Fed staff is behind the curve: 4% is not enough
We have updated our estimates of core CPI price changes distributions to include the month of August 2022.
Given the movements in the distributions (and the evidence of our CI-C model, coming with next email), today’s report is telling us three important messages: (i) the price dispersion (see chart on standard deviation) has moderated, (ii) the median of the distribution is going sideways (in today’s report there are -on net- no idiosyncratic shocks), and (iii) the distribution of the last 3 months is somehow similar to the one of 3 to 6 months ago.
Put it differently, the models are telling us that we are probably entering the “plateau” of inflation. In this new phase, we do not expect large shifts of the distribution over a 3 months period, although in any given month we do expect idiosyncratic shocks sending marginally more or less benign signals. (as usual, please consider that in our experience the Fed staff does not take signal from a single CPI report)
The very bad news for the Fed is that the distribution is clearly centered on a median/mean way above the target (around 2.5 to 3 percentage points higher). Considering the narrative of the incoming data (especially housing and services in general), at this point it is very hard to see core CPI (MoM) converging back to target in a reasonable amount of time, even in case of a drop in used car prices.
VERY IMPORTANT CONCLUSION
For all these reasons, we have now come to the conclusion that the path of the FF rate signaled by FOMC participants will not be enough. The medium-term models (an update of our Pre-FOMC Meeting Package coming tomorrow) continue to signal significant upside risks. At this point, the only way for the Fed is to engineer a recession. And 4% FF rate is probably not be enough.
Details
The distribution of MoM% changes (Figure 1) suggests that positive outliers have been more frequent in the last 12 months compared to pre-Covid. The fitted Kernel density (Figure 2) shows a thicker right shoulder in the last 12 months, indicating that price increases have been more frequent and larger than just the outliers at the end of the right tail.
Looking at the percentiles (Figure 3) we see that in August all percentiles shifted up, except for the 95th. Having said so, July’s report was relative weak so an upside move in some percentiles was expected. Not only, but the percentiles readings in August are very much in line with the average of the last 6 months or so (the reader can deduce this by looking at Figure 3, left panel).
The standard deviation of price changes (Figure 3) remained broadly constant at a low level, which is not good news for the Fed, given the level of the median.
Percentiles details:
- The 5th pct is -14.8% (from -20.3%)
- The 10th pct is -7.5% (from -15.1%)
- The 25th pct is -1.3% (from 3.6%)
- The 50th pct is 5.2% (from 3.8%)
- The 75th pct is 14.4% (from 9.8%)
- The 90th pct is 26.1% (from 20.9%)
- The 95th pct is 37.7% (from 40.2%)
The Kernels of the last 3 months (black line in Figure 4) is (finally) somehow similar to the distribution of 3-6 months ago (yellow line).
The median of the distribution (Figure 5 – left panel) increased in August to 5.2%. The MA(12) of the median (Figure 5 – right panel) moved up in August to 4.6 percent, the highest reading of the last 20 years.
Implications for the Fed Board staff
In our view, today’s reading does have implications for the Fed Board staff because it came in higher than expected, especially in housing and core services.
In our “Pre-September FOMC Meeting” package we assumed that the staff was expecting about 34bps in core CPI space in August (and 3.6% ar in Q3 in core PCE space). Today’s reading should force the Fed staff to revise upward its near-term forecast (and its 2022 forecast).
Having said so, the crucial part is that in our view and experience at this point of the year the Fed staff will **NOT** revise its medium-term forecast (2023-2025). The reason is that the medium-term Fed staff forecast for the next years (in this moment 2023 to 2025) is based on the **calibrated** fundamentals (while the current year is a mix with incoming data). For this reason, we think the Fed staff is where it was last year at this time: behind the curve.
The Fed staff will remain hawkish. But given their medium-term forecast, the models are telling us the Fed staff (and the FOMC) is already behind the curve. The FOMC might not realize it immediately but as mentioned, the path of the FF rate signaled recently is probably not enough to disinflate the US economy in a reasonably amount of time.
Figures
Figure 1. Distribution of MoM changes (CPI prices ex food and energy items, % a.r.)
Note: the Figure shows the distribution of MoM percent changes at annual rate of CPI prices excluding food and energy items.
Figure 2. Kernel of CPI excluding food and energy items changes (%, a.r.)
Note: the Figure shows the fitted Kernel (Epanechnikov) distribution of MoM percent changes at annual rate of CPI prices excluding food and energy items.
Figure 3. Percentiles and Standard Deviation of the distribution of MoM changes (CPI prices excluding food and energy items, % a.r.)
Note: the Figure shows the distribution percentiles of CPI prices changes excluding food and energy items (left panel), and the cross-sectional standard deviation (right panel).
Figure 4. Kernel of CPI price changes excluding food and energy items (%, a.r.)
Note: the Figure shows the fitted Kernel (Epanechnikov) distribution of MoM percent changes at annual rate of CPI prices excluding food and energy items (for a total of 183 items).
Figure 5. Median CPI price increase (%, a.r.) and MA(12) of the median
Note: the Figure shows the median (%, a.r.) of the distribution of CPI prices changes excluding food and energy items (left panel) and the MA(12) of the median (right panel).