The pace of inflation has been coming down.

But over the next few months the pace of inflation is probably going to increase as a result of base effects.

If this happens, will the Fed ignore it, raise rates some more, or simply keep policy tight?

Let’s have a look.

Base effects

What are base effects?

Base effects are a phenomenon in economics where the year-on-year inflation rate appears to be unusually high or low due to a significant change in the underlying price level during the previous year.

This effect occurs because inflation rates are typically calculated by comparing the current prices of a basket of goods and services to the prices of the same basket in the previous year.

If the previous year had an unusually low inflation rate or even deflation (negative inflation), the subsequent year's inflation rate may appear higher than it actually is, even if the actual price increases in the current year are not exceptionally high.

And this is likely to be the case over the next six months.

Consider the table below and the monthly percentage changes in CPI last year - the relevant months (year on year) are circled in red.

Now consider that monthly inflation is currently well above those levels and unless we see disinflation over July/August and November/December this year, the base effects (or denominator) will make inflation appear higher than it actually is.

Equally, base effects can also work the other way, i.e., if the previous year experienced unusually high inflation, the subsequent year's inflation rate may appear lower than it actually is, even if prices are still rising at a decent pace.

Looking at the same table, this could happen when we roll into the first quarter of 2024.

If the monthly percentage changes in January and February 2024 are materially lower than the 0.8% and 0.6% rates that printed in January and February 2023, base effects will make inflation look lower than it actually is.

Clearly, the Fed is aware of the illusory nature of base effects, and they are likely to happen next month and over the next 5 months - and at the same time the Fed also has an agenda to get inflation back to its targeted 2% to 3% range, pronto.

A couple of questions spring to mind.

1. Could the Fed use these illusory effects to justify a harder stance on interest rates in 2023 (more hikes beyond the one already priced in)?

2. And how has the Fed dealt with base effected inflation spikes in the past?

The Fed’s historical reaction to base effects

Dealing with question 2 first, we can’t really look for evidence in 2023 because the trajectory for interest rates has been up every month, other than for one skip in May 2022.

Looking at 2022 is also meaningless because interest rate hikes only started in March 2022, after 12 months of inflation of over 2% (from 1.7% to 2.6% in March 2021).

However, tabled below are some periods in U.S. history where temporary inflation spikes caused by base effects occurred - along with the policy response.

Inflation spikes in the 1970s and early 1980s were notable examples where the Fed responded with quick tightening to address rising inflation.

Clearly the Burns, Miller and Volcker Feds were more hawkish and came from the ‘shoot first, ask questions later’ school of popular thought.

However, in the 1990s, early 2000s, mid-2000s, and the 2021 inflation spike, the Greenspan, Bernanke and Powell Feds all adopted a more patient approach, considering the inflationary pressures as transitory and focusing on the broader economic outlook.

The Jedi mind trick probability

Question 1 is more difficult to answer.

While the historical instances cannot be entirely attributed to base effects alone, it is fair to assume that unless the Fed sees demand and NASDAQ roaring along it may simply ignore the base effects and raise once more this year and be done with it.

But the problem is that NASDAQ is already roaring and mooning plus energy and food prices are climbing once again, and unemployment is still stubbornly low.

Plus, the Powell Fed (which long ago retired the word ‘transitory’) has shifted the narrative back to being data dependent. Maybe this was in anticipation of base effects, maybe not.

In any event, the Powell Fed has given itself latitude to consider policy, meeting to meeting, so if the August inflation print is substantially above 0% (which it probably will be) and if risk markets continue to moon and Powell feels he can summon his inner Jedi, there could be more interest rate tightening this year than what the market is currently pricing in.

The probability of that is not zero. But as always, we’ll have to wait and see.

See you in the market.

Mike