What are Economic Indicators
Economic indicators are tools that indicate the economic well-being (and issue) in the big picture. There are numerous economic indicators for investors to track the economy, but the important thing to focus just on these 5 economic indicators:
- Unemployment rate
- Inflation rate
- Productivity (GDP)
- Fed funds rate
- Quantitative easing (QE)
The investor needs to understand how and when the economy can impact your portfolio, this is the reason why investors need to understand how these economic indicators work and how economic activity is measured.
The inflation rate is the percentage rate of increase in the economy’s average level of prices. If the inflation rate is 6%, then the prices of items that consumers buy are rising by 6%. Normally, inflation is caused by an increase in money supply, and by exceeding demand.
A high inflation rate means the prices (on average) increase, while a low inflation rate means the prices (on average) decrease.
Inflation is the center of these 5 economic indicators because inflation affects the economy in several ways. First, the inflation rate affects the cost of borrowing in capital markets. Seconds, it encourages borrowing more because the loan will be repaid with cheaper money in the future. Finally, inflation strongly influences the level of interest rates because the high inflation rate triggers the central bank to offer more rewards to draw deposits and discourage lending.
Normally, the U.S. inflation rate is directly linked to the Consumer Price Index (CPI) which is released by the Bureau of Labor Statistics (BLS). The CPI tracks retail-level price changes by comparing prices for a specific basket of goods and services (both domestically produced and imported goods) to base-period prices.
The unemployment rate is the number of unemployed persons divided by the labor force (the labor force is the sum of the employed and unemployed). Several months of low unemployment rates can signal that higher inflation is coming.
The higher unemployment rate, the harder to find work. The unemployment rate is an important economic indicator for investors because this directly affects the average purchasing power (of customers).
However, the unemployment rate is a lagging indicator because the Bureau of Labor Statistics (BLS) will be releasing it on the first Thursday of next month.
Productivity growth is the output that a nation produces in total goods and services. The official measure of the economy’s productivity growth in the country is called gross domestic product (GDP). The GPD is an economic indicator that includes all currently produced goods and services sold on the market within a time period. The four major components of the GDP are consumption, investment, government spending, and net exports.
The unemployment rate corresponds exactly to the GDP, when the unemployment rate is high, the GDP is low due to low productivity.
The higher GDP growth, the lower the unemployment rate, but the faster the inflation rate rises. However, this means the easier it is for people to improve his or her standard living.
The U.S. GDP is released by the Bureau of Economic Analysis, U.S. Department of commerce.
Fed Funds Rate
Federal funds rate is the interest rate that the Federal Reserve charges other banks. The Federal Reserve has the power to manipulate the federal funds rate directly, to sets the tone for all other interest rates in the market such as mortgages, car loans, and credit cards.
Normally, the Federal reserve uses the fed funds rate to control U.S. inflation. Higher interest rates mean that more money goes to interest payments and less to shopping. Lower interest rates aid economic expansion, which leads to corporate growth, which increases the value of corporate shares.
However, a change in the federal funds rate doesn’t immediately impact the markets, it indirectly through consumer spending and corporate growth.
Quantitative Easing (QE)
Quantitative easing (QE) occurs when a central bank purchases assets with the purpose of increasing bank reserves. In this operation, the Fed buys up not just government securities but also a wide variety of private securities. The reason that the Fed buys these securities is that the Fed needs to create a demand for these securities to balance the retreat of private market investors.
Normally, the Federal Reserve does quantitative easing when the short-term interest rate is near zero (or already zero).
But the important part of quantitative easing (and any stimulate policy such as yield curve control) as an economic indicator is it indicates how much (and when) money flows into the capital market, which causes all asset prices rise.