Did you know that the foreign exchange market (also known as FX or forex) is the largest market in the world? In fact, more than $3 trillion is traded in the currency markets on a daily basis as of 2009. This article is certainly not a primer for currency trading, but it will help you understand exchange rates and why some fluctuate while others do not.
What Is an Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.
Fixed Exchange Rates
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged
If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.
Floating Exchange Rates
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a "black market", which is more reflective of actual supply and demand, may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, it is less often that the central bank of a floating regime will interfere.
The World Once Pegged
Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade; however, with the start of World War I, the gold standard was abandoned.
At the end of World War II, the conference at Bretton Woods, an effort to generate global economic stability and increase global trade, established the basic rules and regulations governing international exchange. As such, an international monetary system, embodied in the International Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries and therefore that of the global economy.
It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce. What this meant was that the value of a currency was directly linked with the value of the U.S. dollar. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of gold.
From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.
Why Peg?
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.
Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to maintain in the long run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming overvalued. This meant that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get their money out and convert it into foreign currency before the local currency was devalued against the peg; foreign reserve supplies eventually became depleted. In Mexico's case, the government was forced to devalue the peso by 30%. In Thailand, the government eventually had to allow the currency to float, and by the end of 1997, the Thai bhat had lost 50% of its as the market's demand and supply readjusted the value of the local currency. (For more insight, see What Causes A Currency Crisis?)
Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions. The peg is therefore there to help create stability in such an environment. It takes a stronger system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is also required to proceed with some form of economic reform, like implementing greater transparency, in an effort to strengthen its financial institutions.
Some governments may choose to have a "floating," or "crawling" peg, whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually this causes devaluation, but it is controlled to avoid market panic. This method is often used in the transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to devalue in an uncontrollable crisis.
Conclusion
Although the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it. And while a floating regime is not without its flaws, it has proved to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.
Showing posts with label Economics. Show all posts
Showing posts with label Economics. Show all posts
Saturday, August 28, 2010
Friday, August 20, 2010
Can Keynesian Economics Reduce Boom-Bust Cycles?
Why do economic downturns, such as the Great Depression, occur? How does an economy find itself in the perfect storm of high unemployment, a liquidity crisis and rapidly declining consumption? How can the effects of recessions and depressions be mitigated? For years economists struggled with these problems, but a British economist's ideas in the early twentieth century offered a possible solution. Read on to find out how John Maynard Keynes' theories changed the course of modern economics.
Keynesian Economics
John Maynard Keynes (1883-1946) was a British economist educated in economics at the University of Cambridge. He was fascinated by mathematics and history, but eventually took interest in economics at the prompting of one of his professors, famed economist Alfred Marshall (1842-1924). After leaving Cambridge, he took up a variety of government positions, focusing on the application of economics to real world problems. He rose in importance during the World War I, and served as an advisor at conferences leading to the Treaty of Versailles. It was his 1936 book, "General Theory on Unemployment, Interest and Money", however, which would lay the foundations for his legacy: Keynesian economics.
The field of economics studied by Keynes at Cambridge focused on classical economics, whose founders included Adam Smith, the author of "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776). Classical economics focused on a laissez-faire approach to market corrections, and in some ways was still a relatively primitive approach to the field. Prior to classical economics, much of the world was still emerging from a feudal economic system, and industrialization had yet to fully take hold. Keynes' book essentially created the field of modern macroeconomics by looking at the role aggregate demand plays.
The Keynesian theory attributes the emergence of a depression to several factors:
* The circular relationship between spending and earning (aggregate demand)
* Savings
* Unemployment
Aggregate Demand
Aggregate demand is the total demand for goods and services in an economy, and is often considered to be the gross domestic product (GDP) of an economy at a given point in time. It has four key components:
* Consumption (by consumers who buy goods and services) - C
* Investment (by businesses in order to produce more goods and services) - I
* Government spending - G
* Net exports (value of exports minus imports) - NX
Together, these components become C + I + G +NX, the formula for aggregate demand.
If one of the components decreases, another one of the components will have to increase in order to keep GDP at the same level. (To learn more, check out our related article Understanding Supply-Side Economics.)
Savings
Savings is was viewed by Keynes to have an adverse effect on the economy, especially if the savings rate is high or excessive. Because a major factor in the aggregate demand model is consumption, if individuals put money in the bank rather than buying goods or services, the GDP will fall. In addition, a decline in consumption leads businesses to produce less and require fewer workers, which increases unemployment. Businesses also are less willing to invest in new factories.
Unemployment
One of the groundbreaking aspects of the Keynesian theory was its treatment of employment. Classical economics focused on the idea that markets settle at full employment. Keynes theorized, however, that wages and prices are flexible, and that full employment is not necessarily attainable or optimal. This means that the economy seeks to find a balance between the wages that workers demand and the wages that businesses can supply. If the unemployment rate falls, fewer workers are available to businesses looking to expand, which means that workers can demand higher wages. A point exists at which the business will no longer hire.
Wages can be expressed in both "real" and "nominal" terms. Real wages take into account the effect of inflation, while nominal wages do not. To Keynes, businesses would have a hard time forcing workers to cut their nominal wage rates, and it was only after other wages fell across the economy or the price of goods fell (deflation) that workers would be willing to accept lower wages. In order to increase employment levels the real, inflation-adjusted wage rate would have to fall. This, however, could result in a deepening depression, lower sentiment and a decrease in aggregate demand. Additionally, Keynes theorized that wages and prices responded slowly (were "sticky") to changes in supply and demand. One possible solution was direct government intervention.
The Role of Governments
One of the primary players in the economy is the central government. It can influence the direction of the economy through its control of the money supply; both by its ability to alter interest rates or by buying back or selling government-issued bonds. In Keynesian economics the government takes an interventionist approach – it does not wait for market forces to improve GDP and employment. This results in the use of deficit spending.
As one of the components of aggregate demand function mentioned earlier, government spending can create demand for goods and services if individuals are less willing to consume and businesses less willing to build more factories. Government spending can use up the extra production capacity. Keynes also theorized that the overall effect of government spending would be "multiplied" if the businesses employed hire more people, and if the employees spend money through consumption.
It is important to understand that the role of the government in the economy is not solely to dampen the effects of recessions or pull a country out of a depression - it also must keep the economy from heating up too quickly. Keynesian economics suggests that the interaction between the government and the overall economy move in the opposite direction of the business cycle: more spending in a downturn, less spending in an upturn. If an economic boom creates high rates of inflation, the government could cut back its spending or increase taxes. This is referred to as fiscal policy.
Use of the Keynesian Theory
The Great Depression served as the catalyst that shot John Maynard Keynes into the spotlight, though it should be noted that he wrote his book several years after the Great Depression. During the early years of the Depression, many key figures, including then President Franklin D. Roosevelt, felt that the notion of the government "spending the economy to health" seemed too simple a solution. It was by placing the economy in terms of the demand for goods and services that made the theory stick. In his New Deal, Roosevelt employed workers in public projects, both providing jobs and creating demand for goods and services offered by businesses. Government spending also rapidly increased during the World War II, as the government poured billions of dollars into companies manufacturing military equipment.
The Keynesian theory was used in the development of the Phillips curve, which examines unemployment, and the ISLM Model.
Criticisms of Keynesian Theory
One of the more outspoken critics of Keynes and his approach was economist Milton Friedman. Friedman helped develop the monetarist school of thought (monetarism), which shifted its focus toward the role money supply has on inflation rather than the role of aggregate demand. Government spending can push out spending by private businesses because less money is available in the market for private borrowing, and monetarists suggested this be alleviated through monetary policy: the government can increase interest rates (making borrowing money more expensive) or sell Treasury securities (decreasing the amount of available funds for lending) to beat inflation.
Another criticism of the theory is that it leans toward a centrally planned economy. If the government is expected to spend funds to thwart depressions, it is implied that the government knows what is best for the economy as a whole. This eliminates the effects of market forces on decision-making. This critique was popularized by economist Friedrich Hayek in his 1944 work, "The Road to Serfdom". In the forward to a German edition of Keynes' book, it is indicated that his approach might work best in a "totalitarian state".
Conclusion
While the Keynesian theory in its original form is rarely used today, its radical approach to business cycles and solutions to depressions had a profound impact on the field of economics. Today, many governments use portions of this theory to smooth out the boom-and-bust cycles of their economies, and economists combine Keynesian principles with macroeconomics and monetary policy to determine what course of action to take.
Keynesian Economics
John Maynard Keynes (1883-1946) was a British economist educated in economics at the University of Cambridge. He was fascinated by mathematics and history, but eventually took interest in economics at the prompting of one of his professors, famed economist Alfred Marshall (1842-1924). After leaving Cambridge, he took up a variety of government positions, focusing on the application of economics to real world problems. He rose in importance during the World War I, and served as an advisor at conferences leading to the Treaty of Versailles. It was his 1936 book, "General Theory on Unemployment, Interest and Money", however, which would lay the foundations for his legacy: Keynesian economics.
The field of economics studied by Keynes at Cambridge focused on classical economics, whose founders included Adam Smith, the author of "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776). Classical economics focused on a laissez-faire approach to market corrections, and in some ways was still a relatively primitive approach to the field. Prior to classical economics, much of the world was still emerging from a feudal economic system, and industrialization had yet to fully take hold. Keynes' book essentially created the field of modern macroeconomics by looking at the role aggregate demand plays.
The Keynesian theory attributes the emergence of a depression to several factors:
* The circular relationship between spending and earning (aggregate demand)
* Savings
* Unemployment
Aggregate Demand
Aggregate demand is the total demand for goods and services in an economy, and is often considered to be the gross domestic product (GDP) of an economy at a given point in time. It has four key components:
* Consumption (by consumers who buy goods and services) - C
* Investment (by businesses in order to produce more goods and services) - I
* Government spending - G
* Net exports (value of exports minus imports) - NX
Together, these components become C + I + G +NX, the formula for aggregate demand.
If one of the components decreases, another one of the components will have to increase in order to keep GDP at the same level. (To learn more, check out our related article Understanding Supply-Side Economics.)
Savings
Savings is was viewed by Keynes to have an adverse effect on the economy, especially if the savings rate is high or excessive. Because a major factor in the aggregate demand model is consumption, if individuals put money in the bank rather than buying goods or services, the GDP will fall. In addition, a decline in consumption leads businesses to produce less and require fewer workers, which increases unemployment. Businesses also are less willing to invest in new factories.
Unemployment
One of the groundbreaking aspects of the Keynesian theory was its treatment of employment. Classical economics focused on the idea that markets settle at full employment. Keynes theorized, however, that wages and prices are flexible, and that full employment is not necessarily attainable or optimal. This means that the economy seeks to find a balance between the wages that workers demand and the wages that businesses can supply. If the unemployment rate falls, fewer workers are available to businesses looking to expand, which means that workers can demand higher wages. A point exists at which the business will no longer hire.
Wages can be expressed in both "real" and "nominal" terms. Real wages take into account the effect of inflation, while nominal wages do not. To Keynes, businesses would have a hard time forcing workers to cut their nominal wage rates, and it was only after other wages fell across the economy or the price of goods fell (deflation) that workers would be willing to accept lower wages. In order to increase employment levels the real, inflation-adjusted wage rate would have to fall. This, however, could result in a deepening depression, lower sentiment and a decrease in aggregate demand. Additionally, Keynes theorized that wages and prices responded slowly (were "sticky") to changes in supply and demand. One possible solution was direct government intervention.
The Role of Governments
One of the primary players in the economy is the central government. It can influence the direction of the economy through its control of the money supply; both by its ability to alter interest rates or by buying back or selling government-issued bonds. In Keynesian economics the government takes an interventionist approach – it does not wait for market forces to improve GDP and employment. This results in the use of deficit spending.
As one of the components of aggregate demand function mentioned earlier, government spending can create demand for goods and services if individuals are less willing to consume and businesses less willing to build more factories. Government spending can use up the extra production capacity. Keynes also theorized that the overall effect of government spending would be "multiplied" if the businesses employed hire more people, and if the employees spend money through consumption.
It is important to understand that the role of the government in the economy is not solely to dampen the effects of recessions or pull a country out of a depression - it also must keep the economy from heating up too quickly. Keynesian economics suggests that the interaction between the government and the overall economy move in the opposite direction of the business cycle: more spending in a downturn, less spending in an upturn. If an economic boom creates high rates of inflation, the government could cut back its spending or increase taxes. This is referred to as fiscal policy.
Use of the Keynesian Theory
The Great Depression served as the catalyst that shot John Maynard Keynes into the spotlight, though it should be noted that he wrote his book several years after the Great Depression. During the early years of the Depression, many key figures, including then President Franklin D. Roosevelt, felt that the notion of the government "spending the economy to health" seemed too simple a solution. It was by placing the economy in terms of the demand for goods and services that made the theory stick. In his New Deal, Roosevelt employed workers in public projects, both providing jobs and creating demand for goods and services offered by businesses. Government spending also rapidly increased during the World War II, as the government poured billions of dollars into companies manufacturing military equipment.
The Keynesian theory was used in the development of the Phillips curve, which examines unemployment, and the ISLM Model.
Criticisms of Keynesian Theory
One of the more outspoken critics of Keynes and his approach was economist Milton Friedman. Friedman helped develop the monetarist school of thought (monetarism), which shifted its focus toward the role money supply has on inflation rather than the role of aggregate demand. Government spending can push out spending by private businesses because less money is available in the market for private borrowing, and monetarists suggested this be alleviated through monetary policy: the government can increase interest rates (making borrowing money more expensive) or sell Treasury securities (decreasing the amount of available funds for lending) to beat inflation.
Another criticism of the theory is that it leans toward a centrally planned economy. If the government is expected to spend funds to thwart depressions, it is implied that the government knows what is best for the economy as a whole. This eliminates the effects of market forces on decision-making. This critique was popularized by economist Friedrich Hayek in his 1944 work, "The Road to Serfdom". In the forward to a German edition of Keynes' book, it is indicated that his approach might work best in a "totalitarian state".
Conclusion
While the Keynesian theory in its original form is rarely used today, its radical approach to business cycles and solutions to depressions had a profound impact on the field of economics. Today, many governments use portions of this theory to smooth out the boom-and-bust cycles of their economies, and economists combine Keynesian principles with macroeconomics and monetary policy to determine what course of action to take.
Thursday, August 19, 2010
Market Cycles: The Key To Maximum Returns
We've all heard of market bubbles and many of us know someone who's been caught in one. Although there are plenty of lessons to be learned from past bubbles, market participants still get sucked in each time a new one comes around. A bubble is only one part of an important phase in markets, so if you want to avoid being caught off guard, it is essential to know what the different phases are. An understanding of how markets work and a good grasp of technical analysis can help you recognize market cycles.
The Four Phases
Cycles are prevalent in all aspects of life; they range from the very short term, like the life cycle of a June bug, which lives only a few days, to the life cycle of a planet, which takes billions of years.
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No matter what market you are referring to, all have similar characteristics and go through the same phases. All markets are cyclical. They go up, peak, go down and then bottom. When one cycle is finished, the next begins.
The problem is that most investors and traders either fail to recognize that markets are cyclical or forget to expect the end of the current market phase. Another significant challenge is that, even when you accept the existence of cycles, it is nearly impossible to pick the top or bottom of one. But an understanding of cycles is essential if you want to maximize investment or trading returns. Here are the four major components of a market cycle and how you can recognize them:
1. Accumulation Phase
This phase occurs after the market has bottomed and the innovators (corporate insiders and a few value investors) and early adopters (smart money managers and experienced traders) begin to buy, figuring that the worst is over. At this phase, valuations are very attractive, and general market sentiment is still bearish. Articles in the media preach doom and gloom, and those who were long through the worst of the bear market have recently capitulated, that is, given up and sold the rest of their holdings in disgust. But in the accumulation phase, prices have flattened and for every seller throwing in the towel, someone is there to pick it up at a healthy discount. Overall market sentiment begins to switch from negative to neutral.
2. Mark-Up Phase
At this stage, the market has been stable for a while and is beginning to move higher. The early majority are getting on the bandwagon. This group includes technicians who, seeing that the market is putting in higher lows and higher highs, recognize that market direction and sentiment have changed. Media stories begin to discuss the possibility that the worst is over, but unemployment continues to rise, as do reports of layoffs in many sectors. As this phase matures, more investors jump on the bandwagon as fear of being in the market is supplanted by greed and the fear of being left out.
As this phase begins to come to an end, the late majority jump in and market volumes begin to increase substantially. At this point, the greater fool theory prevails. Valuations climb well beyond historic norms, and logic and reason take a back seat to greed. While the late majority are getting in, the smart money and insiders are unloading. But as prices begin to level off, or as the rise slows down, those laggards who have been sitting on the sidelines see this as a buying opportunity and jump in en masse. Prices make one last parabolic move, known in technical analysis as a selling climax, when the largest gains in the shortest periods often occur. But the cycle is nearing the top of the bubble. Sentiment moves from neutral to bullish to downright euphoric during this phase.
3. Distribution Phase
In the third phase of the market cycle, sellers begin to dominate. This part of the cycle is identified by a period in which the bullish sentiment of the previous phase turns into a mixed sentiment. Prices can often stay locked in a trading range that can last a few weeks or even months. For example, when the Dow Jones Industrial Average (DJIA) peaked in Jan 2000, it traded down to the vicinity of its prior peak and stayed there over a period of more than 18 months. But the distribution phase can come and go quickly; for the Nasdaq Composite, the distribution phase was less than a month long, as it peaked in Mar 2000 and then retreated shortly thereafter. When this phase is over, the market reverses direction. Classic patterns like double and triple tops, as well as head and shoulders top patterns, are examples of movements that occur during the distribution phase.
The distribution phase is a very emotional time for the markets, as investors are gripped by periods of complete fear interspersed with hope and even greed as the market may at times appear to be taking off again. Valuations are extreme in many issues and value investors have long been sitting on the sidelines. Sentiment slowly but surely begins to change, but this transition can happen quickly if accelerated by a strongly negative geopolitical event or extremely bad economic news. Those who are unable to sell for a profit settle for a breakeven or a small loss.
4. Mark-Down Phase
The fourth and final phase in the cycle is the most painful for those who still hold positions. Many hang on because their investment has fallen below what they paid for it, behaving like the pirate who falls overboard clutching a bar of gold, refusing to let go in the vain hope of being rescued. It is only when the market has plunged 50% or more that the laggards, many of whom bought during the distribution or early mark-down phase, give up or capitulate. Unfortunately, this is a buy signal for early innovators and a sign that a bottom is imminent. But alas, it is new investors who will buy the depreciated investment during the next accumulation phase and enjoy the next mark-up.
Timing
A cycle can last anywhere from a few weeks to a number of years, depending on the market in question and the time horizon at which you are looking. A day trader using five-minute bars may see four or more complete cycles per day while, for a real estate investor, a cycle may last 18-20 years.
The Presidential Cycle
One of the best examples of the cycle phenomenon is the effect of the four-year presidential cycle on the stock market, real estate, bonds and commodities. The theory about this cycle states that economic sacrifices are generally made during the first two years of a president's mandate. As the election draws nearer, administrations have a habit of doing everything they can to stimulate the economy so that voters go to the polls with jobs and a feeling of economic well being.
Interest rates are generally lower in the year of an election, so experienced mortgage brokers and real estate agents often advise clients to schedule mortgages to come due just prior to an election. This strategy has worked quite well during the last 16 years. The stock market has also benefited from increased spending and decreased interest rates leading up to an election, as was certainly the case in the 1996 and 2000 elections. Presidents know that if voters are not happy about the economy when they go to the polls, chances for re-election are slim to none, as George Bush Sr. learned the hard way in 1992.
Summing Up
Although not always obvious, cycles exist in all markets. For the smart money, the accumulation phase is the time to buy because values have stopped falling and everyone else is still bearish. These types of investors are also called contrarians since they are going against the common market sentiment at the time. These same folks sell as markets enter the final stage of mark-up, which is known as the parabolic or buying climax. This is when values are climbing fastest and sentiment is most bullish, which means the market is getting ready to reverse.
Smart investors who recognize the different parts of a market cycle are more able to take advantage of them to profit. They are also less likely to get fooled into buying at the worst possible time.
The Four Phases
Cycles are prevalent in all aspects of life; they range from the very short term, like the life cycle of a June bug, which lives only a few days, to the life cycle of a planet, which takes billions of years.
.
No matter what market you are referring to, all have similar characteristics and go through the same phases. All markets are cyclical. They go up, peak, go down and then bottom. When one cycle is finished, the next begins.
The problem is that most investors and traders either fail to recognize that markets are cyclical or forget to expect the end of the current market phase. Another significant challenge is that, even when you accept the existence of cycles, it is nearly impossible to pick the top or bottom of one. But an understanding of cycles is essential if you want to maximize investment or trading returns. Here are the four major components of a market cycle and how you can recognize them:
1. Accumulation Phase
This phase occurs after the market has bottomed and the innovators (corporate insiders and a few value investors) and early adopters (smart money managers and experienced traders) begin to buy, figuring that the worst is over. At this phase, valuations are very attractive, and general market sentiment is still bearish. Articles in the media preach doom and gloom, and those who were long through the worst of the bear market have recently capitulated, that is, given up and sold the rest of their holdings in disgust. But in the accumulation phase, prices have flattened and for every seller throwing in the towel, someone is there to pick it up at a healthy discount. Overall market sentiment begins to switch from negative to neutral.
2. Mark-Up Phase
At this stage, the market has been stable for a while and is beginning to move higher. The early majority are getting on the bandwagon. This group includes technicians who, seeing that the market is putting in higher lows and higher highs, recognize that market direction and sentiment have changed. Media stories begin to discuss the possibility that the worst is over, but unemployment continues to rise, as do reports of layoffs in many sectors. As this phase matures, more investors jump on the bandwagon as fear of being in the market is supplanted by greed and the fear of being left out.
As this phase begins to come to an end, the late majority jump in and market volumes begin to increase substantially. At this point, the greater fool theory prevails. Valuations climb well beyond historic norms, and logic and reason take a back seat to greed. While the late majority are getting in, the smart money and insiders are unloading. But as prices begin to level off, or as the rise slows down, those laggards who have been sitting on the sidelines see this as a buying opportunity and jump in en masse. Prices make one last parabolic move, known in technical analysis as a selling climax, when the largest gains in the shortest periods often occur. But the cycle is nearing the top of the bubble. Sentiment moves from neutral to bullish to downright euphoric during this phase.
3. Distribution Phase
In the third phase of the market cycle, sellers begin to dominate. This part of the cycle is identified by a period in which the bullish sentiment of the previous phase turns into a mixed sentiment. Prices can often stay locked in a trading range that can last a few weeks or even months. For example, when the Dow Jones Industrial Average (DJIA) peaked in Jan 2000, it traded down to the vicinity of its prior peak and stayed there over a period of more than 18 months. But the distribution phase can come and go quickly; for the Nasdaq Composite, the distribution phase was less than a month long, as it peaked in Mar 2000 and then retreated shortly thereafter. When this phase is over, the market reverses direction. Classic patterns like double and triple tops, as well as head and shoulders top patterns, are examples of movements that occur during the distribution phase.
The distribution phase is a very emotional time for the markets, as investors are gripped by periods of complete fear interspersed with hope and even greed as the market may at times appear to be taking off again. Valuations are extreme in many issues and value investors have long been sitting on the sidelines. Sentiment slowly but surely begins to change, but this transition can happen quickly if accelerated by a strongly negative geopolitical event or extremely bad economic news. Those who are unable to sell for a profit settle for a breakeven or a small loss.
4. Mark-Down Phase
The fourth and final phase in the cycle is the most painful for those who still hold positions. Many hang on because their investment has fallen below what they paid for it, behaving like the pirate who falls overboard clutching a bar of gold, refusing to let go in the vain hope of being rescued. It is only when the market has plunged 50% or more that the laggards, many of whom bought during the distribution or early mark-down phase, give up or capitulate. Unfortunately, this is a buy signal for early innovators and a sign that a bottom is imminent. But alas, it is new investors who will buy the depreciated investment during the next accumulation phase and enjoy the next mark-up.
Timing
A cycle can last anywhere from a few weeks to a number of years, depending on the market in question and the time horizon at which you are looking. A day trader using five-minute bars may see four or more complete cycles per day while, for a real estate investor, a cycle may last 18-20 years.
The Presidential Cycle
One of the best examples of the cycle phenomenon is the effect of the four-year presidential cycle on the stock market, real estate, bonds and commodities. The theory about this cycle states that economic sacrifices are generally made during the first two years of a president's mandate. As the election draws nearer, administrations have a habit of doing everything they can to stimulate the economy so that voters go to the polls with jobs and a feeling of economic well being.
Interest rates are generally lower in the year of an election, so experienced mortgage brokers and real estate agents often advise clients to schedule mortgages to come due just prior to an election. This strategy has worked quite well during the last 16 years. The stock market has also benefited from increased spending and decreased interest rates leading up to an election, as was certainly the case in the 1996 and 2000 elections. Presidents know that if voters are not happy about the economy when they go to the polls, chances for re-election are slim to none, as George Bush Sr. learned the hard way in 1992.
Summing Up
Although not always obvious, cycles exist in all markets. For the smart money, the accumulation phase is the time to buy because values have stopped falling and everyone else is still bearish. These types of investors are also called contrarians since they are going against the common market sentiment at the time. These same folks sell as markets enter the final stage of mark-up, which is known as the parabolic or buying climax. This is when values are climbing fastest and sentiment is most bullish, which means the market is getting ready to reverse.
Smart investors who recognize the different parts of a market cycle are more able to take advantage of them to profit. They are also less likely to get fooled into buying at the worst possible time.
Monday, August 16, 2010
The Consumer Price Index: A Friend To Investors
Prices of goods and services fluctuate over time, but when prices change too much too quickly, the effects can shock an economy. The Consumer Price Index (CPI), the principle gauge of the prices of goods and services, indicates whether the economy is experiencing inflation, deflation or stagflation. The CPI's results are widely anticipated and watched; the CPI plays a role in many key financial decisions, including Federal Reserve interest-rate policy and the hedging decisions of major banks and corporations. Individual investors can also benefit from watching the CPI when making hedging and allocation decisions.
How the CPI Is Constructed
The U.S. Department of Labor's Bureau of Labor Statistics (BLS) releases the CPI data monthly, though the precise date varies from month to month. (A calendar is available on the BLS's website, and the next release date is on each report.) The report consists of three indexes representing the expenditures of two population groups: the CPI for urban wage earners and clerical workers (CPI-W), the CPI for all urban consumers (CPI-U), and the chained CPI for all urban consumers (C-CPI-U).
The base-year market basket of which the CPI is composed is derived from detailed expenditure information collected from thousands of families across the country. The information is collected via interviews and diaries kept by participants. The basket consists of more than 200 categories of goods and services separated into eight groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Also, the prices of 80,000 items in the market basket are collected monthly from thousands of retail stores, service establishments, rental units, and doctors' offices.
Conditions Illustrated by the CPI
The extensive measures taken to formulate a clear picture of changes in the cost of living helps key financial players get a sense of inflation, which can destroy an economy if it's allowed to run rampant. Both extreme deflation and inflation are feared, though the former is much less common.
We might naturally think of deflation, or falling prices, as a good thing. And they can be--in moderation and within certain limits. The price of phone calls, for example, has fallen for more than a century, and it is likely to continue falling with the shift to calls being funneled through the Internet. That's certainly not something you'll hear consumers complaining about. But deflation can undoubtedly be a bad thing. The best example is the Great Depression, when the legions of unemployed people couldn't afford to buy goods and services at any price.
When price increases get out of control, inflation is referred to as hyperinflation. The best known example of hyperinflation occurred in Germany in the 1920s, where the inflation rate hit 3.25 million percent a month. Then during World War II, Greece hit 8.55 billion percent a month and Hungary 4.19 quintillion a month. Hungary printed a 100 million billion Pengo note in 1946. At that point, money really becomes meaningless, and the government must revalue the currency denominations: what was once, say, a one-million-unit note then becomes a denomination of one unit of whatever the currency may be. Given these historical examples, it's easy to see why any sudden movement in either direction in the CPI can make people very nervous.
There are also several specific types of price fluctuations in the economy, such as disinflation, reflation and stagflation. Disinflation is a slowing of the inflation rate, but it's still an inflationary condition. And when inflation occurs in an economy that isn't growing, the situation is referred to as stagflation, resulting in any inflation being effectively amplified.
Some Uses of the CPI
The CPI is often used to adjust consumer income payments for changes in the dollar's value and to adjust other economic series. Social Security ties the CPI to income eligibility levels; the federal income tax structure relies on the CPI to make adjustments that avoid inflation-induced increases in tax rates; finally, employers use the CPI to make wage adjustments that keep up with the cost of living. Data series on retail sales, hourly and weekly earnings, and the national income and product accounts are all tied to the CPI to translate the related indexes into inflation-free terms.
The CPI and the Markets
Movements in the prices of goods and services most directly affect fixed-income securities. If prices are rising, fixed bond payments are worth less, effectively lowering the bonds' yields. Inflation also poses a serious problem to holders of fixed annuities and pension plans as it erodes the effective value of the fixed payments. Many retirees have watched their pension payment amounts lose buying power over time.
Price volatility can be bad for equities as well. Modest and steady inflation is to be expected in a growing economy, but if the prices of resources used in the production of goods rise quickly, manufacturers may experience profit declines. On the other hand, deflation can be a negative sign indicating a decline in consumer demand. In this situation manufacturers are forced to drop prices to sell their products, but the resources and commodities used in production may not fall by an equivalent amount. Again, the companies' margins are squeezed due to the stickiness of prices for some items and the elasticity of prices for other items.
Protecting Against Inflation
Fortunately, as the financial markets have become more sophisticated over time, investment products have been created to help even the average person hedge inflation risk. Mutual funds or banks concerned about rising inflation might purchase special inflation protected bonds known as TIPS. (You can read more on TIPS in Inflation Protected Securities - The Missing Link.) Furthermore, the Chicago Mercantile Exchange offers futures contracts on the CPI, which can be used to hedge inflation. These contracts also provide useful information about the market consensus for prices in the future.
Also, many people have significant equity in their homes, which is often a good inflation hedge. The investment of many homeowners has not only kept up with inflation, but outpaced it, earning a positive return. Also, products have been created to help people tap into this equity that is otherwise illiquid. With a reverse mortgage, for example, the owner receives payments, and the property is turned over at death. An inheritance may be reduced, but there's a steady stream of income drawn from the equity in the home to fund living expenses. However, this is not necessarily a perfect solution. If the credit options that are selected offer no growth component with an annual draw limit, the owner is exposed to inflation risk.
Conclusion
The CPI is probably the most important and widely-watched economic indicator, and it's the best known measure for determining cost of living changes--which, as history shows us, can be detrimental if they are large and rapid. The CPI is used to adjust wages, retirement benefits, tax brackets, and other important economic indicators. It can tell investors some things about what may happen in the financial markets, which share both direct and indirect relationships with consumer prices. By knowing the state of consumer prices, investors can make appropriate investment decisions and protect themselves by using investment products such as TIPS.
How the CPI Is Constructed
The U.S. Department of Labor's Bureau of Labor Statistics (BLS) releases the CPI data monthly, though the precise date varies from month to month. (A calendar is available on the BLS's website, and the next release date is on each report.) The report consists of three indexes representing the expenditures of two population groups: the CPI for urban wage earners and clerical workers (CPI-W), the CPI for all urban consumers (CPI-U), and the chained CPI for all urban consumers (C-CPI-U).
The base-year market basket of which the CPI is composed is derived from detailed expenditure information collected from thousands of families across the country. The information is collected via interviews and diaries kept by participants. The basket consists of more than 200 categories of goods and services separated into eight groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Also, the prices of 80,000 items in the market basket are collected monthly from thousands of retail stores, service establishments, rental units, and doctors' offices.
Conditions Illustrated by the CPI
The extensive measures taken to formulate a clear picture of changes in the cost of living helps key financial players get a sense of inflation, which can destroy an economy if it's allowed to run rampant. Both extreme deflation and inflation are feared, though the former is much less common.
We might naturally think of deflation, or falling prices, as a good thing. And they can be--in moderation and within certain limits. The price of phone calls, for example, has fallen for more than a century, and it is likely to continue falling with the shift to calls being funneled through the Internet. That's certainly not something you'll hear consumers complaining about. But deflation can undoubtedly be a bad thing. The best example is the Great Depression, when the legions of unemployed people couldn't afford to buy goods and services at any price.
When price increases get out of control, inflation is referred to as hyperinflation. The best known example of hyperinflation occurred in Germany in the 1920s, where the inflation rate hit 3.25 million percent a month. Then during World War II, Greece hit 8.55 billion percent a month and Hungary 4.19 quintillion a month. Hungary printed a 100 million billion Pengo note in 1946. At that point, money really becomes meaningless, and the government must revalue the currency denominations: what was once, say, a one-million-unit note then becomes a denomination of one unit of whatever the currency may be. Given these historical examples, it's easy to see why any sudden movement in either direction in the CPI can make people very nervous.
There are also several specific types of price fluctuations in the economy, such as disinflation, reflation and stagflation. Disinflation is a slowing of the inflation rate, but it's still an inflationary condition. And when inflation occurs in an economy that isn't growing, the situation is referred to as stagflation, resulting in any inflation being effectively amplified.
Some Uses of the CPI
The CPI is often used to adjust consumer income payments for changes in the dollar's value and to adjust other economic series. Social Security ties the CPI to income eligibility levels; the federal income tax structure relies on the CPI to make adjustments that avoid inflation-induced increases in tax rates; finally, employers use the CPI to make wage adjustments that keep up with the cost of living. Data series on retail sales, hourly and weekly earnings, and the national income and product accounts are all tied to the CPI to translate the related indexes into inflation-free terms.
The CPI and the Markets
Movements in the prices of goods and services most directly affect fixed-income securities. If prices are rising, fixed bond payments are worth less, effectively lowering the bonds' yields. Inflation also poses a serious problem to holders of fixed annuities and pension plans as it erodes the effective value of the fixed payments. Many retirees have watched their pension payment amounts lose buying power over time.
Price volatility can be bad for equities as well. Modest and steady inflation is to be expected in a growing economy, but if the prices of resources used in the production of goods rise quickly, manufacturers may experience profit declines. On the other hand, deflation can be a negative sign indicating a decline in consumer demand. In this situation manufacturers are forced to drop prices to sell their products, but the resources and commodities used in production may not fall by an equivalent amount. Again, the companies' margins are squeezed due to the stickiness of prices for some items and the elasticity of prices for other items.
Protecting Against Inflation
Fortunately, as the financial markets have become more sophisticated over time, investment products have been created to help even the average person hedge inflation risk. Mutual funds or banks concerned about rising inflation might purchase special inflation protected bonds known as TIPS. (You can read more on TIPS in Inflation Protected Securities - The Missing Link.) Furthermore, the Chicago Mercantile Exchange offers futures contracts on the CPI, which can be used to hedge inflation. These contracts also provide useful information about the market consensus for prices in the future.
Also, many people have significant equity in their homes, which is often a good inflation hedge. The investment of many homeowners has not only kept up with inflation, but outpaced it, earning a positive return. Also, products have been created to help people tap into this equity that is otherwise illiquid. With a reverse mortgage, for example, the owner receives payments, and the property is turned over at death. An inheritance may be reduced, but there's a steady stream of income drawn from the equity in the home to fund living expenses. However, this is not necessarily a perfect solution. If the credit options that are selected offer no growth component with an annual draw limit, the owner is exposed to inflation risk.
Conclusion
The CPI is probably the most important and widely-watched economic indicator, and it's the best known measure for determining cost of living changes--which, as history shows us, can be detrimental if they are large and rapid. The CPI is used to adjust wages, retirement benefits, tax brackets, and other important economic indicators. It can tell investors some things about what may happen in the financial markets, which share both direct and indirect relationships with consumer prices. By knowing the state of consumer prices, investors can make appropriate investment decisions and protect themselves by using investment products such as TIPS.
Sunday, August 15, 2010
The Importance Of Inflation And GDP
Investors are likely to hear the terms inflation and gross domestic product (GDP) just about every day. They are often made to feel that these metrics must be studied as a surgeon would study a patient's chart prior to operating. Chances are that we have some concept of what they mean and how they interact, but what do we do when the best economic minds in the world can't agree on basic distinctions between how much the U.S. economy should grow, or how much inflation is too much for the financial markets to handle? Individual investors need to find a level of understanding that assists their decision-making without inundating them in piles of data. Find out what inflation and GDP mean for the market, the economy and your portfolio.
Terminology
Before we begin our journey into the macroeconomic village, let's review the terminology we'll be using.
Inflation
Inflation can mean either an increase in the money supply or an increase in price levels. Generally, when we hear about inflation, we are hearing about a rise in prices compared to some benchmark. If the money supply has been increased, this will usually manifest itself in higher price levels - it is simply a matter of time. For the sake of this discussion, we will consider inflation as measured by the core Consumer Price Index (CPI), which is the standard measurement of inflation used in the U.S. financial markets. Core CPI excludes food and energy from its formulas because these goods show more price volatility than the remainder of the CPI. (To read more on inflation, see All About Inflation, Curbing The Effects Of Inflation and The Forgotten Problem Of Inflation.)
GDP
Gross domestic product in the United States represents the total aggregate output of the U.S. economy. It is important to keep in mind that the GDP figures as reported to investors are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured 2% over the same period, GDP growth would be reported as 4%, or the net growth over the period.
The Slippery Slope
The relationship between inflation and economic output (GDP) plays out like a very delicate dance. For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable. Most economists today agree that 2.5-3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects. But where do these numbers come from? In order to answer that question, we need to bring a new variable, unemployment rate, into play. (For related reading, see Surveying The Employment Report.)
Studies have shown that over the past 20 years, annual GDP growth over 2.5% has caused a 0.5% drop in unemployment for every percentage point over 2.5%. It sounds like the perfect way to kill two birds with one stone - increase overall growth while lowering the unemployment rate, right? Unfortunately, however, this positive relationship starts to break down when employment gets very low, or near full employment. Extremely low unemployment rates have proved to be more costly than valuable, because an economy operating at near full employment will cause two important things to happen:
1. Aggregate demand for goods and services will increase faster than supply, causing prices to rise.
2. Companies will have to raise wages as a result of the tight labor market. This increase usually is passed on to consumers in the form of higher prices as the company looks to maximize profits. (To read more, see Cost-Push Versus Demand-Pull Inflation.)
Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once this process is in place, it can quickly become a self-reinforcing feedback loop. This is because in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases. Also, the effects of inflation are not linear; 10% inflation is much more than twice as harmful as 5% inflation. These are lessons that most advanced economies have learned through experience; in the U.S., you only need to go back about 30 years to find a prolonged period of high inflation, which was only remedied by going through a painful period of high unemployment and lost production as potential capacity sat idle.
"Say When"
So how much inflation is "too much"? Asking this question uncovers another big debate, one argued not only in the U.S,. but around the world by central bankers and economists alike. There are those who insist that advanced economies should aim to have 0% inflation, or in other words, stable prices. The general consensus, however, is that a little inflation is actually a good thing.
The biggest reason behind this argument in favor of inflation is the case of wages. In a healthy economy, sometimes market forces will require that companies reduce real wages, or wages after inflation. In a theoretical world, a 2% wage increase during a year with 4% inflation has the same net effect to the worker as a 2% wage reduction in periods of zero inflation. But out in the real world, nominal (actual dollar) wage cuts rarely occur because workers tend to refuse to accept wage cuts at any time. This is the primary reason that most economists today (including those in charge of U.S. monetary policy) agree that a small amount of inflation, about 1-2% a year, is more beneficial than detrimental to the economy.
The Federal Reserve and Monetary Policy
The U.S. essentially has two weapons in its arsenal to help guide the economy toward a path of stable growth without excessive inflation; monetary policy and fiscal policy. Fiscal policy comes from the government in the form of taxation and federal budgeting policies. While fiscal policy can be very effective in specific cases to spur growth in the economy, most market watchers look to monetary policy to do most of the heavy lifting in keeping the economy in a stable growth pattern. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) is charged with implementing monetary policy, which is defined as any action to limit or increase the amount of money that is circulating in the economy. Whittled down, that means the Federal Reserve (the Fed) can make money easier or harder to come by, thereby encouraging spending to spur the economy and constricting access to capital when growth rates are reaching what are deemed unsustainable levels.
Before he retired, Alan Greenspan was often (half seriously) referred to as being the most powerful person on the planet. Where did this impression come from? Most likely it was because Mr. Greenspan's position (now Ben Bernanke's) as Chairman of the Federal Reserve provided him with special, albeit un-sexy, powers - chiefly the ability to set the Federal Funds Rate. The "Fed Funds" rate is the rock-bottom rate at which money can change hands between financial institutions in the United States. While it takes time to work the effects of a change in the Fed Funds rate (or discount rate) throughout the economy, it has proved very effective in making adjustments to the overall money supply when needed.
Asking the small group of men and women of the FOMC, who sit around a table a few times a year, to alter the course of the world's largest economy is a tall order. It's like trying to steer a ship the size of Texas across the Pacific - it can be done, but the rudder on this ship must be small so as to cause the least disruption to the water around it. Only by applying small opposing pressures or releasing a little pressure when needed can the Fed calmly guide the economy along the safest and least costly path to stable growth. The three areas of the economy that the Fed watches most diligently are GDP, unemployment and inflation. Most of the data they have to work with is old data, so an understanding of trends is very important. At its best, the Fed is hoping to always be ahead of the curve, anticipating what is around the corner tomorrow so it can be maneuvered around today.
The Devil Is in the Details
There is as much debate over how to calculate GDP and inflation as there is about what to do with them when they're published. Analysts and economists alike will often start picking apart the GDP figure or discounting the inflation figure by some amount, especially when it suits their position on the markets at that time. Once we take into account hedonic adjustments for "quality improvements", reweighting and seasonality adjustments, there isn't much left that hasn't been factored, smoothed, or weighted in one way or another. Still, there is a methodology being used, and as long as no fundamental changes to it are made, we can look at rates of change in the CPI (as measured by inflation) and know that we are comparing from a consistent base.
Implications for Investors
Keeping a close eye on inflation is most important for fixed-income investors, as future income streams must be discounted by inflation to determine how much value today' money will have in the future. For stock investors, inflation, whether real or anticipated, is what motivates us to take on the increased risk of investing in the stock market, in the hope of generating the highest real rates of return. Real returns (all of our stock market discussions should be pared down to this ultimate metric) are the returns on investment that are left standing after commissions, taxes, inflation and all other frictional costs are taken into account. As long as inflation is moderate, the stock market provides the best chances for this compared to fixed income and cash.
There are times when it is most helpful to simply take the inflation and GDP numbers at face value and move on; after all, there are many things that demand our attention as investors. However, it is valuable to re-expose ourselves to the underlying theories behind the numbers from time to time so that we can put our potential for investment returns into the proper perspective.
Terminology
Before we begin our journey into the macroeconomic village, let's review the terminology we'll be using.
Inflation
Inflation can mean either an increase in the money supply or an increase in price levels. Generally, when we hear about inflation, we are hearing about a rise in prices compared to some benchmark. If the money supply has been increased, this will usually manifest itself in higher price levels - it is simply a matter of time. For the sake of this discussion, we will consider inflation as measured by the core Consumer Price Index (CPI), which is the standard measurement of inflation used in the U.S. financial markets. Core CPI excludes food and energy from its formulas because these goods show more price volatility than the remainder of the CPI. (To read more on inflation, see All About Inflation, Curbing The Effects Of Inflation and The Forgotten Problem Of Inflation.)
GDP
Gross domestic product in the United States represents the total aggregate output of the U.S. economy. It is important to keep in mind that the GDP figures as reported to investors are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured 2% over the same period, GDP growth would be reported as 4%, or the net growth over the period.
The Slippery Slope
The relationship between inflation and economic output (GDP) plays out like a very delicate dance. For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable. Most economists today agree that 2.5-3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects. But where do these numbers come from? In order to answer that question, we need to bring a new variable, unemployment rate, into play. (For related reading, see Surveying The Employment Report.)
Studies have shown that over the past 20 years, annual GDP growth over 2.5% has caused a 0.5% drop in unemployment for every percentage point over 2.5%. It sounds like the perfect way to kill two birds with one stone - increase overall growth while lowering the unemployment rate, right? Unfortunately, however, this positive relationship starts to break down when employment gets very low, or near full employment. Extremely low unemployment rates have proved to be more costly than valuable, because an economy operating at near full employment will cause two important things to happen:
1. Aggregate demand for goods and services will increase faster than supply, causing prices to rise.
2. Companies will have to raise wages as a result of the tight labor market. This increase usually is passed on to consumers in the form of higher prices as the company looks to maximize profits. (To read more, see Cost-Push Versus Demand-Pull Inflation.)
Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once this process is in place, it can quickly become a self-reinforcing feedback loop. This is because in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases. Also, the effects of inflation are not linear; 10% inflation is much more than twice as harmful as 5% inflation. These are lessons that most advanced economies have learned through experience; in the U.S., you only need to go back about 30 years to find a prolonged period of high inflation, which was only remedied by going through a painful period of high unemployment and lost production as potential capacity sat idle.
"Say When"
So how much inflation is "too much"? Asking this question uncovers another big debate, one argued not only in the U.S,. but around the world by central bankers and economists alike. There are those who insist that advanced economies should aim to have 0% inflation, or in other words, stable prices. The general consensus, however, is that a little inflation is actually a good thing.
The biggest reason behind this argument in favor of inflation is the case of wages. In a healthy economy, sometimes market forces will require that companies reduce real wages, or wages after inflation. In a theoretical world, a 2% wage increase during a year with 4% inflation has the same net effect to the worker as a 2% wage reduction in periods of zero inflation. But out in the real world, nominal (actual dollar) wage cuts rarely occur because workers tend to refuse to accept wage cuts at any time. This is the primary reason that most economists today (including those in charge of U.S. monetary policy) agree that a small amount of inflation, about 1-2% a year, is more beneficial than detrimental to the economy.
The Federal Reserve and Monetary Policy
The U.S. essentially has two weapons in its arsenal to help guide the economy toward a path of stable growth without excessive inflation; monetary policy and fiscal policy. Fiscal policy comes from the government in the form of taxation and federal budgeting policies. While fiscal policy can be very effective in specific cases to spur growth in the economy, most market watchers look to monetary policy to do most of the heavy lifting in keeping the economy in a stable growth pattern. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) is charged with implementing monetary policy, which is defined as any action to limit or increase the amount of money that is circulating in the economy. Whittled down, that means the Federal Reserve (the Fed) can make money easier or harder to come by, thereby encouraging spending to spur the economy and constricting access to capital when growth rates are reaching what are deemed unsustainable levels.
Before he retired, Alan Greenspan was often (half seriously) referred to as being the most powerful person on the planet. Where did this impression come from? Most likely it was because Mr. Greenspan's position (now Ben Bernanke's) as Chairman of the Federal Reserve provided him with special, albeit un-sexy, powers - chiefly the ability to set the Federal Funds Rate. The "Fed Funds" rate is the rock-bottom rate at which money can change hands between financial institutions in the United States. While it takes time to work the effects of a change in the Fed Funds rate (or discount rate) throughout the economy, it has proved very effective in making adjustments to the overall money supply when needed.
Asking the small group of men and women of the FOMC, who sit around a table a few times a year, to alter the course of the world's largest economy is a tall order. It's like trying to steer a ship the size of Texas across the Pacific - it can be done, but the rudder on this ship must be small so as to cause the least disruption to the water around it. Only by applying small opposing pressures or releasing a little pressure when needed can the Fed calmly guide the economy along the safest and least costly path to stable growth. The three areas of the economy that the Fed watches most diligently are GDP, unemployment and inflation. Most of the data they have to work with is old data, so an understanding of trends is very important. At its best, the Fed is hoping to always be ahead of the curve, anticipating what is around the corner tomorrow so it can be maneuvered around today.
The Devil Is in the Details
There is as much debate over how to calculate GDP and inflation as there is about what to do with them when they're published. Analysts and economists alike will often start picking apart the GDP figure or discounting the inflation figure by some amount, especially when it suits their position on the markets at that time. Once we take into account hedonic adjustments for "quality improvements", reweighting and seasonality adjustments, there isn't much left that hasn't been factored, smoothed, or weighted in one way or another. Still, there is a methodology being used, and as long as no fundamental changes to it are made, we can look at rates of change in the CPI (as measured by inflation) and know that we are comparing from a consistent base.
Implications for Investors
Keeping a close eye on inflation is most important for fixed-income investors, as future income streams must be discounted by inflation to determine how much value today' money will have in the future. For stock investors, inflation, whether real or anticipated, is what motivates us to take on the increased risk of investing in the stock market, in the hope of generating the highest real rates of return. Real returns (all of our stock market discussions should be pared down to this ultimate metric) are the returns on investment that are left standing after commissions, taxes, inflation and all other frictional costs are taken into account. As long as inflation is moderate, the stock market provides the best chances for this compared to fixed income and cash.
There are times when it is most helpful to simply take the inflation and GDP numbers at face value and move on; after all, there are many things that demand our attention as investors. However, it is valuable to re-expose ourselves to the underlying theories behind the numbers from time to time so that we can put our potential for investment returns into the proper perspective.
What Is Fiscal Policy?
Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy. It is the sister strategy to monetary policy with which a central bank influences a nation's money supply. These two policies are used in various combinations in an effort to direct a country's economic goals. Here we take a look at how fiscal policy works, how it must be monitored and how its implementation may affect different people in an economy. (For background on fiscal policies, see Formulating Monetary Policy.),
Ultimate Forex Guide Walkthrough
Before the Great Depression in the United States, the government's approach to the economy was laissez faire. But following the Second World War, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mixture of both monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments are able to control economic phenomena.
How Fiscal Policy Works?
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money. (To read more on this subject, see Can Keynesian Economics Reduce Boom-Bust Cycles? and How Influential Economists Changed Our History.)
Balancing Act
The idea, however, is to find a balance in exercising these influences. For example, stimulating a stagnant economy runs the risk of rising inflation. This is because an increase in the supply of money followed by an increase in consumer demand can result in a decrease in the value of money - meaning that it will take more money to buy something that has not changed in value.
Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making any money. A government thus decides to fuel the economy's engine by decreasing taxation, giving consumers more spending money while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. Pumping money into the economy is also known as "pump priming". In the meantime, overall unemployment levels will fall. (To learn more about inflation and employement, see Surveying The Employment Report and The Importance Of Inflation And GDP.)
With more money in the economy and less taxes to pay, consumer demand for goods and services increases. This in turn rekindles businesses and turns the cycle around from stagnant to active.
If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in supply decreases the value of money, while pushing up prices (because of the increase in demand for consumer products). Hence, inflation occurs.
For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals. If not closely monitored, the line between an economy that is productive and one that is infected by inflation can be easily blurred. (For more on economic cycles, see Understanding Cycles - The Key To Market Timing and How Much Influence Does The Fed Have?)
And When The Economy Needs To Be Curbed…
When inflation is too strong, the economy may need a slow down. In such a situation, a government can use fiscal policy to increase taxes in order to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative effects of such a policy in the long run could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine tune spending and taxation levels, with the goal of evening out the business cycles.
Who Does Fiscal Policy Affect?
Unfortunately, the effects of any fiscal policy are not the same on everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class.
Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers. A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do much to increase aggregate employment levels.
Conclusion
One of the biggest obstacles facing policymakers is deciding how much involvement the government should have in the economy. Indeed, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to sustain a vibrant economy, on which the economic well being of the population depends.
Ultimate Forex Guide Walkthrough
Before the Great Depression in the United States, the government's approach to the economy was laissez faire. But following the Second World War, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mixture of both monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments are able to control economic phenomena.
How Fiscal Policy Works?
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money. (To read more on this subject, see Can Keynesian Economics Reduce Boom-Bust Cycles? and How Influential Economists Changed Our History.)
Balancing Act
The idea, however, is to find a balance in exercising these influences. For example, stimulating a stagnant economy runs the risk of rising inflation. This is because an increase in the supply of money followed by an increase in consumer demand can result in a decrease in the value of money - meaning that it will take more money to buy something that has not changed in value.
Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making any money. A government thus decides to fuel the economy's engine by decreasing taxation, giving consumers more spending money while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. Pumping money into the economy is also known as "pump priming". In the meantime, overall unemployment levels will fall. (To learn more about inflation and employement, see Surveying The Employment Report and The Importance Of Inflation And GDP.)
With more money in the economy and less taxes to pay, consumer demand for goods and services increases. This in turn rekindles businesses and turns the cycle around from stagnant to active.
If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in supply decreases the value of money, while pushing up prices (because of the increase in demand for consumer products). Hence, inflation occurs.
For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals. If not closely monitored, the line between an economy that is productive and one that is infected by inflation can be easily blurred. (For more on economic cycles, see Understanding Cycles - The Key To Market Timing and How Much Influence Does The Fed Have?)
And When The Economy Needs To Be Curbed…
When inflation is too strong, the economy may need a slow down. In such a situation, a government can use fiscal policy to increase taxes in order to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative effects of such a policy in the long run could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine tune spending and taxation levels, with the goal of evening out the business cycles.
Who Does Fiscal Policy Affect?
Unfortunately, the effects of any fiscal policy are not the same on everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class.
Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers. A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do much to increase aggregate employment levels.
Conclusion
One of the biggest obstacles facing policymakers is deciding how much involvement the government should have in the economy. Indeed, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to sustain a vibrant economy, on which the economic well being of the population depends.
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