The January CPI report was strong. Core CPI came in hotter than expected (39bps vs 23bps expected), and headline CPI was also above our expectations (31bps vs 15bps expected). Our CPI preview is here. For us, this is the largest MoM miss in the last 18 months, unsurprisingly it comes with a January report, by far the hardest to forecast. Table 1 shows our MoM forecast errors. In the last 6 months, our forecast of core CPI (our main focus) has been a bit too low on average. The std error (5bps) and the std dev (11bps) remain good.
Reaction to the incoming data: higher February and March. In our judgmental bottom-up forecast, we took signal from today’s miss because it is broad-based and raised February (core CPI now expected at 29bps MoM sa) and March (core CPI now expected at 27bps MoM sa). Significantly, we now expect the YoY of core CPI at 2.7% in December 2024. At the same time, we now expect the YoY of core PCE at 2.3% (today’s print should translate in about 26bps MoM in core PCE space, to be confirmed with tomorrow’s PPIs).
Red flags from our models. The distribution (in CPI space) remains different than pre-Covid, raising questions whether we can reach and stay at target (note: this is the same sentence we have been writing for several months in the CPI report – on the other hand, the distribution in PCE space is way more friendly). Also, the median jumped up today, not a friendly signal. The CI model suggests that there is some real broad-based pressure in today’s CPI. Finally, the medium-term model revised up its forecast and it is now above the latest SEP.
For the Fed: look at pi*. As mentioned a few times, the real target of the Fed is pi* (in PCE space). Any given single CPI print makes little difference. Pi* is currently around 2.5% (our note here). At this point, likely to remain at 2.5% in Q1 and possibly also in Q2. Powell was clear: pi* must be lower to cut rates.
Table 1. Updated MoM (sa) UnderlyingInflation forecast errors in the last 6 months.
A PDF containing all relevant CPI charts has been posted. You can download it here.
Evidence from the distributions
Distribution, still unfriendly. This month, all percentiles of the distribution moved up (ridge plot here). The median (Figure 2) jumped up to one of the highest reading since Covid hit (!). The median is quite volatile but this is a very unfriendly reading.
In the last three months (black line in Figure 1) the distribution shows only limited progress compared to 3-6 or 6-9 months ago. The shape of the distribution continues to be quite 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 the US economy continues to be more consistent with an inflation rate above target going forward.
Please, note that the last paragraph is identical to what we wrote last month and the previous several months. On the other hand, the distribution in PCE space (as we wrote here) is way more friendly. Put it simply: the distribution in core CPI space suggests a 3%+ reading, while in core PCE space it suggests around 2.5% or lower.
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 model estimates that net of Covid and idiosyncratic shocks, the common component in January is strong. Figure 3 shows the decomposition of the MoM of core CPI in the “common” vs “idiosyncratic” component. The model estimates that in January the common component increased by 31bps, while the idiosyncratic shock is also positive (8bps). The common component expanded at the fastest pace in the last 12 months, although last January it was way stronger (almost the double). The 3m/3m of the “common” component (Figure 4) is on a downward trend but likely to rebound in the coming months. Overall, the evidence of the CI model suggests that the “true” underlying pace of the data is above target.
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.
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 higher. This is the first time we put Q1 in sample; we are working under the assumption that core PCE prices will grow 2.8% QoQ (saar). Based on this, the model-based forecast of core PCE price inflation is at 2.5% in 2024, 2.3% in 2025, and 2.3% in 2026. This forecast is now slightly higher than the latest SEP.
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).
Implications for the Fed Board staff and the FOMC
Fed on hold. Today’s surprise will reinforce the “wait and see” mode of the Fed staff and the FOMC. Per se, in our estimates, the print does not alter much the 2024 forecast of the Fed staff or the SEP. But the risks are now to the upside. Finally, as mentioned, pi* is still way above target. Until it will converge back to 2%, hard to imagine a very dovish Fed.