What is the Base Effect?
The base effect is the distortion in a monthly inflation figure that results from abnormally high or low levels of inflation in the year-ago month. A base effect can make it difficult to accurately assess inflation levels over time. It diminishes over time if inflation levels are relatively constant.
- Base effect refers to the distortion in monthly inflation figures from a sudden spike or decline in them during a short period of time, say a month.
- They are caused by seasonal or monthly variations.
- They can produce variations in overall inflation figures.
Understanding Base Effect
Inflation is often expressed as a month-over-month figure or a year-over-year figure. Typically, economists and consumers want to know how much higher or lower prices are today than they were one year ago. But a month in which inflation spikes may produce the opposite effect a year later, essentially creating the impression that inflation has slowed.
The causes of base effects are varied and range from seasonal variations to changes in demand. From a technical perspective, base effect impact the overall inflation figure. But the case is different when base effects are analyzed from the lens of economics. The figures for base effects are generally analyzed on a month-to-month basis, rather than the overall figure.
Example of Base Effect
Inflation is calculated based on price levels that are summarized in an index. The index may spike in June, for example, perhaps due to a surge in gasoline prices. Over the following 11 months, the month-over-month changes may return to normal, but when June arrives again its price level will be compared to those of a year earlier in which the index reflected a spike in gasoline prices. In that case, because the index for that month was high, the price change this June will be less, implying that inflation has become subdued when, in fact, the small change in the index is just a reflection of the base effect—the result of the higher index value a year earlier.