We have updated our mixed-frequency Dynamic Factor Model (DFM) of “Common Inflation Expectations” (CIE) nowcast to include new readings from Michigan, and TIPS breakeven rates. This is our first update for 2022:Q2.
Keep in mind
The Fed CIE suggests that expectations continue to rise and that they are now at a level consistent with a reading in core PCE price inflation above target. Not only but the Fed staff has recently revised the Fed CIE and the updated index is above the pre-great recession period when core PCE inflation averaged 2.3/2.4 percent. Overall: alarming news for the Fed staff and the FOMC.
Results
Our model currently estimates that the Fed-CIE has ticked up again in 2022:Q2. Also, it estimates a (small) upward revision to 2022:Q1. The upward tick reflects the upward movement of market-based measures of compensations, while survey-based measures of inflation expectations have remained broadly stable. As mentioned, this is the first run for the current quarter so the model relies on Michigan and TIPS data only.
According to our model, the level of the Fed CIE is estimated at 2.12 (C.I. 2.08-2.15) in Q2. We estimate that the current level of inflation expectations is broadly consistent with a reading of core PCE price inflation of 2.2 percent.
(Note: we will update again our Fed-CIE nowcast when we will get SPF data on May 13)
An “updated” Fed CIE index
On April 15, the Fed Board has published the 2022:Q1 figure (for the record, the Fed CIE came in at 2.09, as expected from our nowcast model). You can find the update here. However, the most interesting part of the update is that the Fed staff has released a new “updated” series. This new “updated” series will complement, not substitute the original Fed CIE and the Fed staff has not specified which one to look more closely.
The new “updated” series is very similar to the original Fed CIE. The only difference is the number of series included (i.e. the “updated” index includes expectations from the NY Fed survey of consumers which were originally excluded) and a small change to a technical aspect of the unobserved component model used (the number of lags of the autoregressive component increased from 4 to 5).
Figure 2 below shows a comparison between the original Fed CIE and the “updated” Fed CIE. Overall, the two indexes convey the same message: expectations were broadly stable between 1999 and 2014. Then, both indexes show a rapid decline and a recover post-Covid. The interesting part, however, is that the new “updated” index is trending higher right now and in 2022:Q1 reached a level which is above the pre great recession period. In other words, both indexes suggest that inflation expectations are at a level consistent with a reading of core PCE price inflation above the Fed target: the original Fed CIE suggests a level of about 2.2 percent while the “updated” Fed CIE suggests 2.4%-2.5%. (Preliminary research indicates that the “updated” Fed CIE takes some signal from the NY Fed expectations. The recent increase in these measures can explain most of the gap between the two indexes in this moment).
(Note: going forward, we will continue nowcasting the original series which will be published by the Fed, but we will keep an eye on the “updated” series as well)
Implications for the Fed staff
The Fed CIE has always been a research project so it is not surprising that the Fed Board staff has published an “updated” version. Nevertheless, the evidence of the “updated” series is even more alarming than the original series (which in any case ticked up in Q2).
As discussed after the release of the March FOMC minutes, in our view the Fed staff has revised the level of underlying inflation in 2023-2024 to 2.1%-2.2%. The Fed CIE reinforces the suspect. Therefore, in our view: (i) underlying inflation is on the move, (ii) the Fed staff has enough evidence to conclude that pi* is already above target and trending higher. Translated: no panic (yet) but this is a pretty alarming situation for the staff in our view.
For this reason, we continue to expect the Fed staff to convey a very hawkish message to the FOMC. Consequently, we continue to expect a very hawkish tone of FOMC participants. There is a lot at stake: the FOMC will deliver consequently.
Figures
Figure 1. Published Fed-CIE and our model-based nowcast
Note: the Figure shows the published Fed Common Inflation Expectations (CIE) index (the thick blue bar), and our Dynamic Factor Model (DFM) nowcasts (the black circles). Both series are displayed at quarterly frequency. The latest published quarter of the Fed-CIE is 2022:Q1. The latest circle in the Figure shows our nowcast for 2022:Q2. The dashed-blue lines are estimated confidence intervals. The Fed-CIE model is a DFM that includes 21 measures of inflation expectations. The estimated common factor (which is specified as an autoregressive process of order 4) is projected on a chosen measure of long-term inflation expectations (the SPF PCE 10 years). By construction, the level of the common factor cannot be interpreted because the underlying series are demeaned (in fact, normalized) at the beginning of estimation. Instead, the level of the common factor can be compared to its own history. Our model is run on long-term measures of inflation expectations (8 in total) included in the Fed-CIE because these are the series driving the results.
Figure 2. Original and updated Fed CIE indexes
Note: the Figure shows the published Fed Common Inflation Expectations (CIE) index (the blue line), and the “updated” Fed CIE (the red line). Both series are displayed at quarterly frequency. The latest published quarter of the Fed-CIE is 2022:Q1.
Reminder: The Fed-CIE updates are posted at noon Eastern Time on the third Friday of the first month of each quarter (January, April, July, and October) for the previous quarter. Our model-based CIE nowcast is updated every time a new data becomes available.