We expect the Fed staff to revise up its 2021 core PCE price inflation forecast, as the incoming data have been stronger than expected since the closing day of the November Tealbook. Going beyond this year, we do not expect the Fed staff to change materially its inflation forecast for 2022-2024. (The staff might revise up marginally its 2022 forecast but, in that case, the change would be more cosmetic than substantial). As such, the Fed staff should remain on the ultra-dovish side of the FOMC table. Our set of Phillips curve models suggest that the risks around the staff forecast are skewed to the upside, with high uncertainty. Our set of trend inflation models took signal from the recent strength of the data and suggest that the level of underlying inflation might be above target.
As for the SEP, we expect an upward revision to the median forecast in 2021 and 2022 as the incoming data have been strong and the median FOMC participant appears to be more hawkish than at the time of the September FOMC. In our view, an acceleration of tapering is a done deal (completed by the end of 2022:Q1) as the FOMC has finally realized that the risks are large and skewed to the upside and needs to buy optionality for next year. We also expect upward revisions to the dot plots with the median signaling one hike more in each year than in the September SEP. Having said so, we continue to believe that the actual future path of the federal fund rates will be more dovish than implied by the median SEP, as the median FOMC participant continues to be more hawkish than the median FOMC voter.
The current forecast
Table 1 shows the evolution of the Fed staff forecast (bottom panel) for core PCE price inflation, as well as the evolution of the median SEP forecast (mid panel). In the last few rounds, the Fed staff has revised up the 2021 forecast in reaction to higher-than-expected incoming data. At the same time, the forecast for 2022-2024 has remained largely unchanged.[1] The evolution of the SEP forecast has followed a similar path but there is an important difference between the staff forecast and the SEP forecast: the latter has been above target throughout the entire medium-term horizon since the June 2021 round. Put it differently, the Fed staff continues to be more dovish than the median SEP.
The top panel of Table 1 shows our calibrated decomposition of the contributions to core PCE price inflation, based on the Fed staff framework (history is based on latest published vintage and the forecast is what we think the Fed staff will write in the upcoming Tealbook).[2] In our view, the staff continues to assume that the level of underlying inflation is flat at 1.8 percent.[3] Also, according to our decomposition the staff is assuming that the labor market puts downward pressure on core PCE prices in 2021 but expects resource utilization to tighten and put upward pressure on consumers’ prices in 2022 and beyond. Switching to core import prices, in our decomposition the passthrough from the exchange rate is expected to add about 20bps this year, given the depreciation of the Broad dollar. Going forward, in our view the Fed staff forecast assumes a small Dollar appreciation which results in a small negative contribution of core import prices to core PCE price inflation. As for energy prices, the passthrough from crude oil prices to core PCE prices is expected to be small, if any. Finally, the portion of observed inflation that cannot be attributed to the fundamentals (the “other factors” line) is expected to be large this year but should be much smaller next year, as the Fed staff expects the currently elevated inflation to slow down significantly next year, in line with the estimated fundamentals.
[1] The Fed staff forecast is inferred from the FOMC minutes. This is the relevant part from the November 2021 FOMC minutes: “The staff’s near-term outlook for inflation was revised up, as consumer food and energy prices had risen faster than expected and production bottlenecks and recent wage gains were seen as putting somewhat greater upward pressure on prices than had been anticipated. As a result, the 12-month change in PCE prices was projected to move up further relative to September’s pace and to end the year well above 2 percent. Over the following two years, the boost to consumer prices caused by supply issues was expected to partly reverse, and resource utilization was projected to tighten further. PCE price inflation was therefore expected to step down to 2 percent in 2022 and to 1.9 percent in 2023 before edging back up to 2 percent in 2024”.
[2] The staff framework is explained in Detmeister et al. (2014).
[3] The staff assumption about underlying inflation is explained in Laubach et al. (2014) – “[…] according to the staff’s framework, if long-term inflation expectations remain unchanged, inflation will gravitate toward a fixed level in the absence of resource slack or other shocks. In many macroeconomic models this resting point is numerically identical to the long-term inflation expectations of price and wage setters. […] In the staff baseline, notional long-term inflation expectations are currently estimated to be anchored at 1.8 percent”.
Table 1
Note: Details may not sum to totals because of rounding. The “other factors” line includes the contribution of core non-market inflation, as well as the contributions of factors that are unrelated to other fundamentals. The “Board Staff” line is inferred from the FOMC minutes. The “Core PCE inflation” (top) line reflects latest published vintage (in history) and our view of what the Fed staff will write down as a forecast in the upcoming Tealbook. The 1.8% assumption of underlying inflation is inferred from Laubach et al. (2014).
Figure 1
Note: The Fed staff framework of core PCE price inflation is explained in Detmeister et al. (2014). “Underlying inflation” is the inflation rate that would prevail in the long-run, net of transitory shocks. For a discussion of “underlying inflation” see Rudd (2020). Slack is captured by the unemployment gap. The estimate of the natural rate of unemployment is provided by CBO. “Import prices” and “Energy prices” are expressed in deviation from core PCE prices, market-based.
Risks around the forecast
We assess the risks around the Fed staff / SEP forecasts in two ways. First, we assess whether the staff assumption of underlying inflation (which is set at 1.8 percent, flat in history and forecast) is supported by econometric evidence. Table 2 shows the estimates of trend inflation from our set of econometric models. Our models suggest that trend inflation was about 1.8 percent before the pandemic. However, the models started to take signal from the data last year and they are currently estimating that trend inflation has increased significantly in recent quarters. The average of our models suggests that trend inflation is running at 2.3 percent, half of percentage point higher than pre-Covid. Nevertheless, in our view the Fed staff will wait another quarter (or two) before revising the level of underlying inflation, given the usual uncertainty about the end-of-sample estimation. Overall, this evidence is an upward risk around the Fed staff inflation forecast.
As a second exercise, we use our collection of Phillips curve models to generate a distribution of point forecasts and assess the risks around the staff framework. The results of this exercise are reported in Figure 2. Our set of Phillips curve models include about 200,000 different specifications, differing according to the variables included and the restrictions applied to the model. The results of our exercise are presented splitting between “anchored” and “unanchored” models: in the former, inflation evolves over time but remains “anchored” to a trend (which itself can be flat as in the staff framework or evolve overtime), while in the latter any innovation to actual inflation results in a permanent shift. The top panels of Figure 2 show the distributions of point forecast in 2022-2024 for the “anchored” models. The top left panel shows the distributions of point forecasts stopping the estimation in 2021:Q4, that is the latest run.[1] As a comparison, the right top panel shows the results stopping the estimation in 2021:Q2, similar to the results at the time of the June/July FOMC. Three main conclusions arise. First, if long-term inflation expectations (or alternatively trend inflation) remain stable, the behavior of actual inflation is expected return close to the Fed target. Therefore, monitoring the evolution of the anchor remains crucial. Second, the inclusion of Q3 and Q4 in the sample triggered significant upward revisions throughout the entire medium-term. For instance, the models revised up the median 2022 forecast by about ¾ of percentage point and the median 2023 forecast by about 2-3 tenths (median 2023 forecast is now above Fed target). Finally, if Q3 and Q4 and included in the sample, the dispersion (uncertainty) around the mean/median forecasts increases significantly. The same evidence applies to the “unanchored” world, although in this case the means of the distributions ends up being much higher because the models do not contain an anchor.
Overall, our set of Phillips curve models suggest that the risks around the Fed staff forecast are skewed to the upside, and that the uncertainty around the forecast is high and has increased in the last few months.
[1] Core PCE price inflation in 2021:Q4 is our nowcast (+4.3 percent at annual rate).
Table 2
Note: “Average” refers to the simple mean across all models.
Figure 2. Point forecast distributions from our set of 100,000 Phillips curve models
End of sample 2021:Q4
End of sample 2021:Q2
Anchored models
Unanchored models
Note: whiskers show the distribution of point forecasts in each year over the relevant forecast horizon from the set of Phillips curve models we maintain (total number of models is around 100,000). The models are split between “anchored” and “unanchored, according to the restrictions imposed. Each model differs according to several dimensions: (i) lag structure of each variable, (ii) variable capturing economic slack (i.e. unemployment gap, output gap, etc..), (iii) type of non-linearity (i.e. linear in slack, quadratic in slack, etc..), (iv) variables capturing passthrough from the Dollar, (v) variables capturing the passthrough from Brent, (vi) type of trend (i.e. flat, long moving average, etc..). Each whisker shows the relevant descriptive statistics of the distribution: minimum, maximum, 25th percentile, 75th percentile, the mean (green horizontal bar), and the median (green triangle). The y-axis is expressed in percent.
Conclusion
Our shadow forecast suggests that the Fed staff will revise upward its 2021 core PCE price inflation forecast but will not materially change the 2022-2024 outlook as the fundamentals in those years remain similar to last Tealbook. Our set of econometric models suggest that the risks around the Fed staff forecast are skewed to the upside with significant uncertainty. As for the SEP, we expect an upward revision to the median forecast in 2021 and 2022 as the incoming data have been strong and the median FOMC participant appears to be more hawkish than at the time of the September FOMC. We also expect upward revisions to the dot plots with the median signaling one hike more in each year than in the September SEP. Having said so, we continue to believe that the actual future path of the federal fund rates will be more dovish than implied by the median SEP, as the median FOMC participant continues to be more hawkish than the median FOMC voter.