(Reference Appendix #1a) Recently the Dow Jones Industrial Average has reached historical highs and then receded back to previous levels, leaving investors who are used to consistent and record setting gains month after month, baffled. Both the Dow Jones and the S & P 500 indices have seen modest and even flat performances over the past three months. (Reference #1b)A recent article that was published on the front page of the Wall Street Journal emphasized that returns were flat due to the fact that investors were concerned of the possible on set of inflation. If these concerns are warranted and inflation is thus expected, the Bull market may very well be over. This after all makes sense, inflation has slowed and stopped many run-ups in the past, and the onset of inflation now could very well do the same.
While the article introduced some possibilities, it said nothing of the likelihood, the causes of, the Fed. ‘s reactions to, and the probability of expected inflationary increases in the future. This paper is thus dedicated to expanding on these ideas by exploring the rationality of these concerns by examining the circumstances surrounding inflation. It is my speculation that the Bull market may eventually correct itself in the future, but not in the short term due to immediate inflation.
That is, that the market was in fact flat due investors concerns, but actual imperative inflation does not look to be expected in the near future. In order to begin to understand the nature of market trends and forces, one must first consider the current state of the U. S. economy relative to its’ business cycle.
Certain aggregates can be measured that tell us a great deal about this. These aggregates have a strong history of leading, coinciding, or lagging the relative business cycle with a high amount of regular correlation. In fact the composite index of leading indicators shows that they have not experienced a significant downturn since the early 1980’s, and have been increasing rather sharply over the past 3 years. The fact that all of these indicators are currently rising indicate that the economy is in a period of robust growth, or an expansionary phase. The fruits of this expansion have proven to be many, however it is often said that too much of a good thing can be bad.
In this regard there are factors associated with the degree and nature of this economy, which could cause slowdown. For example, how is inflation measured, and to what degree should we be concerned with the effects and attributes of cost- push and demand- pull sources of inflation in this robust economy? According the Baye and Jansen, inflation can be measured by considering the growth of the money supply, the growth of M velocity, and the growth of real output. Algebraically this is represented by the equation: inflation = (gm + gv) – gy. This equation thus considers the monetary, supply-push, and demand-pull factors.
When the rate of inflation is measured in this way one can see, that over the last few years inflation has been relatively stable about its’ trend. This is in part, a result of the steady growth of GDP over the same period, and is testimony to the success of the Federal Reserve Board’s monetary and fiscal policies. The rates of inflation over the last 10 years are graphically illustrated in Appendix 3A. Cost-push inflation incurs when the prices of inputs for production increase and thus cause profit margins to diminish. If firms are unwilling or unable to accept the declination in operating income, they will pass these increases on to consumers in the form of increased prices. In a competitive market it would seem that firms would be unable to raise prices, unless there was uniform pressure affecting the aggregate whole of suppliers.
(Examples include per unit costs of production, labor costs, energy prices, etc. . ) Both the dollar cost per person per hour, and the output per person have been increasing since 1997. These increases are most likely in response to technological advances in the public and private sectors.
It is worth noting that the advances in compensation have exceeded those in output. Hence firms may have experienced a decline in marginal revenues. Another important aspect regarding wages and output is that the rates of increase for both have been declining since the second quarter of 1998. In the third quarter of 1999, real output was increasing more than the rate at which wages are increasing. This correction may be important when considering cost-push inflationary pressures.
(Appendix 3b) On an aggregate level one can measure rising producer costs by examining the producer price index. Appendix 3c graphically explores trends related to the PPI over the past three years. Upon examination it is clear that producer costs have been increasing steadily since 1997. This may be due in part to rising costs of compensation along with recent run-ups on crude oil prices. There is likely a strong correlation between the producer price index and the consumer price index, (The dependent variable) and is therefore important to include when making a forecast of future inflation.
There may also be inflationary pressures attributable to demand-pull effects. This occurs when there are too many dollars chasing too few goods. A point to consider here is worker compensation and disposable personal income. The aggregate disposable personal income has been increasing over the recent economic prosperity. The key here is that the increases in income have been fairly stable.
It is because of this stability that there appears to be little correlation when disposable personal income is regressed against inflation. Despite the low R^2 variable it still may be a worthy component to add to an inflation forecast. The growth of this economy has been very great, and this is support by strong consumer confidence. An area that would seem to contribute to this robust growth and inflationary pressure is the savings rate.
Regardless of which indices or months one looks at, it is clear that personal saving in 1999 in considerably down from all other years. This may have an impact on the velocity of money and thus inflation in the future. The cyclical and irregular activity of the business cycle can be determined by detrending and deseasonalizing the real GDP data. (Appendix 4a) In doing so, one can see how the rates of inflation are correlated with that of the business cycle. The cyclical percentage changes in GDP serve as a good variable in inflationary forecasts because; significant amounts of real increase or decrease tend to be correlated with changes in inflation. When inflation is regressed against the cyclical increases in real GDP, the R^2 value is approximately 32%, indicating a moderate and useful amount of correlation.
Therefore I have also include this variable in my forecasting models. Perhaps the most significantly correlated variable that I have come across is percentage changes in monetary velocity. This predictor shows R^2 percentages in excess of 76%. Clearly, fluctuations in the velocity of money have a significant effect on inflation.
Once the inflationary pressures of the 1980’s resided the velocity of money began its steady upward climb. Only in the last few years has this rate begun to slow and decline. It would appear that the current trend in the velocity of money is one that reflects optimistic consumer behavior. (Appendix 5a shows the trends in the velocity of money over the past few decades. ) Meanwhile the M2 money stock has been increasing at a fairly consistent rate for some time, with very little variation about its’ trend. (A.
5b) Although in the second quarter the M2 money stock increased by a somewhat larger margin than was originally expected. The above considerations were important when I attempted to create a forecast for inflation by applying techniques discussed in Economic Forecasting 470. In order to attain the most accurate forecast I tried several different methods; including a bivariate, a multivariate, a multivariate with dummy variables, an automatic forecast, and a combination of techniques model. The Bivariate model was based on regressing inflation against the cyclical and irregular behavior of gross domestic product in order to see how the business cycle affected the rate of inflation.
This model produced a significant regression statistic near 32%. In other words, roughly one-third of the variation in inflation can be explained by the stage of the business cycle. Both of the multivariate models contained the following predictor variables; detrended seasonally adjusted GDP, changes in the M2 money stock, changes in the velocity of money, changes in the Ppi, and changes in real wages. The most highly correlated variable being percentage changes in the velocity of money (76)%, and the least correlated being changes in the Ppi (4%). The multivariate model was able to produce a regression statistic of approximately 46%.
The multivariate with dummy variables actually produce a lower R^2 value, and thus a less dependable model. The automatic forecasting method with Smart software produced a model, which could explain 79% of the data. The software chose a single exponential smoothing model for its’ forecast which produced a Durbin Watsin statistic of 1. 85, and standard error statistic of 1. 211. This model eventually proved to be the superior model because of its lower than others error statistics.
The combination model produced lower MAD, MSE, RMSE statistics than did the automatic method, but smoothing model was more accurate in that it produced a significantly lower MAPE. The summary of method errors, as well as forecasting models, are contained in appendix 6a. Therefore, using these crude methods I have been able to determine that Smart’s single exponential smoothing model provides the most accurate forecasting tool for considering this type of numerical data. Based on this model, the forecasted values of inflation for the third and fourth quarters of 1999 are as follows: Q3 = -3.
166*. 258*3. 682 Q4 = -3. 216*. 258*3.
732 Smart software estimates these value ranges with 95% confidence and an average forecast error of 1. 689. By considering some current events that are taking place in the domestic and global economy one might be able to more reasonably estimate this range, and thus assert some greater probabilities upon it. As of August 24, 1999 the Federal Reserve Board took a stance to reduce the leverage of some contributive inflationary aggregates.
These actions included a . 25% increase in the federal funds rate, bringing the total to about 5. 25%. As discussed in Money and Banking, this will have a direct impact on the reserve positions and actions for lending institutions. The FOMC helped to accommodate this position stance by selling treasury securities in the secondary market.
This is but one of the FOMC directives that can produce this effect. By doing so it detracts funds from the banks, thus further tightening their positions. On November 3, 1999, the Federal Reserve Bank of Minneapolis released a document prepared with information accumulated before October 25, 1999. These findings were summarized and placed in the Beige Book.
Within this report there is data pertaining to the latest statistics on consumer spending, manufacturing, labor markets, wages and prices, real estate and construction, and banking and finance. The article points out that the majority of districts are reporting increases in consumer outlays, and only a handful show signs of slowing. Some of these districts report that consumer expenditures might be down only due to the effects of hurricane Floyd. Most reported positive outlooks as the economy continues its’ wild ride and the Holiday seasons are soon approaching. Virtually all districts reported increases in manufacturing across a wide variety of economic sector and industries.
This includes massive increases in biotech’s to strong growth in paper processing. The November 3 Beige Book for Minneapolis also points out that labor markets are saturated and the demand for workers exceeds that of the supply in many areas. This may be taken as good news from a college student’s perspective, but at the same time it might also add to cost-push inflationary pressures. Given the increases in wages and disposable income, it is no doubt that mortgage markets continue to prosper.
The east coast has seen 5 to 6 % increases in property value, but the volume of loans is growing at much smaller rate. (1 to 2%) On December 1, 1999 the Bureau of Economic Analysis (BEA) released their information pertaining to the third quarter of 1999. This article contained much information, including some of the most recent economic estimates and reports. Among them was news concerning the trade deficit.
Because net exports is a component of GDP, it is important to recognize the nature of this sector when considering the future magnitude of GDP, potential inflation, and future monetary and fiscal policies determined by the Fed. It is plain to see that the recent currency crisis, increasing energy costs, and tariff problems with China have had a profound effect on the trade deficit. (As demonstrated graphically in appendix 7a) The rate of increase related to the trade deficit, and imports exceeded that of any other in two decades. It is also noteworthy that export growth during this time had slowed considerably and even decreased.
The BEA noted that for the first time in many months, foreign markets were beginning to show signs of real recovery. Having noted this the article went on to mention that import growth had showed only a slight increase above last quarters, and exports showed a 7% increase over last quarter. If these trends continue it could mean additional growth to gross domestic product. The increases have predominantly from Japan and other industrial countries, while the Asian tigers and Latin America are still in turmoil.
To what extent this news is relevant to the domestic economy in terms of growth and inflationary pressures has yet to be seen. However it does seem logical that we can expect the trade deficit to at least flatten out in the coming months, or even experience some decline depending on the resiliency of the other foreign markets. The BEA also estimated that GDP had increased by approximately 5. 5% in the third quarter up from an increase of 1. 9% in the second.
This number was slightly higher than the upper range of an earlier estimate. Related to this increase the bureau noted that corporate profits related to current production were up, although the profits per unit of real production have decreased. These tendencies might be correlated to the factors earlier discussed relating to wage increases relative to productivity. Though not mentioned by the BEA the rate of unemployment continues to slide toward all time lows. Day in and day out, reports of local, state, and federal record low unemployment is being reported. Thus the amount of cyclical unemployment in the economy is virtually zero, and the economy is operating at near full capacity.
The unemployment rate is graphically illustrated in appendix 7b. This economics student is not ready to say how long the economy can sustain these r. p. m. ‘s, but does know that eventually the engine must be cooled or the economic expansion and bull market may come to an abrupt end.
At the time of the August 24 meeting the Federal Reserve Board and Dr. Greenspan did not anticipate the need for any further tightening of the reserve markets in the near future. Given the fact that the economy has continued to outperform economists expectations over the inter-meeting period, it will be interesting to see what courses of action and concerns the Fed discusses at the next meeting. (Scheduled sometime near the end of November) What do these rapid and consistent increases mean for the domestic economy.
From my perspective, this economy is all I have known. Many of the problems that used to face Americans seem to have been deleted. Leaving us today with the new challenges and fronts to conquer. One of these challenges is keeping this economy heading in a positive and stable direction. A looming threat to the stock markets and domestic economy is inflation.
While doing research for this paper I stumbled across the unofficial fan club for Alan Greenspan. I had never heard of a fan club for an economist, but after seeing how stable the growth rates of GDP and inflation have been, my interest and admiration are growing quickly. Earlier this year Fred Vogelstein wrote an article quoting Mr. Greenspan as saying, “Do worry.
Be unhappy. ” This from an economist with his own fan club; sounds like trouble. The article summarized some of Greenspan’s remarks in which he speculated about the increasing probability of an “inflation spike” and increased interest rates. He also pointed the possibility of a stock market correction, and the possible onset of a bear market. Given the above remarks from Mr.
Vogelstein’s article it seems likely that the inflation forecast previously presented will likely be in the upper portion of the range. That is, it is likely to be between . 25 and 3. 7% for the remainder of 1999. Though it is important to note that this analysis is based strictly on numerical data, and does not consider the realities of global economics.
Inflation to investors generally means that their actual returns are going down. As a result the prices are usually bid down in order to better reflect the required yield on equity. Based on my further analysis of this article it seems that investors concerns about inflation were and are indeed genuine, and the onset of inflation in the future could mean further plateaus in equity prices and increases in interest rates. However, I believe that this course of events might also present diversified and risk adverse investors with several opportunities to strengthen their positions, and add some securities that might be presently overvalued. (Increasing energy prices also increase the attractiveness for companies such as bldp and ucr. ) Bibliography Works Cited (1) Baye/Jansen.
“Money and Banking. ” Houghton Mifflin Publishing Company. (1995) Pages 61-88. (2) Economagic, (1999) “Economic Time Series Page.
” ; http://www. economagic. com/; (3) “Employment Cost Trends. ” BLS, (1999) ; http://stats.
bls. gov/ecthome. htm; (4) Freidma. “PPT Slide Show.
” http://www. ecom. unimelb. edu. au/ecowww/rdixon/101/notes/msi/tsld001. htm (5) The Hutchinson Encyclopedia.
“Inflation” Helicon Publishing (1999) http://ukdb. web. aol. com/hutchinson/encyclopedia/30/M0006130.
htm (6) Manering, Virginia. “BEA News Release. ” Bureau of Economic Analysis (11/24/99) (7) “Minutes of the Federal Open Market Committee” The Federal Reserve Board. (8/24/99) ; http://www. bog. frb.
fed. us/fomc/MINUTES/19990824. HTM; (8) “The Beige Book” The Federal Reserve Board. Summary (11/3/99). (9) Vogelstein, Fred.
“Do Worry. Be Unhappy.” Us News Online (3/8/99) Word Count: 3064