InvestHL Archives | Page 17 of 67

Sep

2023

Front-Running Explained

By Samuel Becker | Growing Wealth, invest, Investing, Terminology | Comments Off

Front running is when a broker trades a financial asset on the basis of non-public information that will influence the price of the asset in order to profit. In most cases front running is illegal because the broker is acting on information not available to the public markets, for their own gain.

Front running is somewhat different from insider trading, where an individual investor working at a company is able to place a trade based on proprietary information about that company. Insider trading is also illegal.

There is another definition of front running, however, that involves index funds. This type of front running is not illegal.

What Is Front Running?

In short, front running trading means that an investor buys or sells a security (a stock, bond, etc.) based on advance, non-public knowledge or information that they believe will affect its stock price. Because the information is not widely available, it gives the trader or investor an advantage over other traders and the market at large.

Based on this definition of front running, it’s easy to see how the practice — though illegal — earned its moniker. Traders, making moves based on privately held information, are getting out ahead of a price movement — they’re running out in front of the price change, in a very literal sense.

In addition to stocks, front running may also involve derivatives, such as options or futures.

Again, although front running is technically different from insider trading, the two are quite similar in practice, and both are illegal. Front running is forbidden by the SEC. It also runs afoul of the rules set forth by regulatory groups like the Financial Industry Regulatory Authority (FINRA).

If a trader has inside knowledge about a particular stock, and makes trades or changes their position based on that knowledge in order to profit based on their expectations derived from that knowledge, that’s generally considered a way of cheating the markets.

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How Front Running Works

The definition of front running and how it works is pretty straightforward, and there are two main ways front running — also called tailgating — can occur.

• A broker or trader gets wind of a large upcoming trade from one of their institutional clients, and the size of the trade is sure to influence the price.

• Or the broker learns of a specific analyst report about a given security that’s likely going to impact the price.

In either case, the trader gains access to price-relevant information that’s not yet available to the public markets, and the broker is well aware that the upcoming trade will substantially impact the price of the asset. So before they place the trade, they might either buy, sell, or short the asset — depending on the nature of the information at hand — and make a profit as a result.

A Front Running Example

Let’s run through a hypothetical example of how one form of front running may work.

Say there’s a day trader working for a brokerage firm, and they manage a number of client’s portfolios. One of the broker’s clients calls up and asks them to sell 200,000 shares of Company A. The broker knows that this is a big order — big enough to affect Company A’s stock price immediately.

With the knowledge that the upcoming trade will likely cause the stock price to fall, the broker decides to sell some of his own shares of Company A before he places his client’s trade.

The broker makes the sale, then executes the client’s order (blurring the lines of the traditional payment for order flow). Company A’s stock price falls — and the broker has essentially avoided taking a loss in his own portfolio.

He may use the profit to invest in other assets, or buy the newly discounted shares of Company A, potentially increasing his long-term profits essentially by averaging down stocks.

The trader would’ve broken the law in this scenario, breached his fiduciary duties to his client, and also acted unethically.

Recommended: Understanding the Risks of Day Trading

Front Running in the Real World

There are many real-world examples of front running that have led to securities fraud, wire fraud, or other charges. Back in 2009, for instance, 14 Wall Street firms were hit with roughly $70 million in fines by the SEC for front running.

“The SEC charged the specialist firms for violating their fundamental obligation to serve public customer orders over their own proprietary interests by ‘trading ahead’ of customer orders, or ‘interpositioning’ the firms’ proprietary accounts between customer orders,” an SEC release read.

Further research into the topic of front running finds that when people (or firms) have insider knowledge that could benefit them in the markets, they’re likely to use it.

As for another real-world example of front running, there was a case in 2011 involving a large global bank, and some foreign exchange traders who found themselves in hot water. The two traders became privy to a pending order from a client, made some moves to get ahead of it, and ended up making their company money.

It was a $3.5 billion transaction, and by front running the trade, the traders were able to make more than $7 million. It’s not a happy ending, however, the people involved ended up sentenced to prison and ordered to pay hundreds of thousands of dollars in fines.

So, while front running does happen, there can be serious consequences if regulators catch wind of it.

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Is Front Running Legal?

No. In almost all cases, front running is illegal.

Are There Times When Front Running Is OK?

Yes, actually. Index front running is not illegal, and is actually fairly common among active investors.

As many investors are aware, index funds track market indexes like the S&P 500 or Dow Jones Industrial Average. These funds are designed to mirror the performance of a market index. And since market indexes are really nothing more than big amalgamations of stocks, they change quite often. Companies are frequently swapped in and out of the S&P 500 index, for instance.

When that happens, the change in an index’s constituents is generally announced to the public, before the swap actually takes place. If a company is being added to the S&P 500, that’s probably considered good news, and can make investors feel more confident in that company’s potential. Conversely, if a company is being dropped from an index, it may be a sign that things aren’t going so well.

That gives some traders an opening to take advantageous positions. Let’s say that an announcement is made that Firm X is being added to the Dow Jones Industrial Average, taking the place of another company. That’s big news for Firm X, and means that it’s likely Firm X’s stock price will go up.

Traders, if they have the right tools, may be able to quickly buy up Firm X shares the next day, and potentially, make a profit if things shake out as expected.

How is this different from regular front running? Because the information was available to the public — there was no secret, insider knowledge that helped traders gain an edge.

The Takeaway

Front-running is the illegal practice of taking non-public information that is likely to impact the price of a certain asset, then placing a trade ahead of that information becoming public in order to profit. Front running is similar to insider trading, although the latter generally involves an individual investor who profits from internal company information.

Fortunately, there are plenty of ways to profit in the markets without resorting to fraudulent activity like front running.

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FAQ

Why is front-running illegal?

Front running is illegal for a few reasons. First, it’s a form of cheating the market, by using non-public information for a gain. Second, in the case of institutional front running, it’s a violation of a broker’s fiduciary duty to a client.

How can I identify if my trades have been affected by front running?

Unfortunately, owing to the non-public nature of the information that typically leads to front-running, it’s very difficult for individual investors to determine whether or not their own trades have been impacted by a front-running event. Financial institutions have more tools at their disposal to detect incidents of front running.

Are there any technological solutions or tools available to detect and prevent front running?

Yes. With so many traders using remote terminals to place trades since the pandemic, trade surveillance technology and trade reconstruction tools are more important than ever. Fortunately, financial institutions have the resources to employ these tools, and other types of algorithms, to monitor the timing of different trades in order to identify front runners and front running.

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Sep

2023

What Are Capital Expenditures?

By Rebecca Lake | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Capital expenditures, or CapEx, refers to the money a company spends or invests to promote its future growth. This is different from operating expenditures, which deal with the day-to-day costs of running a business. Both show up on a business accounting statement, and both matter for maintaining a healthy bottom line.

From an investment perspective, understanding capital expenditures and how a company spends its money can be useful for evaluating stocks when deciding where to invest. More specifically, the capital expenditure formula is often part of a fundamental analysis approach to gauge a company’s overall financial health and stability. Understanding how to calculate capital expenditures can be helpful when comparing stocks.

Capital Expenditures: Definition & Overview

Here’s a simple definition of capital expenditure: A capital expenditure is any amount of money that a company spends to further its growth.

Capital expenditures typically include the purchase, improvement, or maintenance of physical assets, though it can also refer to intangible assets, such as patents or trademarks. It includes assets that a company will own over more than one accounting period, many of which can depreciate in value over time.

Types of Capital Expenditures

The type of capital expenditures a company has depends on the industry it belongs to and the nature of its business. So, if you’re sector investing, the analyses may vary. Generally, capital expenditure examples can include:

• Land

• Buildings or warehouses

• Equipment

• Machinery

• Business vehicles

• Computer hardware and/or software

• Furniture or fixtures

• Patents

• Licenses

Capital expenditures are most often long-term investments that have a shared goal: to help promote or further business growth. For example, a manufacturing company may decide to upgrade its equipment to speed up production and increase efficiency. The return on that investment comes later, when the company increases its output and generates bigger profits.

Capital Expenditures vs. Operating Expenditures

In accounting, capital expenditures are separate from a company’s operating expenditures. An operating expenditure is money a company spends to maintain normal business operations.

Examples of operating expenditures include:

• Rent or lease payments for business property

• Utilities

• Insurance

• Employee payroll

• Inventory

• Marketing costs

• Office supplies

Bottom-up investors use both capital expenditures and operating expenditures to measure how a company spends its money, but it’s important to avoid confusing them. In a nutshell, capital expenditures represent long-term investments in assets that will be used in the future, while the operating expenditures represent short-term outlays.

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How to Calculate Capital Expenditures

Companies calculate capital expenditures and include it on their cash flow statements under the section noted for investing activities. If you have access to a company’s cash flow statement or other key company financial information, you wouldn’t necessarily need to calculate capital expenditures because the relevant numbers would already be included.

But if you don’t have cash flow information available, or you simply want to do the math on your own, there’s a capital expenditures formula you can use. This formula is simple, though it does require that you have certain information about a company’s financial situation, including:

• Depreciation and amortization for capital expenditure assets

• Current period PP&E (Property, Plant & Equipment)

• Prior period PP&E

Property, Plant & Equipment refers to assets listed on a company’s balance sheet. In simpler terms, these are the assets that help generate revenue and profits for the business. So again, this can include things like equipment, machinery, vehicles, office equipment or land. Of those assets, land is the only one that typically doesn’t depreciate in value over time.

If you have these three pieces of information, you can then apply the capital expenditures formula. The formula looks like this:

CapEx = Current period PP&E – Prior period PP&E + Current period depreciation

Here’s how it works using hypothetical numbers. Say you’re evaluating a company that has a current period PP&E of $70,000, a prior period PP&E of $50,000 and $20,000 in current period depreciation. Your capital expenditures formula would look like this:

CapEx = $70,000 – $50,000 + $10,000
CapEx = $30,000

These calculations are relatively easy to do if you have all the relevant details from a company’s balance sheet. Once you can calculate capital expenditures, you can use the formula to evaluate investments.

Capital Expenditures and Fundamental Analysis

Fundamental analysis is one strategy for comparing investments and it’s typically used when investing for the long-term. With this type of analysis, the emphasis is on what makes a company financially healthy. This is something you may be interested in when trying to evaluate a stock appropriately and decide whether to invest in it.

A fundamental analysis approach considers a company’s assets and liabilities. But it also utilizes certain financial ratios that measure how money moves in and out of the company. Some of the most important ratios include:

• Price to earnings (P/E) ratio

• Earnings per share (EPS)

• Current ratio

• Quick ratio

• Return on equity (ROE)

• Book-to-value ratio

• Projected earnings growth (PEG)

All of these ratios measure a company’s value, which is important if you’re using a value investing approach. The goal there is to identify companies that have been undervalued by the market but have long-term growth potential. By investing in these companies and holding on to them, investors can benefit from price appreciation as they rise in value over time.

So where do capital expenditures fit in?

In terms of gauging a company’s value, capital expenditures offer insight into projected growth over the long-term. When a company regularly invests money in purchasing or upgrading assets, that can be a sign of financial strength and an eventual increase in value. On the other hand, a company pulling back on capital expenditures may hint at cash flow struggles that are impeding future growth.

One thing that’s important to keep in mind is that capital expenditures aren’t a foolproof indicator of a company’s long-term growth potential. It’s possible that a company may spend money with good intentions, only to have them backfire.

In an earlier example, we mentioned a manufacturing company purchasing new equipment to boost production. If that investment doesn’t pan out as expected–if, for example, the equipment requires constant maintenance and repairs that eat into profits or it falls short of expectations for increasing production speed–that could inhibit the company’s growth plans.

The Takeaway

Capital expenditures can be particularly helpful to investors if you favor a value investing approach or you lean toward buy-and-hold investing. Understanding how a company is investing in itself for the long-term can help you decide whether it makes sense as part of your portfolio.

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Sep

2023

How Time-Weighted Rate of Return Measures Your Investment Gains

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

One of the most important and most common methods investors use to measure their returns is the time weighted rate of return formula. That’s because the time-weighted rate of return measures a compound rate of growth.

The time-weighted rate of return incorporates the impact of transactions such as portfolios rebalancing, contributions, and withdrawals. That leaves investors with a clearer picture of their portfolio’s overall performance.

What Is the Time-Weighted Rate of Return?

Starting with the basics, a return on investment (ROI) is a measure of how much money investments earn, or how much they’ve grown in value. Returns can be positive or negative (if a stock loses value following its purchase, for example). But obviously, investors make decisions with the goal of earning positive returns.

A rate of return, then, is a measure of the pace at which investments are accruing value, expressed as a percentage. The higher the rate of return, the better. Essentially, it’s a measure of a portfolio’s or investment’s performance over time. Rates of return can be calculated for certain time periods, such as a month or a year, and can be helpful when comparing different types of investments.

But investment portfolios are rarely static. Many investors make contributions or withdrawals to their portfolios on a regular basis. Many people contribute to their 401(k) with each paycheck, for example, or rebalance when market moves throw their asset allocation out of whack.

During these transactions, investors are buying and selling investments at different prices and times based on their investing strategy. That can make it more difficult and complicated to calculate a portfolio’s overall rate of return.

That’s where the time-weighted rate of return formula becomes useful. In short, the time-weighted rate of return formula takes into account a portfolio’s cash flows, and bakes in their effect on the portfolio’s overall returns. That gives investors a better, more accurate assessment of their portfolio’s performance.

That’s why the time-weighted rate of return calculation is, for many in the financial industry, the standard formula for gauging performance, over both the short- and the long-term.

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The Time-Weighted Rate of Return Formula

The time-weighted rate of return formula can look intimidating for even seasoned investors, but it’s an important step in building and maintaining an investment portfolio. But like many other financial formulas, once the variables are identified, it’s a matter of plug-and-play to run through the calculation.

First, let’s take a look at the basic portfolio return calculation:

Basic portfolio return = (Current value of portfolio – initial value of portfolio) ÷ initial value

While this formula provides a value, it assumes that an investor made one investment and simply left their money in-place to grow. But again, investors tend to make numerous investments over several time periods, limiting this calculation’s ability to tell an investor much about their strategy’s effectiveness.

That’s where the time-weighted rate of return comes in. In essence, the time-weighted formula calculates returns for a number of different time periods — usually additional purchases, withdrawals, or sales of the investment.

It then “weights” each time period (assigns them all roughly equal importance, regardless of how much was invested or withdrawn during a given period). Then, the performance of each period is included in the formula to get an overall rate of return for a specified period.

Calculating the time-weighted rate of return over the course of a year, for instance, would include the performance from each individual month. And, yes, that’s a lot of math. Computers and software programs can help, but it’s also doable the old-fashioned way.

This is what the time-weighted rate of return formula looks like:

Time-weighted return = [(1 + RTP1)(1 + RTP2)(1 + RTPn)] – 1

There are variables needed to calculate the equation:

n = Number of time periods, or months
RTP = Return for time period (month) = (End value – initial value + cash flow) ÷ (initial value + cash flow)
RTPn = Return for the time period “n”, depending on how many time periods there are

Let’s break it down again, and assume we’re trying to calculate the time-weighted return over three months. That would involve calculating the return for each individual month, three in all. Then, multiplying those returns together — “weighting” them — to arrive at an overall, time-weighted return.

How to Calculate Time-Weighted Rate of Return

To run through an example, assume we want to calculate a three-month, time-weighted return. An investor invests $100 in their portfolio on January 31. On February 15, the portfolio has a value of $102, and the investor makes an additional deposit of $5. At the end of the three-month period on April 30, the portfolio contains $115.

For this calculation, we wouldn’t think of our time periods as merely months. Instead, the time periods would be split in two — one for when a new deposit was made. So, there was the initial $100 deposit that would constitute a time period that ends on February 15. Then a second time period, when the $5 deposit was made, which constitutes a second time period.

With this information, we can make the calculation. That includes calculating the return for each time period during our three-month stretch. So, for time period one, the basic formula looks like this:

Return for time period = (End value – initial value + cash flow) ÷ (initial value + cash flow)

Now, we plug in our variables and calculate. Remember, there was no additional cash flow during this first period, so that won’t be included in this first calculation.

Time period 1:
($102 – $100) ÷ $100 = 0.02, or 2%

Then, do the same to calculate time period two’s return:

Time period 2:
[$115 – ($102 + $5)] ÷ ($102 + $5) = 0.074, or 7.4%

Now, take the returns from these two time periods and use them in the time-weighted rate of return formula:

Time-weighted return = [(1 + RTP1)(1 + RTP2)(1 + RTPn) – 1

With the variables — remember to properly use percentages!

TWR = [(1 + 0.02) x (1 + 0.074)] – 1 = 0.95, or 9.5%

So, the time-weighted return over this three-month stretch (which included two time periods for our calculation), is 9.5%. If we had simply done a basic return calculation, we’d reach a different number:

Basic portfolio return = (Current value of portfolio – initial value of portfolio) ÷ initial value
$115 – $100 ÷ $100 = 0.15, or 15%

That 15% figure is too high, because it doesn’t account for cash flow. In this case, that was a $5 deposit made in mid-February. The basic return formula folds that into the overall return figure. The time-weighted calculation gives us a more accurate return percentage, and one that accounts for that mid-February deposit.

Other calculations

While the time-weighted rate of return is an important measurement, it’s not the only way to look at a portfolio’s returns. Some investors may also choose to evaluate a portfolio or investment based on its money-weighted rate of return. That calculation is similar to the time-weighted rate of return because it incorporates inflows and outflows, but it does not break the overall investment period into smaller intervals.

Another common measure is the compound annual growth rate, (CAGR), which measures an investment’s annual growth rate over time and does not include the impact of inflows and outflows.

The Takeaway

Having an accurate, timely view of a portfolio’s performance is critical for understanding current investments, planning future investments, and considering changes to your asset allocation. While other rate of return calculations can be useful, it’s important to understand their limitations.

The time-weighted rate of return formula is helpful because it takes into account the numerous inflows and outflows of money over various time periods. Armed with that insight, investors can adjust their strategy to try to increase their rate of return. That may mean reallocating or rebalancing their portfolio to include more aggressive investments or less risky securities.

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Sep

2023

What Is Quantitative Easing?

By Laurel Tincher | Growing Wealth, Investing, Terminology | No Comments

Quantitative easing (QE) is a monetary policy tool in which a central bank attempts to stimulate growth in the economy by buying bonds or other financial assets in the open market.

When the central bank purchases assets, the money they’ve spent gets released into the market, increasing the money supply in an economy. QE is an unconventional monetary policy tool that’s usually used by a central bank when traditional tools — like lowering interest rates — are no longer effective or an option.

How Does Quantitative Easing Work?

Quantitative easing makes it easier for businesses to borrow money from banks, by essentially lowering the cost of borrowing money.

The Federal Reserve, or Fed, is the central bank of the United States. The Fed notably conducted multiple rounds of QE after the 2008 financial crisis. The U.S. central bank also embarked on a QE program in 2020 when quarantine measures were put in place due to the Covid-19 pandemic.

When the Federal Reserve purchases securities from other banks, it issues a credit to the bank’s reserves, thereby figuratively increasing the money supply. No funds actually change hands in a QE program. The funds used to purchase the securities are essentially created out of thin air as a credit. Hence, QE is often referred to as “printing money” since the central bank is boosting the fiat currency supply.

When the Fed purchases Treasuries from the government, this also keeps Treasury yields low by increasing the demand for them. When Treasury yields stay low, long-term interest rates remain low, which can make it easier for consumers to take out loans for a car, house, or other types of debt.

Banks are required to have a certain amount of money on hand each night when they close their books. This is called the bank reserve requirement. QE gives banks more than they need to hit this reserve requirement. When banks have extra money, they lend it out to other banks to make a profit. This can also help stimulate the economy.

In addition to making it easier for banks to give out loans, QE keeps the value of the U.S. dollar lower, which in turn lowers the cost of exports and makes stocks attractive to foreign investors. All of these factors can help to keep the economy running during challenging times.

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When Low Interest Rates Aren’t Enough

While Congress controls government spending and tax rates — what’s known as fiscal policy — the Federal Reserve controls short-term interest rates, which are the main tool used to prevent or lower the impacts of a recession — a system known as monetary policy.

More specifically, the Fed adjusts the rate that banks have to pay to one another to loan money that is held in Fed accounts. If banks can borrow money at a lower rate, they in turn can lend money to their customers at a lower rate.

Central banks have long preferred to lower short-term interest rates to expand the economy and encourage more spending. Similarly, the Federal Reserve raises interest rates to slow inflation. But when interest rate cuts aren’t enough to stimulate the economy, as is now the case, quantitative easing is sometimes used as a last resort.

One limitation on interest rates is that they can’t practically be lowered to less than zero. Technically, negative interest rates are possible, but this would mean that banks would actually be paying people to borrow money, rather than the other way around.

When interest rates fall to near zero, and banks, corporations, and individuals hoard money, this results in a lack of liquidity in the market. Quantitative easing can help release money back into the market. The asset purchases will take place over the course of several months. The goal is to make sure that businesses have sufficient funds to lend to other businesses throughout the economic downturn.

Does Quantitative Easing Cause Inflation?

One of the biggest fears about quantitative easing is that it will cause too much inflation, or price increases. In such a scenario, inflation would occur because there’s a lot of money in the system.

Some economists argue that if the money supply increases quickly, it increases demand as more people have ample money to spend. That, in turn, can raise prices rapidly or encourage reckless financial decisions.

Some degree of inflation is healthy and normal. For instance, in the U.S., the Federal Reserve targets an inflation rate of 2%. But inflation rates that are too high can be painful for consumers. For instance, during the 1970s, the inflation rate averaged 7% and hit double-digit levels in 1974 and 1979, causing the prices of some goods — most notably oil — to skyrocket.

Past Examples of Quantitative Easing

A relatively new strategy, quantitative easing has been used a number of times over the past 20 years, with varying degrees of success.

Quantitative Easing in Japan

The first example of an advanced first-world country implementing a quantitative easing program was Japan in 2000-2006. Japan entered into a recession following the Asian Financial Crisis of 1997.

The Bank of Japan bought private debt and stocks through the QE program, but the program didn’t result in the stimulus they had hoped for. Japan’s GDP fell from $5.45 trillion to $4.52 trillion between 1995 and 2007. Japan also used QE in 2012 when Prime Minister Shinzo Abe was elected and sought to stimulate the economy.

Quantitative Easing in the US

A few rounds of quantitative easing took place throughout the financial crisis from 2008 to 2011.

The most successful example of QE was the $2 trillion stimulus enacted by the U.S. in 2008, despite the fact that it doubled the national debt from $2.1 trillion to $4.4 trillion in just a few years. Although many feel that the QE program helped get the U.S. and global economy through the recession following the financial crisis, this topic has been debated and is hard to quantify.

Some critics argue that banks actually held on to much of the excess money they received through the QE program rather than lending it out, so the program didn’t exactly have the desired effect. However, QE helped to remove subprime mortgages from bank balance sheets and bring the housing market back.

Quantitative Easing in Switzerland

During the 2008 financial crisis, the Swiss National Bank also implemented a QE program. In terms of its ratio to GDP, the Swiss program was the largest ever enacted in the world.

Despite this overwhelming effort that resulted in some economic growth, Switzerland didn’t reach its inflation targets after the use of QE.

Quantitative Easing in the UK

In 2016, the Bank of England launched a QE program worth £70 billion to help alleviate economic concerns about Brexit.

Between 2016 and 2018, business investment grew in the U.K., but it was still growing at a slower rate than it had been in previous years. Economists have not been able to confirm whether growth would have been even slower without the QE program.

Pros and Cons of Quantitative Easing

While QE programs can help stimulate a struggling economy, they have some downsides, and there are reasons they are used as a last resort.

Pros of Quantitative Easing

• QE programs make it easier for businesses to take out loans.

• The influx of money into the market can help keep the economy flowing and release liquidity traps.

• Low interest rates make it easier for consumers to take out loans for cars, homes, and other borrowing needs.

• QE can be an important tool during a financial crisis in order to avert recession, or even severe economic depression.

Cons of Quantitative Easing

• Increasing the supply of money can lead to inflation.

• Stagflation can occur if the QE money leads to inflation but doesn’t help with economic growth. The Fed can’t force banks to lend money out and it can’t force businesses and consumers to take out loans.

• QE can devalue the domestic currency, which makes production and consumer costs higher.

• As a relatively new economic concept, there isn’t data and consensus about whether QE is effective.

What If QE Doesn’t Work?

Previous QE programs implemented by Japan, Switzerland, and the U.K. have not managed to reach the stimulus goals they set out to achieve. However, the QE program enacted in the U.S. during the 2009 recession helped to revive the housing market, stimulate the economy, and restore trust in banks. It didn’t cause rampant inflation as many feared it would.

It’s unclear how effective it was following stimulus measures implemented during the COVID-19 pandemic, too. As a relatively new strategy, there isn’t enough data to confirm whether QE is effective. In fact, there isn’t even agreement about how exactly it’s supposed to work.

Flattening the Yield Curve

Economists have a theory that quantitative easing will work by flattening the yield curve, which is a graph curve that displays the variation of interest rates according to their term of maturity. When the Fed purchases long-term Treasuries, their yield goes down and their prices go up.

This results in the yields of corporate bonds and long-term mortgages going down as well. Lower rates encourage home construction, corporate investment, and other activities that stimulate the economy. Although this sounds good in theory, the issue in the current economy is that the yield curve is already pretty flat.

Losing Effectiveness

A QE program might stimulate the economy for a short amount of time, but it could also lose its effectiveness. If this happens, the government can also turn to fiscal policy, or government spending, to further put money into the economy.

Sometimes QE and government spending can blur together, if the Fed purchases government bonds that are issued to fund government spending.

Some economists also believe that by signaling to the world that the Fed is serious about stimulating the economy, this will help create economic growth and spending and make consumers confident about making purchases. Whether this is true is yet to be seen in the current global situation.

The Takeaway

Quantitative easing is an unconventional monetary policy tool that central banks can use when faced with weak or nonexistent growth. Central banks typically resort to measures like QE when more conventional monetary policy tools, such as lowering interest rates, are no longer effective or not enough to stimulate an economy.

QE is a relatively new phenomenon, but it became more common after the 2008 financial crisis, when multiple central banks around the world resorted to asset purchases to boost economic growth.

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Sep

2023

7 Factors That Cause Inflation

By Colin Dodds | invest, Investing, Preparing for Retirement | Comments Off

There are a number of factors that can cause inflation, including an increase in the cost of raw materials, an increase in the currency supply, and more. When the cost of goods and services rise over time, and consumers have to spend more to buy basic items, that’s considered inflation.

Inflation is an economic reality, but the government tries to regulate inflation so that it remains at a low but steady pace. The target is 2.0%, but historically it’s closer to 3.3%. A period of higher inflation began in early 2021, thanks in part to supply chain bottlenecks resulting from the pandemic.

Inflation isn’t necessarily a bad thing — it can also result from an economic upturn. But when the prices of goods and services rise in relation to the dollar, or the currency in use, the result is that each unit of currency will buy less of just about everything than it previously did.

Here’s a closer look at how to track inflation, and seven factors that cause prices to increase.

How to Track Inflation

The most commonly used measure to track inflation is the Consumer Price Index (CPI), which is produced by the U.S. Bureau of Labor Statistics (BLS) each month. The CPI tracks the average of prices of a set of goods and services. While the CPI leaves out important aspects of consumer spending, such as real estate and education, it is considered a valuable gauge of the ever-changing cost of living.

What Is Core Inflation?

Core inflation also measures the rising cost of goods and services, but it excludes food and energy costs. The reason being that both food and energy prices are partly driven by the price of commodities — which tend to be volatile, owing to speculation in the commodities markets. So the short-term price changes in food and energy make it difficult to include them in a long-term reading of inflationary trends: hence the core inflation metric.

The Consumer Price Index and the core personal consumption expenditures index (PCE) are the two main ways to measure underlying inflation that’s long term.

Inflation also shows up in the wholesale price index (WPI), which measures and tracks the changes in the price of commodities and other goods that are traded between businesses.

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Types of Economic Inflation

There are a range of different types of inflation, although they are fundamentally interrelated.

Cost-Push Inflation

Cost-push inflation occurs when the price of commodities rises, pushing up the price of goods or services that rely on those commodities. For example, owing to high demand for certain types of minerals used in technology equipment, the prices for those goods are likely to rise.

Demand-Pull Inflation

Rising demand for goods and services can trigger inflation when there’s an imbalance in supply vs. demand. This is known as demand-pull inflation. For example, if there’s a high demand for pork (or if there’s a slump on the supply side owing to pork shortages), that could drive up the price of bacon, ham, and other pork products.

Built-In Inflation

Built-in inflation is the result of an upward spiral in wages, as workers seek raises to keep up with the cost of living. This in turn can lead businesses to raise their prices, adding to the higher prices.

As you can see, these three types of inflation are connected through the loop of supply and demand.

Recommended: 5 Tips to Hedge Against Inflation

What Causes Inflation?

While inflation has become a persistent factor in most of the world’s economies, it can result from a range of different causes. Understanding the different causes can help investors manage inflation risk — i.e. the possibility that the money you invest won’t earn enough to keep up with inflation.

1. The Economy Is Going Strong

When the economy is growing, more people have jobs, wages increase in order to hire and keep those workers, and more people have money to spend. As a result, they buy more necessities and some even splurge on luxury items.

In this environment, businesses can increase their prices, and consequently, wholesalers can increase prices. The net result of this cycle of expansion is higher prices across the board: aka inflation.

This scenario is why inflation isn’t always bad news. In fact, the Federal Reserve aims for a target annual inflation rate of around 2%, because it indicates a growing economy. As noted above, this kind of inflation is a type of “demand-pull inflation,” because it is driven by consumer demand.

In fact, deflation — when the prices of goods fall for a period of time — can also be considered unhealthy because it can mean demand among consumers is weak.

2. There Is More Currency Available

Inflation can also occur when the Fed, or another central bank, adds fiat currency into circulation at a rate that exceeds that of the economy’s growth rate. That creates a situation in which there are more dollars bidding on fewer goods and services. The result is that goods and services cost more.

One reason that inflation has been a constant in the U.S. since 1933 is that the Fed has continually increased the money supply. In response to the 2008 financial crisis, the Fed dropped its lending rate close to zero as a way to inject more liquidity into the economy, which led to increased inflation but not hyperinflation. While those increases have usually moved in step with growth, that hasn’t always been the case.

In response to the Covid-19 pandemic and subsequent lockdowns, the Fed released the equivalent of $3.8 trillion in new liquidity in 2020. That amount was equal to roughly 20% of the dollars previously in circulation. And it is one reason why many investors were watching the CPI closely in 2021 — and were not surprised when inflation began to climb through 2022.

3. Basic Materials Increase in Price

In the 1970s in the U.S., inflation was rampant. There were many reasons for this, but one major one was the OPEC oil embargoes. The embargoes led to a gas shortage, higher prices for home-heating oil, higher prices at the pump, and increases in the prices of manufacturing and shipping for nearly every single consumer good.

Between 1973 and 1974, inflation-adjusted oil prices jumped from $25.97 per barrel to $46.35. And as a result, inflation topped 11% that year.

Another one of the most dramatic periods of inflation was the period of 1979-1981, when inflation topped 10% for three straight years. Again, oil was a major contributing factor, as the Iranian Revolution set off further increases in the price of oil.

Recommended: Guide to Investing in Oil

4. The Housing Market Takes Off

The housing market is a major part of the U.S. economy, and it has an outsized impact on the broader economy. When the housing market is strong and home prices are rising, then homeowners have more equity to call upon to make major purchases, which can goose inflation.

At the same time, a strong housing market means that homeowners, contractors, and builders are spending more on home improvements and buying the raw materials that make those new and improved homes possible. That, in turn, drives up the prices of those raw materials, such as steel, lumber, and oil, which can lead to more inflation.

💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.

5. The Government Implements Expansionary Fiscal Policies

The federal government will occasionally try to jumpstart economic growth with new policies. These expansionary fiscal policies often seek to increase the amount of discretionary income that businesses and consumers have to spend.

Often, these policies take the form of reduced taxes with the belief that businesses will spend it on employee compensation and new hiring. That will allow more consumers to spend on goods and services.

Other times, those policies consist of massive infrastructure projects, which can increase the demand for goods and services. The increasing of overall liquidity due to central bank monetary policy is also considered an expansionary policy.

6. New Regulations Increase Costs

While a shortage of an essential commodity, like oil, can cause inflation, so can an increase in costs related to a commodity suddenly becoming more expensive because of government regulations.

Sometimes new tariffs can increase the costs of imported goods, which can lead to inflation. At the same time, new regulations that make a particular commodity or service more expensive or time-consuming to obtain can also increase the costs to consumers, leading to inflation.

7. The Exchange Rate Changes

The value of the U.S. dollar in relation to all other foreign currencies is constantly in flux. If the dollar goes down, then imported commodities and consumer goods get more expensive. But it also makes goods exported from the U.S. cheaper abroad, which can actually be a boost for the economy.

The Takeaway

Inflation in the U.S. has been a constant since 1933. Most years inflation is a slow drip of almost imperceptible price increases, but there have been times when it has risen sharply, as it did during the late 70s and early 80s. This was a painful period for many consumers and inflation became a major political issue.

Inflation was fairly gradual in the decades since then, but after stimulus packages during the Covid-19 pandemic and a reopening of the economy boosted prices and growth, inflation took off. It reached a peak of about 9.02% in June of 2022, and has eased down closer to the historical average of about 3.28% throughout 2023.

The forces that can stir or mitigate inflation are important for investors to understand. Managing your investment strategy in light of the inevitable impact of inflation can help offset inflation risk — the risk that your money won’t retain its purchasing power in the future.

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FAQ

How does raising interest rates help inflation?

Higher interest rates may help slow spending, because the cost of borrowing increases as rates rise. People may also be inclined to take advantage of higher rates by saving more, which can also slow demand and cool the economy.

How quickly does inflation decrease to normal levels?

Cycles of inflation historically have lasted many years, or a couple of months. How quickly inflation subsides depends on economic conditions overall, as well as the origins of a particular bout of inflation. If employment numbers change, if interest rates rise or fall, if demand overshoots supply — these are among the factors that can influence inflation.

Who benefits from inflation?

There are a couple of scenarios where inflation can be beneficial. For example, those with bigger debts can benefit from inflation because the money they’re using to pay off their car or home loan, say, is now less valuable than the money they borrowed. Those working in jobs made more secure by rising demand can also benefit. In some cases, holding foreign currency may be more beneficial in relation to the inflationary currency. Inflation is fluid, and it’s important to gauge which factors are at play before deciding what is beneficial or not.

Who is hurt most by inflation?

Lower-income households are disproportionately affected by inflation, because the cost of goods and services is rising faster than wages. Another group hit hard by inflation is retirees and those living on fixed incomes, because their money is buying less over time.

Photo credit: iStock/Delmaine Donson

Front-Running Explained

What Is Front Running?

How Front Running Works

A Front Running Example

Front Running in the Real World

Is Front Running Legal?

Are There Times When Front Running Is OK?

The Takeaway

FAQ

Why is front-running illegal?

How can I identify if my trades have been affected by front running?

Are there any technological solutions or tools available to detect and prevent front running?

What Are Capital Expenditures?

Capital Expenditures: Definition & Overview

Types of Capital Expenditures

Capital Expenditures vs. Operating Expenditures

How to Calculate Capital Expenditures

Capital Expenditures and Fundamental Analysis

The Takeaway

How Time-Weighted Rate of Return Measures Your Investment Gains

What Is the Time-Weighted Rate of Return?

The Time-Weighted Rate of Return Formula

How to Calculate Time-Weighted Rate of Return

Other calculations

The Takeaway

What Is Quantitative Easing?

How Does Quantitative Easing Work?

When Low Interest Rates Aren’t Enough

Does Quantitative Easing Cause Inflation?

Past Examples of Quantitative Easing

Quantitative Easing in Japan

Quantitative Easing in the US

Quantitative Easing in Switzerland

Quantitative Easing in the UK

Pros and Cons of Quantitative Easing

Pros of Quantitative Easing

Cons of Quantitative Easing

What If QE Doesn’t Work?

Flattening the Yield Curve

Losing Effectiveness

The Takeaway

7 Factors That Cause Inflation

How to Track Inflation

What Is Core Inflation?

Types of Economic Inflation

Cost-Push Inflation

Demand-Pull Inflation

Built-In Inflation

What Causes Inflation?

1. The Economy Is Going Strong

2. There Is More Currency Available

3. Basic Materials Increase in Price

4. The Housing Market Takes Off

5. The Government Implements Expansionary Fiscal Policies

6. New Regulations Increase Costs

7. The Exchange Rate Changes

The Takeaway

FAQ

How does raising interest rates help inflation?

How quickly does inflation decrease to normal levels?

Who benefits from inflation?

Who is hurt most by inflation?

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