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Base effect drives up inflation

A senior Central Bank official says statistical affects could expand headline inflation figures even without price changes, but the bank’s target is to maintain average inflation at round six percent during the year.

Headline inflation, the point-to-point change in the Colombo Consumers’ Price Index jumped to 6.5 percent last January mainly driven by increases in food prices and the ‘base effect’, a statistical term given to anomalies that arise when calculating percentage changes of an index from a previous period of time.

The Consumer Price Index in January 2009 was 203.1 points; in 2010 it was 216.4 points, a 6.5 percent increase.

"Last year’s base was low so when computing the point-to-point change we would get a higher figure, it were higher then inflation figures would be lower. Because of these statistical problems it is better to look at the annual change in inflation and our target is to maintain it 6 percent this year," Chief Economist of the Central Bank, K. D. Ranasighe told the Island Financial Review.

"Because of the base effect, even if price changes remain zero we would still see an increase in headline inflation," he said.

If prices in February remain unchanged then the inflation index would remain at 216.4 points (as it was last January). In February 2009, the index was 202.9 points. So the point-to-point change in inflation could be 6.6 percent, higher than for January at 6.5 percent although prices did not change from January to February 2010.

"It is for this reason that we need to look at annual average inflation, which was 3.1 percent in January 2010," Ranasighe said.

"The Central Bank would target annual average inflation at 6 percent during the year but we expect some fluctuations in the point-to-point change in inflation throughout the year," he said.

If on the hand, the proceeding year’s base was higher, then the point-to-point change in inflation would be understated.

In September 2009, Sri Lanka recorded a headline inflation rate of 0.7 percent. The corresponding index was 208.6 points. While prices had increased from August 2009, 208.1 points on the index, because the base in September 2008 was relatively high at 206.3 it corresponded to a 0.7 percent change.

To highlight this phenomenon, we looked at the base effect argument highlighted in the foreign press.

India experienced high inflation in 2008, 11. 89 percent in June of that year compared to 4 percent in January. A commercial bank in that country analysed the problem which was reported in the Indian press.

"The relentless rise in inflation in recent months is mainly the result of base effect than changes in the wholesale price index (WPI), Axis Bank said in a research note on inflation.

This could provide some solace to the government that is facing the flak for spiraling inflation," reported the Financial Express in 2008.

"Base effect has contributed 95 percent on an average to the inflation level in the last few months," the bank said on Tuesday. This means that inflation has risen much faster than the actual increase in prices on the back of a low base last year," it said.

Sri Lanka suffers from structural inflation caused by persistently higher budget deficits of successive governments.

The Central Bank’s road map for 2010 targets a low inflation, low interest rate regime so that economic growth can be achieved with credit to the private sector growing by 13 percent.

But the Central Bank warned that reckless spending by the government could threaten all this.

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