The Coming Arc of Transitory Inflation

Transitory is defined as being of brief duration, tending to pass away and not persistent. The problem facing the FOMC is that the four factors driving the current wave of inflation will each have a different and longer shelf life. Base Effects are contributing to the near term surge in headline inflation and will prove transitory. Supply chain disruptions will also be transitory but will last longer than Base Effects, so they will offset some of the initial unwinding in Base Effects. Core inflation is likely to continue to increase as service and shelter inflation trend higher. Finally, a number of factors are coming together to lift wage inflation in coming quarters as the reopening of the economy progresses and companies pay more to attract workers. As these four factors unfold headline inflation is unlikely to recede as much as expected and core inflation will hold significantly above the Fed’s 2.0% Core PCE target for the balance of 2021.

Base effect inflation – Temporary and Resistant

In the April and May issues of Macro Tides I discussed all the reasons why headline CPI inflation was poised to jump. “The increase in headline CPI inflation will exceed 3.0% and could approach 3.5% in the next few months and generate attention grabbing headlines.” On Wednesday May 12 the Bureau of Labor Statistics reported that the headline Consumer Price Index (CPI) for April soared 4.2% from a year ago. Base Effects played a big role but some of the comparisons were historic. The surge in the headline CPI was led by Energy prices which jumped 25% from a year earlier, including a 49.6% increase for gasoline, and 37.3% for fuel oil.

The plunge in the CPI in March and April in 2020 was due to falling prices for energy, airfares, hotels and motels, car rentals, events that attract large crowds i.e. sports and entertainment shows, and food prices in restaurants. The chart above illustrates the contribution to the decline in the headline CPI last year by showing the previous 5-year average growth in light blue. Last year these factors subtracted more than -1.5% from the CPI in April and May. The CPI uses a 12 month year over year calculation so the -1.5% reduction last year is adding +1.5% now. As the calendar moves beyond May the sling shot affect from Base Effects will subside.

One way to remove the volatility of Base Effects is to compare prices now to prices in January 2020 before the Pandemic shut down the economy. Most of the items that are much higher than they were in January 2020 are not likely to decline much in coming months with the exception of propane. Restaurants scrambled to buy outdoor heaters so they could serve diners outside their restaurants and needed propane to keep customers warm. They won’t need them once they can serve everyone indoors especially during the summer months. Most of the items that were hit the hardest and are still well below their January 2020 price level are going to recover, although it will take time for public transportation. As workers return to the office, they will be shopping to update their wardrobes, and just about everyone will be jumping on an airplane to go anywhere.