Beware the “Base Effect”

Beware the “Base Effect” 

The Bureau of Labor Statistics (BLS) recently released their much anticipated Consumer Price Index (CPI) report for the month of April. I’ve covered several past reports at length in my columns, but this may just be the most interesting one yet. 

Before we jump into why, let’s take a quick look at some of the topline numbers from the report.

To start – prices still increased, just at a slower pace than in previous months. Annual inflation was up 8.3% over the past twelve months ending in April 2022 which is a welcome reprieve from the 41-year high of 8.5% recorded in March. When you strip out volatile product categories like food and energy, the CPI stood at 6.2% over the same period, less than the 6.5% reported in March.

Taken at face value, this appears to reflect that annual inflation has moderated for the first time in eight straight months. Unfortunately, a closer examination of the data indicates this relief may only be an illusion due to a statistical quirk economists call the “Base Effect.”

Within the context of inflation, the base effect refers to the impact of comparing current price levels in a given month against price levels in the same month a year ago. This can skew the actual rate of inflation in one of two ways: 

  1. Lower-than-normal price levels from the previous year can make price increases in the current year seem higher in terms of their year-over-year percentage increase; or
  2. Higher-than-normal prices from the year prior can make percentage increases for the current year seem less steep because they are being measured from a higher starting point

We’ve actually seen both of these scenarios play out over the course of the past two years. For example, the base effect may have contributed to higher inflation percentages in the spring months of 2021 due to price levels cratering in the spring of 2020. Conversely, this April’s CPI percentage appears to have moderated more than it actually has due to higher-than-normal prices in April of 2021. 

Last spring, the overall inflation rate spiked from 2.6% in March (‘21) to 4.2% in April (‘21). This spring, the CPI registered year-over-year increases of 8.5% in March (‘22) and 8.3% in April (‘22). April’s 4.2% starting point is much higher than March’s 2.6% starting point, meaning this April’s inflation rate looked less steep when in reality prices continued to climb at an alarming rate.

This is why looking at price levels is just as important as looking at inflation rates, and part of why the Federal Reserve views Core CPI as a more accurate measure of inflationary trends.

April’s core inflation measure — the change in the price of goods and services not including food and energy — was 0.6 percent, compared to 0.3 percent in March. This is the largest increase since January of this year and frustratingly higher than Wall Street’s forecast of 0.4%. The change in Core CPI alone is likely to strengthen the Federal Reserve’s resolve to continue raising interest rates by 0.5% (or even 0.75%) until, as Chair Jerome Powell recently said, “financial conditions are in an appropriate place.”

Appropriate, of course, is a relative term and could take a while to get to given the price levels reflected in this recent report. Airfares climbed nearly by 19 percent in the month and have surged over 33.3% year over year, the biggest jump since December of 1980. Housing costs rose by 0.5% for the third month in a row and are up 5.1% on the year. New cars are up 14.2% on the year. Food prices rose 0.9% last month and 9.4% on the year, the biggest jump since April of 1981. Within that category alone, margarine is up 23.5%, Eggs up 22.6%, citrus fruits up 18.6%, bacon up 17.7%, chicken up 16.4%, fresh whole milk up 15.5%, and roasted coffee is up 14.7% on the year.

Mercifully, energy prices fell in April due to gasoline prices dropping 6.1% from their March peak. That said, prices at the pump returned to all-time highs in the first few weeks of May – data not reflected in last week’s report. All told, energy prices on the whole are still up 30% on the year.

So, while the base effect resulted in a deceleration of last month’s inflation rate, price increases on important commodities have only continued to climb. As a result, current consumer sentiment is actually lower now than it was during the height of COVID and over 70-percent of the country considers inflation the top issue facing our nation. 

As both consumers and citizens, we need to keep pressuring policymakers to bring the cost of living back down. To do that, we’ll need to beware the “base effect” on CPI reports for the remainder of the year. Price increases climbed steadily throughout 2021 and economists say the base effect alone could bring down this summer’s inflation rate by several percentage points. If ignored or misunderstood, this phenomenon could lead to major distortions and mistaken conclusions moving forward and put the perception of urgency with which we need to tackle this issue at risk.