Inflation is one of the most hotly debated topics in markets right now.
However, it is starting to become a weird indicator to track as the year overlaps with the worst parts of the pandemic. This is means inflation indicators such as the consumer price index (CPI) and the producer price index (PPI) are being measured against a low base which will exaggerate inflation change as we slowly return to normal.
Inflation is simply the rate of change in prices over time, and while that seems simple and straightforward, it really isn’t. If can’t live with ‘em, can’t live without ‘em were an economic indicator, it would be inflation.
This is because excessive inflation, especially when it is not kept up with through rising wages, results in prices growing at a faster pace than wages, which decreases consumer buying power. If allowed to run wild, this is an income earner's worst nightmare, especially those in the middle and lower class, as 63% of Americans live paycheck to paycheck.
High increases in costs from "hyperinflation" can have an outsized effect on those who have no economic breathing room. This drastically change a country from the ground up by exacerbating socioeconomic issues which predate its onset. In Venezuela, where hyperinflation has run wild since 2017, a massive 5 million people have left the country in search of more stable conditions.
However, on the other side, persistently low inflation signals that the economy is growing slowly and isn't reaching it's full potential. When inflation is too low for too long, it’s a sign that a country isn’t reaching capacity, meaning the economy could handle more jobs if there was more money floating around the economy. Fewer jobs results in lower productivity and slower economic growth.
In recent times, the target rate of inflation in many developed economies has been 2% annually. This rate is deemed high enough to foster economic growth, without creating an overly large burden on wage earners or lenders. However, despite any number of warnings that hyperinflation was right around the corner, the Federal Reserve has admittedly had trouble getting inflation to rise to even that modest level of 2% in the decade and a half since the Financial Crisis.
This brings us to our next topic, the base effect.
The base effect is when growth appears exceptionally high because the rate it is being compared to was exceptionally low. Inflation is monitored on both a monthly and yearly basis, but economists prefer the year-over-year numbers to the monthly ones, which is great when the economy is growing, but can provide misleading figures to the untrained eye during economic downturns.
Month-over-month price swings can be exaggerated by isolated incidents which cause higher volatility for a short period of time. The recent Suez Canal fiasco is a great example of why economists prefer the yearly figures. During March, producers faced an unexpected kink in the supply chain which gave producers higher costs of doing business. Month-over-month, final-demand PPI increased by 1.0%, doubling February’s growth of 0.5%.
Because of this, economists prefer to compare to the yearly numbers. But, the numbers from this point in 2020 reflect the worst of the recession. In April 2020, CPI plummeted 0.7%. After increasing in eleven of twelve trailing months, March 2021 numbers showed 2.6% growth since March 2020, which, in a normal year, would be a red flag. Barring deflation, April and May CPI numbers are set to be just as deceptive as they will also be showing exaggerated growth figures.
So be careful when entertaining arguments that are using these year-over-year growth figures to make a point. People are already warning that the unprecedented level of stimulus spending will lead to high inflation, but measured against a economy that was brought to a sudden stop, the number for the next few months are likely to be misleading.
This also doesn’t mean to discount the numbers completely. Unprecedented spending could come with unprecedented outcomes, however, we aren’t yet at a point where these numbers are sustained. So if someone is selling Armageddon without even acknowledging the base effect’s influence, it might be time to find a more objective and straightforward news source.
