New Underlying Inflation Gauge From NY Fed Supportive of Dudley and "The Dots"

Our friends over at Liberty Street Economics are hard at work generating data analysis for inflation nerds the world over. Their latest innovation is what they call UIG, or the Underlying Inflation Gauge. The NY Fed announced they would be building this measure back in May, and yesterday they hit the tape with the current measure and data back into the 1990s.

This is similar to the analysis of PCE revisions done by the Dallas Fed that I highlighted last month, and probably lends some insight into Dudley’s thought process, which I highlighted around the same time. The new UIG suggests that inflation may be rising faster than implied by the sagging core CPI figures of the past five months.

To quote the article:

“Consumers, financial market participants, and policymakers are particularly interested in the trend, or persistent, component of inflation. But this variable is not observed, which has resulted in a variety of proposed proxy measures….Among its attractive features, the UIG is derived from a large data set that extends beyond price variables and displays greater forecast accuracy than various measures of core inflation.”

Why does this matter? Is it just another number produced by a bunch of ivory tower eggheads? Again to quote (emphasis mine):

“...the underlying trend in inflation plays a critical role in the conduct of monetary policy. Unfortunately, differentiating between persistent and transitory changes in inflation in a timely and reliable manner is a challenge. Consequently, a large research effort has focused on extracting the trend component of inflation from monthly data releases.”

They even stick up for their own model:

3. What evidence suggests the model is useful?

Compared with core inflation measures, the UIG:

– can use information about subcomponent price changes

from the cross-sectional and time-series dimensions;

– can consider data beyond subcomponent price changes and

incorporate a large number of additional series;

– has outperformed core inflation measures in tests of forecast

accuracy over different time horizons;

– provides a more timely and accurate signal of turning points

in inflation.

Put another way, there are some important bosses at the Fed that don’t think core CPI is doing a good job to discern underlying inflation trends, and they want something better. This is what their intrepid staff came up with. The two time series are “prices-only” and “full data-set”. “Prices-only” is just what it sounds, a statistical interpretation of the CPI data, while the “full data-set” incorporates many of the factors implicit in a financial conditions index, like labor market conditions, ISM variables, money supply/credit growth and financial indices (rates, equities, etc.).

Here’s what yesterday’s print said:

• The August CPI showed a further pick up in inflation from June. In response to the firming of CPI inflation, both UIG measures displayed a rise in trend inflation.

-The UIG measures currently estimate trend CPI inflation to be in the 2.2% to 2.7% range, with both registering above the actual twelve-month change in the CPI.

Not only did trend inflation rise in August, it has been rising much of the year, incredibly moving the opposite direction of headline AND core CPI.

Source: New York Federal Reserve Data

If you’re looking for a reason why Yellen and Dudley see inflation on the horizon, or a reason why they are remaining hawkish despite weaker than expected inflation figures, this is it. Given this data, it is actually rather surprising the term structure of “the dots” flattened as it did….but it also makes you ask: where are Yellen and Dudley’s dots? This argues they are closer to the top of the scatter than the middle. And those two dots are the only ones that matter.

The gap from the red dots (the market) to the higher end of the median dots is roughly 50bps in 2018 and >100bps in in 2019. Clearly the market hasn’t taken in a more inflationary economy--only the more hawkish Fed. You can’t separate one from the other.

Here’s the probability distribution for the December meeting--the consensus has shifted to a hike:

But take a look at the distribution for the March meeting--the probability of two hikes by that time is no higher than it was back in July.

Maybe it is a slow Friday afternoon but the bearish flow in the front end isn’t going away. The front end led the curve higher post FOMC, and even when shorts took some profits this morning, by the end of the day the curve had resumed bear flattening.

This chart shows a proxy for the EDH8/EDU8 spread (orange, 6m3m vs 1y3m) and the EDH8/EDU9 spread (6m3m vs. 2y3m). This serves as a proxy for what is priced

I see those two eurodollar spreads continuing to steepen towards their high back in early July, which would be a move from roughly 13bps to 23bps in EDH8/EDU9, 32bps to 55bps in EDH8/EDZ8.

And yes indeed, that would cause a reversal in the USD we’ve been discussing this week, a conversation that DR got rolling before the market woke up to the FOMC rhetoric on Wednesday....I’m slowly starting to move towards DR’s camp. Yet there is reason to be cautious vs. G10:  The WSJ had a good article this morning mentioning that a more hawkish stance from the Fed would give the ECB a green light to start tapering and the BoE to liftoff--so perhaps EUR and GBP aren’t the best choice there--CAD might be in the same camp, where the newly hawkish Poloz is taking no prisoners.  

I’ll stick with my long standing bearish view of JPY and KRW, both of which don’t seem ready to rock the boat--I think EMFX could continue to do well if Chinese demand holds up--and I wouldn’t expect the Fed to hike strongly enough to stop global growth momentum--but I do think there’s a reasonable case for a return to rates, curve spreads and fx levels from earlier this year.

Despite the potential for a coordinated tightening of monetary policy, we should expect some convergence in front end interest rate spreads relative to the move in the dollar.

That’s it from fly-over country….good hunting!   

Shawn
TeamMacroMan2@gmail.com

@EMInflationista