Economic Factors & Business Information

Question 1

What is “purchasing power”?

Answer 1

Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of money can buy.

Purchasing power is important because, all else being equal, inflation decreases the amount of goods or services you would be able to purchase.

Question 2

What is “inflation”?

Answer 2

Inflation has to do with supply and demand. When the demand for goods and services exceeds their supply, prices system-wide begin to rise or inflate.

Question 3

What is deflation?

Answer 3

Deflation occurs when the supply of goods and services is greater than demand. While inflation can make things too expensive for consumers to buy, deflation can make things ever cheaper.

Note: Deflation can squeeze profit margins as companies pay last month’s prices for raw materials and then struggle to sell their finished goods at next month’s cheaper prices.

Question 4

What is the Federal Reserve Board and its Federal Open Market Committee trying to accomplish by moving interest rate targets up or down?

Answer 4

The Fed and its FOMC are trying to achieve

1. maximum employment,
2. stable prices,
   AND
3. stable economic growth.

Question 5

Why does The Fed raise interest rates?

Answer 5

To fight inflation.

Question 6

Why does The Fed lower interest rates?

Answer 6

To stimulate a sagging economy.

Question 7

What is “stagflation”?

Answer 7

Stagflation is a condition of slow economic growth and relatively high unemployment, or economic STAGNATION, accompanied by rising prices, or INFLATION.

It can also be defined as inflation + a decline in gross domestic product (GDP).

Question 8

What is the measure for inflation?

Answer 8

Inflation is measured by the CONSUMER PRICE INDEX (“CPI”). The CPI tracks the prices consumers are paying for the basic things consumers buy (groceries, movie tickets, clothing, gasoline, etc.) and tracks increases or decreases in those prices.

Sometimes economists exclude certain items which are volatile—specifically food and energy—to track what’s called CORE INFLATION.

Question 9

How do investors calculate their “real rate of return”?

Answer 9

Investors take the rate of return and subtract the CPI to calculate their inflation-adjusted or real rate of return.

Examples:

If an investor receives 4% interest on her bond when the CPI is 2%, her inflation-adjusted or real rate of return is 2%.

If an investor receives just 1% when CPI is 2%, her inflation-adjusted or real rate of return would be -1%. This investor is unable to outpace inflation and is thus losing purchasing power.

Question 10

What is the “Producer Price Index (PPI)”?

Answer 10

The PPI is a family of weighted indices that measures sale prices received by domestic producers at all levels of output.

Question 11

What are the three main PPI classification structures?

Answer 11

There are three stages of the PPI:

1. Commodity Classification
2. Industry Classification
3. Final Demand-Intermediate Demand System (FD-ID)

Question 12

What is an “interest rate”?

Answer 12

Interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets.

Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR).

Question 13

What is the “discount rate”?

Answer 13

The discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve’s discount window.

Question 14

What is the “federal funds rate”?

Answer 14

The federal funds rate is the rate at which depository institutions lend reserve balances to other banks on an overnight basis.

Reserves are excess balances held at the Federal Reserve to maintain reserve requirements.

The federal funds rate is subject to daily change and considered the most volatile rate.

Question 15

What is the “broker call loan rate”?

Answer 15

The broker call loan rate is the interest rate on bank loans made to broker-dealers that are borrowing to fund their clients’ margins accounts.

Sometimes the broker loan rate is also called the “call money rate.”

Question 16

What is the “prime rate”?

Answer 16

The prime rate is the interest rate on unsecured loans that commercial banks charge their most credit-worthy customers, determined as those who pose the least amount of risk of default.

Prime rates may not be available to individual borrowers as often as to larger entities, particularly stable corporations.

Question 17

What is “LIBOR”?

Answer 17

LIBOR stands for London Interbank Offered Rate and is a benchmark rate that many international banks charge each other for short-term loans.

Question 18

Who fixes the LIBOR rate? And how is it determined?

Answer 18

LIBOR is fixed daily by the ICE Benchmark Administration (IBA) and represents an average of the world’s most creditworthy banks’ interbank deposit rates for large loans with maturities between overnight and one year.

Question 19

How many LIBOR rates are published each business day?

Answer 19

There are a total of 35 different LIBOR rates each business day representing 5 currencies (euro, pound, dollar, franc, yen) and 7 maturities (overnight, 1 month, 2 month, 3 month, 6 month, 1 year).

Question 20

What is a “swap”?

Answer 20

A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to. Usually, the principal does not change hands. Each cash flow comprises of one leg of the swap. One cash flow is generally fixed, while the other is variable, that is, based on a benchmark interest rate, floating currency exchange rate, or index price.

Question 21

Are swaps public or private arrangements?

Answer 21

Swaps are private arrangements between two parties. That means they trade over-the-counter, as opposed to options and futures, which are standardized products traded on regulated exchanges. While options and futures are traded with clearinghouses acting as a buffer between the two parties, swaps leave both parties with counterparty risk, namely that the other side will default on the contract.

Question 22

What are generally accepted as short-term fixed-income securities?

Answer 22

Bonds with up to three-year maturities.

Question 23

What are generally accepted as intermediate-term fixed-income securities?

Answer 23

Bonds with four to ten-year maturities.

Question 24

What are generally accepted as long-term fixed-income securities?

Answer 24

Bonds with maturities > 10 years.

Question 25

What is a yield curve?

Answer 25

A yield curve displays the yields offered by debt securities of similar credit quality across various terms to maturity.

Typically, the longer the maturity on the bond, the higher the yield demanded by investors.

Question 26

What does a normal yield curve look like?

Answer 26

On a normal yield curve, intermediate bonds yield more than short-term bonds, and long-term bonds yield more than short-term and intermediate-term bonds.

Although yields are higher with long-term bonds, a normal yield curve starts to flatten out instead of forming a steep slope.

Question 27

What is a steep yield curve?

Answer 27

A steep yield curve buckles inward (instead of flattening out) because the yields on longer maturities are so much greater than those on shorter maturities.

Question 28

What does a steep yield curve indicate about the economy?

Answer 28

A steep yield curve often happens before the economy goes into a rapid expansion. The expansion cycle often comes with inflation and higher interest rates, so fixed-income investors demand significantly higher yields on long-term bonds, suddenly creating a steep yield curve.

When the Fed sees inflation up ahead, they raise interest rates — a steep yield curve suggests that this has already been factored into the bond market.

Question 29

What is a flat yield curve?

Answer 29

The same yields among T-Bills, T-Notes, and T-Bonds will result in a flat yield curve.

Question 30

What causes a flat yield curve?

Answer 30

The yield curve flattens when investor expectations for inflation are so low that they are not demanding higher yields to hold long-term debt securities.

Question 31

When does a flat yield curve typically occur?

Answer 31

A flat yield curve typically occurs at the end of a Fed tightening cycle.

As the economy expands, the Fed typically goes into a series of interest-rate tightening. Towards the end, the Fed raises short-term interest rates until they are in line with intermediate- and long-term rates, and temporarily, with investors expecting no immediate threat from inflation, the yields are the same across the board.

Question 32

What does a flat yield curve indicate about the economy?

Answer 32

A flat yield curve is thought to signal an economic slowdown. As the Fed increases short-term interest rates at the end of a tightening cycle, the flattening yield curve indicates the the party is over for the economy, at least for a while.

Question 33

When do we usually see an inverted yield curve?

Answer 33

An inverted yield curve often follows a period of high interest rates. When bond investors feel that interest rates have peaked, they hurry to lock in the high interest rates for the longest period of time. In a rush of activity, they sell off their short-term bonds to buy long-term bonds at the best interest rate they’re likely to see for a while. If the crowd is selling short-term bonds, the price drops and the yield increases. If they’re buying long-term bonds, the price increases and the yield drops. That causes the yield curve to invert.

Question 34

What does an inverted yield curve indicate about the economy? What does it say about expectations for inflation?

Answer 34

An inverted yield curve is thought to be one of the surest signs that the economy is about to contract.

The situation also signals lower inflation up ahead, possibly even deflation.