MNI POLICY: Fed Sees Trend Inflation Edging Closer To 2% Goal

U.S. underlying inflation is softer than official readings suggest and is moving increasingly near the Federal Reserve's official 2%, indicating the recent reduction of prices pressures is likely to persist.

Fed officials advocating a pause can take heart in a new Richmond Fed model of trend inflation that suggests underlying U.S. inflation in the third quarter was 2.35%, lower than might be suggested by the aggregate data. That is also lower than the New York Fed's Multivariate Core Trend, a similar type of model, which in September sat at 2.86%.

The Richmond model looks at how different sectors are behaving and influencing aggregate inflation data and shows that by analyzing sectoral differences, trend inflation is lower than just headline and core inflation data suggests. By comparison, the standard twelve-month headline PCE measure stood at 3.0% in October, while core PCE, seen by Fed officials as a better proxy for underlying inflation, was higher at 3.5%. Three-month annualized core PCE sits at 2.4% and 6-month annualized is 2.5%.

Other trimmed PCE measures from regional Fed banks also suggest an encouraging picture. The Dallas Fed's 12-month Trimmed Mean PCE inflation rate has declined to 3.6%, while the 6-month annual rate is at 2.9%. The Cleveland Fed's Median PCE Inflation rate has posted seven straight monthly declines to 4.2%. Those gauges trim the most extreme observations at both ends of the spectrum and omit outlying changes and focus on the interior of the price distribution.

FURTHER DISINFLATION LIKELY

Fed officials in recent weeks have expressed increasing confidence of further reductions in underlying price pressures. They have said trend inflation is most likely around 3% and could be as low as 2.5%.

The Richmond Fed's sectoral model and the MCT build on a 2016 Stock and Watson paper that used PCE inflation data from 17 sectors and decomposed inflation within each of those into a trend component. The Richmond model is updated quarterly whereas the New York Fed's is monthly.

The Richmond Fed's multisector model weights incoming inflation data by sector and changes over time as the economy changes. The model estimates a trend and provides a snapshot of where inflation is at a point in time, but one could infer that headline and core PCE inflation could ease further in the medium term and eventually converge near the model's 2.35% estimate.

There are however downsides to the approach. The model takes past data, imposes a particular structure on it, and the results are just one lens from which to view inflation.

The vice chair of the FOMC - New York Fed chief John Williams - forecasts PCE inflation will decline to around 2.25% next year, before closing in on 2% in 2025. The Fed is expected to hold off from raising rates again in two weeks and is largely expected to be done hiking altogether, moving on to determining how long to hold rates steady. (See: MNI POLICY: Fed Likely Done Hiking, Focused On Length Of Hold)