Slowing Growth, Global Inflation, Great Inflation and Unemployment Analysis and Risk Aversion

 

Slowing Growth, Global Inflation, Great Inflation and Unemployment Analysis and Risk Aversion

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011

Executive Summary

I Slowing Growth

II Global Inflation

III Great Inflation and Unemployment Analysis

IIIA “New Economics” and the Great Inflation

IIIB Counterfactual with Current Science

IIIC Policy Rule and Politics

IIID Supply Shocks

IIIE Conclusion

IV Risk Aversion

V Valuations of Risk Financial Assets

VI Economic Indicators

VII Interest Rates

VIII Conclusion

References

Executive Summary

The most important macroeconomic challenge of the US is flattening the path of expansion of the federal government debt while exiting monetary accommodation. 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.

The current macroeconomic environment of the US and the world economy is not favorable to debt management and exit from monetary accommodation. Economic growth in the US was only 1.8 percent in the first quarter of 2010 (IQ2011). The rate of growth of personal consumption expenditures (PCE) decelerated from 4.0 percent in IVQ2010 to 2.2 percent in IQ2011. Real disposable personal income has been virtually flat in the first four months of 2011. Labor markets continue to be weak with 26 to 30 million people unemployed or underemployed in part-time jobs while hiring, which is the only exit from job stress, is significantly below pre-crisis levels. There is inflation everywhere in the world economy. Risk aversion is shaking financial markets worldwide with funds flowing into safe havens as revealed by the sharp decline of the yield of the 10-year Treasury note to 3.07 percent on Fri May 27, the yield of the 2-year Treasury security to 0.48 percent and the yield of the 10-year government bond of Germany to 2.99 percent. Risk aversion originates in a variety of factors: (1) sovereign risk doubts in Europe; (2) tough tradeoff of inflation and growth in China; (3) geopolitical events in the Middle East and the earthquake/tsunami in Japan; (4) slow growth with fractured labor market in the US; and (5) uncertainties and the silent tax of inflation that curb growth of demand which could jump start economic growth and job creation. The incidence of several of these factors could stress test financial markets with oscillations that are difficult to anticipate.

I Slowing Growth. Historical parallels are instructive but have all the limitations of empirical research in economics. The more instructive comparisons are not with the Great Depression of the 1930s but rather with the recessions in the 1950s, 1970s and 1980s.

The growth rate and job creation in the expansion of the economy away from recession are subpar in the current expansion compared to others in the past. Four recessions are initially considered, following the reference dates of the National Bureau of Economic Research (NBER) (http://www.nber.org/cycles/cyclesmain.html ): IIQ1953-IIQ1954, IIIQ1957-IIQ1958, IIIQ1973-IQ1975 and IQ1980-IIIQ1980. The data for the earlier contractions illustrate that the growth rate and job creation in the current expansion are inferior. The sharp contractions of the 1950s and 1970s are considered in Table 1, showing the Bureau of Economic Analysis (BEA) quarter-to-quarter, seasonally adjusted (SA), yearly-equivalent growth rates of GDP. The recovery from the recession of 1953 consisted of four consecutive quarters of high percentage growth rates from IIIQ1954 to IIIQ1955: 4.6, 8.3, 12.0, 6.8 and 5.4. The recession of 1957 was followed by four consecutive high percentage growth rates from IIIQ1958 to IIQ1959: 9.7, 9.7, 8.3 and 10.5. The recession of 1973-1975 was followed by high percentage growth rates from IIQ1975 to IIQ1976: 6.9, 5.3, 9.4 and 3.0.

 

Table 1, Quarterly Growth Rates of GDP, % Annual Equivalent SA

	IQ	IIQ	IIIQ	IVQ
1953	7.7	3.1	-2.4	-6.2
1954	-1.9	0.5	4.6	8.3
1955	12.0	6.8	5.4	2.3
1957	2.5	-1.0	3.9	-4.1
1958	-10.4	2.5	9.7	9.7
1959	8.3	10.5	-0.5	1.4
1973	10.6	4.7	-2.1	3.9
1974	3.5	1.0	-3.9	6.9
1975	-4.8	3.1	6.9	5.3
1976	9.4	3.0	2.0	2.9
1979	0.7	0.4	2.9	1.1
1980	1.3	-7.9	-0.7	7.6

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=1&Freq=Qtr&FirstYear=2008&LastYear=2010

 

The NBER dates another recession in 1980 that lasted about half a year. If the two recessions from IQ1980s to IIIQ1980 and IIIQ1981 to IVQ1982 are combined, the impact on lost GDP is comparable to the revised 4.1 percent drop of the recession from IVQ2007 to IIQ2009. The recession in 1981-1982 is quite similar on its own to the 2007-2009 recession. Table 2 provides the BEA quarterly growth rates of GDP in SA yearly equivalents for the recessions of 1981-1982 and 2007 to 2009. There were four quarters of contraction in 1981-1982 ranging in rate from -1.5 percent to -6.4 percent and five quarters of contraction in 2007-2009 ranging in rate from -0.7 percent to -6.8 percent. The striking difference is that in the first seven quarters of expansion from IQ1983 to IIIQ1984, shown in Table 2 in relief, GDP grew at the high quarterly percentage growth rate of 5.1, 9.3, 8.1, 8.5, 7.1, 3.9 and 3.3 while the percentage growth rate in the first seven quarters from IIIQ2009 to IQ2011, shown in relief in Table 2, was mediocre: 1.6, 5.0, 3.7, 1.7, 2.6, 3.1 and 1.8. The data in this and the following tables incorporate the second estimate of IQ2011 by the BEA, with the growth of GDP at 1.8 percent. Inventory change contributed to initial growth but was rapidly replaced by growth in investment and demand in 1983. The key difference may be found in the negative incentive to business and household investment and business hiring from the structural shock to business models resulting from legislative restructurings and regulation with alleged benefits in the long-term but adverse short-term growth and jobs effects.

 

Table 2, Quarterly Growth Rates of GDP, % Annual Equivalent SA

Q	1981	1982	1983	1984	2008	2009	2010
I	8.6	-6.4	5.1	7.1	-0.7	-4.9	3.7
II	-3.2	2.2	9.3	3.9	0.6	-0.7	1.7
III	4.9	-1.5	8.1	3.3	-4.0	1.6	2.6
IV	-4.9	0.3	8.5	5.4	-6.8	5.0	3.1
				1985			2011
I				3.8			1.8
II				3.4
III				6.4
IV				3.1

Source:

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp1q11_2nd.pdf

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf

 

The contributions to the rate of growth of GDP in percentage points (PP) are provided in Table 3. Aggregate demand, personal consumption expenditures (PCE) and gross private domestic investment (GDI) were much stronger during the expansion phase in IQ1983 to IIQ1984 than in IIIQ2009 to IQ2011.

 

Table 3, Contributions to the Rate of Growth of GDP in Percentage Points

	GDP	PCE	GDI	∆ PI	Trade	GOV
2011
I	1.8	1.53	1.45	1.19	-0.06	-1.07
2010
I	3.7	1.33	3.04	2.64	-0.31	-0.32
II	1.7	1.54	2.88	0.82	-3.50	0.80
III	2.6	1.67	1.80	1.61	-1.70	0.79
IV	3.1	2.79	-2.61	-3.42	3.27	-0.34
2009
I	-4.9	-0.34	-6.80	-1.09	2.88	-0.61
II	-0.7	-1.12	-2.30	-1.03	1.47	1.24
III	1.6	1.41	1.22	1.10	-1.37	0.33
IV	5.0	0.69	2.70	2.83	1.90	-0.28
1982
I	-6.4	1.62	-7.50	-5.47	-0.49	-0.03
II	-2.2	0.90	-0.05	2.35	0.84	0.50
III	-1.5	1.92	-0.72	1.15	-3.31	0.57
IV	0.3	4.64	-5.66	-5.48	-0.10	1.44
1983
I	5.1	2.54	2.20	0.94	-0.30	0.63
II	9.3	5.22	5.87	3.51	-2.54	0.75
III	8.1	4.66	4.30	0.60	-2.32	1.48
IV	8.5	4.20	6.84	3.09	-1.17	-1.35
1984
I	8.0	2.35	7.15	5.07	-2.37	0.86
II	7.1	3.75	2.44	-0.30	-0.89	1.79
III	3.9	2.02	-0.89	0.21	-0.36	0.62
IV	3.3	3.38	1.79	-2.50	-0.58	1.75
1985
I	3.8	4.34	-2.38	-2.94	0.91	0.95

Note: PCE: personal consumption expenditures; GDI: gross private domestic investment; ∆ PI: change in private inventories; Trade: net exports of goods and services; GOV: government consumption expenditures and gross investment; – is negative and no sign positive

GDP: percent change at annual rate; percentage points at annual rates

Source:

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp1q11_2nd.pdf

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf

 

Table 4 provides more detailed information on the causes of the deceleration of GDP growth from 3.1 percent in IVQ2010 to 1.8 percent in IQ2011. The Bureau of Economic Analysis (BEA) finds three source of contribution to GDP growth in IQ2011: (1) growth of PCE by 2.2 percent; (2) growth of exports by 9.2 percent; (3) positive contribution of private inventory investment of 1.19 PP; and (4) growth of nonresidential fixed investment (NRI) by 3.4 percent. The factors that contributed to reduction of growth in IQ2011 were: (1) decline in residential fixed investment by 3.3 percent; (2) increase of imports by 7.5 percent, which are a deduction to GDP growth; and (3) contraction of federal and state/local government or combined government (GOV) by 5.1 percent. There are three sources causing deceleration of growth: (1) deceleration of nonresidential fixed investment (NRFI) from 7.7 percent to 3.4 percent; (2) deceleration of PCE growth from 4.0 percent in IVQ2010 to 2.2 percent in IQ2011 (with durable goods growth declining from 21.1 percent in IVQ2010 to 8.9 percent in IQ2011; (3) change of growth of 3.3 percent of RFI in IVQ2010 to -3.3 percent in IQ2011 (data are correct, 3.3 is a coincidence); (4) acceleration of decline of government consumption and expenditures (GOV) from -1.7 percent to negative -5.1 percent with federal government consumption and expenditures decelerating from negative 0.3 percent to negative 7.9 percent, caused by decline in defense expenditures by -11.7 percent, and state/local from -2.6 percent to negative -3.2 percent.

 

Table 4, Percentage Seasonally Adjusted Annual Equivalent Quarterly Rates of Increase, %

	IVQ2010	IQ2011
GDP	3.1	1.8
PCE	4.0	2.2
Durable Goods	21.1	8.9
NRFI	7.7	3.4
RFI	3.3	-3.3
Exports	8.6	9.2
Imports	-12.6	7.5
GOV	-1.7	-5.1
Federal GOV	-0.3	-7.9
State/Local GOV	-2.6	-3.2
∆ PI (PP)	-3.42	1.19
Gross Domestic Purchases	-0.2	1.8
Prices Gross Domestic Purchases	2.1	3.8
Prices of GDP	0.4	1.9
Prices of GDP Excluding Food and Energy	1.1	2.2
Prices of PCE	1.7	3.8
Prices of PCE Excluding Food and Energy	0.4	1.4
Prices of Market Based PCE	1.8	4.0
Prices of Market Based PCE Excluding Food and Energy	0.3	1.3
Real Disposable Personal Income	0.3	0.2
Personal Savings As % Disposable Income	5.4	5.1

Note: PCE: personal consumption expenditures; NRFI: nonresidential fixed investment; RFI: residential fixed investment; GOV: government consumption expenditures and gross investment; ∆ PI: change in

private inventories; GDP - ∆ PI: final sales of domestic product; PP: percentage points; Personal savings rate: savings as percent of disposable income

Source:

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp1q11_2nd.pdf

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_adv.pdf

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=1&FirstYear=2009&LastYear=2010&Freq=Qtr

 

Table 5 shows the percentage point (PP) contributions to the annual levels in the earlier recessions 1958-1959, 1975-1976, 1982-1983 and 2009 and 2010. The most striking contrast is in the rates of growth of annual GDP in the expansion phases of 7.2 percent in 1959, 4.5 percent in 1983 followed by 7.2 percent in 1984 and 4.1 percent in 1985 but only 2.9 percent in 2010 after six consecutive quarters of growth. The annual levels also show much stronger growth of PCEs in the expansions after the earlier contractions. PCEs contributed 1.26 PPs to GDP growth in 2010 of which 0.99 PP in goods and 0.27 PP in services. GDI deducted 3.24 PPs of GDP growth in 2009 of which -2.69 PPs by fixed investment and -0.55 PP of ∆PI and added 1.87 PPs to GDI in 2010 of which 0.48 PPs of fixed investment and 1.40 of ∆PI. Trade, or exports of goods and services net of imports, contributed 1.13 PPs in 2009 of which exports deducted 1.18 PPs and imports added 2.32 PPs. In 2010, trade deducted 0.49 PP with exports contributing 1.34 PPs and imports deducting 1.83 PPs. In 2009, Government added 0.32 PP of which 0.43 PP by the federal government and -0.11 PP by state and local government; in 2010, government added 0.21 PP of which 0.39 PP by the federal government with state and local government deducting 0.18 PP.

 

Table 5, Percentage Point Contributions to the Annual Growth Rate of GDP

	GDP	PCE	GDI	∆ PI	Trade	GOV
1958	-0.9	0.54	-1.25	-0.18	-0.89	0.70
1959	7.2	3.61	2.80	0.86	0.00	0.76
1975	-0.2	1.40	-2.98	-1.27	0.89	0.48
1976	5.4	3.51	2.84	1.41	-1.08	0.10
1982	-1.9	0.86	-2.55	-1.34	-0.60	0.35
1983	4.5	3.65	-1.45	0.29	-1.35	0.76
1984	7.2	3.43	4.63	1.95	-1.58	0.70
1985	4.1	3.32	-0.17	-1.06	-0.42	1.41
2009	-2.6	-0.84	-3.24	-0.55	1.13	0.32
2010	2.9	1.26	1.87	1.40	-0.49	0.21

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=2009&LastYear=2010&3Place=N&Update=Update&JavaBox=no

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf

 

There are two types of very valuable information on income, consumption and prices in Table 6, showing monthly, quarterly and annual equivalent quarterly percentage changes, seasonally adjusted, of current dollar or nominal personal income (NPI), current dollars or nominal disposable personal income (NDPI), real or constant chained (2005) dollars DPI (RDPI), current dollars nominal personal consumption expenditures (NPCE) and constant or chained (2005) dollars PCE. First, the difference between NDPI and RDPI (NDPI/RDPI) and NPCE and RPCE (NPCE/RPCE) indicates inflation. Let the rate of inflation be π, the percentage change in nominal value NV and the change in real value rv. Then:

(1+π)(1+rv) = (1+NV)

Thus, if we know (1+NV) and (1+rv), simple rearrangement provides (1+π):

(1+π) = (1+NV)/(1+rv)

The growing gap between NDPI/RDPI and NPCE/RPCE is inflation and accelerating from the final quarter of 2010 to the first quarter of 2011. The gap becomes more evident in the cumulative percentages Jan-Apr 2011 and IVQ2010 and their annual equivalents Jan-Apr 2011 A and IVQ2010 A. The gap of NDPI/RDPI in Jan-Apr 2011 in Table 6 is 4.3 percent (1.043/1.000), which is much higher than in IVQ2010 of 2.1 percent (1.037/1.016). The gap NPCE/RPCE in Jan-Apr 2011 in Table 6 is 4.3 percent (1.065/1.021), which is much higher than 1.9 percent (1.057/1.037) in IVQ2010. Inflation in the deflator of personal income and outlays is growing toward 5 percent per year. That is, the government is benefitting from a tax known as the inflation tax. By issuing money through its central bank the government buys goods and services. In a situation of sizeable deficits and inflation, the government gains by purchasing before effects of issuing money that causes increases in prices (see http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-monetary.html http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-financial.html Pelaez and Pelaez, International Financial Architecture (2005), 201-12). This is a hidden but actually felt contribution of monetary accommodation to financing bloated government expenditures. The new inflation tax argument is not by increases in inflation resulting from increasing monetary aggregates but by the rise in valuations of assets such as commodities induced through the carry trade of near zero interest rates. Second, while division in quarters is arbitrary, Table 6 shows reduction in the rates of growth of RDPI from 1.6 percent in IVQ2010 to 0 percent in Jan-Apr 2011 and of growth of RPCE from 3.7 percent in IVQ2010 to 2.1 percent in Jan-Apr 2011. There is no evidence of trend but rather the appearance of a slowing rate of growth that is captured by GDP growth of 1.8 percent in IQ2011 and economic indicators in the beginning of IIQ2011.

 

Table 6, Percentage Change from Prior Month Seasonally Adjusted of Personal Income, Disposable Income and Personal Consumption Expenditures %

	NPI	NDPI	RDPI	NPCE	RPCE
2011
Apr	0.4	0.3	0.0	0.4	0.1
Mar	0.4	0.4	0.0	0.5	0.1
Feb	0.4	0.3	-0.1	0.8	0.4
Jan	1.1	0.4	0.1	0.4	0.1
Jan-Apr 2011	2.3	1.4	0.0	2.1	0.7
Jan-Apr 2011 A	7.1	4.3	0.0	6.5	2.1
2010
Dec	0.4	0.4	0.2	0.4	0.1
Nov	0.2	0.2	0.1	0.3	0.3
Oct	0.4	0.3	0.1	0.7	0.5
IVQ10	1.0	0.9	0.4	1.4	0.9
IVQ010 A	4.1	3.7	1.6	5.7	3.7

Notes: NPI: current dollars personal income; NDPI: current dollars disposable personal income; RDPI: chained (2005) dollars DPI; NPCE: current dollars personal consumption expenditures; RPCE: chained (2005) dollars PCE; A: annual equivalent; IVQ2010: fourth quarter 2010; A: annual equivalent

Percentage change month to month seasonally adjusted

Source:

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0411.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0311.pdf

 http://www.bea.gov/newsreleases/national/pi/2011/pi0211.htm

 

Further information on income and consumption is provided by Table 7. The 12-month rates of increase of RDPI and RPCE in the past seven months do not show a trend of deterioration but rather very similar growth with the exception of 1.1 percent growth of RDPI in Apr 2011. Goods and especially durable goods have been driving growth of PCE as shown by the much higher 12-months rates of growth of real goods PCE (RPCEG) and durable goods real PCE (RPCEGD) than services real PCE (RPCES). The faster expansion of industry in the economy is derived from growth of consumption of goods and in particular of consumer durable goods while growth of consumption of services is much more moderate.

 

Table 7, Real Disposable Personal Income and Real Personal Consumption Expenditures Percentage Change from the Same Month a Year Earlier %

	RDPI	RPCE	RPCEG	RPCEGD	RPCES
2011
Apr	1.1	2.6	4.2	9.3	1.8
Mar	1.9	2.5	3.9	8.3	1.9
Feb	2.1	2.7	5.6	12.7	1.3
Jan	2.3	2.8	5.7	12.0	1.4
2010
Dec	2.0	2.6	5.5	10.6	1.2
Nov	2.3	2.7	5.4	10.0	1.4
Oct	2.4	2.5	6.0	12.2	0.9

Notes: RDPI: real disposable personal income; RPCE: real personal consumption expenditures (PCE); RPCEG: real PCE goods; RPCEGD: RPCEG durable goods; RPCES: RPCE services

Numbers are percentage changes from the same month a year earlier

Source:

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0411.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0311.pdf

 

II Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 8 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).

 

Table 8, 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***	0.3	2.5	4.6
China	9.7	5.3	6.8
UK	1.8	4.5* RPI 5.2	5.3* output 17.6* input 12.2**	8.0
Euro Zone	2.5	2.8	6.7	9.9
Germany	5.2 (4.9 working day adjusted)	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

 

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). Japan’s CPI rose 0.3 percent in Apr 2011 from Mar and 0.3 percent over the year, as shown in Table 9. The CPI excluding fresh food rose 0.4 percent in Apr and 0.6 percent on the year. The highest increases were in commodity-influenced expenses, 0.6 percent for fuel, light and water charges and 0.5 percent for transportation and communications. Fuel, light and water charges in the Ku area of Tokyo rose 0.7 percent in the month of Apr and 1.6 percent relative to a year earlier.

 

Table 9, Japan CPI Apr 2011, ∆%

	Apr/Mar ∆%	Year ∆%
CPI	0.3	0.3
CPI excluding Fresh Food	0.4	0.6
CPI excluding Food and Energy	0.2	-0.1
CPI Goods	0.5	0.4
CPI Services	0.0	0.2
CPI Excluding Imputed Rent	0.4	0.5
CPI Fuel, Light, Water Charges	0.6	3.3
CPI Transport Communications	0.5	2.0
CPI Ku-area Tokyo	-0.1	-0.1
Fuel, Light, Water Charges Ku Area Tokyo	0.7	1.6

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

 

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 CPI of Germany flash estimate for May 2011 is 2.3 percent relative to May 2010 and the harmonized CPI flash estimate for May 2011 is 2.4 percent with final results released on Jun 10 (http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/05/PE11__201__611,templateId=renderPrint.psml). Germany’s GDP grew 1.5 percent in IQ2011 relative to the lower weather-influenced growth in IVQ2010 of 0.4 percent and 5.2 percent relative to a year earlier; capital formation rose in construction by 6.2 percent and 4.2 percent in machinery and equipment relative to IQ2010. Table 10 shows the quarterly changes of GDP of Germany from a year earlier in 2009 to 2011. Germany has enjoyed five quarters of strong growth. The adjustment by an extra working day converts the IQ2011 GDP from 5.2 percent to 4.9 percent. The economy of Germany is now at a level higher than in the pre-crisis level of the beginning of 2008 (http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/05/PE11__197__811,templateId=renderPrint.psml

 

Table 10, Germany, GDP ∆% Relative to a Year Earlier

	First Quarter	Second Quarter	Third Quarter	Fourth Quarter
2009	-6.3	-6.8	-4.4	-1.3
2010	2.5	4.3	3.9	3.8
2011	5.2

Source: http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/05/PE11__197__811,templateId=renderPrint.psml

 

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.

The 12-month rates of increase of PCE price indexes are shown in Table 11. Headline 12-month PCE inflation (PCE) has accelerated from slightly over 1 percent in the latter part of 2010 to 2.2 percent in Mar. The Fed uses PCE inflation excluding food and energy (PCEX) on the basis of research showing that current PCEX is a better indicator of headline PCE a year ahead than current headline PCE inflation. This issue is analyzed in subsection IIID (see Blinder 1979, 1982, Blinder and Rudd 2010). The explanation is that commodity price shocks are “mean reverting,” returning to their long-term means determined by aggregate demand and supply after spiking during shortages caused by climatic factors, geopolitical events and the like. Inflation of PCE goods (PCEG) has accelerated sharply, in spite of 12-month declining inflation of PCE durable goods (PCEG-D) while PCE services inflation (PCES) has remained around 1.2 to 1.3 percent. The last two columns of Table 11 show PCE food inflation (PCEF) and PCE energy inflation (PCEE) that have been rising sharply, especially for energy. The Fed expects these increases to revert with its indicator PCEX returning to levels that are acceptable for continuing monetary accommodation.

 

Table 11, Percentage Change in 12 Months of Prices of Personal Consumption Expenditures

	PCE	PCEG	PCEG -D	PCES	PCEX	PCEF	PCEE
2011
Apr	2.2	4.0	-1.1	1.3	1.0	3.2	19.6
Mar	1.8	3.0	-1.6	1.2	0.9	2.9	15.3
Feb	1.6	2.1	-1.4	1.3	0.9	2.4	11.1
Jan	1.2	1.2	-1.9	1.2	0.8	1.7	6.7
2010
Dec	1.1	1.0	-2.2	1.2	0.7	1.2	7.4
Nov	1.0	0.6	-2.0	1.3	0.8	1.3	4.0
Oct	1.2	0.8	-1.8	1.4	0.9	1.3	6.3
Sep	1.3	0.5	-1.4	1.7	1.1	1.3	4.2
Aug	1.4	0.6	-1.0	1.7	1.2	0.7	4.0

Notes: percentage changes in price index relative to the same month a year earlier of PCE: personal consumption expenditures; PCEG: PCE goods; PCEG-D: PCE durable goods; PCEX: PCE excluding food and energy; PCEF: PCE food; PCEE: PCE energy goods and services

Source:

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0411.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0311.pdf

 

The role of devil’s advocate is played by data in Table 12. Headline PCE inflation (PCE) has jumped to 1.4 percent cumulative in Jan-Apr 2011, which is equivalent to 4.3 percent annual, with PCEG jumping to 3.0 percent cumulative and 9.4 percent annual equivalent, PCEG-D rising 0.6 percent cumulative or 1.8 percent annual, and PCES, PCEX and PCEF all rising to 0.7 percent cumulative or 2.1 annual. PCEE has risen to 12.3 percent cumulative in Jan-Apr 2011 or 45.3 percent annual equivalent. Energy prices continue to rise much faster than other prices but prices of goods, and now even durable goods, are showing acceleration.

 

Table 12, Monthly and Quarterly PCE Inflation and Annual Equivalent Jan-Apr 2011 and IVQ2010

	PCE	PCEG	PCEG -D	PCES	PCEX	PCEF	PCEE
2011
Jan-Apr 11	1.4	3.0	0.6	0.7	0.7	0.7	12.3
Jan-Apr 11 A	4.3	9.4	1.8	2.1	2.1	2.1	41.7
Apr	0.3	0.6	0.3	0.2	0.2	0.2	2.3
Mar	0.4	0.8	0.0	0.2	0.1	0.1	3.7
Feb	0.4	0.8	0.2	0.2	0.2	0.2	3.5
Jan	0.3	0.8	0.1	0.1	0.2	0.2	2.3
IVQ10	0.6	1.0	-0.8	0.3	0.1	0.1	6.9
IVQ10 A	2.4	4.1	-3.2	1.2	0.4	0.4	22.2
Dec	0.3	0.6	-0.3	0.1	0.0	0.0	4.1
Nov	0.1	0.0	-0.3	0.1	0.1	0.1	0.1
Oct	0.2	0.4	-0.2	0.1	0.0	0.0	2.7

Notes: percentage changes in a month relative to the same month for the same symbols as in Table. 1Q11: cumulative for Jan-Mar 2011; 1Q11 A: 1Q11 annual equivalent rate; 4Q10: cumulative for Oct-Dec 2010; 4Q10: annual equivalent rate

Source: http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0311.pdf

 

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). Table 13 provides the change in GDP, CPI and the rate of unemployment from 1960 to 1990. There are three waves of inflation (1) in the second half of the 1960s, (2) from 1973 to 1975 and (3) from 1978 to 1981. 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 13, 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.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=2009&LastYear=2010&3Place=N&Update=Update&JavaBox=no

http://www.bls.gov/web/empsit/cpseea01.htm

http://data.bls.gov/pdq/SurveyOutputServlet

 

There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table 14 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 14 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 (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). 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 14, 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 15, 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 15. 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 3.068 percent at the close of market on May 27, 2011, would be equivalent to price of 96.2089 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 4.9 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 15 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 (Table 2 in http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html). On May 25, 2011, the line “Reserve Bank credit” in the Fed balance sheet stood at $2759 billion, or $2.8 trillion, with portfolio of long-term securities of $2529 billion, or $2.5 trillion, consisting of $1432 Treasury nominal notes and bonds, $61 billion of notes and bonds inflation-indexed, $119 billion Federal agency debt securities and $917 billion mortgage-backed securities; reserve balances deposited with Federal Reserve Banks reached $1589 billion or $1.6 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 3.13 percent on Mon May 23 to 3.067 percent on Fri May 27 while the yield of the 10-year German government bond fell from 3.07 percent on Tue May 24 to 2.99 percent on Fri May 27 (http://noir.bloomberg.com/markets/rates/germany.html). Risk aversion from various sources, discussed in section IV, 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 15, 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
05/27/11	3.068	96.2089	-4.9

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 Great Inflation and Unemployment Analysis. Stagflation in the 1970s, or incidence of the highest inflation rates in peacetime history with high rates of unemployment, is a major issue of research. The strands of thoughts are covered in subsections: IIIA “New Economics” and the Great Inflation, IIIB Counterfactual with Current Science, IIIC Policy Rule and Politics, IIID Supply Shocks and IIIE Conclusion.

IIIA “New Economics and the Great Inflation. The New Economics and the Great Inflation. The “new economics,” or in the words of James Tobin (1980, 27), the “neoclassical synthesis,” dominated policy thought in the 1960s and 1970s, as vigorously exposed by Heller (1966), Okun (1970) and Tobin (1972), all of whom served in the Council of Economic Advisers (CEA) (see http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html). According to Heller (1975, 16), the major event breaking with the past was the 1964 tax cut. The target of policy shifted to attaining the economy’s “full employment potential,” following canonical Keynesian economics, while rejecting analysis of structural unemployment.

Heller (1975, 17) reflected on the policy approach of Heller (1966):

“On one hand, the high employment, limited-recession economy forged with our macroeconomic policy tools is indeed an inflation-prone economy—the formula for successful management of high-pressure prosperity is far more elusive than the formula for getting there. Yet on the other hand, success bred great expectations on the part of the public that economics could deliver prosperity without inflation and with ever-growing material gains in the bargain. The message got through that we had ‘harnessed the existing economics…to the purposes of prosperity, stability and growth,’ and that as to the role of the tax cut in breaking old molds of thinking, ‘nothing succeeds like success’(Heller [1966])”.

There is an even more detailed account of the gap management by fiscal/monetary policies away from cyclical adjustment to growth promotion (Burns 1969QFE, 279):

“The central doctrine of this school is that the stage of the business cycle has little relevance to sound economic policy; that policy should be growth-oriented instead of cycle-oriented; that the vital matter is whether a gap exists between actual and potential output; that fiscal deficits and monetary tools need to be used to promote expansion when a gap exists; and that the stimuli should be sufficient to close the gap—provided significant inflationary pressures are not whipped up in the process.”

The “consensus macroeconomic framework, vintage 1970” used by “managers of aggregate demand” in stabilization policies is interpreted by Tobin (1980, 23-5) in terms of five broad components. (1) The key role in determining the rate of inflation is played by the nonagricultural business sector in which prices consist of marked-up labor costs. The standard model is the “augmented Phillips curve.” (2) The only way in which aggregate monetary demand, or nominal income, affects prices, output, wages and employment is through tightness in labor and product markets. Combinations of fiscal and monetary policies that result in the same change in aggregate demand have the same impact on inflation and real economic activity.

(3) Okun’s law or empirical finding is that (Okun 1962):

“In the postwar period, on the average, each extra percentage point in the unemployment rate above four percent has been associated with about a three percent decrement in real GNP”

The statement is careful in expressing the empirical result on the basis of the structure estimated with data of 55 quarters from IIQ1947 to IVQ1960, resulting in the estimated relation (Okun 1962):

Y = 0.30 – 0.30X   (1)

Where Y is the quarterly change in the unemployment rate expressed in percentage points and X is the quarterly percentage change of real GNP. If GNP is unchanged from one quarter to the next, X =0, trend increases in productivity and growth of the labor force result in an increase of the rate of unemployment by 0.3 percentage points. Unemployment is 0.3 point lower for each increment of one percent of GNP (0.30 x X = 0.3 x 1). An increase of one percentage point in unemployment is equivalent to decrease of GNP by 3.3 percent (1/0.3). (4) Tighter markets of products and labor at high employment rates result in acceleration of inflation above those incorporated in inflation expectations and historical trends. Slack in product and labor market causes deceleration of inflation but at a slower rate. The utilization of resources and market tightness at the natural rate of unemployment of Friedman (1968) and Phelps (1968) does not cause upward or downward pressure of wages and prices relative to expected paths. The consensus accepted a nonaccelerating inflation rate of unemployment (NAIRU) but with divergence on whether it coincided with equilibrium or optimum employment. (5) There was no widespread consensus on the instruments of demand management.

Tobin (1980, 19) explained more accurately (see also Tobin 1980AA and Lucas 1981):

“Higher inflation, higher unemployment-the relentless combination frustrated policymakers, forecasters, and theorists throughout the decade. The disarray in diagnosing stagflation and prescribing a cure makes any appraisal of the theory and practice of macroeconomic stabilization as of 1980 a foolhardy venture.”

There are three interpretations of the role of monetary policy in causing the Great Inflation and Unemployment: (1) inflation surprise, (2) inadvertent policy mistake; and (3) imperfect information (for ample discussion see http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). (1) The analysis by Kydland and Prescott (1977, 447-80, equation 5) uses the “expectation augmented” Phillips curve with the natural rate of unemployment of Friedman (1968) and Phelps (1968), which in the notation of Barro and Gordon (1983, 592, equation 1) is:

U_t = Uⁿ_t – α(π_t – π^e) α > 0 (2)

Where U_t is the rate of unemployment at current time t, Uⁿ_t is the natural rate of unemployment, π_t is the current rate of inflation and π^e is the expected rate of inflation by economic agents based on current information. Equation (2) expresses unemployment net of the natural rate of unemployment as a decreasing function of the gap between actual and expected rates of inflation. Equation (2) is used by Barro and Gordon (1983) in showing the temptation of the policymaker to create “inflation surprises” by pursuing an inflation rate that is higher than that expected by economic agents which lowers the difference between the actual and natural unemployment rate by the term – α(π_t – π^e). (2) The baseline monetary policy rule considered by Clarida, Galí and Gertler (CGG) is a simple linear equation:

r*_t = r* + β(inflation gap) + γ(output gap) (3)

Where r*_t is the Fed’s target rate for the fed funds rate in period t, r* is the desired nominal rate corresponding to both inflation and output being at their target levels (CGG 2000, 150), (inflation gap) is the deviation of actual inflation from target inflation and (output gap) is the percentage difference between actual GDP and its target. The rule is forward looking because the two gaps are relative to future desired levels. A second monetary rule is on the implied relation for the real rate of interest target:

rr*_t = rr* + (β -1)(inflation gap) + γ(output gap) (4)

Where rr*_t is the ex ante real rate target and rr* = r* - π* is the long-run equilibrium real rate. Equation (4) shows that the response of policy to the inflation gap depends on whether β is greater or less than one and the response to the output gap on whether γ is positive or negative. The data reveal that the Fed reacted weakly to expectations of inflation by allowing declines in real rates of interest or raising nominal interest but not by enough to increase real interest rates. That is, policy neglected control of the inflation gap and focused instead on the output gap. (3) Orphanides (2003, 2004) emphasizes the erroneous measurement of potential output, and a consequence of the output gap in equation (4), which misled the regulators in pursuing an “activist” policy of trying to prevent the output gap from increasing when it was decreasing. The policy to prevent the erroneously measured output gap from increasing was lowering interest rates but the actual gap was actually tightening and inflation control required higher interest rates.

IIIB Counterfactual with Current Science. The dual mandate of the Fed consists 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). In practice, the Fed has the challenging task of attaining two often conflicting targets: (1) reducing the gap of actual relative to potential output while simultaneously (2) controlling inflation at the target of 2 percent. Conventional monetary policy has one instrument, the fed funds rate, with which the Fed attempts to influence the current short-term interest rates and the term-structure of interest rates, which consists of the rates from one period in the future toward another future period, as for example, the rate at six months from now for investment six months forward or one year from now. Unconventional monetary policy consists of large-scale purchases of long-term securities with the objective of lowering yields on long-term securities that are closely related to borrowing costs for investment and consumption of durable goods.

Empirical economics typically faces counterfactuals. A counterfactual consists of using economic theory and measurement in evaluating what would have been the level and time path of critical economic variables if events and/or policies would have been different. Counterfactuals face not only tough hurdles of choice of appropriate theory in analyzing the issue in question but also availability of relevant data and measurement methods. Economic observations consist of data with mixed effects of what actually happened. Resolution of the counterfactual would require unobserved data of what would have happened under different events and/or policies.

The Great Inflation and Unemployment suggests two critical counterfactuals. First, there is the counterfactual of what would have happened if policy during the early phase of creating the Great Inflation would have been similar to recent and current monetary policy. DeLong (1997) finds the onset of the Great Inflation in the 1960s. Table 16 shows the section of Table 13 for the period 1960 to 1970. A counterfactual of the 1970s immediately rises out of Table 16, 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.

 

Table 16, 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

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.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=2009&LastYear=2010&3Place=N&Update=Update&JavaBox=no

http://www.bls.gov/web/empsit/cpseea01.htm

http://data.bls.gov/pdq/SurveyOutputServlet

 

Second, economists believe that their knowledge of monetary policy has evolved into a more accurate science of optimal control. Orphanides and Williams (2010) pose and analyze the critically-important counterfactual of what would have happened if the Fed in the 1960s had the current science of central banking, availability in real time of correctly measured output gaps and the natural rate of unemployment and more balanced policy of inflation control instead of nearly exclusive emphasis on output gap reduction. The understanding of the Great Inflation has been enriched by their definition of the counterfactual issue and its importance, analysis and empirical method.

The counterfactual issue searched by Orphanides and Williams (2010, 1) is: “what monetary policy framework, if adopted by the Federal Reserve, would have avoided the Great Inflation of the 1960s and 1970s?” The structural model used by Orphanides and Williams (2010, 15-6) consists of two equations to model the unemployment rate and the inflation rate. The unemployment rate equation is:

u_t = ϕ_uu^e_t+1 + (1- ϕ_u)u_t-1 + α_u(i^e_t – π^e_t+1 – r*) + v_t (5)

v_t = ρ_vv_t-1 + e_v,t with e_v ~ N(0, σ²_ev) (6)

Equation (1) expresses the current rate of unemployment, u_t, by means of three terms: (a) the effect the rate of unemployment expected to prevail in the next period, ϕ_uu^e_t+1; (b) the effect of the unemployment rate in the past period, (1- ϕ_u)u_t-1; and (c) term α_u(i^e_t – π^e_t+1 – r*) which is the difference between the expected nominal short-term interest rate, i^e_t, and the rate of inflation expected in the next period, π^e_t+1, or expected ex-ante real rate of interest r^e_t, and the natural rate of interest, that is (i^e_t - π^e_t+1 - r*) = r^e_t - r*.

Orphanides and Williams (2010, 16) use a Phillips equation following a New Keynesian approach with indexation:

π_t = ϕ_ππ^e_t+1 + (1-ϕ_π)π_t-1 + α_π(u_t – u*_t) + e_π,t

with e_π ~ N(0, σ²_eπ) (7)

The Phillips curve in equation (7) expresses the current rate of inflation, π_t, by three effects: (a) the influence of the rate of inflation expected to prevail in next period t+1, or effect ϕ_ππ^e_t+1; (b) indexation that is captured by an effect of inflation in the prior period (1-ϕ_π)π_t-1; and (c) an effect of the difference between the actual rate of unemployment, u_t, and the natural rate of unemployment, u*_t, captured by the term α_π(u_t – u*_t).

Optimal control (OC) policy consists in the central bank choosing the policy instrument to minimize the central bank’s loss function subject to the constraints of the central bank’s model (Orphanides and Williams 2010, 19; see Orphanides and Williams 2008, 2009; Bean 2003; Bean et al 2010; Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 110-6). The OC policy rule is obtained by assuming the central bank knows all parameters and economic agents decide on rational expectations. The loss function used by Orphanides and Williams (2010) is:

ℓ = Var (π -2) + λVar(u – uⁿ) + γVar(∆(i)) (8)

The central bank minimizes the variance of the inflation rate, π, less the inflation target of 2 percent, Var (π -2), plus the variance of the difference between the actual unemployment rate, u, less the natural rate of unemployment, uⁿ, plus the variance of the first difference of the nominal interest rate, (∆(i), or γVar(∆(i)). The emphasis on reduction of the output gap can be captured by alternative values of the parameter λ in equation (8) such as 16, 4 and 1.

The narrative of policy during the 1960s and 1970s by Orphanides and Williams (2010, 31) leads them to conclude that:

“Our narrative account of the Great Inflation squarely attributes the policy failures on mistakes consistent with what was viewed by many to be the latest advances in macroeconomics as embodied in the New Economics. The fine-tuning approach to monetary policy, with its emphasis on stabilizing the level of real activity, might have succeeded if policy makers had possessed accurate real-time assessments of the natural rate of unemployment. In the event, they did not and they failed to account for their imperfect information regarding the economy’s potential and the effects of these misperceptions on the evolution of expectations and inflation. Price and economic stability were only restored after the Federal Reserve, under Chairman Volcker, refocused policy on establishing and maintaining price stability.”

The quantitative research shows that modern OC policy would not have performed much better if the Fed had misperceptions of the natural rate of unemployment, resulting in failure to anchor inflation expectations that would have generated volatile inflation. OC policy would have been successful only with moderate weight on output gap stabilizing with the best results obtained with almost all weight on price stabilization.

IIIC Policy Rule and Politics. The objective of Levin and Taylor (2009) is to reveal the primary cause of the persistence of inflation drift during the Great Inflation by focusing on the path of inflationary expectations to model monetary policy from 1965 to 1980. They derive three stylized facts by use of measurements of inflation expectations. (1) Inflation began in the mid 1960 while it had been contained since the late 1950s at around 1 percent but inflation expectations accelerate beginning in 1965. (2) Long-term inflation expectations stabilized at a high level in the first half of the 1970s but catapulted toward the end of the decade. (3) Long-run inflation expectations only began to decline at the end of 1980. The central bank reaction function analyzed by Taylor (1993, 202, equation (1)) on the basis of prior research is:

r = p +0.5y + 0.5(p-2) + 2 (9)

In equation (9), the federal funds rate, r, is expressed in terms of the rate of inflation over the previous four quarters, the percentage output gap, y, defined as 100(Y-Y*)/Y*, where Y is actual GDP, Y* is trend real GDP (2.2 percent from IQ1984 to IIIQ1992), and the deviation of inflation from the target of 2 percent, 0.5(p-2). The Taylor policy rule in equation (9) triggers an increase in the fed funds rate when inflation exceeds 2 percent or when GDP exceeds trend GDP. If GDP is equal to target, y = 0, and inflation is also equal to target, p = 2, then the real rate of interest as measured by prior inflation, r-p, equal 2 percent. The fed funds rate calculated with this simple policy rule fits remarkably well the actual fed funds rate in 1987-1992 (Taylor 1993, 204, Figure 1).

The simple rule is restated by Levin and Taylor (2010, 16, equation (1)) to account for discrete shifts in the intercept:

r_t = ­r’ + γ_π(π_t – π*) + γ_y(y_t – y*_t) (10)

Equation (10) expresses the short-term real interest rate, r_t, in terms of an effect, γ_π(π_t – π*), of the difference between actual inflation, π_t, and the central’s bank objective for inflation, π*, and an effect, γ_y(y_t – y*_t), of the deviation of actual output, y_t, from trend or steady-state output, y*_t, and r’ stands for the steady-state value of the real rate of interest.

Equation (10) is shown by Levy and Taylor (2010) to provide a good fit of experience during the Great Inflation by allowing for shifts in the central bank’s inflation objective π*. Monetary policy during the Great Inflation can be interpreted by three stop-start events occurring in 1968-70, 1974-76 and 1979-80. Levy and Taylor (2010) conclude that in all three “stop and go” episodes monetary policy “fell behind the curve,” permitting rising inflation before belated tightening and abandoning tightening because of the contraction before inflation was reduced to the level before the event. Lags in effect of monetary policy have been amply discussed in the literature and may have proved important in falling behind the curve (see Culbertson 1960, Friedman 1961, Culbertson 1961, Batini and Nelson 2002 and Romer and Romer 2004).

IIID Supply Shocks. It is difficult to analyze oil price shocks as exogenous determinants of the US economy as Barsky and Kilian (2004) find in an “idiosyncratic” survey of vast literature and data (see Barksy and Kilian 2001). The Great Inflation actually began in the 1960s before the oil price shocks of the 1970s (De Long 1997). Barsky and Killian (2004) analyze five oil shocks with reference of the business cycle dates of the NBER, finding a variety of relations with the aggregate US economy that do not permit a simple link between increases in oil prices and US inflation.

The “Great Inflation” is relabeled by Blinder (1979, 1982) and Blinder and Rudd (2010) as the “Great Stagflation.” The important behavior to be explained is not the drift of inflation but the occurrence of “two episodes of ‘double-digit’ inflation: 1974 and 1979-80” with “many parallels between the 1973-75 period and the 1978-80 period” (Blinder 1982, 261). The issues and analysis of Blinder (1979, 1982) and Blinder and Rudd (2010) are relevant to the views on inflation by the Federal Open Market Committee (FOMC). There are four propositions in the supply shock explanation of the Great Inflation (Blinder and Rudd 2010, 1; Blinder 1982, 262-3). (1) Aggregate demand and aggregate supply determine the economy’s underlying or “core” inflation; headline inflation tends to converge to core inflation. (2) There are multiple factors affecting aggregate demand but not exclusively monetary and fiscal policy; the growth rate of productivity in the long term is the main driving factor of supply but supply shocks restricting aggregate supply can prevail in the short run. (3) The core inflation rate excluding energy and food is a proxy for the rate of inflation of all inflation components other than food and energy. (4) Changes in food and energy prices can temporarily cause headline inflation to deviate from core inflation but there could be other factors such as relaxing wage-price controls in 1974.

Supply shocks affect the capacity of firms in producing GDP, directly affecting prices or quantities of productive inputs and technology. Spending by households, business and government in purchasing GDP originates in demand shocks. An appeal to the aggregate demand and aggregate supply diagram in (y, p) space, y being output and p the price level, explains the difference between supply and demand shocks. Assume aggregate demand is downward sloping and unaltered while upward sloping supply shifts upwardly to the left. There is a higher price level as p moves upward and to the left along the demand curve together with a lower output as y moves toward the origin. The restricting supply shock causes inflation and lower output. An upward shift of demand, say by fiscal/monetary policy, is an upward movement along an upwardly sloping supply curve, resulting in both a higher price level and higher output. The demand shock produces an increase in inflation and output. Restrictive fiscal/monetary policy is an inward movement resulting in lower prices and also lower output. Blinder and Rudd (2010) seek to explain (1) the factors that caused two “inflation hills” in 1973-74 and 1978-80; and (2) the contractions of economic activity and rising unemployment. That is the reason for referring to the 1970s as the “Great Stagflation.”

The actual rise in inflation in 1973-74 was 6 percent. The measurements by Blinder and Rudd (2010, 48) find that energy prices contributed 2.5 percent, food prices 3.5 percent, pass-through of food and energy prices 1.5 percent and the end of the Nixon price controls 2 percent for total 9.5 percent. The actual rise in inflation in 1978-80 was 4 percent. The contributions in the findings of Blinder and Rudd (2010, 48) for 1979-80 are: energy prices 2 percent, food prices 2 percent and pass-through of food and energy prices 2.25 percent for total 6.25 percent. Supply shocks explain more inflation than what occurred without allowing for demand shocks. The “inflation hills” were followed by collapse of headline inflation faster than core inflation because the supply-shocks that caused them disappeared. These calculations also imply that about 60 percent of the increase in unemployment in the 1973-75 recession and about 45 percent in the double-dip recessions of 1980-82 are explained by supply shocks.

IIIE Conclusion. There was “bad policy” that perpetuated the Great Inflation drift in the form of a “central bank that seeks to maintain output at a capacity level which varies through time and also places continuity of the short-term interest rate,” as found by Goodfriend and King (2009, 23). There was also “bad luck” in the form of slowing productivity growth when the inflation rate accelerated. Marvin and Goodfriend (2009, 23) conclude:

“One reason for studying the Great Inflation is to prevent its recurrence. Our interpretation of the period suggests that a preoccupation with short-term interest rates and with maintaining output at capacity would, in the presence of adverse shocks to the growth of capacity output, combine to produce another period of inflation drift with similarly adverse consequences for employment and output.”

There are elements of truth in all the analyses of the Great Inflation and Underemployment. As Goodfriend and King (2009, 23) propose: “an important task of future research is to distinguish empirically between competing theories.” DeLong (1997) and Levin and Taylor (2009) analyze the political unwillingness to control inflation. Meltzer (2005, 145) also finds a major role for politics:

“The Great Inflation of 1965 to the mid-1980s was the central monetary event of the latter half of the 20th century. Its economic cost was large. It destroyed the Bretton Woods system of fixed exchange rates, bankrupted much of the thrift industry, heavily taxed the U.S. capital stock, and arbitrarily redistributed income and wealth. It was also a political event, as are all major policy issues. This paper argues that the Great Inflation cannot be understood fully without its political dimension. Political pressure to coordinate policy reinforced widespread beliefs that coordination of fiscal and monetary policies was desirable.”

Policy coordination is the essence of seigniorage (http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-financial.html http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-financial.html). Table 17 provides data on the fiscal situation of the euro area, European Union, various member countries of the euro area, UK and US both the Federal government and the general government, which is the typical convention internationally and used by Standard & Poor’s (2011Apr18 for US rating analysis) and in seigniorage analysis such as by Buiter (2007). Most countries need consolidation to reduce their budget deficits and growing debts. The adjustment is harder for countries growing more slowly or even negatively because of the difficulty in increasing revenues that depend on income growth. Government outlays are tied to mandatory programs, creating difficult choices in consolidation strategies. Sovereign risk issues may return to plague financial markets. Higher world inflation can raise borrowing costs at a time of budget and debt pressures.

 

Table 17, Government Outlays, Revenue, Deficit and Debt As Percent of GDP 2010 %

	Gvt Outlays	Gvt Revenue	Govt Balance	Govt Debt
Euro Area	50.4	44.4	-6.0	85.1
European Union	50.3	44.0	-6.4	80.0
Germany	46.6	43.3	-3.3	83.2
France	56.2	49.2	-7.0	81.7
Nether- lands	51.2	45.9	-5.4	62.7
Finland	55.1	52.3	-2.5	48.4
Belgium	53.1	48.9	-4.1	96.8
Portugal	50.7	41.5	-9.1	93.0
Ireland	67.0	34.6	-32.4	96.2
Italy	50.5	46.0	-4.6	119.0
Greece	49.5	39.1	-10.5	142.8
Spain	45.0	35.7	-9.2	60.1
UK	50.9	40.6	-10.4	80.0
US Federal  Govt 2010	23.8	14.9	-8.9	62.1
US Federal Govt 2012	23.3	16.3	-7.0	73.9
US 2010 General Govt (IMF)	43.5	30.8	-10.6	64.8
US 2011 General Govt 2011 (IMF)	41.2	30.5	-10.8	72.4

Note: Govt: government

Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-26042011-AP/EN/2-26042011-AP-EN.PDF

http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf

http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx

 

Total reserves of depository institutions at the Fed, R, and base money, B, are provided in Table 18. Total reserves of banks fell by 4.4 percent between 2003 and 2007, but grew from $43 billion in Dec 2007 to $820 billion in Dec 2008, by a multiple of 19 times or almost one trillion dollars. Reserves grew by an additional 38.9 percent in 2009, fell 5.3 percent in 2010 and increased an additional 41.7 percent through Apr 2011 in the second round of quantitative easing beginning in Nov 2010. Reserves in Apr 2011 are higher by 35.5 times relative to Dec 2007. Base money, B, grew by 10.2 percent in 2003-2007, but 142.9 percent in 2007-2010 and by an additional 23.8 percent in the first four months of 2011. Schwartz (2009) complains that the Fed appears to work only with two amounts, zero, as in the interest rate of the fed funds set at 0 to ¼ percent, and trillions of dollars, as the increase of the Fed balance sheet, at $2.7 trillion on May 25 (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1), from much lower levels, such as $902 billion on Jul 25, 2007 (http://www.federalreserve.gov/releases/h41/hist/h41hist1.pdf). There has been de facto coordination of monetary policy and fiscal policy and an exit strategy is timely and quite important.

 

Table 18, 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

 

Monetary and fiscal policy coordination has occurred in multiple historical episodes. Table 19 provides average yearly rates of growth of two definitions of the money stock, M1, and M2 that adds also interest-paying deposits. The data were part of a research project on the monetary history of Brazil using the NBER framework of Friedman and Schwartz (1963, 1970) and Cagan (1965) as well as the institutional framework of Rondo E. Cameron (1967, 1972) who inspired the research (Pelaez 1974, 1975, 1976a,b, 1977, 1979, Pelaez and Suzigan 1978, 1981). The data were also used to test the correct specification of money and income following Sims (1972; see also Williams et al. 1976) as well as another test of orthogonality of money demand and supply using covariance analysis. The average yearly rates of inflation are high for almost any period in 1861-1970, even when prices were declining at 1 percent in 19^th century England, and accelerated to 27.1 percent per year in 1945-1970. There may be concern of an uncontrolled fiscal deficit monetized by sharp increases in base money. The Fed may have desired to control inflation at 2 percent after lowering the fed funds rate to 1 percent in 2003 but inflation rose to 4.1 percent in 2007. There is not “one hundred percent” confidence in controlling inflation because of the lags in effects of monetary policy impulses and the equally important lags in realization of the need for action and taking of action and also the inability to forecast any economic variable (Friedman 1953). Romer and Romer (2004) find that a one percentage point tightening of monetary policy is associated with a 4.3 percent decline in industrial production. There is no change in inflation in the first 22 months after monetary policy tightening when it begins to decline steadily, with decrease by 6 percent after 48 months (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 102). Even if there were one hundred percent confidence in reducing inflation by monetary policy, it could take a prolonged period with adverse effects on economic activity. Certainty does not occur in economic policy, which is characterized by costs that cannot be anticipated.

 

Table 19, Brazil, Yearly Growth Rates of M1, M2, Nominal Income (Y), Real Income (y), Real Income per Capita (y/n) and Prices (P)

	M1	M2	Y	y	y/N	P
1861-1970	9.3	6.2	10.2	4.6	2.4	5.8
1861-1900	5.4	5.9	5.9	4.4	2.6	1.6
1861-1913	4.7	4.7	5.3	4.4	2.4	0.1
1861-1929	5.5	5.6	6.4	4.3	2.3	2.1
1900-1970	13.9	13.9	15.2	4.9	2.6	10.3
1900-1929	8.9	8.9	10.8	4.2	2.1	6.6
1900-1945	8.6	9.1	9.2	4.3	2.2	4.9
1920-1970	17.8	17.3	19.4	5.3	2.8	14.1
1920-1945	8.3	8.7	7.5	4.3	2.2	3.2
1920-1929	5.4	6.9	11.1	5.3	3.3	5.8
1929-1939	8.9	8.1	11.7	6.3	4.1	5.4
1945-1970	30.3	29.2	33.2	6.1	3.1	27.1

Note: growth rates are obtained by regressions of the natural logarithms on time.

Source: See Pelaez and Suzigan (1978), 143; M1 and M2 from Pelaez and Suzigan (1981); money income and real income from Contador and Haddad (1975) and Haddad (1974); prices by the exchange rate adjusted by British wholesale prices until 1906 and then from Villela and Suzigan (1973); national accounts after 1947 from Fundação Getúlio Vargas.

 

IV Risk Aversion. The past three weeks have been characterized by unusual financial turbulence. Table 20 provides beginning values on May 23, high and low values and values on May 27. All data are for New York time at 5 PM. The high and low values exclude observations on May 23 and May 27.

 

Table 20, Risk Financial Assets

	May 23	High	Low	May 27
USD/EUR	1.4165	1.4308	1.4236	1.431
JPY/USD	80.785	81.7185	81.3665	88.77
CHF/USD	0.8835	0.8814	0.8801	0.8540
DJIA	100	100.2	99.8	100.5
DJ Global	100	100.7	100.1	101.6
DAX	100	100.7	100.4	100.6
DJ UBS	100	101.9	100.5	102.9
WTI $/barrel	97.500	101.190	99.740	100.710
Brent $/barrel	109.21	115.00	112.300	114.980
Gold $/ounce	1517.50	1494.60	1484.80	1537.300
10 Y US T %	3.13	3.12	3.06	3.07
10 Y Ger %	3.01	3.07	3.00	2.99

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 20 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 1.431/EUR on May 27, or by 3.5 percent. In the week, the dollar devalued from USD 1.4165 on May 23 to USD 1.431/EUR or by 1.0 percent. The following section IV Valuation of Risk Financial Assets provides percentage changes of variables from Fri May 20 to Fri May 27. 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 appreciated by 3.3 percent during the week. The CHF/USD rate strengthened before the current episode because risk aversion signs preceded the turmoil of the past four weeks.

The last two rows of Table 20 show the decline in the yield of the 10-year Treasury note falling from 3.282 percent on May 2 to 3.07 percent on May 27 and even as low as 3.06 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 2.99 percent on May 27. Investors increase holdings of government securities of the US and Germany during episodes of risk aversion, with demand raising their prices, which is equivalent to lowering yields. Daniel Kruger writing in Bloomberg (Treasuries notes rise for seventh week on Europe, refuge demand http://noir.bloomberg.com/apps/news?pid=20601087&sid=a30O9e4Rh63I&pos=4) finds that prices of Treasury notes have appreciated during seven consecutive weeks, which is the longest such period in two year because of doubts on European sovereign risks and slowing economic activity in the US. The bid/offer ratios in auctions of Treasury five-year securities were the highest in 17 years and for seven-year securities the highest since Feb 2009. Another indicator of risk aversion was the drop of the yield of the two-year Treasury security to 0.48 percent as investors reallocated portfolios away from higher risks.

Table 20 also provides changes 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 23. All three indexes gained within the week.

Commodity prices rose during the week. Table 20 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 9.1 percent from May 2 to May 13 but gained 1.9 percent from May 16 to May 20 and another 2.9 percent from May 23 to May 27. Oil price and gold futures fell sharply in the prior two weeks but gained in the week of May 20 and the gains were consolidated in the week of May 27.

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. Maria Petrakis and Natalie Weeks writing in Bloomberg (Greece’s Papandreou vows to move ahead with austerity steps http://noir.bloomberg.com/apps/news?pid=20601087&sid=aGlc9y1lt4x4&pos=3) inform that another package for Greece requires budget cuts of an additional €8.6 and faster sales of €50 billion of state assets.

The G8 Summit of Deauville on May 26-27, 2011 issued a declaration with the following statement on the global economy (http://www.g20-g8.com/g8-g20/g8/english/live/news/renewed-commitment-for-freedom-and-democracy.1314.html):

“23. The global recovery is gaining strength and is becoming more self-sustained. However, downside risks remain, and internal and external imbalances are still a concern. The sharp increase in commodity prices and their excessive volatility pose a significant headwind to the recovery. In this context, we agreed to remain focused on the action required to enhance the sustainability of public finances, to strengthen the recovery and foster employment, to reduce risks and ensure strong, sustainable and balanced growth, including through structural reforms.

Europe has adopted a broad package of measures to deal with the sovereign debt crisis faced by a few countries, and it will continue to address the situation with determination and to pursue rigorous fiscal consolidation alongside structural reforms to support growth. The United States will put in place a clear and credible medium-term fiscal consolidation framework, consistent with considerations of job creation and economic growth. In Japan, while providing resources for the reconstruction after the disaster, the authorities will also address the issue of sustainability of public finances.

We are determined to take the necessary actions collectively and individually to face current challenges. We will also ensure that our macroeconomic policies promote sound economic growth, aiming, together with our employment and social policies, at reducing unemployment and enabling a quick re-entry into the labour market.

24. We expressed our commitment to the ongoing processes in the G20 to expand policy dialogue and cooperation, particularly on our agenda for financial sector reform, mitigating commodity prices volatility, the strengthening of the international monetary system and the in-depth assessments of the causes of persistently large external imbalances and the full range of policies to foster strong, sustainable and balanced growth under the Mutual Assessment Process.“

V 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 21 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 21 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 20.1 percent by Fri May 27, 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 21 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 21, 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	05/27 /2011
Rate	1.1423	1.5914	1.192	1.431
CNY/USD	01/03 2000	07/21 2005	7/15 2008	05/27/ 2011
Rate	8.2798	8.2765	6.8211	6.4917
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 21A extracts four rows of Table 21 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 23, the dollar has devalued again to USD 1.431/EUR or by 20.1 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 6.4917/USD on May 27, 2011, or by an additional 4.8 percent, for cumulative revaluation of 21.6 percent.

 

Table 21A, 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	05/27 /2011
Rate	1.1423	1.5914	1.192	1.431
CNY/USD	01/03 2000	07/21 2005	7/15 2008	05/27/ 2011
Rate	8.2798	8.2765	6.8211	6.4917

Source: Table 21.

 

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 22. 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 22, 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 21 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 23, 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 05/27/11” with all risk financial assets in the range from 14.0 percent for European stocks to 33.4 percent for the DJ UBS Commodities Index, excluding Japan that has currently weaker performance of 7.9 percent because of the earthquake/tsunami, while the dollar devalued by 20.1 percent and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 5/27/2011” shows the fall of most risk financial assets, with the exception of commodities that had fallen sharply in the week of May 6. 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 23, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 5/ 27/11	∆% Week 5/ 27/11	∆% Trough to 5/ 27/11
DJIA	4/26/ 10	7/2/10	-13.6	11.0	-0.6	28.4
S&P 500	4/23/ 10	7/20/ 10	-16.0	9.3	-0.2	30.2
NYSE Finance	4/15/ 10	7/2/10	-20.3	-6.2	0.2	17.8
Dow Global	4/15/ 10	7/2/10	-18.4	3.0	-0.3	26.3
Asia Pacific	4/15/ 10	7/2/10	-12.5	4.9	-0.2	19.9
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-16.4	-0.9	7.9
China Shang.	4/15/ 10	7/02 /10	-24.7	-14.3	-5.2	13.7
STOXX 50	4/15/10	7/2/10	-15.3	-3.5	-0.02	13.9
DAX	4/26/ 10	5/25/ 10	-10.5	13.1	-1.4	26.3
Dollar Euro	11/25 2009	6/7 2010	21.2	5.4	-1.1	-20.1
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	14.0	1.8	33.4
10-Year Tre.	4/5/ 10	4/6/10	3.986	3.068

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 24 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 lowered the gain to 11.7 percent in the DJIA and to 10.0 in the S&P 500 by Fri May 20. By Fri May 27 the gains were further reduced to 11.0 percent for the DJIA and 9.8 percent for the S&P 500.

 

Table 24, Percentage Changes of DJIA and S&P 500 in Selected Dates

2010	∆% DJIA from earlier date	∆% DJIA from Apr 26	∆% S&P 500 from earlier date	∆% S&P 500 from Apr 26
Apr 26
May 6	-6.1	-6.1	-6.9	-6.9
May 26	-5.2	-10.9	-5.4	-11.9
Jun 8	-1.2	-11.3	2.1	-12.4
Jul 2	-2.6	-13.6	-3.8	-15.7
Aug 9	10.5	-4.3	10.3	-7.0
Aug 31	-6.4	-10.6	-6.9	-13.4
Nov 5	14.2	2.1	16.8	1.0
Nov 30	-3.8	-3.8	-3.7	-2.6
Dec 17	4.4	2.5	5.3	2.6
Dec 23	0.7	3.3	1.0	3.7
Dec 31	0.03	3.3	0.07	3.8
Jan 7	0.8	4.2	1.1	4.9
Jan 14	0.9	5.2	1.7	6.7
Jan 21	0.7	5.9	-0.8	5.9
Jan 28	-0.4	5.5	-0.5	5.3
Feb 4	2.3	7.9	2.7	8.1
Feb 11	1.5	9.5	1.4	9.7
Feb 18	0.9	10.6	1.0	10.8
Feb 25	-2.1	8.3	-1.7	8.9
Mar 4	0.3	8.6	0.1	9.0
Mar 11	-1.0	7.5	-1.3	7.6
Mar 18	-1.5	5.8	-1.9	5.5
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
May 27	-0.6	11.0	-0.2	9.8

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

 

Table 25, 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 25, Exchange Rates

	Peak	Trough	∆% P/T	May 27 2011	∆% T May 27 2011	∆% P May 27 2011
EUR USD	7/15 2008	6/7 2010		5/27 2011
Rate	1.59	1.192		1.431
∆%			-33.4		16.7	-11.1
JPY USD	8/18 2008	9/15 2010		5/27 2011
Rate	110.19	83.07		80.77
∆%			24.6		2.8	26.7
CHF USD	11/21 2008	12/8 2009		5/27 2011
Rate	1.225	1.025		0.854
∆%			16.3		16.7	30.3
USD GBP	7/15 2008	1/2/ 2009		5/27 2011
Rate	2.006	1.388		1.651
∆%			-44.5		15.9	-21.5
USD AUD	7/15 2008	10/27 2008		5/27 2011
Rate	1.0215	1.6639		1.071
∆%			-62.9		43.9	8.6
ZAR USD	10/22 2008	8/15 2010		5/27 2011
Rate	11.578	7.238		6.922
∆%			37.5		4.4	40.2
SGD USD	3/3 2009	8/9 2010		5/27 2011
Rate	1.553	1.348		1.236
∆%			13.2		8.3	20.4
HKD USD	8/15 2008	12/14 2009		5/27 2011
Rate	7.813	7.752		7.780
∆%			0.8		-0.4	0.4
BRL USD	12/5 2008	4/30 2010		5/27 2011
Rate	2.43	1.737		1.594
∆%			28.5		8.2	34.4
CZK USD	2/13 2009	8/6 2010		5/27 2011
Rate	22.19	18.693		17.095
∆%			15.7		8.5	22.9
SEK USD	3/4 2009	8/9 2010		5/27 2011
Rate	9.313	7.108		6.222
∆%			23.7		12.5	33.2
CNY USD	7/20 2005	7/15 2008		5/27 2011
Rate	8.2765	6.8211		6.4917
∆%			17.6		4.8	21.6

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; CNY: Chinese yuan; P: peak; T: trough

Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation

Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

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

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

 

VI Economic Indicators. The economy continues to expand but at a slower pace. Housing and labor markets continue to be under stress. Durable goods manufacturers’ shipments and new orders, seasonally adjusted, are shown for the first quarter of 2011 in Table 26. These data typically show significant volatility and strong seasonal effects. New orders and shipments are weak for the change from Mar into Apr 2011 in nearly all segments with total new orders declining by 3.6 percent. The month was weak even discounting the fall by 30.0 percent of new orders for nondefense aircraft in Mar/Apr after an increase by 39.9 percent in Jan/Feb.

 

Table 26, Durable Goods Manufacturers’ Shipments and New Orders, SA, %

	Mar/Apr ∆%	Feb/Mar ∆%	Jan/Feb ∆%
Total
S	-1.0	3.1	0.0
NO	-3.6	4.4	-1.1
Excluding Transport
S	-0.4	2.5	-0.2
NO	-1.5	2.5	-0.6
Excluding Defense
S	-0.9	3.2	-0.1
NO	-3.6	4.1	0.6
Transport Equipment
S	-3.0	5.1	0.6
NO	-9.5	10.3	-2.4
Motor Vehicles
S	-4.3	6.9	0.7
NO	-4.5	6.6	1.1
Nondefense Aircraft
S	-1.8	2.5	2.7
NO	-30.0	2.3	39.9
Capital Goods
S	-1.9	3.6	0.5
NO	-7.1	5.9	-0.4

Note: S: shipments; NO: new orders; Transport: transportation

Source: http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf

 

Durable goods manufacturers’ shipments and new orders, not seasonally adjusted, grew rapidly when comparing the first four months of 2011 relative to the first four months of 2010, shown in Table 27. The data are not adjusted for changes in prices such that there might be inflation behind double-digit growth.

 

Table 27, Durable Goods Manufacturers’ Shipments and New Orders, NSA, %

	Jan-Apr 2011/Jan-Apr 2010 ∆%
Total
S	7.8
NO	9.2
Excluding Transport
S	9.1
NO	9.5
Excluding Defense
S	9.9
NO	10.0
Transport Equipment
S	3.9
NO	8.2
Motor Vehicles
S	11.9
NO	12.2
Nondefense Aircraft
S	6.0
NO	19.8
Capital Goods
S	4.6
NO	9.4

Note: S: shipments; NO: new orders; Transport: transportation

Source: http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf

 

An optimistic number for the housing market was the increase of seasonally adjusted new home sales at annual equivalent rate by 7.3 percent in Apr relative to Mar, shown in Table 28. It followed an increase by 8.3 percent from Feb into Mar.

 

Table 28, Sales of New Homes at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %

	SA Annual Rate Thousands	∆%
Jan	310	-6.3
Feb	278	-10.3
Mar	301	8.3
Apr	323	7.3

Source: http://www.census.gov/const/newressales.pdf

 

The housing sector continues to be depressed relative to the prior year and the peak in 2005 to 2006. Table 29 shows that new home sales not seasonally adjusted fell 19.3 percent in Jan-Apr 2011 relative to the same period, 73.2 percent relative to the same period in 2006 and 76.8 percent relative to the same period in 2005.

 

Table 29, Sales of New Homes Not Seasonally Adjusted, Thousands and %

	Not Seasonally Adjusted Thousands
Jan-Apr 2011	103
Jan-Apr 2010	127
∆%	-19.3*
Jan-Apr 2006	385
∆% Jan-Apr 2011	-73.2
Jan-Apr 2005	444
∆% Jan-Apr 2011	-76.8

*Computed using unrounded data

Source: http://www.census.gov/const/newressales.pdf

http://www.census.gov/const/newressales_200704.pdf

http://www.census.gov/const/newressales_200604.pdf

 

The Federal Housing Finance Agency (FHFA) House Price Index fell 2.5 percent, seasonally adjusted, from IVQ2010 to IQ2011. The not seasonally adjusted index fell 3.5 percent in IQ2011 relative to IQ2010 (see Table 29).

 

Table 29, Federal Housing Finance Agency (FHFA) House Price Index

	IQ11/IVQ10 SA	IQ11/IQ10 NSA
∆%	-2.5	-3.5

Source: http://www.fhfa.gov/webfiles/21309/1q2011HPIfinalR.pdf

 

The index of pending home sales of the National Association of Realtors, which is a forward-looking indicator based on contract signings but not closings, fell 11.6 percent in Apr relative to Mar. The index is 26.5 percent lower than the peak in Apr 2010 when the home buyer tax credit stimulated house purchases (http://www.realtor.org/press_room/news_releases/2011/05/gains_drop). The Energy Information Administration Weekly Petroleum Status Report is summarized in Table 30. Crude oil stocks rose to 370.9 million barrels in the week of May 20 from 370.3 million in the week of May 13 and are higher by more than 5 million barrels than in the week of May 21, 2010. The world crude oil price declined to $108.48/barrel in the week of May 20 from $110.12/barrel in the week of May 13, but is 52.4 percent higher than $71.17/barrel in the week of May 21, 2010. The price of regular motor gasoline of $3.960/gallon on May 23, 2011 was 38.3 percent higher than $2.864/gallon on May 24, 2010.

 

Table 30, Energy Information Administration Weekly Petroleum Status Report

	Week Ending 05/20/11	Week Ending 05/13/11	Week Ending 05/21/10
Crude Oil Stocks Million B	370.9	370.3	365.1
Crude Oil Imports Thousand Barrels/Day	8,877	8,885	9,815
Motor Gasoline Million B	209.7	205.9	221.6
Distillate Fuel Oil Million B	141.1	143.1	152.5
World Crude Oil Price $/B	108.48	110.12	71.17
	05/23/11	05/16/11	05/24/10
Regular Motor Gasoline $/G	3.960	3.965	2.864

B: barrels; G: gallon

Source: http://www.eia.doe.gov/pub/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/current/pdf/highlights.pdf

 

Initial claims for unemployment insurance seasonally adjusted rose 10,000 to reach 424,000 in the week of May 21 from 414,000 in the week of May 14, as shown in Table 31. Claims not seasonally adjusted rose 10,284 to reach 371,857 in the week of May 21 from 361,573 in the week of May 14.

 

Table 31, Initial Claims for Unemployment Insurance

	SA	NSA	4-week MA SA
May 21	424,000	371,857	438,500
May 14	414,000	361,573	440,250
Change	10,000	10,284	-1,750
May 7	438,000	397,737	437,750
Prior Year	467,000	410,778	464,750

Note: SA: seasonally adjusted; NSA: not seasonally adjusted; MA: moving average

Source: http://www.dol.gov/opa/media/press/eta/ui/current.htm

 

VII Interest Rates. The yield curve of the US shows a segment with rates below 1 percent: 3 months 0.04 percent, 6 months 0.10 percent, 12 months 0.15 percent, 2 years 0.48 percent and 3 years 0.80 percent (http://noir.bloomberg.com/markets/rates/index.html). The 10 year Treasury note is yielding 3.07 percent. Risk aversion has channeled funds to dollar-denominated assets as temporary refuge, causing flattening of the yield curve. Similar risk aversion effects appear present in the fall of the 10-year government bond of Germany to 2.99 percent (http://noir.bloomberg.com/markets/rates/germany.html).

VIII Conclusion. Curbing debt growth and existing monetary accommodation will not be painless especially in view of the current difficult economic and financial environment. It appears likely that the longer the delay in addressing the fiscal and monetary issues in the US may simply worsen the consequences or sacrifices of income and jobs in the future. (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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