Base Effects

The Wall Street Journal explains why investors and economy watchers need to familiarize themselves with the idea of “base effects” right now if they want to keep any perspective about what’s going on…

The problem is when something screwy happens a year earlier. The base from which a year-over-year comparison is calculated becomes distorted. If a company takes a hit in one year and then gets back to normal the next, it can look like its profits are soaring when in fact they are just getting back on track.

Case in point: Earnings per share for companies that make up the S&P 500 stock index were up 225% in the first quarter this year from a year earlier, according to S&P Global, in part because they took such a big hit during the January through March period of 2020.

The Fed is now struggling with this challenge as it relates to inflation. The consumer-price index was up 4.2% in April from a year earlier, about double the central bank’s inflation target of 2%. However, a year ago Covid-19 was causing havoc for the economy in addition to corporate profits. Prices for services like hotels, air flights and car rentals collapsed. The 4% comparison could provide an exaggerated snapshot of price pressures because it is from a deflated base in April 2020.

That’s Jon Hilsenrath writing about the debate taking place both inside of the Federal Reserve and all around it as the pace of stimulus continues apace despite the obviously game-changing “reopen.”

Last spring Morgan Housel, myself and other bloggers were talking about how the comps this years versus last year would look like typos. That Q1 225% earnings growth example is a good one. There’s lots of other examples in everything from auto sales to housing starts. It’s probably better to think about this stuff versus the same time in 2019 as opposed to looking at year over year anything from the first half of 2020.

So, yes, obviously prices are rising for both goods and services throughout the economy. But the statistics are misleading without the context.

Source:

The Fed’s Inflation View Is All About That Base (WSJ)