FREE ESSAY ON EVALUATING INFLATION

EVALUATING INFLATION

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.)
Bibliography
Works Cited
(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.
http://www.ecom.unimelb.edu.au/ecowww/rdixon/101/notes/msi/tsld001.htm
(5) The Hutchinson Encyclopedia. Inflation Helicon Publishing (1999)
http://ukdb.web.aol.com/hutchinson/encyclopedia/30/M0006130.htm
(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)