Morgan Stanley: Don’t relax yet, inflation could easily rebound

A year of declining inflation rates has lulled experts into a false sense of relief, one Morgan Stanley executive says. But that could change soon with indications of a potential rebound.

Inflation topped out at 9.1% last June — its highest peak since the early 1980s — thanks to a mix of supply chain disruptions, government stimulus, and the Fed’s policies.

Since then, inflation has been on the descent—hitting a two-year low of 4% last month, according to The Bureau of Labor Statistics.

Americans are optimistic about where prices are headed, as shown in the following chart. After two years of bracing for higher inflation, they finally expect prices to level off:

But should everybody feel so comfortable? In Morgan Stanley’s recent note, CIO Lisa Shalett argued that people are falling victim to an illusion of the so-called “base effect.”

“Equity markets have embraced the belief that the Fed has executed a soft landing and risks to an inflation rebound are de minimis,” she wrote, “but things are rarely that simple.”

The illusion of the base effect

How does anybody know that inflation is going up or down?

We can tell by comparing prices now to what they were before — a year ago, maybe, or a month ago. For example, when pundits talk about inflation on TV, they most often use a year-over-year (YoY) comparison.

In economics, the difference caused by choosing different points of comparison for a measurement is called the “base effect,” and it’s at the heart of Shalett’s argument.

If we look YoY, 4% inflation seems quite low, because we’re comparing it to last June’s peak of 9.1%. But as we get further and further from that high point, YoY comparisons may start picking up again.

“Analysts might want to acknowledge that a huge source of the ‘accelerating improvement’ in headline inflation is partly a function of the fact that YoY numbers are being compared with June 2022 peak readings, which were above 9%,” Shalett wrote.

Once analysts quit comparing the current situation with how bad it was last year, “inflation will easily appear to be rebounding,” thanks to the current climate of low unemployment, modest economic growth, and fiscal spending.

For a sense of where inflation could go in the coming months, Shalett pointed to the following graph, which utilizes a longer time horizon:

Long-term inflation is expected to decline

Inflation may be unpredictable in the short-term, but the news gets better the further down the line you look.

In its Summary of Economic Projections, Fed members were polled on their projections for inflation rates in 2023 and beyond. Here were their responses:

Two trends are immediately clear from the data.

First, the Fed expects inflation to decline consistently in years to come.

Importantly, too, the members are more aligned in their projections over time. Where there’s some disagreement over 2023 and 2024, all members agree that inflation in the long-term will sit around 2%.

This would be the best-case scenario for the economy.

As the Fed explains in its literature, 2% inflation is the basis of a strong and inclusive economy. “Monetary policy that aims to keep inflation at 2% over the longer run helps to maintain a productive and well-functioning economy, leading to increases in employment and to higher standards of living for U.S. citizens.”

So while Americans can’t be too comfortable about short-term inflation, they shouldn’t be too worried about it in the long run, either.