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Keeping an Eye on the U.S. Dollar

Listening to the experts talk about inflation and the Consumer Price Index can become bewildering when you don't understand how these economic indicators affect you. Here's a quick primer to prepare you for the financial report on tonight's news.

You might be wondering how the economics of the United States impacts your wallet. Economics is defined by www.dictionary.com as "the social science that deals with the production, distribution, and consumption of goods and services and with the theory and management of economies or economic systems." If you are still unclear, you are not alone. People who invest in stocks rely on economic indicators to determine the state of the economy and to predict upturns and downturns before they occur. Even if you don't invest, there are several important economic indicators that can give you insight into the economic status of the country. More importantly, these indicators also affect you.

Let's begin with the cost of products and interest charged for borrowing money. The Consumer Price Index and the Prime Rate contribute to the health of our economy by determining the value of a dollar and the cost of a loan.

Consumer Price Index

Let's say you bought the exact same 20 grocery items every month. Item by item, your cart would contain exactly the same products. Over the course of a year, what do you suppose would happen to the cost of those 20 grocery items? Month by month you'd see changes in the total cost. If you examined the cost of the items throughout the year, you'd see trends in the cost of those goods. The trend would show the same 20 items costing more, less, or the same amount over the 12 months of the year. The Consumer Price Index is based on a monthly comparison of the same groups of products (to determine trends). The U.S. Department of Labor's Bureau of Labor Statistics (www.bls.gov) reports these trends monthly. Their "shopping cart" looks at more than just 20 grocery items. Their comparisons include all items used by the average consumer, for example:

  • Food and beverages
  • Housing
  • Apparel
  • Transportation
  • Medical care
  • Recreation
  • Education and communication
  • Energy

The Bureau of Labor Statistics publishes a detailed report pointing out the key changes found in their comparisons. When an upward trend in cost is reported, inflation is underway. A downward trend in cost means deflation. To you, the consumer, inflation means that the same amount of money buys less over time.

Prime Rate

When the Federal Reserve Bank lends money to banks, the interest rate they charge is called the Discount Rate. The Prime Rate is the interest rate charged by the local banks to their best customers (typically businesses that are doing well and have a high credit rating), and is influenced by the Discount Rate. The interest rate that is passed on to us for personal loans is impacted by the Prime Rate. Depending upon the applicant's creditworthiness, additional percentage points are usually added.

So, when we take out a loan or mortgage, the cost of borrowing money that our bank pays to the Federal Reserve is passed on to us, the consumer. Are you wondering about the source of the interest rate charged by the Federal Reserve Bank? It actually starts with the Federal Reserve System and their Board of Governors. Their target is to minimize inflation while maximizing employment and economic outputs. The Board of Governors of the Federal Reserve System bears the responsibility of keeping watch over the many economic factors that contribute to the financial health of our nation. They set the Discount Rate with the objective of optimizing the performance of our economy. Once set, the Federal Reserve Bank implements the new rate.

What Does The Federal Reserve Do?

Today the Federal Reserve's duties fall into four general areas:

  • Conducting the nation's monetary policy
  • Supervising and regulating banking institutions, and protecting the credit rights of consumers
  • Maintaining the stability of the financial system
  • Helping the government

Remember, the Prime Rate is the rate charged by your bank to their best business customers. Upward trends in the Prime Rate occur, but ideally they occur slowly without having a dramatic impact on the economy. If you were to examine the monthly trends of the Prime Rate, you'd see that it goes up and down to maintain the desired economic balance and to sustain a moderate rate of growth. To learn more about the Federal Reserve, visit www.federalreserve.gov.

Inflation

If the Discount Rate is set too high, banks are likely to set their interest rates high. If consumers feel that the banks have set the interest rate too high, they may stop borrowing money. Without people borrowing money for expensive, durable goods like cars, the supply of such goods exceeds demand. With inflation a snowball effect happens - when consumers have less money, they buy fewer products, retailers lose sales, manufacturers warehouse unsold goods and begin to reduce their workforce, and employment is affected. This downward spiraling effect occurs as the impact of consumers buying less filters back through the manufacturers of goods and providers of services, ultimately slowing down the growth of our economy.

During times of inflation, the cost of housing rises, as do interest rates on mortgages. The housing market suffers when the builders' production is forced to decrease, and the associated manufacturers and supplies are also hit by the slowdown in new construction.

Deflation

If inflation is a trend of prices and interest rates increasing, deflation is the trend toward a decrease in prices and interests rates. While you may think that, logically, deflation must be the opposite of inflation - that is only partly true. The country is already suffering an economic setback when deflation occurs. Despite the idea that paying less for goods or to borrow money sounds like a good idea, a downward trend in prices and interest rates is not favorable to the economics of the country. Deflation typically occurs when times are difficult, similar to the depression in the 1930's. During times like these, unemployment tends to be high due to the depressed economy. The decrease in prices and interest is an attempt to stimulate business. Since our economy is based on supply and demand, when unemployment is high and people have less money to spend on goods, it drives the cost of the goods down. This also applies to money. When less money is borrowed, the prime rate goes down. This may sound like a positive trend, but deflation only occurs at times when the economy is very weak. The desired upturn is the availability of jobs and a decrease in the unemployment rate. The rise in employment creates an environment where consumers are able to buy more and the cycle continues.

Recession and Depression

During times when the employment rate is high and the country's economic output is growing steadily, we experience a time of prosperity. As the government attempts to maintain the stability of the dollar, inflation and higher interest rates may drive the economics of the country into a period of decline. The difference between a recession and a depression is mostly related to degree. There is usually a duration factor that causes experts to define a block of time as having been a depression. A recession is a period of general economic decline, specifically a decline in the Gross Domestic Product for two or more quarters. That being so, a depression is an extended period of time during which business activity drops significantly, unemployment rates are high, and there is a decline in price levels and the supply of money.

What Do These Economic Indicators Mean To You?

People who invest in the stock market keep an eye on economic indicators. By watching the changing trends in the Consumer Price Index and the Prime Rate, they expect to increase their ability to predict the changes in their investments. Whether you invest in stocks or have a curiosity about the economic changes facing the dollar, studying the Consumer Price Index and the Prime Rate, and exploring the other economic indicators, will increase your awareness of these factors, too.

Finding More Information

Aside from the Consumer Price Index and the Prime Rate, there are additional economic indicators that look at information related to:

  • Production, Sales, Orders, and Inventories (example: Housing Starts)
  • Output (example: Gross National Product)
  • Income, Expenditures, and Wealth (example: Disposable Personal Income)
  • Prices (example: Consumer Price Index)
  • Money, Credit, and Interest Rates (example: Money Stock and Components)
  • Transportation (example: Airline Domestic Revenue Passenger Miles)
  • International Statistics (example: Balance on Current Account)

If you are interested in learning more about economic indicators, see the Federal Reserve Bank of New York article Economic Indicators (By the Numbers). Also, The White House provides information about the U.S. national budget and economy. Visit www.whitehouse.gov to view graphs and information depicting the current economic situation of the United States.

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