Professor McKinnon’s “Bubble Economy,” World Inflation, Deregulation by Executive Order and the Dodd-Frank Act

Professor McKinnon’s “Bubble Economy,” World Inflation, Deregulation by Executive Order and the Dodd-Frank Act

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011

The objective of this post is to analyze the recent contributions of Professor Ronald I. McKinnon to the understanding of US monetary policy and its effects on financial risk assets and world financial markets. Some of the implications of the “credit supply constraint” in the analysis of Professor McKinnon are related to the recent efforts of deregulation by White House executive order and the Dodd-Frank Act in (IB). The contents are as follows:

I Professor McKinnon’s “Bubble Economy”

IA “Bubble Economy

IB “Credit Supply Constraint”

IC “Cusp of Worldwide Inflation”

ID “Beggar-Thy-Neighbor Interest Rates”

II Economic Indicators

III Interest Rates

IV Conclusion

References

I Professor McKinnon’s “Bubble Economy.” The objective of this section is providing a synthesis of the revealing analysis by Professor Ronald I. McKinnon, Stanford University, in multiple recent essays of the distortions of monetary policy in the US in originating the financial crisis, preventing economic recovery and creating adverse international repercussions (McKinnon 2009JEA, 2009 IE, 2010BTN, 2010GI, 2010USD, 2011CWI; 2011INF, 2009; McKinnon and Schnabl 2009). Several subsections provide the analysis with titles derived from McKinnon’s various contributions: (IA) “Bubble Economy; (IB) “Credit Supply Constraint;” (IC) “Cusp of World Inflation;” and (ID) “Beggar-Thy-Neighbor Interest Rates.”

IA “Bubble Economy.” McKinnon (2011INF, 2011CWI) provides the essence of his analysis in succinct, accessible text that is rich in interpretation and policy implications. Monetary policy before and during the credit/dollar crisis and global recession and currently is characterized by McKinnon (2011IN, 2011CWI) as the “bubble economy” created by near zero interest rates. There were two shocks of near zero interest rates identified by McKinnon:

1. “Greenspan-Bernanke Interest Rate Shock of 2003-2004”. On the basis of fear of deflation that never materialized (Bernanke 2002), the Federal Open Market Committee (FOMC) lowered the fed funds rate target to 1 percent on Jun 25, 2003 (http://federalreserve.gov/boarddocs/press/monetary/2003/20030625/default.htm) and left it at that level until Jun 30, 2004 (http://federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) when it began to raise it by 17 consecutive increments of 25 basis points in FOMC meetings to reach 5.25 percent on Jun 29, 2006 (http://federalreserve.gov/newsevents/press/monetary/20060629a.htm). There was an initial form of quantitative easing in the suspension of the auction of 30-year bonds by Treasury with the objective of increasing prices of mortgage-backed securities that was equivalent to reducing mortgage rates. McKinnon (20011IN, 2011CWI) explains that the 1 percent target of fed funds rates caused a carry trade from these low rates to two classes of risk assets: (i) auction-traded assets such as commodities soared in value after 2003 and the dollar collapsed in value; and (ii) US home prices increased by over 50 percent from the beginning of 2003 to mid 2006 with a building boom that spread to countries such as the UK, Spain and Ireland. The origin of the credit/dollar crisis is explained by McKinnon (2011CWI, 2) as: “the residue of bad debts, particularly ongoing mortgage defaults, led to the banking crisis and global downturn of 2008 into 2009—all too painfully known.” The now available transcripts of the FOMC meeting on Jun 29, 30, 2005, discussing a presentation on housing, reveal the comments by the Vice-Chairman of the FOMC, Timothy Geithner: “It’s worth noting, though, that these risks—from a cliff in housing prices to a sharp increase in household savings, to a larger and more sustained oil shocks, to less favorable future productivity outcomes, to a sharp increase in risk premia or to declines in asset prices—in general are risks that we can’t really mitigate substantially ex ante through monetary policy” (FOMC 2005JM, 138; see also FOMC 2005PM). Participants of the FOMC meetings in 2005 interviewed by Bloomberg find that the Fed fueled the housing boom by the slow and predictable interest rate policy that added the term “measured” to the FOMC statements as the form of reducing policy accommodation in small increments (FOMC 2005JM, 124, 155, 159, 170; see http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aMsKd2nN3.sY). At the meeting of the FOMC on Jun 29/30, 2005, FRBSF economist John C. Williams estimated with unusual anticipation that the decline of house prices by 20 percent from those prevailing at that time would “reduce household wealth by $3.6 trillion (30% of current GDP)”(FOMC 2005PM, 26). The carry trade of “buying” money at near zero riskless interest rates and shorting the dollar to invest or take long risk positions caused a gigantic valuation of risk financial assets and real estate that is shown in Table 1. McKinnon (20011CWI, 2011IN) also observes the rapid depreciation of the dollar after 2003 that is now shown in Table 1 from $1.1423 on Jun 26, 2003 (using Federal Reserve data) to $1.5914 on Jul 14, 2008 (using WSJ data confirmed by Federal Reserve data) for a cumulative devaluation of 39.3 percent. The last row shows the rise of Dec to Dec consumer price inflation (CPI) rising from 1.9 percent in 2003 to 3.4 percent in 2005 and 4.1 percent in 2007. The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (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).

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	6/26/03	7/14/08	6/03/10	8/13/10
Rate	1.1423	1.5914	1.2126	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
	2003	2005	2007	2010
CPI	1.9	3.4	4.1	1.5

Sources: http://online.wsj.com/mdc/page/marketsdata.html

http://www.census.gov/const/www/newressalesindex_excel.html

http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

2. “Bernanke Shock.” McKinnon (2011CWI, 1) finds policy in this shock as: “the Fed has set U.S. short-term interest rates at essentially zero since Sep 2008 followed in 2010 by QEs 1&2 [quantitative easing 1, Dec 2008 to Mar 2009, and 2, after Nov 3] to drive down long rates.” The result of monetary policy (Ibid, 1) is that: “just in 2010 alone, all items in The Economist’s dollar commodity price index rose 33.5 percent, while the industrial raw materials component soared a remarkable 37.4 percent.” Chairman Bernanke (2010WP) explained on Nov 4 the objectives of purchasing an additional $600 billion of long-term Treasury securities and reinvesting maturing principal and interest in the Fed portfolio. Long-term interest rates fell and stock prices rose when investors anticipated the new round of quantitative easing. Growth would be promoted by easier lending such as for refinancing of home mortgages and more investment by lower corporate bond yields. Consumers would experience higher confidence as their wealth in stocks rose, increasing outlays. Income and profits would rise and, in a “virtuous circle,” support higher economic growth. Yellen (2011AS, 6) broadens the effects of quantitative easing by adding dollar devaluation: “there are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boosts household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.” There are two problems with this analysis of quantitative easing: (i) the general equilibrium model of Tobin (1969) as extended by Andrés et al (2004) consists of a set of j = 1,2,∙∙∙m portfolio balance equations for i = 1,2,∙∙∙n capital assets, A_ij = f(r, x), where r is the 1xn vector of rates of return (interest plus capital gains) r_i and x the vector of other relevant variables (Tobin 1969, 5). Fed policy chooses only three of n capital assets that can be stimulated by Fed policy: (a) long-term securities that are close substitutes of securitization of loans to lower their rates and stimulate investment and consumption of aggregate demand; (b) the US stock market to increase perceived wealth of households in the effort to increase consumption and home buying and construction; and (c) devaluation of the dollar to improve the trade account in the effort to grow the economy by net exports. In practice, the Fed cannot anticipate the carry trade from zero interest rates to the other n-3 capital assets, or actually to the entire n capital assets, including multiple risk financial assets such as auction-traded commodities, currencies and foreign stocks; and (ii) world markets for financial assets have been shocked by bouts of risk aversion resulting from sovereign risk issues in Europe; increase of inflation in China that prompts tight monetary policies that can reduce growth of the Chinese economy, affecting world financial markets, Asian economies and the world economy; and uncertainties about growth in the US in an expansion phase characterized by legislative restructurings, implementation of intrusive regulation, record deficits/government debt and increasing expectations of taxation and sharp increases in interest rates rising from zero. Zero interest rates constitute a necessary condition for higher valuations of capital assets especially risk financial assets in an upward trend, in what McKinnon calls the “Bernanke shock,” but with sharp fluctuations originating in the shocks in Europe, China and the US. A sufficient condition for the “trend is my friend” stimulus to carry trade from zero interest rates to risk financial asset valuations is subdued risk aversion from the shocks in Europe, China and the US. Investors have learned from the losses of the credit/dollar crisis or by avoiding the losses and are more cautious than before, implementing strategies of buying and rapidly realizing profits. Table 2 illustrates the carry trade, which is now trading more opportunistically on a learning curve far ahead of that of the Fed. The trend observed by McKinnon resulted in a rise of valuations of risk financial assets that reached a peak in the second half of Apr. Sovereign risk issues in Europe caused significant risk aversion that lasted until early Jul, which is shown in the fourth column of Table 2, “∆% to Trough,” in sharp declines of all risk financial assets, most of which are in the n-3 segment not mentioned in policy analysis by the Fed and are traded in auction markets such as global stocks, commodities and currencies. The appreciation of the dollar by 21.2 percent shows the flight into temporary safety of dollar assets that caused a collapse of long-term yields of dollar-denominated securities such as Treasury notes and bonds. The final column, “∆% Trough to 1/21/11,” shows the trend of carry trade from zero interest rates in the US to long leveraged positions in risk financial assets all of which soared in valuations except for devaluation of the dollar by 14.3 percent after subdued sovereign risks in Europe.

Table 2, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 1/ 21/11	∆% Week 1/ 21 /11	∆% Trough to 1/ 21 /11
DJIA	4/26/ 10	7/2/10	-13.6	5.9	0.7	22.6
S&P 500	4/23/ 10	7/20/ 10	-16.0	5.4	-0.8	25.5
NYSE Finance	4/15/ 10	7/2/10	-20.3	-3.6	-1.0	21.1
Dow Global	4/15/ 10	7/2/10	-18.4	2.7	-0.1	25.8
Asia Pacific	4/15/ 10	7/2/10	-12.5	6.7	-1.7	21.9
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-9.8	-2.1	16.4
China Shang.	4/15/ 10	7/02 /10	-24.7	-14.2	-2.7	13.9
STOXX 50	4/15/10	7/2/10	-15.3	-1.5	-0.3	16.4
DAX	4/26/ 10	5/25/ 10	-10.5	11.5	-0.2	24.5
Dollar Euro	11/25 2009	6/7 2010	21.2	9.9	-1.7	-14.3
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	11.6	0.1	30.6
10-Year Tre.	4/5/ 10	4/6/10	3.986	3.414

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

Table 2 shows in the fifth column, “∆% Peak to 1/21/11,” that the valuations from the peak in the second half of Apr 2010 to Fri Jan 21, 2011, were modest, such as 5.9 percent for the DJIA from Apr 26, and 5.4 percent for the S&P 500 since Apr 23, compared with 22.6 percent for the DJIA since the trough on Jul 2 and 25.5 percent for the S&P 500 since the trough on Jul 20. The visible exceptions are the DAX stock index of Germany and the DJ UBS commodities index, showing sharp recoveries from their peaks in Apr and also gains over 20 percent since their troughs. Table 3 shows the percentage changes of the DJIA and S&P 500 since Apr 26 with much less dynamism than from their troughs as shown in Table 2. The carry trade from zero interest rates to risk financial assets is not on a friendly trend, as desired by traders, but subject to fluctuations of risks in Europe, Asia and the United States that originated in the adjustment policies to the global recession.

Table 3, Percentage Changes of DJIA and S&P 500 in Selected Dates

2010	∆% DJIA from earlier date	∆% DJIA from Apr 26	∆% S&P 500 from earlier date	∆% S&P 500 from Apr 26
Apr 26
May 6	-6.1	-6.1	-6.9	-6.9
May 26	-5.2	-10.9	-5.4	-11.9
Jun 8	-1.2	-11.3	2.1	-12.4
Jul 2	-2.6	-13.6	-3.8	-15.7
Aug 9	10.5	-4.3	10.3	-7.0
Aug 31	-6.4	-10.6	-6.9	-13.4
Nov 5	14.2	2.1	16.8	1.0
Nov 30	-3.8	-3.8	-3.7	-2.6
Dec 17	4.4	2.5	5.3	2.6
Dec 23	0.7	3.3	1.0	3.7
Dec 31	0.03	3.3	0.07	3.8
Jan 7	0.8	4.2	1.1	4.9
Jan 14	0.9	5.2	1.7	6.7
Jan 21	0.7	5.9	-0.8	5.9

Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004

IB “Credit Supply Constraint.” At its meetings on Dec 16, 2008, “the Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to ¼ percent” (http://federalreserve.gov/newsevents/press/monetary/20081216b.htm). At its latest meeting on Dec 16, 2010, the FOMC decided to “maintain the target range for the federal funds rate at 0 to ¼ percent” and anticipated that conditions “are likely to warrant exceptionally low levels for the federal funds rate for an extended period” (http://federalreserve.gov/newsevents/press/monetary/20101214a.htm). McKinnon (2009IE, 21; 2009JEA, 11) finds that loose monetary policy during the economic contraction was valuable to a certain degree “but flooding the system with excess liquidity that drives short-term interest rates to near zero has been a serious mistake.” The argument for lowering short-term interest rates is that aggregate demand is insufficient to generate growth and could be stimulated by lower interest rates. McKinnon (2009JEA, 11) argues that lowering rates from a low level as from 2.00 percent on Apr 30 to 0 to ¼ percent on Dec 16 (http://federalreserve.gov/monetarypolicy/openmarket.htm) does not result in substantial growth of aggregate demand. Defaults in underlying mortgages in mortgage-backed securities and their derivatives increased counterparty risk perceptions such that banks were uncertain about the quality of the assets in their own balance sheets and of assets in the balance sheets of potential counterparties in financial transactions (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 48-52, 255-7, Regulation of Banks and Finance (2009b), 64-66, 217-24). The wholesale interbank market was nearly paralyzed by sharp increases in spreads of rates on interbank loans relative to the federal funds rate. Banks extend lines of credit to their customers without certainty of how much and at what time will be drawn in what is effectively a forward commitment of the bank to deliver credit in the future. There are no problems for a bank that can always obtain funds by borrowing reserves in the interbank or wholesale market to cover needs for commitments of retail customers at the fed funds rate, which is considered as a riskless rate and as such a floor for other interest rates. The bank does not fear illiquidity because of the availability of funds from the interbank wholesale market. The credit supply constraint is explained by McKinnon (2009JEA, 13) as:

“Positive rates of interest of all terms to maturity are necessary for restoring normal borrowing and lending in the wholesale interbank market. Only then will banks that are liquid—that is, have excess reserves but no good future lending opportunities at retail—will lend to those that are illiquid—that is, have good retail lending opportunities in domestic or foreign trade but no excess reserves. But if the risk-free federal funds rate is close to zero, banks with excess reserves will not bother parting with them for a derisory yield.”

A new executive order mandates review of all regulatory rules throughout the federal government (White House 2011EO, 2011MT, 2011MSB, 2011RS) as explained by the President in an op-ed article in the Wall Street Journal (Obama 2011WSJ). Part of the strategy consists of enhancing the international competitiveness of the US (Immelt 2011WP). The new approach in the executive order mandates “general principles of regulation” (White House 2011EO):

“Our regulatory system must protect public health, welfare, safety and our environment while promoting economic growth, innovation, competitiveness and job creation. It must be based on the best available science. It must take into account benefits and costs.”

Almost simultaneously, the Financial Stability Oversight Council (FSOC) was busy releasing studies and notices of proposed regulation (FSOC 2011VR, 2011LFC, 2011NFC) mandated by the Dodd-Frank Act (United States Congress 2010DF). This regulatory work is not based on “the best available science” and far removed from taking “into account benefits and costs.” Dodd-Frank missed the opportunity for providing balanced regulation actually correcting deficiencies observed during the financial crisis, opening an unusual opportunity for constructive work under the White House executive order on regulation.

Professor David Skeel, of the University of Pennsylvania Law School, analyzes with legal scholarship the Dodd-Frank Act and its “unintended consequences” in a must-read new book (Skeel 2011DF, 8):

“The two themes that emerge, repeatedly and unmistakably, from the 2,000 pages of [Dodd-Frank Act] legislation are (1) government partnership with the largest financial institutions and (2) ad hoc intervention by regulators rather than a more predictable, rules-based response to crises. Each could dangerously distort American finance, making it more politically charged, less vibrant, and further removed from basic rule-of-law principles than ever before in modern American financial history.”

Professor Skeel (2011DF, 13) identifies the “Fannie Mae effect” in Dodd-Frank:

“I have made several references already to the possibility that the government will channel political policy through the large financial institutions that are singled out for special treatment. Historically, this kind of collaboration between the government and large business has been called corporatism. It is a familiar feature of corporate and financial regulation in Europe. Most pervasively, the Dodd-Frank Act invites the government to channel political policy through the big financial institutions by giving regulators sweeping discretion in the enforcement of nearly every aspect of the legislation.”

Dodd-Frank created the “too politically connected to fail” doctrine to protect Fannie and Freddie. There is a credit-supply constraint introduced by Dodd-Frank and its thousands of pages of new rules that are reminiscent of the financial repression in developing countries analyzed by McKinnon (1973) and Shaw (1973) (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 81-6). Credit affects every business and household in the US and its constraint by Dodd-Frank and mandated regulatory rules not only flatten the expansion path of the economy but also erode the competitiveness of financial institutions in the US. The White House executive order on regulation should begin with Dodd-Frank and its rules to secure the general principle of promoting growth and employment.

There are several other uncertainties inhibiting bank lending. FDIC data quoted by the WSJ show that total profits of US banks in the third quarter of 2010 were 48 percent below levels in the third quarter of 2007 while employment in banks fell 9 percent to 2.04 million in the fall of 2010 compared with 2.22 million in the same period in 2007 (http://professional.wsj.com/article/SB10001424052748703921504576094431636101722.html). The KBW Bank Index declined by 83.8 percent from Feb 20, 2007 to Mar 9, 2009 and was lower by 56.4 percent on Jan 20, 2011 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_h_dtabnk&symb=BKX). Basel III rules require capital/risk asset ratios of Tier 1 or shareholder capital that are increasingly more difficult to meet as market valuations of banks decline. Banks’ returns on equity and stock prices differ across all sizes and regions. Write-downs of business lines such as mortgages, consumer credit, debit cards and others continue to cloud the outlook for banking in the midst of an unpredictable regulatory environment. The Dodd-Frank act has created a cloud of uncertainty over financial and even some nonfinancial entities that the White House order can clear. Low interest rates create difficult choices of asset/liability management and prevent profitable operations for insurance companies and mutual and pension fund management.

IC “Cusp of Worldwide Inflation.” On Jan 12, the line “Reserve Bank credit” in the Fed balance sheet stood at $2407,0 billion, or $2.4 trillion, with the portfolio of long-term securities of $2181.2 billion, or $2.2 trillion, composed of $1004.7 billion of notes and bonds, $50.4 billion of inflation-adjusted notes and bonds, $145.9 billion of Federal agency debt securities, and $980.2 billion of mortgage-backed securities; reserves balances with Federal Reserve Banks stood at $1061.6 billion, or $1.1 trillion (http://federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The concern addressed by Yellen (2011AS, 12-4) is that this high level of reserves could eventually result in demand growth that could accelerate inflation. Reserves would be excessively high relative to the levels before the recession. Reserves of depository institutions at the Federal Reserve Banks rose from $45.6 billion in Aug 2008 to $1084.8 billion in Aug 2010, not seasonally adjusted, multiplying by 23.8 times, or to $1038.2 billion in Nov 2010, multiplying by 22.8 times. The monetary base consists of the monetary liabilities of the government, composed largely of currency held by the public plus reserves of depository institutions at the Federal Reserve Banks. The monetary base not seasonally adjusted, or issue of money by the government, rose from $841.1 billion in Aug 2008 to $1991.1 billion or by 136.7 percent and to $1968.1 billion in Nov 2010 or by 133.9 percent (http://federalreserve.gov/releases/h3/hist/h3hist1.pdf). Policy can be viewed as creating government monetary liabilities that ended mostly in reserves of banks deposited at the Fed to purchase $2.1 trillion of long-term securities or assets, which in nontechnical language would be “printing money” (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). The marketable debt of the US government in Treasury securities held by the public stood at $8.7 trillion on Nov 30, 2010 (http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds112010.pdf). The current holdings of long-term securities by the Fed of $2.2 trillion, in the process of converting fully into Treasury securities, are equivalent to 24 percent of US government debt held by the public, and would represent 29.9 percent with the new round of quantitative easing if all the portfolio of the Fed, as intended, were in Treasury securities. Debt in Treasury securities held by the public on Dec 31, 2009, stood at $7.2 trillion (http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds122009.pdf), growing to Nov 30, 2010, by $1.5 trillion or by 20.8 percent. In spite of this growth of bank reserves, “the 12-month change in core PCE [personal consumption expenditures] prices dropped from about 2 ½ percent in mid-2008 to around 1 ½ percent in 2009 and declined further to less than 1 percent by late 2010” (Yellen 2011AS, 3). The PCE price index, excluding food and energy, is around 0.8 percent in the past 12 months, which could be, in the Fed’s view, too close for comfort to negative inflation or deflation. Yellen (2011AS, 12) agrees “that an accommodative monetary policy left in place too long can cause inflation to rise to undesirable levels” that would be true whether policy was constrained or not by “the zero bound on interest rates.” The FOMC is monitoring and reviewing the “asset purchase program regularly in light of incoming information” and will “adjust the program as needed to meet its objectives” (Ibid, 12). That is, the FOMC would withdraw the stimulus once the economy is closer to full capacity to maintain inflation around 2 percent. In testimony at the Senate Committee on the Budget, Chairman Bernanke stated that “the Federal Reserve has all the tools its needs to ensure that it will be able to smoothly and effectively exit from this program at the appropriate time” (http://federalreserve.gov/newsevents/testimony/bernanke20110107a.htm). The large quantity of reserves would not be an obstacle in attaining the 2 percent inflation level. Yellen (2011A, 13-4) enumerates Fed tools that would be deployed to withdraw reserves as desired: (1) increasing the interest rate paid on reserves deposited at the Fed currently at 0.25 percent per year; (2) withdrawing reserves with reverse sale and repurchase agreements in addition to those with primary dealers by using mortgage-backed securities; (3) offering a Term Deposit Facility similar to term certificates of deposit for member institutions; and (4) sale or redemption of all or parts of the portfolio of long-term securities. The Fed would be able to increase interest rates and withdraw reserves as required to attain its mandates of maximum employment and price stability.

Inflation is impenetrable for theory and even more so for policy. Demand pull, cost push, expectations and many other theoretical analyses have been useful but find obstacles in explaining many actual situations. Inflation does occur but is quite difficult to explain. An example is managing household, banks and company affairs in a contemporary inflation that reached 26.1 per month, or 1243 percent annual, with the interbank annual deposit rate at 1348 percent on Jun 10, 1987 (Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). “The Fed on the cusp of worldwide inflation” is an entirely different argument by McKinnon (2001CWI, 2011INF) than the “printing money” argument and is derived from perceptive comparison of the 1970s commodity shocks with the Greenspan-Bernanke shock of 2003-2004 and the Bernanke shock that is still ongoing. In the view of McKinnon, emerging countries are flooded with carry trades into their capital markets and currencies that their central banks sterilize by issuing base money to buy the inflow of dollars, creating downward pressure on interest rates. Sterilization of the growth of money and capital controls can be used “but these measures are hard to enforce” (McKinnon 2011CWI, 1). The key to the three shocks of 1971, 2003-2004 and currently is that “primary commodity prices register enhanced inflationary expectations more quickly because speculators can easily bid for long positions in organized commodity future markets” (McKinnon CWI, 1). The risks cannot be ignored (McKinnon 2011CWI, 2). The Fed raised interest rates to 22 percent in Jul 1981 and inflation receded in the US. Inflows of funds attracted by improved conditions in the US appreciated the dollar that became overvalued, causing a large deficit in current account jointly with the internal deficit. Cheaper imports of manufactures resulted in the US rust belt. The lesson from this experience is that US inflation is processed with a long lag and has costly consequences for the economy and employment.

Table 4 provides CPI inflation in a large variety of countries. There is inflation everywhere with the possible exceptions of Japan and the US. Most countries have emerged with significant fiscal imbalances partly because of the reduction of revenue and the increase in expenses during the global recession. There is a valid concern if the US will escape inflation with hard consequences of its control on the economy and employment that could be more harmful than the second fear of deflation in less than ten years that has not materialized except in counterfactual exercises.

Table 4, CPI Inflation and Government Deficit as Percent of GDP

	CPI 2006	CPI 2010	Deficit 2008 % GDP	Deficit 2010 % GDP
Euro Area	2.2	2.2	-2.6	-4.6
Advanced Economies	1.9	1.1	-3.8	-6.8
Germany	1.8	1.9	-1.6	-3.1
France	1.9	2.0	-3.1	-5.0
USA	2.5	1.5	-4.9	-8.0
UK	2.3	3.7	-5.6	-7.9
Japan	0.2	0.1*	-3.6	-7.6
China	2.5	4.6	7.7	3.5
Brazil	3.1	5.9	-3.5	-1.6
Russia	9.0	8.1*	4.5	-4.3
India	6.7	12.7**	-6.1	-9.6
Korea	2.1	3.0**	1.7	1.4
Singapore	0.8	4.1**	5.2	2.4
Taiwan	0.7	2.3**	-2.4	-3.8
Indonesia	3.1	5.9**	-1.6	-1.5
Thailand	3.5	1.5**	0.1	-2.7

Sources: IMF PIN

http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx

**IMF estimate http://www.imf.org/external/np/sec/pn/2011/pn1102.htm

*Nov

http://www.gks.ru/bgd/free/B00_25/IssWWW.exe/Stg/d000/000710.HTM

http://www.stat.go.jp/english/data/cpi/1581.htm

http://www.stats.gov.cn/english/statisticaldata/monthlydata/t20101227_402693597.htm

http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-14012011-BP/EN/2-14012011-BP-EN.PDF

http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&language=en&pcode=tsieb060&tableSelection=1&footnotes=yes&labeling=labels&plugin=1

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

http://www.bls.gov/news.release/pdf/cpi.pdf

http://www.bcb.gov.br/?INDICATORS

The Financial Times finds warnings of global inflation in the disclosure that UK CPI inflation reached 1 percent in Dec alone and 3.7 percent for 2010, following a jump of euro zone inflation to 2.2 percent in 2010 (http://www.ft.com/cms/s/0/f7fc18da-2593-11e0-8258-00144feab49a.html#axzz1BosJh8ac). The FT finds that expectations by investors measured by break-even rates have increased consistently since Aug to 2.2 percent for the US, 3.1 percent for the UK and 2 percent for Germany (Ibid). Table 5, updated with every comment, shows the yield of the 10-year US Treasury on selected dates, the price calculated at that yield with coupon of 2.625 percent and maturity in exactly ten years and in the final column “∆% 11/04/10” the percentage change in price relative to Nov 4, 2010 when the Fed announced the purchase of an additional $600 billion of long-term Treasury securities. The increase in yield could result from a variety of factors that do not exclude some expectation of higher inflation in the future with unwillingness of the Fed to control it because of the projected weakness of employment over several years. Evans (2011TT) finds market behavior that suggests concerns by investors on stagflation in the US. Analysis of past cycles suggests that the yield curve slopes upward during expansion phases with the sharpest slope occurring early in the recovery. As investors anticipate short-term interest rate increases by the Fed, the yield curve flattens if long-term rates reflect anticipated credibility of the Fed in curbing future inflation and could become downward sloping in expectation of recession. There are two market analyses found by Evans (2011TT): (1) RBS Securities identified a record 4 percentage point spread between the 30-year Treasury bond and 2-year Treasury note with the spread at 3.95 percentage points at the close of market on Jan 21 (http://markets.ft.com/markets/bonds.asp?ftauth=1295789611081); (2) Treasury yields imply a rising annual inflation rate of 3 percent in the 5 to 10 year horizon that has not been detected since the tightening beginning after Jun 2004.

Table 5, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note

Date	Yield	Price	∆% 11/04/10
05/01/01	5.510	78.0582	-22.9
06/10/03	3.112	95.8452	-5.3
06/12/07	5.297	79.4747	-21.5
12/19/08	2.213	104.4981	3.2
12/31/08	2.240	103.4295	2.1
03/19/09	2.605	100.1748	-1.1
06/09/09	3.862	89.8257	-11.3
10/07/09	3.182	95.2643	-5.9
11/27/09	3.197	95.1403	-6.0
12/31/09	3.835	90.0347	-11.1
02/09/10	3.646	91.5239	-9.6
03/04/10	3.605	91.8384	-9.3
04/05/10	3.986	88.8726	-12.2
08/31/10	2.473	101.3338	0.08
10/07/10	2.385	102.1224	0.8
10/28/10	2.658	99.7119	-1.5
11/04/10	2.481	101.2573	-
11/15/10	2.964	97.0867	-4.1
11/26/10	2.869	97.8932	-3.3
12/03/10	3.007	96.7241	-4.5
12/10/10	3.324	94.0982	-7.1
12/15/10	3.517	92.5427	-8.6
12/17/10	3.338	93.9842	-7.2
12/23/10	3.397	93.5051	-7.7
12/31/10	3.228	94.3923	-6.7
01/07/11	3.322	94.1146	-7.1
01/14/11	3.323	94.1064	-7.1
01/21/11	3.414	93.4687	-7.7

Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates

Source:

http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3020

ID “Beggar-Thy-Neighbor Interest Rates.” An essay by Chairman Bernanke in 1999 on Japanese monetary policy received attention in the press, stating that (Bernanke 2000, 165):

“Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and experiment—in short, to do whatever it took to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done”

Quantitative easing has never been proposed by Chairman Bernanke or other economists as certain science without adverse effects. What has not been mentioned in the press is another suggestion to the Bank of Japan (BOJ) by Chairman Bernanke in the same essay that is very relevant to current events and the contentious issue of ongoing devaluation wars (Ibid, 161):

“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. The economic validity of the beggar-thy-neighbor thesis is doubtful, as depreciation creates trade—by raising home country income—as well as diverting it. Perhaps not all those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. A yen trading at 100 to the dollar is in no one’s interest”

Chairman Bernanke is referring to the argument by Joan Robinson based on the experience of the Great Depression that: “in times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others (Robinson 1947, 156). Devaluation is one of the tools used in these policies (Ibid, 157). Banking crises dominated the experience of the United States, but countries that recovered were those devaluing early such that competitive devaluations rescued many countries from a recession as strong as that in the US (see references to Ehsan Choudhri, Levis Kochin and Barry Eichengreen in Pelaez and Pelaez, Regulation of Banks and Finance, 205-9; for the case of Brazil that devalued early in the Great Depression recovering with an increasing trade balance see Pelaez, 1968, 1972; Brazil devalued and abandoned the gold standard during crises in the historical period as shown by Pelaez 1976, Pelaez and Suzigan 1981). Beggar-my-neighbor policies did work for individual countries but the criticism of Joan Robinson was that it was not optimal for the world as a whole. Because of this experience most countries of the world tried to create cooperation through international financial institutions, the International Monetary Fund (IMF) and the World Bank. The global devaluation war is also forcing many countries into painful macroeconomic adjustment and central bank intervention with repeated calls by the IMF for coordination and cooperation in sharing the adjustment to world imbalances. The managing director of the IMF, Dominique Strauss-Khan, warns about obstacles to the operation of the international monetary system: “tensions and risks have been building up in its operations, which manifest themselves in large official reserve accumulation, persistent global imbalances, and capital flow and exchange rate volatility” (http://www.imf.org/external/np/pp/eng/2010/100110c.pdf ).

The interpretation of the competitive devaluations of the 1930s by McKinnon (2011BTN, 2) is different. Britain attempted to restore the Gold Standard in 1925 but austere monetary policies in the form of increasing interest rates and reductions in wages and spending worsened the Great Depression. The gold parity was abandoned by Britain in Sep 1931, causing devaluation of the sterling pound by 25 percent with exit from the gold standard by other countries. Roosevelt then forced sharp depreciation of the dollar relative to gold. As McKinnon 2011BTN, 2) states: “In 1936, the remaining gold bloc countries gave up and depreciated, but not before they suffered a precipitate drop in exports and industrial production. Whence the odium associated with ‘beggar-thy-neighbor’ devaluations.” The current environment is described by McKinnon (2011BTN) as “beggar-thy-neighbor interest rates.” The combination of the zero interest rate after Dec 16, 2008, with quantitative easing of $1750 billion in the first round from Dec 2008 to Mar 2009 and additional $600 billion after Nov 3, 2010 has “unleashed a flood of hot money into most ‘peripheral’ countries in Asia and Latin America as well as Australia, Canada and New Zealand” (Ibid, 4). The mechanism is the carry trade of short positions in short-term interest rates and the dollar combined with long leveraged positions in commodities, emerging market stocks and the large number of risk financial assets left out of the policy analysis of the Fed. Table 6, updated with every comment, shows the sharp appreciation relative to the dollar of most currencies in the world, which is far higher than the Fed’s objective of attaining by quantitative easing “a moderate change in the foreign exchange value of the dollar that provides support to net exports,” as revealed for the first time by Yellen (2011AS, 6).

Table 6, Exchange Rates

	Peak	Trough	∆% P/T	Jan 21 2011	∆% T Jan 21	∆% P Jan 21
EUR USD	7/15 2008	6/7 2010		1/21/ 2011
Rate	1.59	1.192		1.339
∆%			-33.4		12.5	-16.7
JPY USD	8/18 2008	9/15 2010		1/21 2011
Rate	110.19	83.07		82.58
∆%			24.6		0.6	25.1
CHF USD	11/21 2008	12/8 2009		1/21 2011
Rate	1.225	1.025		0.968
∆%			16.3		5.6	20.9
USD GBP	7/15 2008	1/2/ 2009		1/21 2011
Rate	2.006	1.388		1.600
∆%			-44.5		13.3	-25.4
USD AUD	7/15 2008	10/27 2008		1/21 2011
Rate	0.979	0.601		0.990
∆%			-62.9		39.3	1.1
ZAR USD	10/22 2008	8/15 2010		1/21 2011
Rate	11.578	7.238		7.05
∆%			37.5		2.6	39.1
SGD USD	3/3 2009	8/9 2010		1/21 2011
Rate	1.553	1.348		1.283
∆%			13.2		4.8	17.4
HKD USD	8/15 2008	12/14 2009		1/21 2011
Rate	7.813	7.752		7.792
∆%			0.8		-0.5	0.3
BRL USD	12/5 2008	4/30 2010		1/21 2011
Rate	2.43	1.737		1.6676
∆%			28.5		3.9	31.3
CZK USD	2/13 2009	8/6 2010		1/21 2011
Rate	22.19	18.693		17.832
∆%			15.7		4.6	19.6
SEK USD	3/4 2009	8/9 2010		1/21 2011
Rate	9.313	7.108		6.584
∆%			23.7		7.4	29.3

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

The carry trade from zero short-term interest rates in the US to risk financial assets in foreign capital markets, or “hot money” flows as termed by McKinnon (2011BTN), results in central bank purchases of dollars by issuing base money that is not feasible or excessively expensive to sterilize and various unsuccessful attempts to control capital inflows. Table 7 shows the return of the issue of world imbalances with countries experiencing high current account deficits as percent of GDP, such as the US, while other have high current account surpluses as percent of GDP, such as China, Japan and Germany. McKinnon (2010GI) argues that exchange rate adjustments will not correct global imbalances. A different perspective is provided by Feldstein (2011GI).

Table 7, GDP, Debt/GDP and Current Account/GDP for Selected Countries

	GDP $ Billions	Debt/ GDP 2010 %	Debt/ GDP 2015 %	Current Account % GDP 2010	Current Account % GDP 2015
Euro Area	12,067	53.4	67.4	0.2	0.2
Germany	3,652	58.7	61.8	6.1	3.9
France	2,865	74.5	78.7	-1.8	-1.8
Portugal	224	79.9	93.6	-9.9	-8.4
Ireland	204	55.2	71.4	-2.7	-1.2
Italy	2,037	98.9	99.5	-2.9	-2.4
Greece	305	109.5	112.6	-10.8	-4.0
Spain	1,275	54.1	72.6	-5.2	-4.3
Belgium	461	91.4	100.1	0.5	4.1
USA	14,624	65.8	84.7	-3.2	-3.4
UK	2,259	68.8	76.0	-2.2	-1.1
Japan	6,517	120.7	153.4	3.1	1.9
China	5,745	19.1	13.9	4.7	7.8
Brazil	2,023	36.7	30.8	-2.6	-3.3
Russia	1,477	11.1	14.6	4.7	1.3
India	1,430	71.8	67.2	-3.1	-2.2

Source: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx

II Economic Indicators. Industry continues to recover with doubts in housing and job markets. The Empire State Manufacturing Survey of the FRBNY showed strong improvement at 11.92 in Jan relative to 9.89 in Dec with new orders soaring from 2.03 in Dec to 12.39 in Jan and shipments from 7.16 in Dec to 25.39 in Jan (http://www.newyorkfed.org/survey/empire/january2011.pdf). There is similar strong improvement in the Philadelphia Fed’s Business Outlook Survey. The decline of the general business activity index from 20.8 in Dec to 19.3 in Jan obscures the jump in new orders from 10.6 in Dec to 23.6 in Jan; shipments also jumped from 5.2 in Dec to 13.4 in Jan and number of employees from 4.3 in Dec to 17.6 in Jan (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0111.pdf). Inclement winter events may prevent accurate observations of housing activity until the spring. Seasonally adjusted privately-owned housing starts were at the annual rate of 529,000 in Dec, which is equivalent to a decline of 4.3 percent relative to Nov and 8.2 percent below the rate of Dec 2009. In contrast, seasonally adjusted privately-owned building permits were at a seasonally adjusted annual rate of 635,000, equivalent to an increase by 16.7 percent relative to Nov but 6.8 percent below Dec 2009. Not seasonally annualized housing starts in 2010 are estimated at 587,600 (http://www.census.gov/const/newresconst.pdf), which is 71.6 percent lower than 2,068,000 in 2005 and 69.9 percent lower than 1,955,800 in 2004 (http://www.census.gov/const/newresconst_200601.pdf). Initial claims for unemployment insurance, seasonally adjusted, fell by 37,000 to 404,000 in the week ending on Jan 15 from 441,000 in the prior week. The five-week average fell by 4000 to 411,750 in the week ending on Jan 15 relative to 415,750 in the prior week. The second estimate by EUROSTAT finds a current account deficit/GDP ratio of -0.4 percent for the euro zone (EA16) in IIIQ10, which is an improvement relative to -0.9 percent in IIQ10 and -1.0 percent in IQ10 but deterioration relative to the 0.5 percent surplus in IVQ09 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-21012011-AP/EN/2-21012011-AP-EN.PDF). The forecast of surplus for EA16 in the first line, fifth column for 2010 in Table 7 is likely to be changed to deficit.

III Interest Rates. The 10-year US Treasury yield rose to 3.41 percent in the week ending on Jan 21 from 3.32 percent a week earlier and 3.40 percent a month earlier. The 5-year Treasury yield rose to 2.01 percent on Jan 21 from 1.93 percent a week earlier but is lower than 2.06 percent a month before. Yields of 5-year Treasury notes are about 100 basis points above what was estimated would be the objective of quantitative easing of $600 billion after Nov 3. The yield of the 10-year government bond of Germany was traded at 3.18 percent, firmly above 3 percent, for negative spread of 23 basis points relative to the comparable Treasury. The US Treasury note with coupon of 2.63 percent and maturity in 11/20 was traded at yield of 3.41 percent or equivalent price of 93.47 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-210111).

IV Conclusion. The contributions by Professor Ronald I. McKinnon show that the shocks of extremely low interest rates after 2003-2004 encouraged a carry trade from near zero interest rates to long positions in risk financial assets and initially in housing. The continuance of this policy of zero interest rates and quantitative easing is not stimulating aggregate demand because of credit supply constraints. The new approach of devising sound regulatory rules by the executive order of the White House opens the possibility of considering rules mandated by the Dodd-Frank Act in a constructive effort to improve credit conditions, protect consumers and provide for financial intermediation required for economic growth and employment. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

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