Has the inflation peak been exceeded? The misleading base effect

By Pablo Duarte, Senior Analyst at Flossbach von Storch Research Institute

For at least a year and a half, inflation has been rising faster than central banks can tolerate. The central banks of the largest industrialized countries have had to tighten monetary policy to counter inflationary pressures that they initially considered temporary. In recent weeks, the fall in the US inflation rate sparked euphoria in the markets because it generated expectations that the Federal Reserve might slow down its pace of monetary tightening. But is inflation really coming down or are we just seeing a base effect because inflation rose so fast last year?

Inflation and base effect

Inflation is defined as the change in a consumer price index over the same month of the previous year (YoY%). In the United States, for example, October 2022 inflation was 7.8%, the percentage change in the Consumer Price Index (CPI) from October 2021 (276.59) to October 2022 (298.06) (Fig. 1).

Figure 1. U.S.: Inflation Rate and CPI

The changes in the inflation rate thus reflect not only the current inflation dynamics, but also those of the last twelve months. The inflation rate in the United States fell from 8.2% in September to 7.8% in October, a change of - 0.4 percentage points. This change results from the difference between two monthly rates of change: +0.44% between September and October 2022 and +0.84% between September and October 2021 (0.44% - 0.84% = - 0.4%). As the CPI rose less between September and October 2022 than between the same months of the previous year, the inflation rate fell. The base effect caused the inflation rate to decrease.

Base effect in the U.S. and in the Eurozone

Since the evolution of the inflation rate depends, by definition, on the dynamics of the previous month, it is possible to see a falling inflation rate, even if inflationary pressure has remained constant from one month to the next. As an example: the inflation rate for October 2022 in the United States was 7.8%. Thus, the average monthly change in the CPI was 0.62%. Assuming that the CPI maintains its pace and grows by 0.62% each month from November 2022 onwards, the annual inflation rate would continue to fall initially (Fig. 2). This fall in inflation would be the base effect. From July 2023 onwards, the inflation rate would rise again because this time the monthly variations would be higher than in the same months of the previous year. The inflation rate would then reach the annual value of 7.8% as of October 2023.

Figure 2: Inflation rate in the United States. Assuming a monthly inflation rate of 0.64%

The base effect of the core PCE inflation rate, the Fed's preferred index, is minor. If the index were to change monthly as in the 12-month average (0.42%), the core inflation rate would fall slightly at first because of the base effect and then rise back to the 5.2% inflation rate (Fig. 3).

Underlying PCE inflation rate in the U.S. Assuming a monthly inflation rate of 0.42%

In the euro area, a pickup in inflation due to the base effect is still likely to lie ahead. Assuming monthly HICP rates of change were to remain at 0.8%, the monthly average since November 2021, inflation in the euro area would still rise to 11% in January 2023 and then decline slightly, thanks to the base effect (Fig. 4). Therefore, the inflation rate spike may be an artifact.

Figure 4. Harmonized Index of Consumer Prices (HICP) in the euro zone. Assuming a monthly inflation rate of 0.8%

When will inflation have expired?

As mentioned above, the change in the annual inflation rate can be expressed as the difference between the monthly change in the current year's price index and the monthly change in the same month of the previous year. In order for the decline in the inflation rate not to be an artifact, the monthly variation rates must have a downward trend. This was the case in the United States between 1978 and 1983 (Fig. 5). If the monthly change (yellow bars in Fig. 5) was greater than in the same month of the previous year (blue bars), there was a negative base effect. In general, if the blue bars are longer than the yellow bars, the annual inflation rate decreases. Annual CPI rates of change increased until the trend reversed beginning in March 1980. In part, this was the result of the base effect, as monthly changes were higher in 1979 than in 1980. More importantly, however, monthly inflation rates tended to decline as inflationary pressures diminished.

Figure 5. Inflation rate and base effect in the U.S.: 1978 - 1983

Currently, the question is whether the recently recorded spike in the annual inflation rate is mainly due to the base effect. Since July 2022, monthly CPI changes have been notably lower than in the previous year, albeit with an upward trend (Fig. 6).

Inflation rate and base effect in the US: 2021 - 2022 Figure 6

Moreover, the monthly rates of change of both the overall CPI and the core CPI (excluding energy and food) in the US do not yet show a downward trend (Fig. 7). The same is true for the Eurozone, where the trend of the monthly rates of change of the underlying index is only slightly below the trend in the US, but that of the overall index is considerably higher (Fig. 8).

Figure 7. USA: Monthly rate of change of the CPI and trend

Figure 8. Euro area: monthly rate of change of the HICP and trend

Conclusions

The inflation rate is usually defined as the change in a consumer price index compared to the same month of the previous year. Therefore, changes in the inflation rate include, by definition, both the inflation dynamics of the previous month and the same month of the previous year. If in a month the consumer price index rises less than in the same month of the previous year, the inflation rate falls. This makes it possible to reduce the annual inflation rate, even if the current month's inflation is the average of the last 12 months. Therefore, it is possible for the inflation rate to reach a ceiling and begin to fall without the inflation momentum having weakened. In this case, the inflation rate rises again after a few months.

The recent decline in the U.S. inflation rate shows a notable drop in monthly CPI rates of change in July. Since then, however, monthly changes have risen again. Therefore, the base effect has played an important role so far. The decisive factor going forward will be whether the Fed's monetary policy measures have actually slowed inflation dynamics. This cannot yet be seen in the trend of monthly rates. In the Eurozone, the trend in monthly inflation rates remains upward so far and it is likely that peak inflation has not yet been reached. When it does, the extent to which this is due to the base effect or a fundamental change in inflation dynamics will have to be examined.