We have updated our “main” model (as a reminder, the “main” model is an augmented Phillips curve model with anchored expectations as described in Detmeister et al. (2014) that mimics the Fed staff framework).
Keep in mind
The main message of this update is that the model forecast remains a bit higher compared to the time of the July FOMC. The model continues to signal upside risks around the Fed staff (and SEP) forecast, especially in 2023 and 2024.
Assumptions
Sample: This is the first time we include 2022:Q3 in the sample using our initial nowcast (3.8% a.r.). The forecast starts in 2022:Q4.
Exogenous: we continue to follow the latest SEP path of the unemployment rate (gap). The reason is that the aim of our exercise is to assess the risks around the Fed staff (and SEP) forecasts. Therefore, the closer the assumptions, the easier the comparison. Based on the recent behavior of the broad dollar, we now assume that core import prices will growth at an average of 3.6% a.r. in 2022, 1% in 2023 and 1.3% 2024. Finally, as usual, we follow the futures contracts for energy prices.
Results
According to the model core PCE prices will expand 4.15% in 2022, 3.2% in 2023, and 2.8% in 2024 (see Figure 1 below). Importantly, the model continues to signal a (very) low probability of returning back to target by the end of the medium-term.
As for the near-term, the model expects core PCE prices to expand 3.4% (at annual rate) in 2022:Q4.
Comparison with previous forecasts
Compared to the time of the July 2022 FOMC meeting, the model forecast is a bit stronger in each year. Since the day of the July 2022 FOMC, we received the July CPI report, the July PPI report, and labor market data. On net, the incoming data have been weaker than markets expectations. Nevertheless, the incoming data implies a Q3 nowcast of core PCE prices a bit higher than the model forecast stopping the estimation in Q2. For this reason, the model revised up (and not down) its forecast.
An alternative, less favorable scenario
Our “main” model assumes (as in Detmeister et al. (2014)) that pi* (underlying inflation) is flat both in history and in the forecast. A less favorable scenario for the Fed would be if pi* is allowed to evolve over time, for instance if agents will re-set their long-term expectations after a protracted period of high inflation. Using our model, we have simulated a scenario with adaptive expectations in which pi* evolves according to a slow-moving average of realised inflation (for the record: under this scenario, the model is technically still “anchored” but the anchor is allowed to evolve over time).
Under this scenario, the model forecasts core PCE price inflation at 4.5% in 2022, 3.4% in 2023, and 3.1% in 2023. The intuition is simple: the forecast is higher because the current inflationary shock is large enough to push up pi* in 2022/2024.
The main takeaway from this exercise is that the risks around the forecast are still skewed to the upside, especially at the end of the medium-term.
Will core PCE prices increase only 0.1% in July? How much signal will the Fed staff take from this reading?
Based on the July CPI and PPIs, we expect core PCE price to expand 0.14% in July. We expect the wedge between core CPI and core PCE prices in July to be driven by the PPI portfolio management (see Figure 3 below) which feeds into other than market-based core PCE prices. On the other hand, the market-based core PCE prices in July should remain solid (0.3%).
How much signal will the Fed staff take from the low 0.1% reading of core PCE prices in July?
In our view and experience, the Fed staff (and the FOMC) will take little (or no) signal from the low reading in July. There are two reasons: (i) other than market-based prices are extremely volatile and negatively serially correlated (see Figure 2 below), and (ii) the expected downward movement in July of other than market-based prices is driven by PPI portfolio management which is correlated with equity prices (as discussed in previous notes). For this reason, in our view the Fed staff will not only take little (or no) signal from the low July reading but will marginally raise the core PCE prices near-term forecast in Aug-Oct to an average of about 30bps per month. Therefore, in our view in this moment the near-term forecast of the Fed staff is very close to the near-term suggested by our “main” model (but, as mentioned, the model forecast remains significantly higher than the Fed staff forecast beyond the near-term).
Implications for the Fed Board staff
We employ our “main” model as a way to assess the risks around the Fed staff (and SEP) forecast. The main takeaway is that both the Fed staff and the SEP forecasts remain below the model, especially in 2023 and 2024 (in June, the SEP forecast for core PCE price inflation was 4.3% in 2022, 2.7% in 2023 and 2.3% in 2024).
Given the evidence of our “main” model, we now expect the September SEP forecast to show an upward revision in 2023/2024 (and possibly an upward revision of the neutral rate).
All told, we continue to expect the Fed communication to remain very hawkish in the next weeks. The risks continue to be skewed to the upside. Any hint of a pause/pivot right now can have a very high cost.
Figures
Figure 1. Main model forecast (YoY of core PCE, %) - latest run (2022:Q3 in sample)
A. C.I. calculated from parameters distributions
Note: the confidence intervals (C.I.) are estimated using 100,000 draws from the estimated parameters distributions to simulate the path of core PCE price inflation going forward.
First quarter of forecast: 2022:Q4.
B. C.I. calculated using quasi-out-of-sample methods
Note: 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: 2022:Q4.
Figure 2. Market-based and other than market-based core PCE prices
The figure shows the MoM (at annual rate) of core PCE prices market-based (blue line) and core PCE prices other than market-based (yellow line). Latest observation: June 2022. Source: BEA.
Figure 3. Other than market-based core PCE prices and PPI portfolio management
The figure shows the MoM (at annual rate) of PPI portfolio management (red line) and core PCE prices other than market-based (yellow line). Latest observation: June 2022 for other than market-based prices, and July 2022 for PPI portfolio management. Source: BEA, Macrobond.