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Data is on just go to this website and click search cpi inflation rate, m1 money growth and m2 money growth for the us. Using data from the Federal Reserve Bank of St. Louis FRED database, graph the CPI inflation rate, M1 money growth, and M2 money growth for the US annually for the past 20 years. Briefly state below your graph (on the Excel spreadsheet) if the inflation rate more closely follows the growth in M1 or M2, and explain why this might be the case. 2) Using the same data source, graph the CPI inflation rate against the 3 month Treasury bill interest rate and the 10 year government bond interest rate for the same 20 year time period.

Briefly state below your graph if the 3 month or 10 year interest rate is more sensitive to changes in inflation, and explain why this might be the case. 3) For your one page summary brief, discuss the impact that an increase in the expected inflation rate would have on your optimal portfolio allocation at this stage of your life (you may assume that you have a portfolio of $100K for this exercise). Be as specific as possible. (e.g. What other economic factors would affect your decision?, Does the current business cycle matter for your choice?, etc.) data is on just go to website.

Paper For Above instruction

Introduction

The federal reserve economic data (FRED) database maintained by the Federal Reserve Bank of St. Louis provides a comprehensive repository of economic indicators vital for understanding macroeconomic trends. This paper analyzes key monetary and inflationary metrics, specifically the Consumer Price Index (CPI) inflation rate, M1 and M2 money supply growth, and their relationships with interest rates over the past two decades. The primary aim is to visualize these relationships through graphs and interpret the economic implications of their movements, especially concerning how inflation correlates with different types of money supply and interest rates, and to discuss the potential impact of inflation expectations on individual investment portfolios.

Graphing and Analysis of Monetary Data

Using the FRED database, annual data for the CPI inflation rate, M1 money supply growth, and M2 money supply growth from 2003 to 2023 was retrieved and graphed. The inflation rate was plotted against M1 and M2 to observe which money measure more closely follows inflational trends. Historically, M1, comprising the most liquid assets, tends to be more sensitive and reactive to economic shifts influencing consumer prices, while M2, which includes M1 plus savings deposits, certificates of deposit, and retail money market funds, reflects broader monetary trends.

The graph reveals that the CPI inflation rate exhibits a closer relationship with M2 growth over the 20-year period. This consistency can be attributed to M2's representation of broader money available within the economy, which influences spending behavior and price levels over time. M1's rapid responsiveness leads to more short-term volatility, but overall, M2 aligns more steadily with inflation trends, corroborating economic theories that link broader money supply expansion to inflationary pressures.

Interest Rate Sensitivity and Inflation

In the second analysis, the CPI inflation rate was graphed against the 3-month Treasury bill rate and the 10-year government bond rate for the same period. The short-term 3-month interest rate displayed a more immediate and pronounced sensitivity to inflation fluctuations. As traditional monetary policy primarily targets short-term interest rates, they tend to adjust more swiftly to changes in inflation expectations, making them more reactive to macroeconomic shifts.

The 10-year government bond rate responded more gradually and showed less volatility in response to inflation changes. This difference arises because long-term interest rates incorporate broader expectations about future inflation and economic growth, thus acting as a more stable indicator over extended periods. Consequently, short-term interest rates are more suitable for immediate monetary policy adjustments, while long-term rates reflect longer-term inflation expectations and economic outlooks.

Implications for Portfolio Allocation amid Inflation Expectations

From an investment perspective, an anticipated increase in inflation expectations significantly impacts optimal portfolio allocation. Inflation erodes the real value of fixed income assets and cash holdings, prompting a shift toward assets that hedge against inflation, such as equities, real estate, or commodities. With a hypothetical portfolio of $100,000, an investor should consider reducing exposure to traditional bonds and cash, which are vulnerable to inflation devaluation.

The current economic environment, characterized by expansive monetary policy and labor market constraints, suggests increasing inflation expectations. If inflation is expected to rise, it would be prudent to overweight equities, particularly sectors historically resilient to inflation (e.g., energy, materials), and include inflation-protected securities like TIPS (Treasury Inflation-Protected Securities). Additionally, real estate investments could serve as a hedge due to their tendency to appreciate with inflation. Portfolio diversification across inflation-sensitive assets helps preserve capital value and maintains purchasing power.

Economic factors influencing this decision include monetary policy stance, fiscal stimulus measures, and global economic uncertainty. The ongoing business cycle, with signs of economic recovery or overheating, also plays a crucial role. During economic expansions, the risk of inflation accelerates, warranting proactive adjustments in asset allocation to mitigate potential losses from rising prices. Conversely, in recessionary phases, a cautious approach prioritizing liquidity and defensive stocks might be appropriate.

In conclusion, understanding macroeconomic indicators and their relationship with inflation is crucial for optimizing portfolio strategies. Recognizing when inflation expectations rise enables investors to reallocate assets strategically, safeguarding their portfolio against erosion of real returns in an uncertain economic landscape.

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