Higher demand and reduced supply could be drivers for higher reads on inflation. Another reason? Simple math.<\/p>\n
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?<\/p>\n
Percentages dont tell the whole story, which is why looking at price levels can be just as important as looking at inflation rates.<\/p>\n
Economists refer to the distortions in relative price changes as base effects.<\/p>\n
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.<\/p>\n
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.<\/p>\n
But 3% year-over-year increase in May doesnt provide enough context.<\/p>\n
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.<\/p>\n
The difference between those two scenarios illustrates the base effects that can come with year-over-year measures of inflation.<\/p>\n
Yes. Thats because price levels cratered in the spring months of 2020, when a collapse in demand led to falling prices.<\/p>\n
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<\/p>\n
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.<\/p>\n
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.<\/p>\n
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<\/p>\n
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.<\/p>\n
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