We have updated our mixed-frequency Dynamic Factor Model (DFM) of “Common Inflation Expectations” (CIE) nowcast to include new readings from Survey of Professional Forecasters (SPF), university of Michigan survey of consumers, and TIPS breakeven rates. This is our first update for 2022:Q3.
Keep in mind
Inflation expectations have stabilized in the last two months. We estimate that the Fed CIE (the synthetic index used by the Fed staff) is moving sideways in the current quarter. However, the Fed CIE remains elevated and above the level consistent with the Fed target. For this reason, the Fed cannot take much comfort from the recent readings and should remain very hawkish in the near-term.
Results
Our model estimates that the Fed-CIE has moved sideways in Q3. The downward movement in market-based measures of inflation compensation (breakeven rates) is offset by the upward movement in survey-based measures (SPF).
According to our model, the level of the Fed CIE is estimated at 2.17 (C.I. 2.14-2.20) in Q3, unchanged to rounding compared to last quarter. We estimate that the current level of inflation expectations is broadly consistent with a reading of core PCE price inflation of 2.3-2.4 percent.
A technical note
The Fed CIE is a model that contains 21 measures of inflation expectations, 13 of which are short-term measures and the remaining 8 are long-term measures.
Our research suggests that the Fed CIE is driven by long-term measures but large swings in short-term measures (such as those in Q1 and Q2) can affect the index. However, short-term measures do not have any predictive power of future inflation because they are highly correlated with recent (total) inflation. In other words, it remains unclear why the Fed staff included short-term measures in the CIE, what information they add to the model, what signal one should get from a downward movement of the CIE triggered by a decline in gasoline prices, and why other measures of inflation expectations (i.e. business expectations) have been excluded.
Implications for the Fed staff
The Fed staff (and FOMC) have little to celebrate, especially considering the upward tick in SPF and the dispersion of Michigan.
Figure 2 shows long-term inflation expectations (for PCE) from the SPF. In the latest release, long-tem inflation expectations ticked up to 2.45%, the highest reading in history. In our experience, market participants tend to underestimate how important the SPF is for the Fed staff (and the FOMC). The SPF is, in fact, taken internally as a measure of the Fed’s credibility. Admittedly, the SPF tends to be more backward than forward looking. But recent evidence continues to point to upside risks around the Fed staff (and SEP) forecast. The same applies to the dispersion of Michigan 5-10y (Figure 3 below) which shows no signs of stabilization.
For this reason, we continue expect the tone and the actions of the FOMC to remain extremely hawkish in the near-term.
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:Q2. The latest circle in the Figure shows our nowcast for 2022:Q3. 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 normalized at the beginning of estimation. Instead, the level of the common factor can be compared to its own history.
Figure 2. SPF 10y PCE
Note: the Figure shows the SPF 10y expected PCE inflation rate. The red line shows the median of the cross sectional distribution. The shaded areas show the 25th and 75th percentile.
Source: Federeal reserve bank of Philadelphia (link).
Figure 3. Michigan 5-10y ahead inflation expectations, variance
Note: the Figure shows the variance of Michigan (5-10y) inflation expectations. Latest available observation is June 2022.
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.