ECONOMY - OUTLOOK
"This section contains additional data that supplements basic information contained in
Your Money Matters
and should be used in conjunction with the material contained in Your Money Matters.
UNDERSTANDING THE ECONOMY
There are almost as many economic theories as there are economists. Its no wonder that getting a commonsense definition of economics (that is, one that you can use) proves difficult. But the bottom line is that economics deals with the basic consumer law of supply and demand. Not surprisingly, the themes of scarcity and production are central to most economic theories. The greater the demand, the greater the incentive to increase production (supply) to satisfy it. If the resources needed for production arent scarce, demand reduces the cost of the product or services to the point where more consumers can afford it. But if the resources needed are scarce and the demand is strong, then prices will rise.
We are bombarded with economic information, but most people dont understand what is being said. Terms like GNP, leading economic indicators, and prime rate are used as if their meaning were common knowledge. But what do these terms and the numbers that accompany them mean? And what is their relevance to your own financial life? This section will help you understand the economy, show you how to tell where it may be heading, and explain what you might do to take advantage ofeconomic trends rather than having them take advantage of you.
How Economic Developments Affect You
Everyone knows the value of a healthy, growing economy, but not many understand exactly why. A growing economy sets a chain of events in motion that generally benefit almost everyone in the economy, although there are often pockets that stay depressed. Conversely, in a recession, the economic pain is also distributed unevenly: While some areas of the country may suffer only a cessation of long-lasting growth, others may fall into a severe recession.
In theory, nearly everyone benefits from a robust economy. In the ideal model of the growing economy, jobs are created. As jobs are created, unemployment goes down. As unemployment goes down, wages rise employers have to compete for workers by offering higher salaries. As wages rise, workers have more income to buy more goods and services. This prompts the creation of still more jobs.
Economic growth can have a bad side effect inflation , although inflation can also occur in a stagnating economy. In an economy experiencing rapid growth like several South American countries the heating up of the cycle of buying and spending canlead to very high inflation indeed. Monetary policy, set by the FederalReserve, attempts, among other things, to keep inflation in check whilestimulating growth.
Terms You Should Know
The U.S. economy is watched by legions of economic analysts and other pundits at universities, think tanks, corporations, and in the government. These analysts look at a variety of so-called economic indicators to assess how the economy is faring and where it is headed.Since these figures are constantly in the news, understanding what theymean and how they affect you is important.
CAPACITY UTILIZATION. This indicator tracks the operating activity of leading manufacturers. If the manufacturers are operating at more than 85% capacity, its viewed as positive.
CONSUMER PRICE INDEX (CPI). The CPI (also known as COLI, the cost-of-living index) tracks the changes in costs for consumer goods and services, from catsup to your utility bill.
GROSS NATIONAL PRODUCT (GNP). The GNP is the total value of all finished goods produced and services rendered over a set period of time (usually six months to one year). This indicator relates to theexpansion or contraction of the economy as a whole.
INDEX OF LEADING ECONOMIC INDICATORS. There are 12 economic indicators (detailed below) that reflect upward and downward trends in the overall economy. Youll hear this term ad nauseam from businessreporters.
NEW CAR SALES. Cars are big-ticket items, requiring large cash transactions or long-term repayment plans. The number of car sales reflects the number of people who think they can afford to spend largesums of money, which in turn reflects optimism or pessimism about theeconomy.
RETAIL SALES. The retail sales indicator also indicates confidence in the economy. The more you buy, the more optimistic about the economy, your job prospects, and your continuing purchasing power you seem to be.
DEPARTMENT STORE SALES. Every time you buy a T-shirt at J.C. Penny, you contribute to this indicator of, among other things, consumers willingness to buy nonessential items.
UNEMPLOYMENT. The higher the unemployment, the worse off the economy is. This indicator is followed weekly and is always worth noting.
FEDERAL FUNDS RATE. The Fed funds rate is the interest rate that banks charge one another. This rate affects the rates of interest on bank loans to consumers and businesses.
PRIME RATE. The prime lending rate is the interest rate reserved for a banks best customers. It is usually the banks lowest available rate. The lower the rate, the greater the motivation to borrow, therefore the greater the motivation to spend.
BROKER LOAN RATE. This is the interest rate charged to brokers who are borrowing from banks. If interest rates are low, borrowing tends to increase. The result is an increase in investing that may or may not send an optimistic message to the market.
HOUSING STARTS. This refers to new home construction across the nation. The number of housing starts indicates the level of consumeroptimism and willingness to spend.
WAGE SETTLEMENTS. The results of major wage contracts can indicate the magnitude in the rise in the cost of goods and services. Agreements with lower annual salary increases usually mean lower inflation.
PAYROLL EMPLOYMENT. This figure the number of employees on company payrolls is issued on the first Friday of each month in most major newspapers. Not only does it reflect the employment situation, it best predicts future consumer spending patterns, which depend heavily on employment.
THE DOLLAR INDEX. This index shows the value of the dollar against a group of foreign currencies.
INVENTORY-TO-SALES RATIO. This is a crude but useful measure of the extent to which the demand for goods is satisfied. It therefore indicates sales patterns that affect corporate profits. It consists of the dollar value of business inventory nationwide divided by sales and is used monthly. When the economy is flagging, this ratio may be as high as 1.5 to 1, because inventories build up and sales slow. A 1.3 to 1 ratio is considered balanced, because businesspeople like to keep a little extra inventory on hand.
THE STANDARD AND POORS (S&P) STOCK INDEX. The stock market predicts general economic recoveries as no other indicator can, but as the old joke goes, it also predicted nine of the last five recessions. The S&P 500 Stock Index is quoted daily in most newspapers. Its considered a better predictor of the economys future prospectsthan the Dow Jones Industrial Average because the S&P Index is basedon many more stocks than is the Dow.
MONEY SUPPLY. This refers to the amount of the nations money that is available to spend.
Information from the U.S. Department of Commerce is also importantto figuring out what is going on in the economy. Among the data published regularly is the composite index of leading indicators. Thisindex has 12 components, which are appraised monthly. The data for eachcomponent are collected monthly and are then combined to form one index.These measures, when taken together, show how the general business climatewill move in the future.
Changes during a single month may not be significant. Changes over short periods may reflect the influence of random events. Examples of such events are unusual or extreme weather patterns, or a prolonged strike by members of a large labor union, such as the teamsters, the U.A.W., or the mine workers. But when the composite index shows continued gain month by month, this is an indication that business will improve and vice versa.
The 12 components of the composite index of leading economic indicators are listed below:
Twelve Leading Economic Indicators
1. Average work week of procution workers
2. Layoff rate in manufacturing
3. Value of manufacturer's new orders for consumer goods and materials
4. Index of net business formation
5. Standard & Poor's Index of 500 common stock prices
6. Contracts and orders for plant and equipment
7. Index of new private housing units authorized by local building permits
8. Vendor performance - percentage of companies reporting slower deliveries
9. Net change in inventories on hand or on order
10. Change in prices of key raw materials
l l. Change in total liquid assets - the liquid wealth held by private investors
12. Money supply
One of the greatest problems of capitalist economies is their susceptibility to consumers fears and insecurities. When consumers, investors, and businesspeople feel pessimistic, the wheels of the economy can slow dramatically, even if the economy is actually in reasonable shape. Inan age where the media transmit ideas at lightning speed, gloominess canbe extremely infectious. The key to surviving in bad economic times isto break free of this crowd mentality, take stock of whereyou stand, and act accordingly. Opportunities often abound when most people are pessimistic.
In most advanced industrial countries, the monetary system is run by a semi-independent national bank. In theory, at least, this central bank is above the political fray; it sets monetary policy on a rational and dispassionate basis. In the United States, a system of banks rather than one single bank acts as our national bank, and itis called the Federal Reserve System. Congress created the Fed in 1913,granting it the power to coin money and regulate the value thereof, and it has been running our monetary system ever since.
A board of governors, whose members are appointed by the President, presides over the Fed. The Fed chairman wields a great deal of power in deciding how monetary policy should be set; indeed, whomever is the chairman personifies the system as a whole. The Fed chairman, while technically free to regulate this monetary system as he thinks best, must in actuality work closely with the Treasury Department. Since the Secretary of theTreasury is a political appointee and therefore subject to political pressureshimself, the Fed is indirectly influenced by politics. Furthermore, Congresscan summon the Fed chairman to testify about monetary policy and the state of the economy. Congress can thus make its displeasure about monetary policy quite clear, and if it wishes, really hold the chairmans feet to the fire.
How does the Fed set monetary policy? The Fed uses several tools, the most important of which is the discount rate. The discount rate is the rate the Fed charges for the money it loans federally-chartered banks. These banks use funds borrowed from the Fed to bolster their reserves, which in turn allows them to lend more money to their customers. If the Fed wants to restrict the amount of money going into the economy, it can raise the discount rate, discouraging borrowing by making loans more expensive. On the other hand, should the Fed want to increase the flow of cash into the economy, it can lower the discount rate, making borrowed money cheaper.
Because the Fed has such massive cash reserves, it is also free to buy or sell large blocks of U.S. government securities in order to reach its interest rate targets. These activities are called open-marketoperations, and they are another one of the Feds important toolsfor setting monetary policy. If the Fed starts aggressively buying upgovernment securities, it will be pumping great amounts of cash into themonetary system. Conversely, by selling securities, the Fed can soak upa large number of greenbacks, thus restricting the money supply.
Finally, the Fed can set reserve requirements, the amount of money U.S. banks are required to have on hand in liquid form. The lower a banks reserve requirement, the more money it can lend out to businessesand individuals. By raising or lowering reserve requirements, the Fedcan therefore regulate how much money finds its way into the economy.
Whenever the economy goes off track, the Presidents popularity slips in the public opinion polls. As the countrys leader, the President is a natural target for peoples frustration with poor economic conditions; he is similarly the first to benefit politically when the economy is booming. But does the President deserve the share of blame and credit that he gets for the course the economy takes?
The President does have direct control over several important levers to the nations economic machinery. In general, however, government action is slow and ponderous. It is not like a little car that can bejump-started but is more like a supertanker, whose direction and speedtake considerable time and effort to change. Many people think the federalbudget can strongly influence the economy and it can. But there is a greatdeal of lag time between the time the President presents an idea and whenits effect is actually felt. By the time the proposal that the Presidentsubmits to Congress has made its way through the House Ways and MeansCommittee, been reconciled with other competing budgets, and been signedby the President, as much as ten months have elapsed. Then and only then will whatever economic policy actions are included in the act take effect. The upshot of all this is that the effects of federal governmentactions can be so slow that the economy will have either improved or worsenedon its own accord long before the impact of the new budget or other presidentialactions, for that matter, are felt.