Download To Lower Interest Rates To Raise Interest Rates Policy Actions

Chapter Five
Economic Activity
1
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Top-Down Evaluation Process

Macroanalysis of the economy
• Industry variables

Common stocks by expected risk-return
characterisics
• Combine surviving stocks into portfolio of
assets
Change optimal portfolio as conditions change
2
3
Valuation process begins
with an economic analysis
Accurate
forecast
Examination of
economic
Activity
Accurate
stock market
predictions
Industries that
prosper
Valuation
of
potential investments4
Economic Activity and the Business Cycle
Federal Government Economic Policy

Fiscal Policy
Monetary Policy

Government Policy, Real Growth, & Inflation

5
Federal Government Economic Policy
Guided by the Employment Act of 1946, Federal Reserve Board of Governors,
President’s Council of Economic Advisors, and other acts of the U.S. Congress

Stable prices
GOALS
(a low inflation rate)

Business stability at high levels of production
(low levels of unemployment)

Sustained real growth in gross domestic product
(actual economic growth after deducting inflation)

Balance in international payments
(balance of exports and imports as well as
cash flows into and out of the United States)
Goals often conflict because they do not all respond favorably to same stimulus
6
Employment Act of 1946
“The Congress declares that it is the continuing
policy and responsibility of the Federal
Government to use all practical means consistent
with its needs and obligations and other essential
considerations of national policy, with the
assistance and cooperation of industry,
agriculture, labor, and State and Local
governments, to coordinate and utilize all its
plans, functions and resources for the purpose of
creating and maintaining, in a manner calculated
to foster and promote free competitive enterprise
and the general welfare, conditions under which
there will be afforded useful employment
opportunities, including self-employment, for
those willing, able, and seeking to work and to
promote maximum employment, production, and
purchasing power….”
7
Employment Act of 1946
Also established:
 Council of Economic Advisers
to assist the President in implementing
the Act
 Joint Economic Committee of Congress
of Senators and Representatives
to review economic policy at least
annually
 Required an annual:
Economic Report of the President
to be submitted by the President to Congress
8
Federal Government Economic Policy
Guided by the Employment Act of 1946, Federal Reserve Board of Governors,
President’s Council of Economic Advisors, and other acts of the U.S. Congress
INSTRUMENTS


Monetary Policy (conducted by Federal Reserve)
• Control of the money supply (Open Market
Operations)
• Changing reserve requirements of financial
institutions
• Discount rate policy
• Setting margin requirements
• Jawboning
Fiscal Policy (conducted by Federal Government)
• Government spending and taxation
• Import quotas and tariffs, subsidies, regulation
of industry competition
• Possible intervention on the foreign exchange
market
9
Federal Government Economic Policy
1950s-early 1960s 1961-1969 Early 1970s Late 1970s Early 1980s Mid/Late1980s 1990s
2000s
10
PLEASE NOTE
The Next Two Slides
 Show the same
information in a “table”
format as the one shown
in the previous “fish-bone”
diagram
11
Federal Government Economic Policy
Period
1950s early 1960s
1961-1969
Early 1970s
Late 1970s
Goals
Economy & Policy
Focus on employment and economic
• Low inflation
• Moderate growth
 Rapid growth, low unemployment
 Accelerating inflation
 High interest rates at end
 Imbalance in Int’l payments
 Vietnam war
 Devaluations of dollar (twice)
 Abandon gold standard
 Incomes policies
(wage/price controls)
 Imbalance in international
payments
 Interest rates at record high levels
 Oil embargo  4x increase in
gasoline prices
 Stagflation
•Reduce unemployment
•Control inflation,
•Moderate economic growth
Tight monetary policy  Increased
interest rates 
Depressed
stock prices as required rate of
return
rose to record levels
 Large government deficits
 Full employment
 Large increases in money supply
12
Federal Government Economic Policy
Period
Early 1980s
Mid 1980s –
Late 1980s
1990s
2000s
Goals
Economy & Policy
 Three-year tax cut
•Reduced inflation, grew GDP
•Led to record government deficits
• Supply-side economics
• Increased focus on international
issues
• Negotiated reductions in govt spending
• Major bull market started in 1982
•Record employment
•Reduced unemployment %
•Lowered interest rates and inflation
•Bull market followed by 1987 crash
•Steady real growth
•Government surpluses
•Early recession
•Recovery
•Tax increase
• Reduce unemployment,
• Economic growth, …
 Recession
 tax cuts for the rich
9/11 attacks
Iraqi war
13
Fiscal
Policy
Government’s taxing and spending policies

Great impact on direction of economic activity
Deficit spending


Government spends more than it receives
Must be financed by the U.S. Treasury
• If Treasury sells securities to the Federal Reserve,
can be very expansionary: stimulating spending in
economy
• If Treasury sells securities to banks and individuals,
can be less expansionary, less increase in the money
supply, short-term interest rates will rise, some
“crowding out” of private investment unless the Federal
Reserve intervenes

Creating surpluses

Government revenues exceed spending
• Tend to reduce economic growth as government slows its
demand for goods and services relative to its income
14
Fiscal Policy Cont’d
Government’s taxing and spending policies
• Levying taxes or tariffs and quotas on foreign
goods and services
 Gains some trade advantages, protects
some industries and jobs, but provokes retaliation,
diminishes and distorts world trade
 World Trade Organization (WTO) has been
instrumental in breaking down trade barriers
 Lowering or eliminating tariffs and quotas
as well as preferential taxes and subsidies
• expands world trade
• stimulates economic growth
• at the expense of sectors with a
competitive *disadvantage
15
*See the work of Michael Porter on “Competitive Advantage”
Fiscal Policy Cont’d
Government’s taxing and spending policies


Long recognition, legislative and
implementation lags make it difficult to
use fiscal policy effectively.
Fiscal policy initiatives are often
motivated by political considerations
rather than economic concerns
16
Figure 5-3 Panel A: Federal Budget
Seasonally Adjusted Annual Rates
2500
2000
1500
1000
500
0
1965
1970
1975
1980
1985
1990
1995
2000
17
Monetary Policy
Monetary Policy (conducted by Federal Reserve)
attempts to control inflation while promoting
economic and employment growth by controlling
the supply of money and the level of interest
rates in the economy

Open Market Operations (to control the money
supply):
 Instrument most often used by the Federal
Reserve
 Policy determined by the Federal Reserve’s
Open Market Committee
 Open market sales of government securities
by the Federal Reserve

Open market purchases of government
securities by the Federal Reserve
18
Fiscal
Policy
Government’s taxing and spending policies

Great impact on direction of economic activity
Deficit spending


Government spends more than it receives
Must be financed by the U.S. Treasury
• If Treasury sells securities to the Federal Reserve,
can be very expansionary: stimulating spending in
economy
• If Treasury sells securities to banks and individuals,
can be less expansionary, less increase in the money
supply, short-term interest rates will rise, some
“crowding out” of private investment unless the Federal
Reserve intervenes

Creating surpluses

Government revenues exceed spending
• Tend to reduce economic growth as government slows its
demand for goods and services relative to its income
19
Fiscal Policy Cont’d
Government’s taxing and spending policies
• Levying taxes or tariffs and quotas on foreign
goods and services
 Gains some trade advantages, protects
some industries and jobs, but provokes retaliation,
diminishes and distorts world trade
 World Trade Organization (WTO) has been
instrumental in breaking down trade barriers
 Lowering or eliminating tariffs and quotas
as well as preferential taxes and subsidies
• expands world trade
• stimulates economic growth
• at the expense of sectors with a
competitive *disadvantage
20
*See the work of Michael Porter on “Competitive Advantage”
Monetary Policy
Monetary Policy (conducted by Federal Reserve)
attempts to control inflation while promoting
economic and employment growth by controlling
the supply of money and the level of interest
rates in the economy

Open Market Operations (to control the money
supply):
 Instrument most often used by the Federal
Reserve
 Policy determined by the Federal Reserve’s
Open Market Committee
 Open market sales of government securities
by the Federal Reserve

Open market purchases of government
securities by the Federal Reserve
21
Monetary Policy Cont’d

Changing reserve requirements of financial
institutions




Tool less frequently used
Decreasing reserve requirements
Increases the funds that financial
institutions can lend, thereby potentially
increasing the supply of money and
reducing interest rates
Reduces the funds that financial institutions
can lend
22
Monetary Policy Cont’d

Discount rate policy
Changing the interest rate that the Federal
Reserve charges commercial banks when they
borrow short-term from the Fed
• Can influence an individual bank’s willingness
to borrow money for expansionary loans to
industry
• Tends to be a reactionary rather than a
discretionary policy instrument —
the Federal Reserve tends to set a rate
reflecting competitive market conditions
• Banks do not like to borrow from the Fed
23
Monetary Policy Cont’d

Setting margin requirements
• Determines the percentage amount that
investors must put up in “cash” to buy financial
assets
• Was very low in 1920s leading to extreme
leverage and wild speculation that partly led to
the cascading stock market crash that preceded
the great depression
• Now 50% and infrequently adjusted
• Investments “marked to market” daily as prices
change may lead to a “margin call” if the
investor’s equity falls below 30%
• Margin calls require investors to put up more
cash or their broker liquidates their position to 24
pay off the margin loan
Monetary Policy Cont’d

Jawboning
 Issuing policy pronouncements to
influence banks
 Psychological policy tool
 Tends to be ignored
 It is without “teeth” (penalties or
incentives)
25
Economic Policy Goals and Monetary Policy
Economic
Policy Instrument Targets
Raise Interest Rates
Lower Interest Rates
Goals
Sustainable Growth in
Real GDP
High Employment Rates
Low Unemployment
Rates
Balance of International Payments:
Balance of Trade
Over Time
Balance of International Payments:
Cash Flows
Between Countries
Maintain Stable Prices
(Low Inflation Rate)
Results
Reduces Economic Growth Stimulates Economic Growth
Reduces Employment
Increases Employment
Increases Unemployment
Reduces unemployment
Strengthens
Domestic Currency
↑Imports + ↓Exports
Weakens
Domestic Currency
↓ Imports + ↑ Exports
If Currency Stays Strong
If Currency Stays Weak
Increases Foreign
Investment Inflows
Increases
Foreign Investment Outflows
Increases
Possible Inflationary Impact
Reduces Possible
Inflationary Impact
26
Economic Policy Goals and Monetary Policy
Monetary
Tools
Policy Actions
To Raise Interest Rates
To Lower Interest Rates
Open Market
Operations
NY Fed Bank
Sells Securities
NY Fed Bank
Buys Securities
Bank Reserve
Requirements
Raises
Reserve
Requirements
Lowers
Reserve
Requirements
Discount Rate
Increases
Discount Rate
Lowers
Discount Rate
Jawboning
Say Optimistic
Things About
Economy
Say Pessimistic
Things
About Economy27
Economic Policy Goals and Monetary Policy
Policy Actions
Monetary
Tools
To Raise Interest Rates
To Lower Interest Rates
Open Market
Operations
NY Fed Bank
Sells Securities
NY Fed Bank
Buys Securities
Bank Reserve
Requirements
Raises
Reserve
Requirements
Lowers
Reserve
Requirements
Discount Rate
Increases
Discount Rate
Lowers
Discount Rate
Jawboning
Say Optimistic
Things About
Economy
Say Pessimistic
Things
About Economy28
Economic Policy Goals and Monetary Policy
Monetary
Tools
Open Market
Operations
Policy Actions
To Raise Interest Rates
To Lower Interest Rates
NY Fed Bank
Sells Securities
NY Fed Bank
Buys Securities
Lowers prices
of securities
Raises prices
of securities
Raises
Interest Rates
Lowers
Interest Rates
Takes Money
Out of Economy
Puts Money
Into Economy
29
Economic Policy Goals and Monetary Policy
Policy Actions
Monetary
Tools
To Raise Interest Rates
Open Market
Operations
Price of Bonds
Supply0
Supply1
NY Fed Bank
Sells Securities
To Lower Interest Rates
NY Fed Bank
Buys Securities
Lowers prices
of securities
P0
P1
Demand
Quantity of Bonds
30
Economic Policy Goals and Monetary Policy
Policy Actions
Monetary
Tools
To Raise Interest Rates
Open Market
Operations
Interest Rates
Supply1
I1
I0
Supply0
NY Fed Bank
Sells Securities
To Lower Interest Rates
NY Fed Bank
Buys Securities
Lowers prices
of securities
Raises
Interest Rates
Demand
Loanable Funds
31
Economic Policy Goals and Monetary Policy
Monetary
Tools
Policy Actions
To Raise Interest Rates
Open Market
Operations
Price of Bonds
Supply
P1
P0
Demand1
To Lower Interest Rates
NY Fed Bank
Sells Securities
NY Fed Bank
Buys Securities
Lowers prices
of securities
Raises Prices
Of Securities
Raises
Interest Rates
Demand0
Quantity of Bonds
32
Economic Policy Goals and Monetary Policy
Monetary
Tools
Open Market
Operations
Interest Rates
Supply0
Supply1
I0
I1
Policy Actions
To Raise Interest Rates
To Lower Interest Rates
NY Fed Bank
Sells Securities
NY Fed Bank
Buys Securities
Lowers prices
of securities
Raises Prices
of Securities
Raises
Interest Rates
Lowers
Interest Rates
Demand
Loanable Funds
33
Economic Policy Goals and Monetary Policy

Policy Instruments are formulated to achieve
• Policy Targets
• Economic Goals
INFLUENCED BY INTERACTIONS BETWEEN



Policy Makers: Gov’t Admin + Congress, Fed
Reserve
Financial Institutions
General Public
And this determines outcomes in the economy
34
Government Policy, Real Growth,
and Inflation: GDP




November 1991, the United States shifted
its primary measure of economic activity from
Gross National Product (GNP) to
Gross Domestic Product (GDP)
GDP measures only output and consumption
within the United States in a given year
Use of GDP makes our accounts more compatible
with other nations and more consistent with
employment, production, and capacity measures
GDP does not include products made by
US firms in foreign countries
but GNP did include such products
35
Government Policy, Real Growth,
and Inflation: Real GDP

Real Gross Domestic Product reflects
the value of GDP in constant dollars
• Eliminates the distortions of inflation
from GDP by deflating dollar GDP by use
of the “GDP Price Deflator” – a broader
measure than the Consumer Price Index
• Measures output in physical terms

Changes in Real GDP tend to be
inversely related to the rate of
inflation
36
Government Policy, Real Growth,
and Inflation: Components of GDP
To understand the influence of major
sectors in the economy, GDP is
often divided into four basic areas:
1.
2.
3.
4.
Personal consumption expenditures
Government purchases
Gross private investment, and
Net exports
37
Government Policy, Real Growth,
and Inflation: Consumer Spending




Consumer spending has grown faster
than other sectors over the last four
decades, is driving force behind
economic growth
Consumer spending in now more than 60
percent of GDP in the United States
Economic forecasters pay close attention
to the mood of the consumer as a result
University of Michigan surveys consumer
expectations monthly and reports on
their state of optimism
38
Government Policy, Real Growth,
and Inflation: Consumer Spending
Consumer expectations are a leading
indicator of economic activity:

When consumer confidence
increases, spending tends to
increase

When consumer confidence wanes,
spending tends to contract

Consumer expectations tend to
change before recessionary and
expansionary periods
39
Business Cycles and Cyclical
Indicators



The economy expands and contracts
over the business cycle
GDP and other economic data is
useful for tracking the changes over
the cycle
The National Bureau of Economic
Research (NBER) is the final
authority in documenting cyclical
turning points
40
Business Cycles and Cyclical
Indicators
The NBER defines a recession as
a significant decline in economic
activity
spread across the economy,
lasting more than a few months,
and normally visible in real GDP,
employment, industrial production,
and wholesale-retail sales
41
Business Cycles and Cyclical
Indicators




Economic cycles have existed and been
observed for more than 150 years
Troughs represent the end of a recession
and the beginning of an expansion
Peaks represent the end of an expansion
and the beginning of a recession
During eight peacetime cycles from 1945
and 2001, contractions lasted an average
of 10 months and expansions 52 months
for an average complete business cycle
during modern peacetime of five and onequarter years
42
Business Cycles and Cyclical
Indicators




Predicting business cycles is easier said
than done:
No two cycles are alike
Some are related to monetary policy,
others to demand, and some are
inventory-induced
Length and depth of cycles also vary
Not all industries or segments of the
economy are equally affected by cycles
43
Business Cycles and Cyclical
Indicators
Forecasts of the turning points of the
business cycle might enable one to
better choose investments to hold
over its various phases
Economic indicators may help to
evaluate the direction of the business
cycle
The NBER classifies indicators relative
to their performance at economic
peaks and troughs
44
Business Cycles and Cyclical
Indicators
Leading indicators change direction in
advance of general business conditions
• Helps anticipate rising corporate profits and
possible stock market price increases
Coincident indicators move approximately
with the overall economy
Lagging indicators usually change direction
after business conditions have turned
around
The Conference Board publishes Business
Cycle Indicators which also tabulates
moving averages, turning dates, composite
and diffusion indexes, and information on
rates of change
45
Business Cycles and Cyclical
Indicators
Composite indexes of indicators tend to
outperform the individual indicators
although this varies over time:
• The ten leading indicators seem to
provide quite long notices before peaks
but very short warnings before troughs
• Indicators sometimes give false signals
• And sometimes give no clear signal
46
Business Cycles and Cyclical
Indicators


Despite indicators and forecasting methods,
investors cannot escape uncertainty in
managing their portfolios
The stock market itself is the most reliable
and accurate of the leading indicators –
creating a problem if your objective is to
forecast common stock prices – you are
constrained by the fact that the stock
market is anticipatory and works on a lead
time of about nine months at peaks and
five months at troughs
47
Stock Prices and Economic
Variables
Three economic variables very helpful in
forecasting stock prices are:



Money Supply
Gross Domestic Product
Industry Production and
Manufacturing
48
Stock Prices and Economic Variables
Money Supply



Historically popular
Studies have found long-term relationships
between economic growth and the money supply
Monetarists believe that money explains much of
economic behavior:
• As the supply of money increases relative to demand,
people make adjustments in their portfolios of assets
• If people have too much money, they buy bonds and
short-term monetary assets, stocks, and, finally, real
assets. This direct effect of money on stock prices is
sometimes referred to as the liquidity effect
49
Stock Prices and Economic Variables
Gross Domestic Product

There is a strong relationship
between the level of economic
activity measured by GDP and longrun movements in the stock market
50
Stock Prices and Economic Variables
Industrial Production and Manufacturing


Although manufacturing only accounts for
about 20 percent of U.S. GDP and is
declining in importance, it is still valuable
and employs large numbers of people
The Institute of Supply Management
Index (ISM) indicates the expansion and
contraction of manufacturing
• When the ISM index is above 50,
manufacturing is expanding;
when below 50, contracting
51
Stock Prices and Economic Variables
Industrial Production and Manufacturing



In deciding the last recession in 2001,
the NBER gave significant weight to the
continuous decline in manufacturing from
late 1997 though 2001 before it reversed
Measures of output per hour and capacity
utilization help analysts forecast inflation
and interest rates
Rising worker productivity from corporate
investment in technology reduces the cost
of production, constrains prices of
manufactured products, and keeps the
U.S. competitive
52
Stock Prices and Economic Variables
Industrial Production and Manufacturing



Capacity Utilization
When capacity utilization is low, companies
use their most efficient and productive
plant and equipment
As capacity utilization grows, firms employ
less efficient plant and equipment, reducing
profit margins and encouraging price rises
Thus excess capacity, price competition
domestically and from abroad, and
increased worker productivity, suggest
lower inflation fears
53
Business Cycles and Industry
Relationships



Each industry may be affected by the
business cycle differently
Industries with an underlying consumeroriented demand will tend to be sensitive
to short-term business cycle swings
Thus industries producing durable goods
such as washers and dryers, refrigerators,
stoves, and automobiles as well as their
suppliers will feel the brunt of spending
shifts
54
Business Cycles and Industry
Relationships


Necessity-oriented companies such as
food and pharmaceuticals tend to be
consist performers since people have to
eat and illness is not deeply dependent on
the economy
Industries with low-price-elastic products
that are habitual in nature such as
cigarettes and alcohol also are not very
much affected by the business cycle
55
Business Cycles and Industry
Relationships



Some industries prosper during recessions
The movie industry traditionally prospered
during recessions although competition
from convenient use of cable TV, VCRs,
and DVDs may change that relationship
Housing has traditionally done well during
recessions as interest rates fall and more
prospective home buyers can afford
mortgages
56
Business Cycles and Industry
Relationships



Sensitivity to business cycles may also be
seen in industries producing capital goods
Although many service-oriented industries
are less prone to business cycle fluctuations,
some such as architects, civil engineers, and
auto repair shops are very cyclically sensitive
Cyclical industries may sometimes be good
investments because the market does not
look far ahead to see recoveries and their
impact on cyclical profits
57
Federal Government Economic
Policy
1.
2.
3.
4.
Stable prices (a low inflation rate).
Business stability at high levels of
production (low levels of
unemployment).
Sustained real growth in gross domestic
product (actual economic growth after
deduction inflation).
A balance in international payments
(primarily a balance of exports and
imports but also including cash flows in
and out of the U.S.).
www.ibm.com
www.att.com
58
Business Cycles and Cyclical
Indicators


U.S. Business Cycle Expansions and
Contractions
www.nber.com
59
Technology Companies



www.microsoft.com
www.intel.com
www.cisco.com
60
WEBSITE
COMMENTS
www.economy.com
Provides access to economic
data—some sources are fee
based.
http://finance.yahoo.com/
Provides info about companies,
markets, and the economy.
Permits tracking individual
portfolios
www.dismal.com
Contains articles on economies
and tracks info from U.S. and
global sources.
www.fedstats.gov
Has links to economic data.
www.freelunch.com
Has links to other economic sites,
has listings of economic reports
and news events, and provides
61
access to economic data.
WEBSITE
COMMENTS
www.bea.doc.gov
Provides links to sources of U.S.
government economic data.
www.ny.frb.org
Contains links to New York Federal
Reserve Bank analysis and data.
www.stls.frb.org/fred
Contains historic interest rate,
bond and economical data– site is
free
www.mworld.com
Provides industry and economic
data as well as data on money
flows into stock funds.
www.bos.frb.org
Home page of the Federal Reserve
of Boston Providing economic info.
62
WEBSITE
COMMENTS
www.ita.doc.gov
Provides access to U.S.
government reports in
international trade with reports
being fee-based.
www.fool.com
Personal finance website from
the “Motley Fools”
www.smartmoney.com
Has info and news about U.S.
economy.
63
Summary



The valuation process for investment is
based on fundamental analysis of the
economy, industry, and company
This method assumes decisions are based
on economic concepts of value over the
long-term trend of the stock market
The purpose of this analysis is to eliminate
losers and focus on sound investments for
your portfolio
64
Summary



First step in the valuation process is an
analysis of the economy and long-term
economic trends
Difficulties in attaining government policy
goals arise from trade-offs between
conflicting objectives
Monetary and fiscal policy tools attempt to
stimulate sustainable economic activity
without inciting inflationary pressures
65
Summary


Nominal interest rates are influenced
by inflationary expectations resulting
in higher required rates of return for
the investor
Business cycles are short-term
swings in economic activity that
affect stock prices because they
change investor expectations of risk
and return
66
Summary



Leading, lagging, and coincident cyclical
indicators help to forecast economic activity
One index potentially most helpful to an
investor is the composite index of 10 leading
indicators.
The sensitivity of various industries to the
business cycle is an important investment
concern: firms in consumer durable goods as
well as capital goods manufacturing are
perhaps the most vulnerable to the business
cycle
67