Economic factors

The Federal Reserve’s dual mandate requires it to focus on encouraging economic growth and managing inflation levels. So how does the Fed know when the economy needs help? Economists watch a wide range of indicators, data sets, and market signals. This chapter covers:

• GDP/GNP
• Consumer price index (CPI)
• Yield curves
• Leading indicators
• Coincident indicators
• Lagging indicators
• Economic market structures

GDP / GNP

Economic growth is commonly measured by gross domestic product (GDP) or gross national product (GNP).

• GDP measures the value of all goods and services produced within a country’s borders. Economists often use it as a broad measure of domestic economic strength.
• GNP measures the value of all goods and services produced by a country’s residents, even if production happens outside the country (for example, goods sold by a U.S. citizen while temporarily living in Spain).

GDP and GNP are reported in constant dollars, meaning the data are adjusted for inflation. This makes it easier to compare output across different time periods.

When GDP rises, more goods and services are being produced and sold, which signals economic growth. The faster GDP rises, the faster the economy is growing.

When GDP falls, fewer goods and services are being produced and sold, which signals economic weakness. If this continues long enough, the economy may enter a recession or depression.

• A recession is two consecutive quarters (six months) of GDP decline.
• A depression is six straight quarters (a year and a half) of GDP decline.

When GDP declines, the Fed typically pursues loosening (expanding) policies to increase the money supply. As interest rates fall, borrowing becomes cheaper, which can lead consumers to buy more homes, cars, and other goods.

As a reminder, if the economy is shrinking, the Fed may take one or more of these actions:

• Lower their discount rate
• Engage in repurchase agreements with banks
• Lower bank reserve requirements
• Lower Regulation T (margin rules)

Consumer price index (CPI)

The Federal Reserve follows the consumer price index (CPI) to gauge inflation levels. Each month, the U.S. Bureau of Labor Statistics tracks prices for goods and services commonly purchased by households, including gasoline, groceries, cell phone contracts, and real estate.

• If prices rise on average, CPI rises.
• If prices fall on average, CPI falls.

When CPI rises more than expected, the Fed pays close attention. Inflation can be a side effect of the Fed’s own loosening policies: if too much money enters the money supply, prices may rise.

When inflation is rising, the Fed may use one or more tightening (contracting) policies to reduce the money supply and manage inflation:

• Raise the discount rate
• Engage in reverse repurchase agreements with banks
• Raise bank reserve requirements
• Raise Regulation T (margin rules)

These actions reduce the money supply, which tends to push interest rates higher. Money behaves like other goods: when there’s less of it available, it becomes more expensive to borrow. Higher interest rates usually reduce borrowing and spending, which can help stabilize prices over time.

Yield curves

Federal Reserve actions strongly influence the bond market. One way to track changing conditions is with yield curves, which show the yields of similar debt securities across different maturities.

For example:

This is a normal (ascending) yield curve. Short-term maturities have lower yields, and longer maturities have higher yields. This is typical because longer time periods generally involve more risk exposure.

Sometimes, the yield curve reflects a different bond environment. For example:

This is a flat yield curve, which signals uncertainty. Short-term and long-term debt securities offer similar yields, which is unusual.

One way this can happen is if investors sell short-term securities and buy long-term bonds:

• Lower demand for short-term securities pushes prices down and yields up.
• Higher demand for long-term bonds pushes prices up and yields down.

Together, these moves can flatten the curve.

This is an inverted (descending) yield curve, which can signal a pending recession. Short-term debt securities have higher yields than long-term debt securities.

An inverted yield curve often follows the same forces that create a flat curve (the curve may flatten first and then invert). If investors expect a recession, they may sell short-term securities and buy long-term bonds.

Why? The Fed typically tries to lower interest rates during a recession. If investors expect rates to fall, they may buy long-term bonds to lock in higher coupons before rates decline. Also, when interest rates fall, bond prices rise, which creates potential for capital appreciation.

Investors can find yield curves for the overall bond market or for specific sectors (corporate, municipal, U.S. government, etc.). There are also comparative yield curves, sometimes called credit yield spreads, which compare two yield curves - often U.S. government versus corporate.

Corporate debt securities usually have higher yields than U.S. government securities because corporate bonds carry more risk. Comparative yield curves focus on the distance between the two curves.

This picture shows the yield curves widening (moving farther apart), which can signal a recession. Investors may sell riskier corporate bonds and buy safer U.S. government securities.

• Lower demand for corporate bonds pushes prices down and yields up.
• Higher demand for U.S. government bonds pushes prices up and yields down.

This shift toward safety is why a widening yield curve can be a warning sign.

This picture shows the yield curves narrowing (moving closer together), which can signal expansion. Investors may sell safer U.S. government bonds and buy riskier corporate bonds.

• Higher demand for corporate bonds pushes prices up and yields down.
• Lower demand for U.S. government bonds pushes prices down and yields up.

This shift toward risk is why a narrowing yield curve can be a sign of economic strength.