Time to Bet Against the Hawkish Fed
We work under the assumption that “when the evidence chances, we change our mind”: the evidence has changed. In this update we explain why we are not sure that the Fed will hike in July, and we are ready to bet against a second hike in H2.
A lot of progress, even more than implied by the published core. After two months of positive small progresses, this month we got: (i) a distribution showing convincing signs of disinflation, (ii) the median of core PCE price changes dropping to pre-Covid levels, (iii) the common component of our CI-C model trending down, (iv) a MoM reading not distorted by non-market prices, and (v) a (significant) downward revision of our “main” medium-term model.
We remain on a minefield and the timing of the July FOMC is pretty unfortunate. But if our MoM forecast for the next 3 months is correct, core PCE should show additional disinflation over the summer (before bouncing back a bit in Q4). For this reason, we think that (i) the probability of a July hike is lower than what the market is pricing, and (ii) the probability of a second hike in H2 is close to zero. Still way too early to talk about cutting the FF rate. But we now bet against the dots.
Evidence from the distributions
Regaining the mean. This month, all percentiles (except the 5th) moved down. The kernel of the last 3 months (Figure 1) continues to travel to the left. Even more significantly, the median of the distribution (Figure 2) has dropped to 1.6% (ar), a level in line with those recorded pre-Covid. We cannot ignore such a move, it is now very significant.
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 is progressively losing steam. 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 May the common component increased by 18bps. The Covid effect is estimated at 5bps, and the idiosyncratic shock is also positive (8bps). Overall, the common component seems to gradually lose steam (Figure 4), even if it will probably take a lot of time to return to pre-Covid levels.
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 revised down. We have now revised our assumption for Q3 (in-sample) and with this update we have a new path of the exogenous. Overall, the new assumptions imply a lower forecast because Q2 and Q3 are lower than the model expected. The “main” model forecast is: 3.9% in 2023, 3.2% in 2024, and 2.9% in 2025. The model continues to suggest that going back to target will take time and monetary policy will need to remain restrictive. But at least now the confidence bands include the target at the end of the medium-term.
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
Two more hikes, they say. We do not buy it. As we wrote, it is way premature to talk about a dovish Fed or cuts to the FF rate. However, we cannot ignore what the models are telling us. As we wrote recently, it would now take an upward surprise (which is always possible, especially in this environment) to change our minds. For the time being, we are unsure whether the Fed will hike in July and we think that the probability of such event is lower than the market is pricing. Not only, but under our forecast for the next 3 months, the probability of a second hike in H2 is close to zero. From our point of view, time to bet against the hawkish Fed.
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).