Inflation and Base Effects

By Rob Arnott

In January, we posed a thought experiment: what if inflation during 2023 flatlines, with every month matching the trailing three-year average? The answer was an earlier version of the chart below. The gold line answers the question: flatline inflation during 2023 yields anything but a flat line for year-over-year inflation. Inflation would have been expected to tumble to 2.9%, then rebound to 5.7%. ?We described this as our base case.? Of less relevance, if monthly inflation was zero every single month in 2023, year-over-year inflation would’ve tumbled to near zero by June, finishing the year at (of course) zero, as shown in the pale green line.

It’s all about base effects. Inflation in the first half of 2022 approached 13% per annum, and in the second half of the year was near zero, allowing us to finish the year at 6.5% year-over-year inflation. Trailing three-year inflation averaged 47 basis points (bps) per month. So, if we replace 1% monthly inflation with 47 bps, inflation gives us an illusion of freefall down to 2.9%. In the second half of 2023, if we replaced near zero monthly inflation with 47 bps, inflation rebounds to just under 6%.?

The prognosis today is better. The year-to-date reality, in blue, almost exactly matches our January base case, until the startlingly benign monthly report for October. The near perfect fit in this graph is more luck than skill. We have no special prescience on monthly inflation. Inflation this year has averaged 36 bps per month, not far from our 47 bps base case.

That 5.7% base case at the start of the year is certainly too pessimistic today. The red dashed line is the current equivalent of the gold line from the start of the year, replacing January to October with actual results. If November and December match the trailing three-year average, do we wind up anywhere near 3.2%? No, that would require zero inflation in the closing months of the year. Even with just a couple of months of inflation matching the three-year average, the red dashed line shows that we finish the year at 4.2%.

With increasing confidence, we would now expect inflation to finish the year near, and quite possibly above, 4%. Will the Fed, the media, and our political leaders continue to do victory laps, if we finish the year at 4.2%? I think not. Longer term, we believe inflation will moderate at slower pace than consensus due to two risks that garner too little attention:

·???????? Shelter inflation, roughly one-third of CPI, remains stubbornly high at just under 7%, even though home prices and rents have gone flat in the last year.? This is by design.? The two largest components of shelter, OER (owners’ equivalent rent) and RPR (rental of primary residence) are deliberately smoothed and lagged.? OER may be catching up for some time to come.? Again, many Wall Street and Fed economists are behind the curve on this reality.

·???????? Also, war is usually inflationary. While the inflation of 2022 really got out of hand after the Ukraine invasion, and resulting spike in energy prices, the Israel-Hamas war has yet to exact its toll.

[Disclosures: https://bit.ly/3hT1PuD]