Guide to Economic Indicators

by The Economist

  For example, inmid-2006 the real yield on index-linked gilts was roughly 1.7% (depending on inflation assumptions) while the yield on long-datedcon-ventional gilts was 4.5%, implying expected inflation of 2.8% a year.

  However, such calculations should be regarded with suspicion, because the volume of index-linked bonds is so small that individual trades can move the market.

  Yield curves, gaps and ratios

  Measures: Difference between interest yields on different instruments.

  Significance: Indicator of interest and inflation expectations.

  Presented as: Annual percentage rates.

  Focus on: Long-dated government bonds and other interest rates.

  Yardstick: See Table 12.4.

  Released: Almost continuously round the clock.

  Table 12.4 Yields

  Overview

  Various yield differentials signal market perceptions of risks, interest rates, inflation and perhaps exchange-rate movements. You can focus on the difference between any two yields. Four common measures are described below.

  Yield curve

  Strictly speaking, the yield curve is a line on a graph linking interest rates for a whole range of maturities. However, it can be represented numerically by the difference between two maturities, such as the yield on long-term government bonds less three-month Treasury bills (Table 12.4).

  Long rates are usually higher than short rates to allow for the time and inflation risks of holding bonds. However, the curve flattens or inverts when monetary conditions tighten, mainly because of the increase in short rates. The curve may therefore be used as a signal of monetary conditions and a leading indicator of economic activity.

  Bond spread

  The bond spread is the gap between bond yields in two countries. For example, it might be defined as American less British long-term government bond yields, in which case a narrowing of the differential indicates a reduction in the relative attractiveness of the dollar. (See Exchange rates and Interest rates, pages 154 and 183.) Or, more frequently, the premium yield required by those investing in many of the emerging economies over American Treasuries.

  Widespread worries

  Spreads widen alarmingly on government bonds in troubled euro-area economies

  Greece’s debt was downgraded by Standard & Poor’s to “junk” status on Tuesday April 27th, driven in part by fears about delays in aid for Greece from the European Union and the IMF. The agency also cut Portugal’s debt rating by two notches. The moves provided another jolt to euro-area bond markets and added to worries that a bail-out for Greece, even if it came soon, would only delay a default. Contagion has already hit other troubled European economies. Yields on two-year Greek notes rose above 25% on Wednesday, from 4.6% a month ago. Spreads between ten-year Greek bonds and benchmark German bunds the day before spiked to nearly seven percentage points. Spreads also rose substantially for bonds issued by Portugal and Ireland, but only slightly for Italian and Spanish government debt.

  Ten-year government-bond spreads over German bunds

  Sources: Thomson Reuters

  The Economist, April 28th 2010

  Yield gap or reverse yield gap

  The yield gap is the yield on long-term government bonds less the average dividend yield on shares. Decades ago, before the markets were worried about inflation, the yield on shares was higher than that on bonds (that is, the gap was negative), reflecting the greater risk of holding equities. The gap is now generally positive (sometimes called a reverse yield gap) because investors demand a higher return from bonds to compensate for the inflation risk of holding instruments with fixed redemption values. The gap therefore says something about expected inflation.

  In the late 1990s and early 2000s, however, worries about inflation were slight in comparison with the early 1990s and the 1980s. Dividend yields in America (and to a lesser extent in other countries, including Britain) were driven lower as the stockmarket boomed. This widened the reverse yield gap. The gap therefore says something about investors’ optimism about equities as well as about expected inflation.

  Yield ratio

  The yield ratio is the yield on long-term government bonds divided by the average dividend yield on shares. The yield ratio was between 1 and 1.6% in the major markets in mid-2010. Loosely, a high ratio relative to historical experience in the country in question implies that equities are overvalued relative to bonds.

  Real interest rates and yields

  Measures: Any interest rate or yield less the rate of inflation.

  Significance: Determinant of investment behaviour.

  Presented as: Per cent per year.

  Focus on: Three-month money, long-dated government bonds.

  Yardstick: See Table 12.5.

  Released: Almost continuously round the clock.

  Table 12.5 Real yields

  Overview

  Real interest rates are nominal interest rates deflated by the rate of inflation. For simplicity, this may be approximated by subtraction. For example, over the period 2005–08 American three-month interest rates averaged 3.4% and consumer prices rose by 3.3% a year, so the real interest rate was about 3.4 − 3.3 = 0.1%.

  Implicitly at least, investment decisions are based on real interest rates. Since inflation over the period ahead is unknown, it is the expected real interest rate that influences behaviour. This cannot be measured easily, so the latest rate of consumer-price inflation is usually used as a proxy when calculating real interest rates.

  Interpretation is tricky. Logic suggests that high real rates will discourage physical investment, but recent studies suggest that cause and effect run in the opposite direction; it is the demand for investment funds that makes real rates high in the first place.

  Share prices

  Measures: Prices of company share capital.

  Significance: Reflect economic expectations; useful as a leading indicator.

  Presented as: Individual prices in money and indices of average prices.

  Focus on: Broad market indices.

  Yardstick: See Table 12.6.

  Released: Almost continuously round the clock.

  Table 12.6 Share prices

  Overview

  Share prices reflect the discounted value of future dividend payments, with a premium thrown in to reflect the risks. Future dividends depend on company profits, which in turn reflect the quality of management and the state of the economy. For the stockmarket as a whole, variations in management quality average out, leaving perceptions about the state of the economy as a key factor in determining overall share prices.

  Staging a recovery

  Shares recovered in 2009 but are still well below their peaks

  In 2008 large financial firms suffered the biggest declines in share prices of any industry, falling by 56% overall. In 2009 they rose by 28%, but were still 52% below their peak of May 2007. The Morgan Stanley Capital International (MSCI) world index tracks the equity returns of the world’s 1,500 largest companies. Though the index gained 27% last year, it is still 31% below the peak it hit in October 2007. IT and telecoms firms never recovered from the dotcom bust in 2000, though IT companies posted strong gains in 2009.

  Share prices by industry

  *Including chemicals, construction materials, metals and mining companies MSCI world index

  Sources: MSCI; Thomson Reuters

  The Economist, January 7th 2010

  When investors expect recession, they are less keen to buy equities and their prices fall (a bear market). As soon as there is a glimmer of economic recovery, investors switch into equities, pushing up their prices (a bull market). Thus share prices are highly cyclical, and act as valuable leading indicators of expectations.

  Broad indices and sectors

  For economic fortune-telling, focus on broad market indices which average out erratic influences. For example, use the American Standard & Poor’s 500 stock index rather than the Dow Jones Industrial Average of 30 stocks; and the British FTSE
(Financial Times Stock Exchange) all-share index of nearly 800 shares rather than the narrower FTSE 100 index.

  Sector averages, such as indices for consumer goods or building materials companies, may be used to assess market expectations for various parts of the economy.

  Chapter 13

  Prices and wages

  Inflation means that your money won’t buy as much today as it did when you didn’t have any.

  Anon

  Overview

  Price indicators tell you about inflation. An increase in the gen eral level of prices is nothing new: records from the days of the Roman empire show rapid inflation. Since 1946 Britain’s consumer prices have risen every year, but in fact inflation – in the sense of continuously rising prices – is historically the exception not the rule. Linking together various price series (of admittedly varying quality) suggests that in 1914, on the eve of the first world war, British consumer prices were no higher than during the 1660s. During those 250 years periods of rising prices were interspersed with periods of falling prices.

  Inflation has three main adverse effects. First, it blurs relative price signals; that is, it is hard to distinguish between changes in relative prices and changes in the general price level. This distorts the behaviour of individuals and firms, and so reduces economic efficiency. Second, because inflation is never perfectly predictable, it creates uncertainty, which discourages investment. Third, inflation redistributes income: from creditors to borrowers, and from those on fixed incomes to wage-earners.

  It has become economic orthodoxy that price stability should be the goal of central banks. Many central banks now say that this is their aim, and several now have explicit inflation targets as the lodestar of monetary policy. In practice, this does not mean zero inflation, because consumer price indices tend to exaggerate annual inflation rates by 1 or 2 percentage points. So the Bank of England, for example, is expected to achieve an inflation rate of 2% (excluding mortgage-interest payments). The European Central Bank’s target is a rate of below, but close to, 2%. The Reserve Bank of New Zealand, a pioneer in inflation targeting, is supposed to keep inflation between 1% and 3%.

  Causes of inflation

  There are two main theories about the causes of inflation: supply shock and demand pull. The reality is probably a complex mixture of the two.

  Supply shock (or cost push)

  Prices are pushed up by higher wage and raw materials costs; perhaps owing to trade union power, dearer imports as a result of a weak currency, or a jump in commodity prices.

  Demand pull

  Prices are pulled up when spending power (demand) is greater than the availability of goods and services. Factors which can boost aggregate demand include tax cuts, higher government spending, wage rises caused by labour shortages and an increase in consumer borrowing.

  Recent experiences

  Experiences with inflation range from deflation (a fall in prices experienced, for example, during the 1930s depression and by some oil-producing countries in the mid-1980s) to hyperinflation (such as when German wholesale prices rose by about 1.5 trillion % between 1919 and 1923). The most prominent recent example of deflation is Japan, where the consumer price index fell from the late 1990s to 2005. Japan experienced deflation again in 2009. Hyperinflation is frequently associ ated with rapid increases in the money supply (see Chapter 12).

  Industrial countries

  Inflation was moderate in the industrial world in the 1960s, averaging about 3% a year. It jumped sharply after the two oil price shocks in the 1970s before falling again in the 1980s. In the fight to tame inflation, wage and price controls have generally given way to tight monetary and fiscal policies. Inflation generally stayed low in industrial countries during the 1990s and since, thanks to a combination of weak commodity prices and cautious monetary policies.

  Developing countries

  Inflation generally accelerated in the developing countries in the 1980s, and reached over 1,000% in some Latin American countries. The early 1990s saw inflation surge in eastern Europe and the former Soviet Union as ex-communist countries struggled to adjust to a market-based economy. Countries in the former Yugoslavia also experienced high inflation after the break-up of the federation.

  Since the mid-1990s inflation has moderated in developing countries, falling from 90% in 1994 to 9% in 2008. Inflation slowed especially dramatically in Latin America – in Brazil, it dropped from over 2,000% in 1994 to 3.2% in 1998 – and in central and eastern Europe and the former Soviet Union.

  Consumer prices

  In the 12 months ending in October 2009, the rise in consumer prices in major economies slowed or even reversed into deflation as a result of the world financial crisis. America, the euro area and Japan all saw prices decline over the period. In the United Kingdom, however, inflation remained above 1%, although its retail prices saw a small decline.

  Inflation and the economic cycle

  *September

  Source: National statistics

  The Economist, November 28th 2009

  Inflation and the economic cycle

  Cycles set in train by supply shocks are evident in Chart 13.1 on page 196. The analysis of inflation is also aided by an understanding of the effects of the economic cycle, where pressures often come through on the demand side. Prices increase less rapidly or even decline during recession when consumer spending is weak. However, at the top of the cycle when personal incomes are buoyant but businesses cannot increase their output, extra demand pulls up prices.

  13.1 Inflation in industrial countries

  *Forecast

  Source: OECD

  Price indicators

  Price indicators measure levels and changes in particular prices or groups of prices. For example, an oil price index covers one set of hydrocarbons while a consumer price index relates to a basket of goods and services purchased by households. In turn, these price series act as leading indicators of cost pressures and also signal movements in current demand.

  Price indices are sometimes called deflators when they are used to convert (deflate) figures in current prices into constant price terms.

  The composition of price indices

  Most price indices are weighted averages of several prices. It is difficult to choose weights for some indicators, such as commodity price indices (see page 205), although often the basis for the weighting is clear. If 20% of an average family’s spending goes on food, food has a 20% weight in the index of consumer prices. This can cause problems for interpretation, since there may not be an average family. The average rate of inflation is not experienced by a newly married couple with spending dominated by mortgage payments, nor by a retired person with little expend iture on consumer durables. It also poses problems if spending patterns are changing over time.

  Base-weighted indices may be used to measure changes over any period. The weights are the same for each year, so changes in the index reflect changes in prices only. The snag is that the weights may become outdated.

  Implicit deflators reflect changes in prices and spending patterns. For example, the American GDP implicit price deflator measures the difference between current and constant price GDP. Since the weights reflect the composition of GDP in each period, changes in the index reflect movements in both prices and the composition of GDP.

  The transmission of inflationary pressures

  When looking at price indicators, think about their relationship to final prices.

  Sequence

  The briefs on wages and prices are arranged loosely in the order in which inflationary pressures are transmitted through the economy: from raw materials’ prices and wages through producers’ selling prices and consumer prices to the GDP deflator. Indicators towards the end of the chapter are also signals of the state of aggregate demand. Prices in the early stages of production generally fluctuate more than prices at later stages. A 5% change in raw materials prices is generally less worrying than a 5% change in producers’ selling prices.

>   Relationships

  The sequence of cost pressures is clear. However, it is not so simple to identify a fixed relationship between any pair of price indicators.

  There are leads and lags. In general, changes in raw materials costs take longer to feed through to retail prices than movements in producers’ selling prices.

  The ultimate effect depends on the cost mix. For example, if raw materials prices rise by 10% and account for one-tenth of a manufacturer’s costs, and if all other costs are held constant, the effect is a 1% increase in list prices.

  Any movement in output prices will reflect the extent to which higher input costs are absorbed in profits or offset by improved efficiency and productivity.

  Indicators to use

  Consumer prices are the most rapidly available guides to “national” inflation and they can be used as yardsticks for interpreting other price indicators. For example, wage settlements above the rate of consumer price inflation suggest increasing inflationary pressures (unless they are absorbed by productivity growth – see Unit labour costs, page 217).

  Cost pressures are signalled by commodity prices, producer prices and wages and earnings. Surveys of price expectations are valuable leading indicators. The GDP deflator itself may be the best overall guide to inflation and should fluctuate least because it covers so many things, but it is available only after a time lag. Share prices and house prices are useful indicators of asset prices, which influence aggregate demand (see Consumer spending, pages 92–6).

  For reviewing particular groups of prices or their effect on certain industries or groups of consumers, select an appropriate indicator. For example, to track the cost of capital equipment purchased by a particular industry, look for a sub-index in the producer prices or the GDP investment deflators.