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 FeroliChief U.S. EconomistJ.P.Morgan

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Overview of the discussion

• What “Street” economists do

• How we do economics differently

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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

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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.

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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 developmentsis limited. Shorter duration (2 years) more influenced by current economy.

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0

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10

%

88 93 98 03 08

Taylor rule

Fed target

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.

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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

400

500

600

700

800

900

-40-30-20-10

0102030

Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12

Index Spread over Treasuries (bp)

EASI

High-yield credit

EASI: Economic Activity Surprise Index.A measure of the degree to which economic indicators were surprisinglystrong (+) or weak (-).

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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, equityprices don’t have a simple relation to macroeconomic variables. Equities like growth,but not so much growth that the central bank raises interestrates.

90

95

100

105

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115

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0102030

Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12

Index Index, 3 Jan, 2011 = 100EASI

DJIA

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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 ofmacroeconomics on interest rates apply, times two.

Dollar and EASI

Note: no framework works verywell, currency behavior remainssomewhat of a mystery.

0.65

0.70

0.75

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Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12

Index EUR/$

EASI

EUR/$

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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)

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A simple macroeconomic framework

Output growthInflation

Interest rates

Taylor rule

“IS” curve

Phillips curve

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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.

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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

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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 sharesTimely indicators

Retail salesPersonal consumptionConsumer confidenceMotor vehicle sales

Durable goods Factory ordersConstruction spendingHousing startsNew home salesExisting home salesHomebuilders surveyManufacturers’ inventoriesWholesale inventoriesRetail inventories

Federal budget statementConstruction spending

International trade

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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%).

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Watching income and industry output measures

Service-producing industries (68%)

Manufacturing (12%)

Government (14%)

Other goods-producingindustries (agriculture,construction, etc.) (6%)

Compensation of employees (55%)

Corporateprofits (10%)Depreciation and

production taxes (20%)

Other capital income (interest,unincorporatedbusiness, etc.)(15%)

Gross income Value added by industry

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Timely measures of income and industry output

Income Industry output

Employment reportECIPersonal incomeJobless claims

Compensation

Corporateprofits

Quarterly corporate profit report

Depreciation,other capitalincome

Few timely measures

Manufacturing

Industrial productionISMRegional surveys (Philly, Empire State, etc.)

Services

Non-manufacturing ISM,few other indicators(a problem for measuring US economy)

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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

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%oya

M2

Core CPI

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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 negative output gap), inflation pressures are easing. If y>y*, (a positive output gap) inflation pressures are building.

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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 gap Output gap

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Unemployment - NAIRU

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log(GDP) - log(Potential GDP)

60 65 70 75 80 85 90 95 00 05 10

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Consumer prices

Inflation indicators

CPICore (77%) Food and energy (23%)

PCECore* (80%) Food and energy

(20%)

* The core PCE is the Fed’s preferred inflation measure

Broad prices

GDP prices

Business outputprices

Supply prices

Producer price index(PPI)

Commodity prices(JOC, CRB)

Import prices

The dollarLabor costs

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Labor cost inflation indicators

Average hourly earnings

Employment costindex (ECI)

Compensation per hour

Unit labor cost(=compensation per hour / output per hour)

Prices ormargins

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Full circle back to the Fed…

Output growthInflation

Interest rates

Taylor rule

“IS” curve

Phillips curve

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