A kind of lucky reading
The October CPI report was softer than expected. Core CPI came in softer than expected (23bps vs 37bps), and headline CPI was also softer than our expectations (4bps vs 14bps). Our CPI preview is here. The downward surprise in October follows two upside misses we had in August and September. The entire miss in October is due to a downward surprise in two categories: used cars and lodging away from home (which is very volatile and carries no signal about future readings). Conditional on the observed readings for those two categories, our MoM forecast for core and headline would have been 8bps and 27bps (see here the usual preview table modified with the observed readings, as mentioned). In our judgmental bottom-up forecast, we have lowered a bit the core forecast in November (we now expect 28-30bps MoM sa) in reaction to today’s miss.
There are lots of reasons to be cautious. Despite the good reading in October, we remain very cautios for several reasons. First, the distribution of price changes continues to show little progresses (see Figure 1 below) and suggests the US economy can easily land on 3%-ish inflation rate going forward (for the record: the MoM saar of rents/OER in today’s report was 5.3% and the 3m/3m saar of services ex rents/OER was 3.96%). Second, the CI-C model suggests that the common component remains very solid and above target. Third, the latest NFIB survey (see here) shows that the intentions of small firms to raise prices is increasing again (higher since Aug ’22). Finally, the medium-term model of core PCE price inflation continues to deliver a forecast above target at the end of the forecasting horizon.
The Fed is on hold. All told, the Fed is on hold. So far, since the September FOMC, the Fed staff (and the FOMC) got two CPI reports. In our view and estimates, on net, the data have come in roughly as expected or marginally lower. Therefore, there is no reason for the Fed to rush conclusions in December. And there is no reason to revise its outlook significantly (only change at the moment is that Q4/Q4 of core PCE inflation could be revised down in 2023 to 3.6%-3.5%). (Reminder: according to the models, the discussion about cutting rates remain months away, additional help from labor market/fiscal is needed to reach target)
A PDF containing all relevant CPI charts has been posted. You can download it here.
Evidence from the distributions
Distribution still unfriendly. This month, most percentiles moved down (ridge plot here). Having said that, the evolution in the last three months (black line in Figure 1) shows no real progress compared to the previous three months (yellow line). Finally, the shape of the distribution remains very 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 is on its way to remain around 3% in the medium-term without additional help from the labor market/fiscal.
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-C model estimates that net of Covid and idiosyncratic shocks, the common component in October was solid. Figure 3 shows the decomposition of the MoM of core CPI in the “common” component, the “idiosyncratic” component, and the “Covid” effect. The model estimates that in October the common component increased by 20bps, a bit stronger than the average of the previous 4 months. The Covid effect is small (3bps), and the idiosyncratic shock is null.
Overall, we continue to take the results of the CI-C model as evidence that the common component remains above target at around 2½% at annual rate, roughly confirming our estimate of pi* (currently at 2.7% for the US).
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. The “Covid” effect is identified with price variations outside the 10th-90th percentiles of each item pre-Covid price change distribution.
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 little changed. Following today’s release, we are assuming that core PCE prices will expand 3.2% (QoQ ar) in Q4. This is still marginally higher than the model own forecast for Q4, although less than conditional on our pre-CPI estimate. Conditional on that, the Q4/Q4 forecast of the model is: 2.8% in 2024, 2.6% in 2024, 2.6% in 2025, and 2.5% in 2026. The model continues to suggest that the US can remain above target going forward without additional downward surprises or help from the labor market/fiscal.
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). First quarter of forecast: 2024:Q1.
Implications for the Fed Board staff and the FOMC
A good day for the Fed staff and the FOMC. Long-term plan is unchanged: wait until confident of reaching 2%. The September CPI report was “too bad to be true”. The October report looks “too good to be true”. The truth is probably in the middle with core prices gently disinflating but remaining above target with little indications that we can converge to target soon. This gives the Fed a reason for not rasing rates in December and hold (again, in our view the discussion about cutting rates remains months away). The models continue to suggest that core can easily remain above target going forward. Until the models will send different signals, we expect the Fed to push back against relaxing financial conditions (i.e. 10y dropping).