we are more defensive and we like to be on the sidelines, until the next big shot.