We have updated our 11 trend-inflation models through 2022:Q2 to reflect our nowcast for core PCE price inflation, as well as incoming data on long-term inflation expectations, the unemployment rate and other supply-side relevant variables.
Results
The inclusion of the second quarter had little impact on the average across trend models. The average across all models (the solid black line in Figure 1) is estimated at 2.6% in 2022:Q2, unchanged compared to 2022:Q1 (although the first quarter got revised down marginally from 2.7% compared to the time of the May FOMC).
Why is the average across models unrevised in Q2 and why did Q1 got revised down marginally? Our set of trend models include 11 models grouped in 3 categories: Phillips curve type of trend models, state-space models, and time varying parameters vector autoregressive (TVP VAR) models. The Phillips curve trend models are largely unrevised in Q2 because long-term inflation expectations have remained broadly stable. The state-space models took signal from the incoming data and revised up marginally recent history. However, the TVP VAR (with labor cost) revised down history because the incoming data on unit labor cost have been very strong (therefore ULC absorbs part of the strenght of the data that does not end up in the trend). Putting everything together the average across model is unrevised as the upward revisions from some models are offset by the downward revision of the TVP VAR model with labor cost.
Comment
The inclusion of Q2 in sample did not trigger an increase in the average across trend models.
Nevertheless, the main takeaway is that trend inflation (which by construction is very persistent) continues to run significantly above the Fed target.
Implications for the Fed staff
The average across models is one of the three ways to estimate underlying inflation or pi* (the other two are long-term inflation expectations and the general equilibrium approach which considers the interaction between pi* and U*). As a reminder: the level and evolution of pi* is the crucial assumption in the Fed staff framework/forecast and it is possibly the single most important variable for monetary policy. In our view, the Fed staff is currently assuming that pi* is around 2%, possibly a bit higher than 2% in 2022 (and 2023). As such, the evidence from the trend models continues to signal significant upside risks to the medium-term Fed staff forecast.
Figure 1
Note: the chart shows the estimated trend inflation from 11 econometric models. The models are split into three groups. The first group is a collection of Phillips-curve (PC) type of trend inflation models in which a measure of long-term inflation expectations is used as a proxy of trend inflation. The second group is a collection of state-space unobserved component models in which we have modelled trend inflation either as a smooth trend or as an augmented local level. Finally, the third group of models is a collection of Time Varying Parameters Vector AutoRegressive models (TVP-VAR) with different endogenous variables. This set of models follows the FEDS Note by Rudd (2020) “Underlying Inflation: Its Measurement and Significance”. The Fed staff assumption about the level of underlying inflation (set at 1.8 percent) is inferred from Laubach et al. (2014) “Long-term Inflation Expectations and Risks to the Inflation Outlook“.
Table 1
Note: the 70% confidence intervals refer to 2022:Q2. The “Average” line is calculated as a simple mean across all models.