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Posts by Jia Liu, PhD, Research Fellow

How Fear Helps Predict Stock Returns

Stocks are well known for their high volatility. Stocks respond to financial, economic, and political events in real time.  The recent Brexit vote, for example, caused a sharp drop in stock prices. But the U.S. stock market was able to rebound in several days.

Going forward, it is certain that stock markets will be sensitive to events like the upcoming Federal Open Market Committee meeting (July 26-27), the ongoing presidential election, oil shocks, and so on. But it is far from certain whether we can predict future stock returns. However, an index, called VIX, may surprise investors.

VIX, or Volatility Index, calculated by the Chicago Board Option Exchange, measures the market’s expectation of stock market volatility within the next 30 days. Since it captures expected stock volatility in the near future, it is also called a fear index. The chart below shows how VIX relates to S&P 500 returns over time.

Chart: VIX negatively correlates with S&P 500 returns over time

During the past decade, VIX showed a clear negative correlation with S&P 500 returns as the chart shows. When VIX reached its peak at the end of 2008, S&P 500 returns fell to the lowest over the period included in the chart. When VIX appeared rather flat from 2012 to 2015, S&P 500 experienced a period of fairly stable performance.

Recently, VIX rose to a new high of 20 right after the Brexit vote in June, which coincided with a sharp drop in stock returns. Since then, VIX has bounced back to about 12 as of today, lower than the current five-year average. This indicates that there is a good chance that stock returns in the near future will be trending upward.

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Bitcoin’s Halving – Good or Bad News for Investors?

The disappointing performance of the global financial markets this year has left many investors looking for better opportunities. Therefore, an investment like Bitcoin may catch their eyes. After all, its price has jumped from about $430 in January to about $660 today (July 14), a growth rate of slightly more than 50 percent.

But whether Bitcoin is a good financial investment has long been debated. Some argue that Bitcoin, as a virtual currency, is used for mainly illegal activities, such as money laundering. If so, the government will most likely take steps to ban it, which would make BitCoin lose its value as it would be excluded from legal exchanges. Obviously, such a move would make BitCoin an extremely poor investment choice.

In addition, investors who buy and sell bitcoins in hopes of a high rate of return must bear an extremely high risk. The chart below shows that the price of Bitcoin has fluctuated widely over time.

Since 2013 when Bitcoin started to gain value, the price has been extremely volatile. One bitcoin was worth almost $950 by the end of 2013, but dropped to about $200 a year later. Despite Bitcoin’s gain of about 50 percent this year, it would not be surprising to see the price drop again.

On top of the extreme volatility, Bitcoin just experienced the second halving in its history on July 9. That means the reward for BitCoin mining has been cut in half. Mining bitcoins is a process of solving a complex mathematical problem by consuming huge computing resources.  Once the problem is solved, the miner gets bitcoins as a reward. After the halving on July 9, rewards of solving a mathematical problem have been reduced from 25 to 12.5 bitcoins.  As a result, fewer people will find BitCoin mining worth their while. Therefore, bitcoins will be created at a slower pace from now on.

Since the halving was setup as an expected event, Bitcoin value dropped 5 percent on the day before the halving. But in the longer run, investors believe the price would likely rise due to the reduced supply. However, speculation and the concerns about illegal usage have made Bitcoin a suspicious financial investment instrument.

Thus, even though Bitcoin is posting high rates of return this year, investors would be wise to take a broader view.

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One Chart’s Foreboding Message About the Economy

In a Wall Street Journal survey this month, economists estimated a 21 percent probability that a recession will start within the next year, up from just 10 percent a year ago. The Journal reports some economists think the risk is even higher.

A number of economic indicators, from soft business investment to weak auto sales, suggest possible weakness in the economy. However, the sharp slowdown in hiring in May, when the U.S. economy added only 38,000 jobs compared to over 100,000 in earlier months, is widely considered by economists to be a one-month outlier, or a temporary drop . Federal Reserve Chair Janet Yellen said in her press conference last week that the May jobs report only provided one month of data, and we should wait to see more data in coming months.

The hiring slowdown indeed only occurred in May so far. But a broader indicator—the Labor Market Conditions Index—has fallen into negative territory, and continued to fall since January this year. This indicates that the labor market may be worse as a whole than the individual measures show. The disappointing May jobs report may be not an outlier, but may instead be starting to capture a worsening labor market.

The Labor Market Conditions Index is derived from 19 labor market indicators, including measures like the unemployment rate, labor force participation rate, and average hourly earnings. It is constructed and released by the Board of Governors of the Federal Reserve System. The chart below shows the monthly changes in the Labor Market Conditions Index over the past three decades.

labor market (3)

For the last three recessions, the Index was a fairly reliable leading indicator. The Index dropped into   negative territory seven months before the recession that started in December 2007. For the preceding recession, which began in March 2001, the Index fell to a negative reading in April 2000—11 months ahead. In the early 1990s, the Index declined for five consecutive months before the recession occurred in July 1990.

But it’s worth noting that the Index sent a false signal in 1995, when the Index showed negative readings for five straight months, and no recession happened.

Now the Index has been in negative territory and continuing to fall for the first five months of 2016. This is a reason to take notice.

Labor market conditions are only one part of the picture of the entire economy, but with this index’s track record in predicting recessions, it is concerning.

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Fed: A Rate Increase May Not Happen Any Time Soon

Today, the Federal Open Market Committee decided to keep the federal funds rate unchanged, consistent with public expectation after the disappointing May jobs report.

Both labor market conditions and inflation, the Fed’s dual mandate, show no signal for a rate increase any time soon.

As we all know, the May jobs report raised much concern about the sharp hiring slowdown. While some are hoping and waiting to see whether this is only transitory, Fed officials have seen continuously declining labor market conditions over the past several months.

The Labor Market Conditions Index, an index derived from 19 labor market indicators and released by Board of Governors of the Federal Reserve System, has shown declines in seven straight months since December. The disappointing May jobs report may be starting to capture a worsening labor market.  So it may take longer than expected for labor market conditions to turn around.

Inflation, on the other hand, is expected to continue to run below the Fed’s 2 percent target. PCE inflation today is projected to be 1.4 percent for 2016 and Core PCE is projected 1.7 percent by FOMC participants. AIER’s inflation forecast projects a mild inflation rate throughout the rest of the year. A sluggish inflation growth would leave the Fed more reason to hold on to the current policy rate for longer.

All the above analysis is reflected in the projected pace of raising interest rates from the projections in the materials released today. Six FOMC participants, out of 17, think one rate increase is appropriate for 2016, and 11 believe there should be at least two rate hikes this year, compared with 16 participants in March who said there should be at least two rate increases for 2016.

According to federal funds futures, which measures market expectations of the future federal funds rate, the market predicted a nearly zero percent chance of a rate increase in June and July before today’s meeting. After the meeting statement and the projections materials were released at 2 p.m., the market still sees zero probability for July rate increase, but predicts a roughly 16 percent chance of a rate hike in September, down from 25 percent prior to the meeting.

Don’t Forget Inflation When Making Financial Decisions

People predict future inflation in many decisions they make, from taking out a car loan or a mortgage, to deciding whether to put money in CDs, bonds, or stocks.  Future inflation is also important for the expected profitability of business investment projects.

Inflation for the price of a new home, for instance, was about 4.3 percent in 2015. If we estimate that this trend will continue, a home buyer would rather buy a house now than later.

Inflation is also critical to consumption and production. Sluggish price growth (or deflation) would be welcomed by buyers, but would hurt producers’ revenues and then put constraints on wage growth.  But a high inflation that gets out of control would discourage consumption and investment by reducing the purchasing power of incomes and savings.

Given the importance of inflation for economic conditions, both individuals as economic players and policy makers pay close attention to price changes. The U.S. central bank, for example, is tasked with maintaining price stability as one of the goals in its dual mandate—maximum employment and price stability.

But throughout U.S. history, undesirable high and low inflation both existed, and both have proved to be costly to the economy. The stagflation crisis in the late 1970s caused a stock market crash and very high unemployment in the early 1980s. On the other hand, the sluggish price growth in recent years has raised much concern. Some argued low inflation may have contributed to soft business investment and slow wage growth.

So it is helpful to be able to predict inflation. But despite the enormous attention to inflation, inflation forecasting has been lacking good tools and models. The American Institute for Economic Research has developed a new model that improves on the performance of existing models. Our model is based on advanced time series analysis techniques, which take into account various economic variables to capture the trend of inflation changes. More than half a century of data were used to estimate the model and the resulting forecast. The inflation forecasts created with the model have tested well over the last three decades and outperform the existing comparable models.

This model can be used to get a glimpse of the all-important future inflation. For the next six months, the model predicts that the average inflation in the core CPI (the consumer price measure that excludes volatile components of food and energy) will be in the range of 0.14 to 0.17 percent per month, or an annualized 1.7 to 2.1 percent. This is similar to the inflation we have seen in the past five years.

This mild inflation forecast for the coming months confirms what AIER’s Inflationary Pressure Scorecard shows (see the upcoming AIER’s June Business Conditions Monthly). While recent consumer prices posted positive growth, the scorecard shows an easing inflationary pressure for the months ahead.

See more details in AIER’s June Research Brief.

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Does Government Spending Contribute to the Economy?

When governments spend more money than they bring in, they create budget deficits. When deficits accumulate as time goes by, governments incur debt. The U.S. federal government debt as of today is about $19.3 trillion, which, to put it in perspective, equals about 105 percent of the previous 12-month GDP.

From 1966 to 2015, an average deficit of 2.8 percent of GDP was added to the national debt each year, according to the Congressional Budget Office (CBO). The CBO also projects the deficit would increase from 2.9 percent to 4.9 percent of GDP over the next decade if current laws generally remained unchanged.

Chart 1: Total Deficits and Surpluses in the U.S. during 1966-2016

Source: Congressional Budget Office

While most people are concerned about high government deficits, some argue governments should always be in debt and that government deficits contribute to economic growth. Their arguments are twofold: 1. Government deficits contribute to GDP, because government deficits must equal some non-government organizations’ surpluses according to the rule of accounting, and; 2.The federal government cannot possibly go bankrupt due to its debt, since the central bank can always create money to finance the government.

The arguments sound good only if we don’t consider the consequences. High government deficits and debt come with a cost. First, when the central bank creates money to finance the budget deficit, the economy gets exposed to risks of inflation.  For now, about $2.4 trillion created by the Federal Reserve through its quantitative easing programs are sitting in the banking system as excess reserves. But it is a huge amount of money, about 19 percent of the current money supply, measured by M2, ($2.4 trillion excess reserves/$12.6 trillion money supply). If all this liquidity was loaned out, and all else holds equal, there would be 19 percent inflation immediately.

Second, if the government borrows from the public, such as individuals and corporations, it is crowding out private business investment. For instance, in 2015, the federal government spent 16 percent of its outlays on the military. In contrast, only one percent of the government spending went to science. If instead this capital was available for private business investments, as would be the case without enormous government borrowing, the market would likely allocate resources in a more efficient way.

Third, when the government borrows from the public, it drives up interest rates, which makes financing more expensive for businesses. An investment project that would be profitable with two percent interest rate would fall apart if the interest rate was five percent. As interest rates go up, private investment tends to fall, thus slowing the rate of capital formation in the economy, which in turn restrains economic growth.

All in all, government spending may be an effective stimulus during an economic recession when abundant liquidity is available. But over the long run, high government debt or deficits are costly to overall economic growth.

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Consumer Prices Were Lackluster in March


Consumer prices in March, released today, showed weaker-than-expected growth. The headline Consumer Price Index rose 0.1 percent in March from February. Even though it is the fastest monthly growth since December 2015, it was lower than economists’ expectations.

Energy was obviously a big contributor to the CPI growth for the month. Energy prices climbed 0.9 percent last month, the biggest monthly growth since May of last year. Looking into April, crude oil prices have continued to rise. WTI crude oil has climbed from the March average of $38.04 to $42 a barrel today. If this trend continues throughout the rest of the month, we can foresee energy will again drive consumer price growth in April.

The lower-than-expected consumer prices last month mainly came from food and apparel. Food prices were down 0.2 percent in March, a fairly big monthly decline but nothing striking. Food prices are known for being volatile.

Apparel has a more shocking story. It skyrocketed 1.6 percent in February, the biggest monthly growth in the past 7 years, then free-fell 1.1 percent last month. It was as if a conservative grandmother suddenly decided to go bungee jumping: It would be hard to predict her behavior next. So it for apparel prices in April.

Services also grew at weaker rates than usual in March. It could be driven by stronger supply and lower consumer demand. But all this could be adjusted in the short term.

It’s worth noting that core CPI in the medium term has continued to grow strongly. Core CPI rose an annualized 2.6 percent over the previous three months and 2.2 percent during the past 12 months. If the Fed is able to look through month-to-month volatility in consumer prices, its outlook for inflation over the medium term should stay positive, supporting a second rate increase in June or September.

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Cheap Oil Won’t Suppress the Cost of Living for Long

It’s been a recurring storyline in the last couple of years: Plunging energy prices are pushing down the cost of living. But there’s a good reason why you shouldn’t expect to keep seeing it.

While policymakers pay more attention to core inflation (excluding volatile food and energy prices), these volatile expenses inform what households actually pay on a regular basis. So consumers have more direct experience with the headline CPI, from groceries to gasoline, apparel, and education, in trying to gauge whether the cost of living is going up or down.

The headline CPI, released yesterday by the Bureau of Labor Statistics, posted a monthly 0.2 percent decline in February, driven by cheaper oil. Energy prices fell 6.0 percent in February from January, the biggest monthly decline during the past 12 months.

Let’s take a look at how oil prices have related to the CPI in the past several years, and more importantly, how the relation is going to look in the near future.

The chart shows that volatile oil prices don’t always relate to overall consumer prices, but sharp declines in oil prices have always dragged down the CPI. For instance, from June 2014 to January 2015, oil prices fell 55.4 percent and the CPI was down by 1.9 percent. After a short period of rebound in oil prices, they started another round of falling in June 2015. But the CPI on average has been slowly climbing.

Put another way, it isn’t enough for oil prices to merely stay low to hold down the overall cost of living. They need to keep falling.

So in order for oil prices to bring down the CPI this year as much as they did in 2014, oil prices would have to fall at the same rate. But the current oil price is below $40 per barrel. A 55 percent decline would bring it down to below $20, which by many standards is considered unsustainable. In fact, the oil price decline has stalled in recent weeks. Oil prices have picked up in March, which is not reflected in the most recent CPI data for February.

Going forward, even if oil stays as cheap as it is now or slowly rebounds, the downward pressure of cheap oil on the CPI would be largely diminished. In other words, zero growth in oil prices exerts upward pressure onto the CPI compared with big negative numbers in oil price growth in the past.

See our March Everyday Price Index report for how non-energy prices affected cost of living.

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June Rate Increase Is Still A Likely Scenario

Fed BuildingAs widely expected, the Federal Reserve did not raise interest rates at its meeting today. The market is anxious for any signals of the Fed’s policy direction in the near future.

The steady economic growth, an improving labor market, along with a positive outlook for future inflation would point toward the next rate increase coming in June.

Digging deep into the post-meeting statement and the Fed’s projections, several elements, in my opinion, underscore the likelihood of a June increase.

  • Fed officials had a positive outlook for real GDP growth this year. The March projections reveal the Fed’s expectation of 2.2 percent growth in real GDP for 2016, higher than its projections for 2017, 2018 and the longer run. This implies that the Fed is able to see through the recent short-term high volatility in financial markets and global economic slowdown, and has confidence in a steadily growing economy in the U.S. this year.
  • The continuously improving labor market, as reflected in the low unemployment rate, may have served as an important reason for the Fed to believe in solid economic growth and possible higher inflation in the future. All this would call for a tightening monetary policy. The unemployment rate is projected to be 4.7 percent in 2016, 4.6 for 2017, and 4.5 for 2018.
  • As inflation is critical to the Fed’s policy, today’s projections reveal that the Fed has confidence in inflation moving toward its 2 percent target in the longer term. Core CPI, which measures the trend in consumer prices excluding the volatile food and energy costs, posted a solid increase in the last 12 months, at 2.3 percent, possibly indicating firming inflation. Even though the Fed lowered its outlook for future raises, a rate increase in June is still likely.
  • Four out of 17 FOMC participants assessed that four quarter-percentage-point rate increases in 2016 is appropriate, and three participants believed three increases is appropriate. Either way, raising rates in June is likely, given that there are only three big FOMC meetings (the meetings with a projections release and a news conference) scheduled after March for the rest of the year.


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Too Early to Celebrate “Strengthening” Consumer Prices

mall 2The Consumer Price Index for January 2016 has attracted a lot of attention since it was released last Friday. But a look inside the numbers raises questions about its overall message of economic strength.

The overall CPI stayed flat this month, mainly due to the decline in energy prices. But core prices rose 2.2 percent in January from a year earlier, the fastest rate since June 2012, and by 0.3 percent from December last year, the fastest monthly growth since August 2011.

Many cheered this news as a signal that inflation is picking up and the economy is growing Read more