In this note, we update our estimate of “underlying inflation”, the crucial variable for the Fed staff, through Q4. According to our models, “underlying inflation” in Q4 is unchanged at 2.7%, as recent incoming data have been mixed (lower observed inflation but higher expectations), and wage inflation remains elevated. A fall to 2% requires time, given the persistency of pi*. The major risk right now is that markets might underestimate its importance for the Fed staff and its persistency. In our experience, cutting the FF rate requires pi* at (or at least around) 2%, a circumstance unlikely to happen soon.
Our previous note on “underlying inflation” is here.
The definition and why it is important
We defer the reader to our previous note on pi* (here) where we have explained the definitions and why it is a crucial variable for the Fed staff.
The estimation
The estimation of pi* requires three steps. Because underlying inflation is defined in terms of a state of the economy that is unlikely to ever be exactly realized, it cannot be directly observed; rather, it must be inferred from the behavior of actual inflation, either in a univariate context or with additional reference to the behavior of inflation’s other determinants. In theory, pi* can be estimated in three ways: (i) by the use of statistical models to extract the trend of inflation, (ii) by looking at measures of inflation expectations (indeed, in a NK Phillips curve what drives inflation in the long-run are expectations), and (iii) by the general equilibrium of the economy, given the joint behavior of prices and wages.
Models of trend inflation
Trend inflation unchanged (to rounding) in Q4. We have updated our collection of 11 models of trend inflation which mimic Rudd (2020). Figure 1 shows the estimated trends (the gray lines) together with the average across them (the black line). In the latest run (our nowcast of Q4 in-sample, assuming core PCE price inflation at 3.0% QoQ in Q4 after today’s PPIs), the model suggests that, to rounding, trend inflation remains unchanged in the current quarter at 2.7%. The reason why trend inflation models have not -on average- revised down their estimates is because (from the point of view of the models) so far the incoming data in Q4 contain contrasting news (lower observed inflation but higher expectations).
(Note: in Figure 1, the “Average” line seems to tick up at the end of the sample because the value in Q4 is 2.72% vs 2.66% in Q3).
An Excel contaning all numbers of Figure 1 can be downloaded here.
Figure 1. Trend inflation models
Note: the chart shows the estimated trend inflation from 11 econometric models. The models are split into three groups. The first group is a collection of Phillips-curve (PC) type of trend inflation models in which a measure of long-term inflation expectations is used as a proxy of trend inflation. The second group is a collection of state-space unobserved component models in which we have modelled trend inflation either as a smooth trend or as an augmented local level. Finally, the third group of models is a collection of Time Varying Parameters Vector AutoRegressive models (TVP-VAR) with different endogenous variables. This set of models follows the FEDS Note by Rudd (2020) “Underlying Inflation: Its Measurement and Significance”. The Fed staff assumption about the level of underlying inflation (set at 1.8 percent pre-Covid) is inferred from Laubach et al. (2014) “Long-term Inflation Expectations and Risks to the Inflation Outlook“.
Measures of inflation expectations
Inflation expectations in Q4 remain consistent with core PCE price inflation around 2¼-2½ percent. We have updated our nowcast of the Fed CIE (Common Inflation Expectations index), which the Fed staff uses to gauge the evolution of a large set of measures of expectations. Figure 2 shows the published Fed CIE and our updated model-based nowcast. The main takeaway is that the level of expectations is roughly consistent with periods in the past when core PCE price inflation averaged 2¼-2½ percent.
Figure 2. Fed CIE: published and our nowcast
Note: the Figure shows the published Fed Common Inflation Expectations (CIE) index (the thick blue bar), and our Dynamic Factor Model (DFM) nowcasts (the black circles). Both series are displayed at quarterly frequency. The latest published quarter of the Fed-CIE is 2023:Q3. The latest circle in the Figure shows our nowcast for 2023:Q4. The dashed-blue lines are estimated confidence intervals. The Fed-CIE model is a DFM that includes 21 measures of inflation expectations. The estimated common factor is projected on a chosen measure of long-term inflation expectations (the SPF PCE 10 years). By construction, the level of the common factor cannot be interpreted because the underlying series are demeaned (in fact, normalized) at the beginning of estimation. Instead, the level of the common factor can be compared to its own history.
The general equilibrium
Models that consider the joint behavior of wages and prices also suggest pi* is a bit below 3%. Figure 3 shows core PCE price inflation (QoQ, ar) together with the estimated pi* from a general equilibrium model we maintain. The model is called “OUI” because it considers the joint dynamics of Output, Unemployment, and Inflation (both prices and wages). For the nerds, the model documentation is here. Without entering into the details, the idea of the model is to estimate pi* considering the strength of the labor market (wages included). According to the model, pi* remains at 2.7% in Q4.
(As for FRB-US, in the latest run the so-called “PTR”, a rough proxy of pi*, remains above target both in the SEP-consistent dataset and in our “inconsistent” baseline.)
Figure 3. Estimated pi* in “OUI” model
Note: the figure shows published core PCE price inflation (black line, QoQ ar) and the estimated pi* of our “OUI” model. “pi*” refers to “underlying inflation”.
Putting the three pieces together
Pi* is a bit below 3%. Figure 4 shows a slide of our Pre-FOMC meeting package, updated with today’s results. The three ways of estimating pi* agree on a value around 2.7% with some downside risks.
Figure 4. The three ways of estimating pi*
Implications for the Fed staff and the FOMC
Pi* must return to 2%, it will take time. The importance for the Fed staff of “underlying inflation” can be seen in Rudd (2020) and Detmeister et al. (2014). So far, we have been quite silent about the evolution of pi* because it has been roughly stable for a year. The ingredients are finally there for pi* to fall in the next quarters, conditional on further moderation in wage growth, a fall in observed inflation, and some moderation in inflation expectations. The risk is that if the Fed staff (and the FOMC) will wait until pi* has converged to 2%, it might require more time to start cutting the FF rate than currently implied by market expectations (which seem to be based only on observed inflation rather than on pi*). We continue to think (and estimate) that a single good CPI reading is really not enough. The big picture can and will change, but the suspect is that the Fed will need time, at least another 2 quarters or so.