Economic Cycle Explained: Part II Monetary Indicators

We’ve all heard the predictions of financial doom lately, including both financial institutions and, more recently, the automobile industry.

In an effort to add a note of reason to this conversation, this is Part II in a five part series where we will look at current economic data, with an explanation of what it may mean for the future. In part one we discussed Economic Cycle Momentum.

Now, we’ll look at monetary indicators.

PART II – MONETARY INDICATORS

After seeing that 2007 economic cycle momentum indicators predicted the current economic slowdown, now acknowledged as being a recession, we will examine monetary policy. As discussed previously, the economic cycle includes intervention from the Federal Reserve Bank both in easing interest rates when the economy slows down, and in tightening them when the economy heats up. We’ll look at the direction of short, intermediate and long term rates, and what they tell us about both the present and the future direction of economic activity.

The mandate of the Federal Reserve Bank is twofold: one, full employment; and two, price stability. Price stability means that prices are not unduly affected by inflation, which causes higher prices, necessitating higher wages, and if continuing unchecked, both prices and wages tend to spiral upward. To control prices, the Fed can increase the short term interest rates banks pay to borrow money in order to keep a required percentage of their deposit in reserve. These reserves accommodate the money bank customers withdraw from their accounts.

When banks must pay higher reserve rates, they are more careful to control the amount they lend to businesses and consumers. To control the amount of these loans, they charge higher rates, making the loans less attractive to borrowers. With slower borrowing, businesses lessen expansion and hiring, and consumers lessen their discretionary purchases. This set of actions tends to slow the economy.

Remember, though, that price stability is only one of the Fed’s mandates. The other is full employment. As interest rates increase and the economy slows, unemployment rates tend to increase. At the point where inflationary pressures have eased, the Fed will begin to lower these short term interest rates to stimulate the economy. Banks will increase lending; businesses will expand and increase hiring, thus decreasing unemployment rates.

We will look at three types of rates that reflect Fed monetary policy in this discussion – the six month Treasury bill, the ten year Treasury note and the thirty year Treasury bond.

THE TREASURY BILL

The direction of interest rates paid on the six month Treasury bill is often thought to indicate the direction the Fed is taking in regard to short term interest rates. If the T-Bill rate is dropping, the likely tendency is that the Fed is lowering interest rates, and if that rate is rising, the Fed is likely to raise interest rates.

In 2003, the rate averaged 1.03%, and in 2004 it increased to 1.396%, an increase of 35%, correctly predicting the Fed funds rate increase of 26.4% to 1.4% that year.

In 2005, the T-Bill rate averaged 3.215%, an increase of 130% from 2004. During that period, the Fed fund rate increased 57% to 3.25%.

In 2006, the T-Bill rate averaged 4.84%, an increase of 51%, and the Fed fund rate increased 54% to 5%.

In 2007, the T-Bill rate averaged 4.625%, a decrease of 4% from the prior year. The Fed fund rate decreased .4% to 4.979%.

In 2008 with data through November, the T-Bill rate averaged 1.783%, down 61% from 2007. For the same period, the Fed funds rate was down 59% to 2.023%.

As you can see, the direction of the T-Bill rate has been an accurate predictor of the direction of Fed policy, and that policy is “accommodative,” or easing, in order to stimulate the economy during the economic slowdown predicted by the Economic Cycle Momentum indicators discussed in the previous article.

TEN YEAR TREASURY NOTE

The direction in the rate paid on the ten year Treasury note is predictive of the direction of inflation. Before we look at how well this indicator has worked, we must define precisely what we mean by inflation.

Inflation is measured in two ways, wholesale and retail. Wholesale inflation reflects the inflation in the price of producing, thus called the Producer Price Index. Retail inflation reflects the increase in the cost of purchasing goods and services at the consumer level, and is called the Consumer Price Index. In a falling economy, producers will often absorb the increase in costs to produce their goods and services, which decreases their profits, but increases sales in a slow economy. For this reason, we will compare the T-Note to the Producer Price Index (”PPI”).

The long term rate of inflation is 2.5%.

In 2003, the T-Note paid 4.006%, and in 2004, stayed virtually the same at 4.294%. During that period, the PPI rose 4% to 148.6.

In 2005, the T-Note again was virtually unchanged at 4.285%, and the PPI rose to 155.7, or just under 5%.

In 2006, the T-Note rose 11% to 4.778%, and the PPI rose to 160.3, just under 3%.

In 2007, the T-Note was virtually unchanged at 4.654%, and PPI rose 4% to 166.6.

In 2008 with data through September, the T-Note dropped 5% to 3.7%, and PPI dropped 5% also to 158.3.

Is inflation decreasing? Looking back, that is the signal. Looking at the present, however, we must consider the additional effect of the Fed’s actions which flooded the financial system with $700 billion in liquidity to address the unprecedented “freeze” caused by the sub-prime crisis. While this action was certainly necessary, many people, me among them, expect that this action is inflationary, and will be addressed by raising interest rates once the crisis is under control.

THE TREASURY BOND

Generally, the direction of interest rates paid on the 30 year Treasury bond is indicative of the increase or decrease in the national debt. In the past, and likely in the future, this will be a relatively accurate predictor.

Currently, however, with the $700 billion Treasury investment in the financial system, possible “bridge loans” to the auto industry, investment in infrastructure projects projected by the new administration, coupled with a targeted policy to lower long term interest rates in order to address the housing crisis, this indicator is less predictive under current extraordinary circumstances.

These indicators are useful in relatively ordinary financial circumstances, and that can hardly be said for those currently in place. Therefore, we will acknowledge the past predictive effect of this indicator, as well as the fact that current circumstances make it less valuable.

So what can we conclude from reviewing these monetary indicators? The Fed has lowered short term interest rates nearly as far as it is possible, in order to boost the sagging economy predicted by the Economic Cycle Momentum indicators. In addition, it is flooding the economy with money to get the financial system moving again. Finally, it is “targeting” lower mortgage rates in order to slow the decline in housing prices.

For now, the direction of interest rates is steady-to-lower.

When the economy stabilizes, however, we can be almost certain of both higher inflation and higher interest rates, and must watch the Economic Cycle Momentum indicators for signs of such stabilization.

Next, in part three of our series, we will discuss the indicator that is likely most predictive of the direction of the capital markets -Sentiment.