“Something Is Missing Here” – Part II
The August CPI report came in as expected, core CPI was a bit stronger. Core CPI came in a bit stronger than expected (28bps vs 20bps), while headline CPI was in line with our expectations (63bps vs 64bps). Our CPI preview is here.
Overall, the August CPI report is a good proxy of where we are with the battle against inflation. Last month (here) when commenting the really good July report we wrote “…But Something Is Missing Here”. The reason was that, according to the models, disinflation is on its way but it continues to be very difficult to exclude that we will remain above target in the medium-term. Unsurprisingly, today’s report is a confirmation: the distribution of price changes remains very different than pre-Covid, the “common” component of our CI-C model is a bit stronger than last month, and the medium-term forecast remains unfavorable.
Nothing in today’s report seem to suggest that the Fed will raise rates in September (or in Q4). Rather, today’s report seems a good picture of where we are: gentle disinflation is on its way BUT it is almost impossible to exclude that the US economy will remain above target in the medium-term without additional help from the labor market. (pi* in our estimates is always at 2.7%) In our estimates, the Fed does not need to be aggressive again but needs to keep rates high for long.
A PDF containing all relevant CPI charts has been posted. You can download it here.
Evidence from the distributions
Distribution is still not convincing. This month, we do not have a clear signal from the percentiles (ridge plot here), with some moving higher and some moving lower. More importantly, as we have previously discussed, the shape of the distribution remains pretty different than pre-Covid. For this reason, as we wrote in previous notes, we remain careful in declaring victory or claiming that 2% is around the corner. It cannot be done right now. If anything, the evidence in Figure 1 indicates that we can easily remain above target in the medium-term without additional help from the labor market.
Figure 1. Kernel of CPI excluding food and energy items changes (MoM %, 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 2. Median (core) CPI metrics
Note: the Figure shows the median (MoM %, a.r.) of the distribution of CPI prices changes excluding food and energy items (left panel) and the YoY (right panel).
Evidence from our CI-C model
Our CI-C model estimates that net of Covid and idiosyncratic shocks, the common component in August accelerated. Figure 3 shows the decomposition of the MoM of core CPI in the “common” component, the “idiosyncratic” component, and the “Covid” effect. The model estimates that in August the common component increased by 22bps. The Covid effect is a small positive (6bps), and the idiosyncratic shock is close to null.
Th evidence from our CI-C model implies that the inflationary process is losing steam overall. (Reminder: the result of our CI-C model anticipates the “multivariate core trend” model of the NY Fed – see here and here our notes). Having said so, even through the lens of this model, at the moment we cannot exclude that core will remain above target going forward.
Figure 3. Contributions to MoM changes of CPI excluding food and energy items (CI-C model)
Note: the Figure shows the decomposition of the MoM percent changes of CPI prices excluding food and energy items. The contributions are estimated using our CI-C model, a 2-stage OLS-LASSO regression model. The “Covid” effect is identified with price variations outside the 10th-90th percentiles of each item pre-Covid price change distribution.
Figure 4. Estimated “Common” component: YoY, 3m/3m a.r. and 6m/6m a.r.
Note: the Figure shows the 3m/3m at annual rate (green line), the 6m/6m at annual rate (red line), and the YoY (blue line) of the “common component” estimated using our CI-C model.
Implications for the medium-term forecast of core PCE price inflation
The medium-term forecast of core PCE price inflation is little changed. We are assuming that core PCE prices will expand 2.9% (QoQ ar). Conditional on that, the Q4/Q4 forecast of the model is: 3.65% in 2023, 3.0% in 2024, 2.8% in 2025, and 2.7% in 2026. The model continues to suggest that going back to target will take time and monetary policy will need to remain restrictive. But at least, now the confidence bands include the target at the end of the medium-term.
For the record: using our bottom-up approach, we project the YoY of core PCE at 3.6% in December 2023.
Figure 5. “Main” Phillips curve model forecast, core PCE price inflation (YoY, %).
Note: the figure shows the latest run 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). First quarter of forecast: 2023:Q4.
Implications for the Fed Board staff and the FOMC
In our view and estimates, today’s CPI does not have material implications for the FOMC. We invite the reader to refer to our “Pre-September 2023 FOMC Meeting Package” (here). We continue to expect a hakwish pause this round and no additional hikes in 2023.