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Chapter 17 Financial Business Cycles. Importance of Financial Business Cycles This chapter is not usually part of macroeconomics or business cycle texts,

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Presentation on theme: "Chapter 17 Financial Business Cycles. Importance of Financial Business Cycles This chapter is not usually part of macroeconomics or business cycle texts,"— Presentation transcript:

1 Chapter 17 Financial Business Cycles

2 Importance of Financial Business Cycles This chapter is not usually part of macroeconomics or business cycle texts, but is included here for two main reasons. 1. Since the causes of business cycles are increasingly dominated by financial variables, it is useful to understand what cyclical patterns they follow. 2. It is important for business managers to understand what economic variables affect movements in bond and stock prices, although obviously the emphasis here is on longer-run relationships rather than short-term trading.

3 Cyclical Patterns of Monetary and Credit Aggregates We have not said much about the money supply in recent chapters, even though the importance of financial variables has been emphasized. Since the deregulation of the banking sector in 1982, changes in the money supply have not been closely correlated with changes in either real growth or inflation. Instead, fluctuations in loans and credit outstanding have become more important

4 Loans and Consumer Credit Loans and credit outstanding are either coincident or lagging indicators, reflecting borrowing decisions that are made for other reasons, and in that sense are not an endogenous factor causing business cycle fluctuations. Nonetheless, in 1980 and in 1990, changes in credit conditions – the imposition of outright credit controls and much more severe regulations for banks – were major causes of recessions in those years. This emphasizes the degree to which the economy cannot continue to expand without adequate supplies of consumer and business credit.

5 Cyclical Patterns in the Yield Spread We have already noted several times that an inverted yield spread is always followed by a recession the next year. That is one of the few business cycle relationships that remained intact in 2001. When the yield spread becomes inverted, banks would rather purchase Treasury securities than offer loans, and the resulting contraction in credit results in declines in credit-sensitive components of GDP.

6 Inverted Yield Curve – Good Idea or Bad? In that case, maybe the Fed should try to avoid an inverted yield curve. Or conversely, maybe that is a safety valve that keeps recessions short and mild instead of developing into extended periods of stagnation or even depression.

7 Good or Bad Idea, Slide 2 To review, the yield curve inverts when the Fed raises interest rates enough that investors start to believe the demand for loanable funds will soon decrease enough – either because of lower inflation and or lower real GDP – to push bond yields lower and prices higher. If the Fed tightened but the yield spread did not narrow, that would be a signal that investors expected even higher inflation ahead. Yet if the Fed did not tighten, that would send an even clearer signal to investors that the Central Bank had abandoned its duty to keep inflation low.

8 Good or Bad Idea, Slide 3 The best way to keep the yield curve from inverting is for the Fed to act with alacrity when overheating appears probable, and raise the funds rate sooner rather than later. In 1994, the Fed acted quickly, and while the economy slowed down, it did not head into recession, In 1999 and 2000, the Fed acted much more sluggishly, and an inverted yield curve developed, followed by a recession.

9 Good or Bad Idea, Slide 4 Many reasons have been suggested – after the fact, of course – why the Fed failed to tighten in enough in the late 1990s. Inflation remained low, productivity growth was accelerating, and the world financial situation appeared tenuous. Cynics claimed Greenspan did not want to tighten in an election year. Whatever the precise reasons, it now seems clear that the U.S. economy would have been better off with earlier tightening and a less explosive stock market bubble.

10 Cyclical Pattern of Stock Market Prices Obviously we dont have a secret formula for beating the market. The logic of this section is that (a) stock prices have an important impact on capital spending, (b) to a certain extent, stock prices are affected by cyclical variables, notably interest rates and profits, and (c) stock prices can generally be expected to fluctuate in a manner that will have some impact on the overall pattern of business cycles.

11 Impact of Stock Prices on Capital Spending When the P/E ratio rises, the cost of equity capital declines, hence boosting capital spending. Also, a rising P/E may signify an improvement in business optimism, or a technological boom, indicating an increase in the MPK. In that sense, the stock market impacts both sides of the fundamental relationship affecting capital spending decisions.

12 Determinants of Stock Prices Interest rates Corporate earnings Federal budget surplus or deficit Other factors determining expected rate of inflation Foreign saving and investment Random and exogenous events (9/11, Persian Gulf Wars, Enron, etc.) Tax rate on capital gains and dividends relative to rates on other personal and corporate income

13 Focusing on the Risk Factor Difference between the price/earnings (P/E) ratio and the Aaa corporate bond rate is the risk factor. That depends on all the other elements listed on the previous slide. Since 1982, the risk factor has been between 2% and 4%, meaning that the growth rate of earnings would be 2% to 4% above the bond rate. Before 1982, the risk factor generally averaged about 6%.

14 Determinants of the Risk Factor The risk factor rises when inflation rises and when the budget deficit ratio rises. It declines when foreign saving and investment increases relative to GDP Although not part of the risk factor, the P/E rises when the maximum tax rate on capital gains declines relative to the tax rate on other types of income. A cut in the maximum rate on dividends also boosts the P/E ratio.

15 Bubbles Of course there are bubbles from time to time. They are unpredictable, and while it becomes increasingly obvious the market is overvalued, no one really knows at the time when it will turn around. They just tell you later that they knew. Debate continues on whether the Fed should step in more vigorously and keep these bubbles from forming. How could it do that? Very simply: raise the margin rate for purchasing stocks. However, some fear that would be a meat-ax approach.

16 The Stock Market As Part of the Business Cycle Leaving aside bubbles, the general cyclical relationship of the stock market, capital spending, and overall economic performance can be summarized as follows. The Fed reduces interest rates and increases credit availability shortly after a recession gets underway Most of the time, in the absence of specific exogenous forces to the contrary, the stock market reverses course as starts to rise again

17 Stock Market Cycle, Slide 2 The increase in stock prices is one of the factors boosting capital spending, which helps to get the recovery started. As profits rise, and the MPK increases, higher stock prices also reduce the cost of equity capital, thereby strengthening the recovery. When the economy begins to overheat, interest rates rise, reducing stock prices. After the normal lag, capital spending starts to decline.

18 Stock Market Cycle, Slide 3 But suppose interest rates do not rise. The stock market boom turns into a bubble, and the increase in capital spending eventually creates excess capacity. A recession ensues anyhow. Seen in that light, it would be better for the Fed to tighten substantially when signs of a bubble start to appear even if inflation has remained low and stable.

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