Base Effect

The base effect occurs whenever two data points are compared as a ratio where the current data point or point of interest is divided or expressed as a percentage of another data point, the base or point of comparison.

The base effect can lead to distortion in comparisons and deceptive results, or, if well understood and accounted for, can be used to improve our understanding of data and the underlying processes that generate them.

Inflation is often expressed as a month-over-month figure or a year-over-year figure. Base effect a riddle for economic indicators. It is a term generally used in inflation. It refers to the impact of an increase in the price level (i.e., previous years inflation) over the corresponding rise in price levels in the current year (i.e., current inflation).

If the inflation rate was low in the corresponding period of the last year, then even a small increase in the price index will give a high rate of inflation in the current year.

Similarly, if there is a rise in the price index in the corresponding period of last year and recorded high inflation, then an absolute increase in the price index will show a lower inflation rate in the current year.

To understand base effect, we need to revisit Inflation to understand its implication.

Inflation is the ‘rate of change’ of prices.
If for a certain week, the inflation figure is at 12%, it means the price index is 12% higher as compared to the corresponding week in the previous year.

Here’s an example……

To explain base-effect:

Week 30 2020 – index was at 100.
Week 31 2020 – index was at 98.
Week 30 2021 – index is at 112.

(Figures 100,98,112 are just an example)

Thus, inflation is 12% (denoting a 12% increase in prices).

Now

Week 31 2021 – index continues to be at 112.

So as compared to the base exactly one year ago (week 31 2020) inflation would be at 14.29% [(112 -98)/98 ]*100

Now though the index continued to be the same as what it was in week 30 of 2021, the inflation went up as the corresponding base was lower in the previous year.

So even if the prices of the goods that represent the index did not change
as compared with the previous week ( i.e., week 31- 2021 over week 30- 2021), the inflation figure changed due to the effect of the previous year. This is the base-effect for inflation.

Which means….

Every reported inflation number is with reference to the inflation number that existed exactly one year back re-based to 100.

To make it simpler, if we say inflation is 5%, it means that if the price of goods comprising the inflation basket was 100 exactly a year back, it is 105 today.

To sum up

The base effect relates to inflation in the corresponding period of the previous year:
Thus, if the inflation rate was too low in the corresponding period of the previous year, even a smaller rise in the Price Index will arithmetically give a high rate of inflation now.
On the other hand, if the inflation rate was too high in the corresponding period of the previous year a large price rise might land up presenting itself as minor rise in inflation due to the base effect.

Thus, the term ‘base effect’ has a lot of impact while ascertaining inflation numbers and can sometimes appear to misrepresent ground realities because it is dependent on a number that existed one year back.