The Mathflation Jump

We don’t often tip our hat to mainstream financial news coverage, but in the spirit of good sportsmanship, let us give credit where credit is due: The vast majority of financial outlets got inflation right. Instead of freaking out about CPI’s acceleration from 1.7% y/y in February to 2.6% in March and warning of runaway inflation ahead, they calmly explained the jump came from a math quirk known as the “base effect.”^[i] We think that is a point worth reiterating here, as inflation isn’t the only data showing bigtime math skew right now—a key concept for investors to understand as they sift through economic results this spring and summer.

We first highlighted this early last month, after Fed head Jerome Powell started sprinkling base effect warnings in his public comments. Inflation rates, as we explained then, are calculated on a year-over-year basis. So March’s inflation rate is the percentage difference between CPI in March 2020 and March 2021. The “base” is that March 2020 level.

Last year, as lockdowns halted commerce in March, CPI started falling. It fell again in April and May, then started recovering in June. By August, it was back at pre-pandemic levels. Overall, prices surrounding that blip are in line with their long-term trend. But you will not know that from the inflation rates for the next few months as those year-ago bases bounce around. When you divide a given numerator (like March 2021’s consumer price index level) by a smaller denominator (March 2020’s), the result increases—just simple math. The denominator got smaller in March. It will get smaller still in April and May. That will boost annual inflation rates even if prices don’t change month to month. Then the annual inflation rates will probably slow significantly as the denominator gets larger again over the summer.

Neil Irwin at The New York Times offered a handy trick to show this: Compare the year-over-year inflation rate with the 13-month inflation rate, which shows how prices today compare to pre-pandemic prices.^[ii] It removes the skew. While CPI rose 2.6% from March 2020 to March 2021, it rose just 2.3% from February 2020.^[iii] Doing the same exercise in the other direction, March 2021’s CPI is 3.5% above May 2020.^[iv] In other words, if prices are flat the next two months, the inflation rate will still jump to the fastest pace in recent memory. That does not mean inflation is suddenly galloping—it is just math. Mathflation, if you like.

Inflation is the primary US economic data series whose headline result is the year-over-year figure, so it is the main place you will see the base effect skew on our shores. Most other series feature month-over-month, quarter-over-quarter or annualized growth rates. The UK does the same. (You can see month-over-month data for US CPI, too. It rose 0.6% m/m in March, with about half that rise tied to volatile food and fuel prices.^[v]) But in the eurozone, year-over-year industrial production and retail sales results tend to get vastly more ink than their month-over-month counterparts even though the latter are seasonally adjusted. Year-over-year GDP growth also tends to get more coverage there than quarter-over-quarter. So expect to see plenty of base effect skew there.

Emerging Markets are where we will see this the most, though, because most of their statistics agencies don’t seasonally adjust data (or if they do, the data series aren’t mature enough to assess whether those adjustments are reliable). Pretty much all Chinese data are reported on a year-over-year basis. Ditto Taiwanese results and Korea’s monthly figures. All have started showing huge base effect skew. China’s is most instructive, given its lockdowns occurred about two months prior to the US’s. Its March trade data came out this morning, showing exports up 30.6% y/y.^[vi] That is huge. It is also way, way slower than the 60.6% y/y growth in January – February (which the National Statistics Bureau combines to remove base effect skew from the Lunar New Year’s shifting timing).^[vii] Trade didn’t suddenly slow bigtime, though. The base was just lowest in January – February, when China’s lockdowns were toughest, then recovered partially in March as the country reopened.

So for the next six months or so, we recommend not getting worked up over wild year-over-year results—whether those results are wildly good or wildly bad, last year’s swings will be the primary culprit. That is meaningless to stocks, which priced last year’s swings last year. They are now looking forward, and none of these economic data predict what comes next. All are backward-looking. So stay cool and trust the market to see through all the noise.