Price Determination: A Web of Interactions
|One of the fascinations about economics and finance is the matrix of interactions among prices. For some time now, we have focused on the interaction of prices for goods, capital and exchange rates.
Growth and Goods Inflation: One Way Link
When we first examine the pattern of goods prices, one driver is the growth of GDP. GDP has a one-way causal link to the PCE deflator (top graph). As would be expected in the short-run, stronger economic growth tends to raise the rate of inflation as resource utilization increases, thus driving prices higher.
However, there is a problem: the PCE deflator is a mean reverting series but has an autocorrelation problem. That is, the process of the series returning to its long-run mean is painfully slow. The autocorrelation problem suggests that if the PCE deflator series deviates from the long-run mean, then the series will take an extended period of time to return to the mean. Unfortunately, the same conclusion is true for the core PCE deflator series as well. In fact, both series have, to some extent, shifted downward in the last decade. The average for the 2009-2017 period is just 1.3 percent for the PCE deflator and 1.5 percent for the core PCE deflator.
Domestic Demand and the Price of Capital
A second critical price in the economy is the cost of capital, i.e., interest rates. Consider the relationship in the middle graph between real final sales and the two-year Treasury rate. Here, real final sales have a one-way causality link to the two-year benchmark Treasury rate. This may not be surprising in recent months as the rise in economic strength has been accompanied by a rise in the two-year rate. However, this relationship is based upon data over the entire 1982-2017 period—not upon a short/one-time phenomenon.
The real final sales series underwent a downward break in October 2008 so that the period of "low" interest rates since then is perfectly consistent with the downward shift in its driver—real final sales.
Completing the Web: Dollar, Rates and Inflation
Interrelationships between economic and financial factors are fascinating. Consider that both the US dollar and the two-year Treasury rate have oneway causality link to inflation. That is, both the dollar and the two-year Treasury rate influence the behavior of the PCE deflator but the deflator does not drive the behavior of the dollar nor the two-year rate. Yes, there is some influence as you might expect but the link is not statistically significant and thereby unreliable in the forecasting sense.
For the PCE, growth in GDP is the main driver. For our work, the link from the dollar and the two-year Treasury to inflation reinforces our imperative to focus on a broader model of economic behavior than the linear nonrecursive behavior that so dominates popular commentary. Moreover, these statistical results remind us to focus on the significant links and not be distracted by the myriad of minor forces in the economy.
Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these assets. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Open Markets involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of FXStreet nor its advertisers.