Current State of the Economy -Economic Memo #47

Let’s start with the basics. The economy will go through the business cycle on average every 8.4 years. Sometimes it’s longer and sometimes it’s shorter, but if the government doesn’t step in, it will go through the cycle. All of our students learn about the business cycle is at the very beginning of the semester. Here is a little refresher for you.

The business cycle is like a roller coaster. It goes up (creeping inflation), hits a peak (hyperinflation), goes down (recession), and hits a trough (depression). (Note, the fifth stage is very rare called Stagflation, which thanks to George W. Bush, I have seen only once in my long career.)

Of course, if you look at the cycle in fine detail it is not smooth but can have little or big bumps within the up and down areas. We have all been on roller coasters where you flatten out and still get little up and down bumps and then start up again. In unusual periods these can last for many years. The Great Depression is thought by some to have lasted fourteen years.

In the second quarter of 2008 we started down the recession leg of the coaster and it was very steep. Economists call it the Great Recession. Uninterrupted this would have led to financial collapse (we really came close) and another Great Depression. But the government did interfere. It bought GM, bailed out the banks, bought AIG, created an $862 billion dollar stimulus package, and subsidized the housing market, and the Federal Reserve did some unprecedented things with the money supply and interest rate.

In other words, the government instituted Keynesian economic policy to bail out the economy. It worked and worked well. Keynesian economic theory assumes it is the government’s role to balance the economy. It is composed of Fiscal Policy (changing taxes and government spending) and monetary policy (changing the interest rate and the money supply).

Let’s concentrate on the monetary policy part for this memo since it is the current focus of economic policy. During the Great Recession the Federal Reserve lowered the discount rate to near zero (the interest rate is the proportion of a loan that is charged as interest to the borrower) and it created a huge amount of money through other tools to stimulate the economy. It worked! We were losing 818,000 jobs in January 2009 when the Keynesian Obama took office from the Supply-side George W. Bush. We started creating jobs again in January 2010. Monetary and Fiscal policy generally take six to nine months to start working and it took the Obama congress and administration a few months to put the Keynesian policy in place.

The Fed was doing its part as well and today we are back on track creating 271,000 jobs last month. Hours worked (increasing hours worked is a good sign of recovery since it is a precursor to more jobs being created) increased by .3%, and unemployment fell to 5%. We consider 4.5% to be full employment since at any given time, that many jobs exist and it takes time for qualified workers to find them.

Today we can officially say we are in creeping inflation. The employment numbers are creeping toward full employment, prices are rising between 0 and 6% (currently around 2%, the Fed benchmark), and GNP rose in the second quarter 3.9% and 1.5% in the third. Things are humming along.

The Fed Board of Governors have been calling this the “Lift off period.” The implication is that the economy is starting to heat up. Now we don’t want things to skyrocket into hyperinflation so they have threaten to raise the interest rate. Thus, banks and have been cutting back on the money supply over the last year or so.

What will be the result of the interest rate hike?

The following formula shows how a bank makes money with example rates:

Cost of money (borrowed from the FED at the discount rate or savings deposits) .1%

+ Administrative Costs (Tellers, Loan Officers, etc.) 2%

+ Profits 2%

= Prime rate (the loan rate to the very best customer who can pay back the loan in 24 hours) 4.1%

So if the Fed raises the rates, the bank’s cost of money increases and the loan rate to customers’ increases. The non-prime customers will pay more than prime due to the increased risk. This will slow the economic engine a bit.

The Fed has been telegraphing an interest rate hike for some time and it would have happened in the last two months if the Chinese had not created doubt about the strength of the recovery with their stock market collapse and weak growth numbers, and the Europeans’ weak growth.

Economies are so integrated these days the changes in global economic status has to be considered. The October numbers for employment, wages, GNP, and prices have given the Fed a clear reason to overlook those problems and raise the rate at their meeting in early December.

So How Does That Effect You?

Well, if you have a 401K, 403B, IRA, etc. or other defined contribution plan you are going to probably take a hit when stocks decline even more than they have this year. The Dow Jones Industrial Average is down 3.24% so far this year and the S&P 500 is down 1.74%. The NASDAQ dropped 4.2% last week but is still up for the year.

If you think about the market as a teeter-totter that is level at any given time. The returns from interest bearing options are level with the investor’s view of the returns to stocks. If the interest bearing options increase (remember other bonds prices will drop since newer bonds give a higher return) rising higher than stock prices, then the stock prices are going to fall. So for the next couple of months it may be a rough ride.

Most of the forecasts I’ve seen agree with this assessment.

The good news is that historically election years have been good for the market so we can expect a sunnier future next year. Table Below Shows Market Returns for Each Election Year Since 1928
Data below is from Dimensional Funds Matrix Book.
S&P 500 Stock Market Returns
During Election Years
Year Return Candidates
1928 43.60% Hoover vs. Smith
1932 -8.20% Roosevelt vs. Hoover
1936 33.90% Roosevelt vs. Landon
1940 -9.80% Roosevelt vs. Willkie
1944 19.70% Roosevelt vs. Dewey
1948 5.50% Truman vs. Dewey
1952 18.40% Eisenhower vs. Stevenson
1956 6.60% Eisenhower vs. Stevenson
1960 0.50% Kennedy vs. Nixon
1964 16.50% Johnson vs. Goldwater
1968 11.10% Nixon vs. Humphrey
1972 19.00% Nixon vs. McGovern
1976 23.80% Carter vs. Ford
1980 32.40% Reagan vs. Carter
1984 6.30% Reagan vs. Mondale
1988 16.80% Bush vs. Dukakis
1992 7.60% Clinton vs. Bush

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

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