Policy, Inflation, Growth, Unemployment, Rising Yields and Risk Financial Assets

 

Policy, Inflation, Growth, Unemployment, Rising Yields and Risk Financial Assets

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011

The objective of this writing is to relate economic policy to inflation, growth, unemployment and rising yields. The contents are as follows:

I US Economic Policy

II Inflation, Growth and Unemployment

III Rising Yields

IV G20 and Global Imbalances

V Risk Financial Assets

VI Economic Indicators

VII Interest Rates

VIII Conclusion

References

I US Economic Policy. Macroeconomic policy by the US in the global recession consisted of two major measures: (1) fiscal stimulus; and (2) monetary policy stimulus. Fiscal stimulus consisted of Public Law 111-5, of Feb 17, 2009, or ARRA (“American Recovery and Reinvestment Act of 2009”) (http://www.gpo.gov/fdsys/pkg/PLAW-111publ5/pdf/PLAW-111publ5.pdf). The objectives of ARRA were to (http://www.whitehouse.gov/assets/documents/Recovery_Act_Overview_2-17.pdf):

“create or save 3.5 million jobs over the next two years”; “provide nearly 40 percent of the package in direct relief to working and middle class families”; “durable renewable energy generating capacity over three years”; “creates a clean energy financing authority and renewable tax credits that together will leverage an additional $100 billion in private investment in the renewable sector”; “make a $150 billion investment in our nation’s infrastructure—the largest investment since the interstate highway system in the 1950s”; “protect health care coverage for millions of Americans during this recession”; and enact the most significant expansion in tax cuts for low- and moderate-income households ever.”

There are 25.1 million people in job stress in the US, consisting of 13.9 million unemployed, 8.4 million involuntarily employed part time and 2.8 million marginally attached to the labor force. Using the rates of participation of the population in the labor force before the recession the number of people in job stress could be 30 million and the rate of unemployment 12.9 percent instead of 9.8 percent, using data without seasonal adjustments (http://cmpassocregulationblog.blogspot.com/2011/02/jobless-recovery-43-million-on-food.html). There are 43.4 million people receiving SNAP (Supplemental Nutrition Assistance Program) or former federal Food Stamp Program benefits compared with 33.5 million in 2009 (http://www.fns.usda.gov/snap/). Various types of social safety nets, with private and government funding, have to be maintained with significant strains in available resources for rapidly rising needs. The safety net of health care through the Bureau of Primary Health Care of HRSA and the National Health Service Corps (NHSC) is providing health services to more than 19 million people (http://www.bphc.hrsa.gov/) and channeling 30,000 providers since 1972 to health professional shortage areas (http://nhsc.bhpr.hrsa.gov/about/).

These hard times are complicated by the disastrous state of US fiscal affairs at all levels, federal, states and municipalities. Table 1 provides the actual data for US federal fiscal deficits in 2008 and 2009 and the budget proposal for 2011 by the Office of Management and Budget (OMB 2011BP). The most striking fact in Table 1 is deficits in excess of $1 trillion in four consecutive years 2009 to 2012 that erode any credibility that the government can attain significant reduction of deficits without drastic measures. The key to the current fiscal strain is the jump in expenditures as percent of GDP from 21.0 percent in 2008 to 24.7 percent in 2009 because the US has never been able to raise revenues above 20 percent of GDP. In contrast with Japan that finances its budget deficits with internal savings, the US finances a large part of its growing debt with foreign financing because of the “exorbitant privilege” derived from the role of the dollar as international reserve currency (Eichengreen 2011EP). The debt as percent of GDP or economic activity is rising from 40.8 percent of GDP in 2008 to 75.1 percent as projected in the budget proposal. The “exorbitant privilege” could become a debt catastrophe with the movement of the debt/GDP ratio in an unsustainable path in the form of a required risk premium on US Treasury securities and the devaluation of the dollar.

 

Table 1, Budget of the US Government, $ Billion and % GDP

Revenue	2008	2009	2010	2011	2012
Revenue $B	2524	2105	2163	2174	2627
% GDP	17.7	14.8	14.9	14.4	16.6
Outlays $B	2983	3518	3456	3819	3729
% GDP	21.0	24.7	23.8	25.3	23.6
Deficit $B	459	1413	1293	1645	1101
% GDP	3.2	9.9	8.9	10.9	7.0
Debt $B	5803	7543	9019	10856	11881
% GDP	40.8	53.2	62.2	72.0	75.1
GDP $ Trillion	14.2	14.1	14.5	15.1	15.8

Source: 2008: http://www.cbo.gov/ftpdocs/102xx/doc10296/06-16-AnalysisPresBudget_forWeb.pdf

2010 to 2012: http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/tables.pdf  Page 171 Table S-1

 

The fiscal situation of the US is even more complex because of the structure of outlays for 2011 shown in Table 2. Mandatory expenditures are 57.5 percent of total outlays and 14.5 percent of GDP. Discretionary expenditures are 37.1 percent of total outlays but $908 billion are security expenditures out of total discretionary of $1416 billion. An even more important constraint is that the expenditures for Social Security, Medicare and Medicaid are $1506 billion equivalent to 9.9 percent of GDP and 39.4 percent of total outlays. The Sep 2010 projections of the Centers for Medicare and Medicaid (CMS) estimate 2011 Federal expenditures on health, including CHIP (Children’s Health Insurance Program) of $989.6 billion (http://www.cms.gov/NationalHealthExpendData/downloads/NHEProjections2009to2019.pdf).

 

Table 2, Outlays of the 2011 Budget Proposal in $ Billions and Percents of GDP and Total Outlays

	2011
Discretionary	1416
Percent of GDP	9.4
Percent of Total Outlays	37.1
Security	908
Non-security	507
Mandatory	2194
Percent of GDP	14.5
Percent of Total Outlays	57.5
Social Security	742
Medicare	488
Medicaid	276
Subtotal	1506
Percent of GDP	9.9
Percent of Total       Outlays	39.4
Net Interest and Disaster	209
Total Outlays	3819
Percent of GDP	25.3
GDP	15,080

Source: http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/tables.pdf   Page 173, Table S-3.

Note: there are discrepancies between outlays and receipts and the deficit between Table S-1 used for Table 1 in this writing and Table S-4 used for Table 2 in this writing.

 

The Fed mandate consists of (http://www.federalreserve.gov/aboutthefed/mission.htm): “conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” The Fed uses two types of monetary policy tools. First, “conventional” policy consists of setting targets of fed funds rates, currently lower short-terms rates with the objective of stimulating aggregate demand, or investment plus personal consumption expenditures, by lowering costs of borrowing in the short-term and in the long-term by the effect of lower rates throughout the term structure of interest rates. At its meeting on Dec 16, 2008, “the Federal Open Market Committee [FOMC] decided today to establish a target range for the federal funds rate of 0 to ¼ percent” (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). Second, “unconventional” monetary policy has been in the form of purchases of long-term securities by expanding the balance sheet of the Fed financed with the creation of Federal Reserve money, mostly liabilities in the form of bank reserves deposited at Federal Reserve Banks. As of Feb 16, 2011, the line “Reserve Bank credit” in the Fed’s balance sheet stood at $2492 billion, or $2.5 trillion, with a portfolio of long-term securities of $2266 billion, or $2.3 trillion, composed of $1111 billion long-term Treasury notes and bonds, $53 billion of inflation-indexed notes and bonds, $144 billion of Federal agency debt securities and $958 billion of mortgage-backed securities; “reserve balances with Federal Reserve banks” stood at $1224 billion or $1.2 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1).

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 purchase of consumer durable goods 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, adding the last two only after quantitative easing on Nov 3, 2010: (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 (2011CWI, 2011INF) calls the “Bernanke shock,” but with sharp fluctuations originating in the shocks in Europe, China and the US.

There was fear of deflation in 2002-2003 (Pelaez and Pelaez, International Financial Architecture, 18-27, The Global Recession Risk, 83-94). The rationale for lowering the fed funds rate to 1 percent was fear of deflation (Bernanke 2002). When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. Monetary policy in the first round of fear of deflation with fed funds of 1 percent between Jun 2003 and Jun 2004 was implemented jointly with a yearly housing subsidy of $221 billion, policy of affordable housing and the purchase or guarantee of $1.6 trillion of nonprime securities by Fannie and Freddie. Short-term interest rates near zero combined with the housing stimulus distorted risk/return calculations. The carry trade consisted of borrowing at close to zero short-term interest rates and taking long positions in housing and risk financial assets such as commodities, equities, emerging equities, corporate debt, junk bonds and so on. These positions relied on rollover of short-term funding to benefit from the short-term rates in everything from adjustable rate mortgages to sale and repurchase agreements of securitized credit obligations. Liquidity was minimized because of the high alternative-return penalty of near zero interest rates. High risks were assumed in the belief that the Fed would maintain the near zero interest rates forever. Creditworthiness was ignored in the belief that increasing prices, such as in real estate, would cushion losses, such as by selling the house to cover the mortgage. Leverage was magnified because of the perceived certainty of returns in an environment of low interest rates indefinitely. The near zero interest rates of the Fed in 2003-2004 induced the causes of the credit/dollar crisis and global recession: excessive risks, high leverage, low liquidity, reliance on short-term funding and unsound credit decisions (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 3 provides the latest available yearly rates of change of GDP, CPI, PPI and unemployment (UEM) for various countries, showing the sharp contrast of the target of Fed policy of core inflation of personal consumptions expenditure (PCE) of “a little below 2 percent,” or some sort of open interval of (1.9, 2.0) and NAIRU (non-accelerating inflation rate of unemployment) of (5, 6). There is no available knowledge in the form of theory, empirical verification and tested policy tools with which to steer the world economy from the slow recovery, high rates of unemployment and rising producer price inflation and consumer price inflation. Changes in interest rates are not sufficient in a linear policy model to simultaneously attain the two objectives of inflation in the neighborhood of 2 percent and NAIRU in the neighborhood of 5.5 percent. As Tinbergen (1952, 78) elucidated, more targets, inflation and NAIRU, than instruments, interest rates, are incompatible.

 

Table 3, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	2.8	1.6	3.6	9.0
Japan	2.6	-0.4	1.6	4.9
China	9.8	4.9	6.6
UK	1.7	4.0	4.8	7.9
Euro Zone	2.0	2.4	5.3	10.0
Germany	4.0	2.0	5.7	7.4
France	1.5	1.8	5.4	9.7
Belgium	2.0	2.9	7.8	8.1
Portugal	1.2	3.64	5.7	11.1
Ireland		1.7	2.7	13.8
Italy	1.3	2.1	4.6	8.6
Greece	-6.6	5.2	6.9	12.4
Spain	0.6	3.3	5.3	20.2

Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier

Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html 

Wall Street Journal Professional Factiva

 

The corporate goods price index of Japan rose 1.6 percent in Jan with leading increases by petroleum, iron ore and corn prices, creating a possible squeeze for consumers (http://professional.wsj.com/article/SB10001424052748703584804576143754090796740.html?mod=WSJPRO_hps_LEFTWhatsNews). Japan’s GDP fell 1.1 percent in the final quarter of 2010 but grew by 2.6 percent in a year (http://www.esri.cao.go.jp/jp/sna/qe104/jikei_1.pdf). China’s inflation rose by 4.9 percent in Jan relative to a year earlier, higher than 4.6 percent in Dec (http://www.ft.com/cms/s/0/00fcd2b0-38bf-11e0-959c-00144feabdc0.html#axzz1DpuE3lQo). Prices excluding food rose the highest in about six years with increasing rents and growth of the money supply by 48 percent being important factors (http://noir.bloomberg.com/apps/news?pid=20601010&sid=aGcMKfolh1XE). Food prices rose by 10.3 percent and have risen by an average of 10 percent in the past four months. There are concerns about the quality of statistics in China that has revised the weights of its price index and loans without disclosure and is changing the key property price index that is important because the urbanization of China is an important source of industrial commodities and raw materials (http://professional.wsj.com/article/SB10001424052748703703804576145040658003416.html http://professional.wsj.com/article/SB10001424052748703373404576147792827651116.html?mod=WSJPRO_hps_LEFTWhatsNews). China also reported changes in the estimate of hot money, or speculative capital inflows, increasing it to $75 billion (http://professional.wsj.com/article/SB10001424052748704657704576149701694249960.html). In addition, China increased the reserve requirements of banks by half a percentage point to 19.5 percent (http://professional.wsj.com/article/SB10001424052748704900004576151783089244032.html?mod=WSJPRO_hps_MIDDLEThirdNews). The UK’s consumer price index rose to 4.0 percent in Jan from 3.7 percent in Dec, with an increase in the value added tax (VAT) and petroleum prices being important factors; annual inflation by the retail prices index (RPI) rose to 5.1 percent in Jan relative to 4.8 percent in Dec (http://www.statistics.gov.uk/pdfdir/cpi0211.pdf). Prices paid in the Empire State survey of the NYFRB rose from 35.79 in Jan to 45.78 in Feb and prices received rose from 15.79 in Jan to 16.87 in Feb (http://www.newyorkfed.org/survey/empire/february2011.pdf). Prices paid in the index of the Philadelphia FRB rose from 54.3 in Jan to 67.2 in Feb and prices received rose from 54.3 in Jan to 67.2 in Feb (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0211.pdf). In response to a questionnaire, 56.2 percent of respondents increased prices since the beginning of the year and 38.2 percent did not increase prices of their goods; 59.2 percent expect to increase prices in the next three months, 34.2 percent do not expect to increase prices and 1.3 percent expect to decrease prices (Ibid). Without seasonal adjustment or exclusions, the CPI of the US rose 1.6 percent in the 12 months ending in Jan (http://www.bls.gov/news.release/pdf/cpi.pdf). Another way of looking at the CPI is that the rate of 0.4 percent in Jan would compound in a year to 4.9 percent while the 12-month rate is “dead” inflation. The US producer price index rose 0.8 percent in Jan after 0.9 percent in Dec and 0.7 percent in Nov; the PPI rose 3.7 in the 12 months ending in Jan after 4.1 percent in Dec (http://www.bls.gov/news.release/pdf/ppi.pdf). The increase of 0.8 percent in Jan would compound to 10.0 percent in 12 months. Continuing events in the Middle East raise concerns about the potential acceleration of inflation because of geopolitical risks analyzed by Roubini (2011SR) with weak economies and unemployment in the advanced economies that was termed in the past as stagflation. Import prices rose 1.5 percent in Jan 2011 and increased at least 1.0 percent during four consecutive months for the first time since Jul 2008; import prices rose 5.3 percent in the 12 months ending in Jan, which is the largest increase since 8.5 percent in the 12 months ending in May 2010 (http://www.bls.gov/news.release/pdf/ximpim.pdf). Prices for nonfuel imports rose 0.8 percent in Jan, including “prices of nonfuel industrial supplies and materials, finished goods, and foods, feeds, and beverages all contributing to the overall advance” (Ibid, 2). The increase of export prices of 1.2 percent in Jan was broad-based with increases for agricultural and also for nonagricultural prices: “the price index for nonagricultural exports advanced 0.9 percent in Jan. Nonagricultural prices rose 5.3 percent over the past year, led mostly by a 13.9 percent advance in the price index for nonagricultural industrial supplies and machinery” (Ibid, 3). The Tinbergen (1952) policy analysis raises the question of whether monetary policy resembles the circus performer throwing too many bowling pins in the air that cannot be caught when they fall.

III Rising Yields. Table 4, updated with every blog, provides in the second column the yield at the close of market of the 10-year Treasury on the date in the first column. The price in the third column is calculated with the coupon of 2.625 percent of the current 10-year note and the final column “∆% 11/04/10” calculates the percentage change of the price on the date relative to that of 101.2573 at the close of market one day after the decision on quantitative easing by the Fed on Nov 4, 2010. Prices with the new coupon of 3.63 percent in the most recent auction (http://www.treasurydirect.gov/instit/annceresult/press/preanre/2011/2011.htm) are not comparable to prices in Table 4. The highest yield in the decade was 5.510 percent on May 1, 2001 that would result in a loss of principal of 22.9 percent relative to the price on Nov 4. The Fed has created a “duration trap” of bond prices. Duration is the percentage change in bond price resulting from a percentage change in yield or what economists call the yield elasticity of bond price. Duration is higher the lower the bond coupon and yield, all other things constant. This means that the price loss in a yield rise from low coupons and yields is much higher than with high coupons and yields. Intuitively, the higher coupon payments offset part of the price loss. Prices/yields of Treasury securities were affected by the combination of Fed purchases for its program of quantitative easing and also by the flight to dollar-denominated assets because of geopolitical risks in the Middle East. The yield of 3.582 percent at the close of market on Feb 18 would be equivalent to price of 92.0157 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 9.1 percent relative to the price on Nov 4, 2010, one day after the decision on the second program of quantitative easing. If inflation accelerates, yields of Treasury securities may rise sharply.

 

Table 4. 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
01/28/11	3.323	94.1064	-7.1
02/04/11	3.640	91.750	-9.4
02/11/11	3.643	91.5319	-9.6
02/18/11	3.582	92.0157	-9.1

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 and the coupon of 2.625% on 11/04/10

Source:

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

 

IV G20 and Global Imbalances. The main theme of the G20 meeting of finance ministers and governors of central banks in Paris on Feb 18-19 was the issue of global imbalances. This time has recurred over a decade (Pelaez and Pelaez, International Financial Architecture (2005), 1-62, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b) 180-213, Government Intervention in Globalization (2008c), 167-84). The concern is with the development after the Asian crisis of 1997-1998 of imbalances in the form of fiscal and current account deficits in some countries, such as the US, financed with savings in the form of current account surpluses in other countries, such as China and Japan. Table 5 provides the IMF projections showing that the current account deficit of China will reach 7.8 percent of GDP in 2015 and that of the US 3.4 percent of GDP. The vulnerability was in the form of a possible “disorderly correction,” in which the glut of US debt would cause a risk premium on US government securities and devaluation of the dollar. Economic research could not find a parallel case of such disorderly correction but its occurrence could not be ruled out. Before the credit/dollar crisis of 2007, an effort of monitoring and adjusting imbalances was developed under coordination by the IMF. The recovery from the global recession of 2007-2009 has been uneven with emerging and developing economies growing at a faster rate, albeit with the first signs of inflation and currency overvaluation and fiscal/monetary stimulus inherited from the recession while capacity in the economy moved toward full utilization. As explained in the prior comment of this blog, the interests of G20 members are conflicting and reconciliation would require drastic changes in internal monetary and fiscal policies that could affect economic growth and employment. This is typical in collective action by groups (Olson 1965). In brief, China expects to continue its model of exporting while revaluing its currency at a moderate pace in order to maintain a high rate of economic growth that can provide employment to large numbers of new entrants in the labor force and absorb labor from the subsistence sector to alleviate the plight of millions of people surviving on two dollars per day. The US and Europe aspire to reverse trade deficits or in some cases insufficient surpluses in stimulating exports while also competing in internal markets with imports from other countries, thus seeking more favorable world exchange rates. Emerging markets would want to prevent the overvaluation of their currencies caused by the inflows of foreign funds seeking higher returns in their financial markets because of near-zero interest rates by the Fed, European Central Bank, Bank of England and Bank of Japan. All countries find that they have the sovereign right to manage their fiscal, monetary and exchange rate policies in accordance with their national interest

 

Table 5, 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	14,870	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

 

The G20 meeting produced a communiqué on global imbalances that required in its drafting difficult conciliation of interests of multiple members:

“We reviewed the progress made since the Seoul Summit and stressed the need to reduce excessive imbalances and sustain imbalances of the current account balance to sustainable levels by strengthening multilateral cooperation. We agreed on a series of indicators that allow us to focus, through an integrated process in two stages, the major and persistent imbalances that require action. To finalize the first stage, our goal is to reach an agreement by our next meeting in April on the indicative guidelines for the evaluation of each of these indicators, while recognizing the need for account of national or regional situations, including the major producers of raw materials. Without being targets, these indicative guidelines will be used to evaluate the following indicators: debt and deficit, the saving rate and private debt and external imbalances from the trade balance of net income investment and transfers, taking full account of the exchange rate and fiscal policies, monetary or otherwise. We also adopted a timetable for developing the 2011 Action Plan for implementation of our framework for a strong, sustainable and balanced and monitoring the implementation of commitments. As we have decided to Seoul, we urge the IMF to provide us during our October meeting, under the mutual evaluation process, an assessment of progress towards viability of the external position and policy coherence. On this occasion, we also examine a report on the mutual evaluation process including an action plan based on an analysis of root causes of major and persistent imbalances itself based on the guidelines. We will also consider an assessment of progress in implementing the commitments made in Seoul” (http://www.g20.utoronto.ca/2011/2011-finance-110219-fr.html).

That is, the G20 agreed on the economic indicators to monitor vulnerabilities to future economic crises, which are “debt and deficit, the saving rate and private debt and external imbalances from the trade balance of net income and transfers” (Ibid). There will be “full account” of exchange rates and monetary and fiscal policies (http://professional.wsj.com/article/SB10001424052748703407304576153890049850736.html?mod=WSJPRO_hps_LEFTWhatsNews http://www.ft.com/cms/s/0/1a12713e-3c56-11e0-b073-00144feabdc0.html#axzz1ESfgUX5z). There are no targets. All countries must agree on technical issues or there is no agreement, which could mean that there will never be any agreement. The text is similar to those incorporated in recent regulatory legislation such as the Dodd-Frank act but there are no regulators crafting rules to give meaning to the vague words and no process of regulation or enforcement as typical in soft law (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 114-25).

V Risk Financial Assets. This section updates several tables that are essential in analyzing the effects of monetary policy on world risk financial assets. 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). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html New empirical and theoretical contributions will also be analyzed in this section.

Table 6 shows the phenomenal impulse to valuations of risk financial assets originating in the initial shock of near zero interest rates in 2003-2004 with the fed funds rate at 1 percent, in fear of deflation that never materialized, and quantitative easing in the form of suspension of the auction of 30-year Treasury bonds to lower mortgage rates. The charts of risk financial assets show sharp rise in valuations leading to the financial crisis and then profound drops that are captured in Table 6 by percentage changes of peaks and troughs. World financial markets were dominated by Fed and housing policy in the US. Table 6 now has a row for the Chinese yuan (CNY) rate of exchange relative to the US dollar (USD). China pegged the exchange rate at a value that afforded significant competitive power in trade, at around 8.2798 CNY/USD, revalued it from 2005 to 2008 by 17.6 percent, pegged it again to the dollar to avoid loss of competitiveness during the global recession and then revalued it by 3.6 percent by Fri Jan 18, 2011. The first round of quantitative easing and near zero interest rates depreciated the dollar relative to the euro by 39.3 percent between 2003 and 2008, with revaluation of the dollar by 25.1 percent from 2008 to 2010 in the flight to dollar-denominated assets in fear of world financial risks and then devaluation of the dollar by 14.8 percent by Fri Jan 18.

 

Table 6, 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	6/07/10	02/11 /11
Rate	1.1423	1.5914	1.192	1.355
CNY/USD	01/03 2000	07/21 2005	7/15 2008	02/18 2011
Rate	8.2798	8.2765	6.8211	6.5731
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

http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm

http://markets.ft.com/ft/markets/currencies.asp

 

The trends of valuations of global risk financial assets are dominated by the carry trade from near zero interest rates in the US to take long positions in risk financial assets. Investors and financial professionals learned from losses or how to avoid them. The carry trade is now more opportunistic in quickly realizing profits to avoid losses during periods of risk aversion resulting from events such as the European risk issues, fears of the tradeoff of growth and inflation in Asia and slow growth with high unemployment and underemployment in the US together with expectations of increases in taxes and interest rates. When risk aversion is subdued, the combination of near zero interest rates of fed funds and quantitative easing creates again the dream of traders of “the trend is my friend” without as strong a belief in the Bernanke-put, or floor on risk financial asset valuations, as in earlier periods. Table 7 captures the decline of risk financial assets resulting from the European sovereign risk issues after Apr and the sharp recovery that was not interrupted by the second round in late Nov. The final column shows that after Jun there is repetition of the trend of high valuations of risk financial assets with the exception of the dollar that devalued by 14.8 percent.

 

Table 7, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 2/ 18/11	∆% Week 2/ 18 /11	∆% Trough to 2/ 18/11
DJIA	4/26/ 10	7/2/10	-13.6	10.6	0.9	27.9
S&P 500	4/23/ 10	7/20/ 10	-16.0	10.3	1.0	29.9
NYSE Finance	4/15/ 10	7/2/10	-20.3	1.5	1.7	27.4
Dow Global	4/15/ 10	7/2/10	-18.4	7.4	1.9	31.6
Asia Pacific	4/15/ 10	7/2/10	-12.5	9.2	2.8	24.7
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-4.8	2.2	22.9
China Shang.	4/15/ 10	7/02 /10	-24.7	-8.4	2.6	21.7
STOXX 50	4/15/10	7/2/10	-15.3	1.9	1.5	20.3
DAX	4/26/ 10	5/25/ 10	-10.5	17.3	0.8	30.9
Dollar Euro	11/25 2009	6/7 2010	21.2	9.5	1.0	-14.8
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	12.4	0.3	31.4
10-Year Tre.	4/5/ 10	4/6/10	3.986	3.582

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 8 provides the percentage changes of the DJIA and the S&P 500 since Apr 26, around the European sovereign risk issues, from current to previous selected dates and relative to Apr 26. Chairman Bernanke (2010WP) first argued that quantitative easing was also designed to increase the valuations of stocks with the objective of creating a wealth effect that would motivate consumption.

 

Table 8, 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
Jan 28	-0.4	5.5	-0.5	5.3
Feb 4	2.3	7.9	2.7	8.1
Feb 11	1.5	9.5	1.4	9.7
Feb 18	0.9	10.6	1.0	10.8

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

 

The issue of capital controls is actually an issue of exchange rate policy. Table 9, which is updated with every post, shows in the last three rows the Chinese yuan (CNY) to US dollar (USD) exchange rate or number of CNY required to buy one USD. China fixed the rate at around 8.2765 CNY/USD for a long period until Aug 2005. That rate afforded a competitive edge to Chinese products in world markets and in competition of internally-produced goods with foreign-produced imports. China then strengthened the yuan by 17.6 percent until Jul 2008 when it fixed it to the dollar in an effort to prevent the erosion of its competitiveness in world markets and at home to protect the economy from the global recession. China resumed the revaluation of the yuan in 2010, with revaluation by 3.6 percent by Feb 18, 2011. Table 9 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 9, Exchange Rates

	Peak	Trough	∆% P/T	Feb 18 2011	∆% T Feb 18	∆% P Feb 18
EUR USD	7/15 2008	6/7 2010		2/18/ 2011
Rate	1.59	1.192		1.369
∆%			-33.4		12.9	-16.2
JPY USD	8/18 2008	9/15 2010		2/18 2011
Rate	110.19	83.07		83.15
∆%			24.6		-0.1	24.5
CHF USD	11/21 2008	12/8 2009		2/18 2011
Rate	1.225	1.025		0.951
∆%			16.3		7.2	22.4
USD GBP	7/15 2008	1/2/ 2009		2/18 2011
Rate	2.006	1.388		1.625
∆%			-44.5		14.5	-23.5
USD AUD	7/15 2008	10/27 2008		2/18 2011
Rate	1.0215	1.6639		1.014
∆%			-62.9		40.7	3.5
ZAR USD	10/22 2008	8/15 2010		2/18 2011
Rate	11.578	7.238		7.14
∆%			37.5		1.4	38.3
SGD USD	3/3 2009	8/9 2010		2/18 2011
Rate	1.553	1.348		1.274
∆%			13.2		5.5	17.9
HKD USD	8/15 2008	12/14 2009		2/18 2011
Rate	7.813	7.752		7.785
∆%			0.8		-0.4	0.4
BRL USD	12/5 2008	4/30 2010		2/18 2011
Rate	2.43	1.737		1.663
∆%			28.5		4.3	31.6
CZK USD	2/13 2009	8/6 2010		2/18 2011
Rate	22.19	18.693		17.822
∆%			15.7		4.7	19.7
SEK USD	3/4 2009	8/9 2010		2/18 2011
Rate	9.313	7.108		6.385
∆%			23.7		10.2	31.4
CNY USD	7/20 2005	7/15 2008		2/18 2011
Rate	8.2765	6.8211		6.5731
∆%			17.6		3.6	20.6

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; CNY: Chinese yuan; 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

http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm

http://markets.ft.com/ft/markets/currencies.asp

 

VI Economic Indicators. Industry continues to improve but housing and the job market are still weak. The general index of business conditions of the New York FRB registered an improvement of 3.51 points from 11.92 in Jan to 15.43 in Feb but new orders declined by 0.59 points from 12.39 in Jan to 11.80 in Feb while the number of workers fell 4.81 points from 8.42 in Jan to 3.61 in Feb (http://www.newyorkfed.org/survey/empire/february2011.pdf). The general index of the Philadelphia FRB registered sharp improvement from 19.3 in Jan to 35.9 in Feb; new orders were 23.7 in Feb almost the same as 23.6 in Jan; and the number of workers rose from 17.6 in Jan to 23.6 in Feb (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0211.pdf). US retail and food services sales in Jan, seasonally adjusted, rose 0.3 percent from Dec and 7.8 percent from Jan 2010; total sales for Nov 2010 to Jan 2011 rose 7.6 percent relative to the same period a year earlier (http://www.census.gov/retail/marts/www/marts_current.pdf). The combined value of distributive trade sales and manufacturers’ shipments in Dec, seasonally adjusted, rose 1.1 percent in Dec relative to Nov and 8.7 percent relative to Dec 2009; manufacturers and trade inventories rose 0.8 percent in Dec and 8.0 percent relative to a year earlier (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf). The Fed estimates a decline of industrial production of 0.1 percent in Jan after rising by 1.2 percent in Dec but manufacturing output rose 0.3 percent in Jan after 0.9 percent in Dec; excluding motor vehicles and parts factory output rose 0.1 percent in Jan; and capacity utilization stood at 76.1 percent, which is 4.4 percentage points below the average in 1972-2010 (http://www.federalreserve.gov/releases/g17/Current/default.htm). Privately-owned housing starts in Jan were at a seasonally adjusted annual equivalent rate of 596,000, which is 14.6 percent higher than 520,000 in Dec but 2.6 percent lower than the rate of 612,000 in Jan 2010; authorized privately-owned building permits in Jan were at a seasonally adjusted annual equivalent rate of 562,000, which is 10.4 percent lower than 627,000 in Dec and 10.7 percent lower than 629,000 in Jan 2010 (http://www.census.gov/const/newresconst.pdf). New privately-owned houses started in Jan 2011, not seasonally adjusted, were 38,200 (http://www.census.gov/const/newresconst.pdf) while they were 140,700 in Jan 2005 (http://www.census.gov/const/newresconst_0501.pdf) for a decline of 72.3 percent. Euro zone seasonally adjusted industrial production fell 0.1 percent in Dec after increasing 1.4 percent in Nov and was higher by 8.0 percent than in Dec 2009 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-14022011-AP/EN/4-14022011-AP-EN.PDF). Exports of the euro zone grew 20 percent in Dec 2010 relative to Dec 2009 and imports 24 percent; there was a minor trade deficit of €0.5 billion compared with a surplus of €3.2 billion in Dec 2009 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/6-15022011-BP/EN/6-15022011-BP-EN.PDF). Seasonally adjusted construction in the euro zone fell by 1.8 percent in Dec 2010 and 12 percent relative to a year earlier (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-17022011-AP/EN/4-17022011-AP-EN.PDF). Initial claims for unemployment insurance seasonally adjusted rose by 25,000 to 410,000 in the week ending on Feb 12 while unadjusted claims fell 19,271 to 421,713 (http://www.dol.gov/opa/media/press/eta/ui/current.htm).

VII Interest Rates. The 10-year Treasury stood at 3.58 percent on Fri Jan 18, which is lower than 3.65 percent a week before but higher than 3.45 percent a month earlier. The 30-year Treasury stood at 4.69 percent on Fri Jan 18, lower than 4.71 percent in the prior week but higher than 4.61 percent a month earlier (http://markets.ft.com/markets/bonds.asp). The 10-year government bond of Germany traded at 3.24 percent for a negative spread relative to the comparable Treasury of 35 basis points. The 10-year Treasury with coupon of 3.63 percent with maturity in 02/21 traded at yield of 3.59 percent equivalent to price of 100.31 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-180211). The price is not comparable to that in Table 4 because of the different coupon of 2.625 percent and maturity in exactly ten years that is used in an exercise of comparing prices with those prevailing on Nov 4, 2010, a day after the decision on quantitative easing.

VIII Conclusion. Inflation is everywhere in the world economy, including advanced economies and not only in emerging countries. The near zero interest rates of the Fed and other central banks stimulate the carry trade into commodities and other risk financial assets. Unemployment is high in many advanced economies because of the mediocre rate of economic growth. There are major vulnerabilities in the international financial system such as the sovereign risk issues in Europe, the inflation/growth tradeoff in China and growth/unemployment weakness in the US. Budget deficits and government debt are pushing through the threshold of sustainability in many advanced economies, including the US. (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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© Carlos M. Pelaez, 2010, 2011