In this note we outline two scenarios for durable goods prices in 2022 and assess their implications for the Fed staff forecast. While durable goods prices are (partially) flexible, given the current YoY of core PCE prices, in our view the Fed staff forecast assumes that durable goods prices will return to their pre-Covid level by the end of 2022. We see this assumption as generous. A more plausible path of durable goods prices implies that core PCE price inflation will remain a bit above the Fed target at the end of 2022.
Introduction
According to the latest FOMC minutes, in November the Fed staff forecast for PCE price inflation was 2.0 percent in 2022. However, most econometric models (including the Fed staff framework (Detmeister et al. (2014)) in this moment deliver a forecast for 2022 higher than the one of the staff. In our view, the sharp difference between the staff (2.0% in 2022) and the models forecast (around 3.0% in 2022) can be attributed to the fact the staff is assuming to have a larger information set than the models. In other words, while the models are unaware of the narrative of the incoming data, the staff is assuming to know something that the models do not know (for instance that demand will moderate and/or supply will increase going forward). In this dimension, among all possible candidates across core PCE items, durable goods appear to be particularly relevant because of their share in core PCE and the recent evolution of their price level. In this note, we have constructed two scenarios for 2022 and assess their implications for the Fed staff forecast. In both scenarios, durable goods inflation moderates in 2022, an assumption that we see as reasonable considering the likely rebalancing of households’ expenditure towards services. However, in one scenario the level of durable goods prices remains elevated, while in the second scenario it falls back to pre-Covid levels.
The scenarios
Figure 1 shows the level of PCE durable goods prices from January 2015 till the end of 2022. The black line in Figure 1 shows published history, while the blue and red lines show the evolution of the level under the two scenarios we have constructed. Under “Scenario1” (the blue line) the level of PCE durable goods prices increases until December 2021 (at the same rate of last few months), and then declines in the following 12 months at a rate comparable to its historical mean (about 2% per year). In other words, in “Scenario1”, the slope of the blue line is the same as the black line over the period 2015-2019. On the other hand, under “Scenario2”, the level of PCE durable goods prices increases until December 2021 and then declines sharply to reach the pre-Covid value by the end of 2022. In both scenarios, we have assumed that the share of nominal spending on durables declines from 14.5% to 13%.
Figure 1. Level of PCE durable goods prices – history and scenarios.
Implications for core PCE price inflation
Figure 2 shows the contributions of PCE durable goods prices to the YoY of core PCE prices. The black bars in Figure 2 show history and the blue and red bars show the contributions under the two scenarios. On average, over the 2015-2019 period, durable goods prices took away from the YoY of core PCE prices about 2 tenths per year. Following the Covid shock, the contribution of durable goods prices is currently much higher (1¼ percent) and could reach 1¾ percent by December 2021.
Going forward, Figure 2 reveals that base effects in 2022 will be sizable. Under Scenario1, the contribution of durable goods prices will be in line with their historical average by the end of 2022 (-26bps), implying a decrease of the YoY of core inflation of about 150bps. Put it differently, under Scenario1, the YoY of core PCE prices would decelerate from about 4½ at the end of 2021 to 3% at the end of 2022 (all else equal), driven by the base effects of durable goods prices. On the other hand, under Scenario2 the YoY of core PCE prices would decelerate by about 300bps by the end of next year (from about 4½ at the end of 2021 to 1½ at the end of 2022).
Figure 2. Contributions to YoY of PCE prices excluding food and energy items.
Conclusion
Our analysis shows that the base effect of durable goods prices in 2022 will be sizable. However, considering that several parts of core inflation are accelerating, in order to reach target by the end of next year, the level of durable goods prices need to fall significantly and (almost) reach its pre-Covid value by December 2022. We remain skeptical that the level of durable goods prices will reverse entirely within the next 12 months because supply issues appear more persistent than previously anticipated. Under a more plausible scenario, the level of the series in December 2022 will land in between the two scenarios we have constructed, implying all else equal that the YoY of core PCE price inflation will be a bit above the Fed target (a result which happens to be in line with the evidence from our trend inflation models, and our models of alternative measures of core inflation). Overall, the results of this analysis reinforce our view that the risks around the Fed staff forecast are skewed to the upside.