It’s About Pi*
Here it comes, pi*. The new statement cannot be clearer: in order to cut, the FOMC needs to be sure that pi* (underlying inflation) is at 2%, (pi*, not realized inflation!). While most people focus on realized inflation (“is the 3m/3m or 6m/6m of core excluding this and that at target?”), in our experience the Fed staff and the FOMC have in mind pi* (see below for details and previous notes on it). In our pre-FOMC meeting package, we estimated pi* at 2.5%. Apparently, it is still not enough for the FOMC. Having said that, the data received since the closing day of the Tealbook point to a possible downward revision in the coming months. From now on, in our view and experience, the reader should stop paying any attention to realized inflation and all the focus should be on pi*. Should it get close to 2% by March (not impossible), a cut will be on the table.
Everything else in the statement and in the press conference does not matter, in our view. Not only, but the Q&As this time only made a big confusion. For this reason, we do not review the Q&As as we generally do. The message is super clear to us: it is about pi*.
Preamble: today’s ECI reading
ECI came in a bit softer than expected. Table 1 shows the published ECI (private industry workers) numbers, together with the real-time forecast of our model and the current forecast. The bottom line is that the model has taken a bit of signal from today’s miss and lowered its forecast by a touch (the QoQ saar for Q1 went from 3.8% to 3.7%). Overall, the behavior of wages is consistent with an economy that is disinflating, in line with the signals from some JOLTS measures.
Two important points on today’s ECI. (i) The lower reading will feed into the estimate of pi*. The latest estimate was 2.5%, therefore there is a chance the FOMC will enter the March meeting with an estimate of pi* close to target. (ii) If one agrees with FRB-US about the positive TFP shock, then the level of wage growth consistent with target is higher than 3%, and possibly already close to the current level of wage growth. In any case, a dovish signal.
Table 1. Real-time and current ECI forecast.
Figure 1. Phillips curve model-based ECI forecast.
Note: the figure shows the ECI Phillips curve model-based forecast (YoY). The chart refers to the year-over-year percent changes of compensation costs for private industry workers. The confidence intervals are based on the estimated parameters distributions. The table on the right shows a comparison between the current forecast (2023:Q4 last quarter in-sample) and the previous forecast (real-time in 2023:Q3).
The statement
It’s about pi*. The statement got re-written, see below. The key is that the the Committee “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent”. What does it mean? To us, it is straightforward (alghouth it is probably not for the market): it means that pi* (underlying inflation) has to be to 2% or very close to it. In our pre-FOMC meeting package, we have estimated pi* at 2.5%. Given the incoming data on wage inflation, there is a chance pi* will be below 2.5% by the March meeting. We will assess carefully pi* in the coming months, especially close to the next FOMC.
For previous notes on pi*, including how the Fed staff estimates it and why it is so important (in fact, it is everything), see here, here, and here.
There is a reason why our company name is “Underlying Inflation”, afterall..
In this part of the note, we geneally review the Q&As. But this time, it is not necessary. In fact, the Q&As only made a great confusion. The only question the Chair should get is “where do you estimate pi* right now?”.
Remember: it is about pi*. Everything else only generates confusion.