Is there a Second Act of the US Great Inflation and Unemployment?
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011
This comment provides review of the literature attempting to explain the causes and deepening of the Great Inflation of the 1970s, a period which is unique in US peacetime experience with inflation rising to two digit levels that ended with fed funds rates in excess of 20 percent that caused a banking crash and worldwide debt moratorium. The Great Inflation is far more relevant for analysis of current conditions than misplaced comparisons of alleged current deflation similar to that during the Great Depression. The fact that consumer price index (CPI) inflation was 0.7 percent in 1961 just before the beginning of the Great Inflation in the mid 1960s raises the counterfactual of how much worse the Great Inflation would have been if the policy response to inflation in 1961 would have been zero interest rates and trillions of dollars of purchases of long-term securities. The various strands of literature surveyed in section II have a common theme that for different reasons the policies of the Fed in the 1960s and 1970s disregarded inflation control in favor of actively controlling the output gap or percentage deviation of GDP from its potential to promote full employment. The current policy of zero fed funds rate and Fed portfolio of $2.3 trillion of long-term securities is the highest policy accommodation in history at the time when worrisome signs of inflation appear throughout the world economy. The issue for debate is not whether there should be a central bank engaged in monetary policy but rather whether that central bank should engage in exotic policy in the form of experiments with doses such as zero interest rates and purchase of trillions of dollars of securities that appear to have been a primary cause of the financial crash and global recession after 2007. The contents are as follows:
I Inflation and Unemployment
II The American Great Inflation of the 1970s
IIA The Great Inflation
IIB Oil Price Shocks
IIC Inflation Surprise
IID Inadvertent Policy Mistake
IIE Imperfect Information
IIF Current Risks
III Valuation of Risk Financial Assets
IV Economic Indicators
V Interest Rates
VI Conclusion
References
I Inflation and Unemployment. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 1, updated with every post, provides the latest yearly data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of the sovereign risk issues (http://www.ft.com/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1G67TzFqs). Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration. The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are four key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings; (2) the tradeoff of growth and inflation in China; (3) slow growth (see http://cmpassocregulationblog.blogspot.com/2011/02/mediocre-growth-raw-materials-shock-and.html) and continuing job stress of 25 to 30 million people in the US (see http://cmpassocregulationblog.blogspot.com/2011/03/unemployment-and-undermployment.html); and (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies.
Table 1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 2.7 | 2.1 | 5.6 | 8.9 |
| Japan | 2.5 | 0.0 | 1.7 | 4.9 |
| China | 9.8 | 4.9 | 7.2 | |
| UK | 1.5 | 4.0 | 5.3* output 14.6 input 8.5** | 7.9 |
| Euro Zone | 2.0 | 2.4 | 6.1 | 9.9 |
| Germany | 4.0 | 2.2 | 5.5 | 6.5 |
| France | 1.5 | 1.8 | 5.5 | 9.6 |
| Nether-lands | 2.4 | 2.0 | 10.3 | 4.3 |
| Finland | 5.0 | 3.5 | 8.1 | 8.0 |
| Belgium | 1.8 | 3.5 | 9.0 | 8.0 |
| Portugal | 1.2 | 3.5 | 5.7 | 11.2 |
| Ireland | 0.9 | 4.0 | 13.5 | |
| Italy | 1.5 | 2.1 | 4.6 | 8.6 |
| Greece | -6.6 | 4.2 | 6.7 | 12.4 |
| Spain | 0.6 | 3.4 | 6.8 | 20.4 |
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
*Feb Office for National Statistics http://www.statistics.gov.uk/pdfdir/ppi0311.pdf
** Jan EUROSTAT http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-02032011-AP/EN/4-02032011-AP-EN.PDF
Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html
Wall Street Journal Professional Factiva
Table 2 provides 12-months rate of change of the CPI and the PPI in the US. The PPI has been increasing at significantly high 12-month rates for the past year while the CPI has been increasing at much lower rates. Price increases through the production chain have been at relatively high rates for the past year and may eventually pass-through to consumer prices. The DJ-UBS Commodity index has increased 32.9 percent since a low on Jul 2, 2010 (see Table 8 below in section III on Valuations of Risk Financial Assets). According to market data from the Financial Times, Brent crude oil was last priced at $113.93/barrel and has increased by 39.9 percent in the past 52 weeks; the crude oil front month futures was priced in NYMEX at $101.62/barrel, increasing 26.0 percent in the past 52 weeks; COMEX gold 1 futures chain front month was last priced at $1419/ounce, increasing by 28.5 percent in the past 52 weeks; copper high grade front month futures was last priced at CMX at 433.75 cents, increasing by 28.6 percent in the past 52 weeks; and corn front month futures was priced at 684.50 cents at CBT, increasing 82.3 percent in the past 52 weeks (http://markets.ft.com/markets/commodities.asp).
Table 2, Twelve Month CPI and PPI Inflation
| CPI | PPI | |
| Feb 10 | 2.3 | 4.2 |
| Mar 10 | 2.2 | 5.9 |
| Apr 10 | 2.0 | 5.4 |
| May 10 | 1.1 | 5.1 |
| Jun 10 | 1.2 | 2.7 |
| Jul 10 | 1.2 | 4.1 |
| Aug 10 | 1.1 | 3.3 |
| Sep 10 | 1.1 | 3.9 |
| Oct 10 | 1.2 | 4.3 |
| Nov 10 | 1.1 | 3.5 |
| Dec 10 | 1.5 | 4.0 |
| Jan 11 | 1.6 | 3.6 |
| Feb 11 | 2.1 | 5.6 |
Sources: http://www.bls.gov/news.release/ppi.htm
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
The movement of inflation through the production chain is also shown in the responses to the surveys of industry of the New York Federal Reserve Bank (FRB) and the Philadelphia Federal Reserve Bank (PHFRB). Table 3 shows the larger number of responses of increasing prices currently and in six months in both surveys with higher prices paid but not yet fully reflected in prices received. Trade prices have been increasing sharply since Oct 2010. The price of all imports into the US rose 6.9 percent in the 12 months ending in Feb 2011 and the price of exports 8.6 percent. The 12-month rates of increase in Feb 2011 of fuel imports were 18.6 percent and of nonfuel imports 3.6 percent while the 12-month rates of increase of agricultural exports were 33.5 percent and of nonagricultural exports 6.2 percent (http://www.bls.gov/news.release/ximpim.nr0.htm).
Table 3, Questionnaire Reponses of Prices Paid and Received and Diffusion Indexes of the Federal Reserve Banks of Philadelphia (PHFRB) and New York (NYFRB) %
| Higher | Same | Lower | Index | |
| NYFRB-6 | ||||
| Prices Paid | ||||
| Feb | 57.8 | 39.8 | 2.4 | 55.4 |
| Mar | 72.7 | 25.9 | 1.3 | 71.4 |
| Prices Received | ||||
| Feb | 33.7 | 60.2 | 6.0 | 27.7 |
| Mar | 38.9 | 58.4 | 2.6 | 36.4 |
| NYFRB-C | ||||
| Prices Paid | ||||
| Feb | 48.2 | 49.4 | 2.4 | 45.8 |
| Mar | 53.3 | 46.8 | 0.0 | 53.2 |
| Prices Received | ||||
| Feb | 24.1 | 68.7 | 7.2 | 16.9 |
| Mar | 25.9 | 68.8 | 5.2 | 20.8 |
| PHFRB-6 | ||||
| Prices Paid | ||||
| Mar | 68.4 | 28.9 | 1.2 | 73.1 |
| Prices Received | ||||
| Mar | 43.7 | 48.4 | 5.6 | 38.1 |
| PHFRB-C | ||||
| Prices Paid | ||||
| Mar | 63.8 | 36.2 | 0.0 | 63.8 |
| Prices Received | ||||
| Mar | 31.5 | 59.7 | 8.8 | 22.6 |
Note: C: current; 6: six months from now; Higher: percentage responding that prices are higher; Same: percentage responding that prices are the same; Lower: percentage responding that prices are lower
Sources: http://www.newyorkfed.org/survey/empire/3_2011.pdf
http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0311.pdf
II The American Great Inflation of the 1970s. The objective of this section is to provide a description of the stagflation episode known as the American Great Inflation of the 1970s in subsection IIA and analyses of this episode in subsections IIB through IIE. The risks in the current environment of another stagflation are considered in subsection IIF.
IIA The Great Inflation. De Long (1997, 247-8) finds that:
“Aside from wars and the Great Depression, at other times inflation is almost always less than 5% and usually 2-3% per year—save for the decade of the 1970s. The 1970s are America’s only peacetime outburst of inflation. The sustained elevation of inflation for a decade has no parallel in the past century. The cumulative impact of the decade of 5-10% inflation was large. Since 1896, there has been a steady upward drift in the price level. Superimposed on this drift are rapid jumps as a result of World War I and the removal of World War II’s price controls, and a sharp decline during the slide into the Great Depression. On this scale, the inflation of the 1970s was as large an increase in the price level relative to drift as either of this century’s major wars. And the inflation of the 1970s was broad-based: the qualitative pattern is similar no matter which particular price index is examined.”
Table 4 provides the rate of growth of GDP, the percentage change in the consumer price index (CPI) and the rate of unemployment (UE) from 1960 to 1990. Double digit inflation rates plagued the 1970s with the economy running in “stop and go” episodes. The Fed raised the fed funds rate with the effective rate reaching 22.36 percent on Jul 22, 1981 (http://www.federalreserve.gov/releases/h15/data/Daily/H15_FF_O.txt). The rate of unemployment rose to 9.7 percent in 1982 on an annual basis. The CPI data in Table 2 are 12-month rates of change without seasonal adjustment while the unemployment rate is the seasonally adjusted rate in Dec because annual unemployment rates are not available at the BLS before 1975. Comparison with change in real GDP centered on an annual basis is not ideal. Several countries that had borrowed for financing balance of payments deficits declared moratoriums on their foreign debts, impairing balance sheets of money-center banks. The increase in interest rates to deal with stagflation caught the banking industry with short-dated funding and long-term fixed-rate assets. In a parallel of what could happen when the Fed abandons its near zero interest rates, 1150 US commercial banks, around 8 percent of the industry, failed, almost twice the number of banks that failed from establishment of the FDIC in 1934 until 1983 (Benston and Kaufman 1997, 139; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 72-7). More than 900 savings and loans associations, equivalent to around 25 percent of the industry, had to be closed, merged or placed in conservatorship (Ibid). Taxpayer funds in the value of $150 billion were used in the resolution of failed savings and loans institutions. In terms of relative dimensions, $150 billion was equivalent to 2.6 percent of GDP of $5800 billion in 1990 and 3.6 percent of GDP of $4217 billion in 1985 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=1980&LastYear=1990&3Place=N&Update=Update&JavaBox=no). The equivalent in terms of 2.6 to 3.6 percent of US GDP in 2010 of $14,657 billion would be $381 billion to $528 billion (data from Ibid). Wide swings in interest rates resulting from aggressive monetary policy can wreck the balance sheets of families, financial institutions and companies while posing another recession risk. While it is true that the Fed can increase interest rates instantaneously, the increase from zero percent toward much higher levels to contain inflation can have devastating effects on the world economy. The Financial Times/Harris Poll finds that few respondents in the major economies of Europe and the US are not concerned of being affected by inflation (http://www.ft.com/cms/s/0/0354c278-3d0d-11e0-bbff-00144feabdc0.html#axzz1Ead9yEL8). About 40 percent of respondents in the UK, US and Germany expect strong or very strong effects from inflation and 60 percent in Spain and France.
Table 4, US Annual Rate of Growth of GDP and CPI and Unemployment Rate 1960-1982
| ∆% GDP | ∆% CPI | UNE | |
| 1960 | 2.5 | 1.4 | 6.6 |
| 1961 | 2.3 | 0.7 | 6.0 |
| 1962 | 6.1 | 1.3 | 5.5 |
| 1963 | 4.4 | 1.6 | 5.5 |
| 1964 | 5.8 | 1.0 | 5.0 |
| 1965 | 6.4 | 1.9 | 4.0 |
| 1966 | 6.5 | 3.5 | 3.8 |
| 1967 | 2.5 | 3.0 | 3.8 |
| 1968 | 4.8 | 4.7 | 3.4 |
| 1969 | 3.1 | 6.2 | 3.5 |
| 1970 | 0.2 | 5.6 | 6.1 |
| 1971 | 3.4 | 3.3 | 6.0 |
| 1972 | 5.3 | 3.4 | 5.2 |
| 1973 | 5.8 | 8.7 | 4.9 |
| 1974 | -0.6 | 12.3 | 7.2 |
| 1975 | -0.2 | 6.9 | 8.2 |
| 1976 | 5.4 | 4.9 | 7.8 |
| 1977 | 4.6 | 6.7 | 6.4 |
| 1978 | 5.6 | 9.0 | 6.0 |
| 1979 | 3.1 | 13.3 | 6.0 |
| 1980 | -0.3 | 12.5 | 7.2 |
| 1981 | 2.5 | 8.9 | 8.5 |
| 1982 | -1.9 | 3.8 | 10.8 |
| 1983 | 4,5 | 3.8 | 8.3 |
| 1984 | 7.2 | 3.9 | 7.3 |
| 1985 | 4.1 | 3.8 | 7.0 |
| 1986 | 3.5 | 1.1 | 6.6 |
| 1987 | 3.2 | 4.4 | 5.7 |
| 1988 | 4.1 | 4.4 | 5,3 |
| 1989 | 3.6 | 4.6 | 5.4 |
| 1990 | 1.9 | 6.1 | 6.3 |
Note: GDP: Gross Domestic Product; CPI: consumer price index; UNE: rate of unemployment; CPI and UNE are at year end instead of average to obtain a complete series
Source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
http://www.bls.gov/web/empsit/cpseea01.htm
http://data.bls.gov/pdq/SurveyOutputServlet
IIB Oil Price Shocks. It is difficult to analyze oil price shocks as exogenous determinants of the US economy as Barsky and Kilian (2004) find in an “idiosyncratic” survey of vast literature and data (see Barksy and Kilian 2001). The Great Inflation actually began in the 1960s before the oil price shocks of the 1970s (De Long 1997). Barsky and Killian (2004) analyze five oil shocks with reference of the business cycle dates of the NBER, finding a variety of relations with the aggregate US economy that do not permit a simple link between increases in oil prices and US inflation. The following sections focus on the analysis of monetary policy affecting the Great Inflation.
IIC Inflation Surprise. Friedman (1968, 8) defines that “the ‘natural rate of unemployment’ is the level that would be ground out by the Walrasian system of general equilibrium equations” with the multiple structural characteristic of the actual economy. According to Friedman (1968, 8) “Phillips’ analysis of the relation between unemployment and wage change is deservedly celebrated as an important and original contribution” but does not distinguish “between nominal wages and real wages” such that it is based in “a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wages.” Friedman (1968, 8-9) uses an example that inflation of 75 percent per year was widely anticipated in Brazil but when policy was successful in reducing it to 45 percent per year “there was a sharp initial rise in unemployment because under the influence of earlier anticipations, wages kept rising at a pace that was higher than the new rate of price rise, though lower than earlier.” Such a rise in unemployment would be expected in “all attempts to reduce the rate of inflation below that widely anticipated” (Friedman 1968, 9). Phelps (1968) formalizes the role of expectations in the Phillips curve and its steady state properties.
The monetary and fiscal framework to attain monetary stability as compromised by business cycles proposed by Friedman (1948, 246) consists of:
“(1) Government must provide a monetary framework for a competitive order since the competitive order cannot provide one for itself. (2) This monetary framework should operate under the ‘rule of law’ rather than the discretionary authority of administrators. (3) While a truly free market in a ‘competitive order’ would yield far less inequality than currently exists, I should hope that the community would desire to reduce inequality even further.”
An important reason for rules instead of discretion is the existence of lags in economic policy:
“(1) the lag between the need for action and the recognition of this need; (2) the lag between recognition of the need for action and the taking of action; and (3) the lag between the action and its effects.”
Forecasting and measuring appropriate doses of policy are also major hurdles. These lags are even more frustrating in designing, approving and implementing international economic coordination such as the case of global imbalances (Pelaez and Pelaez, The Global Recession Risk (2007), 214).
Lucas (1976) warns about the use in policy of econometric relations estimated from a structure before policy implementation because the parameters are likely to change as the public anticipates the policy change. An example from Lucas (1976) is discussed by Chari (1998). A tax credit on investment may be designed to stimulate the economy away from recession or low employment but the anticipation of the credit results in postponement of decisions until the completion of the political process of approval and the legislation being in force. CARD, the Credit Card Accountability and Responsibility and Disclosure Act of 2009 (http://www.gpo.gov/fdsys/pkg/PLAW-111publ24/pdf/PLAW-111publ24.pdf), was signed by the President on May 22, 2009 but did not go into effect until February 22, 2010. In that nine-month interval, credit card issuers protected the interests of their shareholders reducing credit limits and availability of cards to customers with lower credit rating, thus harming consumers at the time when higher consumption was required for growth and employment. CARD was enacted with the wrong supposition that past behavior of credit card issuers would continue even as they knew exactly how their business would be harmed by the new law. In this case, credit decision functions of card issuers based on current and past structures at the time the law was first considered changed with the net effect of harming instead of benefiting consumers. Much the same is happening with the consumer protection agency being implemented under the financial regulation Dodd-Frank act.
The application of optimal control theory even with a specified social objective function may be the best for the current situation but would not be appropriate unless the decisions of economic agents were invariant to changes in economic policy. Policy may be reversed from intentions even if economic agents only “have some knowledge of how policymakers’ decisions will change as a result of changing economic conditions” (Kydland and Prescott 1976, 474). That simple knowledge could be the anticipated change in administration, such as the Nov 2010 congressional elections or currently that everybody is expecting major tax and interest rate increases in the near future, causing higher savings. Kydland and Prescott (1976, 477) provide an example that resembles the life-losing and economically-costly Katrina Hurricane of 2005. The socially-desirable outcome is not to build residences in a region below sea level that can be devastated by tidal waves preceding hurricanes. Rational economic agents would not live in that area unless they anticipated that the army corps of engineers would build dams and levees. If there were not a law prohibiting building in such exposed areas, people would construct there and the army corps of engineers would build the dams and levees that would prove inadequate for the category 3 hurricane winds of 125 miles per hour Hurricane Katrina that hit Plaquemines Parish Louisiana at 7:10 AM on Aug 29, 2005 (http://www.katrina.noaa.gov/). A rule of law of not permitting construction in such an exposed area would have been optimal instead of the discretionary policy of building dams and levees if people constructed in that area.
The inflation-unemployment example of Kydland and Prescott (1976, 477-80) is extremely relevant to current policy:
“The suboptimality of the consistent policy is not generally recognized for the aggregate demand management problem. The standard policy prescription is to select that policy which is best, given the current situation. This may seem reasonable, but for the structure considered, which we argue is a plausible abstraction of reality, such policy results in excessive rates of inflation without any reduction in unemployment. The policy of maintaining price stability is preferable.”
The analysis by Kydland and Prescott (1977, 447-80, equation 5) uses the “expectation augmented” Phillips curve with the natural rate of unemployment of Friedman (1968) and Phelps (1968), which in the notation of Barro and Gordon (1983b, 592, equation 1) is:
Ut = Unt – α(πt – πe) α > 0 (1)
Where Ut is the rate of unemployment at current time t, Unt is the natural rate of unemployment, πt is the current rate of inflation and πe is the expected rate of inflation by economic agents based on current information. Equation (1) expresses unemployment net of the natural rate of unemployment as a decreasing function of the gap between actual and expected rates of inflation. The system is completed by a social objective function, W, depending on inflation, π, and unemployment, U:
W = W(πt, Ut) (2)
The policymaker maximizes the preferences of the public, (2), subject to the constraint of the tradeoff of inflation and unemployment, (1). The total differential of W set equal to zero provides an indifference map in the Cartesian plane with ordered pairs (πt, Ut - Un) such that the consistent equilibrium is found at the tangency of an indifference curve and the Phillips curve in (1). The indifference curves are concave to the origin. The consistent policy is not optimal. Policymakers without discretionary powers following a rule of price stability would attain equilibrium with unemployment not higher than with the consistent policy. The optimal outcome is obtained by the rule of price stability, or zero inflation, and not more unemployment than under the consistent policy with nonzero inflation and the same unemployment.
Barro and Gordon (1963a,b) provide a positive theory of monetary policy using a natural rate model and an analysis of enhancing reputation by the monetary authority. The model attempts to explain two aspects of the world during the Great Inflation: (1) average rates of inflation and growth of money were excessive as measured by a criterion of efficiency; and (2) the Fed engaged in activist countercyclical monetary policies. Equation (1) reflects “the maximizing behavior of private agents on decentralized markets” (Barro and Gordon 1983b, 592). A second equation permits the movement of the natural rate of unemployment over time in response to autonomous shocks, the past rate of unemployment and the mean of the natural rate of unemployment in the long run. A third equation expresses costs of policy actions in terms of deviations of the actual rate of unemployment from the natural rate of unemployment and the rate of inflation. The policymaker minimizes the discounted present value of costs on behalf of the preferences of society on the basis of the initial information available. Equation (1) shows the temptation of the policymaker to create “inflation surprises” by pursuing an inflation rate that is higher than that expected by economic agents that lowers the difference between the actual and natural unemployment rate by the term – α(πt – πe). Other benefits include the seigniorage, or gain from purchasing goods before the private sector with the issue of money, and the reduction of the real value of government debt by inflation. Systematic inflation surprises are not feasible after the public learns the intentions of the central bank, triggering adjustment in the decisions of private economic agents. The lack of commitment to a rule of price stability results in discretionary equilibrium in which unemployment is now lower than under commitment but inflation is inefficiently high. The inadequacy of monetary institutions providing commitment to price stability is rational calculation resulting in “excessive inflation, apparently unrewarding countercyclical policy response, and reactions of monetary growth and inflation to other exogenous influences” (Barro and Gordon 1983b, 607).
Ireland (1999) adapts Barro and Gordon (1983b) for empirical analysis with quarterly data from the first quarter of 1960 to the second quarter of 1997. The empirical tests find that inflation and unemployment are cointegrated, meaning that the Great Inflation and subsequent disinflation can be explained by the time-consistency problem raised by Barro and Gordon (1983b).
IID Inadvertent Policy Mistake. The Great Inflation from the 1960s and early 1980s and the subsequent disinflation and protracted period or Long Boom (coined by Taylor 1998LB) are analyzed by Clarida, Galí en Gertler (2000) by means of a forward monetary policy rule. The baseline monetary policy rule considered by Clarida, Galí and Gertler (CGG) is a simple linear equation:
r*t = r* + β(inflation gap) + γ(output gap) (3)
Where r*t is the Fed’s target rate for the fed funds rate in period t, r* is the desired nominal rate corresponding to both inflation and output being at their target levels (CGG 2000, 150), (inflation gap) is the deviation of actual inflation from target inflation and (output gap) is the percentage difference between actual GDP and its target. The rule is forward looking because the two gaps are relative to future desired levels. A second monetary rule is on the implied relation for the real rate of interest target:
rr*t = rr* + (β -1)(inflation gap) + γ(output gap) (4)
Where rr*t is the ex ante real rate target and rr* = r* - π* is the long-run equilibrium real rate. Equation (4) shows that the response of policy to the inflation gap depends on whether β is greater or less than one and the response to the output gap on whether γ is positive or negative.
CGG (2000) use quarterly time series for the period IQ1960 to IVQ1996, with the pre-Volcker period before 1979 and the Volcker-Greenspan period after 1979. The baseline estimates show π* at 4.24 percent in the pre-Volcker period and 3.58 percent in the Volcker-Greenspan period; β at 0.83 in pre-Volcker and 2.15 in Volcker-Greenspan; and γ at 0.27 in pre-Volcker and 0.93 in Volcker-Greenspan. The estimates are significant and checked for robustness over several dimensions. The data reveal that the Fed reacted weakly to expectations of inflation by allowing declines in real rates of interest or raising nominal interest but not by enough to increase real interest rates. CGG (2000, 165) argue that their results show that “the persistent and volatile behavior of inflation in the pre-Volcker era may be partly due to the monetary rule in place, independently of the nature of the fundamental shocks that may have impinged on the economy during the period.” The stability of inflation in the Volcker-Greenspan era resulted from increases in real rates of interest that slowed economic activity, reducing inflationary pressures. The oils shocks could have resulted in persistent and rising inflation because of the accommodative stance of monetary policy. Expectations of higher inflation result in declining real interest rates if β is less than one. The decline in real interest rates raises aggregate demand that causes an increase in inflation. The higher expectation of inflation is self-fulfilling. Values of β less than one suggest self-fulfilling fluctuations in the pre-Volcker era. Monetary policy in the form of a target policy rate of interest lower than the expectation of inflation was a determinant of the Great Inflation in the pre-Volcker era; the disinflation in the Volcker-Greenspan era was promoted by a policy rate of interest above the expectation of inflation.
IIE Imperfect Information. Joining peaks of economic output with various types of curves in the presumption of full employment of resources at peaks can illustrate the gaps created by economic fluctuations that were analyzed by interactions of the multiplier and accelerator principles by Hicks (1950). The output gap in equation (3) is part of the dual mandate of the Fed in the Fed’s mission of “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” (http://www.federalreserve.gov/aboutthefed/mission.htm). Burns (1957) analyzed “prosperity without inflation” that Orphanides (2003) has characterized as a “quest.” The main concern of Burns (1957) was with the threat of inflation but he was Chairman of the Board of Governors of the Fed during part of the Great Inflation. The conclusion of Orphanides (2004, 172) is:
“In theory, the activist approach to monetary policy that was followed during the Great Inflation would be workable, if only policymakers could have a solid understanding of the structure of the economy and reliable readings of the state of the economy upon which to base their actions. But what works in theory, often works in theory only. In reality, policymakers did not possess the knowledge necessary for an activist approach to monetary policy. Regrettably, they also lacked an appreciation of their ignorance. Despite the best of intentions, monetary policy itself became the engine of inflation and a source of instability during the Great Inflation.”
Orphanides (2003, 2004) emphasizes the erroneous measurement of potential output, and a consequence of the output gap in equation (3), which misled the regulators in pursuing an “activist” policy of trying to prevent the output gap from increasing when it was decreasing. The policy to prevent the erroneously measured output gap from increasing was lowering interest rates but the actual gap was actually tightening and inflation control required higher interest rates. The measurement error resulted in a bias of monetary policy to increasing inflation. Orphanides (2004) constructs a sample of real time information, consisting of the measurements available to the members of the Federal Open Market Committee (FOMC) to take their decisions. These real-time perceptions of inflation, the output gap and the statement of the economy available for FOMC decisions are used by Orphanides to calculate the parameters in equation (3). In contrast, the estimates by CGG (2000) are based on actual data as it occurred after the decisions. The estimates of Orphanides (2004, 161) are for the pre-Volcker and Greenspan-Volcker periods. The β coefficient of equation (3) using real-time data does not differ in the pre-Volcker and Greenspan-Volcker periods. The γ coefficient in equation (3) is significantly lower in the Greenspan-Volcker era when the misperception of the output gap ended and the Fed concentrated in maintaining the nominal interest rate above inflation, likely resulting in more effective inflation control. Orphanides and Williams (2005) find that misperceptions of the natural rate of unemployment in the 1960s and 1970s together with an activist policy of maintaining the rate of unemployment close to the incorrectly measured natural unemployment rate caused inferior macroeconomic performance. Less activist policy in tightening incorrectly measured output gaps would have resulted in more effective inflation control, avoiding the stagflation of the 1970s. The fine tuning of monetary policy oriented by misperceptions of the output gap is also used by Orphanides (2004, 168-9) to explain the notorious bouts of stop and go instability in the 1970s.
Collard and Dellas (2007) classify the explanations of the Great Inflation into two categories: (1) the Barro and Gordon (1983a,b) analysis of the Fed using inflation surprises to lower the rate of unemployment; and (2) the explanation of policy errors in terms of erroneous understanding of the policy rules developed by CGG (2000) and the policy errors because of misperceptions of the output gap by Orphanides (2003, 2004) and Orphanides and Williams (2005). The two strands of thought on the Great Inflation provide rich predictions but the data do not permit discrimination of the superiority of one over the other. CGG (2000) appear more optimistic that the errors have been corrected while it is possible to conclude from Barro and Gordon (1983b), Ireland (1999) and Orphanides (2003, 2004) and Orphanides and Williams (2005) that policy could again err with substantial consequences on the economy.
IIF Current Risks. Current monetary policy consists of the fed funds rate at 0 to ¼ percent since Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). At the FOMC meeting on March 16, the decision on the fed funds rate was (http://www.federalreserve.gov/newsevents/press/monetary/20110315a.htm):
“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”
The FOMC decision on quantitative easing was (Ibid):
“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 continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.”
On March16, the line “reserve bank credit” in the Fed balance sheet stood at $2567 billion, or $2.6 trillion, with portfolio holdings of long-term securities of $2339 billion, or $2.3 trillion composed of $1199 billion of long-term Treasury notes and bonds, $56 billion of inflation indexed Treasury notes and bonds, $140 billion of federal agency debt securities and $944 billion of mortgage-backed securities; reserve balances with federal reserve banks stood at $1334 billion or $1.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1).
It is instructive to recall equation (3) here:
r*t = r* + β(inflation gap) + γ(output gap) (3)
Current Fed policy is ignoring β in equation (3) on the belief that (http://www.federalreserve.gov/newsevents/press/monetary/20110315a.htm):
“The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.”
The Fed is solely concentrated on γ with dubious results. Quantitative easing and zero policy rates are designed to lower interest rates to increase investment and consumption or aggregate demand that could increase the rate of economic growth and employment. The Fed cannot direct the highest policy accommodation in history to financing investment and consumption. In fact, it is increasingly evident that the zero percent fed funds rate induces the carry trade of short positions in short-dated funds and long leveraged positions in risk financial assets such as commodities, exchange rates and equities. The risk financial asset of choice depends on financial risk factors in the world economy but commodity markets offer depth, leverage and contract exchange transparent prices. The 12-month PPI inflation rates over the past year in Table 2 conflict with the statement of the FOMC that commodity price increases are transitory. In fact, commodity prices are in a “trend is your friend” surge fueled by Fed monetary policy accommodation, in particular, the carry trade from zero fed funds rates to long positions in commodities. The literature on the American Great Inflation illustrates that surging commodity prices can be a problem when accommodated by monetary policy. The effects on US inflation may be magnified by dollar devaluation that is evidently an admitted objective of Fed policy (Yellen 2011AS) if not the main vehicle for reducing the output gap.
Table 5, updated with every blog, provides in the second column the yield at the close of market of the 10-year Treasury note on the date in the first column. The price in the third column is calculated with the coupon of 2.625 percent of the 10-year note current at the time of the second round of quantitative easing after Nov 3, 2010 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 on Nov 4, 2010, one day after the decision on quantitative easing by the Fed on Nov 3, 2010. Prices with the new coupon of 3.63 percent in recent auctions (http://www.treasurydirect.gov/instit/annceresult/press/preanre/2011/2011.htm) are not comparable to prices in Table 5. 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 and subsequently by the tragic earthquake and tsunami in Japan. The yield of 3.273 percent at the close of market on Mar 18 would be equivalent to price of 94.5115 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 6.7 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. Yields are not observed without special yield-lowering effects such as the flight into dollars caused by the events in the Middle East, continuing purchases of Treasury securities by the Fed and now the tragic earthquake and tsunami affecting Japan. Important causes of the rise in yields shown in Table 5 are expectations of rising inflation and US government debt estimated to reach 75 percent in 2015 (http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html). There is no simple exit of this trap with the highest monetary policy accommodation in US history.
Table 5, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note
| Date | Yield | Price | ∆% 11/04/10 |
| 05/01/01 | 5.510 | 78.0582 | -22.9 |
| 06/10/03 | 3.112 | 95.8452 | -5.3 |
| 06/12/07 | 5.297 | 79.4747 | -21.5 |
| 12/19/08 | 2.213 | 104.4981 | 3.2 |
| 12/31/08 | 2.240 | 103.4295 | 2.1 |
| 03/19/09 | 2.605 | 100.1748 | -1.1 |
| 06/09/09 | 3.862 | 89.8257 | -11.3 |
| 10/07/09 | 3.182 | 95.2643 | -5.9 |
| 11/27/09 | 3.197 | 95.1403 | -6.0 |
| 12/31/09 | 3.835 | 90.0347 | -11.1 |
| 02/09/10 | 3.646 | 91.5239 | -9.6 |
| 03/04/10 | 3.605 | 91.8384 | -9.3 |
| 04/05/10 | 3.986 | 88.8726 | -12.2 |
| 08/31/10 | 2.473 | 101.3338 | 0.08 |
| 10/07/10 | 2.385 | 102.1224 | 0.8 |
| 10/28/10 | 2.658 | 99.7119 | -1.5 |
| 11/04/10 | 2.481 | 101.2573 | - |
| 11/15/10 | 2.964 | 97.0867 | -4.1 |
| 11/26/10 | 2.869 | 97.8932 | -3.3 |
| 12/03/10 | 3.007 | 96.7241 | -4.5 |
| 12/10/10 | 3.324 | 94.0982 | -7.1 |
| 12/15/10 | 3.517 | 92.5427 | -8.6 |
| 12/17/10 | 3.338 | 93.9842 | -7.2 |
| 12/23/10 | 3.397 | 93.5051 | -7.7 |
| 12/31/10 | 3.228 | 94.3923 | -6.7 |
| 01/07/11 | 3.322 | 94.1146 | -7.1 |
| 01/14/11 | 3.323 | 94.1064 | -7.1 |
| 01/21/11 | 3.414 | 93.4687 | -7.7 |
| 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 |
| 02/25/11 | 3.414 | 93.3676 | -7.8 |
| 03/04/11 | 3.494 | 92.7235 | -8.4 |
| 03/11/11 | 3.401 | 93.4727 | -7.7 |
| 03/18/11 | 3.273 | 94.5115 | -6.7 |
Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates 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
Equation (3) gives the false impression that the Fed has the “science,” measurements and forecasting to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table 6 when the Fed pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table 5 shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no counterfactual that inflation would have been higher without Fed tightening because of the long lag in effect of monetary policy on inflation. The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery and creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether exotic policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability. A glance at Table 4 shows CPI inflation of 0.7 percent in 1961, creating a counterfactual of what would have been the Great Inflation if the fed had set the policy rate at zero and purchased a third of the outstanding Treasury debt. The symmetric inflation target of “a little less than 2 percent,” or an infinitesimal neighborhood of 2, is an extremely dangerous misplaced analogy with the Great Depression that may bring the economy closer to the relevant historical event of the Great Inflation of the 1970s.
Table 6, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994
| 1994 | FF | 30Y | 30P | 10Y | 10P | MOR | CPI |
| Jan | 3.00 | 6.29 | 100 | 5.75 | 100 | 7.06 | 2.52 |
| Feb | 3.25 | 6.49 | 97.37 | 5.97 | 98.36 | 7.15 | 2.51 |
| Mar | 3.50 | 6.91 | 92.19 | 6.48 | 94.69 | 7.68 | 2.51 |
| Apr | 3.75 | 7.27 | 88.10 | 6.97 | 91.32 | 8.32 | 2.36 |
| May | 4.25 | 7.41 | 86.59 | 7.18 | 88.93 | 8.60 | 2.29 |
| Jun | 4.25 | 7.40 | 86.69 | 7.10 | 90.45 | 8.40 | 2.49 |
| Jul | 4.25 | 7.58 | 84.81 | 7.30 | 89.14 | 8.61 | 2.77 |
| Aug | 4.75 | 7.49 | 85.74 | 7.24 | 89.53 | 8.51 | 2.69 |
| Sep | 4.75 | 7.71 | 83.49 | 7.46 | 88.10 | 8.64 | 2.96 |
| Oct | 4.75 | 7.94 | 81.23 | 7.74 | 86.33 | 8.93 | 2.61 |
| Nov | 5.50 | 8.08 | 79.90 | 7.96 | 84.96 | 9.17 | 2.67 |
| Dec | 6.00 | 7.87 | 81.91 | 7.81 | 85.89 | 9.20 | 2.67 |
Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months
Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
III Valuations of 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
Table 7 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. World financial markets were dominated by Fed and housing policy in the US. Between 2002 and 2008, the DJ UBS Commodity Index rose 165.5 percent largely because of the unconventional monetary policy of the Fed encouraging carry trade from low US interest rates to long leveraged positions in commodities, exchange rates and other risk financial assets. The charts of risk financial assets show sharp increase in valuations leading to the financial crisis and then profound drops that are captured in Table 7 by percentage changes of peaks and troughs. World financial markets were dominated by Fed and housing policy in the US. 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 18.9 percent by Fri Mar 18, 2011. Dollar devaluation is a major vehicle of the Fed in reducing the output gap.
Table 7, 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 | 03/18 /11 |
| Rate | 1.1423 | 1.5914 | 1.192 | 1.418 |
| CNY/USD | 01/03 2000 | 07/21 2005 | 7/15 2008 | 03/18 2011 |
| Rate | 8.2798 | 8.2765 | 6.8211 | 6.5694 |
| 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, geopolitical events such as the ongoing Middle East oil price shock 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 your friend” without as strong a belief in the Bernanke-put, or floor on risk financial asset valuations set by Fed monetary policy, as in earlier periods. Table 8 captures in the fourth column “∆% to Trough” the decline of risk financial assets resulting from the European sovereign risk issues after Apr and the sharp recovery in the last column “∆% Trough to 3/ 11/11” that was not interrupted by the second round of Ireland in late Nov. The final column “∆% Trough to 3/ 11/11” 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 18.9 percent. A major risk of world capital markets is in sustained increases in oil prices that could cause another downturn of risk financial assets similar to the one that occurred in the European sovereign risk event after Apr 2010. That risk could be significant as shown by the decline of valuations of risk financial assets in column “∆% to Trough” with high double-digit losses. The column “∆% Week 3/18/11” shows fresh losses in the week of Mar 18 after similar losses in the prior week ending on Mar 11. Risk financial assets are experiencing significant turbulence because of the joint incidence of geopolitical events in the Middle East, the Japan earthquake and sovereign risk issues in Europe.
Table 8, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 3/ 18/11 | ∆% Week 3/ 18/11 | ∆% Trough to 3/ 18/11 | |
| DJIA | 4/26/ 10 | 7/2/10 | -13.6 | 5.8 | -1.5 | 22.4 |
| S&P 500 | 4/23/ 10 | 7/20/ 10 | -16.0 | 5.1 | -1.9 | 25.1 |
| NYSE Finance | 4/15/ 10 | 7/2/10 | -20.3 | -4.9 | -2.0 | 19.4 |
| Dow Global | 4/15/ 10 | 7/2/10 | -18.4 | 0.3 | -2.1 | 22.9 |
| Asia Pacific | 4/15/ 10 | 7/2/10 | -12.5 | 0.8 | -4.5 | 15.1 |
| Japan Nikkei Aver. | 4/05/ 10 | 8/31/ 10 | -22.5 | -19.9 | -10.2 | 4.3 |
| China Shang. | 4/15/ 10 | 7/02 /10 | -24.7 | -8.2 | -0.9 | 21.9 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -7.5 | -3.4 | 9.2 |
| DAX | 4/26/ 10 | 5/25/ 10 | -10.5 | 5.2 | -4.5 | 17.5 |
| Dollar Euro | 11/25 2009 | 6/7 2010 | 21.2 | 6.3 | -2.0 | -18.9 |
| DJ UBS Comm. | 1/6/ 10 | 7/2/10 | -14.5 | 13.6 | 0.9 | 32.9 |
| 10-Year Tre. | 4/5/ 10 | 4/6/10 | 3.986 | 3.273 |
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 9, updated with every post, 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 on Nov 4, 2010 that quantitative easing was also designed to increase the valuations of stocks with the objective of creating a wealth effect that would motivate consumption. The problem is that the Fed does not control effects over multiple asset classes including riskier financial assets such as commodities and exchange rates. The decline of major US stock indexes in the week of Feb 25 without full recovery in the week of Mar 4 and renewed weakness in the weeks ending on Mar 11 and Mar 18 reduced the valuations of the DJIA and S&P 500 to single digit increases since the effects of the European sovereign risk event beginning around Apr 26.
Table 9, 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 |
| Feb 25 | -2.1 | 8.3 | -1.7 | 8.9 |
| Mar 4 | 0.3 | 8.6 | 0.1 | 9.0 |
| Mar 11 | -1.0 | 7.5 | -1.3 | 7.6 |
| Mar 18 | -1.5 | 5.8 | -1.9 | 5.5 |
Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004
Table 10, 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 3.7 percent by Mar 18, 2011. Table 10 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). Bernanke (2002FD) states:
“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”
Many countries have complained that Fed “nonconventional policy” of near zero interest rates and quantitative easing is designed to cause, or at least results in, competitive devaluation of the dollar that would export US unemployment to other countries. A widening differential between interest rates in the euro area and the US could further devalue the dollar, inducing carry trade from near zero interest rates in the US to risk financial assets.
Table 10, Exchange Rates
| Peak | Trough | ∆% P/T | Mar 18 2011 | ∆% T Mar 18 2011 | ∆% P Mar 18 2011 | |
| EUR USD | 7/15 2008 | 6/7 2010 | 3/18/ 2011 | |||
| Rate | 1.59 | 1.192 | 1.418 | |||
| ∆% | -33.4 | 15.9 | -12.1 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 3/18 2011 | |||
| Rate | 110.19 | 83.07 | 80.55 | |||
| ∆% | 24.6 | 3.0 | 26.9 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 3/18 2011 | |||
| Rate | 1.225 | 1.025 | 0.903 | |||
| ∆% | 16.3 | 11.9 | 2.3 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 3/18 2011 | |||
| Rate | 2.006 | 1.388 | 1.623 | |||
| ∆% | -44.5 | 14.5 | -23.6 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 3/18 2011 | |||
| Rate | 1.0215 | 1.6639 | 0.996 | |||
| ∆% | -62.9 | 39.7 | 1.7 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 3/18 2011 | |||
| Rate | 11.578 | 7.238 | 6.986 | |||
| ∆% | 37.5 | 3.5 | 39.7 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 3/18 2011 | |||
| Rate | 1.553 | 1.348 | 1.272 | |||
| ∆% | 13.2 | 5.6 | 18.1 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 3/11 2011 | |||
| Rate | 7.813 | 7.752 | 7.799 | |||
| ∆% | 0.8 | -0.6 | 0.2 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 3/11 2011 | |||
| Rate | 2.43 | 1.737 | 1.670 | |||
| ∆% | 28.5 | 3.9 | 31.2 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 3/18/ 2011 | |||
| Rate | 22.19 | 18.693 | 17.217 | |||
| ∆% | 15.7 | 7.9 | 22.4 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 3/18 2011 | |||
| Rate | 9.313 | 7.108 | 6.267 | |||
| ∆% | 23.7 | 11.8 | 32.7 | |||
| CNY USD | 7/20 2005 | 7/15 2008 | 3/18/ 2011 | |||
| Rate | 8.2765 | 6.8211 | 6.5694 | |||
| ∆% | 17.6 | 3.7 | 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
IV Economic Indicators. Manufacturing continues to grow in the US and Europe and also worldwide. European international trade is growing at very high rates indicative of worldwide recovery. Jobless claims in the US have settled below 400,000 but job stress continues. The general index of the New York FRB rose from 15.4 in Feb to 17.5 in Mar but new orders fell from 11.8 in Feb to 5.8 in Mar, which are still positive (http://www.newyorkfed.org/survey/empire/march2011.pdf). The Philadelphia FRB general index rose from 35.9 in Feb to 43.4 in Mar with new orders rising from 23.7 in Feb to 40.3 in Mar (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0311.pdf). Manufacturing output in the US rose 0.4 percent in Feb and the increase in Jan was revised up to 0.9 percent after an increase of 1.1 percent in Dec; manufacturing rose 6.9 percent in Feb 2011 relative to Feb 2010; capacity utilization fell 0.1 percentage point to 76.3 percent, which is lower by 4.2 percentage points than the average in 1972-2010 (http://www.federalreserve.gov/releases/g17/Current/). Housing permits seasonally adjusted were at the annual equivalent rate of 517,000 in Feb, which is 8.2 percent lower than the revised Jan rate of 563,000 and 20.5 percent below 650,000 in Feb 2010 (http://www.census.gov/const/newresconst.pdf). Housing starts with seasonal adjustment were at the annual rate of 479,000 in Feb, which is lower by 22.5 percent of the Jan estimate of 425,000 and 20.8 percent below the rate of 605,000 in Feb 2010. Table 11 illustrates the depressed state of housing in the US with housing starts more than 70 percent lower in the first two months of 2010 and 2011 relative to the levels in the first two months of 2005 and 2006. Industrial production in the euro area seasonally adjusted rose 0.3 percent in Jan 2011 relative to Jan 2010 and 6.6 percent relative to a year earlier (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-14032011-AP/EN/4-14032011-AP-EN.PDF). Exports not seasonally adjusted of the euro area rose 20 percent in 2010 and 27 percent in Jan 2011 relative to Jan 2010; imports not seasonally adjusted of the euro area rose 22 percent in 2010 and 29 percent in Jan 2011 relative to Jan 2010 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/6-18032011-AP/EN/6-18032011-AP-EN.PDF). Trade data are in nominal euro values and price effects may account for a significant portion of nominal growth. New jobless claims seasonally adjusted fell 16,000 from 401,000 in the week of Mar 5 to 385,000 in the week of Mar 12; without seasonal adjustment new jobless claims fell 37,313 from 409,683 in the week of Mar 5 to 372,370 in the week of Mar 12 (http://www.dol.gov/opa/media/press/eta/ui/current.htm).
Table 11, Housing Starts Not Seasonally Adjusted in the First Two Months of the Year
| Starts Thousands | ∆% Relative to 2005 | ∆% Relative to 2006 | |
| 2005 | 292.0 | ||
| 2006 | 295.7 | ||
| 2010 | 79.6 | -72.7 | -73.1 |
| 2011 | 72.2 | -75.3 | -75.6 |
Source:
http://www.census.gov/const/newresconst_201102.pdf
http://www.census.gov/const/newresconst_200602.pdf
http://www.census.gov/const/newresconst_0502.pdf
V Interest Rates. The yield of the 10-year Treasury note fell to 3.27 percent on Mar 18 from 3.40 percent a week earlier and 3.59 percent a month earlier. The yield of the 30-year Treasury bond fell to 4.42 percent on Mar 18 from 4.55 percent a week earlier and 4.70 percent a month earlier. The yield of the 10-year government bond of Germany traded at 3.18 percent for negative spread of 9 basis points relative to the comparable Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1300640534439). Events in the Middle East and Japan have caused a flight into the securities of the US and Germany. The US Treasury note with coupon of 3.63 percent and maturity on 02/21 traded on Mar 18 at yield of 3.27 percent or equivalent price of 102.98, which is not comparable to the price in Table 5, which is for a Treasury note with coupon of 2.625 percent maturing in exactly ten years solely for purposes of comparisons with earlier yields.
VI Conclusion. Current monetary policy resembles the concentration on the output gap in disregard of the inflation gap that characterized the Great Inflation of the 1970s. The major difference is the exotic doses and instruments combining zero interest rates with purchases of securities by the Fed in value of trillions of dollars. Monetary policy has again created the threat of another financial crash if there is forced unwinding of the fed balance sheet in a rise of inflation and yields at the same time that taxes are increased because of the rise of the debt to 75 percent of GDP by 2015. (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 )
References
Barro, Robert J. and David B. Gordon. 1983a. Rules, discretion and reputation in a model of monetary policy. Journal of Monetary Economics 12 (1): 101-121.
Barro, Robert J. and David B. Gordon. 1983b. A positive theory of monetary policy in a natural rate model. Journal of Political Economy 91 (4, Aug): 589-610.
Barsky, Robert B. and Lutz Kilian. 2001. Do we really know that oil caused the Great Stagflation? A monetary alternative. NBER Macroeconomics Annual Vol. 16 (2001): 137-83.
Barsky, Robert B. and Lutz Kilian. 2004. Oil and the macroeconomy since the 1970s. Journal of Economic Perspectives 18 (4, Autumn): 115-34.
Benston, George J. and George G. Kaufman. 1997. The FDICA after five years. Journal of Economic Perspectives 11 (3, Summer): 139-58.
Bernanke, Ben S. 2002FD. Deflation: making sure “it” doesn’t happen here. Washington DC, National Economists Club, Nov 21 http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
Bernanke, Ben S. 2010WP. What the Fed did and why: supporting the recovery and sustaining price stability. Washington Post, Nov 4. http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372_pf.html
Burns, Arthur. 1957. Prosperity without inflation. New York: Fordham University Press.
Chari, Varadarajan V. 1998. Nobel Laureate Robert E. Lucas, Jr.: architect of modern macroeconomics. Journal of Economic Perspectives 12 (1, Winter): 71-86.
Clarida, Richard, Jordi Galí and Mark Gertler. 2000. Monetary policy rules and macroeconomic stability: evidence and some theory. Quarterly Journal of Economics 115 (1, Feb): 147-80.
Collard, Fabrice and Harris Dellas. 2007. The great inflation of the 1970s. Journal of Money, Credit and Banking 39 (2-3, Mar-Apr): 713-731.
De Long, J. Bradford. 1997. America’s peacetime inflation: the 1970s. In Christina D. Romer and David H. Romer, eds. Reducing inflation: motivation and strategy. Chicago: University of Chicago Press, 1997.
Friedman, Milton. 1948. A monetary and fiscal framework for economic stability. American Economic Review 38 (3, Jun): 245-264.
Friedman, Milton. 1968. The role of monetary policy. American Economic Review 58 (1, Mar): 1-17.
Hicks, John R. 1950. A contribution to the theory of the trade cycle. Oxford: Clarendon Press.
Ireland, Peter N. 1999. Does the time-consistency problem explain the behavior of inflation in the United States. Journal of Monetary Economics 44 (2): 279-91.
Kydland, Finn E. and Edward C. Prescott. 1977. Rules rather than discretion: the inconsistency of optimal plans. Journal of Political Economy 85 (3, Jun): 473-92.
Lucas, Jr., Robert E. 1976. Econometric policy evaluation: a critique. Carnegie Rochester Conference Series on Public Policy 1 (1976): 16-46.
Orphanides, Athanasios. 2003. The quest for prosperity without inflation. Journal of Monetary Economics 50 (3): 633-63.
Orphanides, Athanasios. 2004. Monetary policy rules, macroeconomic stability and inflation: a view from the trenches. Journal of Money, Credit and Banking 36 (2, Apr): 151-175.
Orphanides, Athanasios and John C. Williams. 2005. The decline of activist stabilization policy: natural rate misperceptions, learning and expectations. Journal of Economic Dynamics & Control 29: 1927-1950.
Pelaez, Carlos M. and Carlos A. Pelaez. 2007. The Global Recession Risk. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2008a. Globalization and the State: Vol. I. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2008b. Globalization and the State: Vol. II. Basingstoke: Palgrave Macmillan.
Pelaez, Carlos M. and Carlos A. Pelaez. 2008c. Government Intervention in Globalization. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2009a. Financial Regulation after the Global Recession. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2009b. Regulation of Banks and Finance. Basingstoke: Palgrave Macmillan.http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Phelps, Edmund S. 1968. Money-wage dynamics and labor-market equilibrium. Journal of Political Economy 76 (4, 2, Jul-Aug): 678-711.
Taylor, John B. 1998LB. Monetary policy and the long boom. Federal Reserve Bank of St. Louis Review (Nov/Dec): 3-11.
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
No comments:
Post a Comment