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We recently had a class assignment – Analyze Alan Greenspan’s decision to keep the interest low for a long time and raising it very slowly. Many say this policy along with a lackluster regulatory policy led to the current housing led credit crisis.

It was a very interesting exercise and though I wasn’t able to reach the “right” conclusion, I felt that the he did indeed keep the interests low for a longer time than needed. This conclusion came based on my analysis of the GDP gap as perceived (based on Taylor rule and then data) by Greenspan vs. my own estimate of the GDP gap. The increasing natural rate of unemployment also provided some direction towards my conclusion. I cannot exactly share my data, charts, and analysis here because … it was an assignment that may be given next year also and I don’t yet know my grades on the assignment .

What I want to discuss here is one of the statements made during the class –  The economists have not yet build a model that can capture the true relationship between Alan Greenspan’s decisions and the housing crisis. My question is – Can such a model be built? Can it be predictive in nature, and not just retrospective? Lets start by asking a more fundamental question…

Can consumer behavior be modeled? To some extent, yes. Marketers tend to model behaviors all the time in order to sell consumers exactly what they want, and do not want, in the most (un)appropriate times. Numerati (Stephen Baker’s book) talks about various such models and how it is revolutionizing the industry. But this behavior is always predicted based on certain other behavioral patterns and not on demographics, access to cash, and spending power (Note that such models also do exist but may not be the right way to segment consumers).

How can you predict what a consumer will do when he is given easy access to large amount of cash? We look for patterns. We look around ourselves and see what do people do in such cases. When a person gets a great job that comes with large salary incentives, what does he purchase first? When a new generation enters the workforce, what do parent recommend them they do with the money earned? When somebody wins a lottery, what is the one thing he invests in? Does ‘buying a house’ answer all the questions above to some extent? Probably yes.

How can we test this hypothesis? Can this pattern be quantified in an equation? Can it lead to building a model that can actually prove that Greenspan is the root cause of this disaster? Thoughts?

Words from our economics professor Ray Hill. He is correct in saying that and I also believe that everyone in business (not just MBAs) should know what inflation is and how to calculate the rate of inflation.

What is Inflation? Per Wikipedia, the definition is – inflation is a rise in the general level of prices of goods and services in an economy over a period of time. So far so good. We all understand this basic concept very well.

Now, how is the rate of inflation calculated? What measures should one use to calculate the rate?  Basically, there are some other measures (or indices) that should be known to you before you decide to calculate the rate. First is CPI or Consumer Price Index – an estimate of average price for goods and services purchased by households. Second is GDP deflator – a measure of level of prices of goods and services that are produced domestically. Third is PCEPI or Personal Consumption Expenditures Price Index – derived from the largest component of the GDP (personal consumption) and measures the change in prices of goods and services consumed by individuals. I will not go into the details of what each of these are and how they differ because lots of literature is already available on the internet.

Calculation of the rate of inflation is very simple indeed.

Rate of inflation (between time period t and T, T>t) = (Value of the index at time T)/(Value of Index at time t) – 1.0

For e.g. – Between December 2006 and 2007, the inflation rate was 4.08% (based on CPI)

But this is where the fun begins. Using these concepts how do you find out what is the real price of a good based on prices in a certain year in the past? Say Coca Cola, 6 pack 12Oz., used to cost 50 cents in 1974 and $1.50 in 2004 (illustrative figures). This $1.50 is the Nominal price of Coca Cola. What is the real price in 1974 dollars? Say the rate of inflation between these time period is 283% (2.83) (this is actually true). Then,

Real price (in 1974 dollars) = Price in 2004/Rate of inflation = 1.5/2.83 = 53 cents. Huh. Not bad is it!

There is another question that begs answering – What index should one use to calculate inflation rate? CPI is measured using a fixed basket..not a good idea because a typical household’s basket of goods purchased changes over time, new products are introduced, and quality of goods changed (for e.g computers, cars…). There have been some changes in the ‘algorithm’ used but still it tends to have an upward bias in the calculation. GDP deflator helps a little bit because it does not rely on a fixed basket but the actual consumption/expenditure patterns of individuals in a given year. This tends to eliminate the upward bias, but not by much.

Some products, specifically food and energy, tend to be affected by supply shocks and the price change may be temporary (we know about the oil prices, right?). So including these components in calculating true inflation may be misleading. If these are eliminated we may be able to see the real picture. This is where Core Inflation, calculated using PCEPI, comes into picture. In fact, Fed nowadays uses this measure to calculate inflation and take monetary decisions.

Note that inflation can be calculated for specific set of assets such as commodities, services, and wages.These set of values are just subsets of the net inflation but the rules of calculations remain the same.

Some important direct links:

CPI (unadjusted) Data Download

GDP Deflator Data Download

PCEPI (Less food and energy) Data Download

News Flash – September inflation data indicated that consumer prices declined 1.3% during the prior 12 months and that core annual inflation, which excludes volatile food and energy prices, rose just 1.5% — well within the Federal Reserve’s comfort range of between 1%-2%.

Hope you now understand what this means…

Its been 40 years since man landed on moon. 40 years ago, on 21st July 1969 Neil Armstrong and Edwin Aldrin set foot in the moon. This very day ‘a giant step for mankind’ was taken. This very day ‘the eagle landed’.

Space exploration has come a long way since then. Many countries are collaborating to create the first space station. Once that is ready our scientists will be able to conduct numerous experiments and figure out a way to know that part of the universe better. Will it happen in our lifetime, don’t think so. But the future generation can sure hope to see some exciting times, just like we saw the amazing spread of Internet.

When will we go to moon again? I know India is planning to send a manned mission by 2020 as a follow up to its unmanned mission in 2008.

Nasa released a rare footage of the moon landing to commemorate the anniversary.

BTW, I also heard on NPR today that NASA had reused (erased) the magnetic tapes on which there were more footage of moon walking. Apparently they were short of tapes and used those present in the archives. Funny!

A sad week for the entertainment industry this week:

Ed McMahon, the well known sidekick to Johnny Carson died at a ripe age of 86

Michael Jackson, a star of stars, died untimely at 50, thanks to his addiction to medication

Farah Fawcett, one of the original Charlie’s Angels, succumbed to cancer at 62

Billy Mays, the boisterous sales person on TV, died mysteriously in his sleep, at just 50

Tensions in Teheran seemingly increases with govt. cracking down on protestors that leaves scores injured and many dead. Things are silent as of now. The protests are dampening and it seems Neda’s sacrifice will have to wait to see its fruit.

US pulled a stunner in the Federation Cup semis to beat world no. 1 Spain in soccer. The world leaders lost 0-2. US goes on to show great promise in the finals against Brazil losing 2-3.

Honduran President, Manuel Zelaya, falls to a military coup. Has dictatorship been prevented?

Craig Barrett, former chairman of Intel, discusses with Thomas Friedman some ‘out of the box’ ways to tackle economic crisis.

The king of pop is no more. It is a sad day for everyone in this world who grooved to his music and loved his fantastic moves. He had won the hearts of people the world over. Even in India, every child wanted to moonwalk like him. I remember those days with fond memories and shy smiles when I used to practice moving like him behind closed doors.

Michael Jackson, in my opinion, lived the perfect showbiz life. Gaining popularity very early in his career, he became media’s darling as well as its target practice. His is a classic tale of reaching the pinnacle of popularity and falling to depths of sorrow and depression.

But no matter what, he will always be remembered as a showman extraoridnaire. His songs, lyrics, and dance will be etched forever in the minds of this generation and it is with fondness will we recollect his memories to our kids. RIP MJ.

A comprehensive coverage on him here. Go read it and learn about the great star.

Best Dance Moves

I had really appreciated the idea of not having to spend my time during the security check at the airport. I travelled often when I was a consultant with Manhattan Associates and was often frustrated by the long lines on Monday mornings.

Flyclear provided regular passengers with a one time security check and a pass to move through the security lines without waiting in line and without any further checks.

When appointed to my company’s professional services advisory board I often heard other consultants request for reimbursement for applying for this facility ($200). But now it is to no avail.

Apparently the firms’ investors such as Lockheed Martin and Spark Capital decided not to further pursue the venture after investing close to $54 million on the company. Valued at about $90 million it seemed apparent that the venture will not bring in the requisite subscribers (250,000 to date).

It seems the closure of this company signals another victim of this wretched economy.

News Source: PEHUB and GigaOm

- Everyone is aware of the political issue in Iran. As I write this blog, the protests are continuing and the toll mounting. It is difficult to say what stance the government is going to take. The opposition parties remain relentless in spite of the fact no leader has come the demonstration themselves. I am curious and hopeful that things will turn for the the better and the voice of the population (yes, democracy!!!) will be heard.

- In my opinion, Barack Obama is doing the right thing by not taking an aggressive stance on this situation. The action has to be timely and in no way provoke the incumbent government to take a drastic action while exercising their ego. He did release a statement today.

- Rafael Nadal has opted to skip Wimbledon this year because of a nagging injury (tendinitis). His aggressive movements across the courts takes a toll on his body that needs to recuperate. Here is an interesting article on him. His omission is a blessing for Roger Federer. He stands to win his record 15th title thus overcoming Pete Sampras’s earlier record. Roger also stands to gain the no. 1 rank if he wins the tournament. I will be watching.

- Apple’s Steve Jobs has been reported to have a liver transplant done. He is expected to be back at the helm soon. I hope this puts to rest all the stories going round about his health to come to a stop.

- We studied in our school that the benefits from a merger are often attributed to synergy between two companies. We were also told that these synergies are always overrated and over valuation leads to non-successful mergers. Then when we did our problems and exercises, we went back to using the same synergies to do our valuations. We learnt, unlearnt, and then learnt it again. Michelle Leder’s footnoted.org has this evaluation of a recent announcement.

Apple unveiled its newest and fastest iPhone yet, the 3GS. I am quite excited about the product as it a much superior product, by leaps and bounds, to other similar products in the market. The app store, iPhone’s greatest strength keeps is ahead of its rivals.

The pricing for the new iPhones are going to be:

• iPhone 3G S will cost $199 (16GB) and $299 (32GB) for new and qualifying customers.
• iPhone 3G will cost $99 (8GB) for new and qualifying customers.
• The 16GB iPhone 3G will be available for $149 while supplies last.

While new customers will definitely be happy with the offering, the old customers will have a tough decision when its comes to their upgrading. AT&T, the quintessential monopolistic provider, has decided to squeeze the previous owners of their money.

Investors are expecting that the reduction in the price of the iphone (by $100) will result in a 100% increase in sales, as it did the last time around. How the stock market (stock ticker: AAPL) responded to the news is shown below:

The market did respond favorably taking the stock to a respectable USD143.8. Volume traded shot up during the last hours of trading. But today the market did not respond well initially bringing the stock down to less than $141 but picked up back again. Let us see what effect the news from AT&T have on the stock in the days to come.