Inflating Inflation Expectations

Rising prices feature in many economic forecasts for the US. It is seen as part of the reflation meme as the vaccines roll out. There seem to be three threads to the discussion.  

The first is practically mathematically certain. Economists refer to it as the base effect. As the pandemic struck and the economy shut down, prices fell. Headline CPI fell by 0.4% in March 2019, by 0.8% in April, and another 0.1% in May. The PCE deflator, which the Fed targets, fell by 0.3% in March and by 0.5% in April. It rose by 0.2% in May. 

The point is the negative prints will drop out of the year-over-year comparisons, and barring a new sharp economic downturn, they will be replaced by higher numbers. This will be reflected in an increase in the year-over-year rate and provide the grist for an inflation scare. In the four months through November, headline CPI has risen by an average of 0.2% a month. The PCE deflator has risen by about 0.1%, on average, over the same period. 

What the base effect gives it can take away. Headline CPI increased by 0.6% in June and again in July before rising 0.4% in August. The core rate rose by 0.2% in June, accelerated to 0.6% in July, and rose by 0.4% in August. The forces that lift measured inflation in spring ease in the summer and return in Q4 2021. The headline and core PCE deflator were flat in October and November. 

The second thread is that the kindling for inflation exists and will likely ignite in the period ahead. Economists seem to differ over the exact nature of the kindling. Some still insist that the creation of reserves with which the central banks buy assets is inherently inflationary, even though before the pandemic, the Federal Reserve, most European central banks, and the Bank of Japan were having grave difficulty in achieving their inflation targets. In the US, real interest rates (minus inflation or inflation expectations) is below zero. Moreover, although US nominal rates have fallen below zero (like Europe and Japan), its real rates are negative and more so than in Europe and Japan.  

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Read more by Marc on his site Marc to Market.

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