What Are Base Effects?
And Is Inflation as Bad as Headlines Indicate?
According to the latest data from the Bureau of Labor Statistics released Wednesday morning, the Consumer Price Index (CPI) rose 3.7% over the prior year in August, an acceleration from July's 3.2% annual increase. But we expected this because of “base effects”, and so the numbers may not mean what most people think they mean.
Inflation "base effects" refer to the impact of past changes in the price level on current inflation calculations. These effects can distort the interpretation of inflation data and make it difficult to assess the true underlying inflation trend. Base effects occur when the inflation rate for a particular period is compared to the inflation rate for the same period in the previous year, and the comparison is affected by unusually high or low price changes in that previous year.
Here's how base effects work:
Low Base Effect: If in the previous year, prices were unusually low for a certain period, the inflation rate for the current year might appear higher than it actually is when compared to the previous year. This is because the current year's prices are rising from a lower starting point. This can make it seem like inflation is accelerating, even if it's not.
High Base Effect: Conversely, if in the previous year, prices were unusually high for a certain period, the inflation rate for the current year might appear lower than it actually is when compared to the previous year. This is because the current year's prices are rising from a higher starting point. This can make it seem like inflation is slowing down, even if it's not.
Base effects can distort the perception of inflation's true direction and can be particularly relevant in economic analysis and policymaking. Economists and central banks often try to account for base effects when assessing inflation trends to avoid making policy decisions based on temporary fluctuations. Seasonal adjustments and core/super-core calculations are among the techniques used to mitigate the impact of base effects and obtain a more accurate understanding of inflation trends.
That said, if we look at month-over-month data, the present report is for a 0.6% increase in August versus 0.2% in July. If you annualize these numbers, then that’s 3.6% for August versus 2.4% for July. That’s still an acceleration of inflation despite the year-over-year base effects and 80% higher than the Fed’s target rate. However, the monthly numbers could also be influenced by the base effects of the seasonal adjustments and other manipulations meant to make the annual changes look less bad. That’s the problem of using government numbers — it’s hard to keep the manipulations sorted out.
That’s why I developed my own custom inflation gauge which takes into account lots of things that the government reports don’t. It uses the personal consumption expenditures index (PCE), import prices, export prices, gross domestic product (GDP), output gap, M1 currency supply, and the 10-year Treasury yield.
According to this indicator, peak inflation during the Housing Bubble in August 2006 was 8.6% and the Taylor rate (the rate presumably needed to quell inflation) was 15%. At the time, the Fed had gotten the Fed Funds rate up to about 5.4%. But by the middle of 2007, the falling stock market induced them to start cutting rates and increasing the currency supply, but it was too little too late to save the bubble. Currency velocity started falling in mid 2008 and that precipitated the crash. The severe contraction in credit and mass bankruptcies brought inflation back down despite the Fed Funds rate never getting anywhere close to the Taylor rate.
Also according to this indicator, the actual inflation rate today is around 25% and the Taylor rate is about 35%. That is, the Fed funds rate should be at 35% in order to bring the economy back into balance and end inflation. It's currently at 5.25%. That said, monetary inflation (green line in the chart) has come down from the stratosphere and is actually negative now, so currency supply is contracting, i.e. deflationary. That has helped to bring inflation down from almost 80% in November 2021 (according to this gauge) and it could still go lower if the Fed sticks to its tightening policy in the face of signals of significant economic recession. The output gap (grey line) is continually increasing (going more negative) as recession deepens. Currency velocity (mustard line) is increasing as people have less and less currency to spend.
Overall, the signal (blue uptrend, gold downtrend) is deeply disinflationary (just shy of -100%) right now and may turn to actual deflation during a panic crash in which banks and other companies go bankrupt and lending is brought to a standstill. As you can see in the chart, this signal can remain pegged to -100% for a period of months during disinflation or deflation (like in late 2019, early 2020). I would anticipate that the recent little tick up was just a “dead cat bounce” and that the economy is probably about to lock up with severe liquidity issues.
In response to a major panic, the Fed will very likely step in with emergency rate cuts and quantitative easing (QE), and then inflation will go stratospheric again, but until that happens, inflation is not my proximal concern. The effects of inflation are certainly still a hangover on the economy, but the near-term threat is total global economic collapse as a result of tight monetary policy popping the copious and pervasive bubbles affecting every sector and financial asset class, particularly stocks and commercial real estate. This will be like the Dot-Com Crash and Housing Crash combined. Worries about inflation should take a back seat until that happens.
CPI is too manipulated to use as a realistic gauge of inflation due to base effects as well as manipulations such as seasonal adjustments, substitutions, hedonic adjustments, weighting, excluding food & energy, etc. Looking at the more holistic view provided by my inflation indicator, it’s clear that although inflation ticked up an insignificant amount recently, the major threat remains disinflation and deflation, as the bubbles holding up the economy are being starved of the liquidity needed to keep them inflated. To save face vis-à-vis their hawkish inflation-fighting stance, the Fed will not act to provide the needed liquidity until Humpty Dumpty has already fallen off the wall, and then it’ll be too late. They will inflate, but not before we suffer a deflationary crash, it won’t repair the popped bubbles. It’ll only inflate new ones (if they’re lucky) or destroy the currency permanently.