Mercurial Essays

Free Essays & Assignment Examples

Inflation Evaluation

Today it is almost impossible to pick up a financial journal without seeing news
on the bull market that some consider to be overvalued. Overvalued or fairly
valued, only the future will show the truth. Either way, this market is one that
has shown greater run ups and returns, than any other market in history.

(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.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now

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. Appendix 2a contains
illustrations, which show graphically the trends of the leading, lagging, and
coincident indicators over the past few years. These graphs are composites of
each group, and upon examination it is clear that all the indicators are rising.

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.)
(1) Baye/Jansen. “Money and Banking.” Houghton Mifflin Publishing
Company. (1995) Pages 61-88. (2) Economagic, (1999) “Economic Time Series
Page.” ;; (3) “Employment Cost
Trends.” BLS, (1999) ;; (4) Freidma.

“PPT Slide Show.”
(5) The Hutchinson Encyclopedia. “Inflation” Helicon Publishing (1999) (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) ;;
(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)


I'm Belinda!

Would you like to get a custom essay? How about receiving a customized one?

Check it out