Recession or Not, Hard to Cut in 2023
May 2023 FOMC: going back to the inflation discussion. The March round was dominated by financial stability concerns. We expect the the inflation discussion to come back at the May FOMC. Overall, this round the data have been roughly consistent (or marginally better) than the Fed staff expected (as inferred from the March FOMC minutes). Having said so, the issue remains the very same of the last 12-16 months: inflation is too high and, most importantly, there is virtually nothing in the models that suggests the US can go back to the 2% target soon. We continue to think that until the models will send dovish signals, it is unlikely the FOMC will pivot. The most likely scenario right now is the one in which the FOMC raises the FF rate a bit above 5% and stays there in 2023 while it evaluates the next steps.
Main points:
- The incoming data on core PCE price inflation have been a bit weaker than the Fed staff forecast inferred from the latest FOMC minutes. The weakness is concentrated in non-market prices as well as in core import prices. We expect the Fed staff to revise down marginally its near-term forecast.
- We expect the Fed staff to let the medium-term judgmental forecast/decomposition unrevised. After revising up the forecast in 2023 and down in 2024 and 2025 at the March meeting, in our estimates there should be little room for the Fed staff to revise the medium-term forecast again (Figure below shows the Q4/Q4 forecast of core PCE prices and its decomposition/contributions). If anything, the forecast can be lowered only marginally in 2023. In any case, the model-based forecast (see next bullet) continues to be well above the Fed staff judgmental forecast, as inferred by the FOMC minutes. Even considering that the information set of the econometrician is larger than the model, we continue to think that the profile of the judgmental forecast is a bit too generous because the Fed staff is assuming no persistency of the “other factors” in 2024 and 2025 (which happens to be what the staff did back in 2021 when looking at 2022, and in 2022 when looking at 2023..).
- Risks around the Fed staff forecast continue to be skewed to the upside. The medium-term model-based forecast of core PCE price inflation (left panel in the figure below) is lower than at the time of the March FOMC as we have folded in a mild recession in the forecast and the incoming data have been a bit weaker than expected. In any case, even with a mild recession, the estimated persistency of the process is high and the forecast remains above target throughout the entire medium-term. When assessing the model uncertainty (thick modelling approach, right panel below), it is clear that alternative specifications convey the same message, although on average they give a higher hope of returning back to target. Simulations shows that the models need to be downwardly surprised by 2-3 consecutive quarters to trigger large downside revisions.
“Main” model forecast (YoY) of core PCE price inflation.
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.
Thick modelling approach.
Note: The figure shows the distribution of point forecasts of core PCE price inflation of a large set of models (around 50,000 in total), each differing by one assumption (i.e. different type of slack, different number of lags of the endogenous variable, etc..).
- Conditional on the new forecasts, the Fed staff (2021) Taylor rule implies a terminal FF rate of 5.3%, 2 tenths lower than in March. The downward revision is due to the expected (mild) recession. Under all model-based simulations (including FRB-US based, not included in the package but available upon request) it is very hard or virtually impossible to get the Fed cutting rates in 2023. Put it simply: we need some real (and protracted) good news on the inflation front first.
As usual, we would be more than happy to schedule a meeting to discuss the details.