We have updated our 11 trend-inflation models through 2022:Q4 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 (our nowcast of) the fourth quarter resulted in an uptick as well as an upward revision of recent quarters.
The average across all models (the solid black line in Figure 1) is estimated at 3.2% in 2022:Q4, 3 tenths higher than at the time of the last FOMC.
The higher estimate is due to an upward tick/revision across all models: time varying parameters vector autoregressive (TVP VAR) models, Phillips curve models, and state-space models.
Comment
The inclusion of Q4 in sample triggered an increase in the average across models. The reason is that while measures of long-term inflation expectations have remained broadly unchanged, the incoming data of consumers’ prices remained above the models estimate of trend inflation. Having said so, as discussed last week after the October CPI report, the monthly distribution of price changes is shifting and might be now centered just a bit above the estimates of trend inflation. For this reason, should the distribution continue their journey and long-term expectations remain at the current level, we are probably approaching the peak of trend inflation.
When the models might start sending dovish signals?
So far, the trend inflation models have been sending very hawkish signals because the average across models is trending higher and remains well above target. Not only, but the estimate of trend inflation is a slow-moving concept that changes only gradually over time. Therefore, we do not expect significant changes this quarter and the next. The first real opportunity for the models to flatten their estimates of trend inflation is in 2023:Q2.
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.)
The latest FOMC minutes suggests, in our view, that the Fed staff is assuming pi* around 2.5%, gradually converging down over the medium-term but remaining a bit above target in 2025.
The evidence of the trend models continues to signal upside risks to the medium-term Fed staff forecast and, as mentioned, it is unlikely they will send dovish signals to the Fed staff before the second quarter of 2023. For this reason, we continue to think that there is now a potential “tension” between the near-term outlook and incoming data and the medium-term. On the one hand, the monthly prints in the next few months will probably be on the “soft” side (0.3%-ish MoM for core CPI) but we doubt the Fed staff (and the FOMC) will pivot any time soon as it will take time for the quarterly medium-term models to take signals from the incoming data and confirm the Fed is on track to deliver its target.
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:Q4. The “Average” line is calculated as a simple mean across all models.