Outside the Box: You shouldn’t freak out over the CPI report — but this is what the Fed should do

1) These figures are exaggerated by base effects. The price index troughed in May of 2020 at 256. So the year-over-year comps start looking exaggerated because of the COVID effect.

Basically, the economy was in crash mode last April and May so prices collapsed. And now the economy is booming so you have an exaggerated base effect where the numbers look high in large part because we’re comparing it to a severely depressed environment.

To get some sense of the future, we can start to think about how these figures might compare to today’s figure. Basically, you’d need a continued surge in some of these unusual items like used cars in order for a 4.2% rate of inflation to persist. That is a very unlikely outcome.

All that said, we’re going to get several more months of what looks like high-ish inflation since the base effect will persist for most of the Summer.

2) These figures are impacted by several acute prices. Used cars contributed 0.35% to core CPI. Add in hotels and car rentals, and almost half of the core CPI increase is caused by 5% of of the index. That’s not gonna continue.

For instance, look at used car prices in the last year. This surge is very unlikely to persist. Hell, we’re more likely to see this sort of index being a DRAG on prices a year from now.

3) What if we’re wrong though? What if the labor market roars back to life in the second half of this year? What if some of these prices aren’t so transitory? I mean, I would have never predicted a four-times increase in lumber prices in the last year.

There are lots of weird supply related things going on in the economy. And while I am fairly confident that these high inflation readings won’t persist, I am also uncertain about many of the things going on in the macroeconomy these days because it’s just such a weird environment. And that’s what break-evens seem to be saying as well. Bond investors are hedging their bets a bit here.

While we want to believe the Federal Reserve and the transitory narrative, I tend to think that the Fed is just trying to reinforce expectations. They like what they’re seeing now since it confirms that the recovery is gaining momentum. Jerome Powell doesn’t care about 4% headline inflation. He cares about seeing 4% unemployment at the end of the year. Then he’ll start getting worried about prices.

Personally, if I ran the Fed, I’d be changing the language and starting to talk about tapering the balance sheet. I think there’s a lot of weird stuff that kind of worries me. It’s not just consumer prices. The real-estate market around the country is whackadoodle. People are buying meme crypto coins just for fun. The GameStop stuff and the endless surge in stocks
SPX,
-1.55%.
There is speculative fervor all over the place.

And while asset prices aren’t a major concern for the Fed, I do think the total amount of weirdness in prices is alarming. Maybe it’s just the risk manager in me speaking, but I’d be hinting at rate hikes by now….

The bottom line is – don’t overreact here. I think the Fed is likely right that this is mostly transitory and inflation will moderate back into the 3% range before long.

Also read: Inflation is running hot. Here’s what that means for the stock market

Cullen Roche is the author of the Pragmatic Capitalism blog, where this column first appeared. Follow him on Twitter @cullenroche.