Global Inflation, Seigniorage, Monetary Policy and Risk Aversion
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011
Executive Summary
I Global Inflation and Unemployment
IA Inflation and Unemployment
IB Indicators of Inflation
IC Hiring Collapse
II Seigniorage and Monetary Policy
IA Monetary Policy
IB Seigniorage
IC Fiscal Imbalance and Base Money
III Risk Aversion
IV Valuation of Risk Financial Assets
V Economic Indicators
VI Interest Rates
VII Conclusion
References
Executive Summary
There is inflation everywhere in the world economy. The major advanced economies are growing less rapidly than in prior cyclical expansions with high unemployment rates and rising inflation. The price segments of the current and expected prices paid on inputs in the surveys of the FRB of New York and Philadelphia verify inflation through the production chain of the economy. Price increases are creeping into prices received on sales of finished goods showing inflation in the distribution chain of the economy. Hiring in the US economy has collapsed relative to levels before the global recession. An important characteristic of the labor market in the US is that total hiring in the nonfarm sector has declined from 5.079 million in Mar 2006 to 4.002 million in Mar 2011, or by 1.077 million, and total hiring by the private sector has fallen from 4.811 million in Mar 2006 to 3.815 million in 2011, or by 0.996 million. Total private hiring in Mar 2011 of 3.815 million is lower by 1.405 million than 5.220 million a decade ago in Mar 2001. The US labor market is fractured, creating fewer opportunities to exit job stress of unemployment and underemployment of 24 to 30 million people and declining inflation-adjusted wages in the midst of fast increases in prices of everything except inadequately measured rents and shelter costs of homeowners. The pressure on the social, economic and health safety net will remain at current high levels for years ahead.
Government finances real expenditures (excluding interest payments on the debt) with (1) taxes and (2) issue of base money that is called seigniorage. If fiscal policy dominates monetary policy forcing financing with base money and there is association of inflation with base money, monetary policy with open market operations under the assumption of (1) constant and equal rate of growth of population and real economic activity, (2) real interest on the debt higher than the rate of growth of economic activity and (3) quantity-theory demand for base money results in an eventual tipping point at which the government deficit cannot be financed by placing debt with the public. The deficit is partly financed with base money. If expectations enter into the demand for money, Sargent and Wallace (1981) demonstrate that the monetary authority does not control inflation now and in the future because expectations of future inflation are equal to expectations of future growth of base money. The deficits from 2009 to 2012 exceed $1 trillion every year and add to $5287 billion, or $5.3 trillion, corresponding to 36.4 percent of GDP of $14,513 in 2010 (CBO http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf Table 1.1, 4). The deficits of the general government calculated by the IMF add to $6090 billion, corresponding to 41.9 percent of 2010 GDP. Federal debt held by the public as percent of GDP rises by 33.6 percentage points from 40.3 percent of GDP in 2008 to 73.9 percent of GDP in 2012 and by 28.2 percentage points for the general government from 48.4 percent in 2008 to 76.6 percent in 2012. The projections for 2016 are for federal debt held by the public of 75.0 percent of GDP and of general government debt of 85.7 percent of GDP. The concern is whether there is a “tipping point” or “debt explosion point” when investors require a risk premium on US debt. The unparalleled fiscal imbalance has been accompanied by the highest monetary policy accommodation in US history. Base money has swollen from $829 billion in Dec 2007 to $2494 billion in Apr 2011, by $1665 billion, for an increase of a multiple of 3 or 200.8 percent. At least de facto, monetary policy has been coordinated with fiscal policy.
I Global Inflation and Unemployment. There are three subsections below: IIA Inflation and Unemployment analyzing data for key economies on GDP, inflation and unemployment; IIB Indicators of Inflation providing current short-term indicators of inflation; and IC Hiring Collapse with the data on hiring in the US economy that still show a fractured jobs market.
IA 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). CPI inflation stabilized in China at 5.3 percent in the 12 months ending in Apr relative to 5.4 percent in the 12 months ending in Mar. Food prices in China soared by 11.7 percent in Mar after 11.0 percent in Feb, 10.3 percent in Jan and 9.6 percent in Dec (http://www.ft.com/cms/s/0/69aa5fcc-670d-11e0-8d88-00144feab49a.html#axzz1J7CmnPhC). Food prices rose 11.5 percent in China in the 12 months ending in Apr relative to 11 percent in the first quarter of 2011 relative to 2010 as analyzed by Jamil Anderlini in the Financial Times (China inflation edges lower to 5.3% http://www.ft.com/cms/s/0/09a22246-7b75-11e0-ae56-00144feabdc0.html#axzz1LqpStZfj
). New loans in local currency rose CNY (Chinese yuan) 740 billion (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aolyrQHuzo4o&pos=4). The People’s Bank of China increased reserve requirements by 50 basis points to 21 percent for the largest lenders in the fifth increase this year and may use other measures of inflation control (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aCS.hGGzvNMU&pos=2). PPI inflation accelerated in Japan to 2.5 percent in Apr year on year; the monthly increase was 0.9 percent of which 0.44 percentage points was from fuels, gasoline and gas and 0.13 percentage points from chemical products; the export price index rose 0.5 percent in Apr relative to Mar of which 0.34 percentage points from metals and 0.27 percentage points from chemicals while cars and motorcycles contributed negative 0.27 percentage points; and import prices soared by 3.9 percent in Apr relative to Mar, mostly by the 2.74 percentage point contribution of petroleum, coal and gas and 0.77 percentage points from metal raw materials such as iron ore, silver and aluminum (http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1104.pdf). EUROSTAT provides a flash estimate of 2.8 percent inflation in the Monetary Union (euro area) Index of Consumer prices for Apr (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-29042011-BP/EN/2-29042011-BP-EN.PDF) and 0.7 percent in Apr for the PPI with 12-month rate of increase of 6.7 percent (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-03052011-CP/EN/4-03052011-CP-EN.PDF). The euro area harmonized consumer price index (HICP), used in monetary policy, was 2.8 percent in Apr, which is higher than 2.7 percent in Mar; the HICP rose 0.6 percent in Apr relative to Mar, which is equivalent to 7.4 percent if repeated over a year (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16052011-BP/EN/2-16052011-BP-EN.PDF). The euro area unemployment rate is estimated at 9.9 percent (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/3-29042011-AP/EN/3-29042011-AP-EN.PDF). 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 six 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 (see section IV in http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html); (2) the tradeoff of growth and inflation in China; (3) slow growth (see http://cmpassocregulationblog.blogspot.com/2011/05/mediocre-growth-world-inflation.html http://cmpassocregulationblog.blogspot.com/2011_03_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/02/mediocre-growth-raw-materials-shock-and.html), weak hiring (http://cmpassocregulationblog.blogspot.com/2011/03/slow-growth-inflation-unemployment-and.html and section III Hiring Collapse in http://cmpassocregulationblog.blogspot.com/2011/04/fed-commodities-price-shocks-global.html ) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (http://cmpassocregulationblog.blogspot.com/2011/05/job-stress-of-24-to-30-million-falling.html http://cmpassocregulationblog.blogspot.com/2011/04/twenty-four-to-thirty-million-in-job_03.html http://cmpassocregulationblog.blogspot.com/2011/03/unemployment-and-undermployment.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the earthquake and tsunami affecting Japan that is having repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) the geopolitical events in the Middle East.
Table 1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 2.9 | 3.2 | 6.8 | 8.8 |
| Japan | -1.0*** | 0.0 | 2.5 | 4.6 |
| China | 9.7 | 5.3 | 6.8 | |
| UK | 1.8 | 4.5* | 5.3* output | 8.0 |
| Euro Zone | 2.5 | 2.8 | 6.7 | 9.9 |
| Germany | 4.8 | 2.7 | 6.1 | 6.3 |
| France | 2.2 | 2.2 | 6.7 | 9.6 |
| Nether-lands | 3.2 | 2.2 | 10.8 | 4.2 |
| Finland | 5.2 | 3.4 | 8.8 | 8.2 |
| Belgium | 3.0 | 3.3 | 10.2 | 7.7 |
| Portugal | -0.7 | 4.0 | 6.9 | 11.1 |
| Ireland | -1.0 | 1.5 | 5.4 | 14.9 |
| Italy | 1.0 | 2.9 | 6.1 | 8.4 |
| Greece | -4.8 | 3.7 | 8.1 | 15.1 |
| Spain | 0.8 | 3.5 | 7.8 | 21.3 |
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
*Office for National Statistics
PPI http://www.statistics.gov.uk/pdfdir/ppi0511.pdf
CPI http://www.statistics.gov.uk/pdfdir/cpi0511.pdf
** Excluding food, beverage, tobacco and petroleum
http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-04042011-AP/EN/4-04042011-AP-EN.PDF
***Change from IQ2011 relative to IQ2010 http://www.esri.cao.go.jp/jp/sna/sokuhou/kekka/toukei/qe111/jikei_1.pdf
Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html
IB Indicators of Inflation. The indexes of the Federal Reserve Banks of New York and Philadelphia continue to show inflation in the production and distribution chain. Table 2 shows the prices paid, or prices of inputs, and the prices received, or prices of products sold, of the FRB of New York Empire State Manufacturing Survey. There are two blocks of data for current prices and expectations of prices in six months. The responses of increasing current prices paid rose from 60.3 percent in Apr to 69.9 percent in May and of prices received from 29.5 percent in Apr to 33.3 percent in May. There was similar increase in relative responses of expected prices paid from 62.8 percent expecting increases in prices paid in Apr to 70.9 percent in May while the expectation of price increases in the next six months fell from 44.9 percent in Apr to 40.9 percent in May. The report finds sharp increases in prices (http://www.newyorkfed.org/survey/empire/may2011.pdf):
”The prices paid index rose sharply, indicating that price increases accelerated over the month. The index advanced twelve points to 69.9, its highest level since mid-2008, with roughly 70 percent of respondents reporting price increases, and none reporting price declines. This index has moved up a cumulative fifty points over the past six months. The prices received index, at 28.0, was one point higher than in April; its rise over the past six months has paralleled the upward trend in the prices paid index.”
Table 2, FRBNY Empire State Manufacturing Survey, Prices Paid and Prices Received, SA
| Higher | Same | Lower | Index | |
| Current | ||||
| Prices Paid | ||||
| Apr | 60.26 | 37.18 | 2.56 | 57.69 |
| May | 69.89 | 30.11 | 0.00 | 69.89 |
| Prices Received | ||||
| Apr | 29.49 | 67.95 | 2.56 | 26.92 |
| May | 33.33 | 61.29 | 5.38 | 27.96 |
| Six Months | ||||
| Prices Paid | ||||
| Apr | 62.82 | 30.77 | 6.41 | 56.41 |
| May | 70.97 | 26.88 | 2.15 | 68.82 |
| Prices Received | ||||
| Apr | 44.87 | 48.72 | 6.41 | 38.46 |
| May | 40.86 | 53.76 | 5.38 | 35.48 |
Source: http://www.newyorkfed.org/survey/empire/5_2011.pdf
Table 3 provides the price segments of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia. There are declines in the percentage of answers for increases in prices paid both currently and the expectation of six months, but the percentages are still quite high, 56.3 percent for current prices paid and 59.1 percent for prices received. The responses for increases in current prices paid declined from 30.2 percent in Apr to 19.7 percent in May and the six month expectation of increases fell from 42.6 percent in Apr to 34.9 percent in May. The report states (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0511.pdf):
“Firms continue to report price increases for inputs as well as their own manufactured goods. The prices paid index declined 7 points this month but remains about 45 points higher than readings just seven months ago. Fifty-nine percent of the firms reported higher prices for inputs this month, compared to 64 percent last month. On balance, firms also reported an increase in prices for their own manufactured goods: The prices received index increased 5 points and has steadily increased over the last eight months. Thirty percent of firms reported higher prices for their own goods this month; just 3 percent reported price reductions.”
Table 3, FRB of Philadelphia Business Outlook Survey, Prices Paid and Prices Received, SA
| Higher | Same | Lower | Index | |
| Current | ||||
| Prices Paid | ||||
| Apr | 58.5 | 40.0 | 1.4 | 57.1 |
| May | 56.3 | 35.6 | 8.0 | 48.3 |
| Prices Received | ||||
| Apr | 30.2 | 67.0 | 2.7 | 27.5 |
| May | 19.7 | 76.2 | 2.9 | 16.8 |
| Six Months | ||||
| Prices Paid | ||||
| Apr | 60.4 | 31.3 | 3.3 | 57.0 |
| May | 59.1 | 33.1 | 6.7 | 52.4 |
| Prices Received | ||||
| Apr | 42.6 | 45.3 | 5.1 | 37.5 |
| May | 34.9 | 53.2 | 7.6 | 27.3 |
Inflation in the production and distribution chain is also evident in nominal trade data for the euro area in Table 4. First-quarter exports rose 21.3 percent in 2011 relative to the same quarter in 2010 and imports by 23.8 percent. Nominal growth from Mar 2010 to Mar 2011 was 16.4 percent for exports and 16.7 percent. These high rates of increase in nominal data are reflecting increasing prices.
Table 4, Exports and Imports of the Euro Area, Billions of Dollars and Percent, NSA
| Exports | Imports | |
| Jan-Mar 2011 | 417.3 | 433.5 |
| Jan-Mar 2010 | 344.0 | 350.2 |
| ∆% | 21.3 | 23.8 |
| Mar 2011 | 157.9 | 155.1 |
| Mar 2010 | 135.6 | 132.9 |
| ∆% | 16.4 | 16.7 |
Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/6-16052011-AP/EN/6-16052011-AP-EN.PDF
IC Hiring Collapse. An appropriate measure of job stress is considered by Blanchard and Katz (1997, 53):
“The right measure of the state of the labor market is the exit rate from unemployment, defined as the number of hires divided by the number unemployed, rather than the unemployment rate itself. What matters to the unemployed is not how many of them there are, but how many of them there are in relation to the number of hires by firms.”
The natural rate of unemployment and the similar NAIRU are quite difficult to estimate in practice (Ibid; see Ball and Mankiw 2002).
The Bureau of Labor Statistics (BLS) created the Job Openings and Labor Turnover Survey (JOLTS) with the purpose that (http://www.bls.gov/jlt/jltover.htm#purpose):
“These data serve as demand-side indicators of labor shortages at the national level. Prior to JOLTS, there was no economic indicator of the unmet demand for labor with which to assess the presence or extent of labor shortages in the United States. The availability of unfilled jobs—the jobs opening rate—is an important measure of tightness of job markets, parallel to existing measures of unemployment.”
The BLS collects data from about 16,000 US business establishments in nonagricultural industries through the 50 states and DC. The data are released monthly and constitute an important complement to other data provided by the BLS.
Hiring in the nonfarm sector (HNF) has declined from 64.9 million in 2006 to 47.2 million in 2010 or by 17.7 million while hiring in the private sector (HP) has declined from 60.4 million in 2006 to 43.3 million in 2010 or by 17.1 million. The ratio of nonfarm hiring to unemployment (RHNF) has fallen from 9.3 in 2006 to 3.2 in 2010 and in the private sector (RHP) from 8.6 in 2006 to 2.9 in 2010 (http://cmpassocregulationblog.blogspot.com/2011/03/slow-growth-inflation-unemployment-and.html). Table 5 provides total HNF and HP in the month of Mar from 2001 to 2011. An important characteristic of the labor market in the US is that HNF has declined from 5.079 million in Mar 2006 to 4.002 million in Mar 2011, or by 1.077 million, and HP has fallen from 4.811 million in Mar 2006 to 3.815 million in 2011, or by 0.996 million. HNF of 4.002 in Mar 2011 is almost unchanged relative to 4.005 million in Mar 2010 and HP in Mar 2011 of 3.815 million is lower by 1.405 million than 5.220 million in Mar 2001. The US labor market is fractured, creating fewer opportunities to exit job stress of unemployment and underemployment of 24 to 30 million people and declining inflation-adjusted wages in the midst of fast increases in prices of everything except inadequately measured rents and shelter costs of homeowners (http://cmpassocregulationblog.blogspot.com/2011/05/job-stress-of-24-to-30-million-falling.html http://cmpassocregulationblog.blogspot.com/2011/04/twenty-four-to-thirty-million-in-job_03.html).
Table 5, Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US in Thousands and in Percentage of Total Employment in Mar Not Seasonally Adjusted
| HNF | Rate RNF | HP | Rate HP | |
| 2001 | 5463 | 4.1 | 5220 | 4.7 |
| 2002 | 4442 | 3.4 | 4215 | 3.9 |
| 2003 | 4199 | 3.3 | 3981 | 3.7 |
| 2004 | 4992 | 3.8 | 4753 | 4.4 |
| 2005 | 5030 | 3.8 | 4806 | 4.4 |
| 2006 | 5079 | 3.8 | 4811 | 4.3 |
| 2007 | 5125 | 3.8 | 4855 | 4.3 |
| 2008 | 4608 | 3.4 | 4383 | 3.8 |
| 2009 | 3638 | 2.8 | 3457 | 3.2 |
| 2010 | 4005 | 3.1 | 3716 | 3.5 |
| 2011 | 4002 | 3.1 | 3815 | 3.6 |
Source: http://www.bls.gov/jlt/data.htm
II Seigniorage and Monetary Policy. The first subsection IIA Monetary Policy discusses the new information provided by the analysis of monetary policy accommodation in the Apr meeting of the Federal Open Market Committee (FOMC). The second subsection IIB Seigniorage provides an analysis of coordination of monetary and fiscal policy. The third subsection IIC Fiscal Imbalance and Base Money analyzes the combination of huge fiscal imbalances with issue of base money that is resulting in de facto coordination of fiscal and monetary policy.
IIA Monetary Policy. Important information on monetary policy is available in the minutes of the FOMC meeting on Apr 26-27 (FOMC 2011Apr27). The staff provided the FOMC a presentation on normalizing the stance, or withdrawal of “current extraordinary degree of accommodation at the appropriate time” as well as “normalizing the conduct of policy” that would consist of “draining the large volume of reserve balances in the banking system and shrinking the overall size of the balance sheet,” which would require that the System Open Market Account (SOMA) be composed, as historically, “essentially only” of Treasury securities (FOMC 2011Apr 27, 2). The staff analyzed various options in three important issues of relaxing monetary policy for consideration by the FOMC.
First, instruments of tightening. The FOMC could tighten policy at a chosen time by “increasing short-term interest rates, by decreasing its holdings of longer-term securities, or both” (FOMC 2011Apr27, 2). Tightening with the two instruments could restrain financial markets that in turn could potentially affect overall economic conditions. Instruments could be combined in various ways to attain desired effects. The same degree of tightening could be attained by the combinations and timing of sales of securities in the Fed balance sheet and increases in fed funds rates. Another alternative is to cease the reinvestment of principal payments in the SOMA portfolio.
Second, relation of asset sales to economic and financial conditions. The FOMC could link the sales of assets in the balance sheet to economic and financial conditions, gaining flexibility in the combination of asset sales and adjustment of fed funds targets. Alternatively, scheduling asset sales in advance by preannouncement could provide the FOMC with the capacity to use the adjustment of fed funds targets as the main policy instrument (FOMC 2011Apr27, 2).
Third, unwinding tools. The Fed has been designing and testing tools for unwinding the balance sheet such as reverse repurchase agreements and term deposits. The FOMC would have to decide the timing and convenience of using these tools in order to administer the relation between the rate paid on excess reserves deposited at the Fed and the adjustment of targets of the fed funds rate (FOMC 2011Apr 27, 3).
The FOMC (2011Apr27) agreed on four important principles, actually five, on the strategy for normalizing monetary policy. These principles are as follows.
First, dual mandate. The FOMC (2011Apr27, 3) reiterated its dual mandate 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). It is debatable if all these goals can be simultaneously attained, in particular in a linear model with three targets and one policy instrument, the fed funds rate. The participants also reiterated that discussion of “normalizing the stance of policy did not mean that the move toward such normalization would necessarily begin soon” (FOMC 2011Apr 27, 3).
Second, monetary policy of fed funds adjustment instead of Fed balance sheet management. An extremely important principle is that the FOMC “agreed that the size of the SOMA’s securities portfolio would be reduced with the implementation of monetary policy through the management of the federal funds rate rather than through variation in the size or composition of the Federal Reserve’s balance sheet” (FOMC 2011Apr 27, 3)
Third, SOMA of only Treasury securities. In a second important new principle, the FOMC decided that “over the intermediate term, the exit strategy would involve returning the SOMA to holding essentially only Treasury securities in order to minimize the extent to which the Federal Reserve portfolio might affect the allocation of credit across sectors of the economy” (FOMC 2011Apr 27, 3). This principle would also require the sale of agency securities.
Fourth, preannounced but flexible sale of securities. The FOMC also decided that “asset sales would be implemented within a framework that had been communicated to the public in advance, and at a pace that potentially could be adjusted in response to changes in economic or financial conditions” (FOMC 2011Apr 27, 3).
Fifth, reinvestment of principal. There was wide support by participants that “the first step toward normalization should be ceasing to reinvest payments of principal on agency securities and, simultaneously or soon after, ceasing to reinvest principal payments on Treasury securities” (FOMC 2011Apr27, 3). It was recognized at the meeting that ceasing reinvestments would be an initial step in reducing the balance sheet but it was recognized that it would “constitute a modest step toward policy tightening, implying that the decision should be made in the context of the economic outlook and the Committee’s policy objectives” (FOMC 2011Apr27, 3). Normalization of policy accommodation would require changes in the statement. The FOMC (2011Apr 27) considered other issues with less agreement by participants that are conveniently summarized in an article on “The Fed’s exit: what’s up for debate?” by the Wall Street Journal (http://blogs.wsj.com/economics/2011/05/18/the-feds-exit-whats-up-for-debate/).
IIB Seigniorage and Base Money. The monetary and fiscal framework of Friedman (1948, 248-9) proposes a progressive tax system “with primary reliance on the personal income tax”. The calculation of tax rates, exemptions and so on would be on the basis of expected yield corresponding to full employment at a specified price level. Friedman (1948, 249) states:
“The budget principle might be either that the hypothetical yield should balance government expenditure, including transfer payments (at the same hypothetical level of income) or that it should lead to a deficit sufficient to provide some specified secular increase in the quantity of money.”
In the analysis by Fischer (1982) of countries using a foreign currency, or dollarization, the budget process is similar to the US financing of government by taxes and borrowing as well as printing money or seigniorage with the difference that the country using foreign money gives up seigniorage as a taxing alternative (see Humpage 2002 for 16 countries engaged in dollarization). Currency unions are analyzed by seigniorage (Buiter 1999; see Pelaez and Pelaez International Financial Architecture (2005), 211). In the government budget constraint, growth of nominal money balances per unit of output equals the monetized part of the government deficit (Sargent, Williams and Tao 2009). Understanding general constraints of central banking and seigniorage requires a period budget constraint and an intertemporal budget constraint (Buiter 2007).
In search of optimal seigniorage, Mankiw (1987, 328) specifies the government budget constraint as:
∫exp(-ρs)G(t+s) + B(t) = ∫exp(-ρs)T(t+s)ds (1)
Where integration is from 0 to ∞, G(t) is real government expenditure at time t, T(t) is real revenue at t, B(t) is real government debt at t and ρ is a constant discount rate. Expenditure is assumed exogenous and future expenditure is a random variable, with the government receiving new information over time. There are two sources of government revenue, an output tax, such as on income or sales, and seigniorage, or printing of money. There are deadweight social losses resulting from taxes and seigniorage. Assuming a simple quantity of money equation (Mankiw 1987, 329):
M(t)/P(t) = kY(t) (2)
Where M(t) is outside money at time t, P(t) the price level at (t) and k a constant. The real revenue from seigniorage is (Mankiw 1987, 329):
(π + g)kY (3)
Where π is inflation, g is the growth rate of output and Y output. Mankiw (1987, 329) derives total revenue as:
T = τY + (π + g)kY (4)
Where τ is the tax rate on output. The deadweight social loss from the tax is denoted by f(τ)Y(t) with f’>0 and f’’>0 and the social loss from inflation is denoted by h(π)Y with h’>0 and h’’>0.
Government minimizes the expected present value of social losses (Mankiw 1987, 330):
Et∫exp(-ρs)[f(τ )+ h(π)]Yds (5)
Subject to the budget constraint
∫exp(-ρs)Gds + B(t) = ∫exp(-ρs)T(τ + πk + gk)Yds (6)
The range of integration is taken from 0 to ∞ and the notation is simplified by omitting time arguments. There are three first-order conditions: (1) equality of marginal social cost of taxation currently and in the future; (2) equality of marginal social cost of inflation currently and in the future; and (3) current equality of the marginal social cost of revenue from direct taxes and the marginal social cost of revenue from seigniorage.
There is vast literature on the causes and end of the US Great Inflation (in addition to contributions cited in earlier comments of this blog see Cogley, Premiceri and Sargent 2010, Premiceri 2005, 2006, Meltzer 2005, 2010a, 2010b, Romer 2005, Sargent 1983, Sargent and Wallace 1981, 1987, Sargent, Walliams and Zha 2006, 2009). The chart in the homepage of Professor Thomas J. Sargent provides compelling motivation for this research: http://homepages.nyu.edu/~ts43/ There is significant wisdom for current policy in the unpleasant arithmetic of monetary policy provided in the contribution by Sargent and Wallace (1981), which recalls the analysis by Friedman (1968) of what monetary policy can do and what monetary policy cannot do. Friedman (1968, 5) discusses what monetary policy cannot do:
“From the infinite world of negation, I have selected two limitations of monetary policy to discuss: (1) It cannot peg interest rates for more than very limited periods; (2) It cannot peg the rate of unemployment for more than very limited periods.” An example of what monetary policy can do is (Friedman 1968, 14):
“If, as now [1968], an explosive federal budget threatens unprecedented deficits, monetary policy can hold any inflationary dangers in check by a slower rate of monetary growth than would otherwise be desirable. This will temporarily mean higher interest rates than would otherwise prevail—to enable to the government to borrow the sums needed to finance the deficit—but by preventing speeding up of inflation, it may well mean both lower prices and lower nominal interest rates for the long pull.”
The variables that money cannot permanently influence are real output level, unemployment and real rates of return on securities but Sargent and Wallace (1981) argue that monetary policy cannot permanently influence the rate of inflation under monetarist assumptions and open market policy operations.
The assumptions of the monetarist economy of Sargent and Wallace (1981, 1) are:
(1) There is a close connection between the monetary base, or monetary liabilities of the government (consisting of currency held by the public and reserves of depository institutions at the central bank), and the price level
(2) The monetary authority can obtain seigniorage, defined as creating money
There are two constraints of government finance in the monetary economy of Sargent and Wallace (1981, 1) imposed by the demand for issuing interest-bearing securities or, say, bonds, as debt:
(1) The demand for bonds by the public sets a limit on the ratio of the real stock of government bonds and the size of the economy
(2) The demand for bonds affects the interest rate paid by the government on its bonds
These two constraints affect the effectiveness of the government on permanently controlling inflation depending on coordination of alternative arrangements of fiscal and monetary policy. There are two polar extremes of coordination arrangement analyzed by Sargent and Wallace (1981).
First, monetary policy dominates fiscal policy. The monetary authority has the choice of the amount of seigniorage that it will supply to the fiscal authority. Thus, the monetary authority has complete freedom in setting the path of base money, such as by announcing its rate of growth in the current and future periods. Under this coordination arrangement, monetary policy can permanently influence inflation.
Second, fiscal policy dominates monetary policy. The monetary authority divides government debt between government bonds and monetary base. The only form of controlling inflation is by holding on the rate of growth of base money. The demand by the public for government bonds constrains the effectiveness of inflation policy by the monetary authority. If the real rate of interest of the government bonds exceeds the rate of growth of the economy, the growth of the stock of real bonds will exceed the rate of growth of the size of the economy. The public’s demand for government bonds sets a limit on the ratio of the stock of bonds to the size of the economy. After reaching that limit, seigniorage must provide part of financing for maturing principal and interest, that is, additional base money must be printed. In a monetarist economy there is inflation after some point in time.
The model of “unadulterated monetarism” used by Sargent and Wallace (1981) includes the assumption of a natural rate of unemployment or growth of real income that monetary policy cannot affect and a real rate of interest on securities that monetary policy cannot influence. Specifically, there are three assumptions:
(1) An equal constant rate of growth of real income and population, denoted by n
(2) A constant real rate of government securities exceeding n
(3) The analysis includes two different specifications of the demand for money: (a) a quantity theory demand function for base money with constant income velocity; and (b) specification of the demand for base money including expected inflation.
Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:
D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (7)
Equation (7) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,
{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:
N(t+1) = (1+n)N(t), n>-1 (8)
The per capita form of the budget constraint is obtained by dividing (7) by N(t) and rearranging:
B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]
+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (9)
On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.
If the demand for base money depends on inflation expectations together with the other assumptions, loser monetary policy can result in higher inflation now and also in the future. Sargent and Wallace (1973, 1046) show that if the demand for real cash balances depends on the expected rate of inflation, “the equilibrium value of the price level at the current moment is seen to depend on the (expected) path of the money supply from now until forever.” The anticipation of high rates of base money growth in the future may increase the rate of inflation now. Sargent and Wallace (1981) show that currently tight monetary policy may not be potent to even lower the current rate of inflation. If fiscal policy dominates monetary policy with a sequence of deficits D(t), monetary policy has to adapt within the budget constraint of equation (7). If the sequence D(t) is “too big for too long,” under the assumptions of the model, “the monetary authority can make money tighter now only by making it looser later” (Sargent and Wallace 1981, 7). In the analysis of the hyperinflations in Europe, Sargent (1983, 89-90) concludes:
“The essential measures that ended hyperinflations in each of Germany, Austria, Hungary, and Poland were, first, the creation of an independent central bank that was legally committed to refuse the government’s demand for additional unsecured credit and, second, a simultaneous alteration in the fiscal policy regime. These measures were interrelated and coordinated. They had the effect of binding the government to place its debt with private parties and foreign governments which would value that debt according to whether it was backed by sufficiently large prospective taxes relative to public expenditures. In each case that we have studied, once it became widely understood that the government would not rely on the central bank for its finance, the inflation terminated and the exchanges stabilized. The four incidents we have studied are akin to laboratory experiments in which the elemental forces that cause and can be used to stop inflation are easiest to spot. I believe that these incidents are full of lessons about our own, less drastic predicament with inflation, if only we interpret them correctly.”
IIC Fiscal Imbalance and Base Money. The fiscal imbalance of the US from 2009 to 2012 appears to be the highest in peacetime US history. Table 6 provides the outlays, revenue, deficit and debt held by the public in billions of dollars and as percent of GDP for the federal government as provided by the Congressional Budget Office (CBO) and for the general government as provided by the International Monetary Fund (IMF). The deficits from 2009 to 2012 exceed $1 trillion every year and add to $5287 billion, or $5.3 trillion, corresponding to 36.4 percent of GDP of $14,513 in 2010 (CBO http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf Table 1.1, 4). The deficits of the general government calculated by the IMF add to $6090 billion, corresponding to 41.9 percent of 2010 GDP. Federal debt held by the public as percent of GDP rises by 33.6 percentage points from 40.3 percent of GDP in 2008 to 73.9 percent of GDP in 2012 and by 28.2 percentage points for the general government from 48.4 percent in 2008 to 76.6 percent in 2012. The projections for 2016 are for federal debt held by the public of 75.0 percent of GDP and of general government debt of 85.7 percent of GDP. The concern is whether there is a “tipping point” or “debt explosion point” when investors require a risk premium on US debt.
Table 6, US Government Outlays, Revenues, Deficit and Debt, Billions of Dollars and % of GDP
| 2008 | 2009 | 2010 | 2011 | 2012 | |
| Federal Gov | |||||
| Outlays $ B | 2,983 | 3,518 | 3,456 | 3,708 | 3,655 |
| Outlays % GDP | 20.7 | 25.0 | 23.8 | 24.7 | 23.3 |
| Revenue $ B | 2,524 | 2,105 | 2,162 | 2,228 | 2,555 |
| Revenue % GDP | 17.5 | 14.9 | 14.9 | 14.8 | 16.3 |
| Deficit $ B | -459 | -1,413 | -1,294 | -1,480 | -1,100 |
| Deficit % GDP | -3.2 | -10.0 | -8.9 | -9.8 | -7.0 |
| Debt $ B | 7,544 | 5,803 | 9,018 | 10,430 | 11,598 |
| Debt % GDP | 40.3 | 53.5 | 62.1 | 69.4 | 73.9 |
| General Gov | |||||
| Outlays $ B | 5,610 | 6,141 | 6,027 | 6,280 | 6,327 |
| Outlays % GDP | 39.0 | 43.5 | 41.1 | 41.2 | 39.8 |
| Revenue $ B | 4,679 | 4,352 | 4,475 | 4,637 | 5,131 |
| Revenue % GDP | 32.6 | 30.8 | 30.5 | 30.5 | 32.3 |
| Deficit $ B | -931 | -1,789 | -1,552 | -1,643 | -1,106 |
| Deficit % GDP | -6.5 | -12.7 | -10.6 | -10.8 | -7.5 |
| Debt $ B | 6,955 | 8,451 | 9,502 | 11,025 | 12,174 |
| Debt % GDP | 48.4 | 59.9 | 54.8 | 72.4 | 76.6* |
Note: GOV: government
General Gov: includes federal, state and local
*Projected 85.7 % in 2016 for general gov and 75.0 % for federal gov.
Sources: http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf
http://www.cbo.gov/ftpdocs/120xx/doc12039/HistoricalTables[1].pdf
http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
An important fact of Table 6 is that outlays remain above 20 percent of GDP indefinitely. The only similar episode in the past four decades is in the 1980s. Table 7 provides federal government outlays, revenue, deficit and debt as percent of GDP from 1980 to 1989. The concern arises from the fact that the highest revenue to GDP ratio in the past four decades was 20.6 percent of GDP in 2000. Federal outlays above 20 percent of GDP cannot be effectively taxed as shown by US historical statistics. The major difference of the experience in the 1980s with that after 2009 is the much higher rate of economic growth in the 1980s (http://cmpassocregulationblog.blogspot.com/2011/05/mediocre-growth-world-inflation.html) that maintained revenues closer to 20 percent of GDP. Nevertheless, debt as percent of GDP rose by 14.5 percentage points from 26.1 percent of GDP in 1980 to 40.6 percent of GDP in 1989. The ratio of federal debt to GDP rose to a peak of 49.1 percent of GDP in 1994, declining to 34.7 percent of GDP in 2000 and staying below the peak of 36.9 percent of GDP in 2001 to 2007.
Table 7, Federal Government Outlays, Revenue, Deficit and Debt as Percent of GDP 1980-1989
| Outlays % GDP | Revenue % GDP | Deficit % GDP | Debt % GDP | |
| 1980 | 21.7 | 19.0 | -2.7 | 26.1 |
| 1981 | 22.2 | 19.6 | -2.6 | 25.8 |
| 1982 | 23.1 | 19.2 | -4.0 | 28.7 |
| 1983 | 23.5 | 17.5 | -6.0 | 33.1 |
| 1984 | 22.2 | 17.3 | -4.8 | 34.0 |
| 1985 | 22.8 | 17.7 | -5.1 | 36.4 |
| 1986 | 22.5 | 17.5 | -5.0 | 39.5 |
| 1987 | 21.6 | 18.4 | -3.2 | 40.6 |
| 1988 | 21.3 | 18.2 | -3.1 | 41.0 |
| 1989 | 21.2 | 18.4 | -2.8 | 40.6 |
Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/HistoricalTables[1].pdf
The unparalleled fiscal imbalance has been accompanied by the highest monetary policy accommodation in US history. As shown in Table 8, base money has swollen from $829 billion in Dec 2007 to $2494 billion in Apr 2011, by $1665 billion, for an increase of a multiple of 3 or 200.8 percent. At least de facto, monetary policy has been coordinated with fiscal policy.
Table 8, Total Reserves of Depository Institutions (R) and Base Money (B) (Dollar Billions Not Seasonally Adjusted)
| R | ∆% | B | ∆% | |
| D-2003 | 42 | 752 | ||
| D-2004 | 46 | 9.5 | 765 | 1.7 |
| D-2005 | 45 | -2.2 | 793 | 3.7 |
| D-2006 | 43 | -4.4 | 818 | 3.2 |
| D-2007 | 43 | 0 | 829 | 1.3 |
| D-2008 | 820 | 1806.9 | 1659 | 100.1 |
| D-2009 | 1139 | 38.9 | 2022 | 21.9 |
| D-2010 | 1078 | -5.3 | 2014 | -0.4 |
| Apr 2011 | 1528 | 41.7 | 2494 | 23.8 |
Source: http://www.federalreserve.gov/releases/h3/hist/h3hist1.pdf
Neumann (1992, 33, 36) states:
“If the security dealers do not hold but resell the Treasury securities to Reserve Banks after a short duration, it is, in fact, the Fed that supplies the borrowed funds to the Treasury. At the same time, these transactions permit the security dealers to buy another load of new debt from the Treasury…The dominating source component of fiscal seigniorage is the outright acquisition of government securities by the Fed…The seigniorage flow to government must not be identified with the Fed’s payment of ‘interest on Federal Reserve notes.’ In servicing the debt held by the Fed, the Treasury makes interest payments of roughly the same order of magnitude as the Fed pays to the Treasury. Indeed, the Fed’s portfolio of US government securities can be interpreted as an interest-free loan to the Treasury.”
Another form of viewing this issue is that to the extent that monetary policy of issuing $1.7 trillion of base money to acquire a portfolio of securities of $2.5 trillion was successful in lowering the rate paid on government securities, the government collected seigniorage from holders of government securities at home and abroad by the difference on what interest rates would have been without the target on fed funds rate of zero percent and quantitative easing. An issue of the exit strategy of the Fed is the impact of higher interest costs of Treasury debt that may affect the sustainability of the federal debt or the capacity to continue financing the US government with the “exorbitant privilege” deriving from use of the dollar as international reserve that allows the US to fund internationally at cheaper rates in its own dollar-denominated liabilities (Gourinchas and Rey 2005, Eichengreen 2011; see Pelaez and Pelaez, The Global Recession Risk (2007), 14, 44-7).
Is there a “tipping” or “explosion” point of that “exorbitant privilege”? The coordination deliberate or de facto of monetary and fiscal policy does resemble that during the Great Inflation (Meltzer 2005, 2010a, 2010b; see http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html). Sargent and Wallace (1981, 6) show how such coordination can result in a perverse example:
“This example is spectacular in that the easier, or looser, monetary policy is uniformly better than the tighter policy. In this example, the tighter current monetary policy fails to even temporarily reduce inflation below the level it would be under the looser policy.”
DeLong (1997, 247-8) shows that the 1970s were the only peacetime period of inflation in the US without parallel in the prior century. The price level in the US drifted upward since 1896 with jumps resulting from the two world wars: “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” (DeLong, 1997, 248). Monetary policy focused on accommodating higher inflation, with emphasis solely on the mandate of promoting employment, has been blamed as deliberate or because of model error or imperfect measurement for creating the Great Inflation (http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). As DeLong (1997) shows, the Great Inflation began in the mid 1960s, well before the oil shocks of the 1970s (see also the comment to DeLong 1997 by Taylor 1997, 276-7). A counterfactual of the 1970s immediately rises out of Table 9, which consists of simulating current monetary and fiscal policies in doses much more aggressive than in the 1960s and 1970s proposed as a true rose garden without thorns (http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html). What would have been the Great Inflation and Unemployment if the Federal Reserve would have lowered interest rates to zero in 1961, in fear of deflation because of 0.7 percent CPI inflation, and purchased the equivalent of 30 percent of the Treasury debt in long-term securities, subsequently engaging in quantitative easing II in 1964 after CPI inflation of 1.0 percent? The counterfactual would not be complete without including the unknown path of the US debt, tax and interest rate increases to exit from unsustainable debt and the largest monetary accommodation in US history. In one of his multiple important contributions to understanding the Great Inflation, Meltzer (2005) distinguishes between one-time price jumps, such as by oil shocks, and a “maintained” inflation rate. Meltzer (2005) uses a dummy variable to extract the one-time oil price changes, resulting in a maintained inflation rate that was never higher than 8 to 10 percent in the 1970s. There is revealing analysis of the Great Inflation and its reversal by Meltzer (2005, 2010a, 2010b).
Table 9, 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
There is a false impression that there is a monetary policy “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 10 when monetary policy 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 10 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 valid 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 while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.
Table 10, 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.t
Table 11, updated with every blog comment, 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 10. 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, subsequently by the tragic earthquake and tsunami in Japan and now again by the sovereign risk doubts in Europe. The yield of 3.146 percent at the close of market on May 13, 2011, would be equivalent to price of 95.5625 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 5.6 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, the tragic earthquake and tsunami affecting Japan and recurring fears on European sovereign credit issues. Important causes of the rise in yields shown in Table 10 are expectations of rising inflation and US government debt estimated to exceed 70 percent of GDP in 2012 (http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html), rising from 40.8 percent of GDP in 2008 and 53.5 percent in 2009 as shown in Table 6 (Table 2 in http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html). On May 18, 2011, the line “Reserve Bank credit” in the Fed balance sheet stood at $2742 billion, or $2.7 trillion, with portfolio of long-term securities of $2514 billion, or $2.5 trillion, consisting of $1408 Treasury nominal notes and bonds, $61 billion of notes and bonds inflation-indexed, $121 billion Federal agency debt securities and $924 billion mortgage-backed securities; reserve balances deposited with Federal Reserve Banks reached $1536 billion or $1.5 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). There is no simple exit of this trap created by the highest monetary policy accommodation in US history together with the highest deficits and debt in percent of GDP since World War II. The yield of the 10-year Treasury note fluctuated during the week from 3.15 percent on Mon May 16 to 3.146 percent on Fri May13 while the yield of the 10-year German government bond fell from 3.12 percent on Mon May 16 to 3.06 percent on Fri May 20 (http://noir.bloomberg.com/markets/rates/germany.html). Risk aversion from various sources, discussed in the following section III, has been affecting financial markets for several weeks. The risk is that in a reversal of risk aversion that has been typical in this cyclical expansion of the economy yields of Treasury securities may back up sharply.
Table 11, 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 |
| 03/25/11 | 3.435 | 93.1935 | -7.9 |
| 04/01/11 | 3.445 | 93.1129 | -8.0 |
| 04/08/11 | 3.576 | 92.0635 | -9.1 |
| 04/15/11 | 3.411 | 93.3874 | -7.8 |
| 04/22/11 | 3.402 | 93.4646 | -7.7 |
| 04/29/11 | 3.290 | 94.3759 | -6.8 |
| 05/06/11 | 3.147 | 95.5542 | -5.6 |
| 05/13/11 | 3.173 | 95.3387 | -5.8 |
| 05/20/11 | 3.146 | 95.5625 | -5.6 |
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
III Risk Aversion. The past three weeks have been characterized by unusual financial turbulence. Table 12 provides beginning values on May 16, high and low values and values on May 20. All data are for New York time at 5 PM. The high and low values exclude observations on May 16 and May 20.
Table 12, Risk Financial Assets
| May 16 | High | Low | May 20 | |
| USD/EUR | 1.4165 | 1.4308 | 1.4236 | 1.4160 |
| JPY/USD | 80.785 | 81.7185 | 81.3665 | 81.680 |
| CHF/USD | 0.8841 | 0.8814 | 0.8801 | 0.8780 |
| DJIA | 100 | 100.5 | 99.5 | 99.71 |
| DJ Global | 100 | 100.3 | 99.5 | 99.6 |
| DAX | 100 | 99.6 | 98.2 | 98.4 |
| DJ UBS | 100 | 102.2 | 99.8 | 101.9 |
| WTI $/barrel | 97.010 | 99.700 | 97.490 | 99.930 |
| Brent $/barrel | 110.32 | 112.090 | 110.480 | 112.39 |
| Gold $/ounce | 1490.00 | 1494.60 | 1484.80 | 1513.50 |
| 10 Y US T % | 3.15 | 3.18 | 3.12 | 3.15 |
| 10 Y Ger % | 3.12 | 3.12 | 3.09 | 3.06 |
Note: USD: US dollars; EUR: euro; JPY: Japanese Yen;
Source: http://noir.bloomberg.com/intro_markets.html
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
Exchange rates provide important indicators of risk aversion. The first three rows of Table 12 provide key exchange rates. The dollar devalues on a trend as a result of zero interest rates but the trend is reversed during periods of risk aversion as the dollar does not currently have a challenge by another currency of its “exorbitant privilege” of cheap financing as international reserve currency. Investors short the overnight or low-maturity segment of the yield curve, which is equivalent to borrowing, short the dollar and invest in risk financial assets by taking long, highly-leveraged positions. This strategy is known as the “carry trade,” in which low short-term US interest rates are the “carry cost” of positions in risk financial assets such as commodities, stocks, emerging stocks and so on. The dollar (USD) revalued relative to the euro (EUR) from USD 1.483/EUR on May 2 to USD 1.4160/EUR on May 20, or by 4.5 percent. Continuing aversion is shown by the tight range of trading of the USD/EUR and in fact of all risk financial assets. The Japanese yen (JPY) has been on its own carry trade for a longer period because zero interest rates go back more than a decade. The Swiss franc (CHF) is an important indicator of flight to safety of a strong banking deposit and investment center. The CHF/USD rate strengthened before the current episode because risk aversion signs preceded the turmoil of the past three weeks. The last two rows of Table 12 show the decline in the yield of the 10-year Treasury note declining from 3.282 percent on May 2 to 3.146 percent on May 20 and even as low as 3.12 percent. Similar behavior is exhibited by the 10-year government bond of Germany with decline in yield from 3.282 percent on May 2 to 3.06 percent on May 20. Investors hold government securities of the US and Germany during episodes of risk aversion, with demand raising their prices, which is equivalent to lowering yields.
Table 12 also provides indexes of three stock market indices, Dow Jones Industrial Average (DJIA), Dow Jones Global (DJ Global) and DAX of Germany with value of 100 on May 20. All four indexes fell slightly as investors abandoned risk positions and sought safety havens.
The sharpest decline was in commodity prices. Table 12 provides the value of the DJ UBS Commodity Index and the futures prices of WTI and Brent oil and gold. The DJ UBS Commodity Index fell 8.1 percent from May 2 to May 13 but gained 1.9 percent from May 16 to May 20. Oil price and gold futures fell sharply in the prior two weeks but gained in the week of May 20.
In the current expansion phase of the business cycle after the credit/dollar crisis and global recession of 2007-2009, risk aversion has occurred in the form of: (1) sovereign risk doubts in the euro area; (2) slower growth in China because of the tough tradeoff of inflation and growth; (3) geopolitical events in the Middle East and subsequently the earthquake/tsunami in Japan; (4) mediocre growth, job stress, wage stagnation and fiscal/monetary imbalance in the US; and (5) increasingly the rise of inflation everywhere in the world that injects uncertainty in financial and economic decisions, or allocation disruptive effect of Bailey (1956), and redistributions of income and wealth, or income/wealth redistributive effect of Bailey (1956). The strongest impact occurred in Apr to Jul 2010 because of the sovereign doubts in Europe, recurring less strongly in Nov 2010 and again in Mar 2011. Fitch downgraded Greece’s sovereign bonds to B+ negative watch (http://www.fitchratings.com/index_fitchratings.cfm). The new rating is based on the expectation that Greece will need some form of restructuring or new profile of its sovereign bonds that could trigger a default rating by Fitch. Default is technically any change in the original bond agreement. Fitch’s watch will find resolution after the review of the joint European Union and IMF agreement to be completed in the second half of Jun. David Oakley, Kerin Hope and Ralph Atkins, writing in the Financial Times on “Greece worries markets on reform plan” (http://www.ft.com/intl/cms/s/0/4237d354-830d-11e0-85a4-00144feabdc0.html#axzz1N5tRskA5), analyze the repercussions in financial markets resulting from the delay of Greece’s reform plans: depreciation of the euro relative to the dollar and rise in yields of sovereign bonds of Greece and Spain. Melodie Warner, Nick Cawley and Neelabh Chaturvedi writing in the Wall Street Journal on “Fitch cuts Greek ratings; investors retreat to German bonds” (http://professional.wsj.com/article/SB10001424052748704904604576335032185731202.html?mod=WSJ_hp_LEFTWhatsNewsCollection), find that the 4.6 percent Greek bond maturing in May 2013 rose 0.46 percentage points to yield 24.61 percent and the Spanish two-year bond rose 0.19 percentage points to yield 3.62 percent.
IV Valuation 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 13 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 monetary and housing policies in the US. Between 2002 and 2008, the DJ UBS Commodity Index rose 165.5 percent largely because of the unconventional monetary policy 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 13 by percentage changes of peaks and troughs. 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 18.8 percent by Fri May 20, 2011. Dollar devaluation is a major vehicle of monetary policy in reducing the output gap that is implemented in the probably erroneous belief that devaluation will not accelerate inflation. The last row of Table 13 shows CPI inflation in the US rising from 1.9 percent in 2003 to 4.1 percent in 2007 even as the Fed increased the fed funds rate from 1 percent in Jun 2004 to 5.25 percent in Jun 2006.
Table 13, 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 | 05/20 |
| Rate | 1.1423 | 1.5914 | 1.192 | 1.416 |
| CNY/USD | 01/03 | 07/21 | 7/15 | 05/20/ 2011 |
| Rate | 8.2798 | 8.2765 | 6.8211 | 6.493 |
| 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
Table 13A extracts four rows of Table 13 with the Dollar/Euro (USD/EUR) exchange rate and Chinese Yuan/Dollar (CNY/USD) exchange rate that reveal pursuit of exchange rate policies resulting from monetary policy in the US and capital control/exchange rate policy in China. The ultimate intentions are the same: promoting internal economic activity at the expense of the rest of the world. The easy money policy of the US was deliberately or not but effectively to devalue the dollar from USD 1.1423/EUR on Jun 26, 2003 to USD 1.5914/EUR on Jul 14, 2008, or by 39.3 percent. The flight into dollar assets after the global recession caused revaluation to USD 1.192/EUR on Jun 7, 2010, or by 25.1 percent. After the temporary interruption of the sovereign risk issues in Europe from Apr to Jul, 2010, shown in Table 14, the dollar has devalued again to USD 1.416/EUR or by 18.8 percent. Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment. China fixed the CNY to the dollar for a long period at a highly undervalued level of around CNY 8.2765/USD until it revalued to CNY 6.8211/USD until Jun 7, 2010, or by 17.6 percent and after fixing it again to the dollar, revalued to CNY 6.4930/USD on May 20, 2011, or by an additional 4.8 percent, for cumulative revaluation of 21.5 percent.
Table 13A, Dollar/Euro (USD/EUR) Exchange Rate and Chinese Yuan/Dollar (CNY/USD) Exchange Rate
| USD/EUR | 6/26/03 | 7/14/08 | 6/07/10 | 05/20 |
| Rate | 1.1423 | 1.5914 | 1.192 | 1.416 |
| CNY/USD | 01/03 | 07/21 | 7/15 | 05/20/ 2011 |
| Rate | 8.2798 | 8.2765 | 6.8211 | 6.493 |
Source: Table 13.
Dollar devaluation did not eliminate the US current account deficit, which is projected by the International Monetary Fund (IMF) at 3.2 percent of GDP in 2011 and also in 2012, as shown in Table 14. Revaluation of the CNY has not reduced the current account surplus of China, which is projected by the IMF to increase from 5.7 percent of GDP in 2011 to 6.3 percent of GDP in 2012.
Table 14, Fiscal Deficit, Current Account Deficit and Government Debt as % of GDP and 2011 Dollar GDP
| GDP $B | FD %GDP 2011 | CAD %GDP 2011 | Debt %GDP 2011 | FD%GDP 2012 | CAD%GDP 2012 | Debt %GDP 2012 | |
| US | 15227 | -10.6 | -3.2 | 64.8 | -10.8 | -3.2 | 72.4 |
| Japan | 5821 | -9.9 | 2.3 | 127.8 | -8.4 | 2.3 | 135.1 |
| UK | 2471 | -8.6 | -2.4 | 75.1 | -6.9 | -1.9 | 78.6 |
| Euro | 12939 | -4.4 | 0.03 | 66.9 | -3.6 | 0.05 | 68.2 |
| Ger | 3519 | -2.3 | 5.1 | 54.7 | -1.5 | 4.6 | 54.7 |
| France | 2751 | -6.0 | -2.8 | 77.9 | -5.0 | -2.7 | 79.9 |
| Italy | 2181 | -4.3 | -3.4 | 100.6 | -3.5 | -2.9 | 100.4 |
| Can | 1737 | -4.6 | -2.8 | 35.1 | -2.8 | -2.6 | 36.3 |
| China | 6516 | -1.6 | 5.7 | 17.1 | -0.9 | 6.3 | 16.3 |
| Brazil | 2090 | -2.4 | -2.6 | 39.9 | -2.6 | -2.9 | 39.4 |
Note: GER = Germany; Can = Canada; FD = fiscal deficit; CAD = current account deficit
Source: http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table 13 after the first policy round of near zero fed funds and quantitative easing by withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, low wages, depressed hiring and high job stress of unemployment and underemployment in the US. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets with fluctuations provoked by events of risk aversion. Table 15, which is updated for every comment, shows the deep contraction of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough” and the sharp recovery after around Jul 2010 in the last column “∆% Trough to 05/20/11” with all risk financial assets in the range from 14.0 percent for European stocks to 30.9 percent for the DJ UBS Commodities Index, excluding Japan that has currently weaker performance of 8.9 percent because of the earthquake/tsunami, while the dollar devalued by 18.8 percent and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 5/20/2011” shows the fall of most risk financial assets, with the exception of commodities that had fallen sharply in the week of May 6, because of the risk aversion in the week of May 20. Aggressive tightening of monetary policy to maintain the credibility of inflation not rising above 2 percent—in contrast with timid “measured” policy during the adjustment in Jun 2004 to Jun 2006 after the earlier round of near zero interest rates—may cause another credit/dollar crisis and stress on the overall world economy. The choices may prove tough and will magnify effects on financial variables because of the corner in which policy has been driven by aggressive impulses that have resulted in the fed funds rate of 0 to ¼ percent and holdings of long-term securities close to 30 percent of Treasury securities in circulation.
Table 15, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 5/ | ∆% Week 5/ | ∆% Trough to 5/ | |
| DJIA | 4/26/ | 7/2/10 | -13.6 | 11.7 | -0.7 | 29.2 |
| S&P 500 | 4/23/ | 7/20/ | -16.0 | 9.5 | -0.3 | 30.4 |
| NYSE Finance | 4/15/ | 7/2/10 | -20.3 | -6.4 | -0.6 | 17.5 |
| Dow Global | 4/15/ | 7/2/10 | -18.4 | 3.4 | -0.9 | 26.7 |
| Asia Pacific | 4/15/ | 7/2/10 | -12.5 | 5.2 | -1.2 | 20.2 |
| Japan Nikkei Aver. | 4/05/ | 8/31/ | -22.5 | -15.7 | -0.4 | 8.9 |
| China Shang. | 4/15/ | 7/02 | -24.7 | -9.7 | 0.4 | 19.9 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -3.5 | -0.04 | 14.0 |
| DAX | 4/26/ | 5/25/ | -10.5 | 14.8 | -1.8 | 28.2 |
| Dollar | 11/25 2009 | 6/7 | 21.2 | 6.4 | -0.4 | -18.8 |
| DJ UBS Comm. | 1/6/ | 7/2/10 | -14.5 | 11.9 | 1.6 | 30.9 |
| 10-Year Tre. | 4/5/ | 4/6/10 | 3.986 | 3.146 |
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.
Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. Table 16 shows a gain by Apr 29, 2011 in the DJIA of 14.3 percent and of the S&P 500 of 12.5 percent since Apr 26, 2010, around the time when sovereign risk issues in Europe began to be acknowledged in financial risk asset valuations. There were still fluctuations. Reversals of valuations are possible during aggressive changes in interest rate policy. In the week of May 6, return of risk aversion, resulted in moderation of the valuation of the DJIA to 12.8 percent and that of the S&P 500 to 10.6 percent. There was further loss of dynamism in the week of May 13 with the DJIA reducing its gain to 12.4 percent and the S&P 500 to 10.4 percent. Further declines have lowered the gain to 11.7 percent in the DJIA and to 10.0 in the S&P 500 by Fri May 20.
Table 16, Percentage Changes of DJIA and S&P 500 in Selected Dates
| 2010 | ∆% DJIA from earlier date | ∆% DJIA from | ∆% S&P 500 from earlier date | ∆% S&P 500 from |
| 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 |
| Mar 25 | 3.1 | 9.1 | 2.7 | 8.4 |
| Apr 1 | 1.3 | 10.5 | 1.4 | 9.9 |
| Apr 8 | 0.03 | 10.5 | -0.3 | 9.6 |
| Apr 15 | -0.3 | 10.1 | -0.6 | 8.9 |
| Apr 22 | 1.3 | 11.6 | 1.3 | 10.3 |
| Apr 29 | 2.4 | 14.3 | 1.9 | 12.5 |
| May 6 | -1.3 | 12.8 | -1.7 | 10.6 |
| May 13 | -0.3 | 12.4 | -0.2 | 10.4 |
| May 20 | -0.7 | 11.7 | -0.3 | 10.0 |
Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004
Table 17, updated with every post, shows that exchange rate valuations affect a large variety of countries, in fact, almost the entire world, in magnitudes that cause major problems for domestic monetary policy and trade flows. Dollar devaluation is expected to continue because of zero fed funds rate, expectations of rising inflation and the large budget deficit of the federal government (http://professional.wsj.com/article/SB10001424052748703907004576279321350926848.html?mod=WSJ_hp_LEFTWhatsNewsCollection) but with interruptions caused by risk aversion events.
Table 17, Exchange Rates
| Peak | Trough | ∆% P/T | May 20 2011 | ∆% T May 20 2011 | ∆% P May 20 2011 | |
| EUR USD | 7/15 | 6/7 2010 | 5/20 | |||
| Rate | 1.59 | 1.192 | 1.416 | |||
| ∆% | -33.4 | 15.8 | -12.3 | |||
| JPY USD | 8/18 | 9/15 | 5/20 2011 | |||
| Rate | 110.19 | 83.07 | 81.68 | |||
| ∆% | 24.6 | 1.7 | 25.9 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 5/20 2011 | |||
| Rate | 1.225 | 1.025 | 0.878 | |||
| ∆% | 16.3 | 14.3 | 28.3 | |||
| USD GBP | 7/15 | 1/2/ 2009 | 5/20 2011 | |||
| Rate | 2.006 | 1.388 | 1.623 | |||
| ∆% | -44.5 | 14.5 | -23.6 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 5/20 | |||
| Rate | 1.0215 | 1.6639 | 1.066 | |||
| ∆% | -62.9 | 43.6 | 8.2 | |||
| ZAR USD | 10/22 2008 | 8/15 | 5/20 2011 | |||
| Rate | 11.578 | 7.238 | 6.912 | |||
| ∆% | 37.5 | 4.5 | 40.3 | |||
| SGD USD | 3/3 | 8/9 | 5/20 | |||
| Rate | 1.553 | 1.348 | 1.238 | |||
| ∆% | 13.2 | 8.2 | 20.3 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 5/20 | |||
| Rate | 7.813 | 7.752 | 7.774 | |||
| ∆% | 0.8 | -0.3 | 0.5 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 5/20 2011 | |||
| Rate | 2.43 | 1.737 | 1.625 | |||
| ∆% | 28.5 | 6.5 | 33.1 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 5/20 | |||
| Rate | 22.19 | 18.693 | 17.259 | |||
| ∆% | 15.7 | 7.7 | 22.2 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 5/20 2011 | |||
| Rate | 9.313 | 7.108 | 6.305 | |||
| ∆% | 23.7 | 11.3 | 32.3 | |||
| CNY USD | 7/20 2005 | 7/15 | 5/20 | |||
| Rate | 8.2765 | 6.8211 | 6.493 | |||
| ∆% | 17.6 | 4.8 | 21.5 |
Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; 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
V Economic Indicators. Demand for US long-term securities continues to be strong. Industry continues to expand at perhaps a lower rate. The housing sector and labor markets continue to be in weak conditions. Crude oil stocks and imports continue at adequate levels and gasoline prices remain high. Cross-borders flows of US long-term securities in the Treasury international capital report are shown in Table 18. There were strong foreign net purchases of US long-term securities, increasing from $32.6 billion in Feb to $54.7 billion in Mar that were driven by an increase in net purchases of securities by the private sector rising from $12.5 billion in Feb to $44.9 billion in Mar, with the private sector, rising from $12.5 billion in Feb to $44.9 billion in Mar, compensating for the official sector declining from $20.2 billion in Feb to $9.9 billion in Mar.
Table 18, Net Cross-Borders Flows of US Long-Term Securities, Billion Dollars, NSA
| Feb 2011 | Mar 2011 | |
| Net Foreign Purchases of US LT Securities | 32.6 | 54.7 |
| Private | 12.5 | 44.9 |
| Treasury | 14.7 | 19.9 |
| Agency | -7.3 | 6.9 |
| Official | 20.2 | 9.9 |
| Treasury | 15.9 | 6.8 |
| Agency | 5.8 | 2.6 |
| Net US Purchases of LT Foreign Securities | -5.5 | -30.7 |
| Net Foreign Purchases of US LT Securities | 27.2 | 24.0 |
Source: http://www.treasury.gov/press-center/press-releases/Pages/tg1177.aspx
US industrial production and capacity utilization in the Fed report (http://www.federalreserve.gov/releases/g17/current/) in the first four months of 2011 and relative to the same period in 2010 are shown in Table 19. The excellent charts provided by the Fed allow comparisons with earlier cycles. The sharp acceleration of industrial production and capacity in the Fed’s Chart 1 (http://www.federalreserve.gov/releases/g17/current/ipg1.gif) appears to be significantly explained by the high-technology revolution in Chart 2 (http://www.federalreserve.gov/releases/g17/current/ipg3.gif). There is an evident deceleration of industry and capacity after 2000. The NBER cyclical reference dates permit the conclusion that the best comparison in terms of intensity is with the recessions in the 1970s and 1980s instead of the meaningless appeal to comparison with the Great Depression of what was a different economy with much sharper and prolonged contraction. Industrial production did not change in Apr after increasing 0.7 percent in Mar. The Feb estimate was revised from an increase of 0.1 percent to decline by 0.3 percent. Total industrial production rose 5.0 percent in Jan/Apr 2011 relative to Jan/Apr 2010 but the annual equivalent growth rate in the first four months of 2011 is 1.5 percent. At the margin, industry, which is the driver of the recovery, appears to be decelerating. The key aspect of the report is the fall in manufacturing by 0.4 percent in Apr. Manufacturing rose by 4.6 percent in the first four months of 2011 relative to the first four months of 2010 but the annual equivalent rate of extrapolating the Jan-Mar cumulative increase for a full year is 3.0 percent. Manufacturing had increased during nine consecutive months. Vehicle assembly fell from the annual equivalent rate of 9.0 million units in Mar to 7.9 million in Apr because of the lack of parts originating in the earthquake/tsunami of Japan. Excluding motor vehicles and parts, manufacturing rose 0.2 percent in Apr. The rate of capacity utilization of industry fell 0.1 percentage points to 76.9 percent, which is 3.5 percentage points less than the average from 1972 to 2010.
Table 19, Industrial Production and Capacity Utilization, SA %
| Jan | Feb | Mar | Apr | Jan-Apr 2011/ 2010 | |
| Total | 0.1 | -0.3 | 0.7 | 0.0 | 5.0 |
| Markets | |||||
| Final Products | 0.7 | -0.1 | 0.5 | -0.5 | 5.2 |
| Consu-mer Goods | 0.3 | -0.5 | 0.9 | -0.7 | 3.9 |
| Business Equip-ment | 1.8 | 0.9 | -0.5 | -0.4 | 9.9 |
| Non Industry Supplies | -0.1 | -0.4 | 0.7 | 0.4 | 2.7 |
| Cons- truction | 0.5 | -0.6 | 1.2 | -0.1 | 3.0 |
| Mat- erials | -0.4 | -0.3 | 0.9 | 0.3 | 5.4 |
| Groups | |||||
| Manu- facturing | 0.6 | 0.2 | 0.6 | -0.4 | 4.6 |
| Mining | -1.2 | -0.9 | 1.4 | 0.8 | 4.1 |
| Utilities | -1.7 | -2.3 | 0.7 | 1.7 | 8.0 |
| Capacity | 76.8 | 76.5 | 77.0 | 76.9 | -0.1 |
Sources:
http://www.federalreserve.gov/releases/g17/current/
The Empire State Manufacturing Survey of the FRB of New York (http://www.newyorkfed.org/survey/empire/may2011.pdf) in Table 20 shows expansion at a slower pace from Apr to May but expectation of acceleration in the next six months. The statement by the FRBNY is:
“The Empire State Manufacturing Survey indicates that conditions for New York manufacturers improved in May, but at a slower pace than in April. The general business conditions index fell ten points to 11.9. The new orders index declined five points to 17.2, and the shipments index slipped three points to 25.8. The inventories index climbed to 10.8, its highest level in a year. Future indexes continued to convey a high level of optimism about the six-month outlook, although prices are widely expected to rise.”
Table 20, FRB of New York Empire State Manufacturing Survey, Diffusion Index SA
| Apr | May | |
| Current | ||
| General Index | 21.7 | 11.9 |
| New Orders | 22.3 | 17.2 |
| Shipments | 28.3 | 17.2 |
| Unfilled Orders | 2.6 | 9.7 |
| Number Employees | 23.1 | 24.7 |
| Average Employee Workweek | 10.3 | 23.4 |
| Expectation Six Months | ||
| General Index | 47.4 | 52.7 |
| New Orders | 43.6 | 47.3 |
| Shipments | 37.2 | 41.9 |
| Unfilled Orders | 7.7 | 19.3 |
| Number Employees | 32.1 | 20.4 |
| Average Employee Workweek | 6.4 | 12.9 |
Source: http://www.newyorkfed.org/survey/empire/may2011.pdf
The Business Outlook Survey of the FRB of Philadelphia (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0511.pdf) in Table 21 shows expansion in the form of a positive index for May of 3.9 but deceleration relative to 18.5 in Apr. There is similar deceleration in the six month expectation from 33.6 in Apr to 16.6 in May. Both the New York and Philadelphia indexes show gradually improving labor markets.
Table 21, FRB of Philadelphia Business Outlook Survey Diffusion Index SA
| Apr | May | |
| Current | ||
| General Index | 18.5 | 3.9 |
| New Orders | 18.8 | 5.4 |
| Shipments | 29.1 | 6.5 |
| Unfilled Orders | 12.9 | -7.8 |
| Number Employees | 12.3 | 22.1 |
| Average Employee Workweek | 17.7 | 3.9 |
| Expectation Six Months | ||
| General Index | 33.6 | 16.6 |
| New Orders | 29.2 | 16.8 |
| Shipments | 37.8 | 20.4 |
| Unfilled Orders | 14.1 | -1.0 |
| Number Employees | 37.7 | 22.3 |
| Average Employee Workweek | 18.4 | 9.8 |
Sources:http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0411.pdf http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0511.pdf
Housing starts in Apr, seasonally adjusted at an annual equivalent rate, fell in Apr by 10.6 percent relative to Mar and building permits fell 4.0 in Apr relative to Mar (http://www.census.gov/const/newresconst.pdf) as shown in Table 22.
Table 22, Housing Starts and Permits Seasonally Adjusted Annual Equivalent Rates, Thousands of Units, %
| Housing Starts | Housing Permits | |
| Apr 2011 | 523 | 551 |
| Mar 2011 | 585 | 574 |
| ∆% Apr/Mar 2011 | -10.6 | -4.0 |
Source: http://www.census.gov/const/newresconst_201104.pdf
Housing starts, not seasonally adjusted, fell 12.6 percent in Jan-Apr 2011 relative to Jan-Apr 2010 and new permits fell 14.1 percent, as shown in Table 23. Housing starts fell 72.5 percent in Jan-April 2011 relative to the same period in 2006 and 72.9 percent relative to the same period in 2005. New permits fell 73.6 percent relative to Jan-Apr 2006 and 73.9 percent relative to Jan-Apr 2005.
Table, 23 Housing Starts and New Permits, Thousands of Units, NSA, and %
| Housing Starts | New Permits | |
| Jan-Apr 2011 | 171.6 | 176.1 |
| Jan-Apr 2010 | 196.3 | 205.0 |
| ∆%/ Jan-Apr 2011 | -12.6 | -14.1 |
| Jan-Apr 2006 | 624.6 | 667.9 |
| ∆%/Jan-Apr 2011 | -72.5 | -73.6 |
| Jan-Apr 2005 | 632.8 | 675.7 |
| ∆%/ Jan-Apr 2011 | -72.9 | -73.9 |
Source: http://www.census.gov/const/newresconst.pdf
http://www.census.gov/const/newresconst_200704.pdf
http://www.census.gov/const/newresconst_200604.pdf
New claims for unemployment insurance fell by 29,000 in the week of May 14 relative to the week of May 7, as shown in Table 24, and by 39,865 not seasonally adjusted. There is continuing stress in labor markets.
Table 24, Initial Claims for Unemployment Insurance
| SA | NSA | 4-week MA SA | |
| May 14 | 409,000 | 357,872 | 439,000 |
| May 7 | 438,000 | 397,737 | 437,750 |
| Change | -29,000 | -39,865 | 1250 |
| Apr 30 | 478,000 | 415,974 | 432,250 |
| Prior Year | 477,000 | 414,572 | 462,250 |
Note: SA: seasonally adjusted; NSA: not seasonally adjusted; MA: moving average
Source: http://www.dol.gov/opa/media/press/eta/ui/current.htm
Data of the Weekly Status Report of the Energy Information Administration in Table 25 show no change in commercial crude oil stocks in the US at 370.3 million barrels, excluding the strategic petroleum reserve) in the four weeks ending on May 13, 2011 relative to the week ending on May 6, 2011 and an increase of 10.1 million barrels relative to a year earlier. Average crude oil imports in average thousands of barrels per day rose from 8756 in the week of Apr 6 to 8885 in the week of Apr 13 but are lower than 9753 a year earlier. The world crude oil price fell from $117.12 on May 6 to $110.12 on May 13. Regular motor vehicle gasoline at $3.960/gallon on Apr 16 was lower than $3.965 on Apr 9 but much higher than $2.864 a year earlier.
Table 25, Energy Information Administration Weekly Petroleum Status Report
| Week Ending 05/13/11 | Week Ending 05/06/11 | Week Ending 05/14/10 | |
| Crude Oil Stocks Million B | 370.3 | 370.3 | 360.2 |
| Crude Oil Imports Thousand Barrels/Day | 8,885 | 8,756 | 9,753 |
| World Crude Oil Price $/B | 110.12 | 117.12 | 76.56 |
| 05/16/11 | 05/09/11 | 05/17/10 | |
| Regular Motor Gasoline $/G | 3.960 | 3.965 | 2.864 |
B: barrels; G: gallon
VI Interest Rates. The Treasury note with coupon of 3.125 percent and maturity on May 15, 2021, traded on May 20 at yield of 3.15 percent equivalent to price of 99.8125 (http://noir.bloomberg.com/markets/rates/index.html), which is not comparable to the price in Table 11 that is based on a coupon of 2.625 percent of a hypothetical note maturing in exactly ten years. The yield curve has a segment of Treasury bills with near zero interest rates: 0.04 percent for 3 months, 0.09 percent for 6 months and 0.16 percent for 12 months. The two year Treasury note yields 0.51 percent, the 5 year yields 1.79 percent and the 7 year yields 2.48 percent. The zero interest rate on fed funds together with quantitative easing have created artificial interest rates that distort risk/return decisions. Risk aversion is shown in the 10-year government bond of Germany trading at 3.06 percent on May 20 (http://noir.bloomberg.com/markets/rates/germany.html).
VII Conclusion. Inflation may prompt faster adjustment to normalcy in monetary policy than currently anticipated. The unwinding of the highest monetary accommodation in history may be quite complex. Financial markets are vulnerable to multiple risk factors in the international financial system. (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
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