Commentary on Political Economy

Thursday, 12 August 2021


All About That Base (Effect)

The base effects on U.S. inflation from the traumatic events of early 2020 are beginning to pass out of the equation. As a result, it looks like inflation is just a little easier to predict. It doesn’t, alas, mean that it’s much easier to tell whether the current dose is only transitory or part of a secular upswing.​

One of the few benefits of the inflation scare of the last few months is that we are all far more familiar with the ingredients that go into the Bureau of Labor Statistics’ consumer price sausage. Here then is my attempt to give you a swift and impartial guided tour of the welter of information that the BLS publishes (and which you can play with to your heart’s content on the Bloomberg terminal).​

Most readers will already know the headlines. The most positive news is that core inflation (excluding food and fuel), was only 0.3% in the month of July, compared with 0.9% in June. That sounds good. Further, the headline number, including the hugely inflated fuel products, avoided a rise. It is still 5.4% year-on-year, as it was a month earlier. And the greatest relief for all concerned is that after three months of being blindsided by inflation numbers far higher than forecast, July’s​ was bang​ in line with average expectations.​

Note also that the gap between the highest and lowest estimates reported to Bloomberg has been growing wider. There is a big and confused spectrum of opinion. And while core inflation did dip slightly, it is still far above anything the Federal Reserve​ can accept for any extended period of time. This had better be transitory.​

Now, though, there are some more negative angles to take. After the last few months, we know far more about the different ways to slice and dice the inflation numbers. The Cleveland Fed produces a “trimmed mean” in which the biggest outlying​ components in both directions are excluded. It takes an average of the rest, and a median — the component in the middle of the distribution. Both are statistically legitimate ways to handle the fact that much of the rise in the headline number is concentrated in a few sectors that have obviously been badly affected by the pandemic, such as rental cars.

The bad news that both the median and the trimmed mean rose last month. To add to the confusion, they are sending contradictory messages. The median is still toward​ the lower end of its typical range for the last decade; the trimmed mean is its highest since the brief oil-driven price spike in the crisis year of 2008:

For further guarded good news, the BLS now publishes a measure for what might be called “core core” inflation, excluding not only food and fuel, but also shelter and used cars. The reason for excluding the last is that it has suffered eye-popping inflation since the pandemic started. Here again, the news is mixed. This measure​ strips out a lot that matters, but it does give some idea of underlying inflation. This measure has ticked down (good news), but it’s still sitting at a level never previously seen this century:

Going further into the guts of the report, we find that recreation, another sector that might be expected to see greater demand as reopening continues, has climbed to its highest level in decades. Maybe this is transitory, but it’s a new development:

Other transitory effects are still working to keep inflation lower. The persistent rise in college tuition fees, putting higher education further and further out of the reach of many Americans, has been a quiet, ongoing scandal. But colleges are having difficulty dealing with the pandemic, and many are discounting to try to fill campuses next month. As a result, inflation in this​ huge part of the household budget (for anyone who has to pay it, like me) has dropped to only 0.2%, its lowest since the series began 40 years ago:

Perhaps most important is shelter, which accounts for about a third of the entire index. The bad news is that it’s rising, as many had predicted. The good news is that it’s still not at any kind of alarming level. On this crucial measure, with many rental leases still not renewed since the start of the pandemic, it is quite possible that we will see significant increases​ ahead. But that remains a matter of conjecture, as does any suggestion that shelter costs will stay under control. It’s simply too early to say:

My main conclusion from this exercise is that compiling inflation statistics is a heroic endeavor. For all those who insist that inflation is being deliberately understated, or that the selection of products and services in the basket is unrepresentative, the BLS gives you all the data broken down so you can reconstitute it however you like. And going through the numbers reveals just how many different contradictory factors in different sectors of the economy are smooshed into one number.

For one favorite example, two sectors have suffered a sharp post-pandemic rise, and last month fell back slightly to 18% and 19% respectively. The two products in question: washing machines and airline tickets. Both have endured periods of outright deflation within the last year. And both have been rocked by (differing) transitory effects caused by the pandemic:

Reality is messy and resisting the attempts of bulls and bears to impose a pattern on it. Some extreme transitory effects appear to have peaked, but the fact that median and trimmed measures are still rising, and that the headline level is unchanged, suggest that inflation pressure is still growing, albeit at a much less startling rate than the headline number. We don’t yet know whether this is transitory or a secular shift.

Markets and Inflation

As for market reactions, they have calmed down somewhat. The dollar weakened slightly, and inflation breakevens barely moved, so investors don’t see this report as clarifying much. Intriguingly, the 50 U.S. stocks that are most strongly correlated with 5-year breakevens (in other words, that benefit from rising inflation), have started to pick up in the last couple of weeks, after lagging badly behind the broader market as the inflation scare abated:

Given some of the extreme trends afoot within the data, it remains fair to say that you are being offered a much more generous price for protecting against inflation than for protecting against deflation. And with inflationary pressure not abating, it is fair to expect the dollar to strengthen further in the weeks ahead.

The Post-Golden Age

There will be no Points of Return tomorrow, and instead there will be a special one on Sunday morning, to celebrate the 50th anniversary of Richard Nixon’s announcement in 1971 that he was unpegging the dollar from gold. It turned out to be the most consequential economic decision of the post-war era, and arguably one of the most crucial turning points.

One interesting question that comes up is whether it really mattered that much. Growth was much the same before and after the Nixon shock, and the U.S. remains firmly at the center of the global financial system. But one point made to me by Edin Mujagic economist at Dutch fund manager OHV who has just published a book (in Dutch) on the Nixon shock, is that the removal of gold discipline had a massive and immediate effect on government debt.​

He certainly has a point. This is federal debt as a proportion of gross domestic product, going back to 1945. You can indeed tell that something happened in the early 1970s:

Under the Bretton Woods system, the U.S. took the opportunity to gain control of the debt it took on to finance the war. In the 1970s, debt stayed roughly constant, as the lack of the limiting factor of gold was counteracted by the highest inflation in decades. But after 1981, when Treasury yields peaked (and the stock market troughed) as the sentiment took hold that inflation was at last under control, the buildup in debt was inexorable.​

As Mujagic says, it is hard to see how this would have been possible with the dollar pinned to gold. Even before projections for the debt taken on during the pandemic, by the end of 2019 gross federal debt was already bigger than GDP once more. The lack of the gold straitjacket, combined with confidence that inflation and bond yields can never rise, has helped a massive increase. While yields and inflation stay so low, that isn’t a problem. Should they start to move up, the world economy might be in need of another shock.


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