After several weeks of inflation and interest rate anxieties, the release of CPI data on March 10 showing a less than expected increase is welcomed news for investors. While consensus forecasts called for a 0.4% increase in the core consumer price index, the actual increase was a paltry 0.1%. The overall consumer price index, which includes food and energy, also came in well under forecasts.
Where inflation goes from here is still open to debate, with some economists forecasting higher inflation driven by COVID stimulus, income growth, and an economic revival as the pandemic wanes. The recent surge of Treasury yields seems to support that view. Others, including Federal Reserve officials, dismiss those concerns with expectations that any significant uptick in inflation will be short-lived.
Accounting for the Base Effect
What the Fed knows that many people don’t is the rate of inflation will almost certainly jump in April and
May as the result of the “base effect.” The base effect works like this: The CPI is measured on a yearover-year basis, comparing the current month’s price level to the same month’s level from the prior year. Starting in March 2020, the CPI dropped precipitously due to the deflationary pressures of the pandemicinduced recession. There’s nothing unusual about that.
However, when April 2021 comes around, the year-over-year change will be compared against the prior year’s CPI, which had turned negative. So, regardless of how minuscule the CPI increases for the month, the index is likely to jump well above its current level, making it appear as though inflation is surging. The May 2021 index is expected to see an even larger surge. But it won’t be an accurate measure of inflation, merely a distortion of the data caused by the base effect.
Barring any actual surge in prices in April and May, the consumer price index will likely start normalizing, returning to its present trend. As the chart shows, the base effect will have run its course by July. Where the inflation rate lands at that time, nobody really knows. If the economy shows signs of roaring back by then, we could see inflation expectations picking up.
Still No Sign of an Inflation Surge
Presently, the Fed doesn’t appear to be concerned about an inflation resurgence, stating that the forces that have been containing price pressures for more than a decade are still in place. That’s why it also views the recent surge in Treasury yields as transitory.
So, don’t let the coming spike in the inflation rate worry you. While we can’t know how inflation will perform on the other side of the base effect, we’re not concerned. Actually, we would welcome some inflation. That’s because we focus on companies with strong brands and dominant market positions, which gives them pricing power. That pricing power enables our companies to raise their prices without hurting the demand for their products, which translates into higher revenue and profits. Also, since our companies have very low debt levels, an increase in interest rates won’t have any impact at all as well. Companies with high levels of debt selling high-priced items (which we own none of) will be most affected by these two potential headwinds. Inflation and interest rate rises have been on our minds since the 2008 financial crisis and subsequent increases in the money supply. Owning only the highest-quality businesses in the world positions us to do well in any environment.
Respectfully,
Jonathan Dash
CEO & Chief Investment Officer
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