After consumer inflation accelerated almost continuously from –0.3% in December 2020 to 13% in November 2022, the opposite trend was observed in the past 13 months, during which inflation slowed down to 5.4% in December, thus remaining at an elevated level. However, current (or contemporaneous) inflationary pressures are only reflected with a lag in the annual inflation rate, which shows the overall change in the level of prices throughout the previous year. Also, the change in the annual inflation rate depends not only on current inflation but also on the statistical "base effects", i.e. on possible unusually strong changes in prices a year ago. All components of current monthly inflation have been at usual average levels since autumn. If current pressures remain at their current low level, the annual inflation rate will decline due to the gradual drop out of elevated monthly inflation rates (recorded up to autumn 2023) from the calculation. Due to these base effects, Croatia’s annual inflation might fall below 3% by the end of 2024. Such a mechanical projection is subject to risks that may be reflected in a rise in current inflation, which would to some extent offset favourable base effects. Base effects often determine the change in the annual inflation rate across the euro area as well. The acceleration of inflation in December 2023 (to 2.9% from 2.4% in November) almost entirely reflects unfavourable base effects, in particular energy prices.
Although the annual inflation rate was still elevated towards the end of 2023, despite a considerable decrease over that year, indicators of current inflation suggest a significant easing of inflationary pressures. The annual inflation rate declined over the past year from its peak of 13% in November 2022 to 5.4% in December 2023. This level remains well above long-term averages and is often interpreted by the public as an indicator of continuing inflationary pressures. However, the annual inflation rate tracks changes in current inflationary pressures with important delay as it aggregates the change in the price level over the past twelve months. For that reason, current inflationary pressures are often analysed on the basis of monthly inflation rates, which are mostly averaged over a few months (usually 3 or 6 months) in order to reduce volatility and are then annualised (see Methodological framework A: Calculating inflation). The six month average of month-over-month (MoM) inflation rates, for example, peaked in mid-2022, approximately half a year before the peak of the annual inflation rate. By the end of 2023, it again returned closer to normal values, suggesting a significant easing of current inflationary pressures (Figure 1, panel a)). Individual components of consumer inflation followed the profile of the aggregate indicator – services, industrial products and processed food, after an exceptionally long period of sharp increase, all came much closer to or have already reached the usual values (Figure 2, panel a)). Energy inflation and unprocessed food inflation, on the other hand, are both influenced by the highly volatile commodity markets and thus deviate from trend values more strongly. Nevertheless, in recent months they also returned close to their usual levels (Figure 2, panel b)).
Figure 1 Deviations of month-on-month (MoM) inflation from normal developments
Note: Data in the figures refer to six-month moving averages of the contribution of unusual developments to the monthly rate of change.
Inflation fell considerably in the preceding year due to the fading out of the base effects related to significant price increases in 2022, particularly in the first half of the year. Whereas the annual rate of inflation is a slow-moving measure by definition, its change – which is often in the focus of public interest – in addition to change in month-over-month inflation, reflects the monthly change in prices in the same month of the previous year, i.e. base effects (a detailed definition and methodology for the calculation of base effects are shown in Methodological framework B). The decomposition of changes in inflation based on the described methodology leads to the conclusion that developments in the annual inflation rate in the previous two and a half years were mostly determined by the substantial price increases seen between mid-2021 and mid-2022 (Figure 2). From July 2021 to June 2022, annual inflation accelerated sharply (full line, grey shaded area) and increased by almost 10 percentage points in total. This increase resulted from a strong contribution of the unusually high current inflation (grey striped bars), which amounted to approximately 11 percentage points over the period under review. On the other hand, base effects in that period did not significantly mitigate the rise in annual inflation (Figure 3, left panel). Similar developments were also observed for all the main subcomponents of inflation in that period, which picked up speed under the dominant influence of current inflation. The only exception to some extent is energy price inflation, due to a faster and sharper increase in energy prices and then their more rapid fall. As a result, the negative base effects are much more pronounced for energy than for other components (Figure 3, left panel, Energy). From December 2022 onwards, annual inflation has decelerated mainly due to negative base effects, i.e. the gradual exclusion of unusually high month-on-month inflation rates in 2022 from the calculation of the annual inflation rate (white striped bars). Despite the still elevated current inflation (the contribution of unusually high current inflation exceeded 5 percentage points), high negative base effects led to a slowdown in the annual inflation rate. Inflation slowed down by approximately 7 percentage points in that period, with the negative effects reducing overall inflation by as much as 12 percentage points (Figure 3, right panel). Findings similar to those for overall inflation also apply to all the main subcomponents.
Figure 2 Importance of base effects and current inflation for overall consumer inflation
Figure 3 Cumulative effects of current inflation and base effects on the annual inflation rate
If current (Month-over-Month) inflation remains at present low levels, that is, unless some new disruptions in global markets occur or domestic inflationary pressures build up, base effects will significantly reduce the annual inflation rate this year. The waning of the base effects of elevated current inflation in 2023 should gradually slow down the annual inflation rate in Croatia up to September 2024. By December 2024, the cumulative base effects of unusually steep price hikes in the first nine months of 2023 will contribute 2.8 percentage points to the decline in annual inflation during 2024 (Figure 4). The said negative contribution to the annual inflation rate reflects the above-average high current inflation in the period from January to September 2023 (Figure 2, grey striped bars), which will disappear from the calculation of the annual inflation rate only towards the end of 2024. Assuming that current inflation remains at normal levels, to which it has converged in recent months after a long time, annual inflation could drop below 3% by the end of 2024 from 5.4% in December 2023. However, such a mechanical projection is subject to numerous risks and uncertainties that may affect current inflation in the coming months. Should current inflation pick up from present low levels, this could somewhat offset the impact of favourable base effects.[2]
Figure 4 Base effects in 2024
As a result of base effects, euro area inflation accelerated to 2.9% in December, raising the issue of slowing inflation towards the target level. In contrast to Croatia, where inflation slowed down from 5.5% in November to 5.4% in December, inflation in most euro area countries, including Germany and France, accelerated noticeably. In the euro area as a whole, inflation thus picked up from 2.4% in November to 2.9% in December (Figure 5, panel a)), which was in some cases misinterpreted as a new wave of price increases. However, the acceleration of inflation in the euro area was expected in December and fully reflects the unfavourable base effects, particularly as a result of the fall in energy prices (Figure 5, panel c)). More specifically, the monthly decrease in the prices of refined petroleum products was much more pronounced in December 2022 than in December 2023. In addition, a large number of euro area countries introduced measures to contain rising energy prices for households in December 2022. This monthly decrease in energy prices affected the annual inflation rate from December 2022 to November 2023, after which it ceased to affect the annual inflation rate in December 2023, which thus rose perceptibly.
Figure 5 Contribution of current inflation and base effects to changes in inflation in selected countries
Note: Current inflation and base effects have been adjusted for normal developments, which are relatively stable and do not have a significant impact on annual inflation.
Sources: Eurostat and authors’ calculations.
Methodological framework A: Calculating inflation
The most frequently commented measure of inflation that central banks target is the annual rate of change in consumer prices – the total change in the level of consumer prices over the last 12 months (year-over-year, YoY). This inflation rate is well approximated by the sum of monthly price changes (month-over-month, MoM) over the previous 12 months:
\(\begin{aligned} & \pi_t=\frac{p_t-p_{t-12}}{p_{t-12}}=(\text { approximation })=\log \left(p_t\right)-\log \left(p_{t-12}\right)=\log \frac{p_t}{p_{t-1}}+\log \frac{p_{t-1}}{p_{t-2}}+\ldots+\log \frac{p_{t-11}}{p_{t-12}}= \\ & (\text { approximation })=\frac{p_t-p_{t-1}}{p_{t-1}}+\ldots+\frac{p_{t-11}-p_{t-12}}{p_{t-12}} \end{aligned} \)
where is the annual inflation rate and is the level of the price index.
The logarithmic approximation is more accurate for lower inflation rates. In normal times, annual inflation is at around 2% (more precisely, it averaged 2.2% between 2000 and 2019), which is the inflation rate targeted by central banks. However, consumer inflation deviated significantly from its usual values since the end of 2021, rising to 13% in November 2022, after which it started to decelerate.
Methodological framework B: What are base effects and how are they calculated?
Changes in the annual inflation rate, currently reflecting a slowdown, are influenced by monthly changes in prices in the current month ("current inflation") and monthly changes in prices in the same month of the previous year ("base effects"). The change in inflation between two consecutive months may be expressed as the difference between current inflation and base effects:
\(\pi_t-\pi_{t-1}=\log \left(p_t\right)-\log \left(p_{t-12}\right)-\left(\log \left(p_{t-1}\right)-\log \left(p_{t-13}\right)\right)=\log \frac{p_t}{p_{t-1}}-\log \frac{p_{t-12}}{p_{t-13}} \)
The annual inflation rate for two successive periods: March (red rectangle in Figure x) and April (blue rectangle in Figure x) of 2023 differs only in these two monthly rates of price change. The other monthly rates, from May 2022 to March 2023 are common for both rates, and are thus included in both the red and the blue rectangles. In the calculation of the April rate, the most recent monthly inflation rate (1.15%) is added to the year-over-year rate for the preceding period, while the monthly rate in the same month of the previous year is excluded (2.65%). The year-over-year rate in April (8.5%) will be lower than in March (10%) precisely by the difference between monthly rates in April 2023 and April 2022: 1.15% – 2.65% = – 1.5%. Generally, any of these two monthly rates – current inflation or base effects – can determine the direction and intensity of change in annual inflation from March to April. This means that the change in the annual rate with current price movements (in t = 0), which are most frequently commented, also reflects the change in prices in a relatively distant past of a year ago (in t – 12). For example, retail prices may rise relatively strongly from the previous month, but at the same time, annual inflation may fall rapidly due to base effects. This is precisely the case in the chosen example, with annual inflation declining due to "base effects" despite the fact that consumer prices grew increasingly rapidly over the last few months of the period under review (monthly rates since January are positive and rising). The significance of base effects sometimes makes it difficult to interpret inflation changes, so it is useful to separate it from current price changes.
Figure x Impact of current inflation and base effects on annual consumer price inflation
Note: The annual inflation rate was approximated by the difference in the logarithms of price indices.
Sources: Eurostat and authors’ calculations.
In order to be able to properly interpret the relative importance of base effects and current price changes for annual inflation, it is necessary to distinguish "normal", expected, developments in monthly inflation rates from "unusually" strong price changes. When monthly rates for the same month during the year are very similar or the same, for example, because of pronounced seasonality of prices and the absence of price shocks (e.g. strong changes in raw material or energy prices under the impact of geopolitical instability or weather events), annual inflation will not change much from month to month. Had the monthly rates been identical in April 2022 and April 2023, i.e. had they been exclusively influenced by normal developments, annual inflation in Figure x would not have changed from March to April. However, current inflation in April 2022 was influenced by unusually strong shocks, which is why it significantly exceeded normal values. This also resulted in a large impact of base effects on inflation, i.e. a decrease in annual inflation in April 2023. Thus, any unusually strong increase in current inflation is reflected in a sharp acceleration in annual inflation rates and, after a year, a sharp slowdown in current inflation. The identification of the unusual dynamics of monthly inflation is therefore crucial for separating the impact of base effects and current developments on the change in annual inflation.
Figure y Monthly inflation: actual values, normal values and deviations from normal values
Normal developments may be associated with seasonal fluctuations in inflation, while the unusual values are deviations from these fluctuations. The usual component of the monthly inflation rate was estimated on the basis of the trend (ten-year moving average) and the seasonal component obtained using the ARIMA X12 method (Figure y). The seasonal component refers to a monthly rate of change in prices that is specific for a particular month, due to which the monthly inflation rate deviates from its trend. The seasonal component includes, for example, the summer (June/July) and the winter (December/January) seasonal fall in the prices of clothing and footwear, the seasonal increase in the prices of accommodation services over the summer months, etc. The remaining part of the monthly rate of change refers to unusual factors and includes everything that cannot be explained by the trend and seasonal components.
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The authors would like to thank Vedran Šošić for his very useful comments. ↑
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For more information on the factors that might affect the maintenance of current inflation at above-average levels, albeit lower than in 2022 and 2023, see Macroeconomic Developments and Outlook No. 15, pp. 59 – 61. ↑