FREE ESSAY ON ECOMOMIC FORECAST FOR 200

ECOMOMIC FORECAST FOR 200

Evaluating the bull market 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. 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.)