Economics
4. The new widgets are more expensive than those previously in inventory, lowering your profit margins. If it wasn't for the highly competitive nature of the widget industry you
would raise your prices, but you fear retaliation by competitors who may have seen the price increases coming before you did and stocked up at lower prices. If you raised your widget price you could leave yourself open to a severe decline in market share. You must wait until the industry, on a whole, increases price (see discussion of consumer price index).
The Labor Department reports the PPI approximately two days before the consumer price index and indicates the average percentage change from the previous period (month prior).
Consumer Price Index
The consumer price index (CPI) is a measure of inflation that is often most directly attributable to the individual investor—the percentage change in the rate of inflation that directly affects your pocket over time. To obtain a more
definitive explanation of the inflationary trends within the economy, the Department of Labor compiles a sample basket of goods representing the typical consumer's purchasing habits. The consumer price index measures the monthly changes associated with this basket. This report is published in the month following the measurement (in June the CPI for May is reported). It is presented as the percentage change over the prior month. However, the percentage change from the same month the year earlier is much more sensitive, for it factors out the monthly statistical
deviations ("noise").
Often we are told that the CPI (also reported in PPI) may have increased by 0.02% for the month, but the core rate of inflation, which factors out the volatile food and energy sectors, was down 0.01%.
This testifies not only to the volatility within those sectors (for the government would not have had—or the markets would not have demanded—to break them out separately if they weren't so volative), but also to the sensitivity of the U.S. markets to their old nemesis (recall the Misery Index).
It is interesting to witness how the economic system becomes sensitized by the market and the demands of the investors (suppliers of the capital).
A formidable effort has been placed on the redefining of the CPI; specifically a recent assessment that suggests the CPI overstates inflation by as much as 1.1%. As in most scientific disciplines, however, an argument suggests the opposite—that the CPI actually understates the true rate of
inflation. This view is based on the notion that housing (the largest component of the CPI, accounting for approximately 40% of the basket of goods and services) is vastly understated. Mr. Stephen Roach, chief economist of Morgan Stanley Group and an advocate of the understates theory, postulates that the difference in housing measurement could add as much as 0.6% to the CPI.
Gross National Product
Gross national product (GNP)—a measure of spending and income on a domestic and international basis—is the most extensive measure of macroeconomic activity in the U.S. economy. The GNP summarizes the total economic output of the nation with two different methods; the demand method and the income method. The demand concept (also known as the product side) refers to end-use markets for goods and services produced, whereas the supply method (income side) attempts to reconcile the costs involved in producing these goods and services. The following example illustrates the components of these two methods (% data are estimates from July 1986, Survey of Current
Business, Bureau of Economic Analysis, U.S. Department of Commerce).
Demand Method
Personal consumption expenditures 65%
Durable goods 9.0
Nondurable goods 22.6
Services 33.4
Gross private domestic investment 16.6
Business plant and equipment 11.5
New housing construction 4.8
Inventory change 0.3
Net exports (2.0)
Exports 9.2
Imports (11.2)
Government purchases 20.4
Federal 8.9
State and local 11.5
Total 100%
Supply Method
Compensation of employees 65.6%
Wages and salaries 42.8
Supplements 10.1
Unincorporated business profits 6.4
Farm 0.7
Nonfarm 5.6
Rental income 0.2
Corporate profits 7.0
Net interest 7.8
Sales and property taxes 8.3
Depreciation allowances 10.9
Business transfers, government subsidies,
government enterprises 0.3
Statistical discrepancy (0.1)
Total 100%
The GNP is reported on a quarterly basis (as an annualized rate) by the Bureau of Economic Analysis (division of the U.S. Department of Commerce) and is subject to revisions throughout the following months and even into the next couple of years. As a matter of fact, a Wall Street adage suggests that if you want to know what the actual GNP was (grew at) this year, talk to me in about three years when the revision process finally posts the amount to the record books.
TABLE 2.1 Economic Releases Calendar Week 1
Leading economic indicators for months prior (released last business day of previous month).
National Association of Purchasing Managers Report for previous month.
Construction expenditures for two months prior.
Personal income and expenditures for two months prior.
Domestic and imported car sales for previous month.
The employment situation for previous month.
Week 2
Producer price index for prior month.
Retail sales for prior month.
Consumer price index for prior month.
Capacity utilization for prior month.
Industrial production for prior month.
Week 3
Manufacturing and trade inventories and sales for two months ago.
U.S. international trade in goods and services for two months prior.
Housing starts and building permits for prior month.
Week 4
National Association of Realtors existing home sales for prior month.
Advance report on durable goods for prior month.
Appendix—International Parity Conditions
Two methods are typically relied on to forecast exchange rates:
1. Balance of payments method. As in many economic scenarios, supply and demand describe the price of the good being exchanged; in the case of currency, the exchange of financial ''goods" between nations determines the price (exchange rate) charged in the market.
2. Asset market approach. In this approach, we rely on two parity conditions to provide some guidance to the future exchanges rates between nations. The concepts surrounding
purchasing power parity (PPP) and interest rate parity (IRP) are critical to understanding currency exchange rate forecasting.
Interest rate differentials and inflation rate differentials remain the most common and practical drivers to currency exchange rate movement, although these parity conditions do not affect the short run for several reasons. Before exploring the parity conditions and their individual nuances, it is necessary to define certain terms:
If it holds (a matter of debate, at least on the practical level), the purchasing power parity (PPP) implies that the real (inflation-adjusted) "cost" of any good is identical for investors in any country.
In lay terms, purchasing power parity presumes the cost for a McDonald's burger is equal, no matter in which nation it is being purchased and with which currency.
As any traveler to the Far East would attest, PPP does not hold, at least not in the short run (research by Adler & Dumas suggests that inflation differentials contribute less than 5% of the short-term volatility in exchange rates). Although the empirical evidence suggests that PPP is useful in
forecasting exchange rate movements over a longer term period, according to Bruno Solnik (1991),
"Usually it has taken more than several years for the deviation from PPP to be corrected in the foreign exchange market."
Why doesn't this parity condition hold in the short run? Consider the following factors:
• Cultural differences. Different cultures consume differently; for example, people in the Far East are much more prolific savers than people in the West, who are predominately spenders. The standard of living is a good deal higher in the West, but this alone does not fully account for the huge differences in cultures.
• Measurement difficulties with consumer basket differences. Inflation is typically measured via a basket of goods currency weighted to a level value. But other nations may value their basket
differently due to the resources available to that nation. Furthermore, inflation among nations is not uniformly measured in this basket format, which only increases the difficulty in measuring this intangible value.
• Transfer costs, import taxes, and restrictions. These restrictive measures on trade subject a cost structure into the parity condition that was never anticipated (or more likely just neglected) by the economic theorists who first postulated these theories. With costs like taxes and shipping impeded against trade, how could one expect to have a parity condition (which reflects the effect of one variable on another) hold in the short run? Time is needed to work through these additional costs.
Considering the preceding information, one may question the benefits of using the PPP in exchange rate forecasts. In the short run, PPP is not much help, partly because of the restrictions previously mentioned and the fact that exchange rates move very frequently while inflation adjusts
slowly over time. But how about in the long run? Long-run exchange rate forecasting is important for two reasons:
1. Multinational businesses use these forecasts to calculate their exchange rate exposure (and