3% Is the New 2%
The September CPI report was stronger than expected. Core CPI came in stronger than expected (32bps vs 20bps), and headline CPI was also stronger than our expectations (40bps vs 24bps). Our CPI preview is here. This is the first sizable upward miss in a while, and we take it seriously because the miss was widespread across sectors. Last month (here), when commenting a 28bps core CPI we wrote: “the August CPI report is a good proxy of where we are in the battle against inflation”. The September report was marginally worse in several dimensions, but one in particular: there is no evidence of progress in the distribution of price changes. At this point, the distributions and the models all seem to suggest that “3% is the new 2%”. In a sense, this is no surprise given that our estimate of pi* is currently at 2.7% (here our note). For the record, the September CPI report was particularly worrying in some dimensions. For instance, the index of core services ex rents and OER, increased around 7% MoM saar. The reader can see the metrics of this index here (an Excel file with the calculations is here). The reader can also refer to the NSA core CPI level by year here, from which it is clear the still unfriendly nature of the process.
The Fed is in a corner. We expect the FOMC to wait (for now) and be part of the problem. As discussed in private meetings in the last 2-3 weeks, the Fed is now in a corner. It is in this corner partially because it put itself by being more dovish, and partially because fiscal has not cooperated. Going forward, we think the game will become tough: go back hiking or accepting an economy with higher inflation? Tertium non datur (“third option not given”). For now, we expect the FOMC to take time and say nothing to the fiscal authority. And by doing so, we expect the FOMC to make everything worse by being part of the problem.
A PDF containing all relevant CPI charts has been posted. You can download it here.
Evidence from the distributions
Distribution still unfriendly. This month, we do not have a clear signal from the percentiles (ridge plot here), with some moving higher and some moving lower. More importantly, as we have previously discussed, the shape of the distribution remains pretty 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 September 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 September the common component increased by 18bps. The Covid effect is a solid (14bps), and the idiosyncratic shock is null.
We are often asked how to interpret the “Covid effect”, whether it is more a common shock or an idiosyncratic term. The answer is not easy because it can, indeed, be interpreted in both ways. For this reason, we have run the CI-C model the way we used pre-Covid, that is not including the Covid effect (from “CI-C” to “CI” as in Luciani (2020)). MoM decomposition can be seen here, while the metrics of the “common” component are here. The model estimates that the common component has moderated but continues to run above target (at around 2.5%). To us, this is a fair assessment of the strength of the data.
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 marginally higher. We are assuming that core PCE prices will expand 2.6% (QoQ ar) in Q3, two tenths (to rounding) higher than pre-CPI release. Conditional on that, the Q4/Q4 forecast of the model is: 3.6% in 2023, 2.7% 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.
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: 2023:Q4.
Implications for the Fed Board staff and the FOMC
A very bad day for the Fed staff. FOMC on hold. In today’s report we see zero good news for the Fed staff which might even be forced to revise up (marginally) its 2023 core PCE forecast in the upcoming round (say from 3.5% to 3.6%). However, the very bad news is that in the last 9 months (see again Figure 1) the progress has been very limited. Not only, but the next 2-3 reports can be on the strong side. In other words, in our view and estimates it is now just a matter of time before more and more market participants will question again the ability of the Fed to go back to 2%. We expect the FOMC to hold in November. And by doing so they will become part of the problem, as we have discussed recently. (here the report from our tour) The main question remains the same: how can we go back to 2% with a more dovish central bank and no help from fiscal?