3% is the new 2% – part XVII
Strong Start: Setting the Tone for 2025. The January CPI report came in stronger than expected, with core inflation rising 45 basis points (bps) month-over-month (MoM), compared to our forecast of 33bps. Table 1 outlines our MoM forecast errors. In the last 6 months, the standard error (2bps) and a standard deviation (6bps) of our core CPI forecast have been very competitive. Today’s upward surprise is not driven by revised seasonal effects but simply stronger repricing.
Key Takeaway: 3% is the New 2%. The main message from this report is clear: January’s distribution of price changes showed a substantial rightward skew (see here), with a pronounced right tail, signaling strong repricing pressures with no signs of inflation returning to the Fed’s 2% target anytime soon. In our view, this confirms a shift to a 3% inflation environment, a position we first argued 17 months ago (see here). This report likely sets the tone for the entire year— in our estimate, 2025 will be defined by persistent inflation around 3%+.
Reaction to the incoming data: raised near-term forecast. In response to this data, we have raised our near-term inflation forecasts, as we did last year under similar circumstances. We expect the repricing pressures seen in January to carry through the next two months. Additionally, we’ve incorporated 15bps of inflationary pressure (on the YoY) from newly announced tariffs. We project February core CPI at 34bps and anticipate the YoY of core CPI (PCE) to reach 3.4% (2.8%) by June 2025, and 3.2% (2.9%) by December 2025.
Models Insights: Persistent Inflationary Pressures. The broader inflation picture remains unchanged, with a persistent departure from pre-Covid trends. The distribution of price changes continues to show significant rightward skew, and little progress has been made over the last nine months in reducing inflation pressures. In fact, the distribution shifted further to the right in the past three months, with January showing a particularly large right tail. Our common inflation (CI) model estimates the core inflation trend (pi*) at around 2.5% in PCE terms and close to 3% in CPI terms. Meanwhile, our main medium-term model has been revised upward, maintaining forecasts above target through the horizon.
Conclusion: Inflation is Here to Stay. January’s report underscores the fact that we are now in an environment where inflation consistently exceeds the 2% target, sitting closer to 3% in CPI terms. With additional upside risks, including tariffs, this environment raises serious questions about the Federal Reserve’s policy flexibility. While the bar for further rate hikes remains high, the prospect of rate cuts seems increasingly unlikely in this inflationary landscape.
Table 1. Updated MoM (sa) UnderlyingInflation real-time 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
The distribution remains unfavorable and inconsistent with the target. This month, the distribution is highly dispersed with a very thick right tail (see ridge plot). The median (Figure 2) ticked upward. As shown in Figure 1, the overall picture remains unchanged: the distribution continues to differ from the pre-Covid pattern, with little to no progress over the past nine months. In fact, the last three months show a noticeable shift to the right. At this point it is very clear: we are in a 3% environment.
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, excluding idiosyncratic shocks, the common component remains above target. Figure 3 illustrates the decomposition of the MoM core CPI into “common” and “idiosyncratic” components. This month, the model estimates that the common component increased by 31bps, while the idiosyncratic shock contributed positively (13bps). The 3m/3m of the “common” component (Figure 4) stands at 2.94%. Overall, the CI model indicates that the “true” underlying pace of the data remains above target and close to 3%.
Figure 3. Contributions to MoM changes of CPI excluding food and energy items (CI 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 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 model.
Implications for the medium-term forecast of core PCE price inflation
The medium-term revised up. Today’s data had a material impact on our Q1 nowcast (revised up 8 tenths QoQ saar). Also, we have revised up the path of core import prices following the tariffs anncouncements. The new (Q4/Q4) model forecast is as follows: 2.9% in 2025, 2.5% in 2026, and 2.5% in 2027. The model forecast is revised up by about 10bps as a reflection of the tariffs in 2025, while the remaining part is due to the incoming data.
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).