Hawkish Pause
Long story short: hawkish pause, as the positive news on core PCE price inflation has been offset by the strong labor market. The model-based forecasts are little changed compared to July and we do not expect major changes in the Fed staff forecast. As for the SEP, we expect the new projections to signal lower core inflation in 2023 (to 3.5%-3.6%) but a stronger economy (higher GDP growth and a touch lower unemployment rate). In the Taylor rules, the net effect of two (lower inflation but stronger economy) is close to zero and the suggested path of the FF rate is nearly identical to the June SEP. We think that the models and the Taylor rules are correct this time. Indeed, in this environment it does make sense to take a pause (no hike) but remain hawkish with the optionality of an extra hike in 2023, just in case. At some point, it will become clear whether the Fed has done enough. Until then, it makes sense to take a pause but remain in the “for longer” highland.
Main points:
- The incoming data have been roughly in line with the Fed staff forecast inferred from the latest FOMC minutes. In our view, the Fed staff should not materially revise the near-term forecast. The incoming data have brought good news, as the distribution of price changes is slowly moving back to its pre-Covid shape and the common component across items is converging back towards target. Having said so, it is still too early ot declare victory because the last mile will not necessarily be easy and the medium-term model forecast continues to be above target at the end of the horizon.
Figure 1. Core PCE MoM prices change distributions.
- The Fed staff medium-term judgmental forecast should also be little changed. The story of this round is that the positive news of the core PCE prices incoming data have been offset by the strong(er than expected) labor market data. In the end, the “main” model forecast (black line in Figure 2) is little changed compared to July. Importantly, both the “main” model and the (July) Fed staff forecasts are below the June SEP. For this reason, we expect the September SEP to revise down the core PCE price inflation projection in 2023 (to 3.5%-3.6%). The forecasts in 2024-2025 should be little changed (with the 2026 forecast converging at target in the SEP).
Figure 2. Comparison of the evolution of the 2023 (Q4/Q4) core PCE price inflation forecast.
- The terminal FF rate is at 5.6%-5.8%. Both the Fed staff (2021) Taylor rule and the 1999 inertial Taylor rule imply a terminal rate of 5.6%, while FRB-US has a terminal rate of 5.8%. In the end, we expect the SEP dots to be little changed. We expect the SEP to signal higher growth, lower unemployment rate and lower inflation in 2023. Putting everything together, the FF rate should remain in line with the June SEP, as the lower path of core PCE is offset by the stronger labor market.
Figure 3. Taylor rules.
As usual, we would be more than happy to schedule a meeting to discuss the details.