May 25, 2021
By Dr. George CalhounHanlon Advisory Board MemberExecutive Director of the Hanlon Financial Systems Center
Download the PDF version of this Educational Series.
“Everyone knows that the headline [inflation] number will look bad for the next few months…” – John Authers, Bloomberg (April 14)
Everyone knows? Apparently much of the media do not know.
They do know – or at least they tell us – that “Real Inflation is coming!” With the publication of the April “headline number” today – a robust 4.2% – the headlines are shouting it:
- “Consumer prices rise in April, stoking worries about an overheating economy” – Washington Post (May 12)
- “Consumer prices jumped in April, climbing faster than economists had expected.” – New York Times NYT +1.9% (May 12)
- “US Inflation Rises 4.2% in April: Highest Since 2008…Will Stoke Further Surges” – Financial Times (May 12)
- “U.S. Consumer Prices Jump Most Since 2009, Outpacing Estimates” – Bloomberg (May 12)
But does the number make inflation “look” worse than it really is? Is there something wrong with the metrics?
The authors of this rather famous study (two Federal Reserve economists!) used “high frequency” (tick-level) price data to craft a day-trading strategy (“buying the SPX at 2 pm the day before a scheduled FOMC announcement, and selling 15 minutes before the announcement”). This alpha was unusually potent.
The Consumer Price Index is the single most important economic statistic there is. The CPI sets the Cost-of-Living Adjustment (COLA) for Social Security payments going to 60+ million Americans, along with adjustments in labor contracts and private pensions for tens of millions more. It sets the interest rate for half a trillion dollars of Inflation-Protected Treasury Bonds (TIPS). It defines the inflation target that is the principal focus for monetary policy decisions by the Federal Reserve, influencing policy measures controlling many more trillions of dollars. It is the tripwire for decisions to raise interest rates. If the measurement of this fundamental quantity is flawed, and the number is not what it seems, it creates a problem far larger than a statistical quibble.
Let’s break down these questions.
- What is the “headline number”?
- Why will it “look bad”? Why for only a few months?
- How exactly does the headline number distort the true picture?
- Does this distortion really matter?
The Headline Number
Any measure of inflation is in reality a bundle of assumptions and adjustments, masquerading as a Concrete Fact. There are many ways to construct this Fact, and many different “numbers” that may wear the “inflation” label.
The so-called Headline Number – the Consumer Price Index– is the simplest version, with the fewest adjustments. The CPI tracks the price of the consumer’s “basket” of regularly purchased goods and services, which correspond to an assumed basic standard of living in the community. The basket includes obvious day-to-day consumables such as groceries, clothing, utilities, as well as bigger-ticket items like housing, college tuition, taxes, and services like health care, insurance… There are other measures but the basic CPI remains the version of “inflation” that captures the most attention in the media.
Why Will the CPI “Look Bad” for the next few months?
The CPI has averaged about 2% for the past decade. However, last year it was only half that, as the pandemic crushed consumer spending and drove down prices.
The pandemic impact hit in March 2020. By May, the CPI was down 2.25% from the start of the year. It recovered its original trajectory 6 months later, in September. We can compare the actual CPI with what it would have been if the pandemic had not depressed the numbers from March through August of last year.
The Base Effect
This creates a phenomenon known as the “base effect.”
The year-over-year calculation for the Headline number is very simple:
If the pre-pandemic trend had continued, the calculation would have been different:
The year-over-year comparison is exaggerated because of the dip in the prior-year. The March 2020 number was about 0.4% lower than the trend-line.
Is It Really That Bad? – Yes, The Inflation of Inflation
The base effect thus adds about 0.4% to the calculated CPI for March 2021. The reported CPI was 2.637%. Remove the base effect, and “inflation” would have been only 2.231%. The reported “official” inflation figure is 18% higher than it “should have been.”
It will indeed get worse (“look bad”) in the next several months. The “compensatory” bulge will grow to nearly 1.4% “too high” when May’s numbers are reported next month.
Of course the actual headline number could be higher, or lower based on “real” price trends. But whatever the May numbers show, they will be “inflated” by the base effect about 1.4% in absolute terms – which is a big discrepancy.
Another way to look at it is that May’s number will likely be something like 50% higher than it “should be.”
What is the Impact of an Inflation Figure That “Looks Bad”?
- “Simple Math Is About to Cause an Inflation Problem” – Washington Post
April’s 4.2% headline inflation figure would look more like 3% – if the base effect is taken into account. A 3% rise is still a healthy uptick (for other reasons, see the next column), but far less alarming that 4.2% — a level not seen since 2008.
Is it a real alarm bell? Ask yourself: If you had a blood pressure monitor, say, and you knew it was giving a false reading 50% higher than it should be, would you still rush to the emergency room?
The CPI is going to give us a false reading (“look bad”) for the next few months. It will be artificially inflated. Shall we pretend not to understand this?
The Fed knows this is coming. Jerome Powell emphasizes that the effect is both artificial and temporary, and that it has no long-term significance.
- “We think inflation will move up in the near term [because of] the base effect. Twelve-month measures of inflation are likely to move well above 2 percent over the next few months as the very low inflation readings recorded in March and April of last year drop out of the calculation. These base effects will contribute about one percentage point to headline inflation and about 7/10 of a percentage point to core inflation in April and May. They’ll disappear over the following months. And they’ll be transitory. They carry no implication for the rate of inflation in later periods.” – Powell’s April 28 Press Conference
Powell has it right. Most private economists agree. The economy’s real problem is still the crippled labor market, not a phony inflation spike.
- “For the economy as a whole, payroll employment is 8.4 million below its pre-pandemic level. The unemployment rate remained elevated at 6 percent in March, and this figure understates the shortfall in employment, particularly as participation in the labor market remains notably below pre-pandemic levels.”
These sensible, sanguine views may not be enough to hold off the panic. If we see distorted headline numbers – up to even 4 or 5% for a month or two – the media will play them up. (They aren’t called “headline numbers” for nothing.) Pundits and experts, from the dubious (Larry Summers) to the legendary (Warren Buffett) will provide name-brand scare-quotations. James Mackintosh, The Wall Street Journal’s lead investment analyst, is in melt-down.
- “Everything Screams Inflation: Investors are woefully unprepared for what may be a once-in-a-generation shift in the market… Investors will lose horribly … a loss of spending power … extremely painful …would be massacred….”
The real risk is that regulators, politicians, and investors will react to these quasi-fake-news headlines, and take steps that make things worse. The markets will sell off, in fear of the Fed capitulating and starting to tighten. Bonds will sell off, because maybe the inflation is real… Unhelpfully, and inappropriately, Janet Yellen suggested last week that interest rates should be raised to prevent “overheating.”
This is the real risk here.
- “Raising interest rates — the Fed’s traditional anti-inflation tool — would chill all sectors, not just those afflicted with rising prices. In the Fed’s view, enduring a temporary bout of higher prices in some industries is the price of a full economic recovery.”
A rate rise might cool off the housing market, and bring down the price of lumber, say – but is that what we deem “success” here? Is a “supercycle” of rising commodity prices really something to fear? Or is it to be welcomed as a sign of a revival of demand and a robust economic recovery in the making?
Hopefully, the market will find its footing, and refocus on the powerful economic recovery that is underway, and a couple months from now, the inflation panic will have subsided as the numbers fall back to the trend line.
Still, there is something shocking about all this. The current CPI is a defective measure, for many reasons. The “base effect” is one of the worst of its flaws, because it is so obvious, so meaningless, and yet so consequential.
Hanlon Investment Management is an SEC registered investment adviser with its principal place of business in the State of New Jersey with offices at 3393 Bargaintown Rd., Egg Harbor Township, NJ 08234. Being a registered investment advisor does not imply any level of skill or training. This material should not be construed as an offer to sell or the solicitation to buy any security. We are not soliciting any action based on this material. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. Hanlon Investment Management and its representatives are in compliance with the current registration and notice filing requirement imposed upon registered investment advisers by those states in which Hanlon Investment Management maintains clients. Hanlon Investment Management may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by Hanlon Investment Management with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status, service and fees of Hanlon Investment Management, please contact Hanlon Investment Management or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).
For additional information about Hanlon Investment Management, including fees and services, send for our disclosure statement as set forth on Form ADV from Hanlon Investment Management using the contact information herein. Please read the disclosure statement carefully before you invest or send money.