What is Base Rate Fallacy?

Abhijeet Modi/ August 30, 2021/ Blog

Base rate fallacy, commonly known as the base rate bias or base rate neglect, is an extremely widespread form of financial philosophy. People tend to completely ignore the established average interest rate favoring the latest, most accurate information, and completely disregard the base interest rate’s influence. In reality, the interest rate should be considered along with other factors when formulating a budget or economic plan. Otherwise, any budget is destined to fail.

Importance of Understanding Base Rate Fallacy

For this reason, students, business professionals, and many other consumers need to become aware of what is base rate fallacy and what it does to their lives. This will allow them to see that ignoring the financial numbers can result in poor financial decisions and poor financial outcomes. Additionally, a failure to heed the base rate fallacy will ultimately lead to bad personal & business finance decisions, leading to negative business outcomes. Thus, a fundamental understanding of the base rate fallacy is necessary to develop sound fiscal and economic management skills.

Worth-Mentioning Arguments Against Base Rate Fallacy

  • Argument 1

One of the major arguments against the base rate fallacy revolves around the notion that it is impossible to develop an actual long-term interest rate. The Federal Reserve is quite upfront because it cannot ever produce a truly special long-term interest rate. The central bank will get to intervene in the market to control short-term interest rates to maintain healthy inflation levels. However, those who subscribe to the base rate fallacy believe that the Fed has no business attempting to control the level of short-term interest rates. They fail to understand that the central bank’s goal is not only to control long-term inflation but also to control short-term inflation.

  • Argument 2

Another argument that is often made against the base rate fallacy is that it is a politically driven attempt to control the economy’s views. For example, some people argue that the low inflation levels are due to political influences. Others attribute the lack of inflation to the fact that the supply of goods has become too cheap relative to the demand for them. Regardless of which side of the base rate fallacy a person reacts to, the truth is that the supply of goods has been increasing rapidly, and there is certainly no shortage of goods available.

  • Argument 3

The third argument that is often made against the base rate fallacy revolves around event-specific information. This information has allowed economists to construct a detailed statistical model that analyzes both the macroeconomic indicators and the individual consumption and income decisions. The model is then used to generate an accurate measure of what is currently being spent regularly. Thus, even if a person cannot correctly pin down what is being spent on a particular item, he/she can still get a good idea of what is being spent in the aggregate on a given period. The problem with this particular type of analysis is that the person cannot be sure that he/she will react in a certain way to a certain event. Thus, they may not act in the way they would logically expect based on the base rate.

Summing Up

When looking into base rate fallacy in the realm of behavioral finance, you must keep in mind that the purpose of this discussion is to delve into the usefulness of both macro and micro indicators. Thus, you must look into the different sources of macroeconomic data and the various events-specific information that these sources contain. By doing so, you will find a useful tool that will help you understand what is currently going on in your local market.

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