CPI Inflation Gauge(Measure of price inflation in retail goods and services)

Web address: www.bls.gov/cpi/No monthly revision, annual revision in February.

CPI:Inflation affects the following activitiesCosts of doing businessInvestment decisionsRetirees quality of lifeLabor contracts & rental contractsGovernment macroeconomic policySocial security benefits, food stamps, alimony, child support payments

CPI is an index number which leads to a historical perspective of inflation.(1982-84 =100)

Inflation Explanations:

Monetarist View – excessive money supply growth. Too many dollars, chasing to few goods. If M/M > Y/Y then P/P > 0

Keynesian View – AD > AS => shortage => Pricesinflation is a function of the state of the business cycle and level of production slack/idle capacity/resource scarcity

Core-CPI - best measure of underlying inflation

2 Population Groups:CPI-W (wage earners & clerical workers) 32% of population

benchmark for pay increases in collective bargaining agreements and for yearly cost-of-living adjustments on social security checks.

CPI-U (all urban workers)

CPI Inflation Gauge(Measure of price inflation in retail goods and services)

Deflationary Spiral: prices => corporate profits => job layoffs => household income => consumption spending => inventories => prices

Forecasting Tool:Business can anticipate future technology and medical costsInvestors can reassess investment strategiesUnion leaders use inflation forecasts in pay negotiationsCPI is a lagging economic indicator

6 Other Price Gauges:PCE, Producer Prices, Import Prices, Employment Cost Index, Unit Labor Costs, GDP deflator.---------------------------------------------------------------------------------------------------------

Unexpected increase in inflationBond Market: bond demand => bond price => nominal interest rates

Stock Market: nominal interest rates => borrowing costs => profits=> stock pricesFederal Reserve nominal interest rates => borrowing costs => profits => stock pricesFirms prefer an increase in output rather than an increase in prices to boost revenues

FX Market:AD > AS => unexpected inflation Y => r => exchange rate (good investment environment) P/P => i => exchange rate (erodes dollar-based investments held by foreigners)

Inflation (CPI)(year over year % growth)

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HeadlineCore (excludes food and energy)

Deflation leads to:•Households postpone spending•Rising real interest rates•Rising debt burdens

Deflation can lead to:Falling goods & services pricesFalling home pricesFalling stock pricesFalling wages

Hoarding money => deflationAusterity => stagnation/deflationDeflation => rising purchase power of dollarDeflation => lower wages => rising debt burden

Phillips Curve:• Shows short-run inverse relationship between the

P/P and U.R.• Not a structural economic relationship

• Basic behavioral relationship that remains unchanged over long periods

• Not a permanent long-run tradeoff• Long-run Phillips Curve is vertical

• Not a reliable menu of P/P and U.R. combinations in the long run.

Quantitative Easing 2(Fed creating money to purchase assets)

QE1 2009-2010: Fed bought $1.75 Trillion MBS and Treasury Securities

QE-2 Cost/Benefit Analysis

What are the tradeoffs?

Quantitative Easing 2QE-2

(11/3/10)

Fed’s statutory mandate – foster maximum employment and price stability

1. Fed will purchase a further $600 billion of longer-term Treasury securities for the System Open Market Account (SOMA) by June 2011.

2. The open market trading desk will continue to reinvest principle payments from agency debt and agency MBS ($300 billion over next 8 months)

QE2 Benefits

QE2 Financial Effects:1. Lower nominal interest rates (Treasury, corporate, mortgage) if the fall in real

interest rates exceeds the rise in inflation expectations. Nominal interest rates = real interest rates + inflation expectations.

2. Lower real interest rates 3. Lower dollar exchange rate4. Higher stock prices5. Higher inflation expectations

QE2 Benefits

QE2 Real Economy Effects1. Additional 2011 economic growth of 0.6%

2. Additional 2011 job growth of 500,000

3. Lower 2011 unemployment rate by 0.4 percentage points

4. Debt refinancings will lower debt burdens and repair households and firms balance sheets

5. Rising exports

6. Chase investors into riskier assets

7. Higher stock prices will encourage additional business capital expenditures and hirings

8. Higher stock prices will boost household net worth, reducing savings rates and boosting consumption spending

9. Lower corporate risk premium => increase capital formation => job creation

10. Rising inflation => rising nominal returns on investment

11. Rising inflation expectations => boost consumption spending today at the expense of future consumption

12. Rising inflation expectations => falling real interest rates => rising consumer spending and business investment

QE2 Costs/Risks1. May send signal to investors the Fed is panicking2. The Fed is “pushing on a string” as demonstrated by the large holdings of excess reserves 3. Fed is monetizing the additional Treasury debt through June 20114. Low U.S. yields will chase capital abroad, appreciate foreign currencies, create global economic

distortions. For example, asset price bubbles and excess accumulation of reserves.5. QE2 will not significantly lower nominal interest rates: lower real interest rates will be offset by

higher inflation expectations.6. Falling dollar will decrease the Chinese Yuan because of its peg.7. Low interest rates are suppose to mobilize resources, but it could misallocate resources.8. Low interest rates may boost the economy today, only to collapse it tomorrow.9. Low interest rates subsidize borrowers at the expense of savers.10. Competitive Quantitative Easing – Countries competing by printing more money to reduce

exchange rates. This is inherently unstable. Someone must lose share of world trade at expense of others who gain share.

11. Trade Wars – Boosting export strategy can turn into blocking imports policy12. Gold bubble13. QE-2 won’t work because households and firms are repairing and deleveraging their balance

sheets.14. Firm’s cash stock piles are at record levels15. Fed’s determination to avoid deflation could actually cause deflation: ELEP is a sign the Fed

expects underemployed resources for an “extended period” => private sector pessimism => business expect investments to fail and households expect falling prices => cash hoarding => weak economy => deflation.

Monetary policy options to prevent deflation and increase inflation expectations1. Quantitative easing: print money to buy long-term government debt2. Buy private-sector debt3. Change expectations by announcing it will keep short-term rates low

for a long time4. Raise its long-run inflation target (encourage borrowing, discourage cash hoarding)5. Reduce the interest rate paid on excess reserves.6. Move from inflation targeting (rate of change) to price level targeting

Anticipated inflation is expected and built into planningUnanticipated inflation is unexpected and disrupts planning•Alters expected outcome of long-term projects•Reduces long-term investment•Distorts the information in prices – reduces the effectiveness of markets•Results in actions based on price anticipation, instead of production

Consumer Confidence/Sentiment Index(Real Time Measures of Consumers Attitudes on Economy, Personal Finance, and Future Spending)

Web: http://www.conference-board.org/economics/consumerConfidence.cfm

Web: http://www.sca.isr.umich.edu/main.phpMinor revisions

Happy consumers are good for business so index is useful for predicting consumer spending. Unfortunately, the relationship between confidence index and spending is not a close one.

Difficult to predict how humans will behave. Sales are the best method of measuring consumer confidence.

A six month moving average of confidence is a better indicator of future household outlays.

Index is important during economic turning points. Better at forecasting recessions than recoveries.

Consumer confidence Index polls 5,000 new households, the survey has 5 questions with emphasis on labor market conditions - which can lag the economy

Consumer Sentiment Index polls 500 new and continuing households (the rotating interview strategy is 60% new and 40% second time interviews => less erratic index), 50 questions with emphasis on financial and personal income expectations which is a driving force behind consumer spending => better leading indicator.

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Market Analysis:Bonds: Confidence => borrowing/spending => P/P => DBonds => iBonds

Stocks: Confidence => borrowing/spending => Y/Y => profits => PStocks

Dollar: Confidence => borrowing/spending => Y/Y => iBonds => dollar

Consumer Confidence & Sentiment Index

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Recession Confidence Sentiment

Source: Conference Board & University of Michigan