A Very Difficult Report to Interpret
A very difficult report. The October PCE report is, to our memory, one of the most difficult report to interpret (and possibly less friendly than it appears). Core PCE prices grew 16bps MoM sa in October, as expected (remember: core PCE prices tend to run a bit lower in H2 compared to H1). Havig said so, the reading is distorted by a large drop in non-market prices (Figure 0). Netting out imputed prices and despite the favorable reading in core CPI space, core PCE market-based grew at an annual rate of 3.0% in October (Figure 0). (reminder: core PCE market-based is the portion of core PCE the Fed staff takes more signal from, in our experience). Indeed, Figure 0 reveals that the improvements in core PCE market-based are still not convincing (and the next reading can be higher than 3%). The good news is that the median of the distribution has dropped in October, although the Kernel of the last 3 months continues to show no real progress compared to 3-6 months ago. Implications for the medium-term are minimal.
We expect a careful Fed, not declaring victory any time soon. In our view, the new SEP will show a downward revision to core PCE in 2023 and (maybe) a marginal downward revision in 2024 (pre FOMC meeting package, including updated FRB-US run coming soon). Nevertheless, the impression is that markets are ahead of the curve. We still have to go through several things, including updated CPI seasonals, residual seasonality boost in H1, January re-pricing effect, etc.. and still, the medium-term models do not even converge to target. For this reason, very difficult to imagine a path of the FF rate in the December SEP meaningfully different than the last one (risks are of course skewed to the downside).
(For the record: we expect the YoY of core PCE at 3.4% in December 2023)
A PPT containing all relevant CPI/PCE charts can be downloaded here.
Figure 0. Core PCE Prices – MoM saar
Evidence from the distributions
Shifting left. This month, most percentiles moved down (Figure 1), in contrast with last month. Looking at the last three months (Figure 2) the distribution shows no signs of progress, reinforcing the message that going back to 2% will take time. The good news in today’s report is that the median of the distribution (Figure 3) dropped to the lowest level since 2020, a very promising sign that needs to be confirmed in the next reports.
To sum up: we probably made a step in the right direction in October. But going back to target requires more.
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 a solid “common” component. 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 October the common component increased by 18bps, marginally higher than the last 2 months. The Covid effect is null, while the idiosyncratic shock is very small (-2bp). Overall, the common component is losing steam (Figure 5) but it is still too early to conclude we can go back and remain at 2%.
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 little changed. We are working under the assumption that core PCE prices will expand at 2.9% QoQ saar in Q4. Conditional on this forecast, the “main” model forecast is: 2.6% in 2024, 2.5% in 2025, and 2.4% in 2026. Compared to the run at the time of the October CPI (here), the model forecast is just a touch lower.
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
Today’s data is (probably) a step in the right direction but in our view and estimates will not derail the December FOMC. As mentioned, today’s report is not an easy one, especially considering that the “true” signal (market-based core PCE) is not so friendly. It seems to us that markets cannot wait to celebrate and run. In a sense, that is how the game works. But we fear that the Fed staff (and the FOMC) are not in line with markets and will not be there for another (at least) 5-6 months.