Base effect: or, why the Right will be screaming “inflation!!” even as we go into deflation

I am not saying it is going to happen – deflation that is.  But some elements of the near future are predictable, and that is because of Base Effects.

The headline inflation rate* is, quite simply, the difference between this month’s index and the index 12 months before.

P (t)/P (t-1)   – 1

One part of this equation, P(t-1) is known.  We know where the CPI index was in Dec 2008, up to Nov 2009.    P(t) is something we can guess reasonably well – it moves up a bit each month, with some predictable contributions (e.g. fuel, the upcomingVAT hike).   Here is how the monthly index has changed in the last few months:

You can see the deflation of the beginning of the year clearly, and the oil-induced hikes of mid 2008.

So, given that we know where the base (i.e. P(t-1)) is going to move in the next few months, we can make a reasonable guess as to where inflation will be on a headline basis.  First, let us assume that CPI goes up by about 2% per year, like this.

So, even if inflation sticks robustly to its steady path, the economically-illiterate will shout ‘inflation nation‘.

In fact, (and this is the nightmare scenario), we could even get shouts of inflation as we set off into a round of deflation. Because of base effects, and the VAT rise bumping up inflation, a weakening economy might well still co-exist with those headlines.  This scenario imagines the VAT rise to 17.5 putting the price index up less than 2 points between January and May next year, and then a weak economy (VAT rise, fiscal cutting) bringing deflation:

Is Mark Bathgate of the Spectator correct when he says “David Cameron’s comments in his conference speech that printing money was the wrong solution to the UK’s debt problems and risked inflation are looking increasingly prescient.”  No.   We have printed £200bn, tripling the monetary base, and yet even with the VAT rising effects I describe above we are heading for 3% inflation.   Over 2 years, even with the biggest run up in commodity prices since the 1970s, the two year rate of inflation will be 5.6%, or 2.8% per year.

Repeat after me.  Inflation Is Not The Problem**.

And this is serious, because if the right medicine is more stimulus/more QE, then voices like the Spectator or John Redwood can perhaps stop it from happening.

*I’m sticking to CPI right now, and have no time to discuss different indices, etc.  RPI has mortgage payments.  RPIX does not, but has elements of housing costs that are related to house prices via depreciation.  Look up our “politics of inflation” paper if you are interested.

**As an economist, I reserve the right to add Yet.   Can we make inflation?  Yes.  Will we?  If we have an impossible Fiscal situation, then yes.  What will bring us an impossible fiscal situation?  Lack of growth.  What will cause that?  Lots of things – but one of them might be worrying about inflation.