Is inflation on the horizon?

As consumers, we’ve undoubtedly seen inflation creep into our daily lives. Certain products appear more expensive than they were a year ago, or potentially just a few months ago. Is inflation here to stay, or is it a short-term phenomenon caused by ample liquidity and supply constraints as the economy reopens?

Reade Pickert, of Bloomberg News, discusses this topic in his article, “How Simple Math Can Be Casting an Inflation Illusion,” an article we found particularly interesting. Reade explains why inflation numbers seen in newspaper headlines may be deceiving, given how low these same figures fell in the midst of the COVID crisis.

“How Simple Math Can Be Casting an Inflation

By: Reade Pickert

No economic question is being debated more hotly right now than whether the U.S. will see a sharp rise in inflation. But the answer at least for a few months is simple: Yes.

Due to the way the government’s inflation metrics are calculated, what will appear to be significant price increases are all but guaranteed. The phenomenon is known as the base effect, a term worth keeping in mind when new figures make the argument even wilder.

Year-over-year comparisons are already appearing as large jumps for a host of economic indicators — in the U.S. and, for that matter, elsewhere in the world — after the pandemic and related business shutdowns curbed activity during the same periods in 2020. But arguably no data point is more in the spotlight on this front right now than inflation.

1.     What is the base effect?

Inflation metrics are calculated on both a month-over-month and year-over-year basis. Economists and investors tend to look at the year-over-year figure, since there can be a lot of monthly volatility. But what happens when the month you’re harking back to coincides with the onset of a global pandemic? That’s where the base effect comes into play. Price indexes fell in March and April and stayed low in May amid lockdowns and widespread business closures. And while prices soon began picking up, the year-over-year increases for March-May will appear abnormally large as the figures are compared to the very low readings of last year.

2.    How would that work?

For example, the unadjusted consumer price index (CPI) plummeted 0.7% in April 2020 from the prior month, the steepest drop since the end of 2008. That brought the index down to 256.389, just 0.3% higher than a year earlier. Since then, the gauge has risen in all but one month. In February, it stood at 263.014. The base effect exaggerated a stronger-than-expected pickup in prices, with the year-over-year measure climbing in March by the most since August 2018. Even in the unlikely event that the unadjusted CPI stays flat in coming months, the index will be up 3.3% in both April and May from a year ago. Despite expectations for a modest rise in prices from the prior month, the median forecast in a Bloomberg survey of economists is for the year-over-year measure to surge to 3.6%.

3.     Which figures will it impact?

For one, the CPI figures. The CPI, which was up 1.7% in February from the prior year, was up 2.6% in March in part due to base effects. The April figure, out May 12, will be biased even higher. The CPI is a weighted “basket” of consumer goods and services. Its goal is to give a sense of to what degree the average American’s out-of-pocket spending is being affected by price changes. For instance, even if the price of breakfast cereal spikes, because it only makes up about 0.1% of the basket, the impact on the overall measure is modest.

4.    Is the CPI the only figure that matters?

No. Economists often look at the “core” measure, or the CPI index minus food and energy — categories that tend to be volatile. The core CPI rose 1.3% in February from the same month last year and 1.6% in March. It’s expected to jump 2.3% year-over-year in April. There’s also the personal consumption expenditures price index (PCE) that includes some things the CPI doesn’t, like medical care paid for by employer-sponsored insurance and Medicare. Because of the base effect it’s also poised to pop, though more generally it tends to rise at a slower pace than CPI. This figure is also important because it’s what the Federal Reserve uses as the basis for its 2% inflation target. While the PCE price index has had periods of briefly rising above 2%, the measure has largely held under 2% for more than a decade. The figure rose 1.5% in the year through February but advanced above the Fed’s target in March to 2.3%.

5.     What’s the worry?

The outsize numbers will come on the heels of a $1.9 trillion pandemic relief package signed by President Joe Biden, and in the midst of an intense debate about the path of inflation. Economists and Fed officials have warned about the illusory readings expected due to base effects, but that likely won’t stop some from viewing the figures as a confirmation that inflation is surging.

6.     But will I still see prices rise?

Yes, some prices are likely to go up, perhaps sharply, for some period of time. That’s due to two ways that the pandemic has disrupted the economy. Producers are citing huge jumps in materials costs, and some companies have already said they plan to pass these costs along to consumers. Aside from merchandise, a surge in pent-up household demand for services such as airfares, hotel stays and theme park visits in the wake of widespread vaccinations is set to push those prices higher. A massive buildup of excess savings along with the latest stimulus package have also lined the wallets of many Americans who are ready to spend.

7.     So, real inflation is coming?

Maybe. Whether any price increases that the end of the pandemic generates will be sustained — a key component of inflation in terms of policy making — is unclear. In addition, there are questions of how accurate inflation measures like CPI have been amid rapid changes in consumer spending habits.

8.     What does the Fed think?

To some extent, a pickup in inflation would be welcome news for the Fed. Even at the tail-end of the longest U.S. economic expansion on record, inflation in 2019 fell short of the central bank’s 2% target. Fed Chair Jerome Powell has talked about both base effects and the potential for a burst in spending to create upward pressure on inflation. ‘In both cases, we don’t see those as either lasting or particularly large,’ Powell said at a press conference in late January. Others aren’t so sure — instead expecting the price increases to last much longer than the jump due to base effects.”

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named author at the time written.  Actual economic or market events may turn out differently than as presented. © 2021 Madison Wealth Management