Page 541 - ES 2020-21_Volume-1-2 [28-01-21]

168 Economic Survey 2020-21 Volume 2

group (mainly services) has increased substantially under 2016 series vis-à-vis earlier series.
The linking factor for the two series is 2.88. Linking factor allows us to maintain continuity in
the time series data on the price index. This would help in comparing the new series with the
old one. The linking factor has been derived by taking the ratio of average of monthly indices
of old series to new series for the period of 12 months (from September 2019 to August 2020).

INFLATION TREND: MOMENTUM AND BASE EFFECT
5.6 Inflation trends are usually interpreted using the twelve-month change in the index to
eliminate the effect of seasonal fluctuations. However, one challenge with using the YoY change
in inflation is that it does not distinguish between recent price changes and price changes a year
before.
When changes in the CPI in the base month have a considerable effect on changes in YoY
inflation, this is referred to as base effect. Base effects are therefore the contribution to changes
in the annual rate of measured inflation from abnormal changes in the CPI in the base period.
Hence, we need to distinguish whether changes in inflation are caused by price changes in the
current month, or by extreme price changes in the base period (Central Bank of Iceland, 2007).

5.7 Arithmetically, the explanation of why π (YoY inflation in period t-1) moved to π (YoY
t
t–1
inflation in period t) consists of two parts:
1. Momentum: why p moved to p (month-on-month change in price index). It captures
t-1
t
the recent price changes.
2. Base effect: why p t-12 moved from p t-13. It captures the price changes a year ago.
5.8 Thus, the difference between the YoY inflation rates in two subsequent months is ap-
proximately the same as the difference between the month-on-month rate in the current month
and the month-on-month rate twelve months previously (European Central Bank, 2005). A low-
er base effect or higher momentum has a positive impact on the change in inflation.

Figure 7: CPI-C and core inflation

Source: NSO