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Fed Policy: Why Do Rates Hikes Hurt Stock Markets?

On December 18th, the Federal Reserve announced a rate hike of 25 basis points. For the U.S. economy, this is the fourth increase of 2018 and it brings the Fed funds rate to a range of 2.25% to 2.5%.  The move came despite strong opposition from U.S. President Donald Trump, and equities prices fell quickly in response to the decision.

As a clear indication that investors are also unhappy with the move, stock markets are now set to close the 2018 in negative territory for the first time since 2009.  So, what exactly is the reason stocks tend to fall when central banks raise interest rates?

Reasons Central Banks Raise Interest Rates

In order to understand why rate hikes tend to weigh on stock markets, we first need to understand why a central bank might want to raise interest rates in the first place.  The first part of the equation can be found in consumer spending habits, which tend to increase whenever lending costs are low. This makes it cheaper to utilize credit cards or to take large loans from a bank.  But with any credit purchase or loan agreement, there is a chance that the borrower will not repay the balance due.

Banks and credit card companies compensate for these risks by charging interest rate fees to their customers. When a central bank keeps interest rates low, it is easier for these banks and credit card companies to offer access to cheap credit agreements.  In most cases, this inspires an increase in consumer spending activity. This stimulates the economy and raises stock valuations for the company’s with improved earnings results which occur due to the rise in consumer spending.

In the chart above, we can see some of the effects interest rate policy can have on consumer spending within the broader economy.  The period which followed the 2008-2009 financial crisis was characterized by record low interest rate levels. This action from the Fed generated strong gains in consumer spending within most asset classes.  Even major purchases like automobiles and homes benefited from the trend, as reduced lending rates made credit agreements easier to make large purchases.

Conversely, when interest are high, consumer spending activity tend to slow because the cost of credit is more expensive.  This typically reduces corporate earnings performances and creates a lagging effect in broader economic metrics like national GDP growth.  The negative sentiment which is created by these expectations also tends to dampen the optimism which is required to generate bullish rallies in the stock market.  

When this occurs, important benchmarks like the S&P 500, NASDAQ, and Dow Jones Industrial Average often see declines.  In the chart above, we can see why this tends to be the case. During policy tightening cycles at the Federal Reserve (grey bars), we tend to see a slowdown in mortgage applications, credit card spending, and automobile purchases.  This is because lending costs make these purchases more expenses, and the reductions in consumer spending will generally weigh on corporate earnings. As a result, stock valuations tend to fall sharply during these periods.

The Fed’s Market Outlook for 2019

Earlier in the year, the Federal Reserve released several public commentaries which suggested a strong possibility for three interest rate increases in 2019.  With inflationary pressures stable and the unemployment rate low, annualized prospects for GDP growth remain relatively robust from the historical perspective.

This positive economic activity gives the Federal Reserve some extra leeway in terms of its ability to continue raising interest rates until they reach more normalized levels.  If this does occur, we could see additional volatility in the stock market as slower earnings growth starts to eat away at the potential for upside momentum. In any case, we can see that the Federal Reserve wields a great deal of power in macroeconomic environments which are characterized by hawkish changes in monetary policy.  For these reasons, investors will continue to pay close attention to the next set of clues which will be released by the U.S. central bank in the months and quarters ahead.

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Financial Markets: What Is The Price To Earnings Ratio?

For those without experience, the stock market can seem like a complicated entity.  But the reality is that most of the strategic conclusions that are drawn by hedge funds and other large investors can be boiled down to relatively simple math equations.

One example is the price-to-earnings ratio, or P/E ratio.  This financial metric is often used to assess a stock’s market price level in relation to its ability to generate corporate earnings over a specified period of time.  The P/E ratio can be useful in determining whether a stock is “cheap” or “expensive” when compared to the rest of the market.

P/E Ratio: Understanding the Calculations

The first step in understanding the P/E ratio (and its applications) is to look at the equation itself.  Here, we can see that we can arrive at the P/E ratio by dividing the current share price by the company’s earnings per-share.

To clarify, a company’s earnings per-share uses numbers reported each financial quarter (3 months).  This gives us an understanding of the financial health of the company, and net income figures for the year are tabulated by combining earnings from the prior four quarters.  

The earnings per-share calculation then requires us to divide net income for the year by the total number of shares outstanding in the market.  This is an important market term that is commonly used when discussing finance and when studying more advanced concepts in economics.

For example, Apple Inc. (NASDQAQ:AAPL) is currently trading at a share price of $183.83.  According to Apple’s earnings reports, the company is showing earnings of $9.73 in the trailing twelve month (TTM) period:  183.83/9.73 = 18.8.

This means we can say that APPL is currently trading at a trailing P/E ratio of 18.8.  It is then possible to compare Apple’s P/E ratio to that of other companies in the same industry.  This is important because it is one way of determining which companies are trading at low valuations within the industry.  

We should remember that a stock’s P/E ratio is constantly changing.  The current number will always depend on the price of the stock and on the results of upcoming earnings report released by the company.

Theory in Practice: What is the Impact of Interest Rates?

More broadly, P/E ratios are important when understanding the market as a whole.  Classical economics tells us that rising inflation tends to be associated with rising interest rates at the Federal Reserve.  

Higher interest rates mean more expensive credit costs, and this can weigh on consumer spending. In the chart below, we can see some of the ways market P/E valuations can be impacted by rising interest rates:

Interestingly, many of the market’s most famous stock crashes have come during times of rising interest rates at the Federal Reserve.  This type of event has been seen in 1929, 1966, and after the tech bubble in 2000.

The P/E ratio gives us additional information about the earnings strength of a company (when compared to simple prices by themselves). This makes the P/E ratio a valuable statistic when making investment decisions or when making academic assessments about the economy.  

The financial markets can seem complex at first glance.  But many of the most basic economic ideas are actually simple math equations that can be completed by anyone.  The P/E ratio is a good example of this, as it can offer an alternate way of looking at the economy or at the strength of a company’s performance.  If we want to know which companies are cheap compared to the rest of their respective industries, the P/E ratio is one of the best ways of making that determination.  

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A number of people and students wonder about the relationship between inflation rate movements and the quarterly interest rate (nominal and real interest rate). Here are observations based on Canadian data over a 50 years period that tracks T-Bill interest rate, consumer price index, and real interest rate.



This graph illustrates a number of movements. Firstly, inflation rate and the real interest rate appear to move in opposite directions at all time. Secondly, generally in the long-run the nominal interest rate appears to lag behind the movements of the inflation rate, however, moves direction, whether up or down. What causes these phenomenons to occur?

Generally the movements of all three curves is relatively small in the years prior to the 1970’s. However, upon the monetary policy shift from a classical perspective to a more short run Keynesian ideology, substantial movements between the lines are observed. Increased government spending during the 1970’s created an immediate increase in the money supply.

The quantity theory of money suggests that once the governments began spending, thus increasing the money stock, the inflation rate would rise as well. In order to counteract this movement, monetary policy began to respond to the inflationary trends. An attempt to curb spending and decrease the money supply was made by raising nominal interest rates. The fiscal decisions, and subsequent monetary responses caused interests rates and inflation to fluctuate and rise dramatically. The real interest rate is a mere measure of the movements between these two variables.

The reason why the real interest rate moves in the opposite direction of both nominal interest rate and inflation is due to how we derive the real interest value and what it represents. We understand the relationship to be ~ real interest rate = nominal interest rate – inflation rate. This relationship suggests real interest rate measures the return-the nominal interest value-s-minus the purchasing power lost through inflation, of a particular investment. Therefore the inverse movements of the two variables is described by the position of these particular variable. If the price level has risen more than your nominal holdings of cash, then your real value of this particular holding will be decrease, or move in a negative direction. The same concept applies tel interest rates, however, the nominal value of interest rates is in fact policy controlled, and can be manipulated to increase the real interest rate, or decrease inflation.

More resources in the trackback comments.

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Economics: The Study of how society deals with scarcity.

Here is a brief article on the introductory components of any economy with a macroeconomic slant.

In the economy we expect to find these four components: resource endowment, technology, preference, institutions.

Some key terms that you should be aware of include:

Scarcity: Resources are limited in any environment relative to the needs and desires of the people who control them.

Opportunity cost: value of most highly valued foregone alternative; every benefit has a cost. Another way to look at it is trade offs –> hence in this system people will respond to incentives.

So we can create a broad understand of the economics by stating:

ECONOMICS: –> Scarcity –> Opportunity Cost –> Response to Incentives

An example of this relationship can be made when we use the law of demand:

Whereby if price (p) of a good or service increases; opportunity cost of consuming good will increase; therefore consumers respond by decreasing their demand.

Generally when discussing the economy in introductory and broad strokes you use ‘best case scenarios’, like perfectly competitive markets, in examples.

Perfectly Competitive Markets: is the amount any single buyer (or seller) offers to purchase (sell) in the market is small relative to the total quantity transacted. Thus the buyer takes prices as gives and choosing quantity based on prices.

Another important term:

Equilibrium: decisions of producers are consistent with those of consumers. Only at this price is there no pressure for change. a set of choices for the individuals and a corresponding social state such that no individual can make themselves better off with an alternate choice.

Here is a diagram I drew to offer an image of this process.

[tags]Perfectly Competitive Markets, scarcity, opportunity cost, macro, macroeconomics, economy, demand, supply[/tags]

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This article continues on from a previous entry in our macroeconomic blog category called Balance of Payments explained. This article provides an example of the national income accounting scheme in action within an open economy. Comments are always welcome.


Remember the income identity: Y = C + I + G + CA

Well in an open economy aggregate savings = Y – C – G = I + CA, OR, I = S-CA

To finance investment you can either go to the current account or savings (or borrow from the world). I (investment) is domestic investment financed by savings and foreign savings.

Some examples: Case 1 (Closed economy):
EX=IM, CA = 0, thus S=I (closed economy).

Case 2: (remember we plug into identity above)
CA>0, EX>IM, (FA<0), means there is a net capital outflow. If were to put numbers into the example we’d find out that private savings pays for the CA and G.

Case 3:
CA<0 (net capital inflow).

Those are three possible scenarios. Note, we can also conclude that a negative budget account does not always imply a negative current account.

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The Bank of Canada announced that it is maintaining its target for the overnight rate at 1/2 per cent. The Bank Rate is 3/4 per cent and the deposit rate is 1/4 per cent.

Although inflation is heading back to a 2% target by next year, the global economy continues to show signs of weakness. Although the economy South of the border has picked up, they are currently in an election and economic uncertainty coupled with no major policy shifts for the rest of the year, means no significant economic changes on the horizon.

The energy sector, coupled with significant fires in Alberta’s oil sands capital Fort McMurray, will see the country pick up a very small, around 1 percent, GDP growth for 2016. The target overnight lending rate is not expected to rise for another year.

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Including Intro to Balance of Payments

Here is a brief tutorial to aid newbie economists understand the constructs behind national income accounting and balance of payments (the two are related). To do so we’ll introduce the two measures of national income which most of you are familiar with: GDP (gross domestic product) and GNP (gross national product).

Gross Domestic Product (GDP): the total value of all FINAL goods and services produced in an economy (country) domestically in a given time period.

Gross National Product (GNP): the total value of all FINAL goods and services (G&S) produced by a countries factors of production (including labour) in a given time period.

Here is a calculation to help.


GNP = GDP + G&S produced by country's factors of production abroad - G&S produced by foreigners domestically.

Components of GNP are:

C (Consumption), G (Government Expenditures), NX (Net Exports, (Current Accounts)), I (Investment, (additional capital stock))

What is the current account? CA = Current Account.

if CA = 0, exports = imports and a trade balance exists.
if CA > 0, EX>IM (imports), trade surplus exists.
if CA < 0, EX
While on the subject, we mind as well discuss National Income and National Product.

GNP = National Income (change to GNP to get National Income).

National Income is basically comprised of:

- subtract depreciation
+unilateral transfers (aid, etc.)
-indirect business tax

So approximately, Y = GNP which approximately equals Income. More on National Income Accounting in our next installment.

[tags]national income accounting, current account, gdp, gnp, national income, gross domestic product, gross national product[/tags]

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The federal reserve today increased the overnight lending rate by a quarter percentage to 1/2 a percent. This is the first increase in nearly a decade dating back to 2006. Increasing the benchmark rate is an indicator that the American economy is starting to not only improve but is becoming resilient as well.

The increase means major lenders now borrow at a higher rate. Eventually there will be a trickle-down effect that will impact the consumer as well.

The increase coincides with the Fed’s goal of maintaining a 2% inflation target.



Their statement sites the improved conditions and the labor market as a primary indicator of overall economic health.

The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.

Other factors considered in the rate increase include:

Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft. A range of recent labor market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labor resources has diminished appreciably since early this year. Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation remain low; some survey-based measures of longer-term inflation expectations have edged down.

Although the current interest rate at half a percent seems paltry, it pales in comparison to the one time zero-overnight lending rate seen at the lowest point in the 2008 economic downturn.

The Fed revisit the overnight rate in quarterly announcements. The next one will be in March.

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Business’ may cry foul, but Alberta, despite being one of the wealthiest provinces in the country, when the oil price is high, has the lowest minimum wage in Canada. The affects on the economy will be negative, say small business owners and service related industries. Of course, every argument has two sides. Here are some examples where minimum has not crippled the economy, and why it won’t happen in Alberta.

Here are some helpful sources to suggest minimum wage won’t throw the economy into a permanent recession.


http://www.seattletimes.com/seattle-news/studies-look-at-what-happened-when-cities-raised-minimum-wage/

http://journalistsresource.org/studies/economics/inequality/the-effects-of-raising-the-minimum-wage

http://escholarship.org/uc/item/86w5m90m

http://www.bloombergview.com/articles/2015-05-27/finally-an-answer-to-the-old-minimum-wage-question

http://www.cepr.net/documents/publications/min-wage-2013-02.pdf

http://davidcard.berkeley.edu/papers/njmin-aer.pdf

https://www.policyalternatives.ca/sites/default/files/uploads/publications/National%20Office/2014/10/Dispelling_Minimum_Wage_Mythology.pdf

Lawrence F. Katz and Alan B. Krueger, “The Effect of the Minimum Wage on the Fast Food Industry,” Industrial Relations Section, Princeton University, February 1992.

David Card, “Using Regional Variation in Wages to Measure the Effects of the Federal Minimum Wage,” Industrial and Labor Relations Review, October 1992.

David Card and Alan Krueger, Myth and Measurement: The New Economics of the Minimum Wage (Princeton, NJ: Princeton University Press, 1995).

David Card and Alan B. Krueger, “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania: Reply,” American Economic Review, December 2000 (in this reply, Card and Krueger update earlier findings and refute critics).

Jared Bernstein and John Schmitt, Economic Policy Institute, Making Work Pay: The Impact of the 1996-97 Minimum Wage Increase, 1998.

Jerold Waltman, Allan McBride and Nicole Camhout, “Minimum Wage Increases and the Business Failure Rate,” Journal of Economic Issues, March 1998.

A Report by the National Economic Council, The Minimum Wage: Increasing the Reward for Work, March 2000.

Holly Sklar, Laryssa Mykyta and Susan Wefald, Raise The Floor: Wages and Policies That Work For All Of Us (Boston: South End Press, 2001/2002), Ch. 4 and pp. 102-08.

Marilyn P. Watkins, Economic Opportunity Institute, “Still Working Well: Washington’s Minimum Wage and the Beginnings of Economic Recovery,” January 21, 2004.

Amy Chasanov, Economic Policy Institute, No Longer Getting By: An Increase in the Minimum Wage is Long Overdue, May 2004.

Fiscal Policy Institute, States with Minimum Wages above the Federal Level Have Had Faster Small Business and Retail Job Growth, March 2006 (update of 2004 report).

John Burton and Amy Hanauer, Center for American Progress and Policy Matters Ohio, Good for Business: Small Business Growth and State Minimum Wages, May 2006.

Paul K. Sonn, Citywide Minimum Wage Laws: A New Policy Tool for Local Governments, (originally published by Brennan Center for Justice) National Employment Law Project, May 2006, includes a good summary of impact research.

Liana Fox, Economic Policy Institute, Minimum Wage Trends: Understanding past and contemporary research, November 8, 2006.

Paul Wolfson, Economic Policy Institute, State Minimum Wages: A Policy That Works, November 27, 2006.

Arindrajit Dube, Suresh Naidu and Michael Reich, “The Economic Effects of a Citywide Minimum Wage,” Industrial & Labor Relations Review, July 2007.

Jerold L. Waltman, Minimum Wage Policy in Great Britain and the United States (New York: Algora, 2008), pp. 17-19, 132-136, 151-162, 178-180.

Sylvia Allegretto, Arindrajit Dube and Michael Reich, Do Minimum Wages Really Reduce Teen Employment?, Institute for Research on Labor and Employment, Univ. of CA, Berkeley, June 28, 2008.

Michael F. Thompson, Indiana Business Research Center, “Minimum Wage Impacts on Employment: A Look at Indiana, Illinois and Surrounding Midwestern States,” Indiana Business Review, Fall 2008.

Hristos Doucouliagos and T. D. Stanley, “Publication Selection Bias in Minimum-Wage Research? A Meta-Regression Analysis,” British Journal of Industrial Relations, vol. 47, no. 2, 2009.

Sylvia Allegretto, Arindrajit Dube and Michael Reich, Spacial Heterogeneity and Minimum Wages: Employment Estimates for Teens Using Cross-State Commuting Zones, Institute for Research on Labor and Employment, Univ. of CA, Berkeley, June 25, 2009.

Arindrajit Dube, T. William Lester and Michael Reich, Minimum Wage Effects Across State Borders: Estimates Using Contiguous Counties, Institute for Research on Labor and Employment, Univ. of CA, Berkeley, August 2008. Published by The Review of Economics and Statistics, November 2010.

John Schmitt and David Rosnick, The Wage and Employment Impact of Minimum?Wage Laws in Three Cities, Center for Economic and Policy Research, March 2011.

Sylvia Allegretto, Arindrajit Dube and Michael Reich, Do Minimum Wages Really Reduce Teen Employment? Accounting for Heterogeneity and Selectivity in State Panel Data, Institute for Research on Labor and Employment, Univ. of CA, Berkeley, June 21, 2010. Published by Industrial Relations, April 2011.

Anne Thompson, What Is Causing Record-High Teen Unemployment? Range of Economic Factors Drives High Teen Unemployment, But Minimum Wage Not One of Them, National Employment Law Project, October 2011.

Sylvia Allegretto, Arindrajit Dube, Michael Reich and Ben Zipperer, Credible Research Designs for Minimum Wage Studies, Institute for Research on Labor and Employment, IRLE Working Paper No. 148-13, 2013

John Schmidt, Why Does the Minimum Wage Have No Discernible Effect on Employment?, Center for Economic and Policy Research, Febuary 2013.

Michael Reich, Ken Jacobs and Miranda Dietz (eds.), When Mandates Work: Raising Labor Standards at the Local Level (Berkeley CA: University of California Press) 2014.

Michael Reich, The Troubling Fine Print In The Claim That Raising The Minimum Wage Will Cost Jobs, (Response to CBO report), Think Progress, February 19, 2014.

Michael Reich, No, a Minimum-Wage Boost Won’t Kill Jobs, (Response to CBO report), Politico, February 21. 2014.

Michael Reich, Ken Jacobs and Annette Bernhardt, Local Minimum Wage Laws: Impacts on Workers, Families and Businesses, Institute for Research on Labor and Employment, IRLE Working Paper No. 104-14, March 2014.

Dale Belman and Paul J. Wolfson, The New Minimum Wage Research, W.E. Upjohn Institute for Employment Research, Employment Research 21:2, 2014.

Dale Belman and Paul J. Wolfson, What Does the Minimum Wage Do?, W.E. Upjohn Institute for Employment Research, (book) 2014.

Center for Economic and Policy Research, States That Raised Their MinimumWage in 2014 Had Stronger Job Growth Than Those That Didn’t, April 2014.

Center for Economic and Policy Research, Update on the Thirteen States that Raised their Minimum Wage, August 2014.

Daniel Kuehn, The Importance of Study Design in the Minimum Wage Debate, Economic Policy Institute, September 2014.

National Employment Law Project, City Minimum Wage Laws: Recent Trends and Economic Evidence on Local Minimum Wages, December 2014.

David Cooper, Lawrence Mishel and John Schmit, We Can Afford a $12.00 Federal Minimum Wage in 2020, Economic Policy Institute, April 2015.

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