Economic scenarios can be highly complex due to factors such as monetary policy, geopolitical situations, bilateral trade agreements, and the state of the labor market. This complicated reality of economics often requires a simplified interpretation to understand the underlying patterns and dynamics within scenarios. Stylized facts serve as guiding stars in navigating vast amounts of economic data and providing key insights into the behaviors and relationships that drive economic indicators.
We explore stylized facts in economic scenarios by analyzing historical trends and correlations of the economic indicators. We compile a list of qualitative stylized facts that can provide an intuitive interpretation of historical and generated economic scenarios.
Stylized Facts for Interest Rates
Interest rates have the most stylized facts as they directly or indirectly impact every aspect of the economy. The Fed Funds rate stands out as a key benchmark among the broad spectrum of interest rates. The Federal Reserve Board (FRB or the Fed) controls this overnight borrowing rate between financial institutions. The Fed Funds rate is set primarily based on the current and foreseeable future state of the economy.
Short-term interest rates, such as Treasury 1-month and 3-month, closely follow the Fed Funds rate. In fact, the correlation between The Fed Funds rate and the Treasury 3-month rate is over 99%.
Longer-term rates, such as 5-year and 10-year Treasury rates, are less correlated with the Fed Funds rate. Generally, long-term rates are higher than short-term rates (such as the Fed Funds rate), shaping a normal yield curve. However, in a high-rate environment, short-term rates can be higher than longer-term ones, forming an inverted yield curve.
Mortgage rates mainly follow long-term Treasury rates with a level shifted up. For example, the 30-year mortgage rate tracks the 10-year Treasury rate with a 1.5% – 3% spread.
Interest Rate and the Economy
Let’s explore a few stylized facts that capture the impact of interest rates on inflation and employment.
The Fed Funds rate is an important tool for managing inflation. When the inflation rate is high or on an increasing path, the Fed raises the Fed Funds rate to control the inflation. Higher Fed Funds rate increases borrowing costs for businesses and consumers resulting in less spending and a lower inflation rate.
On the other hand, when the unemployment rate is high, the Fed reduces the rate to stimulate the economy and improve the labor market.
The unemployment rate and inflation generally have an inverse relationship, meaning that lower unemployment rates are associated with higher inflation rates.
As described earlier, the interest rate (specifically the Fed Funds rate) is an important driver in this unemployment vs inflation relationship. It is a double-edged sword since a lower interest rate may improve employment and increase inflation while a higher interest rate helps suppress inflation but may increase unemployment.
In the subsequent stylized facts describing relationships between economic indicators, the interest rate plays an important role behind the scenes even though we may not explicitly mention it.
Unemployment Rate vs Real GDP
The unemployment rate has an inverse relationship with real GDP growth since higher unemployment results in slower or negative growth.
This stylized fact is prominent during economic downturns and less noticeable in other periods.
Inflation vs Real Disposable Income
Generally, the real disposable income has a growing trend. The growth rate may vary depending on the state of the economy, particularly inflation. For example, during high inflationary periods, the real disposable income has a slower growth due to a lag in wage increases.
On the other hand, during the deflationary periods, when prices of goods and services fall, the real disposable income may have a temporary sharp increase due to negative inflation. Note that the nominal disposable income (actual dollar value) may not change, however, due to lower prices of goods and services it has more buying power which translates into a higher real disposable income.
Another stylized fact is that during economic downturns (usually a reason for deflation), government stimulus and tax credits may further support real disposable income growth.
Stylized Facts for Stock Market Indicators
The S&P 500 index and VIX are some of the most popular stock market indicators. While the S&P 500 index generally has a growing trend, it is very volatile and may even trend down for an extended time. VIX measures the stock market volatility, which may increase or spike during periods of uncertainty.
The S&P 500 index growth and VIX are negatively correlated. The strength of the correlation depends on the granularity of the stock market data. For instance, the correlation is stronger in daily data, where the S&P 500 index growth is measured using daily open and close levels. In contrast, with monthly or quarterly data, the correlation between S&P 500 index growth and VIX is weaker since the longer measurement periods allow the stock market to recover from losses.
Stylized Facts for House Price Index
House prices generally have an upward trend with seasonal effects. Usually, the growth rate is faster during spring and summer seasons and much slower in fall and winter.
Housing prices strongly depend on supply and demand. During periods of tight supply and high demand, HPI growth is faster. Conversely, during the recessionary periods, when supply increases and demand falls, house prices may decline.
A lower mortgage rate may accelerate HPI growth due to more affordable mortgages and increased demand. However, a high mortgage rate may still result in faster HPI growth due to a lower supply as homeowners may be reluctant to sell their property with an existing low-rate mortgage. This is known as the rate lock-in effect.
Real disposable income can be a positive driver for house price growth since a consistently higher income increases affordability. Real disposable income can rise due to a booming economy or tax reforms that lead to lower taxes.
Do the Stylized Facts Always Hold?
The stylized facts described above capture the general relationship between economic indicators. However, it is important to note that these stylized facts do not always hold due to the impact of a third factor. For example, in the 1970s, the US economy experienced stagflation, when unemployment, inflation, and interest rates were volatile for an extended period. The main reason for the stagflation was a sharp increase in oil prices.
Summary of Stylized Facts in Economic Scenarios
Stylized facts provide a simplified view of complex economic realities to reveal underlying patterns and dynamics. We summarized the stylized facts described above into bullet points.
- Interest rates:
- Short-term interest rates strongly correlated with the Fed Funds rate.
- Longer-term rates are less correlated with the Fed Funds rate.
- In a low-rate environment, the long-term rates are generally higher than the short-term rates, forming a normal yield curve.
- In a high-rate environment, long-term rates are more likely to be less than short-term rates, resulting in an inverted yield curve.
- Mortgage rates track long-term rates with a 1.5% – 3% spread.
- Interest Rate and the Economy:
- A high interest rate lowers inflation by reducing consumer borrowing and spending.
- Lower interest rates stimulate the economy and reduce unemployment.
- Unemployment and inflation generally have an inverse relationship.
- Interest rates influence the unemployment-inflation relationship, balancing employment and inflation.
- The unemployment rate and real GDP have an inverse relationship; higher unemployment leads to slower or negative GDP growth.
- Inflation vs. Real Disposable Income:
- Real disposable income generally grows but varies with inflation.
- During deflation, real disposable income may temporarily spike.
- S&P 500 and VIX are negatively correlated; the strength of correlation depends on data granularity (stronger in daily data).
- House Price Index (HPI):
- House prices generally rise with seasonal effects.
- HPI growth depends on market supply and demand.
- Lower mortgage rates can accelerate HPI growth due to more affordable mortgages.
- High rates can also result in HPI growth due to the rate lock-in effect (tight supply).
Finally, note that there are many other stylized facts involving oil prices and currency exchange rates not covered here.
Our AI-generated macroeconomic scenarios reflect these stylized facts providing a coherent dynamics of economic indicators. Reach out to find out more about the scenarios and the behavior of the economic indicators.