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What are base effects and how do they distort inflation?: Yahoo U

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Higher demand and reduced supply could be drivers for higher reads on inflation. Another reason? Simple math.

Consider, for example, if prices increase by 30%. But what if prices fell by 30% before? Would that mean prices are back up to where they were?

Percentages don’t tell the whole story, which is why looking at price levels can be just as important as looking at inflation rates.

Economists refer to the distortions in relative price changes as “base effects.”

What are base effects?

Within the context of inflation, base effects refer to the impact of comparing current price levels in a given month against price levels in the same month a year ago.

These types of year-over-year comparisons are the most commonly cited measures of inflation, and are often the figures cited in major media reports covering new inflation data.

But “3% year-over-year increase in May” doesn’t provide enough context.

For example, a “3% year-over-year increase in May” after an already elevated price level in May of last year would imply higher price levels than a “3% year-over-year increase” after a depressed price level in May of last year.

The difference between those two scenarios illustrates the “base effects” that can come with year-over-year measures of inflation.

Are base effects skewing inflation data out of the COVID-19 crisis?

Yes. That’s because price levels cratered in the spring months of 2020, when a collapse in demand led to falling prices.

The Consumer Price Index is a major measure of inflation (the other being Personal Consumption Expenditures). Price levels as measured in the CPI declined in the early months of the pandemic. Source: Bureau of Labor Statistics
The Consumer Price Index is a major measure of inflation (the other being Personal Consumption Expenditures). Price levels as measured in the CPI declined in the early months of the pandemic. Source: Bureau of Labor Statistics

That means year-over-year measures of inflation through the spring months of 2021 saw base effects that may have contributed to the high inflation prints.

Gregory Daco, chief U.S. economist at Oxford Economics, estimated that about 40% of the Consumer Price Index inflation reading in June could be due to base effects.

Oxford Economics estimated the impact of base effects on CPI inflation (one major measure of inflation) by looking at what the price level change would be when compared to the pre-pandemic price levels of January 2021 (effectively stripping out the base effects of pandemic declines in prices). Source: Oxford Economics
Oxford Economics estimated the impact of base effects on CPI inflation by looking at what the price level change would be when compared to the pre-pandemic price levels of January 2021 (effectively stripping out the base effects of pandemic declines in prices). Source: Oxford Economics

Base effects should fall out as year-over-year figures start to compare against year ago months in which the economy began to re-open.

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