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.
BREAKING DOWN 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.
Inflation is calculated based on price levels that are summarized in an index. The index may spike in June, for example, perhaps because of a surge in gasoline prices. Over the following 11 months, the month-over-month changes may return to normal over the following 11 months, 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.