The way inflation is calculated, last year’s prices of goods and services are just as important as last month’s. If last year’s prices are high, the inflation rate gets a breather in what is popularly known as the base effect. That’s where the good news for the markets lie in the coming months.

The pet peeve of investors today is inflation, as it is eating into nominal returns. Inflation being on the higher side and asset class returns being muted, it is adding to the woes. It is a global phenomenon, with inflation at multi-year highs in some countries.

But inflation is set to ease in six months. You would be wondering, how could that happen?

Let us look at it from a different perspective. That is, how inflation is measured.

Concept of base effect

There is an index for measurement of inflation, which is the price of a basket of certain defined goods and a little bit of services. It is measured every month. The index for a month is compared with that of the corresponding month of the previous year. The percentage increase in the index of the current month over the corresponding month of the previous year is the inflation data we get to see.

A simple analysis of this method implies that for inflation to be high or low, while the price levels this month is of course important, that of the corresponding month in the previous year is as important. In other words, inflation is determined by not only the current prices, but prices last year as well. And that is what we are discussing here. This is referred to as the “base effect”, which means if the base last year is high, the inflation rate—or the percentage rise in prices—could be muted this year, and vice-versa.

The immediate positive

The latest data point on CPI inflation we have is for September 2022, which is 7.41 per cent. The Consumer Price Index for September 2022 was 175.3 and that for September 2021 was 163.2. The calculation is as follows: (175.3 – 163.2) / 163.2 = 7.41 percent. This base number, 163.2, was only marginally higher than that of August 2021, which was 162.9. Hence the base effect for September 2022 was a muted positive.

As against this, the CPI for October 2021 was 165.5, which is significantly higher than that of September 2021. The implication is that the inflation print for October 2022, to be announced in the second week of November, will be lower than 7.41 percent, driven by a positive base effect. In November 2021 the CPI was 166.7, which is also palpably higher than October 2021. With the support of a positive base, inflation for November 2022, to be declared in the second week of December 2022, will remain muted.

The medium term

What happens thereafter? In December 2021 and January 2022, the CPI actually came down. Hence inflation in December 2022 (to be declared in the second week of January 2023) and in January 2023 will nudge upwards. In February 2022, it is mildly positive. And then comes the crux of this discussion. March 2022 onwards, the CPI goes only one way, up. Hence, inflation in March 2023 (to be announced in the second week of April 2023), with the support of a positive base effect, is going to ease. This is supported by the data points available as of now.

Current price levels

We are not saying that current price levels are to be ignored while taking a view on inflation. It is important, and we will take a quick look at it.
Prices of commodities like crude oil and metals that shot up significantly after the Russia-Ukraine war broke out in February 2022 remain on the higher side, but are off the post-war peak levels touched in March or April 2022.

Almost half of the CPI basket comprises food or food-related items. While cereal/fruit/vegetable prices remain stubborn, unless it goes up substantially from current levels, they will not exert as much pressure on inflation going ahead. The rupee has depreciated against the dollar and that does add to “imported inflation” but the same logic applies. If it does not depreciate much from current levels, the incremental impact on inflation would be less.

Conclusion

Whether this method of computation of year-on-year inflation—where last year’s data has as much bearing on the current data point—is correct or not is a point of debate. However, this is what is universally followed, not just in India. And we will live with this method.

Source: https://www.moneycontrol.com/news/business/personal-finance/why-inflation-is-set-to-ease-in-six-months-and-why-thats-good-news-for-markets-9391961.html?