What to expect when you are… reflecting

Stocks had a mixed close on Friday with tech leaving the field dejected, because stocks also go down sometimes 😉. Three weeks of declines for the S&P500 leaves investors in the lurch, wondering if earnings can be the ointment needed to ease the pain.

A humble submission. I had a few charts I wanted to share with you, but so much has been happening I almost forgot. Later this week we are going to get a PCE Deflator release which is the Fed’s favorite inflation indicator. The more broadly popular Consumer Price Index / CPI came out earlier this month, and you may recall that it showed slightly hotter-than-expected inflation. You may have noticed that stocks and treasuries have been behaving rather poorly since the announcement. So, ya, inflation fear… or rather fear or what the Fed won’t do because of inflation fear, is still very much a thing.

A few weeks ago, I spent some with some very, very bright people and we decided to have a go at forecasting inflation. Can you imagine such a bold endeavor? Imagine us. No TV personalities amongst us, no Fed economists… no, just a bunch of overachievers USING THE SAME TOOLS used by Fed economists. Here is what we found. Oh, pay close attention, I am going to go fast. Here are CPI releases since 2020.

You can see how the numbers have been creeping up recently, and most importantly, the last time any of those numbers were at or below the Fed’s +2.0% target was back in February of 2021. Here, you can see that quite clearly on the following chart.

Be, patient with me, because here is where it gets interesting. If we observe the history, we can decompose it into 3 components. We can look at the trend, seasonality, and randomness. Randomness accounts for observations that cannot be explained by the other 2… er, randomness. Check out the breakdown in the next chart.

On this chart, you can see inflation in the top panel. In the “trend” panel we can see that inflation peaked in 2022 and is, indeed trending downward but clearly not where it started, back when the Fed was not angry. What is interesting in the “seasonal” panel is just how clear seasonality occurred in past observations. I will address the “random” panel in a moment, but I am hoping that you can get an idea of what goes into making a forecast.

Ok, now on to the actual forecast. Based on prior observations, we forecasted CPI for the next 6 months, and you can see it in the following chart. Take a look, we are almost done.

WHAT AM I LOOKING AT? The black line above is where inflation has been, and the blue line at the right-hand side of the chart is our 6-month forecast, based on the “stuff” I mentioned earlier. So, if this is correct, inflation may go higher yet before retreating once again. Wait, before you get nervous, please consider the following. First, the Fed economists are using almost the exact same method as me and using the exact same software, SO THEY ALREADY KNOW THIS. That is probably why they are not rushing to cut rates. There is more. They also see that the rates will come down after peaking in a few months, AND if you remember from the chart above, seasonality suggests that rates will moderate even more in final months of the year. The Fed knows this as well, which is why FOMC members are not panicking. Finally, let’s talk about that “random” panel from above. That shows us how much of the prior observations that could not be explained with trend and seasonality. You can see how it recently increased, but more importantly, how it is around the average since 2020, so the amount of randomness, or the likelihood of a “miss” by economists is kind of around where it has been for the most part (sorry, for the not-so-scholarly description, but I don’t want to get caught in the weeds). If you look back at the chart you can see that the randomness suggests that those projections can get as high as +5%… … … but also as low as +2% in the coming months. SO, please take this all with a grain of salt, because the Fed, in its own words, is “data dependent,” which means it will react to the actual numbers that are released, and not rely on… forecasts. At least you know what those smart folks are carrying around in their briefcases. Class is dismissed.

FRIDAY’S MARKETS

NEXT UP

• Chicago Fed Nation Activity Index (March) may have inched higher to 0.07 from 0.05.
• No Fed speakers leading up to next week’s FOMC meeting. They are busy preparing and forecasting inflation 😉.
• The week ahead: lots of earnings, flash PMIs, housing numbers, Durable Goods Orders, GDP, Personal Consumption, Personal Income, PCE Deflator, and University of Michigan Sentiment. Download the attached earnings and economic calendars for times and details.