Temptation island
Better than expected data, still not at target. The story for this round is the following: the incoming data have been a bit softer (2 tenths in our calculation) than expected by the Fed staff. The models revised down marginally (1 tenth) their medium-term forecast which remains above target. Crucially, the estimate of underlying inflation (pi*) remains well above target. The Taylor rules (and FRB-US) suggest a path of the FF rate either in line with the September SEP or marginally higher (because growth is stronger and financial conditions have eased).
Putting everything together: welcome to the temptation island. We expect the FOMC to signal stronger growth, possibly a marginally higher unemployment rate and marginally lower core PCE price inflation. The net effect on the FF rate should be small with the risks skewed to the downside (doves are tempted..). Having said so, it is very hard to see the new dots validating the number of cuts in 2024 currently priced. If anything, the evidence continues to favor a less dovish Fed.
(Note: to us, Powell’s words today went in the direction of the material contained in this package. He tried to pushed back against markets’ action. Markets are not listening but in our view and estimates, Powell is not bluffing)
Main points:
- The incoming data have been a bit weaker (2 tenths) than expected by the Fed staff forecast inferred from the latest FOMC minutes. In our view, the Fed staff can revise down marginally its 2023 core PCE price forecast. There are some progresses in the data but right now it is still difficult to conclude that the US economy can reach and stay at target, given the shape of the distribution.
Figure 1. Core PCE MoM prices change distributions.
- The Fed staff medium-term judgmental forecast (the Tealbook) should be little changed or marginally lower. Standard practice is to wait to have at least some data of a given year before changing the forecast. If anything, the forecast for 2024 and 2025 can be marginally lower than in November, as the estimated models revised down a touch (1 tenth) their forecast (Figure 2). The 2024 forecast of the “main” model is now marginally lower than the latest SEP (Figure 3).
Figure 2. Current and previous FOMC round “main” model forecast of core PCE price inflation.
Figure 3. Comparison of the evolution of the 2024 (Q4/Q4) core PCE price inflation forecast.
- The estimate of “underlying inflation” (pi*), the crucial variable in the Fed staff forecast, remains well above target. In our view, the Fed staff is estimating pi* around 2.7%, gradually declining in the medium-term. Until the estimate of pi* will be lower and close to target, it will be hard to imagine a real dovish Fed.
- The Taylor rules signal a path of the FF rate very similar to the September SEP. Both the inertial Taylor rule (1999) and the Fed staff (2021) rule are very similar to the September SEP. The latest run of FRB-US implies a path of the FF rate a touch higher than the SEP, given higher growth and lower yields (than the previous run). Risks for the dots are to the downside, as the FOMC has probably reached maximum hawkishness in September. Having said that, using these Taylor rules it is very hard to see a Fed that validates the number of cuts currently priced.
Figure 3. Taylor rules.
Figure 4. Latest run of FRB-US model.
As usual, we would be more than happy to schedule a meeting to discuss the details.