No More Hikes
No More Hikes in 2023. Last month we wrote (here) “The Models Have Spoken”. In retrospective, it was the right thing. Not only, but back on June 30 (here) we wrote it was time to bet against the hawkish Fed (for the record: the 1y Treasury yield on June 30 was breaking out at 5.40ish%, therefore we are not surprised it is still trading at that level right now). Today, we go one step further. Without big upward surprises, we expect no more hikes in 2023. The reason is once again the evidence of the models: the distribution is slowly regaining its pre-Covid shape, the median has fallen and remains low, the common component is approaching 2%, and core PCE market-based (which in our experience is the portion of core items the Fed staff takes more signal from) is already below target sequentially (see here). Unfortunately, the medium-term forecast remains unfavorable (although it is below the latest SEP) and core services ex rents/OER are not disinflating yet. But in this environment in our view there is no reason to be aggressive with the front end of the curve. The Fed can be patient, at least until the end of the year.
A PPT containing all relevant CPI/PCE charts can be downloaded here.
Evidence from the distributions
Regaining the mean. This month, we have mixed signals from the percentiles, with some moving up and other down (Figure 1). The kernel of the last 3 months (Figure 2) continues to travel to the left and gain mass around the pre-Covid mean. Importantly, the distribution is now looking similar to pre-Covid. Finally, the median of the distribution (Figure 3) has dropped recently and remains to a level just above those recorded pre-Covid. Translated: unless we have large shocks going forward, in the near-term we continue to expect moderate readings.
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 July the common component increased by 14bps. The Covid effect is null, and the idiosyncratic shock is small positive (8bps). Overall, the common component is losing steam (Figure 5).
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 unchanged. The “main” model forecast is: 3.6% in 2023, 2.9% in 2024, and 2.7% in 2025. The model forecast for 2023 continues to be below the June SEP (and it is in line with our judgmental bottom-up forecast, which currently stands at 3.5% in December 2023).
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
All the ducks are in a row. The FOMC and the Fed staff are finally well positioned, the data and the models are cooperating. If anything, the FOMC might revise down its core PCE price inflation forecast in the upcoming September SEP. In our view and estimate, the Fed staff has no reason to push for an aggressive monetary policy. Nothing says that the last mile (bringing core down to target) will be easily or painless. But in this environment, we think that the Fed can just be patient, at least until the end of the year.