World Inflation, Quantitative Easing Transmission, Unwinding the Fed Balance Sheet and Devaluation Wars
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011
The objective of this post is to relate world inflation to the Fed’s new intended channels of transmission of quantitative easing by the wealth effect of rising stock markets and devaluation of the dollar. The content is as follows:
I World Inflation
II Transmission of Quantitative Easing
IIA Theory
IIB Policy
IIC Evidence
IID Unwinding Strategy
IIE Alternative Interpretation
IIF World Devaluation Wars
III Economic Indicators
IV Interest Rates
V Conclusion
References
I World Inflation. A new policy issue for most regions in the world is the increase in inflation that is occurring with higher fiscal imbalances left from the decline in revenue and in some cases increase in expenditures during the global recession, as shown in Table 1. The rise of 12 month of the harmonized consumer price inflation of the euro area to 2.2 percent in Dec above the guideline of 2 percent, provoked comments by the President of the European Central Bank reasserting the alertness and determination to maintain price stability (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aTgkZnX515gM&pos=5). The People’s Bank of China, the country’s central bank, determined an increase of the ratio of required reserves to deposits of banks by 0.5 percentage points to 19 percent for major lenders as of Jan 20. The ratio was already the highest since its introduction in policy in the mid 1980s and the sixth increase in a year (http://www.ft.com/cms/s/0/157c8aaa-1fd8-11e0-b458-00144feab49a.html#axzz1BCgtECH2). The measure is intended to curb inflation that rose to 5.1 percent in the 12 months ending in Nov.
Table 1, 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 | 2.6 | -5.6 | -7.9 |
| Japan | 0.2 | 0.1* | -3.6 | -7.6 |
| China | 2.5 | 5.1* | 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
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
II Transmission of Quantitative Easing. Janet L. Yellen, Vice Chair of the Board of Governors of the Federal Reserve System, provides analysis of the policy of purchasing large amounts of long-term securities for the Fed’s balance sheet. The new analysis provides now three channels of transmission of quantitative easing to the ultimate objectives of increasing growth and employment and increasing inflation to the Fed “levels of 2 percent or a bit less that most Committee participants judge to be consistent, over the long run, with the FOMC’s dual mandate” (Yellen 2011AS, 4, 7):
“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 boost household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”
The new analysis by Yellen (2011AS) is considered below in six separate subsections: (IIA) Theory; (IIB) Policy; (IIC) Evidence; (IID) Unwinding Strategy; (IIE) Alternative Interpretation; and (IIF) World Devaluation Wars.
IIA Theory. The transmission mechanism of quantitative easing can be analyzed in three different forms. (1) Portfolio choice theory. General equilibrium value theory was proposed by Hicks (1935) in analyzing the balance sheets of individuals and institutions with assets in the capital segment consisting of money, debts, stocks and productive equipment. Net worth or wealth would be comparable to income in value theory. Expected yield and risk would be the constraint comparable to income in value theory. Markowitz (1952) considers a portfolio of individual securities with mean μp and variance . The Markowitz (1952, 82) rule states that “investors would (or should” want to choose a portfolio of combinations of (μp, that are efficient, which are those with minimum variance or risk for given expected return μp or more and maximum expected μp for given variance or risk or less. The more complete model of Tobin (1958) consists of portfolio choice of monetary assets by maximizing a utility function subject to a budget constraint. Tobin (1961, 28) proposes general equilibrium analysis of the capital account to derive choices of capital assets in balance sheets of economic units with the determination of yields in markets for capital assets with the constraint of net worth. A general equilibrium model of choice of portfolios was developed simultaneously by various authors (Hicks 1962; Treynor 1962; Sharpe 1964; Lintner 1965; Mossin 1966). If shocks such as by quantitative easing displace investors from the efficient frontier, there would be reallocations of portfolios among assets until another efficient point is reached. Investors would bid up the prices or lower the returns (interest plus capital gains) of long-term assets targeted by quantitative easing, causing the desired effect of lowering long-term costs of investment and consumption.
(2) General Equilibrium Theory. Bernanke and Reinhart (2004, 88) argue that “the possibility monetary policy works through portfolio substitution effects, even in normal times, has a long intellectual history, having been espoused by both Keynesians (James Tobin 1969) and monetarists (Karl Brunner and Allan Meltzer 1973).” Andres et al. (2004) explain the Tobin (1969) contribution by optimizing agents in a general-equilibrium model. Both Tobin (1969) and Brunner and Meltzer (1973) consider capital assets to be gross instead of perfect substitutes with positive partial derivatives of own rates of return and negative partial derivatives of cross rates in the vector of asset returns (interest plus principal gain or loss) as argument in portfolio balancing equations (see Pelaez and Suzigan 1978, 113-23). Tobin (1969, 26) explains portfolio substitution after monetary policy:
“When the supply of any asset is increased, the structure of rates of return, on this and other assets, must change in a way that induces the public to hold the new supply. When the asset’s own rate can rise, a large part of the necessary adjustment can occur in this way. But if the rate is fixed, the whole adjustment must take place through reductions in other rates or increases in prices of other assets. This is the secret of the special role of money; it is a secret that would be shared by any other asset with a fixed interest rate.”
Andrés et al. (2004, 682) find that in their multiple-channels model “base money expansion now matters for the deviations of long rates from the expected path of short rates. Monetary policy operates by both the expectations channel (the path of current and expected future short rates) and this additional channel. As in Tobin’s framework, interest rates spreads (specifically, the deviations from the pure expectations theory of the term structure) are an endogenous function of the relative quantities of assets supplied.”
The interrelation among yields of default-free securities is measured by the term structure of interest rates. This schedule of interest rates along time incorporates expectations of investors. (Cox, Ingersoll and Ross 1985). The expectations hypothesis postulates that the expectations of investors about the level of future spot rates influence the level of current long-term rates. The normal channel of transmission of monetary policy in a recession is to lower the target of the fed funds rate that will lower future spot rates through the term structure and also the yields of long-term securities. The expectations hypothesis is consistent with term premiums (Cox, Ingersoll and Ross 1981, 774-7) such as liquidity to compensate for risk or uncertainty about future events that can cause changes in prices or yields of long-term securities (Hicks 1939; see Cox, Ingersoll and Ross 1981, 784; Chung et al. 2011, 22).
(3) Preferred Habitat. 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 or more; and asset managers and bank treasury managers are active in maturities of less than 10 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 “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 “roll-down” trade. The carry trade is the mechanism by which bond yields adjust to changes in current and expected short-term interest rates. 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.
IIB Policy. A simplified analysis could consider the portfolio balance equations Aij = f(r, x) where Aij is the demand for i = 1,2,∙∙∙n assets from j = 1,2, ∙∙∙m sectors, r the 1xn vector of rates of return, ri, of n assets and x a vector of other relevant variables. Tobin (1969) and Brunner and Meltzer (1973) assume imperfect substitution among capital assets such that the own first derivatives of Aij are positive, demand for an asset increases if its rate of return (interest plus capital gains) is higher, and cross first derivatives are negative, demand for an asset decreases if the rate of return of alternative assets increases. Theoretical purity would require the estimation of the complete model with all rates of return. In practice, it may be impossible to observe all rates of return such as in the critique of Roll (1976). Policy proposals by the Fed have been focused on the likely impact of withdrawals of stocks of securities in specific segments, that is, of effects of one or several specific rates of return among the n possible rates. There have been six approaches on the role of monetary policy in purchasing long-term securities that have increased the classes of rates of return targeted by the Fed:
i. Suspension of Auctions of 30-year Treasury Bonds. Auctions of 30-year Treasury bonds were suspended between 2001 and 2005. This was Treasury policy not Fed policy. The effects were similar to those of quantitative easing: withdrawal of supply from the segment of 30-year bonds would result in higher prices or lower yields for close-substitute mortgage-backed securities with resulting lower mortgage rates. The objective was to encourage refinancing of house loans that would increase family income and consumption by freeing income from reducing monthly mortgage payments.
ii. Purchase of Long-term Securities by the Fed. Between Nov 2008 and Mar 2009 the Fed announced the intention of purchasing $1750 billion of long-term securities: $600 billion of agency mortgage-backed securities and agency debt announced on Nov 25 and $850 billion of agency mortgaged-backed securities and agency debt plus $300 billion of Treasury securities announced on Mar 18, 2009 (Yellen 2011AS, 5-6). The objective of buying mortgage-backed securities was to lower mortgage rates that would “support the housing sector” (Bernanke 2009SL). The FOMC statement on Dec 16, 2008 informs that: “over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and its stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant” (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). The Mar 18 statement of the FOMC explained that: “to provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities up to $1.25 trillion this year, and to increase its purchase of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months” (http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm). Policy changed to increase prices or reduce yields of mortgage-backed securities and Treasury securities with the objective of supporting housing markets and private credit markets by lowering costs of housing and long-term private credit.
iii. Portfolio Reinvestment. On Aug 10, 2010, the FOMC statement explains the reinvestment policy: “to help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in long-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature” (http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm). The objective of policy appears to be supporting conditions in housing and mortgage markets with slow transfer of the portfolio to Treasury securities that would support private-sector markets.
iv. Increasing Portfolio. As widely anticipated, the FOMC decided on Dec 3, 2010: “to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month” (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm). The emphasis appears to shift from housing markets and private-sector credit markets to the general economy, employment and preventing deflation.
v. Increasing Stock Market Valuations. 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. Bernanke (2000) analyzes the role of stock markets in central bank policy (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 99-100). Fed policy in 1929 increased interest rates to avert a gold outflow and failed to prevent the deepening of the banking crisis without which the Great Depression may not have occurred. In the crisis of Oct 19, 1987, Fed policy supported stock and futures markets by persuading banks to extend credit to brokerages. Collapse of stock markets would slow consumer spending.
vi. Devaluing the Dollar. 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.”
IIC Evidence. There are multiple empirical studies on the effectiveness of quantitative easing that have been covered in past posts such as (Andrés et al. 2004, D’Amico and King 2010, Doh 2010, Gagnon et al. 2010, Hamilton and Wu 2010). On the basis of simulations of quantitative easing with the FRB/US econometric model, Chung et al (2011, 28-9) find that:
”Lower long-term interest rates, coupled with higher stock market valuations and a lower foreign exchange value of the dollar, provide a considerable stimulus to real activity over time. Phase 1 of the program by itself is estimated to boost the level of real GDP almost 2 percent above baseline by early 2012, while the full program raises the level of real GDP almost 3 percent by the second half of 2012. This boost to real output in turn helps to keep labor market conditions noticeably better than they would have been without large scale asset purchases. In particular, the model simulations suggest that private payroll employment is currently 1.8 million higher, and the unemployment rate ¾ percentage point lower, that would otherwise be the case. These benefits are predicted to grow further over time; by 2012, the incremental contribution of the full program is estimated to be 3 million jobs, with an additional 700,000 jobs provided by the most recent phase of the program alone.”
An additional conclusion of these simulations is that quantitative easing may have prevented actual deflation. Empirical research is continuing.
IID Unwinding Strategy. Fed Vice-Chair Yellen (2011AS) considers four concerns on quantitative easing discussed below in turn. First, Excessive Inflation. Yellen (2011AS, 9-12) considers concerns that quantitative easing could result in excessive inflation because fast increases in aggregate demand from quantitative easing could raise the rate of inflation, posing another problem of adjustment with tighter monetary policy or higher interest rates. The Fed estimates significant slack of resources in the economy as measured by the difference of four percentage points between the high current rate of unemployment above 9 percent and the NAIRU (non-accelerating rate of unemployment) of 5.75 percent (Ibid, 2). Thus, faster economic growth resulting from quantitative easing would not likely result in upward rise of costs as resources are bid up competitively. The Fed monitors frequently slack indicators and is committed to maintaining inflation at a “level of 2 percent or a bit less than that” (Ibid, 13), say, in the narrow open interval (1.9, 2.1).
Second, Inflation and Bank Reserves. On Jan 12, the line “Reserve Bank credit” in the Fed balance sheet stood at $2450,6 billion, or $2.5 trillion, with the portfolio of long-term securities of $2175.7 billion, or $2.2 trillion, composed of $987.6 billion of notes and bonds, $49.7 billion of inflation-adjusted notes and bonds, $146.3 billion of Federal agency debt securities, and $992.1 billion of mortgage-backed securities; reserves balances with Federal Reserve Banks stood at $1095.5 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 $2.1 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 agreement 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.
Third, Financial Imbalances. Fed policy intends to lower costs to business and households with the objective of stimulating investment and consumption generating higher growth and employment. Yellen (2011A, 14-7) considers a possible consequence of excessively reducing interest rates: “a reasonable fear is that this process could go too far, encouraging potential borrowers to employ excessive leverage to take advantage of low financing costs and leading investors to accept less compensation for bearing risks as they seek to enhance their rates of return in an environment of very low yields. This concern deserves to be taken seriously, and the Federal Reserve is carefully monitoring financial indicators for signs of potential threats to financial stability.” Regulation and supervision would be the “first line of defense” against imbalances threatening financial stability but the Fed would also use monetary policy to check imbalances (Yellen 2011AS, 17).
Fourth, Adverse Effects on Foreign Economies. The issue is whether the now recognized dollar devaluation would promote higher growth and employment in the US at the expense of lower growth and employment in other countries. The first three concerns are considered below in (IIE) Alternative Interpretations and the fourth in (IIF) World Devaluation Wars.
IIE Alternative Interpretation. Quantitative easing is implemented because interest rates have been set by the Fed at near zero percent. The shocks of rate of returns of assets in the portfolio balance equations Aij cause “financial imbalances” by triggering carry trade arbitrage of financial assets that were a major cause of the credit/dollar crisis and global recession after 2007. This arbitrage is analyzed below in three categories of arguments.
First, Duration Trap of Quantitative Easing. Positions in securities that are professionally and actively managed are leveraged 10:1 and lead market yields. If there is an expectation of a trend of backup of yields, professional money managers will dump duration, feeding the trend of increases in yields. There is a dramatic example from recent history. The worldwide crash of bond markets in 1994 began at the Fed in fear of inflation resulting from commodity prices that never materialized. The Fed increased the fed funds target from 3 percent in Jan to 6 percent in Dec with the yield of the 30-year Treasury jumping from 6.29 percent to 7.87 percent, causing price declines of 13 percent, and the yield of the 30-year mortgage rose from 7.07 percent to 9.20 percent (Pelaez and Pelaez, The Global Recession Risk (2007), 206-7). Assuming a 30-year Treasury with coupon of 7 percent priced at 99.999 with yield of 7 percent, the instantaneous rise in yield to 9 percent would result in price of 79.3619 for a principal loss of 20.6 percent. European bond prices crashed throughout 1994 as analysts advised of decoupling from the US experience that never materialized. The correlation of G3 (Europe, US and Japan) bond yields was only 0.18 and 0.40 for stock markets but G3 bonds collapsed. Statistical models used in stress tests, as in the episode of Long-term Capital Management in 1998, may not capture actual crash of fixed-income securities and stock markets. Policy errors such as this one raise doubts about the infallibility of monetary and fiscal policy. There are fluctuations around trends and sometimes fluctuations without trends. A problem in one asset class spreads to other assets classes as dealer capital is reduced by margin calls and financing-price haircuts that force paring positions in other classes, as it happened in 2007-2009 and in 1994. Duration is higher the lower bond yields and coupons, ceteris paribus. Lowering bond yields by quantitative easing with the Fed aiming to maintain holdings of about 30 percent of Treasury securities in circulation poses the risk of an uncontrollable upward trend of yields, magnified by market anticipations of risk of principal loss. Table 2, updated with every post, provides in column 2 the yield of the 10-year Treasury note on the date in column one and in column 3 the price at the current coupon of 2.625 percent with maturity in exactly 10 years. Column four, “∆% 11/04/10,” calculates the instantaneous change in price relative to the price actually observed on 11/04/10, a day after the announcement by the Fed of the decision to buy an additional $600 billion of Treasury securities. In Jun 2003, the Fed reduced the overnight fed funds rate to 1 percent in fear of deflation similar to the one today with a relative trough of the yield of the 10-year note at 3.112 percent on 06/12/07. The recent peak of the yield of the 10-year note occurred on 06/12/07 at 5.297 percent. There was no deflation but consumer price inflation rose from 1.9 percent in 2003 to 4.1 percent in 2007, partly causing the rise in the Treasury yield to 5.297 percent on 06/12/07 for a loss in price of 17.1 percent relative to the price on 06/10/03 and a loss of price of 21.5 percent relative to the price on 11/04/10. There may be an operationally impossible task of the Fed to timely anticipate the need of actions, take the required measures and have their effects processed through multiple lags to prevent shocks of higher interest rates on financial stability and economic activity. The Fed does not have the knowledge and tools to control risk/return asset choice decisions of the financial system and the overall economy using monetary policy and regulatory/supervision in forcing behavior as desired by the FOMC that can incur in the same errors as the private sector. The presumption is that FOMC decisions are errorless and correct all failures of the private sector, which is wanting in existing economic knowledge and effectiveness and timeliness of forecasts and operational tools. There is no satisfactory explanation for the backup in yields in Table 1 after Nov 4: the forecast was misleading because it did not anticipate declining risk aversion as European sovereign risks eased, the policy impulse was unnecessary and the effects were adverse by mostly feeding the carry trade.
Table 2, 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 |
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
Second, Asset Volatility. The Fed does not have control of what type of asset valuations it may ultimately influence. Near zero interest rates encourage the carry trade of borrowing at extremely low short-term rates and taking long positions in financial risk assets such as commodities, currencies, stocks and so on. Families, investors and most everybody worldwide were encouraged to benefit from the low interest rates originating in Fed policy of 1 percent fed funds rate in 2003-2004 and housing subsidies by borrowing significantly or high leverage, ignoring potential future adverse events or taking high risks, investing fully or having little or no cash assets or low liquidity and induced easy lending or taking unsound credit decisions. The carry trade of borrowing at extremely low short-term rates and taking long positions in risk financial assets is shown in Table 3 in the form of high valuations in most risk financial assets and then eventual collapse in the form of the credit/dollar crisis and global recession after 2007. The financial crisis and global recession were caused by interest rate and housing 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). 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). The Fed increased the fed funds rate in 17 doses of 25 basis points during consecutives FOMC meetings from 1 percent in Jun 2004 to 5.25 percent in Jun 2006. 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). The Fed has the state of the art in competent staff and board members but that is insufficient to manage with monetary policy, regulation and supervision the risk/return decisions of the entire economy without creating major risks of financial stability, growth and employment.
Table 3, 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
Third, Carry Trade Learning from Losses. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table 3 after the first policy round of near zero fed funds and quantitative easing by withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China and legislative restructuring, regulation, insufficient growth and high job stress of unemployment and underemployment in the US. The “trend is my friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets with fluctuations provoked by events of risk aversion. Table 4 shows the deep contraction of risk financial assets after the Apr sovereign risk issues and the sharp recovery after around Jul with all risk financial assets in the range from 17.1 percent to 30.4 percent while the dollar devalued by 12.3 percent and even higher before the new bout of sovereign risk issues in Europe. Aggressive tightening by the Fed to maintain the credibility of inflation not rising above 2 percent—in contrast with timid “measured” policy during the earlier round of near zero interest rates—may cause another credit/dollar crisis and stress on the overall world economy. The choices may prove tough and will magnify effects on financial variables because of the corner in which policy has been driven by aggressive impulses that have resulted in the fed funds rate of 0 to ¼ percent and holdings by the Fed that move toward 30 percent of Treasury securities in circulation.
Table 4, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 1/14 /11 | ∆% Week 1/714 /11 | ∆% Trough to 1/14 /11 | |
| DJIA | 4/26/10 | 7/2/10 | -13.6 | 5.2 | 0.9 | 21.7 |
| S&P 500 | 4/23/10 | 7/20/10 | -16.0 | 6.2 | 1.7 | 26.5 |
| NYSE Finance | 4/15/10 | 7/2/10 | -20.3 | -2.6 | 4.1 | 22.3 |
| Dow Global | 4/15/10 | 7/2/10 | -18.4 | 2.8 | 2.5 | 25.9 |
| Asia Pacific | 4/15/10 | 7/2/10 | -12.5 | 8.6 | 0.7 | 24.0 |
| Japan Nikkei Average | 4/05/10 | 8/31/10 | -22.5 | -7.8 | -0.4 | 18.9 |
| China Shanghai | 4/15/10 | 7/02 /10 | -24.7 | -11.8 | -1.7 | 17.1 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -1.2 | 1.4 | 16.7 |
| DAX | 4/26/10 | 5/25/10 | -10.5 | 11.7 | 1.8 | 24.8 |
| Dollar Euro | 11/25 2009 | 6/7 2010 | 21.2 | 11.5 | -3.7 | -12.3 |
| DJ UBS Comm. | 1/6/10 | 7/2/10 | -14.5 | 11.5 | 2.5 | 30.4 |
| 10-Year Tre. | 4/5/10 | 4/6/10 | 3.986 | 3.323 |
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 5 shows that all financial risk assets are valued lower at the end of 2010 relative to the levels in 2007 and 2006 in spite of significant valuations in 2008 and 2009. A percentage decline is not fully recovered by a subsequent percentage increase by the same magnitude. Recovery has been characterized by fluctuations caused by events described in the earlier paragraph. The risks of global financial turbulence during aggressive tightening policy appear to be significant.
Table 5, Percentage Change of Year-end 2010 Values of Financial Assets Relative to Year-end Values 2006-2009
| 2009 | 2008 | 2007 | 2006 | |
| DJIA | 11.0 | 31.9 | -12.7 | -7.4 |
| S&P 500 | 12.8 | 39.2 | -14.3 | -11.7 |
| NYSE Fin | 5.0 | 28.8 | -40.3 | -48.3 |
| Dow Glo bal | 4.6 | 36.8 | -25.5 | -2.5 |
| Dow Asia-P | 15.9 | 58.2 | -11.7 | 0.8 |
| Nikkei Av | -3.0 | 16.9 | -33.2 | -40.4 |
| Shanghai | -11.9 | 53.2 | -46.6 | 9.4 |
| STOXX 50 | -0.1 | 28.3 | -28.8 | -30.4 |
| DAX | 16/1 | 43.7 | -14.3 | 4.6 |
| USD/EUR | 6.7 | 3.9 | 8.4 | -0.9 |
| DJ UBS Com | 16.7 | 38.5 | -12.2 | -2.3 |
Sources: http://online.wsj.com/mdc/page/marketsdata.html
http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm
Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis by the Fed on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. Table 6 shows a gain in the DJIA of 5.2 percent and of the S&P 500 of 6.7 percent since Apr 26 around the time when sovereign risk issues in Europe began to be acknowledged in financial risk asset valuations. There were still fluctuations. Reversals of valuations are possible during aggressive changes in interest rate policy.
Table 6, 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 |
Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004
IIF World Devaluation Wars. A common complaint is that the hunt for yields resulting from 0 to ¼ percent fed funds rates plus quantitative easing diverts flows of capital to emerging markets that inflate asset valuations such as commodities, exchange rates and emerging market stocks. Yellen (2011AS, 18) finds that: “as shown in figure 7, net private capital flows to Latin American and Asian EMEs (reported as a share of the aggregate GDP of those EMEs) were substantial in the second half of 2009 and the first half of 2010 but were not obviously outsized compared with levels prior to the crisis.” Figure 7 in Yellen (2011AS) actually strengthens the argument showing the phenomenal growth of the cumulative sum of flows to emerging markets in the first bout of 1 percent fed funds rates cum housing subsidy in 2001-2007 and the recent continuing sharp trend in 2009-2010. Yellen (2011AS, 19) argues that the impact of dollar devaluation on foreign economies consists of two effects: (1) higher economic growth in the US from monetary policy “is likely to boost demand for foreign goods and promote growth abroad”; and (2) there are also “moderate movements in the foreign exchange value of the dollar that tend to lower US demand for foreign goods.” The conclusion is that “whether foreign demand is ultimately boosted or diminished by US monetary policy depends on the relative sizes of these two effects and is ultimately an empirical question” (Ibid, 19). There is an added difficulty in separating effects of US policy from domestic economic conditions and policies in economies experiencing valuation of their currencies. Table 7, updated with every post, shows that the valuations affect a large variety of countries, in fact, almost the entire world, in magnitudes that cause major problems for domestic monetary policy and trade flows and have given rise to the IMF accepting capital controls (http://www.imf.org/external/np/tr/2011/tr010611.htm).
Table 7, Exchange Rates
| Peak | Trough | ∆% P/T | Jan 14 2011 | ∆% T Jan 14 | ∆% P Jan 14 | |
| EUR USD | 7/15 2008 | 6/7 2010 | 1/14 2011 | |||
| Rate | 1.59 | 1.192 | 1.339 | |||
| ∆% | -33.4 | 10.9 | -18.8 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 1/14 2011 | |||
| Rate | 110.19 | 83.07 | 82.84 | |||
| ∆% | 24.6 | 0.3 | 24.8 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 1/14 2011 | |||
| Rate | 1.225 | 1.025 | 0.964 | |||
| ∆% | 16.3 | 5.9 | 21.3 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 1/14 2011 | |||
| Rate | 2.006 | 1.388 | 1.587 | |||
| ∆% | -44.5 | 12.5 | -26.4 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 1/14 2011 | |||
| Rate | 0.979 | 0.601 | 0.988 | |||
| ∆% | -62.9 | 38.6 | 0 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 1/14 2011 | |||
| Rate | 11.578 | 7.238 | 6.918 | |||
| ∆% | 37.5 | 4.4 | 40.2 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 1/14 2011 | |||
| Rate | 1.553 | 1.348 | 1.288 | |||
| ∆% | 13.2 | 4.5 | 17.1 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 1/14 2011 | |||
| Rate | 7.813 | 7.752 | 7.774 | |||
| ∆% | 0.8 | -0.3 | 0.5 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 1/14 2011 | |||
| Rate | 2.43 | 1.737 | 1.686 | |||
| ∆% | 28.5 | 2.9 | 30.6 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 1/14 2011 | |||
| Rate | 22.19 | 18.693 | 18.181 | |||
| ∆% | 15.7 | 2.7 | 18.1 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 1/14 2011 | |||
| Rate | 9.313 | 7.108 | 6.656 | |||
| ∆% | 23.7 | 6.4 | 28.5 |
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
International economic policy and cooperation among countries has been also placed in a policy dilemma because of the new fiscal and current account imbalances shown in Table 8. Negotiation of solutions is far more difficult in an environment where trade is an opportunity to increase domestic demand and employment that is frustrated by exchange rate movements (for global imbalances see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b) and Government Intervention in Globalization (2008c)).
Table 8, 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
III Economic Indicators. The Fed Beige Book finds that: “reports from the twelve Federal Reserve Districts suggest that economic activity continued to expand moderately from Nov through Dec. Conditions were generally said to be better in Districts’ manufacturing, retail and nonfinancial services sectors than in financial services or real estate” (http://federalreserve.gov/fomc/beigebook/2011/20110112/fullreport20110112.pdf). The Fed total index of industrial production rose 5.9 percent in Dec 2010 relative to Dec 2009 and 0.8 percent relative to Nov. The level of industrial production in Dec was still 94.9 percent of the average in 2007. Industrial production in the fourth quarter rose to an annual rate of 2.4 percent. Capacity utilization for total industry stood at 76.0 percent in Dec, which is 4.6 percentage points below the average in 1972-2009 (http://federalreserve.gov/releases/g17/Current/default.htm). Sales of merchant wholesalers, excluding manufacturers’ sales branches and offices, seasonally adjusted, rose 1.9 percent in Nov and 12.2 percent relative to a year earlier while total inventories fell 0.2 percent in Nov and rose 5.5 percent relative to a year earlier; and the inventories/sales ratio stood at 1.15 in Dec compared to 1.19 a year earlier (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf). Distributive trade sales and manufacturers’ shipments in Nov 2010, seasonally adjusted, rose 1.2 percent relative to Oct and 8.4 percent relative to Nov 2009; inventories rose 0.2 percent in Nov relative to Oct and 6.8 percent relative to a year earlier; and the inventories/sales ratio was 1.25 percent in Nov relative to 1.27 a year earlier (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf). The advance estimate of US retail and food services sales rose 0.6 percent in Dec 2010 relative to Nov 2010 and 7.9 percent relative to Dec 2009. Total sales for the 12 months in 2010 exceeded the level in 2009 by 6.6 percent and were higher in the quarter of Oct-Dec 2010 by 7.8 percent relative to the same period in 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf). US exports of goods and services in Nov were $159.6 billion and imports $198.0 billion for a trade deficit of $38.3 billion, which was slightly lower than $38.4 billion in Oct. US exports of goods in Jan-Nov 2010, not seasonally adjusted, rose by 20.9 percent relative to Jan-Nov 2009 and imports rose by 23.7 percent in the same period (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf). The seasonally-adjusted producer price index rose 1.1 percent in Dec relative to Nov and the unadjusted index is higher by 4.0 percent in 2010 compared with an increase by 4.3 percent in 2009 (http://www.bls.gov/news.release/pdf/ppi.pdf). The US consumer price index rose 0.5 percent in Dec, seasonally adjusted, relative to Nov and by 1.5 percent, seasonally unadjusted, in the 12 months ending in Dec (http://www.bls.gov/news.release/pdf/cpi.pdf). Initial unemployment insurance claims, seasonally adjusted, rose by 35,000 to 445,000 in the week ending on Jan 8 relative to the revised 410,000 a week earlier and the 4-week moving average rose by 5500 to 416,500 in the week ending on Jan 8 relative to the revised 411,000 a week earlier. Initial claims not seasonally adjusted rose by 191,686 to 770,413 in the week ending on Jan 8 relative to 578,727 a week earlier. The unadjusted number of persons claiming unemployment benefits in all programs was 9.2 million on Dec 25, of whom 4.6 million, or 50.4 percent for 26 weeks or more (http://www.dol.gov/opa/media/press/eta/ui/current.htm). Industrial production rose 1.2 percent in the euro area in Nov and 1.4 percent in the European Union and 7.4 percent and 7.8 percent, respectively, in Nov 2010 compared with Nov 2009 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-12012011-AP/EN/4-12012011-AP-EN.PDF). The euro area registered a trade deficit of €0.4 billion in Nov with seasonally adjusted exports increasing 0.2 percent and imports 4.4 percent. Euro area exports in Jan-Nov 2010 grew by 20 percent relative to the same period in 2009 and imports by 22 percent (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/6-14012011-AP/EN/6-14012011-AP-EN.PDF). Yearly inflation in the euro area was 2.2 percent in Dec 2010 compared with 0.9 percent yearly inflation a year earlier (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-14012011-BP/EN/2-14012011-BP-EN.PDF).
IV Interest Rates. The yield of the 10-year Treasury note was 3.33 percent on Jan 14, unchanged from that a week earlier but lower than 3.51 percent a month before. The yield of the 5-year Treasury note was 1.93 percent on Jan 14, lower than 1.96 percent a week earlier and 2.06 percent a month before. The yield of the 10-year German government bond rose again above 3 percent to 3.05 percent with negative spread relative to the equivalent Treasury of 28 basis points (http://markets.ft.com/markets/bonds.asp). The yield of the US Treasury with coupon of 2.63 percent, maturing in 11/20 was quoted at a yield of 3.33 percent or price of 94.13 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-140111).
V Conclusion. Inflation is rising in many countries around the world with fiscal and current account imbalances that pose difficult adjustment. The Fed is trying to accelerate growth by increasing demand with long-term purchases of securities intended to lower costs of investment and consumption, increase valuations of equities to create higher wealth that induces confidence in consumption and devaluation of the dollar to increase net exports that would add to aggregate demand and employment. In an environment of restraint of business models by legislative restructurings and their implementation with thousands of pages of regulation a significant part of monetary “stimulus” will simply feed a far more effective carry trade from zero interest rates in the US to risk financial assets worldwide. Monetary policy is lagging in the learning curve of the carry trade in the earlier bout of near zero interest rates and housing subsidy in 2003-2004. Appropriate information was available to the Fed on the “cliff” of housing prices and financial risk as revealed by recent transcripts of the FOMC meetings in 2005 but it was not effectively used in policy or perhaps there was no policy to contain what had already been done. The highest risk may be in the intention to crush financial imbalances created in response to Fed easy lending by using both the heavy hand of regulation/supervision and monetary policy. The outcome could be another financial crisis and possible stress on the overall world economy.
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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.
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Yellen, Janet L. 2011AS. The Federal’s Reserve’s asset purchase program. Denver, Colorado, Allied Social Science Association Annual Meeting, Jan 8 http://federalreserve.gov/newsevents/speech/yellen20110108a.pdf
© Carlos M. Pelaez, 2010, 2011
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