In this note, we show the models forecast putting 2024:Q1 and 2024:Q2 in-sample. The bottom line is that the medium-term models have converged towards the estimate of pi*: 2.5% in core PCE space in the medium-term. At this point, this forecast is unlikely to change substantially in the next few months, and the risks are well balanced. Returning to the Fed target is still a question mark.
The main model
Main model revised up, forecast at 2½ percent. Now that we have a better understanding of the current quarter, we are currently assuming that core PCE price inflation will grow 3.1% (QoQ saar) in Q1 and 2.6% (QoQ saar) in Q2 (for the record: we assume the following MoM sa: 37bps in Jan, 25bps in Feb, 25bps in Mar, 21bps in Apr, 19bps in May, and 19bps in June – risks are slightly to the upside). We also assume that real GDP growth will be 2.5% (QoQ saar) in both Q1 and Q2, and that the unemployment rate stays flat. Figure 1 (left panel) shows the model forecast putting Q1 in-sample. The model forecast is: 2.8% (Q4/Q4) in 2024, 2.5% in 2025, and 2.5% in 2026. Compared to the previous run, the model revised up the entire path due to higher incoming data of the left-hand-side, as well as some exogenous (core import prices). The right-hand-side of Figure 1 shows what happens if we include our forecast of Q2 in-sample. The point is that the model forecast is largely unrevised, just a touch lower in 2024, and still does not converge to target.
Figure 1. “Main” model core PCE price inflation forecast.
Q1 in-sample
Q2 in-sample
Note: the Figure shows the forecast of our “main” Phillips curve model. The confidence intervals (C.I.) are estimated using quasi-out-of-sample methods (estimate the model over a sub-sample, forecast, and calculate the root mean squared forecast errors).
Underlying Inflation (Pi*)
Pi* at 2.5% in Q1 and in Q2. As we have previously explained, pi* is a crucial input of the Fed staff forecast, and there are 3 pillars of its estimation: trend-based measures, measures of inflation expectations, and the general equilibrium (see Rudd (2020)). Figure 2 shows (i) the estimate of trend inflation (both putting Q1 and Q2 in-sample), (ii) the Fed “Common Inflation Expectations” (CIE) index (again in Q1 and Q2), and (iii) the estimate of pi* of our “OUI” general equilibrium model. The good news is that expectations are ticking down and becoming consistent with the Fed target. However, the estimate of trend inflation (at 2.65% in Q1 and 2.54% in Q2) and the general equilibrium (at 2.8% in both quarters) are very persistent and go sideways in the current quarter and the next. Overall, we estimate that under reasonable assumptions, pi* is at 2.48% in Q1 and expected at 2.45% in Q2. In other words, pi* is basically going sideways.
(If the reader is unfamiliar with the definition of pi*, we point to this note)
Figure 2. Estimates of pi* in core PCE space.
Measures of trend inflation – Q1 in-sample
Measures of trend inflation – Q2 in-sample
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“.
Fed CIE – Q1 nowcast
Fed CIE – Q2 forecast
Note: the Figure shows the published Fed Common Inflation Expectations (CIE) index (the thick blue bar), and our Dynamic Factor Model (DFM) nowcasts (the black circles). Both series are displayed at quarterly frequency. The latest published quarter of the Fed-CIE is 2023:Q4. The latest circle in the Figure shows our nowcast for 2024:Q1 and 2024:Q2, repsectively. The dashed-blue lines are estimated confidence intervals. The Fed-CIE model is a DFM that includes 21 measures of inflation expectations. The estimated common factor (which is specified as an autoregressive process of order 4) is projected on a chosen measure of long-term inflation expectations (the SPF PCE 10 years). By construction, the level of the common factor cannot be interpreted because the underlying series are normalized at the beginning of estimation. Instead, the level of the common factor can be compared to its own history.
“OUI” model – Q1 in-sample
“OUI” model – Q2 in-sample
Note: the figure shows published core PCE price inflation (black line, QoQ ar) and the estimated pi* of our “OUI” model. “pi*” refers to “underlying inflation”.
FRB-US model
Updated baseline above December SEP. We have updated FRB-US baseline with the same assumptions for Q1 and Q2 of the other models (for core PCE, GDP growth, and the unemployment rate). Results are shown in Figure 3. Bottom line is that compared to the previous run (here), the model delivers a more hawkish forecast, with the FF rate above the December SEP in 2024 and 2025. After that, the FF rate is slightly below the December SEP because the output gap is more negative. The upward revision of the FF rate forecast comes from the higher-than-expected core PCE figures as well as an unemployment rate that remains flat (by assumption) in Q1 and Q2. The forecast of core PCE does not converge to target at the end of the medium-term. (Please note that FRB-US is now forecasting the YoY of core PCE at 2.7% in 2024:Q4). As usual, in Figure 3 the red lines show the updated baseline while the blue lines show the latest SEP.
Figure 3. Updated FRB-US baseline (red lines) and latest SEP (blue lines)
Note: Real GDP growth and core inflation are expressed as YoY. Core inflation is core PCE price inflation. The blue lines show the latest SEP. The red lines show the “inconsistent FRB-US” forecast (the current baseline), that is the model-based forecast removing the “add-factors” put by the Fed staff to match the latest SEP, updated as specified in the text.
Conclusion
pi* at 2.5%. As shown, right now all models converge to the same answer: underlying inflation is around 2.5% in core PCE space. Under reasonable assumptions, we expect pi* to remain at this level also next quarter.