The Dallas Fed has released an analysis (“What Might Inflation Look Like Next Year?“) that outlines some scenarios for core PCE price inflation in ’22. Please, find below our review.
What the paper does
The Dallas Fed analysis splits core PCE inflation in three categories: (i) vehicles, (ii) housing, and (iii) everything else. As a reminder: (i) vehicle inflation experienced a sharp increase in ’21 due to elevated demand and supply issues, (ii) housing inflation is projected by many (including the Dallas Fed) to increase substantially in the coming months, and (iii) the remaining part of the core PCE price index also experienced an increase due to re-opening sectors.
The authors make the following assumption: they assume that inflation in (iii) will remain elevated (that is, at the current 2.8% YoY level in ’22). They then simulate different scenarios for (i) and (ii). Specifically, the assume two scenarios for vehicles: in the “baseline” the level of the series drops moderately in ’22 (consistent with its own history), while in the “low” scenario the level of the series reverts back by the end of ’22. As for housing, the authors assume two scenarios: in the baseline housing inflation accelerates moderately (3.3% YoY in ’22), while in the “high” scenario it accelerates sharply (7% YoY in ’22).
In the worse case, core inflation is at 3.2% by the end of ’22, while in the best scenario core inflation is at 2.2%.
Comment
This exercise is informative because it gives a range of possible outcomes. However, we do not agree with the authors about the assumption for the remaining sectors (iii). In our view, inflation in the re-opening sectors should moderate in ’22, therefore we take the scenarios in Table 1 as an upperbound estimates. For this reason, we think that the most likely outcome (conditional on today’s information set) is for core PCE price inflation to be moderately above 2% by the end of ’22.
Implications for the Fed Board staff
The Fed Board staff will probably take the Dallas Fed simulations as a general confirmation that the currently high readings of core PCE price inflation will not persist in ’22. The staff will continue to forecast inflation in the medium-term according to the fundamentals so it will not revise up ’22 inflation until it will start receiving incoming monthly data at the beginning of ’22). Nevertheless, we re-iterate that models simulations (see “think modelling” exercise) and bottom-up forecasts continue to suggest that the risks around the staff forecast lie to the upside.