Do Not Celebrate Yet
(Once again we apologize for the delay. IT issues have been solved. Greetings from NY)
A step in the right direction but the main issue is still there. We keep it simple, given the delay: the August PCE report was a step in the right direction. Most percentiles of the distribution moved down and the common component of the CI-C model continued to moderate. There is little doubt that inflation is unlikely to re-accelerate and/or we will land on a 4% inflation economy. But the main issue is still there: neither the distribution of price changes nor (most importantly) the medium-term models can take the 2.5%-3% risk of the table right now. Put it differently, the models say that the “Ackman scenario” is probably not the baseline. But the same models cannot exclude Ackman is wrong. Until then, we suspect that the tensions on the bond market will continue.
A PPT containing all relevant CPI/PCE charts can be downloaded here.
Evidence from the distributions
Slowly regaining the mean. This month, most percentiles moved down (Figure 1), a promising signal. The kernel of the last 3 months (Figure 2) continues to travel to the left and gain mass around the pre-Covid mean. Having said that, the distribution remains different than pre-Covid, signalling that there is still work to be done. Finally, the median of the distribution (Figure 3) has dropped recently and remains to a level above those recorded pre-Covid. Translated: unless we have large shocks going forward, in the near-term we continue to expect moderate readings but the main issue for the bond market remains on the table: we do not have a clear indication (yet) that the US economy is on a 2% steady-state (as opposed to 2.5% or more).
Figure 1. Distribution of PCE 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 PCE prices excluding food and energy items. The colors indicate the percentiles: 0-10pct, 10-25pct, etc. The dashed line shows the median of the distribution.
Figure 2. Kernel of PCE 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 PCE prices excluding food and energy items.
Figure 3. Median PCE price increase
Note: the Figure shows the median (MoM %, a.r.) of the distribution of PCE 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 strength of the data is losing steam. Figure 4 shows the decomposition of the MoM of core PCE in the “common” component, the “idiosyncratic” component, and the “Covid” effect. The model estimates that in August the common component increased by 14bps. The Covid effect and the idiosyncratic shock are very small and offset each other. Overall, the common component is losing steam (Figure 5). The next few months can tell whether the common component will land at 2% or whether it will remain above it. We have promising signals but it is still too early to conclude.
Figure 4. Contributions to MoM changes of PCE excluding food and energy items (CI-C model)
Note: the Figure shows the decomposition of the MoM percent changes of PCE 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 5. 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 is little changed. The “main” model forecast is: 3.6% in 2023, 2.75% in 2024, 2.6% in 2025, and 2.5% in 2026. The model forecast for 2023 continues to be below the SEP (the YoY of our judgmental bottom-up forecast is at 3.4% in December).
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
Nothing has changed. The August PCE report is a step in the right direction but the clouds over the medium-term are still there. There is little doubt that the Fed has achieved some disinflation. We still need time to understand whether we can go down to 2%. In the meantime, we expect no more hikes from the Fed and unchanged “for longer” message.