Pi* For the Win
Look at pi*. In August 2023, we estimated pi* at 2.7% (see Figure 4 in our note here). Since then, including today’s report, we got 7 PCE readings. Unsurprisingly, the average of the MoM (saar) of these 7 readings is precisely 2.7%. Needless to say, it has been bumpy: a “good” month below pi* and everyone celebrates, a “bad” month above pi* and we need to reprice the Fed.
We currently estimate pi* (see slide 19 here) around 2.5%+. The signals of the models contained in this email confirm it. Going forward, we continue to expect a bumpy road and the baseline is to remain above target.
A PPT containing all relevant CPI/PCE charts can be downloaded here.
Evidence from the distributions
Some cooling, still inconsistent with target. This month, unsurprisingly, the entire distribution has shifted down following the January “repricing effect” (Figure 1). Looking at the last three months (Figure 2) the distribution shows some movements to the right, a signal that should not be dismissed but which is probably driven by the January reading. The median (Figure 3) moved down but remains elevated.
To sum up: the distribution suggests near-term readings above target (around 2.5%+ MoM saar).
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 Common-Idiosyncratic (CI) model
Our CI model estimates a strong common component, in acceleration. Figure 4 shows the decomposition of the MoM of core PCE in the “common” component (blue bars) and the “idiosyncratic” component (yellow bars). The model estimates that in February the common component increased by 19bps, in line with the average of the last year. The idiosyncratic shock is positive (7bp). Overall, the common component (Figure 5) has bottomed and it shows some acceleration in recent months, likely to continue in the near-term.
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 is little changed. We are currently assuming that core PCE price inflation will grow 3.4% (QoQ saar). Compared to last run, the model forecast is little changed. The model forecast is: 3.0% (Q4/Q4) in 2024, 2.6% in 2025, and 2.55% in 2026. This forecast is above the latest SEP at every horizon.
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).
Implications for the FOMC and the Fed Board staff
Raising doubts. Contrary to what it is generally perceived by markets participants, pi* (“underlying inflation”) is crucial for the Fed (see for instance, slide #8 here in the January 2018 Fed staff presentation to the FOMC). Until the models will signal a lower pi*, we will remain very careful in declaring victory.