Increasing Risk Aversion, Analysis of the Debt/Dollar Crisis and Global Recession and Global Inflation

 

Increasing Risk Aversion, Analysis of the Debt/Dollar Crisis and Global Recession and Global Inflation

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011

Executive Summary

I Increasing Risk Aversion

II Analysis of the Debt/Dollar Crisis and Global Recession

IIA New Classical

IIB Monetary and Fiscal Theory

III Global Inflation

IV Hiring Collapse

V Valuation of Risk Financial Assets

VI Economic Indicators

VII Interest Rates

VIII Conclusion

References

Executive Summary

Risk aversion has been increasing in world financial markets because of the simultaneous occurrence of three factors: (1) slowing growth of the US economy in the first quarter of 2011 to 1.8 percent annual equivalent; short-term indicators in Apr and May are also showing slower growth; (2) decline of property values and transactions in China that if continuing could slow growth in Asia with repercussions in the rest of the world; and (3) recurring doubts on sovereign risks in Europe. The US stock market has declined in six consecutive weeks for the first time since 2002. Risk aversion has consisted of a flight into government securities of the US and Germany. The flight to these debt safe havens also occurred during the dollar/debt crisis and Global Recession after 2007.

Global inflation continues at high levels. Most of the increases in prices are in commodities and raw materials. A current of analysis and measurement suggests that increases in prices of commodities and raw materials are transitory and have limited impact on production costs and ultimate prices of consumer goods. Another view finds a steady increase of prices of commodities and raw materials  during the past decade that is not transitory and affects total or headline inflation. Nominal values of production, trade and throughout production and distribution chains are evidently showing inflation and not only volumes. There may be excessive weight to analysis based on the period of low inflation in recent decades that inflation can be anticipated by unobservable expectations and slack in the economy. Inflation has indeed occurred in episodes of low economic growth and unemployment. The vigilance should be on the possible threat of stagflation and not on illusory deflation.

The release by the Bureau of Labor Statistics of the Job Openings and Labor Turnover Survey confirms the significant decline in total and private hiring in the US. Total hiring in the nonfarm sector has declined from 64.9 million in 2006 to 47.2 million in 2010 or by 17.7 million while hiring in the private sector has declined from 60.4 million in 2006 to 43.3 million in 2010 or by 17.1 million. An important characteristic of the labor market in the US is that total hiring in the nonfarm sector has declined from 5.736 million in Apr 2006 to 4.289 million in Apr 2011, or by 1.447 million, and private-sector hiring has fallen from 5.450 million in Apr 2006 to 4.099 million in Apr 2011, or by 1.351 million. Total hiring in the nonfarm sector of 4.289 million in Apr 2011 is almost unchanged relative to 4.258 million in Apr 2010 and private-sector hiring in Apr 2011 of 4.099 million is lower by 1.622 million than 5.721 million in Apr 2001. The US labor market is fractured, creating fewer opportunities to exit job stress of unemployment and underemployment of 24 to 30 million people and declining inflation-adjusted wages in the midst of fast increases in prices of everything.

The Bureau of Labor Statistics (BLS) also calculates alternative measures of labor underutilization for the US and all states. There is dramatic rise in the broad measure of labor underutilization, U6, or total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons as percent of the labor force plus all marginally attached workers. U6 rose from 5.6 percent in 2006 to 16.5 percent in the first quarter of 2011. This blog provides the numerator of U6 after the release of every employment situation report by the BLS. The number for May is 24.688 million in job stress (see Table 1 in http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html) but using a different rate of participation of the population in the labor force the number could be 29.664 million (see Table 2 and discussion in http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html).

I Increasing Risk Aversion. The past five weeks have been characterized by unusual financial turbulence. Table 1 provides beginning values on Jun 6 and daily values throughout the week ending on Jun 10. All data are for New York time at 5 PM. The first three rows provide three key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. The dollar appreciated by 1.91 percent relative to the euro with appreciation occurring mostly from Wed Jun 8 to Fri Jun 10 because of the uncertainty of European sovereign risks. The Japanese yen appreciated to JPY 79.905USD by Wed Jun 8 as the currency was used as safe haven from world risks while fears of another Japanese and G7 intervention subsided. The Swiss franc depreciated 0.72 percent during the week with the strength of the dollar but the strong level of CHF 0.842/USD could be a signal of risk aversion by funds fleeing temporarily to safe haven in a strong deposit and investment market.

 

Table 1, Daily Valuation of Risk Financial Assets

	Jun 6	Jun 7	Jun 8	Jun 9	Jun 10
USD/ EUR	1.4572 0.39%	1.4683 -0.36%	1.4567 0.43%	1.4507 0.84%	1.435 1.91%
JPY/ USD	80.148 0.14%	80.034 0.28%	79.905 0.44%	80.311 -0.06%	80.310 -0.06%
CHF/ USD	0.8360 0.0%	0.8361 -0.01%	0.8363 -0.04%	0.8416 -0.67%	0.842 -0.72%
10 Year T Note Yield	3.00	2.99	2.95	2.99	2.973
2 Year T Note Yield	0.42	0.40	0.38	0.41	0.40
10 Year German Bond Yield	3.02	3.09	3.05	3.03	2.96
DJIA	-0.50% -0.50%	-0.66% -0.16%	-0.84 -0.18%	-0.22 -0.63%	-1.64% -1.42%
DJ Global	-0.69% -0.69%	-0.41% 0.28%	-1.19% -0.78%	-0.86% 0.34%	-2.38% -1.53%
DAX	-0.34% -0.34%	-0.08% 0.26%	-0.69% -0.61%	0.71% 1.41%	-0.55 -1.25%
WTI $/b	98.910	99.210	101.02	101.74	99.050
Brent $/b	114.26	116.880	117.800	119.600	118.420
Gold $/ounce	1543.03	1544.40	1538.30	1545.00	1532.70

Note: For the exchange rate appreciation is a positive percentage and depreciation a negative percentage; USD: US dollar; JPY: Japanese Yen; CHF: Swiss Franc; AUD: Australian dollar; B: barrel; for the three stock indexes the upper line is the percentage change since the past week and the lower line the percentage change from the prior day;

Source: http://noir.bloomberg.com/intro_markets.html

http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata

 

The three yields in Table 1 capture risk aversion in the flight to the safety of US Treasury securities and German securities. The 2-year US Treasury note is highly attractive because of minimal duration or sensitivity to price change and its yield continued declining for a sustained period to 0.40 percent per year on Fri Jun 10. Much the same is true of the 10-year Treasury note and the 10-year bond of the government of Germany, falling to 2.973 percent for the 10-year Treasury note and to 2.96 percent for the 10-year government bond of Germany. Serena Ng and Matt Wirz, writing on Jun 10 in the Wall Street Journal on “As ‘junk’ bonds fall, some blame the Fed” (http://professional.wsj.com/article/SB10001424052702304259304576375233556859772.html?mod=WSJ_hp_LEFTWhatsNewsCollection), find declines in prices of subprime mortgage securities of 15 to 20 percent since Mar, with concern by traders that New York Fed sales of its portfolio of subprime securities acquired in the corporate rescue of 2008 may be causing the decline. The sales of subprime mortgages by the New York Fed may be also affecting the market for high-yield corporate securities that absorbed the issue of $114 billion by Jun 2, 2011, which is higher by 27 percent than in the comparable period in 2010. The Fed has sold about $10 billion of the portfolio it acquired in the rescue of AIG in 2008. Although the prices of high-yield corporate bonds have declined after the sales of the Fed portfolio of subprime mortgages, Ng and Wirz inform that the JP Morgan Domestic High Yield Index has increased 5.7 percent this year. The financial crisis was precipitated by a flight to quality from private-sector debt to government debt (see Cochrane 2011Jan, Duffie 2010JEP). The recent rise in yield of Treasury securities could be partly the result of the injection of subprime securities.

All three stock market indexes in Table 1 accumulated declines during the week that intensified with the risks of low growth and unemployment in the US and doubts on the new rescue package for Greece plus delays in stress tests of European banks. The upper line in the stock indexes in Table 1 measures the percentage cumulative change since the closing level in the prior week on Jun 3 and the lower line measures the daily percentage change. E. S. Browning, writing on Jun 11 in the Wall Street Journal on “Stocks swoon, worry rises” (http://professional.wsj.com/article/SB10001424052702304259304576377970959834268.html?mod=WSJ_hp_LEFTWhatsNewsCollection), correctly attributes the new round of risk aversion to concerns about slowing growth in the US, doubts on European sovereign risks and slowing growth in Asia. The DJIA has accumulated a decline of 6.7 percent in six weeks, or 1.1 percent on average, from the high level in Apr. Section IV Valuation of Risk Financial Assets tracks financial risk and opportunities with emphasis on the European sovereign risk issues that developed between Apr and Jul 2010 and recurred in Nov 2010 with Ireland and now after Mar with Portugal. The revealing chart in the WSJ Browning article (http://professional.wsj.com/article/SB10001424052702304259304576377970959834268.html?mod=WSJ_hp_LEFTWhatsNewsCollection) shows that the DJIA last declined during six consecutive weeks in 2002. There were sharp declines in 2008 during several weeks but interrupted by some favorable weeks. On Jun 7, Chairman Bernanke delivered a speech with sober evaluation of the current state of the economy (http://www.federalreserve.gov/newsevents/speech/bernanke20110607a.pdf):

“US economic growth so far this year looks to have been somewhat slower than expected. Aggregate output increased at only 1.8 percent at an annual rate in the first quarter, and supply chain disruptions associated with the earthquake and tsunami in Japan are hampering economic activity this quarter. A number of indicators also suggest some loss of momentum in the labor market in recent weeks.”

The remarks of Chairman Bernanke were delivered at 3:45 PM, just five minutes before markets closed. Steven Russolillo and Brendan Conway, writing on Jun 7 in the WSJ on “Bernanke’s talk kills stock rally” (http://professional.wsj.com/article/SB10001424052702304432304576371032577629562.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that stocks erased earlier gains in the day after the remarks of Chairman Bernanke, closing down for the fifth consecutive day.

The final three columns of Table 1 provide the prices of oil and gold. Oil prices have stabilized from the recent decline of WTI from around $110/barrel and Brent from $126/barrel. The spike in oil prices on Jun 8 and 9 could perhaps have some relation to the decision of the OPEC meeting (http://www.opec.org/opec_web/en/2072.htm):

“The 159^th Meeting of the OPEC Conference was held in Vienna, Austria, on 8 June 2011. No formal decision was reached on a production agreement. However, the Organization abides by its longstanding commitment to order and stability in the international oil market. The 160^th Meeting of the Conference will take place on 14 December 2011 in Vienna, Austria. This will be preceded by the Ministerial Monitoring Sub-Committee on 13 December 2011.”

Econometric research has not uncovered much evidence of causality between OPEC meetings and decisions and oil prices (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 28-33). Grant Smith and Wael Mahdi, writing on Jun 10 in Bloomberg on “Saudis show they’re ready to deliver on surge in oil production” (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aT7SHVE5TBE4&pos=2), inform that a group of six members frustrated the efforts by Saudi Arabia to increase production quotas to compensate for the loss of oil from Lybia. Saudi Arabia is prepared to increase its oil output after the failure of such a measure within OPEC.

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.

In an article for the WSJ, Feldstein (2011Jun8) argues that US economic growth will be subpar in the best conditions with continuing high levels of unemployment and underemployment. Feldstein (2011Jun8) analyzes the decline in the rate of growth of GDP from 3.2 percent in IVQ2010 (fourth quarter of 2010) to 1.8 percent in IQ2011. Table 2 shows that he decomposition of the rate of growth of GDP of 1.8 percent in IQ2011 attributes 1.19 percentage points to change in inventories (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html). GDP data are seasonally-adjusted quarterly growth rates expressed in annual equivalent. The argument by Feldstein (2011Jun8) is that growth of final sales after deducting inventory change was only 0.6 percent, which is equivalent to growth of only 0.15 percent in the quarter ((1.006)^1/4 or 0.6 percent discounted four quarterly periods). The economy stalled. Inventory accumulation cannot sustain economic growth that requires increasing demand in investment and consumption. Business only invests when sales increase. Consumers need to see their income growing and the evidence is that real disposable income stagnated in the first four months of 2011 (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html). Real wages are falling, 44 million people struggle with food stamps, hiring has collapsed and between 24 and 30 million people are unemployed or underemployed (http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html). Feldstein (2011Jun8) also finds significant weakness in short-term economic indicators, which are analyzed in this blog weekly.

 

Table 2, 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

 

Growth of the economy of China could also have important effects on risk aversion. The main fear in China is the need to curb inflation that could have unpredictable effects on economic growth. Most of the concern has centered on property values. Bob Davis, in an article on Jun 9 for the Wall Street Journal on “The great property bubble of China may be popping” (http://professional.wsj.com/article/SB10001424052702304906004576367121835831168.html?mod=WSJPRO_hpp_LEFTTopStories), finds that property prices in China are beginning to fall after years of rapid increases. Davis quotes estimates by Rosealea Yao of Dragonomics (http://www.dragonomics.net/) that property values in nine cities in China fell 4.9 percent in the 12 months ending in Apr 2011 after increasing by 21.5 percent in 2010 and that sales volume has declined by one half since the beginning of the year. Real Time Economics in an article on Jun 9 in the Wall Street Journal on “What a China slowdown means for the world” (http://blogs.wsj.com/economics/2011/06/09/what-a-china-slowdown-means-for-the-world/), analyzes how lower growth in China could affect commodity exporting countries by lower commodity prices resulting from lower Chinese demand, regions producing industrial products such as steel by lower prices of competing Chinese products and producers of high-technology good in a possible reduction of demand by China. Simon Rabinovitch, in an article on Jun 10 in the Financial Times on “China trade surplus hits $13 billion in May” (http://www.ft.com/intl/cms/s/0/4ada05fa-931a-11e0-a038-00144feab49a.html#axzz1OmAttNMZ), informs that the year-on-year growth of exports of China fell from 29.9 percent in Apr to 19.4 percent in May while year-on-year imports increased from 21.8 percent in Apr to 28.4 percent in May. These data include world inflation. Deceleration of export growth by China, if continuing, could be a symptom of lower world growth.

The euro zone has some members that have larger economies growing more rapidly and are competitive in placing goods and services in world markets. There are other countries with deteriorating fiscal situations, which have smaller economies growing negatively or at low rates and are not as competitive in placing their domestically-produced goods in world markets. Some of the sovereign debts may be excessively high for the individual countries’ capacity to serve them, that is, paying interest and principal timely and under contractual obligations. It is difficult to generate primary surpluses of revenues less expenditures, excluding interest payments, in the countries with low growth. Revenue growth requires dynamic economies but some are contracting and others growing slowly. Reducing expenditures may be as politically unfeasible as raising taxes because expenditures include many benefits provided by the government such as retirement and health and commitments in government employment. Sales of government assets are also politically sensitive, attracting low or no bids because of the fear of subsequent nationalization. Belt-tightening measures of freezing and other forms of reductions of salaries and benefits while inflation increases can generate political events with unknown trajectories.

There is no magical wand to solve the sovereign risk doubts. Debt restructuring is not an orderly process anywhere. Any change to the contractual obligations of a debt agreement is considered default that can cause three gravely adverse repercussions. (1) The defaulting sovereign and its private sector will not be able to borrow in international markets. (2) Balance sheets of banks of countries in the euro zone, including the domestic ones of the defaulting country, will be forced to deduct the loss in value of their exposures to the defaulting countries. This is not a mythical “contagion” but the mechanism by which the crisis in the defaulting countries will spread to the internal economy of the defaulting country as well as to those of other member countries and also to countries with exposures that are not members of the euro zone. (3) Weakening economic conditions in Europe will spread to financial markets and the world economy much the same as during the stress period from Apr to Jul 2010 but perhaps much more strongly in the case of a sovereign default.

II Analysis of the Debt Dollar Crisis and Global Recession. The objective of this section is to analyze several theories that can provide insight into the credit/dollar crisis after 2007, the depth of the contraction of the economy and turnaround mechanism, which can also help to understand slow growth with high unemployment in the expansion. There are multiple other alternative interpretations that will be considered separately in future posts. Two subsections are as follows: IIA New Classical discusses the recent analysis by Robert E. Lucas, Jr. (2011May19); and IIB Monetary and Fiscal Theory analyzes the fiscal theory of the price level by John H. Cochrane (2010).

IIA New Classical. The approach of Lucas (2011May19) is to evaluate the performance of the economy in terms of policies required for recovery but without neglect of efficiency in the use of productive resources and growth in long-term productive capacity. Business cycles could be analyzed as departures from a strong long-term trend of growth. Lucas (2011May19, 5) finds that real income per capita in the US multiplied by a factor of 12 between 1870 and 2010. Output in the US grows at a rate of 3 percent per year in the long-run and output per person at the rate of 2 percent. Business cycles can be measured as deviations from this long-term trend. Lucas (2011May 19, 7) provides the rates of growth of eight economies (US, UK, France, Germany, Canada, Italy, Spain and Japan) since 1870, showing that relative growth rates accelerated in countries starting from lower income levels until about the 1970s. The rate of growth of rich economies has continued at about 2 per cent per year but the income gap has stabilized. Different national policies could explain the slower reduction of income gaps. US GDP fell 30 percent below trend by 1933 and is currently about 10 percent below trend, as measured by Lucas (2011May19, 16).

The key to understanding the 2008 financial crisis in the view of Lucas (2011May19, 29-31) is the change in the structure of finance. Securitization replaced traditional banking. Securitization consists of agglutinating receivables, such as credit card debt, student loans, mortgages, car loans and so on, into one bond or security. The process received the blessing of regulators and supervisors which viewed them as credit-risk transfer, reducing concentration of credit exposures in lenders by distributing them to investors. For example, a mortgage contracted by a home buyer is insured by Fannie Mae or Freddie Mac to obtain AAA credit rating and combined with similarly rated mortgages into a bond called mortgage-backed security (MBS). More generally, the receivables of all types of obligations, including everything from credit card debts to mortgages, are combined into a bond called asset-backed security (ABS). The issue that concerns Lucas (2011May 19, 29-31) is that the ABS were converted into short-term liquidity. The acquiring investor financed the ABS in the “repo market.” Repo is a sale and repurchase agreement, which ultimately generates the cash for provided by the mortgage in the purchase of the home, credit card purchases and so on. The investor finances the ABS by a loan in which it obtains overnight or short-term cash from a financial entity with the ABS as collateral, or sale of the ABS, with the promise of repurchasing the ABS the following day or at a specified near date in the future at a contract-specified price plus the interest on the repo. An excellent analysis is provided by Duffie (2010JEP; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 59-60, 217-24, Financial Regulation after the Global Recession (2009a), 48-52, 153-5). In short, what Lucas (2011May19, 29-31) argues is that securitization provided an instrument to invest funds with liquidity, or availability of funds, similar to that provided by banks. The problem is that perceptions of risk were distorted in that Lehman collateral securities were viewed as having riskless or no default properties close to those of Treasury bills. The financial crisis of 2008, in the view of Lucas (2011May19, 31) consisted of a flight from risky private-sector securities to government obligations of all terms. The crisis was ended with the Fed increasing bank reserves from $45 billion in Aug 2008 to $821 billion in Dec 2008 (Lucas 2011May19, 32).

IIB Monetary and Fiscal Theory. Another interpretation of the financial crisis is provided by the “fiscal theory of the price level,” which is proposed by Cochrane (2011Jan). The subtitle of Cochrane (2011Jan) is “some unpleasant fiscal arithmetic.” It is thus instructive to consider the “unpleasant monetarist arithmetic” of Sargent and Wallace (1981). The “monetarist arithmetic,” considered first below, proposes that in a pure monetarist model the central bank loses control of inflation now and in the future if fiscal policy dominates monetary policy and there are expectations of inflation. The alternative fiscal theory of the price level proposes that monetary policy is always impotent and that the price level is determined by the valuation of government debt. These two interpretations are considered in turn: IIB1 Unpleasant Monetarist Arithmetic and IIB2 Unpleasant Fiscal Arithmetic.

IIB1Unplesant Monetarist Arithmetic. There is vast literature on the causes and end of the US Great Inflation (in addition to contributions cited in earlier comments of this blog see Cogley, Premiceri and Sargent 2010, Premiceri 2005, 2006, Meltzer 2005, 2010a, 2010b, Romer 2005, Sargent 1983, Sargent and Wallace 1981, 1983, 1987, Sargent, Williams and Zha 2006, 2009). The chart in the homepage of Professor Thomas J. Sargent provides compelling motivation for this research: http://homepages.nyu.edu/~ts43/ There is significant wisdom for current policy in the unpleasant arithmetic of monetary policy provided in the contribution by Sargent and Wallace (1981), which recalls the analysis by Friedman (1968) of what monetary policy can do and what monetary policy cannot do. Friedman (1968, 5) discusses what monetary policy cannot do:

“From the infinite world of negation, I have selected two limitations of monetary policy to discuss: (1) It cannot peg interest rates for more than very limited periods; (2) It cannot peg the rate of unemployment for more than very limited periods.”

An example of what monetary policy can do is (Friedman 1968, 14):

“If, as now [1968], an explosive federal budget threatens unprecedented deficits, monetary policy can hold any inflationary dangers in check by a slower rate of monetary growth than would otherwise be desirable. This will temporarily mean higher interest rates than would otherwise prevail—to enable to the government to borrow the sums needed to finance the deficit—but by preventing speeding up of inflation, it may well mean both lower prices and lower nominal interest rates for the long pull.”

The variables that money cannot permanently influence are real output level, unemployment and real rates of return on securities but Sargent and Wallace (1981) argue that monetary policy cannot permanently influence the rate of inflation under monetarist assumptions and open market policy operations.

The assumptions of the monetarist economy of Sargent and Wallace (1981, 1) are:

(1) There is a close connection between the monetary base, or monetary liabilities of the government (consisting of currency held by the public and reserves of depository institutions at the central bank), and the price level

(2) The monetary authority can obtain seigniorage, defined as creating money

There are two constraints of government finance in the monetary economy of Sargent and Wallace (1981, 1) imposed by the demand for issuing interest-bearing securities or, say, bonds, as debt:

(1) The demand for bonds by the public sets a limit on the ratio of the real stock of government bonds and the size of the economy

(2) The demand for bonds affects the interest rate paid by the government on its bonds

These two constraints affect the effectiveness of the government on permanently controlling inflation depending on coordination of alternative arrangements of fiscal and monetary policy. There are two polar extremes of coordination arrangement analyzed by Sargent and Wallace (1981).

First, monetary policy dominates fiscal policy. The monetary authority has the choice of the amount of seigniorage that it will supply to the fiscal authority. Thus, the monetary authority has complete freedom in setting the path of base money, such as by announcing its rate of growth in the current and future periods. Under this coordination arrangement, monetary policy can permanently influence inflation.

Second, fiscal policy dominates monetary policy. The monetary authority divides government debt between government bonds and monetary base. The only form of controlling inflation is by holding on the rate of growth of base money. The demand by the public for government bonds constrains the effectiveness of inflation policy by the monetary authority. If the real rate of interest of the government bonds exceeds the rate of growth of the economy, the growth of the stock of real bonds will exceed the rate of growth of the size of the economy. The public’s demand for government bonds sets a limit on the ratio of the stock of bonds to the size of the economy. After reaching that limit, seigniorage must provide part of financing for maturing principal and interest, that is, additional base money must be printed. In a monetarist economy there is inflation after some point in time.

The model of “unadulterated monetarism” used by Sargent and Wallace (1981) includes the assumption of a natural rate of unemployment or growth of real income that monetary policy cannot affect and a real rate of interest on securities that monetary policy cannot influence. Specifically, there are three assumptions:

(1) An equal constant rate of growth of real income and population, denoted by n

(2) A constant real rate of government securities exceeding n

(3) The analysis includes two different specifications of the demand for money: (a) a quantity theory demand function for base money with constant income velocity; and (b) specification of the demand for base money including expected inflation.

Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:

D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (1)

Equation (1) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,

{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:

N(t+1) = (1+n)N(t), n>-1 (2)

The per capita form of the budget constraint is obtained by dividing (1) by N(t) and rearranging:

B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (3)

On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.

If the demand for base money depends on inflation expectations together with the other assumptions, loser monetary policy can result in higher inflation now and also in the future. Sargent and Wallace (1973, 1046) show that if the demand for real cash balances depends on the expected rate of inflation, “the equilibrium value of the price level at the current moment is seen to depend on the (expected) path of the money supply from now until forever.” The anticipation of high rates of base money growth in the future may increase the rate of inflation now. Sargent and Wallace (1981) show that currently tight monetary policy may not be potent to even lower the current rate of inflation. If fiscal policy dominates monetary policy with a sequence of deficits D(t), monetary policy has to adapt within the budget constraint of equation (1). If the sequence D(t) is “too big for too long,” under the assumptions of the model, “the monetary authority can make money tighter now only by making it looser later” (Sargent and Wallace 1981, 7). In the analysis of the hyperinflations in Europe, Sargent (1983, 89-90) concludes:

“The essential measures that ended hyperinflations in each of Germany, Austria, Hungary, and Poland were, first, the creation of an independent central bank that was legally committed to refuse the government’s demand for additional unsecured credit and, second, a simultaneous alteration in the fiscal policy regime. These measures were interrelated and coordinated. They had the effect of binding the government to place its debt with private parties and foreign governments which would value that debt according to whether it was backed by sufficiently large prospective taxes relative to public expenditures. In each case that we have studied, once it became widely understood that the government would not rely on the central bank for its finance, the inflation terminated and the exchanges stabilized. The four incidents we have studied are akin to laboratory experiments in which the elemental forces that cause and can be used to stop inflation are easiest to spot. I believe that these incidents are full of lessons about our own, less drastic predicament with inflation, if only we interpret them correctly.”

The fiscal imbalance of the US from 2009 to 2012 appears to be the highest in peacetime US history. Table 3 provides the outlays, revenue, deficit and debt held by the public in billions of dollars and as percent of GDP for the federal government as provided by the Congressional Budget Office (CBO) and for the general government as provided by the International Monetary Fund (IMF). The deficits from 2009 to 2012 exceed $1 trillion every year and add to $5287 billion, or $5.3 trillion, corresponding to 36.4 percent of GDP of $14,513 in 2010 (CBO http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf Table 1.1, 4). The deficits of the general government calculated by the IMF add to $6090 billion, corresponding to 41.9 percent of 2010 GDP. Federal debt held by the public as percent of GDP rises by 33.6 percentage points from 40.3 percent of GDP in 2008 to 73.9 percent of GDP in 2012 and by 28.2 percentage points for the general government from 48.4 percent in 2008 to 76.6 percent in 2012. The projections for 2016 are for federal debt held by the public of 75.0 percent of GDP and of general government debt of 85.7 percent of GDP. The concern is whether there is a “tipping point” or “debt explosion point” when investors require a risk premium on US debt.

 

Table 3, 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

 

An important fact of Table 3 is that outlays remain above 20 percent of GDP indefinitely. The only similar episode in the past four decades is in the 1980s. Table 4 provides federal government outlays, revenue, deficit and debt as percent of GDP from 1980 to 1989. The concern arises from the fact that the highest revenue to GDP ratio in the past four decades was 20.6 percent of GDP in 2000. Federal outlays above 20 percent of GDP cannot be effectively taxed as shown by US historical statistics. The major difference of the experience in the 1980s with that after 2009 is the much higher rate of economic growth in the 1980s (http://cmpassocregulationblog.blogspot.com/2011/05/mediocre-growth-world-inflation.html) that maintained revenues closer to 20 percent of GDP. Nevertheless, debt as percent of GDP rose by 14.5 percentage points from 26.1 percent of GDP in 1980 to 40.6 percent of GDP in 1989. The ratio of federal debt to GDP rose to a peak of 49.1 percent of GDP in 1994, declining to 34.7 percent of GDP in 2000 and staying below the peak of 36.9 percent of GDP in 2001 to 2007.

 

Table 4, Federal Government Outlays, Revenue, Deficit and Debt as Percent of GDP 1980-1989

	Outlays % GDP	Revenue % GDP	Deficit % GDP	Debt % GDP
1980	21.7	19.0	-2.7	26.1
1981	22.2	19.6	-2.6	25.8
1982	23.1	19.2	-4.0	28.7
1983	23.5	17.5	-6.0	33.1
1984	22.2	17.3	-4.8	34.0
1985	22.8	17.7	-5.1	36.4
1986	22.5	17.5	-5.0	39.5
1987	21.6	18.4	-3.2	40.6
1988	21.3	18.2	-3.1	41.0
1989	21.2	18.4	-2.8	40.6

Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/HistoricalTables[1].pdf

 

The unparalleled fiscal imbalance has been accompanied by the highest monetary policy accommodation in US history. As shown in Table 5, base money has swollen from $829 billion in Dec 2007 to $2494 billion in Apr 2011, by $1665 billion, for an increase of a multiple of 3 or 200.8 percent. At least de facto, monetary policy has been coordinated with fiscal policy.

 

Table 5, Total Reserves of Depository Institutions (R) and Base Money (B)  (Dollar Billions Not Seasonally Adjusted)

	R	∆%	B	∆%
D-2003	42		752
D-2004	46	9.5	765	1.7
D-2005	45	-2.2	793	3.7
D-2006	43	-4.4	818	3.2
D-2007	43	0	829	1.3
D-2008	820	1806.9	1659	100.1
D-2009	1139	38.9	2022	21.9
D-2010	1078	-5.3	2014	-0.4
Apr 2011	1528	41.7	2494	23.8

Source: http://www.federalreserve.gov/releases/h3/hist/h3hist1.pdf

 

Neumann (1992, 33, 36) states:

“If the security dealers do not hold but resell the Treasury securities to Reserve Banks after a short duration, it is, in fact, the Fed that supplies the borrowed funds to the Treasury. At the same time, these transactions permit the security dealers to buy another load of new debt from the Treasury…The dominating source component of fiscal seigniorage is the outright acquisition of government securities by the Fed…The seigniorage flow to government must not be identified with the Fed’s payment of ‘interest on Federal Reserve notes.’ In servicing the debt held by the Fed, the Treasury makes interest payments of roughly the same order of magnitude as the Fed pays to the Treasury. Indeed, the Fed’s portfolio of US government securities can be interpreted as an interest-free loan to the Treasury.”

Another form of viewing this issue is that to the extent that monetary policy of issuing $1.7 trillion of base money to acquire a portfolio of securities of $2.5 trillion was successful in lowering the rate paid on government securities, the government collected seigniorage from holders of government securities at home and abroad by the difference on what interest rates would have been without the target on fed funds rate of zero percent and quantitative easing. An issue of the exit strategy of the Fed is the impact of higher interest costs of Treasury debt that may affect the sustainability of the federal debt or the capacity to continue financing the US government with the “exorbitant privilege” deriving from use of the dollar as international reserve that allows the US to fund internationally at cheaper rates in its own dollar-denominated liabilities (Gourinchas and Rey 2005, Eichengreen 2011; see Pelaez and Pelaez, The Global Recession Risk (2007), 14, 44-7).

Is there a “tipping” or “explosion” point of that “exorbitant privilege”? The coordination deliberate or de facto of monetary and fiscal policy does resemble that during the Great Inflation (Meltzer 2005, 2010a, 2010b; see http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html). Sargent and Wallace (1981, 6) show how such coordination can result in a perverse example:

“This example is spectacular in that the easier, or looser, monetary policy is uniformly better than the tighter policy. In this example, the tighter current monetary policy fails to even temporarily reduce inflation below the level it would be under the looser policy.”

IIB2 Unpleasant Fiscal Arithmetic. An interesting analogy of the “fiscal theory of the price level” is provided by Cochrane (2005). In that analogy, the stock of Microsoft is the numeraire in which case the prices of goods are expressed as fractions of a share of Microsoft. Financial obligations are expressed as promises to pay in terms of fractions of Microsoft shares. In particular, bonds are obligations to pay specified numbers of Microsoft shares at a future date. The argument by Cochrane (2005, 502) is that “such a monetary system can establish a well-determined price level.” The price level can be understood in terms of the “usual stock valuations equation” (Cochrane 2005, 502):

Number of shares/price level =

Expected present value of future dividends or earnings (4)

The rationale for the price level, expressed in number of shares per good, as denominator on the left-hand side of (4) is that it is the inverse of the price of a share. Microsoft stock is a residual claim to its earnings. The analogy of Cochrane (2005, 502) is that “the fiscal theory of the price level recognizes that nominal debt, including the monetary base, is a residual claim to government primary surpluses, just as Microsoft stock is a residual claim to Microsoft’s earnings.” There are two alternatives to the government if the primary surpluses are not sufficient: default or reduce the value of the debt by inflation. This analysis leads to the
“valuation equation for government debt” (Cochrane 2005, 502):

Nominal government debt/Price level

= Expected present value of primary surpluses (5)

An important issue in the fiscal theory of the price level is the budget constraint in equation (1). The analysis of Sargent and Wallace (1981) consists of two equations, formulated by Cochrane (2011Jan, 2) as:

(M_t + B_t)/P_t = E_t∫(Λ_t+τ/Λ_t)(T_t+τ – G_t+τ)dτ (6)

Equation (6) is the intertemporal budget constraint expressing the monetary liabilities of the government, M_t, at time t, plus government debt, B_t, scaled by the price level, P_t, in terms of the expected value discounted by a stochastic discount, Λ, of the primary surplus equal to the difference between tax revenue including seigniorage, T, and government expenditure, G, with the integral from 0 to ∞. The second equation (7) completes the model of Sargent and Wallace (1981), formulated by Cochrane (2011Jan) as:

M_tV(i_t, ·) = P_tY_t (7)

In this equation, V is velocity that depends on the nominal interest rate, i_t, and other variables.

Two controversies have dominated the debate on the fiscal theory of the price level (Bassetto 2008; see Kocherlakota and Phelan 1999). (1) The price level is defined as the inverse of money but the fiscal theory is concerned with the price level as an inverse relation with the value of government debt. (2) In what is called “Ricardian rule” the intertemporal budget constraint in equations (1) and (6) is assumed to hold all the time, but the fiscal theory of the price level assumes that equations (1) and (6) hold only in equilibrium (Christiano and Fitzgerald 2000, 3), which is called the “non-Ricardian rule.” The monetarist arithmetic finds that if fiscal policy dominates monetary policy and there are expectations of inflation, the monetary authority does not have control over current and future inflation. The fiscal theory of the price level concludes that inflation is a fiscal instead of a monetary phenomenon such that inflation results from changes in the valuation of government debt such that monetary policy has no influence on inflation or for that matter deflation.

Buiter (2002EJ, 2007) argues that the intertemporal budget constraint must hold at all times and not only in equilibrium (see an alternative critique by Niepelt 2004). Buiter (2007, 460) defines a ”fiscal-financial monetary programme (FFMP)” as “a complete set of rules specifying spending, taxes, transfers, money issuance (seigniorage) and bond issuance in each period.” The government is defined by Buiter (2002EJ, 460) as including the general government, that is, central government plus all state and local levels, and the central bank. In the Ricardian rule, following Buiter (2002EJ, 461), the government intertemporal constraint or solvency rule of equations (1) and (6) must hold for all sequences of variables that enter into the constraint. The government is either restricted to FFMPs that always meet contractual debt obligations or it fails to satisfy its contractual debt obligations. The government intertemporal budget constraint in the Ricardian rule “becomes a pricing kernel for the public debt, determining the effective value of the public debt and overriding its notional or contractual value” (Buiter 2002EJ, 461). In the non-Ricardian rule, the government intertemporal budget constraint holds only in equilibrium and the government is required to meet its obligations. There are two cases of the Ricardian rule: (1) the FFMP must leave one degree of freedom to meet exactly the government’s contractual debt obligations; or (2) without degrees of freedom the government cannot meet its contractual obligations, resulting in partial or complete default or “supersolvency.” There is a third case in the non-Ricardian rule of the fiscal theory of the price level in which there are no degrees of freedom but the contractual debt obligations of the government must be met exactly. The non-Ricardian rule of the fiscal theory of the price level results in an over determined FFMP. As a result, “once the possibility of explicit default is properly allowed for, non-Ricardian regimes become Ricardian regimes and the fiscal theory of the price level vanishes” (Buiter 2002EJ, 478).

Buiter (2002EJ, 468) also concludes that:

“In the Unpleasant Monetarist Arithmetic model, the government meets its contractual debt obligations exactly. The Sargent and Wallace FFMP therefore represents a Ricardiam FFMP with contract fulfillment. The Sargent-Wallace FFMP respects the proper roles of budget constraints and equilibrium conditions and is not an example of the FTPL confusion at work.”

Monetary economists have not been highly interested in fiscal issues especially after the Great Moderation because of the decline of volatility of output growth and inflation (Bernanke 2004). Rogoff (2006, 14) finds a decline in quarterly output growth volatility of the US by 50 percent from the 1970s to the 1990s and first half of the 2000s. Inflation declined and monetary policy was assumed victorious in its control. Asset price volatility continued even with the decline of real output volatility (Rogoff 2006). There is a break currently as observed by Cochrane (2011Jan, 2):

“These are new times, with massive fiscal deficits, credit guarantees, and Federal Reserve purchases of risky private assets. At some points fiscal constraints must take hold. There is a limit to how much taxes a government can raise, a top of a Laffer curve, a fiscal limit to monetary policy. At that point, inflation must result, no matter how valiantly the central bank attempts to split government liabilities between money and bonds. Long before that point, the government may choose to inflate rather than further raise distorting taxes or reduce politically important spending.”

The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:

(M_t + B_t)/P_t = E_t∫(1/R_{t, t+τ})s_t+τdτ (8)

Equation (8) expresses the monetary, M_t, and debt, B_t, liabilities of the government, divided by the price level, P_t, in terms of the expected value discounted by the ex-post rate on government debt, R_{t, t+τ}, of the future primary surpluses s_t+τ, which are equal to T_t+τ – G_t+τ in equation (6) or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post R_{t, t+τ}. The second equation of Cochrane (2011Jan, 5) is:

M_tV(i_t, ·) = P_tY_t (9)

This is the same as equation (7) and could also include demand deposits. Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (9), which deprives the debt valuation equation (8) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):

“We are here to think about what happens when [8] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [8] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [9]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [8] determines the price level.”

An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.

There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:

(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress

(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality

(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations

Inflation and unemployment in the period 1966 to 1985 is analyzed by Cochrane (2011Jan, 23) by means of a Phillips circuit joining points of inflation and unemployment. The same Chart 1 for Brazil that is published in Pelaez (1986, 94-5) was reprinted in The Economist in the issue of Jan 17-23, 1987. Cochrane (2011Jan, 23) argues that the Phillips circuit shows the weakness in Phillips curve correlation. The explanation is a shift in aggregate supply, rise in inflation expectations or loss of anchoring. The case of Brazil in Chart 1 cannot be explained without taking into account that the increase in the fed funds rate to 22 percent in 1981 in the Volcker Fed precipitated the moratorium on a foreign debt bloated by financing balance of payments deficits with bank loans in the 1970s; the loans were used in projects, many of state-owned enterprises with low present value in long gestation. The combination of the insolvency of the country because of debt higher than its ability of repayment and the huge government deficit with declining revenue as the economy contracted caused adverse expectations on inflation and the economy. Gordon (1985) provides an expectational Phillips curve to analyze the experience of the 1970s and early 1980s incorporating the supply shocks of that period. The reading of the Phillips circuits of the 1970s by Cochrane (2011Jan, 25) is doubtful about the output gap and inflation expectations:

“So, inflation is caused by ‘tightness’ and deflation by ‘slack’ in the economy. This is not just a cause and forecasting variable, it is the cause, because given ‘slack’ we apparently do not have to worry about inflation from other sources, notwithstanding the weak correlation of [Phillips circuits]. These statements [by the Fed] do mention ‘stable inflation expectations. How does the Fed know expectations are ‘stable’ and would not come unglued once people look at deficit numbers? As I read Fed statements, almost all confidence in ‘stable’ or ‘anchored’ expectations comes from the fact that we have experienced a long period of low inflation (adaptive expectations). All these analyses ignore the stagflation experience in the 1970s, in which inflation was high even with ‘slack’ markets and little ‘demand, and ‘expectations’ moved quickly. They ignore the experience of hyperinflations and currency collapses, which happen in economies well below potential.”

 

Chart 1. Phillips Circuit for Brazil 1963-1987 %

©Carlos Manuel Pelaez, O cruzado e o austral. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.

 

Professor Cochrane (2011Jan) does not provide a forecast but rather a scenario. In this scenario, the environment for inflation begins with slow growth, increasing taxes and uncertainty on economic policy. As it was true in the debt crisis of 1982, government budgets are squeezed by slow growth and a fortiori by economic contraction that prevents increasing government revenue. The government would face calls on its credit guarantees. Anticipations by investors would result in fire sales of government debt and assets denominated in dollars. A risk premium on US government debt could magnify the decline on that debt caused by inflation. Unpredictability of forecasting economic policy prevents forecasting economic and financial variables even if there were a true model of the economy and financial markets.

III Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 6 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 6, 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	-0.7***	0.3	2.2	4.7
China	9.7	5.3	6.8
UK	1.8	4.5* RPI 5.2	5.3* output 15.7* input 10.9**	8.0
Euro Zone	2.5	2.7	6.7	9.9
Germany	4.8	2.7	6.4	6.1
France	2.2	2.2	6.4	9.4
Nether-lands	3.2	2.2	11.7	4.2
Finland	5.8	3.4	8.5	8.0
Belgium	3.0	3.3	10.6	7.7
Portugal	-0.7	4.0	6.5	12.6
Ireland	-1.0	1.5	5.0	14.7
Italy	1.0	2.9	5.5	8.1
Greece	-4.8	3.7	7.9	15.1
Spain	0.8	3.5	7.3	20.7

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/ppi0611.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/gaiyou/main_1.pdf

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

 

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 HICP flash estimate for May is 2.7 percent (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-31052011-AP/EN/2-31052011-AP-EN.PDF). The euro area unemployment rate is estimated at 9.9 percent for Apr (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/3-31052011-BP/EN/3-31052011-BP-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 I Increasing Risk Aversion in this post and 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/slowing-growth-global-inflation-great.html 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.

Japan’s corporate goods price index (CGPI), formerly wholesale price index (WPI), fell 0,1 percent in May, after increasing 0.9 percent in Apr, increasing by 2.2 percent year-on-year, as shown in Table 7. The rate of increase for the first five months is equivalent to an annual rate of increase of 5.2 percent. These are very high rates of price increase for Japan.

 

Table 7, Japan Corporate Goods Price Index (CGPI)  ∆%

	Month	Year
May	-0.1	2.2
Apr	0.9	2.5
Mar	0.6	2.0
Feb	0.2	1.7
Jan	0.5	1.5

Source: http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1105.pdf

 

The 12 months rate of increase of the UK’s index of output prices are shown in Table 8. The percentage change of the index of all prices jumped from 4.2 percent in Dec 2010 to over 5 percent in the first five months of 2011, showing 5.5 percent in May. The percentage change in the total index excluding food, beverage and petroleum jumped from 2.7 percent in Dec 2010 to over 3 percent in the first five months of 2011, with 3.4 percent in May. The percentage change of the total index excluding taxes rose from 4.0 percent in Dec 2010 to more than 5 percent in the first five months of 2011, with 5.4 percent in May.

 

Table 8, UK Output Prices 12 Months   ∆% NSA

	All	Excluding Food, Beverage and Petroleum	All Excluding Duty
Dec 2010	4.2	2.7	4.0
2011
May	5.3	3.4	5.4
Apr	5.5	3.6	5.7
Mar	5.6	3.1	5.5
Feb	5.3	3.1	5.2
Jan	5.0	3.3	5.0

Source: http://www.statistics.gov.uk/pdfdir/ppi0611.pdf

 

UK’s input prices rose at the 12-month rate of increase of 15.7 percent in May and at 10.0 percent excluding food, tobacco, beverages and petroleum, as shown in Table 9. There has been an acceleration of input prices similar to that of output prices but the gap in rates of increase suggests a possible squeeze in profit margins. The highest rate of increase occurred in Apr with 17.9 percent for the total index and 10.9 percent with the exclusions. The decline in commodity prices especially petroleum appears to have had effects on the rhythm of input prices.

 

Table 9, UK Input Prices 12 Months  ∆% NSA

	Materials and Fuels Purchased	Excluding Food, Tobacco, Beverages and Petroleum
2010 Dec	13.1	9.0
2011
May	15.7	10.9
Apr	17.9	12.1
Mar	14.8	10.3
Feb	14.9	10.7
Jan	14.2	10.5

Source: http://www.statistics.gov.uk/pdfdir/ppi0611.pdf

 

Euro zone industrial producer prices rose 0.9 percent in Apr and 6.7 percent in 12 months as shown in Table 10. The total excluding energy rose a high 4.4 percent in 12 months and 0.4 percent in Apr. Inflation was highest in energy with an increase of 2.0 percent in Apr and 13.3 percent in 12 months. There were milder increases in durable and non-durable consumer goods but still high by relatively high percentages.

 

Table 10, Euro Zone Industrial Producer Prices ∆%

	Apr	12 months Apr
Total excluding construction	0.9	6.7
Total excluding construction and energy	0.4	4.4
Intermediate goods	0.6	7.3
Energy	2.0	13.3
Capital goods	0.1	1.3
Durable consumer goods	0.2	2.0
Non-durable consumer goods	0.5	3.4

Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-06062011-AP/EN/4-06062011-AP-EN.PDF

 

The argument by Lorenzo Bini Smaghi (2011Jun1, 2011Mar4; see http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html) that inflation of food and energy has been increasing on a strong long-term trend and not in transitory surges with quick reversals is supported by Table 11. As argued by Smaghi (2011Jun1) inflation of food prices rose steadily at the average rate of 7.5 percent during the past decade with interruptions only in 2002 and 2009. The 12 months rates of increases in the first five months of 2011 have ranged from a low of 32.4 percent in Jan to 42.2 percent in Apr.

 

Table 11, Food Price Index of the Food and Agriculture Organization ∆%

	∆%
2001	3.3
2002	-3.2
2003	8.9
2004	14.3
2005	4.5
2006	8.5
2007	25.2
2008	25.8
2009	-21.5
2010	17.8
2010/2000	105.6
Average Yearly Percentage  Rate 2000-2010	7.5
∆% 12 months 2011
Jan	32.4
Feb	39.1
Mar	41.7
Apr	42.2
May	41.2

Source: http://www.fao.org/worldfoodsituation/wfs-home/foodpricesindex/en/ The 12 month rates Jan to Apr 2011 are from the Excel dataset that can be downloaded in that page. The percentage change for May is different in the two sources and unavailable in the site.

 

Table 12 provides the rates of increase of the final report on first quarter sales of wholesalers except manufacturers’ sales branches and offices. These data are not adjusted for price changes. The increase of total sales from IQ2010 to IQ2011 is 15.4 percent, 13.9 percent for durable goods and 16.4 percent for nondurable goods. There is a strong inflation component in these data.

 

Table 12, First Quarter Sales of Merchant Wholesalers Except Manufacturers’ Sales Branches and Offices, Billions of Dollars and %

	IQ2010 $ B	IQ2011 $ B	∆%
US Total	964	1112	15.4
Durable	429	489	13.9
Not Durable	535	623	16.4

Sources: http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf

 

Inflation is also showing in nominal dollar values of international trade. Table 13 provides Jan-Apr 2010 and Jan-Apr 2011 exports and imports in nominal dollar values and their percentage changes. Exports rose by 19.3 percent and imports by 18.3 percent. The only decline is for US exports of crude oil, which are $428 million and have share of only 0.09 percent in total exports of $480,663 million and the decline was caused by lower exported volume. All categories expanded by double digits percentages.

 

Table 13, Exports and Imports of  Goods, Not Seasonally Adjusted Millions of Dollars and %

	Jan- Apr 2011 $ Millions	Jan-Apr 2010 $ Millions	∆%
Exports	480,663	402,825	19.3
Manu- factured	310,411	275,852	12.5
Agricultural Commodities	49,342	37,020	33.3
Mineral Fuels	38,269	23,988	59.5
Crude Oil	428	635	-32.6
Imports	695,510	588,036	18.3
Manu- factured	500,636	427,005	17.2
Agricultural Commodities	32,628	27,182	20.0
Mineral Fuels	140,892	116,636	20.8
Crude Oil	101,831	83,470	21.9

Source: http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf

 

Inflation of prices of exports and imports in the 12 months ending in May and in annual equivalent for the first four months is shown in Table 14. There are major percentage changes in most categories with three exceptions for imports: (1) consumer goods, which would affect the CPI, rose by only 0.6 percent in 12 months but by 2.7 percent in annual equivalent; (2) capital goods rose 1.4 percent in 12 months and only 2.7 percent in annual equivalent; and (3) autos increased 2.3 percent in 12 months but 4.3 percent in annual equivalent. High increases in export prices are concentrated on agricultural goods with 30.1 percent in 12 months but 16.4 percent in annual equivalent in the first five months. Non-agricultural prices rose a high 7.0 percent in 12 months and 12.0 percent in annual equivalent in the first five months. The highest 12-month and five-month annual equivalent rates are for consumer goods excluding autos and nondurable manufactured consumer goods. There is inflation in prices of traded goods worldwide.

 

Table 14, Prices of Exports and Imports 12 Months May and Annual Equivalent Four Months Jan-May 2011, %

	12 Month  ∆%May 2011	Annual ∆%Equivalent Four Months Jan-May 2011
Imports	12.5	22.1
Fuel	42.3	84.6
Nonfuel	4.4	7.1
Capital Goods	1.4	2.7
Autos	2.3	4.3
Consumer Goods	0.6	2.7
Durables Manufactured	-0.4	3.7
Non-Manufactured Consumer Goods	6.3	10.3
Exports	9.0	12.3
Agricultural	30.1	16.4
Non-Agricultural	7.0	12.0
Industrial Supplies and Materials	18.8	28.6
Capital Goods	0.8	1.4
Autos, parts and engines	1.4	1.9
Consumer Goods Excluding Autos	3.2	4.2
Nondurable Manufactured	2.3	4.2
Durables Manufactured	3.1	0.7

Source: http://www.bls.gov/news.release/ximpim.nr0.htm

 

Table 15 provides estimates for sales of merchant wholesalers except manufacturers’ sales branches and offices unadjusted for seasonality and price changes in 12-month rates of increase. The high percentage changes unadjusted for price changes show again the progress of inflation throughout the production and distribution chain. Increases are higher for goods that use intensively commodities and raw materials, such as farm products, chemicals and petroleum and nondurable goods in general. There is also inflation in durable goods of 10.7 percent in 12 months, including 11.1 percent for automotive and 9.1 for computer equipment. Real wages and income of the population are being squeezed by inflation as well as earnings of individuals on fixed nominal income such as social security benefits, fixed nominal pensions and income from fixed-income financial products.

 

Table 15 , Estimates of Sales of Merchant Wholesalers Except Manufacturers’ Sales Branches and Offices Unadjusted for Seasonality and Price Change ∆%

	Apr 2011/Apr 2010 ∆%
US Total	14.4
Durable	10.7
Automotive	11.1
Computer Equipment	9.1
Nondurable	17.5
Groceries	9.2
Farm Products	49.6
Chemicals	12.6
Petroleum	39.2

Source: http://www2.census.gov/wholesale/pdf/mwts/currentwhl.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/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html 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 16 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 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
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 17 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 17 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 17, 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 18, 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 18. 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 2.973 percent at the close of market on Jun 10, 2011, would be equivalent to price of 97.0106 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 4.2 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 18 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 Jun 8, 2011, the line “Reserve Bank credit” in the Fed balance sheet stood at $2795 billion, or $2.8 trillion, with portfolio of long-term securities of $2564 billion, or $2.6 trillion, consisting of $1464 billion Treasury nominal notes and bonds, $63 billion of notes and bonds inflation-indexed, $119 billion Federal agency debt securities and $918 billion mortgage-backed securities; reserve balances deposited with Federal Reserve Banks reached $1660 billion or $1.7 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 3.00 percent on Mon Jun 6 to 2.973 percent on Fri Jun 10 while the yield of the 10-year German government bond fell from 3.07 percent on Tue May 24 to 2.96 percent on Fri Jun 10 (http://noir.bloomberg.com/markets/rates/germany.html). Risk aversion from various sources, discussed in section I, 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 18, 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
06/03/11	2.990	96.8672	-4.3
06/10/11	2.973	97.0106	-4.2

Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates and the coupon of 2.625% on 11/04/10

Source:

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

 

IV Hiring Collapse. An appropriate measure of job stress is considered by Blanchard and Katz (1997, 53):

“The right measure of the state of the labor market is the exit rate from unemployment, defined as the number of hires divided by the number unemployed, rather than the unemployment rate itself. What matters to the unemployed is not how many of them there are, but how many of them there are in relation to the number of hires by firms.”

The natural rate of unemployment and the similar NAIRU are quite difficult to estimate in practice (Ibid; see Ball and Mankiw 2002).

The Bureau of Labor Statistics (BLS) created the Job Openings and Labor Turnover Survey (JOLTS) with the purpose that (http://www.bls.gov/jlt/jltover.htm#purpose):

“These data serve as demand-side indicators of labor shortages at the national level. Prior to JOLTS, there was no economic indicator of the unmet demand for labor with which to assess the presence or extent of labor shortages in the United States. The availability of unfilled jobs—the jobs opening rate—is an important measure of tightness of job markets, parallel to existing measures of unemployment.”

The BLS collects data from about 16,000 US business establishments in nonagricultural industries through the 50 states and DC. The data are released monthly and constitute an important complement to other data provided by the BLS.

Hiring in the nonfarm sector (HNF) has declined from 64.9 million in 2006 to 47.2 million in 2010 or by 17.7 million while hiring in the private sector (HP) has declined from 60.4 million in 2006 to 43.3 million in 2010 or by 17.1 million, as shown in Table 19. The ratio of nonfarm hiring to unemployment (RNF) has fallen from 47.7 in 2006 to 36.4 in 2010 and in the private sector (RHP) from 52.9 in 2006 to 40.3 in 2010 (http://cmpassocregulationblog.blogspot.com/2011/03/slow-growth-inflation-unemployment-and.html).

 

Table 19, Annual Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US and Percentage of Total Employment

	HNF	Rate RNF	HP	Rate HP
2001	63,766	48.4	59,374	53.6
2002	59,797	45.9	55,665	51.1
2003	57,787	44.5	54,082	49.9
2004	61,624	46.9	57,534	52.4
2005	64,498	48.2	60,444	54.0
2006	64,870	47.7	60,419	52.9
2007	63,326	46.0	58,760	50.9
2008	53,986	39.5	50,286	44.0
2009	45,372	34.7	41,966	38.8
2010	47,234	36.4	43,299	40.3

Source: http://www.bls.gov/jlt/data.htm

 

Table 20 provides total HNF and HP in the month of Apr from 2001 to 2011. An important characteristic of the labor market in the US is that HNF has declined from 5.736 million in Apr 2006 to 4.289 million in Apr 2011, or by 1.447 million, and HP has fallen from 5.450 million in Apr 2006 to 4.099 million in Apr 2011, or by 1.351 million. HNF of 4.289 million in Apr 2011 is almost unchanged relative to 4.258 million in Apr 2010 and HP in Apr 2011 of 4.099 million is lower by 1.622 million than 5.721 million in Apr 2001. The US labor market is fractured, creating fewer opportunities to exit job stress of unemployment and underemployment of 24 to 30 million people and declining inflation-adjusted wages in the midst of fast increases in prices of everything (http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html http://cmpassocregulationblog.blogspot.com/2011/05/job-stress-of-24-to-30-million-falling.html http://cmpassocregulationblog.blogspot.com/2011/04/twenty-four-to-thirty-million-in-job_03.html).

 

Table 20, Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US in Thousands and in Percentage of Total Employment in Apr Not Seasonally Adjusted

	HNF	Rate RNF	HP	Rate HP
2001 Apr	6006	4.5	5721	5.2
2002 Apr	5575	4.3	5299	4.9
2003 Apr	5256	4.0	5019	4.7
2004 Apr	5705	4.4	5457	5.0
2005 Apr	5890	4.4	5620	5.1
2006 Apr	5736	4.2	5450	4.8
2007 Apr	5820	4.2	5522	4.8
2008 Apr	5036	3.7	4802	4.2
2009 Apr	4095	3.1	3762	3.5
2010 Apr	4258	3.3	3972	3.7
2011 Apr	4289	3.3	4099	3.8

Source: http://www.bls.gov/jlt/data.htm

 

The Bureau of Labor Statistics (BLS) also calculates alternative measures of labor underutilization for the US and all states. Table 21 shows six measure of underutilization described in the note to Table 21. There is dramatic rise in the broad measure of labor underutilization, U6, or total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons as percent of the labor force plus all marginally attached workers. This blog provides the numerator of U6 after the release of every employment situation report by the BLS. The number for May is 24.688 million in job stress (see Table 1 in http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html) but using a different rate of participation of the population in the labor force the number could be 29.664 million (see Table 2 and discussion in http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html).

 

Table 21, Alternative Measures of Labor Underutilization %

	U1	U2	U3	U4	U5	U6
IIQ10 to IQ11	5.6	5.8	9.4	10.1	10.9	16.5
2010	5.7	6.0	9.6	10.3	11.1	16.7
2009	4.7	5.9	9.3	9.7	10.5	16.2
2008	2.1	3.1	5.8	6.1	6.8	10.5
2007	1.5	2.3	4.6	4.9	5.5	8.3
2006	1.5	2.2	4.6	4.9	5.5	5.6

Note: LF: labor force; U1, persons unemployed 15 weeks % LF; U2, job losers and persons who completed temporary jobs %LF; U3, total unemployed % LF; U4, total unemployed plus discouraged workers, plus all other marginally attached workers; % LF plus discouraged workers; U5, total unemployed, plus discouraged workers, plus all other marginally attached workers % LF plus all marginally attached workers; U6, total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons % LF plus all marginally attached workers

Source: http://www.bls.gov/lau/stalt11q1.htm

 

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 22 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 22 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 20.4 percent by Fri Jun 10, 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 22 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 22, 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	06/10 /2011
Rate	1.1423	1.5914	1.192	1.435
CNY/USD	01/03 2000	07/21 2005	7/15 2008	06/10 2011
Rate	8.2798	8.2765	6.8211	6.4804
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 22A extracts four rows of Table 22 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 24, the dollar has devalued again to USD 1.435/EUR or by 20.4 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 6.4804/USD on Jun 10, 2011, or by an additional 4.9 percent, for cumulative revaluation of 21.7 percent.

 

Table 22A, 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	06/10 /2011
Rate	1.1423	1.5914	1.192	1.435
CNY/USD	01/03 2000	07/21 2005	7/15 2008	06/10 2011
Rate	8.2798	8.2765	6.8211	6.4804

Source: Table 22.

 

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 23. 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 23, 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 22 after the first policy round of near zero fed funds and quantitative easing by the equivalent of 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, falling real 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 24, which is updated for every comment, shows the deep contraction of valuations 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 06/10/11” with all risk financial assets in the range from 9.2 percent for European stocks to 33.6 percent for the DJ UBS Commodities Index, excluding Japan that has currently weaker performance of 7.8 percent because of the earthquake/tsunami, while the dollar devalued by 20.4 percent and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 6/10/2011” shows the sharp fall of most risk financial assets, with the exception of decline of commodities by a milder 0.2 percent. There is a fundamental change in Table 24 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2011. That change is best perceived in the column “∆% Peak to 6/10/11” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event. Most financial risk assets had gained not only relative to the trough as shown in column “∆% Trough to 6/10/11” but also relative to the peak in column “∆% Peak to 6/10/11.” There are multiple indexes below the peak: NYSE Finance by 10.8 percent, Dow Global by 0.8 percent, Nikkei Average by 16.5 percent but mostly because of the earthquake/tsunami, Shanghai Composite by 14.5 percent and Stoxx 50 by 7.5 percent. The only gainers relative to the peak in Apr 2010 are: Dax by 11.6 percent, Asia Pacific by 3.6 percent, S&P 500 by 4.4 percent, DJIA by 6.7 percent and the DJ UBS Commodities Index by 14.2 percent. The factors of risk aversion have adversely affected the performance of financial risk assets. 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 24, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 6/ 10/11	∆% Week 6/ 10/11	∆% Trough to 6/ 10/11
DJIA	4/26/ 10	7/2/10	-13.6	6.7	-1.6	23.4
S&P 500	4/23/ 10	7/20/ 10	-16.0	4.4	-2.2	24.3
NYSE Finance	4/15/ 10	7/2/10	-20.3	-10.8	-2.9	11.9
Dow Global	4/15/ 10	7/2/10	-18.4	-0.8	-2.4	21.6
Asia Pacific	4/15/ 10	7/2/10	-12.5	3.6	-1.3	18.3
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-16.5	0.2	7.8
China Shang.	4/15/ 10	7/02 /10	-24.7	-14.5	-0.8	13.5
STOXX 50	4/15/10	7/2/10	-15.3	-7.5	-1.8	9.2
DAX	4/26/ 10	5/25/ 10	-10.5	11.6	-0.6	24.7
Dollar Euro	11/25 2009	6/7 2010	21.2	5.2	-1.9	-20.4
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	14.2	-0.2	33.6
10-Year Tre.	4/5/ 10	4/6/10	3.986	2.973

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 25 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. The stock market of the US then entered a period of six consecutive weekly declines. 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. In the fifth consecutive week of declines in the week of Fri June 3, the DJIA fell 2.3 percent, reducing the cumulative gain to 8.4 percent, and the S&P 500 also lost 2.3 percent, resulting in cumulative gain of 7.3 percent. The DJIA lost another 1.6 percent and the S&P 500 also 2.2 percent in the week of Jun 10, reducing the cumulative gain to 6.7 percent for the DJIA and of 4.9 percent for the S&P 500. The DJIA has lost 6.7 percent between Apr 29 and Jun 10, 2011, and the S&P 500 has lost 6.8 percent.

 

Table 25, 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
Jun 3	-2.3	8.4	-2.3	7.3
Jun 10	-1.6	6.7	-2.2	4.9

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

 

Table 26, 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 26, Exchange Rates

	Peak	Trough	∆% P/T	Jun 10 2011	∆% T Jun  10 2011	∆% P Jun 10 2011
EUR USD	7/15 2008	6/7 2010		6/10 2011
Rate	1.59	1.192		1.435
∆%			-33.4		16.9	-10.8
JPY USD	8/18 2008	9/15 2010		6/10 2011
Rate	110.19	83.07		80.31
∆%			24.6		3.3	27.1
CHF USD	11/21 2008	12/8 2009		6/10 2011
Rate	1.225	1.025		0.842
∆%			16.3		17.9	31.3
USD GBP	7/15 2008	1/2/ 2009		6/10 2011
Rate	2.006	1.388		1.622
∆%			-44.5		14.4	-23.7
USD AUD	7/15 2008	10/27 2008		6/10 2011
Rate	1.0215	1.6639		1.053
∆%			-62.9		42.9	7.0
ZAR USD	10/22 2008	8/15 2010		6/10 2011
Rate	11.578	7.238		6.801
∆%			37.5		6.0	41.3
SGD USD	3/3 2009	8/9 2010		6/10 2011
Rate	1.553	1.348		1.237
∆%			13.2		8.2	20.3
HKD USD	8/15 2008	12/14 2009		6/10 2011
Rate	7.813	7.752		7.784
∆%			0.8		-0.4	0.4
BRL USD	12/5 2008	4/30 2010		6/10 2011
Rate	2.43	1.737		1.597
∆%			28.5		8.1	34.3
CZK USD	2/13 2009	8/6 2010		6/10 2011
Rate	22.19	18.693		16.843
∆%			15.7		9.9	24.1
SEK USD	3/4 2009	8/9 2010		6/10 2011
Rate	9.313	7.108		6.323
∆%			23.7		11.0	32.1
CNY USD	7/20 2005	7/15 2008		6/10 2011
Rate	8.2765	6.8211		6.4804
∆%			17.6		4.9	21.7

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. Table 27 provides the data on consumer credit in the Fed report. The rate of growth of total consumer credit in the quarter Feb to Apr has been around 3 percent in seasonally-adjusted annual equivalent, with 3.1 percent in Apr after the decline to 2.4 percent in Mar. Growth originated mostly in nonrevolving credit increasing at the annual equivalent rate of 5.3 percent in Apr while revolving credit fell at the annual rate of 1.4 percent. There is here a combination of the effects of the Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD) (http://www.gpo.gov/fdsys/pkg/PLAW-111publ24/pdf/PLAW-111publ24.pdf) that reduced credit limits and increased interest rates for most cardholders while cards of many debtors with lower credit scores were cancelled together with the flight to thriftiness by debtors because of economic and tax uncertainties.

 

Table 27, Consumer Credit Seasonally Adjusted Annual Percentage Rate and Billions of Dollars

	1Q2011	Feb	Mar	Apr
∆%
Total	2.4	3.2	2.4	3.1
Revol-ving	-4.8	-6.2	0.1	-1.4
Non-revol -ving	6.0	7.9	3.5	5.3
$ Billions
Total	2421.9	2417.1	2421.9	2428.3
Revol-ving	791.1	791.0	791.1	790.1
Non-revol -ving	1630.9	1626.1	1630.9	1638.1

Source: http://www.federalreserve.gov/releases/g19/current/g19.htm

 

Table 28 provides important data in the weekly report by the Energy Information Administration. The release of the report on Wed Jun 8 together with the lack of decision in the OPEC meeting helped the valuation of oil futures contract. Because of the drop of crude oil imports from 9037 thousand barrels per day on average in the week of May 27 to 8946 in the week of Jun 3, there was a draw on crude oil stocks that fell from 373.8 million barrels in the week of May 27 to 369.0 million barrels in the week of Jun 3. Higher use of refinery capacity caused an increase in the stocks of motor gasoline and distillate fuel oil. The world crude oil price rose to $111.45/barrel in the week of Jun 3, which is 57.0 percent higher than the price of $70.97/barrel in the week of Jun 4, 2010. The national price of regular motor gasoline was $3.891/gallon on Jun 6, which is higher by 42.8 percent than the price of $2.725/gallon on Jun 7, 2010.

 

Table 28, Energy Information Administration Weekly Petroleum Status Report

	Week Ending 06/03/11	Week Ending 05/27/11	Week Ending 06/04/10
Crude Oil Stocks Million B	369.0	373.8	361.4
Crude Oil Imports Thousand Barrels/Day	8,946	9,037	9,653
Motor Gasoline Million B	214.5	212.3	219.0
Distillate Fuel Oil Million B	140.9	140.1	154.8
World Crude Oil Price $/B	111.45	108.48	70.97
	06/06/11	05/30/11	06/07/10
Regular Motor Gasoline $/G	3.891	3.794	2.725

B: barrels; G: gallon

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

 

Initial claims for unemployment insurance seasonally adjusted rose by 1000 in the week of Jun 4 relative to the week of May 28, as shown in Table 29. The second column shows the actual numbers not seasonally adjusted with a decline of 16,990 claims to 364,507 in the week of Jun 4 from 381,497 in the week of May 28. The not seasonally adjusted number of claims is close to the level of 398,864 a year ago. The four-week moving average fell by 2750 claims.

 

Table 29, Initial Claims for Unemployment Insurance

	SA	NSA	4-week MA SA
Jun 4	427,000	364,507	424,000
May 28	426,000	381,497	426,750
Change	1,000	-16,990	-2,750
May 21	429,000	376,252	439,750
Prior Year	464,000	398,864	468,000

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

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

 

VI Interest Rates. The yield curve of the US shows very low nominal percentage yields: 0.04 three-months, 0.10 six months, 0.17 12 months, 0.40 two years, 0.71 three years, 1.56 five years, 2.26 seven years, 2.97 ten years and 4.18 thirty years. There is no current deflation or expectation of deflation. The real interest rate approximated by the difference between the nominal rate and the expectation of inflation is likely negative throughout the yield curve. Interest rates on government debt have been negative in real terms for several years in pursuit of deflation that never materialized or threatened. There are multiple adverse consequences for resource allocation and risk/return calculations from the policy of maintaining negative real rates of interest.

VII Conclusion. There is a much tougher environment of risk aversion. The world economy appears to be slowing but it is not yet evident if the slowdown will worsen. The US job market is fractured with job stress affecting 24 to 30 million. Inflation is eroding wages and fixed nominal incomes. (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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