Inflation: All About That Base

According to Bloomberg, markets are expecting inflation to reach 7 percent when the December numbers are announced on Wednesday. That sounds pretty scary. If the forecasters turn out to be correct, how scared should we be?

There are two ways to answer this question. We can think about the economic implications. Or we can think about the implications for Fed behavior. Let’s try to consider both aspects, but really quickly, since the Fed announcement is coming soon.

Start with the economic implications. A 7 percent reading should be a major embarrassment for Team Transitory, who just a few month ago forecast that the December rate would come in at …. 2 percent. But we know that the Team is tenacious. So be prepared for more stories from them about how inflation really will go away soon. Truly. Promise. We just need to be patient. The Fed doesn’t need to do much of anything at all.

Um, sure. That could happen. Inflation could just disappear on its own. Usually that doesn’t happen. But, hey, this time could be different! So, we need to look at the evidence, to see if there are any signs inflation pressures are abating. We’ll get some major clues tomorrow.

In interpreting these clues, we’ll need to be careful. Look at the chart below. It shows that month after month inflation just continues to climb. In November, the rate reached 6.8 percent. So, if it reaches 7 percent in December, then clearly inflation pressures are continuing to rise. No?

Actually, no. Normally, this way of looking at things is perfectly fine. But in 2020 some strange things were happening to the price level. When the pandemic first hit, people were locked down, and no one was going out and spending, prices actually fell for a few months. Then when the lockdowns ceased, prices quickly rebounded.

These gyrations are affecting – one could say, distorting – the year-on-year numbers. So, to get a clearer picture of what is happening to inflationary pressures, it is better to look at the month-on-month numbers. Here’s the chart.

This chart naturally tells a more complex story, since month-to-month (m-m) movements are always a bit erratic. That’s why people normally prefer to look at the year-on-year numbers! But we can still see two distinct periods. All the way through February 2021, inflation was subdued. Then, starting in March 2021, when the vaccines became widely available and people started to go out and spend, inflation shot up. It has remained high ever since. Specifically: in the nine months from March to November, inflation has averaged 0.65 percent per month.

So let’s make a simple assumption. Let’s assume that inflation stays at this rate until March 2022. What happens to year-on-year inflation? The answer is in the chart below. You can see that in December, it climbs above 7 percent, then keeps rising until it reaches 8 percent in February-March!

To be clear: this is not a prediction. We leave predictions to others. Our point is analytic, namely that the yearly inflation rates could rise over the next few months, even if (monthly) inflation pressures remain the same. This phenomenon is known as the “base effect”. What’s going on is that the 12-month inflation rate is rising simply because as we move toward March the months of low inflation in early 2021 are dropping out and being replaced by months with much higher inflation rates.

We are now in a position to answer the question posed at the outset. If inflation increases to 7 percent in December and even 8 percent over the coming months, it doesn’t not mean that inflation is lurching out of control. No need to be that scared. But neither of course would it be cause for any cheer. Instead, such numbers would imply that inflation pressures are remaining high, rather than easing as Team T expects.

How will the Fed react? It’s unlikely that a run of high inflation numbers over the next few months would really change the Fed’s analysis, as it is firmly on the side of Team Transitory. But the Fed reacts not only to its own analysis; it also reacts to public pressure. And if the public sees the “headline” inflation number keeps rising toward 8 percent, the pressure on the Fed to tighten its stance to will intensify. Sharply. At some point, the Fed will finally need to respond — far more quickly and far more forcefully than it is currently planning. (See my earlier post on this.)

Meghan Trainor told us long ago that it’s all about that base. But that was some time ago. So consider this a reminder: focus on the month-on-month number to see if inflation pressures are rising or easing. But focus on the year-on-year number to see how the Fed will react.

And hang on to your hat. Because the Fed’s got that boom boom.

You’re welcome.  

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