Investors’ bane today is inflation as it kills nominal returns. This adds to problems given rising inflation and subdued returns across asset classes. This is a global phenomenon, with inflation in some countries at multi-year highs.
But inflation should decline in six months. You may wonder how this happened?
Let’s look at it from a different angle. In other words, how is inflation measured?
Basic effect concept
There is an index to measure inflation, which is the price of a basket of certain defined goods and some services. It is measured monthly. The index of a month is compared with that of the corresponding month of the previous year. The percentage increase in the index for the current month compared to the corresponding month last year corresponds to the inflation data we see.
A simple analysis of this method implies that for high or low inflation, of course, the price level in that month is as important as that of the corresponding month last year. In other words, inflation is determined not only by current prices but also by last year’s prices. And that is what we are discussing here. This is called the “base effect,” meaning that on a high year-over-year basis, the rate of inflation, or the percentage increase in prices, could moderate this year, and vice versa.
For its part, the CPI for October 2021 was 165.5, well above that of September 2021. It follows that inflation for October 2022, which will be announced in the second week of November, will be below 7.41%. , driven by a positive base effect. In November 2021, the CPI stood at 166.7, which is also significantly higher than in October 2021. Supported by a positive base, November 2022 inflation, to be announced in the second week of December 2022, will remain moderate.
the medium term
What happens next? In December 2021 and January 2022, the CPI fell. Therefore, inflation will increase in December 2022 (to be reported in the second week of January 2023) and January 2023. In February 2022 it is slightly positive. And then comes the heart of this discussion. As of March 2022, the ICC will only go in one direction, up. Thus, inflation for March 2023 (to be announced in the second week of April 2023) will moderate, supported by a positive base effect. This is supported by the data points available so far.
current price level
We are not saying that current price levels should be ignored when accounting for inflation. That’s important, and we’ll get to that in a moment.
Commodity prices such as crude oil and metals, which rose sharply after the outbreak of the Russo-Ukrainian war in February 2022, continue to rise but are below post-war levels reached in March or April 2022.
Nearly half of the CPI basket contains groceries or food-related items. While grain, fruit, and vegetable prices remain bullish, they won’t put as much pressure on inflation going forward unless they rise significantly from current levels. The rupee has depreciated against the dollar and this is contributing to “imported inflation”, but the same logic applies. Unless it depreciates sharply from current levels, the additional impact on inflation would be minor.
Whether or not this method of calculating annual inflation, where last year’s data has such a large impact on the current data point, is debatable or not. However, this is followed universally, not just in India. And we will live with this method.