1. March 2012 M A C R O E C O N O M I C S: F O R E C A S T I N G, I N D I C A T O R S, M A R K E T S Michael Feroli Chief U.S. Economist J.P.Morgan

2. 1 Overview of the discussion What “Street” economists do How we do economics differently

3. 2 Economics on Wall Street Non-financial business Only limited interest in macroeconomic trends More interest in microeconomics Financial business Very interested in macroeconomics All asset classes affected Extreme case: macro hedge funds

4. 3 Macroeconomics and asset prices In general, any asset price is the product of: an expected future payoff (for example, a coupon or a dividend) and how that future payoff is valued in today’s terms (that is, the interest rate used for discounting). Macroeconomic forces influence both the asset’s payoff and the discounting factor, or interest rate.

5. 4 Interest rates and macroeconomics Taylor rule and target federal funds rate Simplest asset: Treasury security (no risk*, no embedded options). Payoff is simple, what’s interesting is the discounting: the interest rate. Long term interest rates = expected average short term interest rate + term premium. Shortest-term interest rate set by the central bank. Central bank sets short term rate following news on growth and inflation. Thus, Treasury rates are expectations of central bank action on growth and inflation. Very long term rate (30 years) the influence of current economic developments is limited. Shorter duration (2 years) more influenced by current economy. Taylor rule: rough formula that describes how a central bank should set short-term interest rates. From the rule, short-term rates rise with inflation and fall with the unemployment gap.

6. 5 Credit and macroeconomics Credit: a claim on corporations operating income. Credit returns are commonly cited as a spread over comparable Treasury returns. Credit spreads a reflection of default risk, and investors appetite for that risk. Stronger growth -> lower default risk. High-yield credit spreads and EASI EASI: Economic Activity Surprise Index. A measure of the degree to which economic indicators were surprisingly strong (+) or weak (-).

7. 6 Equities and macroeconomics DJIA and the EASI Equity asset pricing: discounted stream of future corporate earnings. Discount factor is interest rates Strong growth, higher inflation -> higher interest rate -> lower equity prices. Corporate earnings: revenue less expenses. Revenue growth tied to economic growth. Strong growth -> higher earnings -> higher equity prices. Unlike interest rates, equity prices don’t have a simple relation to macroeconomic variables. Equities like growth, but not so much growth that the central bank raises interest rates.

8. 7 Currencies and macroeconomics Two broad frameworks for thinking about currencies and macroeconomics. PPP (purchasing power parity): useful in the long run, or thinking about currencies in high-inflation countries. Interest rate parity: probably more useful in shorter-run analysis or with pairs of low inflation countries. In interest rate parity framework, all of the earlier cited impacts of macroeconomics on interest rates apply, times two. Dollar and EASI Note: no framework works very well, currency behavior remains somewhat of a mystery.

9. 8 A simple macroeconomic framework The main variables of interest: Output growth, or GDP growth, or just simply growth Inflation Interest rates The main relations: Output growth is a function of interest rates, plus “other stuff” (changes in tax policy, natural disasters, etc.) Inflation is a function of output growth, relative to potential output growth, plus “other stuff” (import prices, energy prices, etc) The interest rate set by the Fed is a function of inflation and output growth and “other stuff” (credibility, financial crises, etc)

10. 9 A simple macroeconomic framework Output growth Inflation Interest rates Taylor rule “IS” curve Phillips curve

11. 10 Data watching growth GDP, the central focus in assessing growth, is defined as the market value of all final goods and services produced in a country in a given period. Three ways of measuring GDP which are equivalent (in principle): The expenditure measure. Output is measured by the type of final purchase: consumption, investment, government spending and net exports. This is the preferred measure in the most countries. The industry output measure. The sum of value added across industries. This is the preferred measure in fewer countries. The income measure. The costs incurred and income earned in producing output; often divided into labor compensation, several components of capital income, and some other small technical categories. This is a subsidiary measure of output in most countries.

12. 11 Importance of GDP Traditional reason. The usual stuff: determines employment, inflation pressures -> interest rates Data watching reason. Disciplines an economic view: only one GDP. Financial markets unconvinced of macro forecasting models

13. 12 Building up expenditure-based GDP in the US Consumption (71%) Investment (13%) Government (20%) Net exports (-4%) Services (47%) Goods(24%) Business fixed (13%) Residential (2%) Inventories(0.5%) Federal (8%) State and local (12%) Exports (14%) Imports (18%) GDP shares Timely indicators Retail sales Personal consumption Consumer confidence Motor vehicle sales Durable goods Factory orders Construction spending Housing starts New home sales Existing home sales Homebuilders survey Manufacturers’ inventories Wholesale inventories Retail inventories Federal budget statement Construction spending International trade

14. 13 Building up expenditure-based GDP in the US Timely indicators help to estimate how GDP growth is tracking within each quarter. Recent example of this in practice (from JPMorgan’s US economic commentary): (January 26) …orders and shipments for nondefense capital goods (ex- aircraft) both increased 2.9%...Today's report leaves us on track for a 3.0% or 3.1% print on GDP in tomorrow's first look at Q4 growth, and the strength in the capital goods numbers late last quarter sets up a relatively firm trajectory for capital equipment spending heading into Q1.… (November 15) …Retail sales were solid in October, increasing 0.5%... We don't have much other hard data for the quarter yet (particularly for imports and inventories, which could be swing factors) but our best estimate is now that overall GDP growth in Q4 is also tracking close to 3.0% (our previous estimate was 2.5%).

15. 14 Watching income and industry output measures Service-producing industries (68%) Manufacturing (12%) Government (14%) Other goods-producing industries (agriculture, construction, etc.) (6%) Compensation of employees (55%) Corporate profits (10%) Depreciation and production taxes (20%) Other capital income (interest, unincorporated business, etc.) (15%) Gross incomeValue added by industry

16. 15 Timely measures of income and industry output IncomeIndustry output Employment report ECI Personal income Jobless claims Compensation Corporate profits Quarterly corporate profit report Depreciation, other capital income Few timely measures Manufacturing Industrial production ISM Regional surveys (Philly, Empire State, etc.) Services Non-manufacturing ISM, few other indicators (a problem for measuring US economy)

17. 16 Inflation: some fundamentals Inflation: a continued rise in the overall price level. Milton Friedman: inflation is always and everywhere a monetary phenomenon. In the US, however, the link between inflation and measure of monetary aggregates broke down decades ago. Inflation and the money supply

18. 17 Inflation: some fundamentals After money “broke down” US economists returned to analyzing resource utilization as the main driver of the change in inflation rates. Two approaches: Traditional Phillips curve. Given a natural rate of unemployment, or NAIRU, denoted u*, inflation pressures will be determined by where the actual unemployment rate, u, is in relation to NAIRU. If u>u*, inflation pressures are easing. If u<u*, inflation pressures are building. Output gap-based Phillips curve. Given the full-employment potential output of the economy, denoted y*, inflation pressures will be determined by where the actual output, y, is in relation to potential. If y y*, (a positive output gap) inflation pressures are building.

19. 18 Inflation: some fundamentals Money replaced with “gaps-based” approach: inflation pressure determined by how far economy operating from its full-capacity potential. There are two problems with practical implementation: NAIRU and potential output are unobserved. The estimates we have are often revised after several years. In the short-run, other factors such as supply shocks can influence inflation as well as distort the signal of true, underlying inflation NAIRU gapOutput gap

20. 19 Consumer prices Inflation indicators CPI Core (77%) Food and energy (23%) PCE Core* (80%) Food and energy (20%) * The core PCE is the Fed’s preferred inflation measure Broad prices GDP prices Business output prices Supply prices Producer price index (PPI) Commodity prices (JOC, CRB) Import prices The dollar Labor costs

21. 20 Labor cost inflation indicators Average hourly earnings Employment cost index (ECI) Compensation per hour Unit labor cost (=compensation per hour / output per hour) Prices or margins

22. 21 Full circle back to the Fed… Output growth Inflation Interest rates Taylor rule “IS” curve Phillips curve

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