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Current issues facing the Fed

Economics
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What is the current state of the labor market, inflation, and financial markets?

Jan 25th, 2015

The state of the labor market is of paramount importance to the overall well-being of the economy. This means that a weakening or strengthening labor market can influence the economy. For example, a weakening labor market often translates into lower corporate profits. The basic premise is that when people are out of work, they cannot buy homes or make the necessary purchases that drive corporate profits.

Inflation 
The mandate of the Federal Reserve is to promote economic growth and price stability in the economy. Price stability is measured as the rate of change in inflation, so market participants eagerly monitor monthly inflation reports in order to determine the future course of Federal Reserve monetary policy.

There are many indicators of inflation, but perhaps most widely known is theConsumer Price Index, or CPI. The CPI measures the change in consumer prices and theoretically determines to what extent life is getting more expensive for the average consumer. Another important measure is the Producer Price Index, or PPI. PPI fluctuations measure the rate of change in inflation for producer goods; if these prices increase substantially, it is more likely that companies will eventually pass the price increases along to consumers. Many economists and market participants prefer to analyze both CPI and PPI without the impact of food and energy, as these industries are known to be very volatile.

Market participants also keep track of the price of key commodities such as oil. Since oil is such a key component of economic activity around the globe, its price is worth paying special attention to. Increases in the price of oil can sometimes have offsetting effects. However, higher oil prices can lead to higher prices for a wide variety of goods because oil is part of many materials as well as a determinate in the cost of transporting goods waiting to be sold. (For more on inflation and the economy, see The Importance Of Inflation And GDP.)

Inflation is a useful metric of corporate valuation because the discount rate to perform discounted cash flow analysis factors is the rate of inflation. Higher inflation corresponds with a high discount rate and subsequently lower project value. On the other hand, deflation is also dangerous because decreased revenue means future layoffs for firms that cannot maintain their full workforce.

As overseas investors have become increasingly important participants in the U.S. financial markets, measures of their activities have garnered more attention. One of the most closely watched reports focuses the purchase of U.S. Treasuries by foreign central banks. When central banks are buying more Treasuries, interest rates often head lower – when rates are lower, stock prices tend to move higher. The reverse – less buying, higher interest rates and depressed stock prices – also tends to hold true. Knowing what economic and market indicators move markets is only half the battle; the real trick is interpreting the indicators and determining their likely market impact. In addition to the absolute level of an indicator, two other important factors to consider are the trend in the indicator and the market's expectation for that indicator. Taken together, these often determine the market's reaction to a given economic or market report. Learning to anticipate the market's reaction to various indicators requires careful monitoring of financial markets as well as experience interpreting these reports. As with most aspects of investing, hard work and persistence will help an investor determine the likely reaction to economic and market data. 

Jan 25th, 2015

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Jan 25th, 2015
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Jan 25th, 2015
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