Braking Down The News

The Fed’s Inflation View Is All About That Base

Comparisons to one year ago are a challenge, so try two

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Federal Reserve officials are talking a lot these days about base effects.

That relates to how the economy looks now compared with a year ago. Such year-over-year comparisons provide a sense of how the economy is changing over time. Corporate profits are often deciphered based on year-ago comparisons, too.

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.

 

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