Inflation, Interest Rates, and The Economy Finance 335 Professor Bruce Finnie March 10, 2008 By: Trevor Jacka Brian Lubeck Cait Campbell Finance 335 2 Determinants of Inflation CPI: Understanding that interest rates in the economy are determined by inflation and expected inflation added together, as discussed in class, we can analyze what the effects of higher inflation rates are, and what causes inflation to rise. Inflation is simply the percent change in CPI from year to year. Therefore, we cannot examine why inflation is rising or falling without looking at why the CPI is rising or falling. Lets start with a basic explanation of what the CPI is and what it measures. The CPI measure that is used to analyze overall inflation is calculated from the CPI-U, which is the measurement of all consumer prices within urban areas. This figure is important because 87% of the United States population is within urban areas (http://www.bls.gov/cpi/cpiovrvw.htm#item2, March 5, 2008). Consumer prices include all goods and services purchased for consumption by urban households, which include things like public utilities, excise and sales tax, rents, energy, clothing, and food. The tracking of these prices becomes hard as prices change from region to region within the U.S. For example, a latte in Albuquerque, New Mexico is not the same price as a latte in Manhattan, New York. The Bureau of Labor Statistics uses a consumer expenditure survey given to wage earning residents of 87 different U.S. urban cities. The average amount spent on an item becomes the way in which the BLS determines price (Bureau of Labor Statistics, www.bls.gov, March 9, 2008). Energy moving inflation 20.0% 15.0% 10.0% Commodities Inflation Energy 5.0% Shelter 0.0% Overall 98 99 00 01 02 03 04 05 06 07 -5.0% 19 19 20 20 20 20 20 20 20 20 -10.0% Year (Figure 1.1) The line graph labeled figure 1.1 tracks the individual average inflation rates of energy, shelter, and commodities since 1997. The graph also includes the overall average inflation rate for the last ten years. The X variable labeled 1998 represents the change in CPI from 1997 to 1998. In the last ten years, overall inflation has risen by an average of 2.5% with a high of 3.3% in years 2000, and a low of 1.5% in 1998. At the same time, when we look at the inflation of energy prices in the last ten years, we see a low of negative 8.4% in 1998 to a high of 14.5% in 2005 (Bureau of Labor Statistics, www.bls.gov, March 7, 2008). From figure 1.1 we can see that overall inflation moves in line with energy inflation. It appears the three variables (shelter, commodities, and overall inflation) are moving in line with each other in a relatively small band. However, the line representing energy spikes and dips tremendously higher than the other variables and it could be concluded that energy is moving Finance 335 3 the overall inflation rate. This makes sense when logically thinking about overall inflation rates, because energy is the main component in an economy. The higher oil prices get, the more expensive it becomes to produce plastics, drive automobiles, provide power to residents and businesses, and grow food. All of these activities require a certain amount of energy, usually from oil. Although oil prices were not available on the data set, figures 1.2 and 1.3 clearly indicate that inflation follows the rise and fall of oil prices. This relationship is simply explained and begins with the inherent fact that oil is used in the production of the majority of consumer products. When oil prices rise, the price of consumer products must also rise to compensate the increase in production costs. The consumer product price changes are monitored by the Consumer Price Index. Consequently, inflation is derived from this index, thus indicating why oil is correlated with the rise and fall of inflation. Inflation over Time 16.00 14.00 12.00 Inflation 10.00 8.00 6.00 4.00 2.00 0.00 69 70 72 73 75 76 78 79 81 82 84 85 87 88 90 91 93 94 96 97 99 00 02 03 05 06 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 Time (Figure 1.2) (Figure 1.3) (http://www.wtrg.com/prices.htm) Because we see the high volatility in energy, according to the Federal Reserve Bank of Cleveland, it is common to measure core inflation as the change in CPI prices less food and energy, food being highly volatile historically as well. Using a core inflation measure, as we can see from figure 1.2 below, calms the drastic shifts in inflation due to energy prices and food and we see the line moving within a smaller band. However, also from figure 1.2, we see the waterfall effect higher energy costs have, i.e. oil used in production of plastics or growing crops, moving the core inflation line in correlation with the inflation line that includes energy and food. Therefore, overall price measures are affected by the prices of energy even if we take their direct prices out of the CPI. Finance 335 4 Inflation Variables 4.0% 3.5% 3.0% Avg. base inflation 2.5% Inflation Avg. inflation excluding 2.0% energy and food 1.5% Avg. inflation less shelter 1.0% 0.5% 0.0% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year (Figure 1.4) Figure 1.4 above tracks average inflation, starting in 1998, of overall consumer prices, consumer prices excluding energy and food, and consumer prices excluding shelter. If we examine the amenities that are essential, within the U.S., to everyday life, a couple of things come to mind; including housing, food and water, and energy (electricity generation, heating, and transportation). From this we can conclude that energy, food, and shelter have a big role in inflation because they are the most common expenses among households. From figure 1.4, we can see that average inflation less energy and food moves within a narrower band than inflation including these variables. Also, we can see that average inflation less shelter moves in a much more volatile way between a larger band than average inflation including shelter. These observations may lead us to believe that the price of energy and food is more volatile than inflation as a whole. It also may lead us to believe that the price of shelter is less volatile than inflation as a whole. Therefore, we may conclude that for the last ten years, energy prices have done much to drive higher inflation numbers, while shelter prices have done much to stabilize inflation numbers. Determinants of Interest Rates Inflation: Below, Figure 1.5 measures 10 year Treasury Bond rates (k) as a function of inflation rates since 1960. Interestingly, a positive correlation exists between these two metrics. As inflation rises, eroding the purchasing power of the dollar, interest rates rise because more money is needed to entice banks to make loans. The cost of borrowing money increases because inflation rates rise. Understanding how inflation rates affect interest rates may highlight the importance of declining any variable rate loan. Variable rate loans may look enticing when interest rates are low (i.e inflation is low). Unfortunately, banks have the option of increasing interest rates to combat inflation and cost the costumer more money. Fixed rate loans fix banks into a lending rate. Finance 335 5 16.00 14.00 K (10 Year Treasury Bond) 12.00 10.00 8.00 6.00 4.00 2.00 0.00 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 Inflation Rate (Figure 1.5) Economic Effects Related to Inflation and Interest Rates Equity and Fixed Income Market: P/E - Inflation 50.00 45.00 40.00 35.00 30.00 P/E 25.00 20.00 15.00 10.00 5.00 0.00 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 Inflation (Figure 1.6) Earnings Yield - Inflation 16.00 14.00 12.00 Earnings/Price 10.00 8.00 6.00 4.00 2.00 0.00 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 Inflation (Figure 1.7) Finance 335 6 The PE – Inflation graph provides a tremendous amount of insight regarding the impacts of inflation on the equities market. The negative correlation between the P/E ratio and inflation indicates that inflation has an adverse effect on equities. As previously discussed, as inflation rises, interest rates rise. Because the cost of borrowing money has increased and inflation has weakened the dollar, consumer spending decreases because the public now has to pay more for the same amount of a particular good. Thus, the market suffers due to the lack of cash infusion causing stock prices on indexes, such as the S&P, to decline. Increased inflation decreases stock prices (the numerator in the P/E ratio), which explains the negative correlation in the graph. A low PE ratio indicates a good time to buy stock, as there is earning potential for the investor. The inverse is true for the Earnings Yield – Inflation graph. A positive correlation exists in this graph because the numerator (price) in the PE Ratio becomes the denominator in the Earnings yield. e/p - 10 year 16.00 14.00 Earnings Yield (E/P) 12.00 10.00 8.00 6.00 4.00 2.00 0.00 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 10 Year Treasury Bond Rate (Figure 1.8) Price/Earnings - 10 Year Bond 50.00 45.00 40.00 35.00 P/E Ratio 30.00 25.00 20.00 15.00 10.00 5.00 0.00 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 10 Year Treasury Bond Rate The PE Ratio – 10 year Treasury Bond Rate graph and the Earnings Yield – 10 year Treasury Bond Rate graph are examples of how interest rates effect the Equities market. When bond rates rise, prices in the stock market fall. Thus, equity earnings rise because the denominator (price) is declining. This explains why the earnings yield and the 10 year bond rates are positively correlated. Conversely, Finance 335 7 when bond rates are high the PE ratio will be low. Ultimately, The four previous graphs conclude that the equities market strives when inflation and interest rates are low. As an investor, understanding the relationship between Earnings Yield and the 10 year Treasury Bond Rate is crucial in determining which market is producing a better return on the dollar. Let Kb equal the percent return on the bond market, and let Ke = E/P equal the percent return on the equities market. If Kb > Ke, than investors should buy bonds. If, however, Kb < Ke, than investor should buy stocks. Although disequilibrium may exist between the two markets momentarily, the equity and bond markets keep themselves balanced because investors chase returns. .