Quantitative Easing Theory, Evidence and Debate and the Global Devaluation War
Carlos M. Pelaez
©Carlos M. Pelaez, 2010
The objective of this post is to analyze the theory and evidence on quantitative easing by the Fed to probe the heated debate on Fed large-scale purchase of Treasury securities and the repercussions on the dollar and other currencies. The contents are as follows:
Introduction
I Theory and Evidence of Quantitative Easing
II Debate on Quantitative Easing
III Global Yield Hunt
IV Global Devaluation War
V Economic Indicators
VI Interest Rates
VII Conclusion
References
I Theory and Evidence of Quantitative Easing. The critical issues of quantitative easing are the theoretical framework explaining how massive injections of base money in large-scale asset purchases (LASP) prevent deflation, increase aggregate demand and motivate private-sector hiring and what empirical evidence supports these intended effects. This section considers a specific explanation of how quantitative easing by LSAP of Treasury securities can lower yields by appeal to the preferred-habitat theory of the term structure of interest rates (Culbertson 1957, 1963; Modigliani and Sutch 1966) as reformulated by Vayanos and Vila (2009) and analyzed empirically by D’Amico and King (2010).
The central issue is deriving theoretically how changes in the quantity of securities held by the public by monetary policy affect yields of securities, that is, how massive withdrawals of long-term Treasury securities reduce yields in the target maturity that in turn could reduce borrowing costs to the private sector, motivating investment and hiring. Quantitative easing is often referred as “unconventional” monetary policy such as in the statement by Bernanke (2010KC) on Aug 27 (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm): “the [Federal Open Market] Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary.” Conventional monetary policy consists of reducing fed funds rates that jointly with subdued inflation expectations by the private sector result in lower short-term real interest rates, or nominal interest rates less inflation expectations (Svensson 2003, 146) lower real rates of longer maturities that stimulate aggregate demand and output, moving the economy out of recession. Conventional policy is not feasible when fed fund rates are as currently at 0 to ¼ percent.
The expectations hypothesis of the term structure of interest rates states “that the relationship between interest rates on different maturities is determined in the main by expectations as to the future course of interest rates” (Lutz 1940, 62). Consider an example by Kessel (1965, 6) that the one-year rate is 2 percent and the two-year rate 3 percent. The forward rate is the rate implied between the one-year and two-year rates. The current price of the one-year security is exp (-0.2) = exp (-0.02) = 0.98020 and the price of the two-year security is exp (-0.2x3) = exp (-0.06) = 0.94176. The forward rate between the two-year security and the one-year security is: ln (exp(-.rn)/exp(-.r(n-1)) = ln (exp -0.02/exp(-0.06) = 0.04 or 4 percent, where ln is the natural logarithm, r the yield of the security and n the number of periods. The unbiased expectations hypothesis states that “the forward rates are unbiased estimates of future short-term rates. Four percent is not only the forward rate—it is the expected one-year rate one year hence, i.e., it is what the market thinks the one-year rate will be one year hence” (Kessel 1965, 6).
In conventional monetary policy the effects on long-term yields are processed through the lowering of short-term interest rates, such as lower fed funds rates in the US. Lutz (1940, 37) argues that in an economy with (1) perfect foresight or accurate forecasting, (2) zero investment costs for borrowers and lenders and (3) borrowers and lenders shift throughout all maturities, the long-term rate can be conceived “as a sort of average of the future short-term rates.” Let f(t, T) be the forward rate that is derived, as 4 percent in the example, from the rates at time t, one-year security in the example, and time T, two-year security in the example, that is the rate that applies from extending maturity by one year from t (one year) to T (two years). Let rT be the one-year rate at time T, then in the certain economy f(t, T) = rT for all t ≤ T. This equality is assured by the lack of arbitrage opportunities because otherwise arbitrageurs could obtain a profit trading in bonds of periods T and T+1. The unbiased expectations hypothesis states that E[r] = f(t, T) for all t ≤ T (Ingersoll 1987, 387-92). It is not possible to find a specification for effects on yields of altering quantities of securities by monetary policy withdrawals in the expectations hypothesis (D’Amico and King, 7-9).
An optimizing model from microeconomic foundations is developed by Andrés et al. (2004) with the assumption of imperfect substitution between different classes of securities. The estimates of this model using quarterly data for the US from 1980 to 1999 “confirm that some of the observed deviations of long-term rates from the expectations theory of the term structure can be traced to movements in the relative stocks of financial assets, just as claimed by Tobin (1969)” (Andrés et al, 688). The traditional channel of transmission of monetary policy is by influencing long-term interest rates with changes in the expected path of short-term rates. The “unconventional” or “quantitative easing” channel of monetary policy is processed by increases in base money that alter relative prices of financial securities, thus reducing long-term yields and increasing aggregate demand.
Another approach is by the preferred-habitat models proposed by Culbertson (1957, 1963) and Modigliani Sutch (1966). This approach is formalized by Vayanos and Vila (2009). The model considers investors or “clientele” who do not abandon their segment of operations unless there are extremely high potential returns and arbitrageurs who take positions to profit from discrepancies. Pension funds matching benefit liabilities would operate in segments above 15 years; life insurance companies operate around 15 years; and asset managers and bank treasury managers are active in segments around 15 years (Ibid, 1). Hedge funds, proprietary trading desks and bank maturity transformation activities are examples of potential arbitrageurs. The role of arbitrageurs is to incorporate “information about current and future short rates into bond prices” (Ibid, 12). Suppose monetary policy raises the short-term rate above a certain level. Clientele would not trade on this information, but arbitrageurs would engage in carry trade, shorting bonds and investing at the short-term rate, in a carry “roll-up” trade, resulting in decline of bond prices or equivalently increases in yields. This is a situation of an upward-sloping yield curve. If the short-term rate were lowered, arbitrageurs would engage in carry trade borrowing at the short-term rate and going long bonds, resulting in an increase in bond prices or equivalently decline in yields, or carry “roll-down” trade. The risk premiums of bonds are positively associated with the slope of the term structure (Ibid, 13). Fama and Bliss (1987, 689) find with data for 1964-85 that “1-year expected returns for US Treasury maturities to 5 years, measured net of the interest rate on a 1-year bond, vary through time. Expected term premiums are mostly positive during good times but mostly negative during recessions.” Vayanos and Vila (2009) develop a model with two-factors, the short-term rate and demand or quantity. The term structure moves because of shocks of short-term rates and demand. An important finding is that demand or quantity shocks are largest for intermediate and long maturities while short-rate shocks are largest for short-term maturities.
The research by D’Amico and King (2010) analyzes the impact of the purchase of $300 billion Treasury securities by the Fed between Mar and Oct 2009. The effects of LSAP of Treasury securities may have broader implications especially now that an additional $600 billion may be purchased while the maturing portfolio is reinvested in Treasury securities. The model of Vayanos and Vila (2009) permits a specification of the term structure including both short-rate and quantity independent variables. The empirical results suggest a “flow” effect of decreasing bond yields by 3.5 basis points in the days of Fed purchases and a “stock” effect of downward shift of the yield curve by 50 basis points over the period of the program with strongest effects in the 10 to 15-year segment.
II Debate on Quantitative Easing. A group of academics, market participants, political and economic analysts and former senior government officials sent a letter to Fed Chairman Ben Bernanke published on Nov 15 (http://blogs.wsj.com/economics/2010/11/15/open-letter-to-ben-bernanke/). The letter advises that quantitative easing should be reevaluated and abandoned because it is not appropriate or required under current conditions. There are risks of dollar devaluation and inflation without attaining the objective of increasing employment. The letter quotes Chairman Bernanke on the inability of the Fed to solve on its own all the problems of the economy. Promoting economic growth would require adjustment in tax, spending and regulation but not additional monetary stimulus. The letter challenges the need to increase inflation and expresses the concern that financial markets will be distorted by more LSAPs with interest rates near zero after a year of recovery from recession. Efforts by the Fed to normalize monetary policy in the future would be jeopardized.
Chairman Bernanke explained again the policy of quantitative easing on Nov 19, arguing that it is adequate in current conditions (http://www.federalreserve.gov/newsevents/speech/bernanke20101119a.htm). The effects of quantitative easing are similar to conventional monetary policy but acting more directly in lowering long-term interest rates that “support household and business spending” and proved effective because “financial conditions eased notably in anticipation of the Federal Reserve’s policy announcement” (Ibid, 6). The Fed will maintain inflation not higher than 2 percent or lower than “a bit less” of 2 percent, in what is known as a symmetric price target. Bernanke reiterated that the Fed has tools with which to increase interest rates again whenever warranted by economic conditions. Bernanke summarizes the policy dilemma as follows (Ibid, 7):
“On its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank alone. The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combined near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.”
III Global Yield Hunt. Chairman Bernanke argues that LSAP or quantitative easing affects “the yield on the acquired securities and, via substitution effects in investors’ portfolio, on a wider range of assets” (Ibid, 6). D’Amico and King (2010, 7) find that there are two conditions for quantitative easing to meaningfully reduce private interest rates: Condition 1 requires that LSAP reduce Treasury yields; and Condition 2 requires that private-sector credit interest rates depend on Treasury yields. There is apparent contradiction in these conditions. Financial assets related to private-sector credit, such as securitized bonds of mortgages, credit cards, vehicle purchases, consumer loans, bank loans, corporate debt and the like, must be close substitutes for Treasury securities acquired by quantitative easing. There is a dimension issue in that “the pool from which the Treasury LSAP program was draining included not just Treasuries themselves but at least some portion of the vast markets for mortgages, consumer credit and corporate debt—to say nothing of foreign securities—and by this standard $300 billion would appear to be an almost trivial amount” (Ibid, 7).
McKinsey & Co (2007, 32) provides measurements of a broad financial aggregate of the financial stock in 2005, including equities, bonds, loans and deposits, that was $51 trillion in the US, $38 trillion in the euro area and $20 trillion in Japan, without counting emerging markets (see Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 168-79). The near zero interest rates in 2003-2004, in an earlier fear of deflation at the Fed, caused the carry trade of borrowing at near zero in the US and taking long positions in commodities, emerging market stocks, exchange rates and financial assets that caused the world hunt for yields documented in Table 2. Vayanos and King (2009) calculate the price of risk of the short-term interest rate. The near-zero interest rate caused mispricing of this risk. Fed policy, the US housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie distorted risk/return calculations in the financial sector that resulted in excessively high risks and leverage, low liquidity and unsound credit decisions that caused the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4).
The consequences of the global hunt for yields induced by monetary and housing policy are shown in Table 2. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, a more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, an increase in the Shanghai Composite index of 444.2 percent in 2005-7, jump in the Nikkei Average by 131.2 percent between 2003 and 2007, rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates induced significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and debt securities, junk bonds and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 203-4, Government Intervention in Globalization (2009c), 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 percent on Jun 12, 2007, collapsing to 2.247 percent on Dec 31, 2008, and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. Central bank policy induced the financing of nearly everything with short-dated funding at very low interest rates. When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2008 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. The combination of short-term zero interest rates, similar effects to quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.
Table 1, Volatility of Assets
| DJIA | 10/08/02-10/01/07 | 10/01/07-3/4/09 | 3/4/09- 4/6/10 | |
| ∆% | 87.8 | -51.2 | 60.3 | |
| NYSE Financial | 1/15/04- 6/13/07 | 6/13/07- 3/4/09 | 3/4/09- 4/16/07 | |
| ∆% | 42.3 | -75.9 | 121.1 | |
| Shanghai Composite | 6/10/05- 10/15/07 | 10/15/07- 10/30/08 | 10/30/08- 7/30/09 | |
| ∆% | 444.2 | -70.8 | 85.3 | |
| STOXX EUROPE 50 | 3/10/03- 7/25/07 | 7/25/07- 3/9/09 | 3/9/09- 4/21/10 | |
| ∆% | 93.5 | -57.9 | 64.3 | |
| UBS Com. | 1/23/02- 7/1/08 | 7/1/08- 2/23/09 | 2/23/09- 1/6/10 | |
| ∆% | 165.5 | -56.4 | 41.4 | |
| 10-Year Treasury | 6/10/03 | 6/12/07 | 12/31/08 | 4/5/10 |
| % | 3.112 | 5.297 | 2.247 | 3.986 |
| USD/EUR | 7/14/08 | 6/03/10 | 8/13/10 | |
| Rate | 1.59 | 1.216 | 1.323 | |
| New House | 1963 | 1977 | 2005 | 2009 |
| Sales 1000s | 560 | 819 | 1283 | 375 |
| New House | 2000 | 2007 | 2009 | 2010 |
| Median Price $1000 | 169 | 247 | 217 | 203 |
Sources: http://online.wsj.com/mdc/page/marketsdata.html
http://www.census.gov/const/www/newressalesindex_excel.html
IV Global Devaluation War. Bernanke reminds that coordinated policy actions by many countries, such as in monetary policy by central banks, were instrumental in recovering from the global recession (http://www.federalreserve.gov/newsevents/speech/bernanke20101119a.htm). National interests are diverging from those of the global economy as a whole because of the “two-speed recovery” manifested in output 8 percent below pre-crisis levels in advanced countries and only 1.5 percent below pre-crisis levels in emerging countries. Output has grown by 70 percent in China since the beginning of 2005 and by 55 percent in India. In the US, the unemployment rate has remained just below 10 percent in the past 18 months. The “two-speed” recovery requires continuing easing of monetary policy in the advanced countries while the emerging countries face tightening as inflation resurfaced. Bernanke argues that dollar fluctuation reflects risk aversion shocks with the dollar appreciating when risk aversion increases and depreciating as capital flows to risk assets again. Bernanke argues that “to a large degree, these capital flows have been driven by perceived return differentials that favor emerging markets, resulting from factors such as stronger expected growth—both in the short term and in the longer run—and higher interest rates, which reflect differences in policy settings as well as other factors” (Ibid, 9). A key factor is the expectation of further appreciation of currencies in emerging countries because appreciation reflecting fundamentals is, according to Bernanke, incomplete as a result of intervention by authorities to prevent or contain full appreciation. In this view, some countries, primarily China, have undervalued their currencies pursuing a long-term export-led growth strategy that have created global imbalances, such as a projected current account surplus in 2015 in China of 7.8 percent of GDP and a mirror projected current account deficit in the US of 3.3 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx). Monetary policy easing is required to accelerate growth in the US without which global growth would not be adequate, harming the welfare of the world as a whole. Bernanke reminds the experience with the gold standard that contributed to the Great Depression because of national policies that prevented adjustment, causing worldwide reduction of welfare (for a survey of literature on the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217). A mechanism to promote adjustment of global imbalances would be required currently to promote rebalancing of growth that can ensure prosperity for the world economy as a whole and for all countries.
There is a more convincing analytical narrative of carry trade arbitrage in world capital markets. Reserve bank credit in the Fed balance sheet on Nov 17 stood at $2.297 trillion, with a portfolio of long-term securities of $1.993 trillion, consisting of $0.806 trillion of US Treasury notes and bonds, $0.149 trillion of federal agency debt securities and $1.038 mortgage-backed securities. Reserve balances of depository institutions with the Federal Reserve stood at $0.986 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The Fed balance sheet would reach $2.9 trillion if the LSAP or quantitative easing of an extra $0.6 trillion is fully executed. The US dollar continues to be the reserve currency in the world, as Bernanke finds, in exit into dollars from risk financial assets in search of temporary haven during shocks of turbulence originating recently in European sovereign issues and doubts on restraint of growth in China because of accelerating inflation. The target of the fed funds rate, or key short-rate, in the US economy has been 0 to ¼ percent since Dec 16, 2008 (http://www.federalreserve.gov/monetarypolicy/openmarket.htm).
The carry trade of borrowing at close to the fed funds rate of 0 to ¼ percent and taking long positions in higher maturity Treasury securities is the advisable trade with an upward-sloping yield curve. It is also the mechanism of transmission of monetary policy from short-term interest rates to long-term Treasury yields. The long position in Treasury securities of higher maturities by arbitrageurs increases the prices of Treasury notes and bonds or equivalently lowers yields. Banks and other financial institutions accomplish maturity transformation by mismatching asset/liability maturities, funding with short-term deposits, paying close to the fed funds rate, and lending at higher long-term rates. Arbitrageurs face alternative allocations of financial assets to take long positions while borrowing at near-zero short rates. High returns in commodities, equities and other risk financial assets are more desirable to professional investors. The carry trade from near zero short-term interest rates to long-term Treasury securities probably occurred as suggested by the research of D’Amico and King (2010). It is likely dwarfed by the carry trade from near zero short-term rates into higher risk financial assets.
Tobin’s q variable is the ratio of the market value of capital to the reproduction cost of capital. The concept of capital extends to houses, plants, equipment, durable goods and others (Tobin 1969, 29). Money, M, in Tobin’s complete model of money, physical capital, securities and banks is “high-powered money,” consisting of currency held by the public and reserves of commercial banks at the Fed. Tobin derives the sensitivity of q to M as ∂q/∂M > 0, that is, an increase in base money, M, causes an increase in q, which is the price of the market value of capital relative to its reproduction cost. Current production and asset accumulation increase (see also Pelaez and Suzigan 1978, 120-3). According to Tobin (1969, 25-6): “the essential characteristic is that the interest on money is exogenously fixed by law or convention, while the rate of return on securities is endogenous, market determined. If the roles of the two assets in this respect were reversed, so also would be the economic impacts of changing their supplies. The way for the central bank to achieve an expansionary monetary impact would be to buy money with securities!” The effect of an increase in the supply of an asset with non-fixed rate is a change in its own rate of return. When the rate of return is determined exogenously, as in the case of outside money, the adjustment is by changes in the rates of return of other assets or equivalently their prices. Large scale purchases of securities, or quantitative easing, inject high-powered money or bank reserves in exchange for withdrawal of the supply of duration-rich bonds, reducing their rates of return or increasing their prices. The intended effect is to lower the reproduction cost of capital, or long-term borrowing costs, such that Tobin’s q or its expectation increases, augmenting the demand for physical assets such as plant, equipment, houses, durables goods and the like.
The lack of pass-through from quantitative easing to private-sector investment, consumption and hiring is not insufficient monetary stimulus but the uncertainties created by legislative restructuring, regulation, persistent unemployment, anticipations of large increases in taxes and the lack of belief that the Fed can bloat its balance sheet to $3 trillion without major future increases in interest rates. Lowering short-term interest rates to near zero while injecting $3 trillion of base money does not create growth stimulus but rather excites carry trades on a world financial stock of some $100 trillion. The Fed has to rethink the risks of creating distortions of financial markets, in particular the illusion of near zero price of risk.
The anticipation of another LSAP program or quantitative easing gained traction after the speech of Chairman Bernanke on Aug 27 (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm). Table 2 is updated in this blog every week to track the financial turbulence created by events such as sovereign risk doubts in Europe and recurring inflation and growth fears in China. The last column provides what daily market participants have been observing that the dollar has depreciated by 14.7 percent from its high on Jun 7, 2010, while all risk financial assets have gained by high double digit percentages in a few months. The major effect of unconventional monetary policy or combination of near-zero short-term interest rates with injection of trillions of dollars of base money is carry trade into risk financial assets without much repercussion in increasing investment, consumption and hiring. Unconventional monetary policy has created an illusory put on financial wealth that creates professional carry trade by realizing profits rapidly instead of believing in long-term trades as in the earlier incarnation after 2003. Who wants to be long when the Federal Open Market Committee (FOMC) evaluates that inflation is accelerating and rate increases are desired? Expectations cause bond price debacles now and not on the date of the announcement of tight monetary policy.
Table 2, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% to 11/19 | ∆% Week 11/19 | ∆% T to 11/19 | |
| DJIA | 4/26/10 | 7/2/10 | -13.6 | -0.02 | 0.1 | 15.6 |
| S&P 500 | 4/23/10 | 7/20/10 | -16.0 | -1.4 | 0.04 | 17.3 |
| NYSE Finance | 4/15/10 | 7/2/10 | -20.3 | -2.8 | -0.3 | 19.1 |
| Dow Global | 4/15/10 | 7/2/10 | -18.4 | -2.7 | 0.1 | 19.2 |
| Asia Pacific | 4/15/10 | 7/2/10 | -12.5 | 2.9 | -0.5 | 17.6 |
| Japan Nikkei Average | 4/05/10 | 8/31/10 | -22.5 | -12.0 | 3.1 | 13.6 |
| China Shanghai | 4/15/10 | 7/16/10 | -24.7 | -8.7 | -3.2 | 19.2 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -5.5 | -0.7 | 11.6 |
| DAX | 4/26/10 | 5/25/10 | -10.5 | 4.3 | 1.7 | 16.5 |
| Dollar Euro | 11/25 2009 | 6/7 2010 | 21.2 | 9.5 | 0.1 | -14.7 |
| DJ UBS Comm. | 1/6/10 | 7/2/10 | -14.5 | -0.01 | -1.9 | 16.9 |
| 10-Year Tre. | 4/5/10 | 4/6/10 | 3.986 | 2.877 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://online.wsj.com/mdc/page/marketsdata.html
Advice to the Bank of Japan by Bernanke before joining the Fed emphasizes the needs to devalue to escape deflation (http://www.iie.com/publications/chapters_preview/319/7iie289X.pdf 161): “The BOJ could probably undertake yen depreciation unilaterally; because the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its mandated objective.” Is depreciation of the dollar the best available tool currently for achieving the dual mandate of higher inflation and lower unemployment? Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):
“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the US deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”
Should the US devalue the dollar following the example of Roosevelt?
Fed policy is seeking, deliberately or as a side effect, what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher, 1933, 350). The Fed has created not only high volatility of assets but also what many countries are regarding as a competitive devaluation similar to those criticized by Nurkse (1944). There is increasing unrest within the G20 and worldwide about the appreciation of exchange rates of most countries while the dollar devalues, as shown in Table 3. Global coordination of policies with free riders in an institution of diverse interests such as the G20 is unlikely. Distortions of financial markets in the US and worldwide depend only on more sober evaluation of risks of unconventional policies at a body without free riders, the FOMC.
Table 3, Exchange Rates
| Peak | Trough | ∆% P/T | Nov 19 2010 | ∆% T Nov 19 | ∆% P Nov 19 | |
| EUR USD | 7/15 2008 | 6/7 2010 | 11/19 2010 | |||
| Rate | 1.59 | 1.192 | 1.367 | |||
| ∆% | -33.4 | 12.8 | -16.3 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 11/19 2010 | |||
| Rate | 110.19 | 83.07 | 83.54 | |||
| ∆% | 24.6 | -0.6 | -24.2 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 10/22 2010 | |||
| Rate | 1.225 | 1.025 | 0.999 | |||
| ∆% | 16.3 | 2.5 | 18.5 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 11/19 2010 | |||
| Rate | 2.006 | 1.388 | 1.598 | |||
| ∆% | -44.5 | 13.2 | -25.5 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 11/19 2010 | |||
| Rate | 0.979 | 0.601 | 0.986 | |||
| ∆% | -62.9 | 39.0 | 0.7 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 11/19 2010 | |||
| Rate | 11.578 | 7.238 | 6.986 | |||
| ∆% | 37.5 | 3.4 | 39.7 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 11/19 2010 | |||
| Rate | 1.553 | 1.348 | 1.295 | |||
| ∆% | 13.2 | 3.9 | 16.6 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 11/19 2010 | |||
| Rate | 7.813 | 7.752 | 7.764 | |||
| ∆% | 0.8 | 0 | 0.8 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 11/19 2010 | |||
| Rate | 2.43 | 1.737 | 1.716 | |||
| ∆% | 28.5 | 1.2 | 29.4 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 10/22 2010 | |||
| Rate | 22.19 | 18.693 | 18.038 | |||
| ∆% | 15.7 | 3.5 | 18.7 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 11/19 2010 | |||
| Rate | 9.313 | 7.108 | 6.857 | |||
| ∆% | 23.7 | 3.5 | 26.3 |
Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough
Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation
Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000
V Economic Indicators. The economy is expanding moderately without consumer price inflation but higher producer price inflation while employment markets remain weak. Consumer price inflation has risen in the euro area to an annual rate of 1.9 percent in Oct 2010 relative to a negative annual rate of 0.1 percent in Oct 2009. Advanced US retail and food services sales seasonally adjusted (SA) rose 1.2 percent in Oct relative to Sep and 7.3 percent relative to Oct 2009. In the quarter Aug to Oct 2010 US retail and food services sales rose by 6.3 percent relative to the same quarter in 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf). Manufacturers’ distributive trade sales and shipments SA rose 0.5 percent in Sep relative to Aug and 8.9 percent relative to Sep 2009 while manufacturers’ and trade inventories rose by 0.9 percent and 6.3 percent relative to a year earlier (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf). Housing starts in Oct were at a SA annual rate of 519,000 or 11.7 percent below the revised Sep estimate and 1.9 percent below the rate of 529,000 in Oct 2009. Housing permits were higher by 0.5 percent in Oct relative to Sep and 4.5 percent below the rate in Oct 2009 (http://www.census.gov/const/newresconst.pdf). Housing starts not seasonally adjusted (NSA) were 508,000 in Jan-Oct 2010 (http://www.census.gov/const/newresconst.pdf Table 1, 2) or a decline by 72.2 percent relative to 1,825,200 in Jan-Oct 2005 (http://www.census.gov/const/newresconst_200510.pdf Table 1, 2). Total industrial production in the US was unchanged in Oct after declining by 0.2 percent in Sep but manufacturing output rose by 0.5 percent in Oct after falling by 0.1 percent in Sep. Total industry capacity utilization was unchanged at 74.8 percent in Oct, 6.6 percentage points above the low in Jun 2009 but 5.8 percentage points lower than the average from 1972 to 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm). The Empire State Manufacturing Survey of the New York Fed for Nov was disappointing with a decline of the general business conditions index by 27, reaching -11.1. The decline in the new orders index was atrocious, by 37 points to -24.4 (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html). The Philadelphia Fed business outlook survey was extremely good with the index of current activity jumping from 1.0 in Oct to 22.5 in Nov, for the highest reading since Dec 2009. Indexes of new orders and shipments also rose by 15 points (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2010/bos1110.pdf). Initial claims SA were 439,000 in the week ending on Nov 12 for an increase of 2.000 from the previous week’s revised estimate of 437,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm). The consumer price index rose 0.2 percent SA from Oct and 1.2 percent NSA relative to Oct 2009. The core index, excluding food and energy, SA, was unchanged in Oct for the third consecutive month and increased by 0.6 percent relative to a year earlier (http://www.bls.gov/news.release/pdf/cpi.pdf). The producer price index SA rose 0.4 percent in Oct for three consecutive monthly increases by 0.4 percent in Aug to Oct. The index NSA rose by 4.3 percent in the 12 months ending in Oct 2010 (http://www.bls.gov/news.release/pdf/ppi.pdf). Annual inflation in the euro area was 1.9 percent in Oct 2010, higher than 1.8 percent in Sep and minus 0.1 percent in Oct 2009 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16112010-AP/EN/2-16112010-AP-EN.PDF).
VI Interest Rates. The yield curve continues to move upwardly. The yield of the 10-year Treasury was 2.88 percent on Nov 19, higher than 2.76 percent a week ago and 2.54 percent a month ago. The 10-year government bond of Germany was 2.70 percent for negative spread relative to the comparable Treasury of 17 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1290359527848). On Nov 19, the US Treasury with coupon of 2.63 maturing in 11/20 traded at price of 97.86 or equivalent yield of 2.87 percent (http://markets.ft.com/markets/bonds.asp?ftauth=1290359527848). The same bond would trade at price of 100.7896 or yield of 2.54 percent a month earlier for a loss of 2.9 percent in one month, at price of 88.9135 or yield of 3.986 percent traded on Apr 4, 2010, for loss of 9.1 percent, and at price of 79.5131 or yield of 5.297 percent traded on Jul 12, 2007, for a loss of 18.7 percent. The eventual back up of short-term rates and yields undermines exit strategies of quantitative easing because of the pain caused on investors and the balance sheet of the Fed.
VII Conclusion. The jump of euro zone annual inflation from minus 0.1 percent in Oct 2009 to 1.9 percent in Oct 2010 and of consumer price inflation in China to 4.4 percent illustrate the risks of a symmetric inflation target that may attempt to raise inflation to 1.99 percent but may overshoot to 4 percent. Who wants to own risk financial assets in that overshooting? Unconventional monetary policy encourages high-risk carry trades that could cause another financial crisis if unwound suddenly but cannot jump-start investment and consumption decisions that have been shocked by legislative restructurings, regulation and fears of taxation and increases in interest rates.
References
Andrés, Javier, J. David López-Salido and Edward Nelson. 2004. Tobin’s imperfect asset substitution in optimizing equilibrium. Journal of Money, Credit and Banking 36 (4, Aug): 665-90.
Bernanke, Ben S. 2010KC. The economic outlook and monetary policy. Jackson Hole, WY, FRBKC, Aug 27. http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.pdf
Culbertson, John M. 1957. The term structure of interest rates. Quarterly Journal of Economics 71 (4, Nov): 485-517.
Culbertson, John M. 1963. The term structure of interest rates: reply. Quarterly Journal of Economics 77 (4, Nov): 691-6.
D’Amico Stefania and Thomas B. King. 2010. Flow and stock effects of large-sale Treasury purchases. Washington, DC, Federal Reserve board, Sep. http://www.federalreserve.gov/pubs/feds/2010/201052/201052pap.pdf
Fisher, Irving. 1933. The debt-deflation theory of great depressions. Econometrica 1 (4, Oct): 337-57.
Ingersoll, Jr., Jonathan E. 1987. Theory of financial decision making. Totowa, NJ: Rowan.
Kessel, Reuben A. 1965. Explanations of the term structure of interest rates. In The cyclical behavior of the term structure of interest rates. NBER Occasional Paper 91. http://www.nber.org/chapters/c1662.pdf
Lutz, Friedrich A. 1940. The structure of interest rates. Quarterly Journal of Economics 55 (1, Nov): 36-63.
McKinsey & Co. 2007. Sustaining New York’s and the US’ global financial services leadership. New York: McKinsey & Co.
Modigliani, Franco and Richard Sutch. 1966. Innovations in interest rate policy. American Economic Review 56 (1/2, Mar): 178-97.
Nurkse, Ragnar. 1944. International currency experience: lessons of the interwar experience. Geneva: League of Nations.
Pelaez, Carlos M. and Carlos A. Pelaez. 2005. International Financial Architecture. Basingstoke: Palgrave Macmillan. http://us.macmillan.com/QuickSearchResults.aspx?search=pelaez%2C+carlos&ctl00%24ctl00%24cphContent%24ucAdvSearch%24imgGo.x=26&ctl00%24ctl00%24cphContent%24ucAdvSearch%24imgGo.y=14 http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2007. The Global Recession Risk. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2008a. Globalization and the State: Vol. I. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2008b. Globalization and the State: Vol. II. Basingstoke: Palgrave Macmillan.
Pelaez, Carlos M. and Carlos A. Pelaez. 2008c. Government Intervention in Globalization. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2009a. Financial Regulation after the Global Recession. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2009b. Regulation of Banks and Finance. Basingstoke: Palgrave Macmillan.http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos Manuel and Wilson Suzigan. 1978. Economia Monetária. São Paulo, Atlas.
Svensson, Lars E. O. 2003. Escaping from a liquidity trap and deflation: the foolproof way and others. Journal of Economic Perspectives 17 (4, Autumn): 145-66.
Tobin, James. 1969. A general equilibrium approach to monetary theory. Journal of Money Credit and Banking 1(1, Feb): 15-29.
Vayanos, Dimitri and Jean-Luc Vila. 2009. A preferred-habitat model of the term structure of interest rates. New Orleans, AFA Meetings Paper, Nov 1. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=971439
©Carlos M. Pelaez, 2010
No comments:
Post a Comment