World Inflation Waves and Monetary Policy, World Financial Turbulence and Economic Slowdown
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011
Executive Summary
I United States Inflation and Monetary Policy
IA Current Monetary Policy
IB United States Inflation
IC Conclusions
ID Quantitative Easing and Portfolio Rebalancing
II World Financial Turbulence
IIA Appendix on Sovereign Bond Valuation
III Global Inflation
IV World Economic Slowdown
IVA United States
IVB Japan
IVC China
IVD Euro Area
IVE Germany
IVF France
IVG Italy
IVH United Kingdom
V Valuation of Risk Financial Assets
VI Economic Indicators
VII Interest Rates
VIII Conclusion
References
Appendix I The Great Inflation
Executive Summary
This comment provides data on inflation in the US and relates it to the carry trades from zero interest rates to commodity futures. The carry trade fluctuates now in three waves in 2011 that are repeated in worldwide inflation. Unconventional monetary policy of zero interest rates and large-scale purchase of securities for the balance sheet of the central bank intends to lower long-term costs of borrowing to stimulate investment and consumption that can increase economic growth and employment. In practice, the central bank cannot direct the use of huge volumes of cash that can be borrowed at nearly zero interest rates to investment and consumption. Cheap cash has many alternative uses in allocations to a wide range of real and financial risk assets. Risk financial assets that can attract cheap cash include equities, emerging-market equities and fixed income, currencies, commodity futures and so on. The carry trade consists of short dollar and immediate-term fixed income jointly with long, highly-leveraged positions in risk financial assets. The carry trade is unwound during episodes of risk aversion such as the fears of repercussions in financial markets of disruption of European sovereign debt. Inflation in 2011 has been dominated by carry trades into commodity futures during periods of risk appetite that are unwound during periods of risk aversion.
The analysis of world inflation in this blog reveals three waves of inflation of producer and consumer prices. In the first wave from Jan to Apr of 2011, lack of risk aversion channeled cheap money into commodity futures, causing worldwide increase in inflation. In the second wave in May and Jun, risk aversion because of the sovereign debt crisis in Europe caused unwinding of the carry trade into commodity futures with resulting decline in commodity prices and inflation. In the third wave since Aug, alternations of risk aversion revived carry trades of commodity futures with resulting higher and lower inflation.
Table ES1 provides annual equivalent rates of inflation for producer prices indexes followed in this blog. The behavior of the US producer price index in 2011 shows neatly three waves. In Jan-Apr, without risk aversion, US producer prices rose at the annual equivalent rate of 17.3 percent. After risk aversion, producer prices increased in the US at the annual equivalent rate of 0.8 percent in May-Jul. Since Jul, producer prices have increased at the annual equivalent rate of 2.7 percent. Resolution of the European debt crisis would result in jumps of valuations of risk financial assets. Increases in commodity prices would cause the same high producer-price inflation experienced in Jan-Apr. There are seven producer-price indexes in Table ES1 showing very similar behavior in 2011. Zero interest rates without risk aversion cause increases in commodity prices that in turn increase input and output prices. Producer price inflation rose during the first part of the year for the US, China, Germany, France, Italy and the UK when risk aversion was contained. With the increase in risk aversion in May and Jun, inflation moderated as carry trades were unwound. Producer price inflation has returned since July, with alternating bouts of risk aversion.
Table ES1, Annual Equivalent Rates of Producer Price Indexes
| INDEX 2011 | AE ∆% |
| US Producer Price Index | |
| AE ∆% Jul-Oct | 2.7 |
| AE ∆% May-Jul | 0.8 |
| AE ∆% Jan-Apr | 17.3 |
| Japan Corporate Goods Price Index | |
| AE ∆% Jul-Oct | -2.4 |
| AE ∆% Jan-Apr | 7.1 |
| China Producer Price Index | |
| AE ∆% Jul-Oct | -1.8 |
| AE ∆% Jan-Jun | 20.4 |
| Germany Producer Price Index | |
| AE ∆% Jul-Oct | 4.6 |
| AE ∆% Jun-May | 1.2 |
| Jan-Apr | 7.1 |
| France Producer Price Index for the French Market | |
| AE ∆% Jul-Sep | 2.4 |
| AE ∆% May-Jun | -3.5 |
| AE ∆% Jan-Apr | 11.4 |
| Italy Producer Price Index | |
| AE ∆% Jul-Sep | 2.4 |
| AE ∆% Jun-May | -1.2 |
| AE ∆% Jan-April | 10.7 |
| UK Output Prices | |
| AE ∆% May-Oct | 2.0 |
| AE ∆% Jan-Apr | 12.0 |
| UK Input Prices | |
| AE ∆% Jul-Oct | -1.0 |
| AE ∆% May-Jun | -8.7 |
| AE ∆% Jan-Apr | 35.6 |
Sources: http://www.bls.gov/ppi/data.htm
http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1110.pdf
http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20111109_402764953.htm
http://www.insee.fr/en/themes/info-rapide.asp?id=25&date=20111031
http://www.istat.it/it/archivio/43892
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/october-2011/index.html
Annual equivalent consumer price inflation in the US in Jan-Apr reached 7.5 percent as carry trades raised commodity futures, as shown in Table ES2. Return of risk aversion in May to Jul resulted in annual equivalent inflation of 2.0 percent in May-Jul. Inflation then rose again in Jul-Oct to annual equivalent 3.3 percent with alternation of bouts of risk aversion. The three waves are neatly repeated in consumer price inflation for China, the euro zone, Germany, France, Italy and the UK. In the absence of risk aversion, zero interest rates with guidance now forever, induce carry trades that raise commodity prices.
Table ES2, Annual Equivalent Rates of Consumer Price Indexes
| Index 2011 | AE ∆% |
| US Consumer Price Index | |
| AE ∆% Jul-Oct | 3.3 |
| AE ∆% May-Jul | 2.0 |
| AE ∆% Jan-Apr | 7.5 |
| China Consumer Price Index | |
| AE ∆% Jul-Oct | 4.3 |
| AE ∆% Apr-Jun | 2.0 |
| AE ∆% Jan-Mar | 8.3 |
| Euro Zone Harmonized Index of Consumer Prices | |
| AE ∆% Aug-Oct | 5.3 |
| AE ∆% May-Jul | -2.4 |
| AE ∆% Jan-Apr | 5.2 |
| Germany Consumer Price Index | |
| AE ∆% Jul-Oct | 1.5 |
| AE ∆% May-Jun | 0.6 |
| AE ∆% Feb-Apr | 4.9 |
| France Consumer Price Index | |
| AE ∆% Jul-Oct | 0.8 |
| AE ∆% May-Jun | 1.2 |
| AE ∆% Feb-Apr | 6.6 |
| Italy Consumer Price Index | |
| AE ∆% Jul-Oct | 3.7 |
| AE ∆% May-Jun | 1.2 |
| AE ∆% Jan-Apr | 4.9 |
| UK Consumer Price Index | |
| AE ∆% Aug-Oct | 5.3 |
| AE ∆% May-Jul | 0.4 |
| AE ∆% Jan-Apr | 6.5 |
Sources: http://www.bls.gov/cpi/data.htm
http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20111109_402764943.htm
http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home
http://www.bdm.insee.fr/bdm2/choixCriteres.action?request_locale=en&codeGroupe=142
http://www.istat.it/it/archivio/45391
http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/october-2011/index.html
I United States Inflation and Monetary Policy. There are two distinguishing characteristics of current monetary policy: (1) symmetric targets; and (2) unconventional monetary policy. These two characteristics are discussed in turn in subsection IA Current Monetary Policy. Subsection IB United States Inflation provides data and analysis. Subsection IC Conclusions summarizes arguments. More technical analysis of monetary policy is available in Subsection ID Appendix Quantitative Easing and Portfolio Rebalancing for convenience of reference and in past comments of this blog, including http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html 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 )
IA Current Monetary Policy. There are two main principles of current monetary policy: (1) symmetric inflation targets; and (2) unconventional monetary policy.
A. Symmetric Targets. The current view of the Federal Open Market Committee (FOMC) intends to restrain inflation “to a rate at or below the 2 percent or a bit less that most FOMC participants consider to be consistent with the Committee’s dual mandate to promote maximum employment and price stability” (Bernanke 2011Sep8). In this view, there are two types of risks: (1) inflation declines below 2 percent; and (2) inflation increases above 2 percent.
1. Inflation below 2 percent. There are two arguments in favor of preventing inflation from declining below 2 percent.
i. Room for Interest Rate Policy. If inflation declines below 2 percent, the central bank may not have sufficient space to lower interest rates that would maintain maximum employment by stimulating consumption and investment or aggregate demand. Nominal interest rates cannot decline below zero or what is called the zero bound. The nominal rate of interest denoted by i must always be nonnegative, that is, i ≥ 0 (Hicks 1937, 154-5):
“If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently, the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall”
ii. Fear of Deflation. Inflation declining below 2 percent could pose the risk of deflation. There have been two episodes in which the central bank has been concerned with deflation. First, there was fear of deflation in 2003 that motivated maintaining the fed funds rate at 1 percent from Jun 2003 to Jun 2004 (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, Pelaez and Pelaez, The Global Recession Risk (2007) 83-95). Second, there was fear of deflation that motivated maintaining the fed funds rate at 0 to ¼ percent since Dec 16, 2008.
2. Inflation above 2 percent. There is fear of inflation above 2 percent because the central bank could lose credibility in preventing even higher inflation. The relevant historical experience is the Great Inflation of the 1960s and 1970s during which the economy moved in “stop and go” bursts that created the term stagflation (see 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 and Appendix I The Great Inflation to this comment). Central banking is concerned with “anchoring” inflation expectations to prevent the repetition of that experience (Bernanke 2003, 9-10):
“The upshot is that the deep 1973-75 recession was caused only in part by increases in oil prices per se. An equally important source of the recession was several years of over expansionary monetary policy that squandered the Fed's credibility regarding inflation, with the ultimate result that the economic impact of the oil producers' actions was significantly larger than it had to be. Instability in both prices and the real economy continued for the rest of the decade, until the Fed under Chairman Paul Volcker re-established the Fed's credibility with the painful disinflationary episode of 1980-82. This latter episode and its enormous costs should also be chalked up to the failure to keep inflation and inflation expectations low and stable.”
3. Policy Objectives. Central banking in this view considers a symmetric inflation target. Inflation should not deviate above or below 2 percent. Inflation below 2 percent prevents the use of monetary policy of lowering interest rates to maintain maximum employment because the fed funds rate cannot be set below zero, which means that a borrower would be paid interest for borrowing. There is the added fear that inflation could become negative, depreciating collateral in loans that would deteriorate balance sheets of banks (Fisher 1933, Bernanke 1983; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), section Debt Deflation Theories, 200-1). Thus, the central bank should be prepared to prevent deflation. Inflation accelerating above 2 percent may be difficult to control. The objective of this section is to provide current inflation in the US and evidence in the past three decades that permits understanding of the symmetric targets of central banking.
B. Unconventional Monetary Policy. There are two measures of unconventional monetary policy: (1) zero central bank policy rates; and (2) quantitative easing.
1. Zero central bank policy rates. If the value of collateral given in pledge for a loan depreciates during deflation the borrower would be unable to repay the loan contracted at a higher interest rate. Suppose land worth $1 million is pledged as collateral for a loan. If property values depreciate, land would be worth less than $1 million, deteriorating the quality of the loan because the lender would not recover the principal in the event of default. Depreciation of the collateral of borrowers impairs balance sheets of lending banks, which could result in a financial crisis. In the imminence of inflation the central bank can set the policy rate at or near zero to compensate for the deterioration of collateral of borrowers. This policy measure has been used in two occasions.
i. Fear of deflation in 2003. At the meeting on Jun 25, 2003, the FOMC “decided to lower its target for the federal funds rate by 25 basis points to 1 percent” (http://www.federalreserve.gov/boarddocs/press/monetary/2003/20030625/default.htm). The statement was crafted to include the phrase that subdued inflation would warrant the 1 percent policy rate “for the foreseeable future.” The fed funds rate was maintained at 1 percent until the meeting on Jun 30, 2004, when the FOMC “decided to raise its target for the federal funds rate by 25 basis points to 1 ¼ percent” (http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm).
ii. Fear of deflation in 2008. On Dec 16, 2008, “The Federal Open Market Committee decided to establish a target range for the federal funds rate of 0 to ¼ percent. The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time” (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). At the meeting on Sep 21, 2011, the FOMC “decided to keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2011” (http://www.federalreserve.gov/newsevents/press/monetary/20110921a.htm).
2. Quantitative easing. When fed funds rates reach zero, the central bank does not have the conventional measure of lowering interest rates in executing its policy mandate of maintaining maximum employment. Quantitative easing consists of the purchase of securities for the balance sheet of the central bank to increase their price that is equivalent to reducing their yields. Consider an example with data from the current ten-year Treasury note. Assume that there is no accrued interest. The coupon is 2.0 percent payable semiannually. Maturity is exactly in ten years. The price of the security is 100. Assume that the central bank purchases substantial amounts of the ten year note. The price, say, would rise to 102 because the government must bid up the price in large-scale purchases. The equivalent yield would be 1.7808 percent. The objective of this policy is to reduce the yield or cost of securities with maturity in ten years. Most credit is securitized in an asset-backed security, which consists of bundling in one bond a collection of loans of similar credit quality and maturity. If the yields of asset-backed securities decline, the cost of financing ten-year loans for investment and consumption also falls. Investors and consumers may decide to invest and consume because of the lower interest rate, which raises aggregate demand, economic growth and hiring. The central bank could also attempt to lower the costs in certain markets. For example, the central bank could lower mortgage costs by acquiring mortgage-backed securities that bundle mortgages of the same credit quality and maturity. Large-scale purchases of mortgage-backed securities could have the same effect of increasing their prices that is equivalent to reducing their yields or lowering mortgage rates. On Nov 16, 2011, the balance sheet of the Fed had $2597 billion of securities, or $2.6 trillion, consisting of $1580 billion of Treasury notes and bonds, $68 billion of inflation-indexed notes and bonds, $107 billion of federal agency debt securities and $842 billion of mortgage-backed securities; reserves of banks at the Federal Reserve were $1575 billion or $1.6 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). This large portfolio has been acquired in two rounds of quantitative easing followed by Let’s Twist Again monetary policy in Sep 2011 (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html).
IB United States Inflation. This section provides data on inflation in the US and relates it to the carry trades from zero interest rates to commodity futures. The carry trade fluctuates now in three waves in 2011 that are repeated in worldwide inflation. Unconventional monetary policy of zero interest rates and large-scale purchase of securities for the balance sheet of the central bank intends to lower long-term costs of borrowing to stimulate investment and consumption that can increase economic growth and employment. In practice, the central bank cannot direct the use of huge volumes of cash that can be borrowed at nearly zero interest rates to investment and consumption. Cheap cash has many alternative uses in allocations to a wide range of real and financial risk assets. Risk financial assets that can attract cheap cash include equities, emerging-market equities and fixed income, currencies, commodity futures and so on. The carry trade consists of short dollar and immediate-term fixed income jointly with long, highly-leveraged positions in risk financial assets. The carry trade is unwound during episodes of risk aversion such as the fears of repercussions in financial markets of disruption of European sovereign debt. Inflation in 2011 has been dominated by carry trades into commodity futures during periods of risk appetite that are unwound during periods of risk aversion.
The analysis of world inflation in this blog reveals three waves of inflation of producer and consumer prices. In the first wave from Jan to Apr of 2011, lack of risk aversion channeled cheap money into commodity futures, causing worldwide increase in inflation. In the second wave in May and Jun, risk aversion because of the sovereign debt crisis in Europe caused unwinding of the carry trade into commodity futures with resulting decline in commodity prices and inflation. In the third wave since Aug, alternations of risk aversion revived carry trades of commodity futures with resulting higher and lower inflation.
Table 1 provides annual equivalent rates of inflation for producer prices indexes followed in this blog. The behavior of the US producer price index in 2011 shows neatly three waves. In Jan-Apr, without risk aversion, US producer prices rose at the annual equivalent rate of 17.3 percent. After risk aversion, producer prices increased in the US at the annual equivalent rate of 0.8 percent in May-Jul. Since Jul, producer prices have increased at the annual equivalent rate of 2.7 percent. Resolution of the European debt crisis would result in jumps of valuations of risk financial assets. Increases in commodity prices would cause the same high producer-price inflation experienced in Jan-Apr. There are seven producer-price indexes in Table 1 showing very similar behavior in 2011. Zero interest rates without risk aversion cause increases in commodity prices that in turn increase input and output prices. Producer price inflation rose during the first part of the year for the US, China, Germany, France, Italy and the UK when risk aversion was contained. With the increase in risk aversion in May and Jun, inflation moderated as carry trades were unwound. Producer price inflation has returned since July, with alternating bouts of risk aversion.
Table 1, Annual Equivalent Rates of Producer Price Indexes
| INDEX 2011 | AE ∆% |
| US Producer Price Index | |
| AE ∆% Jul-Oct | 2.7 |
| AE ∆% May-Jul | 0.8 |
| AE ∆% Jan-Apr | 17.3 |
| Japan Corporate Goods Price Index | |
| AE ∆% Jul-Oct | -2.4 |
| AE ∆% Jan-Apr | 7.1 |
| China Producer Price Index | |
| AE ∆% Jul-Oct | -1.8 |
| AE ∆% Jan-Jun | 20.4 |
| Germany Producer Price Index | |
| AE ∆% Jul-Oct | 4.6 |
| AE ∆% Jun-May | 1.2 |
| Jan-Apr | 7.1 |
| France Producer Price Index for the French Market | |
| AE ∆% Jul-Sep | 2.4 |
| AE ∆% May-Jun | -3.5 |
| AE ∆% Jan-Apr | 11.4 |
| Italy Producer Price Index | |
| AE ∆% Jul-Sep | 2.4 |
| AE ∆% Jun-May | -1.2 |
| AE ∆% Jan-April | 10.7 |
| UK Output Prices | |
| AE ∆% May-Oct | 2.0 |
| AE ∆% Jan-Apr | 12.0 |
| UK Input Prices | |
| AE ∆% Jul-Oct | -1.0 |
| AE ∆% May-Jun | -8.7 |
| AE ∆% Jan-Apr | 35.6 |
Sources: http://www.bls.gov/ppi/data.htm
http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1110.pdf
http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20111109_402764953.htm
http://www.insee.fr/en/themes/info-rapide.asp?id=25&date=20111031
http://www.istat.it/it/archivio/43892
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/october-2011/index.html
Annual equivalent consumer price inflation in the US in Jan-Apr reached 7.5 percent as carry trades raised commodity futures, as shown in Table 2. Return of risk aversion in May to Jul resulted in annual equivalent inflation of only 2.0 percent in May-Jul. Inflation then rose again in Jul-Oct to annual equivalent 3.3 percent with alternation of bouts of risk aversion. The three waves are neatly repeated in consumer price inflation for China, the euro zone, Germany, France, Italy and the UK. In the absence of risk aversion, zero interest rates with guidance now forever, induce carry trades that raise commodity prices.
Table 2, Annual Equivalent Rates of Consumer Price Indexes
| Index 2011 | AE ∆% |
| US Consumer Price Index | |
| AE ∆% Jul-Oct | 3.3 |
| AE ∆% May-Jul | 2.0 |
| AE ∆% Jan-Apr | 7.5 |
| China Consumer Price Index | |
| AE ∆% Jul-Oct | 4.3 |
| AE ∆% Apr-Jun | 2.0 |
| AE ∆% Jan-Mar | 8.3 |
| Euro Zone Harmonized Index of Consumer Prices | |
| AE ∆% Aug-Oct | 5.3 |
| AE ∆% May-Jul | -2.4 |
| AE ∆% Jan-Apr | 5.2 |
| Germany Consumer Price Index | |
| AE ∆% Jul-Oct | 1.5 |
| AE ∆% May-Jun | 0.6 |
| AE ∆% Feb-Apr | 4.9 |
| France Consumer Price Index | |
| AE ∆% Jul-Oct | 0.8 |
| AE ∆% May-Jun | 1.2 |
| AE ∆% Feb-Apr | 6.6 |
| Italy Consumer Price Index | |
| AE ∆% Jul-Oct | 3.7 |
| AE ∆% May-Jun | 1.2 |
| AE ∆% Jan-Apr | 4.9 |
| UK Consumer Price Index | |
| AE ∆% Aug-Oct | 5.3 |
| May-Jul | 0.4 |
| Jan-Apr | 6.5 |
Sources: http://www.bls.gov/cpi/data.htm
http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20111109_402764943.htm
http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home
http://www.bdm.insee.fr/bdm2/choixCriteres.action?request_locale=en&codeGroupe=142
http://www.istat.it/it/archivio/45391
http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/october-2011/index.html
Key percentage average yearly rates of the US economy on growth and inflation are provided in Table 3 updated with release of new data. The choice of dates prevents the measurement of long-term potential economic growth because of two recessions from IQ2001 (Mar) to IVQ2001 (Nov) with decline of GDP of 0.4 percent and the drop in GDP of 5.1 percent in IVQ2007 (Dec) to IIQ2009 (June) (http://www.nber.org/cycles.html) followed with unusually low economic growth for an expansion phase after recession with the economy growing at the annual equivalent rate of 0.8 percent in the first half of 2011 (http://cmpassocregulationblog.blogspot.com/2011/10/us-growth-standstill-at-08-percent.html). Between 2000 and 2010, real GDP grew at the average rate of 1.6 percent per year, nominal GDP at 3.9 percent and the implicit deflator at 2.5 percent. The average rate of CPI inflation was 2.4 percent per year and 2.0 percent excluding food and energy. PPI inflation increased at 2.7 percent per year on average and at 1.6 percent excluding food and energy. There is also inflation in international trade. Import prices grew at 2.6 percent per year between 2000 and 2010 and 3.3 percent between 2000 and 2011. The commodity price shock is revealed by inflation of import prices of petroleum at 12.7 percent per year between 2000 and 2010 and at 14.4 percent between 2000 and 2011. The average growth rates of import prices excluding fuels are much lower at 1.8 percent for 2002 to 2010 and 2.1 percent for 2000 to 2011. Export prices rose at the average rate of 2.1 percent between 2000 and 2010 and at 2.5 percent in 2000 to 2011. What spared the US of sharper decade-long deterioration of the terms of trade, (export prices)/(import prices) was its diversification and competitiveness in agriculture. Agricultural export prices grew at the average yearly rate of 5.5 percent from 2000 to 2010 and at 6.0 percent from 2000 to 2011. US nonagricultural export prices rose at 1.8 percent per year in 2000 to 2010 and at 2.2 percent in 2000 to 2011. These dynamic growth rates are not similar to those for the economy of Japan where inflation was negative in seven of the 10 years in the 2000s.
Table 3, US, Average Growth Rates of Real and Nominal GDP, Consumer Price Index, Producer Price Index and Import and Export Prices, Percent per Year
| Real GDP | 2000-2010: 1.6% |
| Nominal GDP | 2000-2010: 3.9% |
| Implicit Price Deflator | 2000-2010: 2.5% |
| CPI | 2000-2010: 2.4% |
| CPI ex Food and Energy | 2000-2010: 2.0% |
| PPI | 2000-2010: 2.7% |
| PPI ex Food and Energy | 2000-2010: 1.6% |
| Import Prices | 2000-2010: 2.6% |
| Import Prices of Petroleum and Petroleum Products | 2000-2010: 12.7% |
| Import Prices Excluding Fuels | 2002-2010: 1.8% |
| Export Prices | 2000-2010: 2.1% |
| Agricultural Export Prices | 2000-2010: 5.5% |
| Nonagricultural Export Prices | 2000-2010: 1.8% |
Note: rates for price indexes in the row beginning with “CPI” and ending in the row “Nonagricultural Export Prices” are for Oct 2000 to Oct 2010 and for Oct 2001 to Oct 2011. Import prices excluding fuels are not available before 2002.
Sources:
http://www.bea.gov/iTable/index_nipa.cfm http://www.bls.gov/ppi/data.htm
http://www.bls.gov/mxp/data.htm http://www.bls.gov/cpi/data.htm
Unconventional monetary policy of zero interest rates and large-scale purchases of long-term securities for the balance sheet of the central bank is proposed to prevent deflation. The data of CPI inflation of all goods and CPI inflation excluding food and energy for the past six decades show only one negative change by 0.4 percent in the CPI all goods annual index in 2009 but not one year of negative annual yearly change in the CPI excluding food and energy annual inflation (http://cmpassocregulationblog.blogspot.com/2011/08/world-financial-turbulence-global.html). Zero interest rates and quantitative easing are designed to lower costs of borrowing for investment and consumption, increase stock market valuations and devalue the dollar. In practice, the carry trade is from zero interest rates to a large variety of risk financial assets including commodities. Resulting commodity price inflation squeezes family budgets and deteriorates the terms of trade with negative effects on aggregate demand and employment. Excessive valuations of risk financial assets eventually result in crashes of financial markets with possible adverse effects on economic activity and employment.
Producer price inflation history in the past five decades does not provide evidence of deflation. The finished core PPI does not register even one single year of decline. The headline PPI experienced only six isolated cases of decline (http://cmpassocregulationblog.blogspot.com/2011/08/world-financial-turbulence-global.html):
-0.3 percent in 1963,
-1.4 percent in 1986,
-0.8 percent in 1986,
-0.8 percent in 1998,
-1.3 percent in 2001
-2.6 percent in 2009.
Deflation should show persistent cases of decline of prices and not isolated events. Fear of deflation in the US has caused a distraction of monetary policy. Symmetric inflation targets around 2 percent in the presence of multiple lags in effect of monetary policy and imperfect knowledge and forecasting are mostly unfeasible and likely to cause instability instead of desired price stability.
Chart 1 provides US nominal GDP from 1980 to 2010. The only major bump in the chart occurred in the recession of IVQ2007 to IIQ2009. Tendency for deflation would be reflected in persistent bumps. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.5 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). The comparison of the global recession after 2007 with the Great Depression is entirely misleading.
Chart 1, US, Nominal GDP 1980-2010
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Chart 2 provides US real GDP from 1980 to 2010. Persistent deflation threatening real economic activity would also be reflected in the series of long-term growth of GDP. There is no such behavior in Chart 3 except for periodic recessions in the US economy that have occurred throughout history.
Chart 2, US, Real GDP 1980-2010
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Deflation would also be in evidence in long-term series of prices in the form of bumps. The GDP implicit deflator series in Chart 3 from 1980 to 2010 shows rather dynamic behavior over time. The US economy is not plagued by deflation but by long-run inflation.
Chart 3, US, GDP Implicit Price Deflator 1980-2010
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Chart 4 provides percent change from preceding quarter in prices of GDP at seasonally-adjusted annual rates (SAAR) from 1980 to 2010. There is one case of negative change in IIQ2009. There has not been actual deflation or risk of deflation in the US that would justify unconventional monetary policy.
Chart 4, Percent Change from Preceding Period in Prices for GDP Seasonally Adjusted at Annual Rates 1980-2010
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Chart 5 provides percent change from preceding year in prices of GDP from 1980 to 2010. There was not one single year of deflation or risk of deflation in the past three decades.
Chart 5, Percent Change from Preceding Year in Prices for Gross Domestic Product 1980-2010
Source: http://www.bea.gov/iTable/index_nipa.cfm
The producer price index of the US from 1960 to 2011 in Chart 6 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.
Chart 6, US, Producer Price Index, Finished Goods, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart 7 provides 12 month percentage changes of the producer price index from 1960 to 2011. The distinguishing event in Chart 7 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2011.
Chart 7, US, Producer Price Index, Finished Goods, 12 Months Percentage Change, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The producer price index excluding food and energy from 1974, the first historical data of availability in the dataset of the Bureau of Labor Statistics (BLS), to 2011, shows similarly dynamic behavior as the overall index, as shown in Chart 8. There is no evidence of persistent deflation in the US PPI.
Chart 8, US Producer Price Index, Finished Goods Excluding Food and Energy, SA, 1974-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart 9 provides 12 months percentage rates of change of the finished goods index excluding food and energy. The dominating characteristic is the Great Inflation of the 1970s. The double hump illustrates how inflation may appear to be subdued and then returns with strength.
Chart 9, US Producer Price Index, Finished Goods Excluding Food and Energy, 12 Month Percentage Change, NSA, 1974-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The producer price index of energy goods from 1974 to 2011 is provided in Chart 10. The first jump occurred during the Great Inflation of the 1970s analyzed in various comments of this blog (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) and in Appendix I. There is relative stability of producer prices after 1986 with another jump and decline in the late 1990s into the early 2000s. The episode of commodity price increases during a global recession in 2008 could only have happened with interest rates dropping toward zero, which stimulated the carry trade from zero interest rates to leveraged positions in commodity futures. Commodity futures exposures were dropped in the flight to government securities after Sep 2008. Commodity future exposures were created again when risk aversion diminished around Mar 2011 after the finding that US bank balance sheets did not have the toxic assets that were mentioned in proposing TARP in Congress (see Cochrane and Zingales 2009). Fluctuations in commodity prices and other risk financial assets originate in carry trade when risk aversion ameliorates.
Chart 10, US, Producer Price Index, Finished Energy Goods, NSA, 1974-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart 11 shows the 12 month percentage change of the producer price index of finished energy goods from 1975 to 2011. This index is only available after 1974 and captures only one of the humps of energy prices during the Great Inflation. Fluctuations in energy prices have occurred throughout history in the US but without provoking deflation. Two cases are the decline of oil prices in 2001 to 2002 that has been analyzed by Barsky and Kilian (2004) and the collapse of oil prices from over $140/barrel with shock of risk aversion to the carry trade in Sep 2008.
Chart 11, US, Producer Price Index, Finished Energy Goods, 12 Month Percentage Change, NSA, 1974-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart 12 provides the consumer price index NSA from 1960 to 2011. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.
Chart 12, US, Consumer Price Index, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart 13 provides 12 month percentage changes of the consumer price index from 1960 to 2011. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.
Chart 13, US, Consumer Price Index, All Items, 12 Month Percentage Change 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart 14 provides the consumer price index excluding food and energy from 1960 to 2011. There is long-term inflation in the US without episodes of deflation.
Chart 14, US, Consumer Price Index Excluding Food and Energy, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart 15 provides 12 months percentage changes of the consumer price index excluding food and energy from 1960 to 2011. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.
Chart 15, US, Consumer Price Index Excluding Food and Energy, 12 Month Percentage Change, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The consumer price index of housing is provided in Chart 16. There was also acceleration during the Great Inflation of the 1970s. The index flattens after the global recession in IVQ2007 to IIQ2009. Housing prices collapsed under the weight of construction of several times more housing than needed. Surplus housing originated in subsidies and artificially low interest rates in the shock of unconventional monetary policy in 2003 to 2004 in fear of deflation.
Chart 16, US, Consumer Price Index Housing, NSA, 1967-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart 17 provides 12 months percentage changes of the housing CPI. The Great Inflation also had extremely high rates of housing inflation. Housing is considered as potential hedge of inflation.
Chart 17, US, Consumer Price Index, Housing, 12 Month Percentage Change, NSA, 1968-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Consumer price inflation has accelerated in recent months. Table 4 provides the 12 months and annual equivalent rate for the months of Jul to Oct of the CPI and major segments. CPI inflation in the 12 months ending in Oct reached 3.9 percent and the annual equivalent rate Jul-Oct was 3.3 percent. Excluding food and energy, CPI inflation was 1.8 percent. There is no deflation in the US economy that could justify further quantitative easing. Consumer food prices in the US have risen 4.7 percent in 12 months and 4.3 percent in annual equivalent in Jul-Oct. Monetary policies stimulating carry trades of commodities that increase prices of food constitute a highly regressive tax on lower income families for whom food is a major portion of the consumption basket. Energy prices returned with increase of 14.2 percent in 12 months and 12.5 percent in annual equivalent in Jul-Oct. For the lower income families, food and energy are a major part of the family budget. Inflation is not low or threatening deflation in annual equivalent in Jul-Oct in any of the categories in Table 4.
Table 4, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%
| ∆% 12 Months Oct 2011/Oct | ∆% Annual Equivalent Jul-Oct 2011 SA | |
| CPI All Items | 3.5 | 3.3 |
| CPI ex Food and Energy | 2.0 | 1.8 |
| Food | 4.7 | 4.3 |
| Food at Home | 6.2 | 5.8 |
| Food Away from Home | 2.7 | 3.0 |
| Energy | 14.2 | 12.5 |
| Gasoline | 23.5 | 20.4 |
| Fuel Oil | 26.8 | -9.5 |
| New Vehicles | 3.4 | -0.9 |
| Used Cars and Trucks | 5.2 | 1.2 |
| Medical Care Commodities | 3.1 | 1.8 |
| Apparel | 3.5 | 4.9 |
| Services Less Energy Services | 2.1 | 2.4 |
| Shelter | 1.8 | 2.4 |
| Transportation Services | 3.0 | 2.1 |
| Medical Care Services | 3.1 | 3.9 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The weights of the CPI, US city average, are shown in Table 5. Housing has a weight of 41.460 percent. The combined weight of housing and transportation is 58.768 percent or more than one half. The combined weight of housing, transportation and food and beverages is 73.56 percent of the US CPI.
Table 5, US, Relative Importance, 2007-2008 Weights, of Components in the Consumer Price Index, US City Average, Dec 2010
| All Items | 100.000 |
| Food and Beverages | 14.792 |
| Food | 13.742 |
| Food at home | 7.816 |
| Food away from home | 5.926 |
| Housing | 41.460 |
| Shelter | 31.955 |
| Rent of primary residence | 5.925 |
| Owners’ equivalent rent | 24.905 |
| Apparel | 3.601 |
| Transportation | 17.308 |
| Private Transportation | 16.082 |
| New vehicles | 3.513 |
| Used cars and trucks | 2.055 |
| Motor fuel | 5.079 |
| Gasoline | 4.865 |
| Medical Care | 6.627 |
| Medical care commodities | 1.633 |
| Medical care services | 4.994 |
| Recreation | 6.293 |
| Education and Communication | 6.421 |
| Other Goods and Services | 3.497 |
Source:
US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart 18 provides the US consumer price index for housing from 2001 to 2011. Housing prices rose sharply during the decade until the bump of the global recession and are increasing again in 2011 with some stabilization currently. The CPI excluding housing would likely show much higher inflation. Income remaining after paying for indispensable shelter has been compressed by the commodity carry trades resulting from unconventional monetary policy.
Chart 18, US, Consumer Price Index, Housing, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart 19 provides 12 month percentage changes of the housing CPI. Percentage changes collapsed during the global recession but have been rising into positive territory in 2011.
Chart 19, US, Consumer Price Index, Housing, 12 Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
There have been three waves of consumer price inflation in the US in 2011 that are illustrated in Table 6. The first wave occurred in Jan-Apr and was caused by the carry trade of commodity prices induced by unconventional monetary policy of zero interest rates. Cheap money at zero opportunity cost was channeled into financial risk assets, causing increases in commodity prices. The annual equivalent rate of increase of the all-items CPI in Jan-Apr was 7.5 percent and the CPI excluding food and energy increased at annual equivalent rate of 2.8 percent. The second wave occurred during the collapse of the carry trade from zero interest rates to exposures in commodity futures as a result of risk aversion in financial markets created by the sovereign debt crisis in Europe. The annual equivalent rate of increase of the all items CPI dropped to 2.0 percent in May-Jul but the annual equivalent rate of the CPI excluding food and energy increased to 3.2 percent. The third wave occurred in the form of increase of the all items annual equivalent rate to 3.3 percent in Jul-Oct with the annual equivalent rate of the CPI excluding food and energy dropping to 1.8 percent. The conclusion is that inflation accelerates and decelerates in unpredictable fashion that turns symmetric inflation targets in a source of destabilizing shocks to the financial system and eventually the overall economy.
Table 6, US, Headline and Core CPI Inflation Monthly SA and 12 Months NSA ∆%
| All Items SA Month | All Items NSA 12 month | Core SA | Core NSA | |
| Oct 2011 | -0.1 | 3.5 | 0.1 | 2.1 |
| Sep | 0.3 | 3.9 | 0.1 | 2.0 |
| Aug | 0.4 | 3.8 | 0.2 | 2.0 |
| Jul | 0.5 | 3.6 | 0.2 | 1.8 |
| AE ∆% Jul-Oct | 3.3 | 1.8 | ||
| Jun | -0.2 | 3.6 | 0.3 | 1.6 |
| May | 0.2 | 3.6 | 0.3 | 1.5 |
| AE ∆% May-Jul | 2.0 | 3.2 | ||
| Apr | 0.4 | 3.2 | 0.2 | 1.3 |
| Mar | 0.5 | 2.7 | 0.1 | 1.2 |
| Feb | 0.5 | 2.1 | 0.2 | 1.1 |
| Jan | 0.4 | 1.6 | 0.2 | 1.0 |
| AE ∆% Jan-Apr | 7.5 | 2.8 | ||
| Dec 2010 | 0.4 | 1.5 | 0.1 | 0.8 |
| Nov | 0.1 | 1.1 | 0.1 | 0.8 |
| Oct | 0.2 | 1.2 | 0.0 | 0.6 |
| Sep | 0.2 | 1.1 | 0.0 | 0.8 |
| Aug | 0.2 | 1.1 | 0.1 | 0.9 |
| Jul | 0.3 | 1.2 | 0.1 | 0.9 |
| Jun | -0.2 | 1.1 | 0.1 | 0.9 |
| May | -0.1 | 2.0 | 0.1 | 0.9 |
| Apr | 0.0 | 2.2 | 0.0 | 0.9 |
| Mar | 0.0 | 2.3 | 0.0 | 1.1 |
| Feb | 0.0 | 2.1 | 0.1 | 1.3 |
| Jan | 0.1 | 2.6 | -0.1 | 1.6 |
Note: Core: excluding food and energy; AE: annual equivalent
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The behavior of the US consumer price index NSA from 2001 to 2011 is provided in Chart 20. Inflation in the US is very dynamic without deflation risks that would justify symmetric inflation targets. The hump in 2008 originated in the carry trade from interest rates dropping to zero into commodity futures. There is no other explanation for the increase of oil prices toward $140/barrel during the global recession. The unwinding of the carry trade with the TARP announcement of toxic assets in banks channeled cheap money into government obligations (see Cochrane and Zingales 2009).
Chart 20, US, Consumer Price Index, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart 21 provides 12 month percentage changes of the consumer price index from 2001 to 2011. There was no deflation or threat of deflation from 2008 into 2009. Commodity prices collapsed during the panic of toxic assets in banks. When stress tests revealed US bank balance sheets in much stronger position, cheap money at zero opportunity cost exited government obligations and flowed into carry trades of risk financial assets. Increases in commodity prices drove again the all items CPI with interruptions during risk aversion originating in the sovereign debt crisis of Europe.
Chart 21, US, Consumer Price Index, 12 Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The trend of increase of the consumer price index excluding food and industry in Chart 22 does not reveal any threat of deflation that would justify symmetric inflation targets. There are mild oscillations in a neat upward trend.
Chart 22, US, Consumer Price Index Excluding Food and Energy, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart 23 provides 12 month percentage change of the consumer price index excluding food and energy. Past-year rates of inflation fell toward 1 percent from 2001 into 2003 as a result of the recession and the decline of commodity prices beginning before the recession with declines of real oil prices. Near zero interest rates with fed funds at 1 percent between Jun 2003 and Jun 2004 stimulated carry trades of all types, including in buying homes with subprime mortgages in expectation that low interest rates forever would increase home prices permanently, creating the equity that would permit the conversion of subprime mortgages into creditworthy mortgages (Gorton 2009EFM; see http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Inflation rose and then collapsed during the unwinding of carry trades and the housing debacle of the global recession. Carry trade into 2011 gave a new impulse to CPI inflation, all items and core. Symmetric inflation targets destabilize the economy by encouraging hunts for yields that inflate and deflate financial assets.
Chart 23, US, Consumer Price Index Excluding Food and Energy, 12 Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The headline and core producer price index are in Table 7. The headline PPI fell 0.3 percent SA in Oct, lowering the 12-month rate NSA to 5.9 percent. The core PPI SA was flat in Oct and rose 2.5 percent in 12 months. Analysis of annual equivalent rates of change shows three different waves. In the first wave, the absence of risk aversion from the sovereign risk crisis in Europe motivated the carry trade from zero interest rates into commodity futures that caused the average equivalent rate of 17.3 percent in the headline PPI in Jan-Apr and 5.3 percent in the core PPI. In the second wave, commodity futures prices collapsed in May with the return of risk aversion originating in the sovereign risk crisis of Europe. The annual equivalent rate of headline PPI inflation collapsed to 0.8 percent in May-Jul but the core annual equivalent inflation rate was much higher at 3.2 percent. In the third wave, headline PPI inflation resuscitated with annual equivalent 2.7 percent in Jul-Oct and core PPI inflation was 2.1 percent. Core PPI inflation has been persistent throughout 2011 and has jumped from around 1 percent in the first four months of 2010 to 2.8 percent in 12 months and 2.1 percent in annual equivalent rate. It is impossible to forecast PPI inflation and its relation to CPI inflation. “Inflation surprise” by monetary policy could be proposed to climb along a downward sloping Phillips curve, resulting in higher inflation but lower unemployment (see Kydland and Prescott 1977, Barro and Gordon 1983 and past comments of this blog 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). The architects of monetary policy would require superior inflation forecasting ability compared to forecasting naivety by everybody else. In practice, we are all naïve in forecasting inflation and other economic variables and events.
Table 7, US, Headline and Core PPI Inflation Monthly SA and 12 Months NSA ∆%
| Finished | Finished | Finished Core SA | Finished Core NSA | |
| Oct 2011 | -0.3 | 5.9 | 0.0 | 2.8 |
| Sep | 0.8 | 6.9 | 0.2 | 2.5 |
| Aug | 0.0 | 6.5 | 0.1 | 2.5 |
| Jul | 0.4 | 7.2 | 0.4 | 2.5 |
| AE ∆% Jul-Oct | 2.7 | 2.1 | ||
| Jun | -0.3 | 7.0 | 0.3 | 2.3 |
| May | 0.1 | 7.1 | 0.1 | 2.1 |
| AE ∆% May-Jul | 0.8 | 3.2 | ||
| Apr | 0.8 | 6.6 | 0.3 | 2.3 |
| Mar | 0.7 | 5.6 | 0.3 | 2.0 |
| Feb | 1.5 | 5.4 | 0.2 | 1.8 |
| Jan | 1.0 | 3.6 | 0.5 | 1.6 |
| AE ∆% Jan-Apr | 17.3 | 5.3 | ||
| Dec 2010 | 0.9 | 3.8 | 0.2 | 1.4 |
| Nov | 0.5 | 3.4 | 0.0 | 1.2 |
| Oct | 0.6 | 4.3 | -0.3 | 1.6 |
| Sep | 0.3 | 3.9 | 0.2 | 1.6 |
| Aug | 0.6 | 3.3 | 0.1 | 1.3 |
| Jul | 0.1 | 4.1 | 0.2 | 1.5 |
| Jun | -0.3 | 2.7 | 0.1 | 1.1 |
| May | -0.2 | 5.1 | 0.2 | 1.3 |
| Apr | -0.1 | 5.4 | 0.1 | 0.9 |
| Mar | 0.7 | 5.9 | 0.2 | 0.9 |
| Feb | -0.4 | 5.4 | 0.0 | 1.0 |
| Jan | 1.1 | 3.6 | 0.3 | 1.0 |
Note: Core: excluding food and energy; AE: annual equivalent
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The US producer price index NSA from 2001 to 2011 is shown in Chart 24. There are two episodes of decline of the PPI during recessions in 2001 and in 2008. Barsky and Kilian (2004) consider the 2001 episode as one in which real oil prices were declining when recession began. Recession and the fall of commodity prices instead of generalized deflation explain the behavior of US inflation in 2008.
Chart 24, US, Producer Price Index, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The 12 months rates of change of the PPI NSA from 2001 to 2011 are shown in Chart 25. It may be possible to forecast trends a few months in the future under adaptive expectations but turning points are almost impossible to anticipate especially when related to fluctuations of commodity prices in response to risk aversion. In a sense, monetary policy has been tied to behavior of the PPI in the negative 12 months rates in 2001 to 2003 and then again in 2009 to 2010. Monetary policy following deflation fears caused by commodity price fluctuations would introduce significant volatility and risks in financial markets and eventually in consumption and investment.
Chart 25, US, Producer Price Index, 12 Month Percentage Change NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The US PPI excluding food and energy from 2001 to 2011 is shown in Chart 26. There is here again a smooth trend of inflation instead of prolonged deflation as in Japan.
Chart 26, US, Producer Price Index Excluding Food and Energy, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The 12 months rates of percentage change of the producer price index excluding food and energy are shown in Chart 27. Fluctuations replicate those in the headline PPI. There is an evident trend of increase of 12 months rates of core PPI inflation in 2011.
Chart 27, US, Producer Price Index Excluding Food and Energy, 12 Month Percentage Chance, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The US producer price index of energy goods from 2001 to 2011 is in Chart 28. There is a clear upward trend with fluctuations that would not occur under persistent deflation.
Chart 28, US, Producer Price Index Energy Goods, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart 29 provides 12 months rates of change of the producer price index of energy goods from 2001 to 2011. The episode of declining prices of energy goods in 2001 to 2002 is related to the analysis of decline of real oil prices by Barsky and Kilian (2004). Interest rates dropping to zero during the global recession explain the rise of the PPI of energy goods toward 30 percent. Bouts of risk aversion with policy interest rates held close to zero explain the fluctuations in the 12 months rates of the PPI of energy goods in the expansion phase of the economy. Symmetric inflation targets induce significant instability in inflation and interest rates with adverse effects on financial markets and the overall economy.
Chart 29, US, Producer Price Index Energy Goods, 12 Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
IC Conclusions. Table 8 provides 12 month percentage changes of the CPI all items, CPI core and CPI housing from 2001 to 2011. There is no evidence in these data supporting symmetric inflation targets that would only induce greater instability in inflation, interest rates and financial markets. Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). The impact on the overall economy and the financial system of errors of policy are magnified by large-scale policy doses of trillions of dollars of quantitative easing and zero interest rates. The US economy has been experiencing financial repression as a result of negative real rates of interest in the past few years and programmed in monetary policy statement until 2013 or, for practical purposes, forever. The essential calculus of risk/return in capital budgeting and financial allocations has been distorted.
Table 8, CPI All Items, CPI Core and CPI Housing, 12 Months Rates of Change, NSA 2001-2011
| Oct | CPI All Items | CPI Core | CPI Housing |
| 2011 | 3.5 | 2.1 | 1.8 |
| 2010 | 1.2 | 0.6 | -0.3 |
| 2009 | -0.2 | 1.7 | -0.5 |
| 2008 | 3.7 | 2.2 | 3.5 |
| 2007 | 3.5 | 2.2 | 2.9 |
| 2006 | 1.3 | 2.7 | 4.1 |
| 2005 | 4.3 | 2.1 | 3.1 |
| 2004 | 3.2 | 2.0 | 2.8 |
| 2003 | 2.0 | 1.3 | 2.4 |
| 2002 | 2.0 | 2.2 | 2.3 |
| 2001 | 2.1 | 2.6 | 3.5 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
ID Quantitative Easing and Portfolio Rebalancing. Janet L. Yellen, Vice Chair of the Board of Governors of the Federal Reserve System, provides analysis of the policy of purchasing large amounts of long-term securities for the Fed’s balance sheet. The new analysis provides now three channels of transmission of quantitative easing to the ultimate objectives of increasing growth and employment and increasing inflation to “levels of 2 percent or a bit less that most Committee participants judge to be consistent, over the long run, with the FOMC’s dual mandate” (Yellen 2011AS, 4, 7):
“There are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boost household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”
The new analysis by Yellen (2011AS) is considered below in four separate subsections: ID1 Theory; ID2 Policy; ID3 Evidence; and ID4 Unwinding Strategy.
ID1 Theory. The transmission mechanism of quantitative easing can be analyzed in three different forms. (1) Portfolio choice theory. General equilibrium value theory was proposed by Hicks (1935) in analyzing the balance sheets of individuals and institutions with assets in the capital segment consisting of money, debts, stocks and productive equipment. Net worth or wealth would be comparable to income in value theory. Expected yield and risk would be the constraint comparable to income in value theory. Markowitz (1952) considers a portfolio of individual securities with mean μp and variance. The Markowitz (1952, 82) rule states that “investors would (or should” want to choose a portfolio of combinations of (μp, σp) that are efficient, which are those with minimum variance or risk for given expected return μp or more and maximum expected μp for given variance (risk) or less. The more complete model of Tobin (1958) consists of portfolio choice of monetary assets by maximizing a utility function subject to a budget constraint. Tobin (1961, 28) proposes general equilibrium analysis of the capital account to derive choices of capital assets in balance sheets of economic units with the determination of yields in markets for capital assets with the constraint of net worth. A general equilibrium model of choice of portfolios was developed simultaneously by various authors (Hicks 1962; Treynor 1962; Sharpe 1964; Lintner 1965; Mossin 1966). If shocks such as by quantitative easing displace investors from the efficient frontier, there would be reallocations of portfolios among assets until another efficient point is reached. Investors would bid up the prices or lower the returns (interest plus capital gains) of long-term assets targeted by quantitative easing, causing the desired effect of lowering long-term costs of investment and consumption.
(2) General Equilibrium Theory. Bernanke and Reinhart (2004, 88) argue that “the possibility monetary policy works through portfolio substitution effects, even in normal times, has a long intellectual history, having been espoused by both Keynesians (James Tobin 1969) and monetarists (Karl Brunner and Allan Meltzer 1973).” Andres et al. (2004) explain the Tobin (1969) contribution by optimizing agents in a general-equilibrium model. Both Tobin (1969) and Brunner and Meltzer (1973) consider capital assets to be gross instead of perfect substitutes with positive partial derivatives of own rates of return and negative partial derivatives of cross rates in the vector of asset returns (interest plus principal gain or loss) as argument in portfolio balancing equations (see Pelaez and Suzigan 1978, 113-23). Tobin (1969, 26) explains portfolio substitution after monetary policy:
“When the supply of any asset is increased, the structure of rates of return, on this and other assets, must change in a way that induces the public to hold the new supply. When the asset’s own rate can rise, a large part of the necessary adjustment can occur in this way. But if the rate is fixed, the whole adjustment must take place through reductions in other rates or increases in prices of other assets. This is the secret of the special role of money; it is a secret that would be shared by any other asset with a fixed interest rate.”
Andrés et al. (2004, 682) find that in their multiple-channels model “base money expansion now matters for the deviations of long rates from the expected path of short rates. Monetary policy operates by both the expectations channel (the path of current and expected future short rates) and this additional channel. As in Tobin’s framework, interest rates spreads (specifically, the deviations from the pure expectations theory of the term structure) are an endogenous function of the relative quantities of assets supplied.”
The interrelation among yields of default-free securities is measured by the term structure of interest rates. This schedule of interest rates along time incorporates expectations of investors. (Cox, Ingersoll and Ross 1985). The expectations hypothesis postulates that the expectations of investors about the level of future spot rates influence the level of current long-term rates. The normal channel of transmission of monetary policy in a recession is to lower the target of the fed funds rate that will lower future spot rates through the term structure and also the yields of long-term securities. The expectations hypothesis is consistent with term premiums (Cox, Ingersoll and Ross 1981, 774-7) such as liquidity to compensate for risk or uncertainty about future events that can cause changes in prices or yields of long-term securities (Hicks 1939; see Cox, Ingersoll and Ross 1981, 784; Chung et al. 2011, 22).
(3) Preferred Habitat. Another approach is by the preferred-habitat models proposed by Culbertson (1957, 1963) and Modigliani and Sutch (1966). This approach is formalized by Vayanos and Vila (2009). The model considers investors or “clientele” who do not abandon their segment of operations unless there are extremely high potential returns and arbitrageurs who take positions to profit from discrepancies. Pension funds matching benefit liabilities would operate in segments above 15 years; life insurance companies operate around 15 years or more; and asset managers and bank treasury managers are active in maturities of less than 10 years (Ibid, 1). Hedge funds, proprietary trading desks and bank maturity transformation activities are examples of potential arbitrageurs. The role of arbitrageurs is to incorporate “information about current and future short rates into bond prices” (Ibid, 12). Suppose monetary policy raises the short-term rate above a certain level. Clientele would not trade on this information, but arbitrageurs would engage in carry trade, shorting bonds and investing at the short-term rate, in a “roll-up” trade, resulting in decline of bond prices or equivalently increases in yields. This is a situation of an upward-sloping yield curve. If the short-term rate were lowered, arbitrageurs would engage in carry trade borrowing at the short-term rate and going long bonds, resulting in an increase in bond prices or equivalently decline in yields, or “roll-down” trade. The carry trade is the mechanism by which bond yields adjust to changes in current and expected short-term interest rates. The risk premiums of bonds are positively associated with the slope of the term structure (Ibid, 13). Fama and Bliss (1987, 689) find with data for 1964-85 that “1-year expected returns for US Treasury maturities to 5 years, measured net of the interest rate on a 1-year bond, vary through time. Expected term premiums are mostly positive during good times but mostly negative during recessions.” Vayanos and Vila (2009) develop a model with two-factors, the short-term rate and demand or quantity. The term structure moves because of shocks of short-term rates and demand. An important finding is that demand or quantity shocks are largest for intermediate and long maturities while short-rate shocks are largest for short-term maturities.
ID2 Policy. A simplified analysis could consider the portfolio balance equations Aij = f(r, x) where Aij is the demand for i = 1,2,∙∙∙n assets from j = 1,2, ∙∙∙m sectors, r the 1xn vector of rates of return, ri, of n assets and x a vector of other relevant variables. Tobin (1969) and Brunner and Meltzer (1973) assume imperfect substitution among capital assets such that the own first derivatives of Aij are positive, demand for an asset increases if its rate of return (interest plus capital gains) is higher, and cross first derivatives are negative, demand for an asset decreases if the rate of return of alternative assets increases. Theoretical purity would require the estimation of the complete model with all rates of return. In practice, it may be impossible to observe all rates of return such as in the critique of Roll (1976). Policy proposals by the Fed have been focused on the likely impact of withdrawals of stocks of securities in specific segments, that is, of effects of one or several specific rates of return among the n possible rates. There have been six approaches on the role of monetary policy in purchasing long-term securities that have increased the classes of rates of return targeted by the Fed:
i. Suspension of Auctions of 30-year Treasury Bonds. Auctions of 30-year Treasury bonds were suspended between 2001 and 2005. This was Treasury policy not Fed policy. The effects were similar to those of quantitative easing: withdrawal of supply from the segment of 30-year bonds would result in higher prices or lower yields for close-substitute mortgage-backed securities with resulting lower mortgage rates. The objective was to encourage refinancing of house loans that would increase family income and consumption by freeing income from reducing monthly mortgage payments.
ii. Purchase of Long-term Securities by the Fed. Between Nov 2008 and Mar 2009 the Fed announced the intention of purchasing $1750 billion of long-term securities: $600 billion of agency mortgage-backed securities and agency debt announced on Nov 25 and $850 billion of agency mortgaged-backed securities and agency debt plus $300 billion of Treasury securities announced on Mar 18, 2009 (Yellen 2011AS, 5-6). The objective of buying mortgage-backed securities was to lower mortgage rates that would “support the housing sector” (Bernanke 2009SL). The FOMC statement on Dec 16, 2008 informs that: “over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and its stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant” (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). The Mar 18, 2009, statement of the FOMC explained that: “to provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities up to $1.25 trillion this year, and to increase its purchase of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months” (http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm). Policy changed to increase prices or reduce yields of mortgage-backed securities and Treasury securities with the objective of supporting housing markets and private credit markets by lowering costs of housing and long-term private credit.
iii. Portfolio Reinvestment. On Aug 10, 2010, the FOMC statement explains the reinvestment policy: “to help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in long-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature” (http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm). The objective of policy appears to be supporting conditions in housing and mortgage markets with slow transfer of the portfolio to Treasury securities that would support private-sector markets.
iv. Increasing Portfolio. As widely anticipated, the FOMC decided on Dec 3, 2010: “to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month” (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm). The emphasis appears to shift from housing markets and private-sector credit markets to the general economy, employment and preventing deflation.
v. Increasing Stock Market Valuations. Chairman Bernanke (2010WP) explained on Nov 4 the objectives of purchasing an additional $600 billion of long-term Treasury securities and reinvesting maturing principal and interest in the Fed portfolio. Long-term interest rates fell and stock prices rose when investors anticipated the new round of quantitative easing. Growth would be promoted by easier lending such as for refinancing of home mortgages and more investment by lower corporate bond yields. Consumers would experience higher confidence as their wealth in stocks rose, increasing outlays. Income and profits would rise and, in a “virtuous circle,” support higher economic growth. Bernanke (2000) analyzes the role of stock markets in central bank policy (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 99-100). Fed policy in 1929 increased interest rates to avert a gold outflow and failed to prevent the deepening of the banking crisis without which the Great Depression may not have occurred. In the crisis of Oct 19, 1987, Fed policy supported stock and futures markets by persuading banks to extend credit to brokerages. Collapse of stock markets would slow consumer spending.
vi. Devaluing the Dollar. Yellen (2011AS, 6) broadens the effects of quantitative easing by adding dollar devaluation: “there are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boosts household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”
ID3 Evidence. There are multiple empirical studies on the effectiveness of quantitative easing that have been covered in past posts such as (Andrés et al. 2004, D’Amico and King 2010, Doh 2010, Gagnon et al. 2010, Hamilton and Wu 2010). On the basis of simulations of quantitative easing with the FRB/US econometric model, Chung et al (2011, 28-9) find that:
”Lower long-term interest rates, coupled with higher stock market valuations and a lower foreign exchange value of the dollar, provide a considerable stimulus to real activity over time. Phase 1 of the program by itself is estimated to boost the level of real GDP almost 2 percent above baseline by early 2012, while the full program raises the level of real GDP almost 3 percent by the second half of 2012. This boost to real output in turn helps to keep labor market conditions noticeably better than they would have been without large scale asset purchases. In particular, the model simulations suggest that private payroll employment is currently 1.8 million higher, and the unemployment rate ¾ percentage point lower, that would otherwise be the case. These benefits are predicted to grow further over time; by 2012, the incremental contribution of the full program is estimated to be 3 million jobs, with an additional 700,000 jobs provided by the most recent phase of the program alone.”
An additional conclusion of these simulations is that quantitative easing may have prevented actual deflation. Empirical research is continuing.
IID4 Unwinding Strategy. Fed Vice-Chair Yellen (2011AS) considers four concerns on quantitative easing discussed below in turn. First, Excessive Inflation. Yellen (2011AS, 9-12) considers concerns that quantitative easing could result in excessive inflation because fast increases in aggregate demand from quantitative easing could raise the rate of inflation, posing another problem of adjustment with tighter monetary policy or higher interest rates. The Fed estimates significant slack of resources in the economy as measured by the difference of four percentage points between the high current rate of unemployment above 9 percent and the NAIRU (non-accelerating rate of unemployment) of 5.75 percent (Ibid, 2). Thus, faster economic growth resulting from quantitative easing would not likely result in upward rise of costs as resources are bid up competitively. The Fed monitors frequently slack indicators and is committed to maintaining inflation at a “level of 2 percent or a bit less than that” (Ibid, 13), say, in the narrow open interval (1.9, 2.1).
Second, Inflation and Bank Reserves. On Jan 12, the line “Reserve Bank credit” in the Fed balance sheet stood at $2450,6 billion, or $2.5 trillion, with the portfolio of long-term securities of $2175.7 billion, or $2.2 trillion, composed of $987.6 billion of notes and bonds, $49.7 billion of inflation-adjusted notes and bonds, $146.3 billion of Federal agency debt securities, and $992.1 billion of mortgage-backed securities; reserves balances with Federal Reserve Banks stood at $1095.5 billion, or $1.1 trillion (http://federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The concern addressed by Yellen (2011AS, 12-4) is that this high level of reserves could eventually result in demand growth that could accelerate inflation. Reserves would be excessively high relative to the levels before the recession. Reserves of depository institutions at the Federal Reserve Banks rose from $45.6 billion in Aug 2008 to $1084.8 billion in Aug 2010, not seasonally adjusted, multiplying by 23.8 times, or to $1038.2 billion in Nov 2010, multiplying by 22.8 times. The monetary base consists of the monetary liabilities of the government, composed largely of currency held by the public plus reserves of depository institutions at the Federal Reserve Banks. The monetary base not seasonally adjusted, or issue of money by the government, rose from $841.1 billion in Aug 2008 to $1991.1 billion or by 136.7 percent and to $1968.1 billion in Nov 2010 or by 133.9 percent (http://federalreserve.gov/releases/h3/hist/h3hist1.pdf). Policy can be viewed as creating government monetary liabilities that ended mostly in reserves of banks deposited at the Fed to purchase $2.1 trillion of long-term securities or assets, which in nontechnical language would be “printing money” (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). The marketable debt of the US government in Treasury securities held by the public stood at $8.7 trillion on Nov 30, 2010 (http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds112010.pdf). The current holdings of long-term securities by the Fed of $2.1 trillion, in the process of converting fully into Treasury securities, are equivalent to 24 percent of US government debt held by the public, and would represent 29.9 percent with the new round of quantitative easing if all the portfolio of the Fed, as intended, were in Treasury securities. Debt in Treasury securities held by the public on Dec 31, 2009, stood at $7.2 trillion (http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds122009.pdf), growing to Nov 30, 2010, by $1.5 trillion or by 20.8 percent. In spite of this growth of bank reserves, “the 12-month change in core PCE [personal consumption expenditures] prices dropped from about 2 ½ percent in mid-2008 to around 1 ½ percent in 2009 and declined further to less than 1 percent by late 2010” (Yellen 2011AS, 3). The PCE price index, excluding food and energy, is around 0.8 percent in the past 12 months, which could be, in the Fed’s view, too close for comfort to negative inflation or deflation. Yellen (2011AS, 12) agrees “that an accommodative monetary policy left in place too long can cause inflation to rise to undesirable levels” that would be true whether policy was constrained or not by “the zero bound on interest rates.” The FOMC is monitoring and reviewing the “asset purchase program regularly in light of incoming information” and will “adjust the program as needed to meet its objectives” (Ibid, 12). That is, the FOMC would withdraw the stimulus once the economy is closer to full capacity to maintain inflation around 2 percent. In testimony at the Senate Committee on the Budget, Chairman Bernanke stated that “the Federal Reserve has all the tools its needs to ensure that it will be able to smoothly and effectively exit from this program at the appropriate time” (http://federalreserve.gov/newsevents/testimony/bernanke20110107a.htm). The large quantity of reserves would not be an obstacle in attaining the 2 percent inflation level. Yellen (2011A, 13-4) enumerates Fed tools that would be deployed to withdraw reserves as desired: (1) increasing the interest rate paid on reserves deposited at the Fed currently at 0.25 percent per year; (2) withdrawing reserves with reverse sale and repurchase agreement in addition to those with primary dealers by using mortgage-backed securities; (3) offering a Term Deposit Facility similar to term certificates of deposit for member institutions; and (4) sale or redemption of all or parts of the portfolio of long-term securities. The Fed would be able to increase interest rates and withdraw reserves as required to attain its mandates of maximum employment and price stability.
Third, Financial Imbalances. Fed policy intends to lower costs to business and households with the objective of stimulating investment and consumption generating higher growth and employment. Yellen (2011A, 14-7) considers a possible consequence of excessively reducing interest rates: “a reasonable fear is that this process could go too far, encouraging potential borrowers to employ excessive leverage to take advantage of low financing costs and leading investors to accept less compensation for bearing risks as they seek to enhance their rates of return in an environment of very low yields. This concern deserves to be taken seriously, and the Federal Reserve is carefully monitoring financial indicators for signs of potential threats to financial stability.” Regulation and supervision would be the “first line of defense” against imbalances threatening financial stability but the Fed would also use monetary policy to check imbalances (Yellen 2011AS, 17).
Fourth, Adverse Effects on Foreign Economies. The issue is whether the now recognized dollar devaluation would promote higher growth and employment in the US at the expense of lower growth and employment in other countries.
II World Financial Turbulence. The past three months have been characterized by financial turbulence, attaining unusual magnitude in the past few weeks. Table 9, updated with every comment in this blog, provides beginning values on Fr Nov 11 and daily values throughout the week ending on Mon Nov 14 of several financial assets. Section V Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Nov 11 and the percentage change in that prior week below the label of the financial risk asset. The first five asset rows provide five 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. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing inflation. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.375/EUR in the first row, first column in the block for currencies in Table 9 for Fri Nov 11, appreciating to USD 1.3630/EUR on Mon Nov 14, or by 0.9 percent. The dollar appreciated because fewer dollars, $1.3630, were required on Nov 14 to buy one euro than $1.375on Nov 11. Table 9 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention is required to maintain consistency in characterizing movements of the exchange rate in Table 9 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3730/EUR on Nov 14; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Nov 11, to the last business day of the current week, in this case Fri Nov 18, such as appreciation of 1.7 percent for the dollar to USD 1.3517/EUR by Nov 18; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (positive sign) by 0.3 percent from the rate of USD 1.375/EUR on Fri Nov 11 to the rate of USD 1.3517/EUR on Fri Nov 18 {[(1.3517/1.375) – 1]100 = -1.7%} and depreciated by 0.4 percent from the rate of USD 1.3461 on Thu Nov 17 to USD 1.3517/EUR on Fri Nov 18 {[(1.3517/1.3461) -1]100 = 0.4%}. The dollar appreciated during the week because fewer dollars, $1.3517, were required to buy one euro on Fri Nov 18 than $1.375 required to buy one euro on Fri Nov 11. The depreciation of the dollar in the week was caused by increasing risk aversion, largely resulting with the uncertainty on European sovereign risks, with purchases of risk financial investments by reduction of dollar-denominated assets.
Table 9, Weekly Financial Risk Assets Nov 14 to Nov 18, 2011
| Fri Nov 11, 2011 | M 14 | Tu 15 | W 16 | Th 17 | Fr 18 |
| USD/ 1.375 0.3% | 1.3630 0.9% 0.9% | 1.3532 1.6% 0.8% | 1.3467 2.1% 0.5% | 1.3461 2.1% 0.0% | 1.3517 1.7% -0.4% |
| JPY/ 77.14 1.4% | 77.1018 0.0% 0.0% | 77.0765 0.1% 0.1% | 77.0670 0.1% 0.0% | 76.9705 0.2% 0.1% | 76.88 0.3% 0.1% |
| CHF/ 0.899 -1.2% | 0.9073 -0.9% -0.9% | 0.9154 -1.8% -1.8% | 0.9195 -2.3% -0.4% | 0.9217 -2.5% -0.2% | 0.916 -1.9% 0.6% |
| CHF/EUR 1.2387 -1.5% | 1.2367 -0.2% -0.2% | 1.2387 0.0% 0.2% | 1.2383 0.0% 0.0% | 1.2408 -0.2% -0.2% | 1.2390 0.0% 0.1% |
| USD/ 0.9729 -0.9% | 1.0207 0.9797 -0.7% -0.7% | 1.0182 0.9821 -0.9% -0.2% | 1.0083 0.9918 -1.9% -0.9% | 0.9995 1.0005 -2.8% -0.9% | 1.001 0.9990 -2.7% 0.1% |
| 10 Year 2.057 | 2.04 | 2.05 | 2.00 | 1.97 | 2.003 |
| 2 Year T Note 0.23 | 0.23 | 0.24 | 0.25 | 0.26 | 0.282 |
| Germany Bond 2Y 0.40 10Y 1.89 | 2Y 0.31 10Y 1.78 | 2Y 0.31 10Y 1.78 | 2Y 0.40 10Y 1.81 | 2Y 0.45 10Y 1.89 | 2Y 0.47 10Y 1.97 |
| DJIA 12153.68 1.4% | -0.6% -0.6% | -0.5% 0.1% | -2.0% -1.6% | -3.2% -1.1% | -2.9% 0.2% |
| DJ Global 1862.40 0.1% | -0.8% -0.8% | -1.5% -0.7% | -2.6% -1.2% | -3.8% -1.3% | -4.2% -0.5% |
| DJ Asia Pacific 1202.13 -2.3% | 1.0% 1.0% | 0.2% -0.8% | -1.0% -1.2% | -1.1% -0.1% | -2.6% -1.6% |
| Nikkei 8514.47 -3.3% | 1.0% 1.0% | 0.3% -0.7% | -0.6% -0.9% | -0.4% 0.2% | -1.6% -1.2% |
| Shanghai 2481.08 -1.9% | 1.9% 1.9% | 1.9% 0.0% | -0.6% -2.5% | -0.7% -0.1% | -2.6% -1.9% |
| DAX 6057.03 1.4% | -1.2% -1.2% | -2.0% -0.9% | -2.4% -0.3% | -3.4% -1.1% | -4.2 -0.9% |
| DJ UBS Commodities 148.93 -0.4% | -0.7% -0.7% | 0.0% 0.7% | 0.2% 0.2% | -2.3% -2.5% | -2.7% -0.4% |
| WTI $ B 99.05 4.8% | 98.17 -0.9% -0.9% | 99.48 0.4% 1.3% | 101.64 2.6% 2.2% | 98.90 -0.1% -2.7% | 97.81 -1.2% -1.1% |
| Brent $/B 114.15 1.6% | 112.00 -1.9% -1.9% | 112.40 -1.5% 0.4% | 110.70 -3.0% -1.5% | 107.84 -5.5% -2.6% | 107.58 -5.8% -0.2% |
| Gold $/OZ 1790.0 1.9% | 1782.0 -0.4% -0.4% | 1788.60 -0.1% 0.4% | 1761.8 -1.6% -1.5% | 1722.0 -3.8% -2.3% | 1723.7 -3.7% 0.1% |
Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss
Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce
http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
Risk aversion returned in the weeks of Nov 11 and Nov 18 because of the uncertainties on rapidly moving political development in Greece, Italy and now Spain and lack of substantive measures at the G20 meeting. Most currency movements in Table 9 reflect risk aversion. The dollar appreciated 1.7 percent relative to the euro after appreciating 0.3 percent in the prior week. Safe-haven currencies, such as the Swiss franc (CHF) and the Japanese yen (JPY) have been under threat of appreciation. A characteristic of the global recession would be struggle for maintaining competitiveness by policies of regulation, trade and devaluation (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation War (2008c)). Appreciation of the exchange rate causes two major effects on Japan.
1. Trade. Consider an example with actual data (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-72). The yen traded at JPY 117.69/USD on Apr 2, 2007 and at JPY 102.77/USD on Apr 2, 2008, or appreciation of 12.7 percent. This meant that an export of JPY 10,000 to the US sold at USD 84.97 on Apr 2, 2007 [(JPY 10,000)/(USD 117.69/USD)], rising to USD 97.30 on Apr 2, 2008 [(JPY 10,000)/(JPY 102.77)]. If the goods sold by Japan were invoiced worldwide in dollars, Japanese’s companies would suffer a reduction in profit margins of 12.7 percent required to maintain the same dollar price. An export at cost of JPY 10,000 would only bring JPY 8,732 when converted at JPY 102.77 to maintain the price of USD 84.97 (USD 84.97 x JPY 102.77/USD). If profit margins were already tight, Japan would be uncompetitive and lose revenue and market share. The pain of Japan from dollar devaluation is illustrated by Table 58 in the Nov 6 comment of this blog (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html): The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 75.812/USD on Oct 28, 2011, for cumulative appreciation of 31.2 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Oct 28, 2011 (JPY 75.812) was 8.7 percent.
2. Foreign Earnings and Investment. Consider the case of a Japanese company receiving earnings from investment overseas. Accounting the earnings and investment in the books in Japan would also result in a loss of 12.7 percent. Accounting would show fewer yen for investment and earnings overseas.
There is a point of explosion of patience with dollar devaluation and domestic currency appreciation. Andrew Monahan, writing on “Japan intervenes on yen to cap sharp rise,” on Oct 31, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204528204577009152325076454.html?mod=WSJPRO_hpp_MIDDLETopStories), analyzes the intervention of the Bank of Japan, at request of the Ministry of Finance, on Oct 31, 2011. Traders consulted by Monahan estimate that the Bank of Japan sold JPY 7 trillion, about $92.31 billion, against the dollar, exceeding the JPY 4.5 trillion on Aug 4, 2011. The intervention caused an increase of the yen rate to JPY 79.55/USD relative to earlier trading at a low of JPY 75.31/USD. The JPY appreciated to JPY76.88/USD by Fri Nov 18 for cumulative appreciation of 3.4 percent from JPY 79.55 just after the intervention. The JPY appreciated another 0.3 percent in the week of Nov 18. Historically, interventions in yen currency markets have been unsuccessful (Pelaez and Pelaez, The Global Recession Risk (2007), 107-109). Interventions are even more difficult currently with daily trading of some $4 trillion in world currency markets. Risk aversion with zero interest rates in the US diverts hot capital movements toward safe-haven currencies such as Japan, causing appreciation of the yen.
Exchange rate controls by the Swiss National Bank (SNB) fixing the rate at a minimum of CHF 1.20/EUR (http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf) has prevented flight of capital into the Swiss franc. The Swiss franc depreciated 1.9 percent relative to the USD in the week of Nov 18 and remained unchanged relative to the euro. Risk aversion is evident in the depreciation of the Australian dollar by cumulative 2.7 percent in the week of Fr Nov 18 after additional depreciation by 0.9 percent in the week of Nov 11. Risk appetite would be revealed by carry trades from zero interest rates in the US and Japan into high yielding currencies such as in Australia with appreciation of the Australian dollar (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4, Pelaez and Pelaez, Government Intervention in Globalization (2008c), 70-4).
Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing risk aversion is captured by decrease of the yield of the 10-year Treasury note from 2.326 percent on Oct 28 to 2.003 percent on Fri Nov 18. The 10-year Treasury yield is still at a level well below consumer price inflation of 3.5 percent in the 12 months ending in Oct (http://www.bls.gov/cpi/). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury with declining yield of 0.234 percent on Nov 4 from 0.293 percent on Oct 28, 0.23 percent through the week of Nov 11 and increase to 0.282 on Nov 18. Investors are willing to sacrifice yield relative to inflation in defensive actions to avoid turbulence in valuations of risk financial assets but may be managing duration more carefully. During the financial panic of Sep 2008, funds moved away from risk exposures to government securities. A similar risk aversion phenomenon occurs in Germany. The estimate of euro zone CPI inflation is at 3.0 percent for the 12 months ending in Oct (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16112011-AP/EN/2-16112011-AP-EN.PDF) but the yield of the two-year German government bond remained at 0.47 by Nov 18 and the yield of the 10-year German government bond also remained at the low level of 1.97 percent. Safety overrides inflation-adjusted yield but there could be duration aversion.
World equity markets traded cautiously during the week in the uncertainty of the details and implementation of the deal of the European bank and sovereign debt deal and rapidly moving political development in Greece, Italy and now Spain. All the equity indexes in Table 9 fell during the week of Nov 18 with sharp equal drops of 4.2 percent for the Dow Global and Dax. The DJIA lost 2.9 percent, the Shanghai Composite and the DJ Asia Pacific fell 2.6 percent and the Nikkei dropped 1.6 percent. Increases in sovereign bonds of Italy and Spain drove the declines but moderated by Fri Nov 18.
Financial risk assets increase during moderation of risk aversion in carry trades from zero interest rates and fall during increasing risk aversion. Commodities fell together with equity indexes. The DJ-UBS commodities index fell 2.7 percent in the week of Nov 18. Brent lost 5.7 percent in reversal of hedges relative to WTI that fell 1.2 percent. Even gold lost 3.7 percent in the week of Nov 18.
There are three factors dominating valuations of risk financial assets that are systematically discussed in this blog.
1. Euro zone survival risk. The fundamental issue of sovereign risks in the euro zone is whether the group of countries with euro as common currency and unified monetary policy through the European Central Bank will (i) continue to exist with the same currency; (ii) downsize to a limited number of countries with the same currency; or (iii) revert to the prior system of individual national currencies.
2. United States Growth, Employment and Fiscal Soundness. Recent posts of this blog analyze the mediocre rate of growth of the US in contrast with V-shaped recovery in all expansions following recessions since World War II, deterioration of social and economic indicators, unemployment and underemployment of 30 million, decline of yearly hiring by 17 million, falling real wages and unsustainable central government or Treasury debt (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html http://cmpassocregulationblog.blogspot.com/2011/10/us-growth-standstill-at-08-percent.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html http://cmpassocregulationblog.blogspot.com/2011/09/global-growth-standstill-recession.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html).
3. World Economic Slowdown. Careful, detailed analysis of the slowdown of the world economy is provided in Section IV World Economic Slowdown. Data and analysis are provided for regions and countries that jointly account for about three quarters of world output.
Fiscal consolidation is facilitated by higher rates of economic growth as analyzed by Blanchard (2011WEOSep). The President of the ECB finds difficult environment for economic growth in the euro zone that was important in reaching the decision to lower the ECB’s policy rate (http://www.ecb.int/press/pressconf/2011/html/is111103.en.html):
“Let me now explain our assessment in greater detail, starting with the economic analysis. Real GDP growth in the euro area, which slowed in the second quarter of 2011 to 0.2% quarter on quarter, is expected to be very moderate in the second half of this year. There are signs that previously identified downside risks have been materialising, as reflected in unfavourable evidence from survey data. Looking forward, a number of factors seem to be dampening the underlying growth momentum in the euro area, including a moderation in the pace of global demand and unfavourable effects on overall financing conditions and on confidence resulting from ongoing tensions in a number of euro area sovereign debt markets. At the same time, we continue to expect euro area economic activity to benefit from continued positive economic growth in the emerging market economies, as well as from the low short-term interest rates and the various measures taken to support the functioning of the financial sector.”
Willem Buiter (2011Oct 31) writing on “EFSF needs bigger bazooka to maximize its firepower,” published on Oct 31 in the Financial Times (http://www.ft.com/intl/cms/s/0/c4886f7a-03d3-11e1-bbc5-00144feabdc0.html#axzz1cMoq63R5) provides tough but enlightened analysis of the needs for resolving the European sovereign risk crisis and the resources committed in the agreement of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES). According to Buiter (2011Oct31) the Oct 26 agreement only provided temporary and incomplete solutions to the three problems of (1) restructuring insolvent sovereigns; (2) recapitalizing multiple European banks; and (3) maintaining market access of sovereigns such as Spain and Italy. Buiter (2011Oct31) find that the “fire power” or “bazooka” of the European Financial Stability Facility (EFSF) (http://www.efsf.europa.eu/about/index.htm) must be somewhere between €2500 and €3000 billion to prevent an assault on Spain and Italy. The crisis is likely to worsen. The ultimate solution may be only through the financing in sale and repurchase agreements (SRP) with the European Central Bank the sovereign debt acquired by the EFSF. The showdown, according to Buiter (2011Oct31), will occur in choosing between the end of the euro area and the fiscal use or “abuse” of the European Central Bank.
In his first speech outside the European Central Bank, the President of the ECB Mario Draghi (2011Nov18) emphasized three essential principles of the institution in its history of 13 years:
1. Continuity. The ECB has the prime objective of ensuring medium-term price stability
2. Consistency. ECB policy is designed to maintain the main objective of price stability currently and in the future
3. Credibility. Draghi (2011Nov18) defines credibility as the success of “anchoring inflation expectations over the medium and longer term.” Credibility of sound policy is essential in preventing measures that can reverse policy (Kydland and Prescott (1977). Draghi (2011Nov18) finds that “this is the major contribution we can market in support of sustainable growth, employment creation and financial stability. And we are making this contribution in full independence.”
Draghi (2011Nov18) further states:
“National economic policies are equally responsible for restoring and maintaining financial stability. Solid public finances and structural reforms—which lay the basis for competitiveness, sustainable growth and job creation—are the two essential elements. But in the euro area there is a third essential element for financial stability and that must be rooted in a much more robust economic governance of the union going forward. In the first place now, it implies the urgent implementation of the European Council and Summit decisions. Where is the implementation of these long-standing decisions?”
Brian Blackstone and Marcus Walker, writing on Nov 19, 2011, on “European bank chief pushes back,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204517204577046501705055174.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the speech of Draghi (Nov18) in relation to other statements by authorities and the turmoil in sovereign debt in the week of Nov 18. Sovereign bond yields of Italy, Spain and France have been increasing in Nov. Italy punctured 7 percent and Spain came close. Blackstone and Walker find the view in markets that the ECB will continue the policy of buying modest amounts of sovereign bonds. Ralph Atkins and Victor Mallet, writing on Nov 18, 2011, on “ECB hits back at calls for intervention,” published by the Financial Times (http://www.ft.com/intl/cms/s/0/be180b56-11c9-11e1-a114-00144feabdc0.html#axzz1e0DWDBxp) also find that the call by Draghi (2011Nov18) to implement fiscal and structural reforms is a signal that the ECB will not compromise its credibility with large-scale purchases of sovereign debt. The program would be different from quantitative easing by the Fed that has concentrated in the purchase of highly-rated securities. Yields of several sovereign bonds in Europe incorporate default probabilities. Part of the turmoil in Spanish bond markets is related to elections on Sunday Oct 20.
Even with leverage of the EFSF, which Buiter (2011Oct 31 finds unfeasible), the solution turns again to taxpayers in Germany and possibly France with tough dimensions of needs versus feasible availability and political restraints. Those same taxpayers would have to recapitalize the European Central Bank if fiscal use or “abuse” of the euro zone central bank is opted versus collapse of the euro zone. The economic issue is not whether Germany should, which would be decided in elections, but whether Germany can pay alone for the profligacy of other sovereigns in the European Monetary Union. The Wriston “doctrine” on sovereign lending was predicated on the argument that countries do not bankrupt (Wriston 1982). Another Wriston idea was that the old Citibank should be more valuable dead than alive: if Citibank followed the model of the old Merrill Lynch and sold the individual components or franchises the value would be higher than that of the unbroken Citibank. There was a rise in leveraged buy outs (LBO) in the 1980s that has been extensively analyzed in academic literature (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 159-66). The debt crisis of the 1980s and many other episodes in history actually proved that a country can bankrupt and that many countries can bankrupt simultaneously.
The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the following Subsection IIA Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. Throughout the week of Nov 11 the yield of the 2-year bond of the government of Greece was quoted at over 75 percent and the 10-year bond yield traded at over 30 percent. In contrast, the 2-year US Treasury note traded at 0.282 percent and the 10-year at 2.003 percent while the comparable 2-year government bond of Germany traded at 0.47 percent and the 10-year government bond of Germany traded at 1.97 (see Table 9). There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. Financial turbulence during the week originated in the jump of the yield of the 10-year government bond of Italy above 7 percent. Markets calmed with the vote on the austerity program in Italy, auction of short-term government debt of Italy and prospects for implementation of austerity measures by a new administration of technocrats that received parliamentary vote of confidence. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt of 120 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIA links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy.
Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.
Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:
“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”
If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.
The prospects of survival of the euro zone are dire. Table 10 is constructed with current IMF World Economic Outlook database for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2010.
Table 10, World and Selected Regional and Country GDP and Fiscal Situation
| GDP 2010 | Primary Net Lending Borrowing | General Government Net Debt | |
| World | 62,911.2 | ||
| Euro Zone | 12,167.8 | -3.6 | 65.9 |
| Portugal | 229.2 | -6.3 | 88.7 |
| Ireland | 206.9 | -28.9 | 78.0 |
| Greece | 305.4 | -4.9 | 142.8 |
| Spain | 1,409.9 | -7.8 | 48.8 |
| Major Advanced Economies G7 | 31,716.9 | -6.5 | 76.5 |
| United States | 14,526.6 | -8.4 | 68.3 |
| UK | 2,250.2 | -7.7 | 67.7 |
| Germany | 3,286.5 | -1.2 | 57.6 |
| France | 2,562.7 | -4.9 | 76.5 |
| Japan | 5,458.8 | -8.1 | 117.2 |
| Canada | 1,577.0 | -4.9 | 32.2 |
| Italy | 2,055.1 | -0.3 | 99.4 |
| China | 5,878.3 | -2.3 | 33.8* |
| Cyprus | 23.2 | -5.3 | 61.6 |
*Gross Debt
Source: http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
The data in Table 10 are used for some very simple calculations in Table 11. The column “Net Debt USD Billions” in Table 11 is generated by applying the percentage in Table 10 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2010 is $3853.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3531.6 billion. There is some simple “unpleasant bond arithmetic” in the two final columns of Table 11. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.
Table 11, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %
| Net Debt USD Billions | Debt as % of Germany Plus France GDP | Debt as % of Germany GDP | |
| A Euro Area | 8,018.6 | ||
| B Germany | 1,893.0 | $7385.1 as % of $3286.5 =224.7% $5424.6 as % of $3286.5 =165.1% | |
| C France | 1,960.5 | ||
| B+C | 3,853.5 | GDP $5849.2 Total Debt $7385.1 Debt/GDP: 126.3% | |
| D Italy | 2,042.8 | ||
| E Spain | 688.0 | ||
| F Portugal | 203.3 | ||
| G Greece | 436.1 | ||
| H Ireland | 161.4 | ||
| Subtotal D+E+F+G+H | 3,531.6 |
Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
There is extremely important information in Table 21 for the current sovereign risk crisis in the euro zone. Table 12 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Sep. German exports to other European Union members are 58.9 percent of total exports in Sep and 59.7 percent in Jan-Sep. Exports to the euro area are 40.0 percent in Sep and 40.1 percent in Jan-Sep. Exports to third countries are only 40.4 percent of the total in Sep and 40.3 percent in Jan-Sep. There is similar distribution for imports. Economic performance in Germany is closely related to its high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone.
Table 12, Germany, Structure of Exports and Imports by Region, € Billions and ∆%
| Sep 2011 | 12 Months | Jan-Sep | Jan-Sep 2011/ | |
| Total | 95.0 | 10.5 | 791.7 | 13.5 |
| A. EU | 56.6 % 58.9 | 10.8 | 472.3 % 59.7 | 12.7 |
| Euro Area | 38.0 % 40.0 | 11.5 | 317.4 % 40.1 | 11.4 |
| Non-euro Area | 18.6 % 19.6 | 9.5 | 154.9 % 19.6 | 15.4 |
| B. Third Countries | 38.4 % 40.4 | 10.1 | 319.4 % 40.3 | 14.8 |
| Total Imports | 77.6 | 11.6 | 672.8 | 15.3 |
| C. EU Members | 50.1 % 64.5 | 13.8 | 426.5 % 63.4 | 16.0 |
| Euro Area | 34.7 % 44.7 | 13.0 | 300.3 % 44.6 | 15.2 |
| Non-euro Area | 15.4 | 15.6 | 126.2 | 17.9 |
| D. Third Countries | 27.5 % 35.4 | 7.9 | 246.4 % 36.6 | 14.2 |
Notes: Total Exports = A+B; Total Imports = C+D
IIA Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unepleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.
First, Unpleasant Monetarist Arithmetic. 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.
Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+τ 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 Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (5)
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 (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):
“We are here to think about what happens when [4] 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 [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. 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 [4] 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.
III Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 13 updated with every post, provides the latest annual 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). Newly available data on inflation is considered below in this section. The data in Table 13 for the euro zone and its members is updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table 13. Data for other countries in Table 13 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section IV World Economic Slowdown following with individual country and regional data tables.
Table 13, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 1.6 | 3.5 | 5.9 | 9.0 |
| Japan | 0.0 | 0.0 | 1.7 | 4.2 |
| China | 9.1 | 5.5 | 5.0 | |
| UK | 0.5 | 5.0* | 5.7* output | 8.3 |
| Euro Zone | 1.4 | 3.0 | 5.8 | 10.2 |
| Germany | 2.6 | 2.9 | 5.5 | 5.2 |
| France | 1.6 | 2.5 | 6.0 | 9.9 |
| Nether-lands | 1.1 | 2.8 | 7.5 | 4.5 |
| Finland | 2.8 | 3.2 | 6.2 | 7.8 |
| Belgium | 1.8 | 3.4 | 6.9 | 6.7 |
| Portugal | -1.7 | 4.0 | 5.5 | 12.5 |
| Ireland | NA | 1.5 | 4.2 | 14.2 |
| Italy | NA | 3.8 | 4.7 | 8.3 |
| Greece | -5.2 | 2.9 | 8.1 | 17.6 |
| Spain | 0.8 | 3.0 | 7.1 | 22.6 |
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.ons.gov.uk/ons/rel/ppi2/producer-price-index/october-2011/index.html
CPI http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/october-2011/index.html** Excluding food, beverage, tobacco and petroleum
Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html
Table 13 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.6 percent in IIIQ2011 relative to IIIQ2010 (Table 8, p 11 in http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp2q11_3rd.pdf); Japan’s GDP is flat in IIIQ2011 relative to IIIQ2010 but contracted 1.1 percent in IIQ2011 relative to IIQ2010 because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011; the UK grew at 0.5 percent in IIIQ2011 relative to IIIQ2010; and the Euro Zone grew at 1.4 percent in IIIQ2011 relative to IIIQ2010. These are stagnating or “growth recession” rates, which are positive growth rates instead of contractions but insufficient to recover employment. The rates of unemployment are quite high: 9.0 percent in the US but 18.1 percent for unemployment/underemployment (see Table 3 in http://cmpassocregulationblog.blogspot.com/2011/11/twenty-nine-million-unemployed-or.html), 4.2 percent for Japan, 8.3 percent for the UK with high rates of unemployment for young people and 10.2 percent in the Euro Zone. Twelve months rates of inflation have been quite high, even when some are moderating at the margin: 3.5 percent in the US, 0.0 percent for Japan and 3.0 percent for the Euro Zone also in the Oct. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). 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 II in this post http://cmpassocregulationblog.blogspot.com/2011/11/recovery-without-hiring-world-financial.html http://cmpassocregulationblog.blogspot.com/2011/11/twenty-nine-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html http://cmpassocregulationblog.blogspot.com/2011/10/properity-without-inflation-world.html http://cmpassocregulationblog.blogspot.com/2011/10/odds-of-slowdown-or-recession-united.html http://cmpassocregulationblog.blogspot.com/2011/10/twenty-nine-million-unemployedunderempl.html http://cmpassocregulationblog.blogspot.com/2011/10/us-growth-standstill-at-08-percent.html http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html http://cmpassocregulationblog.blogspot.com/2011/09/financial-turbulence-wriston-doctrine.html http://cmpassocregulationblog.blogspot.com/2011/09/global-growth-standstill-recession.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/08/world-financial-turbulence-global.html http://cmpassocregulationblog.blogspot.com/2011/08/global-growth-recession-25-to-30.html section II in http://cmpassocregulationblog.blogspot.com/2011/08/global-growth-recession-25-to-30.html http://cmpassocregulationblog.blogspot.com/2011/07/twenty-five-to-thirty-million.html http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html and Section I Increasing Risk Aversion in http://cmpassocregulationblog.blogspot.com/2011/06/increasing-risk-aversion-analysis-of.html 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 I Slow Growth by Reducing Savings in http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html http://cmpassocregulationblog.blogspot.com/2011/10/us-growth-standstill-at-08-percent.html http://cmpassocregulationblog.blogspot.com/2011/09/global-growth-standstill-recession.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/08/global-growth-recession-25-to-30.html http://cmpassocregulationblog.blogspot.com/2011/07/growth-recession-debt-financial-risk.html http://cmpassocregulationblog.blogspot.com/2011/06/financial-risk-aversion-slow-growth.html 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 (see Section I Recovery without Hiring, Section I United States Hiring Collapse in http://cmpassocregulationblog.blogspot.com/2011/11/recovery-without-hiring-world-financial.html http://cmpassocregulationblog.blogspot.com/2011/10/odds-of-slowdown-or-recession-united.html, http://cmpassocregulationblog.blogspot.com/2011/09/financial-turbulence-wriston-doctrine.html http://cmpassocregulationblog.blogspot.com/2011/08/world-financial-turbulence-global.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 (see Section I Twenty Nine Million Unemployed or Underemployed in http://cmpassocregulationblog.blogspot.com/2011/11/twenty-nine-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/10/twenty-nine-million-unemployedunderempl.html http://cmpassocregulationblog.blogspot.com/2011/09/global-growth-standstill-recession.html http://cmpassocregulationblog.blogspot.com/2011/07/twenty-five-to-thirty-million.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 http://cmpassocregulationblog.blogspot.com/2011/03/unemployment-and-undermployment.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see II Budget/Debt Quagmire in http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html 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 Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had 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.
There were no changes of direction in the meeting of the Federal Open Market Committee (FOMC) from Nov 1 to Nov 2, 2011. The FOMC released the statement as follows (http://www.federalreserve.gov/newsevents/press/monetary/20111102a.htm):
“For immediate release
Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year. Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has increased at a somewhat faster pace in recent months. Business investment in equipment and software has continued to expand, but investment in nonresidential structures is still weak, and the housing sector remains depressed. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.”
The FOMC also released the economic projections of governors of the Board of Governors of the Federal Reserve and Federal Reserve Banks presidents shown in Table 14. It is instructive to focus on 2012, as 2011 is almost gone, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC. The first row for each year shows the projection introduced after the meeting of Nov 2 and the second row “Jun PR” the projection of the Jun meeting. There are three major changes in the view.
1. Growth “GDP ∆.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun to 2.5 to 2.9 percent in Nov.
2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun to 8.5 to 8.7 percent in Nov.
3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun to virtually the same of 1.4 to 2.0 percent in Nov.
Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun of 1.4 to 2.0 percent and the Nov projection of 1.5 to 2.0 percent.
Table 14, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, November 2011
| ∆% GDP | UNEM % | ∆% PCE Inflation | ∆% Core PCE Inflation | |
| Central | ||||
| 2011 | 1.6 – 1.7 | 9.0 – 9.1 | 2.7 – 2.9 | 1.8 – 1.9 |
| 2012 | 2.5 – 2.9 | 8.5 – 8.7 | 1.4 – 2.0 | 1.5 – 2.0 |
| 2013 | 3.0 – 3.5 3.5 – 4.2 | 7.8 – 8.2 | 1.5 – 2.0 | 1.4 – 1.9 |
| 2014 | 3.0 – 3.9 | 6.8 – 7.7 | 1.5 – 2.0 | 1.5 – 2.0 |
| Longer Run | 2.4 – 2.7 | 5.2 – 6.0 | 1.7 – 2.0 | |
| Range | ||||
| 2011 | 1.6 – 1.8 | 8.9 – 9.1 | 2.5 – 3.3 | 1.7 – 2.0 |
| 2012 | 2.3 – 3.5 | 8.1 – 8.9 | 1.4 – 2.8 | 1.3 – 2.1 |
| 2013 | 2.7 – 4.0 | 7.5 – 8.4 | 1.4 – 2.5 | 1.4 – 2.1 |
| 2014 | 2.7 – 4.5 | 6.5 – 8.0 | 1.5 – 2.4 | 1.4 – 2.2 |
| Longer Run | 2.2 – 3.0 | 5.0 – 6.0 | 1.5 – 2.0 |
Notes: UEM: unemployment; PR: Projection
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20111102.pdf
An old advice of business economists recommends: “Do not forecast but if you must forecast then forecast often.” The FOMC actually forecasts infrequently or at least reveals forecasts with long lags. Indicators followed by the comments in this blog do show strengthening growth from 0.8 percent at annual equivalent for the first half of 2011 to 1.4 percent for the first three quarters of 2011 (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html). Recent recovery has been driven by decline in the savings rate from 5.1 percent to 4.1 percent while real disposable income has fallen by 1.7 percent. Labor markets continue to be fractured with unemployment or underemployment of 29 million, weak hiring and falling real wages. Inflation has been moving on waves with acceleration in more recent months relative to moderation in May-Jul (see section I, http://cmpassocregulationblog.blogspot.com/2011/10/properity-without-inflation-world.html). The translation of current trends or appearance of trends into forecasts with statistical predictive value is very difficult or nearly impossible. FOMC policy in the statement is to increase economic growth to reduce the rate of unemployment in accordance with its statutory dual mandate (http://www.federalreserve.gov/aboutthefed/mission.htm):
“The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.
Today, the Federal Reserve's duties fall into four general areas:
· conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
· supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers
· maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
· providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system”
The key phrase in this mission is: “influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.”
The Board of Governors of the Federal Reserve and the Federal Reserve Banks has competence at the frontiers of knowledge to develop optimum projections based on the state of the art. The need for projections originates in the belief in lags in effect of monetary policy based on technical research (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). Innovative research by Romer and Romer (2004, 1081) concludes:
“Estimates of the effects of policy using the new shock series indicates that monetary policy has large and statistically significant effects on real output. In our baseline specification, a shock of one percentage point starts to reduce industrial production after five months, with a maximum fall of 4.3 percent after two years. The peak effect is highly statistically significant. For prices, we find that the one-percentage point shock has little effect for almost two years, but then lowers the inflation rate by 2 to 3 percentage points. As a result, the price level is about 6 percent lower after four years. This estimate is overwhelmingly significant. The most important uncertainty concerns the lag in the impact of policy on prices: in some specifications, the price level begins falling within six months after the policy shock, while in others it is unchanged for as much as 22 months.”
In short, a monetary policy impulse implemented currently has effects in the future. Thus, monetary policy has to anticipate economic conditions in the future to determine doses and timing of policy impulses. Policy is actually based on “projections” such as those in Table 14 (on central banking see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 69-90, Regulation of Banks of Finance (2009b), 99-116). Bernanke (2003, 9) and Bernanke and Mishkin (1997, 106) characterize “inflation targeting” as “constrained discretion.” The constrained part means that the central bank is under the constraint of maintaining inflation at the desired level of 2.0 percent per year. The “discretion” part means that the central bank is concerned with maintaining output at the level that results in full employment. Central banks anchor inflation expectations at 2.0 percent by means of credible policy measures, that is, economic agents believe that central banks will take all required measures to prevent inflation from deviating from the goal of 2.0 percent. That credibility was lost during the stagflation of the 1960s and 1970s, which was an episode known as the Great Inflation and Unemployment (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011_05_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation). A more general and practical approach is analyzed by Svensson (2003, 429) in which central banks consider specific objectives, target levels, available information and “judgment.” Svensson (2003, 466) finds that actual practice consists of targeting forecasts of inflation. In fact, central banks also target output gaps. Policy is designed to attain the inflation forecast on the basis of existing technical knowledge, empirical information and judgment with minimization of the changes in the output gap. There is as much imprecision and resulting uncertainty in this process as in managing risk exposures by finance professionals on the basis of risk management techniques, existing information and “market sentiment.” In fact, Greenspan (2004, 36-7) has compared central banking to financial risk management (see Pelaez and Pelaez, The Global Recession Risk (2007), 212-14):
“The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term "uncertainty" is meant here to encompass both "Knightian uncertainty," in which the probability distribution of outcomes is unknown, and "risk," in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.
As a consequence, the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks. In essence, the risk management approach to monetary policymaking is an application of Bayesian decision making.”
Monetary policy is not superior in technique to “proprietary trading” by financial institutions but may actually be more difficult in implementation because of the complexity of knowledge of the entire economy with all of its institutions, including those engaged in trading. Traders can constantly observe changes in conditions that allow them to reverse risk exposures immediately or use loss limit rules. Traders also work in structures with tight chain of command. Rogue traders do cause major problems but infrequently. In contrast, central banks cannot reverse instantaneously the effects of policies because of the long and uncertain lags in effects of monetary policy. Central banks act in delegation of duties by the principals in Congress and the administration who also act in delegation of the ultimate principal consisting of electors. There is long delay in action of the electors in correcting policy errors.
There are two categories of responses in the Empire State Manufacturing Survey of the Federal Reserve Bank of New York (http://www.newyorkfed.org/survey/empire/nov2011.pdf): current conditions and expectations for the next six months. There are responses in the survey for two types of prices: prices received or inputs of production and prices paid or sales prices of products. Table 15 provides the responses and indexes for the two categories and within them for the two types of prices for May to Nov of 2011. Current prices paid were rising at an accelerating rate in May but the rate of increase has dropped significantly as shown by the decline in the index from 68.89 in May to 22.47 in Oct and now 18.29 in Nov. The index fell in every month from May to Aug and then again in Nov and Oct. The index of current prices received also fell sharply from 27.96 in May to 4.49 in Oct but rose to 6.10 in Nov, meaning that prices are increasing at a moderate rate relative to May. Responses of no change in prices received dominate with 79.78 percent in Oct and 69.51 in Nov. In the expectations for the next six months, the index of prices paid has also declined from 68.82 in May to 36.59 in Nov but there is still a high percentage of 42.68 percent of responses expecting rising prices. The index of expectations for the next six months of prices received has also fallen from 35.48 in May to 25.61 in Nov with 54.88 percent expecting no change in prices paid. As in prices paid, the expectation of prices received increased to 25.61 in Nov.
Table 15, US, FRBNY Empire State Manufacturing Survey, Prices Paid and Prices Received, SA
| Higher | Same | Lower | Index | |
| Current | ||||
| Prices Paid | ||||
| May | 69.89 | 30.11 | 0.00 | 69.89 |
| Jun | 58.16 | 39.80 | 2.04 | 56.12 |
| Jul | 47.78 | 47.78 | 4.44 | 43.33 |
| Aug | 34.78 | 58.70 | 6.52 | 28.26 |
| Sep | 34.78 | 63.04 | 2.17 | 32.61 |
| Oct | 29.21 | 64.04 | 6.74 | 22.47 |
| Nov | 26.83 | 64.63 | 8.54 | 18.29 |
| Prices Received | ||||
| May | 33.33 | 61.29 | 5.38 | 27.96 |
| Jun | 17.35 | 76.53 | 6.12 | 11.22 |
| Jul | 14.44 | 76.67 | 8.89 | 5.56 |
| Aug | 15.22 | 71.74 | 13.04 | 2.17 |
| Sep | 17.39 | 73.91 | 8.70 | 8.70 |
| Oct | 12.36 | 79.78 | 7.87 | 4.49 |
| Nov | 18.29 | 69.51 | 12.20 | 6.10 |
| Six Months | ||||
| Prices Paid | ||||
| May | 70.97 | 26.88 | 2.15 | 68.82 |
| Jun | 58.16 | 38.78 | 3.06 | 55.10 |
| Jul | 56.67 | 37.78 | 5.56 | 51.11 |
| Aug | 46.74 | 48.91 | 4.35 | 42.39 |
| Sep | 54.35 | 44.57 | 1.09 | 53.26 |
| Oct | 47.19 | 46.07 | 6.74 | 40.45 |
| Nov | 42.68 | 51.22 | 6.10 | 36.59 |
| Prices Received | ||||
| May | 40.86 | 53.76 | 5.38 | 35.48 |
| Jun | 30.61 | 58.16 | 11.22 | 19.39 |
| Jul | 38.89 | 52.22 | 8.89 | 30.00 |
| Aug | 23.91 | 67.39 | 8.70 | 15.22 |
| Sep | 33.70 | 55.43 | 10.87 | 22.83 |
| Oct | 28.09 | 61.80 | 10.11 | 17.98 |
| Nov | 35.37 | 54.88 | 9.76 | 25.61 |
Source: http://www.newyorkfed.org/survey/empire/nov2011.pdf
http://www.newyorkfed.org/survey/empire/sep2011.pdf
http://www.newyorkfed.org/survey/empire/july2011.pdf
http://www.newyorkfed.org/survey/empire/aug2011.pdf
Current prices for the Oct survey the Business Outlook index of the Federal Reserve Bank of Philadelphia in Table 16 are showing increases. Prices paid increased from 20.0 in Oct to 22.8 in Nov while prices received moved from contraction territory of minus 2.5 in Oct to 2.6 in Nov. The expectation for the next six months shows decline of prices paid from 44.7 in Oct to 40.9 in Nov. The expectation for the next six months shows prices received increasing from 25.4 in Oct to 29.7 in Nov.
Table 16, US, FRB of Philadelphia Business Outlook Survey, Prices Paid and Prices Received, SA
| Increase | No Change | Decrease | Index | |
| Current | ||||
| Prices Paid | ||||
| Nov | 31.4 | 56.3 | 8.5 | 22.8 |
| Oct | 30.6 | 58.1 | 10.6 | 20.0 |
| Sep | 28.9 | 58.1 | 5.7 | 23.2 |
| Aug | 26.1 | 59.4 | 13.3 | 12.8 |
| Jul | 32.6 | 59.9 | 7.5 | 25.1 |
| Jun | 36.6 | 49.6 | 9.8 | 26.8 |
| May | 56.3 | 35.6 | 8.0 | 48.3 |
| Prices Received | ||||
| Nov | 15.4 | 69.0 | 12.8 | 2.6 |
| Oct | 12.2 | 69.3 | 14.7 | -2.5 |
| Sep | 17.5 | 61.6 | 16.7 | 0.9 |
| Aug | 10.1 | 69.9 | 19.1 | -9.0 |
| Jul | 17.7 | 65.1 | 16.6 | 1.1 |
| Jun | 16.8 | 66.5 | 12.4 | 4.4 |
| May | 19.7 | 76.2 | 2.9 | 16.8 |
| Six Months | ||||
| Prices Paid | ||||
| Nov | 47.8 | 40.9 | 6.9 | 40.9 |
| Oct | 51.4 | 35.4 | 6.7 | 44.7 |
| Sep | 44.2 | 44.8 | 7.9 | 36.3 |
| Aug | 42.6 | 48.7 | 8.0 | 34.6 |
| Jul | 44.6 | 43.4 | 5.9 | 38.7 |
| Jun | 40.4 | 40.0 | 12.9 | 27.5 |
| May | 59.1 | 33.1 | 6.7 | 52.4 |
| Prices Received | ||||
| Nov | 37.5 | 52.5 | 7.7 | 29.7 |
| Oct | 34.3 | 48.9 | 8.9 | 25.4 |
| Sep | 27.6 | 56.5 | 9.4 | 18.2 |
| Aug | 30.1 | 54.6 | 13.6 | 16.5 |
| Jul | 22.5 | 61.4 | 14.2 | 8.3 |
| Jun | 19.3 | 56.0 | 16.7 | 2.5 |
| May | 34.9 | 53.2 | 7.6 | 27.3 |
Source: http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2011/bos1111.pdf
http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0911.pdf
Inflation in the euro zone in Table 17 is following three waves. In the first wave, inflation rose in Jan-Apr toward 3 percent in 12 months, with 2.8 percent in the twelve months ending in Apr. Annual equivalent inflation in Jan-Apr was 5.2 percent. In the second wave, inflation in May-Jul was equivalent to minus 2.4 percent for a full year and the 12 months rate stabilized between 2.5 percent and 2.7 percent. In the third wave, inflation in Aug-Oct rose to 5.3 percent in annual equivalent and settled at 3.0 percent in the 12 months ending in Oct.
Table 17, Euro Area Harmonized Index of Consumer Prices Month and 12 Months ∆%
| Month ∆% | 12 Months ∆% | |
| Oct 2011 | 0.3 | 3.0 |
| Sep | 0.8 | 3.0 |
| Aug | 0.2 | 2.5 |
| Aug-Oct | 5.3 | |
| Jul | -0.6 | 2.5 |
| Jun | 0.0 | 2.7 |
| May | 0.0 | 2.7 |
| AE ∆% May-Jul | -2.4 | |
| Apr | 0.6 | 2.8 |
| Mar | 1.4 | 2.7 |
| Feb | 0.4 | 2.4 |
| Jan | -0.7 | 2.3 |
| AE ∆% Jan-Apr | 5.2 | |
| Dec 2010 | 0.6 | 2.2 |
AE: annual equivalent
Source: http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database
Inflation in the euro zone remained subdued below 2 percent in the first five years of the euro zone from 1999 to 2004, as shown in Table 18. Inflation climbed above 2.0 percent after 2005, peaking at 3.7 percent in 2008 with the surge in commodity prices but falling to 1.0 percent in 2009 with the collapse of commodity prices. Inflation climbed back above 2.1 percent in 2010 and 2011.
Table 18, Euro Area, Yearly Percentage Change of Harmonized Index of Consumer Prices, ∆%
| Year | ∆% |
| 1999 | 1.2 |
| 2000 | 1.9 |
| 2001 | 2.2 |
| 2002 | 2.1 |
| 2003 | 2.0 |
| 2004 | 2.0 |
| 2005 | 2.2 |
| 2006 | 2.2 |
| 2007 | 2.3 |
| 2008 | 3.7 |
| 2009 | 1.0 |
| 2010 | 2.1 |
Eurostat provides the decomposition in percentage point contributions of the rate of inflation in 12 months in Oct 2011 relative to Oct 2010 shown in Table 19. Energy-rich components account for the 12 month rate of inflation with percentage point contributions: 0.55 by fuel for transport, 0.19 by heating oil and 0.12 by electricity. Table 19 only lists highest magnitudes of positive and negative contributions.
Table 19, Euro Area, Harmonized Index of Consumer Prices Sub-Indices with Most Important Impact %
| Oct 2011/ | Weight 2011 % | Rate ∆% | Impact |
| Positive Contribution | |||
| Fuel for Transport | 46.9 | 14.1 | 0.52 |
| Heating Oil | 9.5 | 24.1 | 0.19 |
| Electricity | 24.5 | 7.5 | 0.11 |
| Gas | 16.7 | 10.1 | 0.12 |
| Tobacco | 24.8 | 6.4 | 0.09 |
| Jewelry & Watches | 5.3 | 12.0 | 0.05 |
| Negative Contribution | |||
| Cars | 39.3 | 1.2 | -0.07 |
| Restaurants & Cafés | 70.1 | 2.0 | -0.08 |
| IT Equipment | 5.0 | -12.3 | -0.08 |
| Vegetables | 15.8 | -3.7 | -0.10 |
| Rents | 59.8 | 1.4 | -0.11 |
| Telecom | 30.1 | -2.0 | -0.16 |
PP: percentage points
Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16112011-AP/EN/2-16112011-AP-EN.PDF
Eurostat provides the decomposition in percentage point contributions of the rate of inflation of 0.3 percent in Oct 2011 relative to Sep 2011 shown in Table 20. The largest positive contribution originated in 0.12 percentage points from inflation of garments. Several items contributed 0.3 percentage points: footwear, gas and tobacco. In contrast, fuels for transport contributed minus 0.03 percentage points.
Table 20, Euro Area, Harmonized Index of Consumer Prices Sub-Indices with Most Important Impact %
| Oct 2011/ | Weight 2011 % | Rate ∆% | Impact Percentage Points |
| Positive Contribution | |||
| Garments | 49.5 | 2.7 | 0.12 |
| Footwear | 13.8 | 2.6 | 0.03 |
| Gas | 16.7 | 2.0 | 0.03 |
| Tobacco | 24.8 | 1.4 | 0.03 |
| Fruit | 11.7 | 2.1 | 0.02 |
| District Heating | 5.1 | 3.0 | 0.01 |
| Negative Contribution | |||
| Restaurants & Cafés | 70.1 | 0.1 | -0.02 |
| Air Transport | 5.8 | -2.7 | -0.02 |
| Package Holidays | 15.1 | -1.2 | -0.02 |
| Accommodation Services | 15.7 | -1.4 | -0.03 |
| Rents | 59.8 | -0.1 | -0.03 |
| Fuels for Transport | 46.9 | -0.3 | -0.03 |
Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16112011-AP/EN/2-16112011-AP-EN.PDF
The producer price index of Germany rose 0.3 percent in Oct relative to Sep and 5.3 percent in the 12 months ending in Oct, as shown in Table 21. The producer price index of Germany has the same three waves of inflation as in many other countries. In the first wave from Jan to Apr, the annual equivalent rate of producer price inflation was 7.1 percent, propelled by carry trades from zero interest rates to exposures in commodity futures in a mood of risk appetite. In the second wave in Apr and May, the annual equivalent rate of producer price inflation was only 1.2 percent because of the collapse of the carry trade in fear of risk from the European sovereign risk situation. In the third wave from Jul to Oct, producer price inflation in Germany has been 4.6 percent with fluctuations in commodity prices resulting from perception of the sovereign risk crisis in Europe. The producer price index fell 5.2 percent in the 12 months ending in Dec 2009 as a result of the fall of commodity prices originating in risk aversion after the panic of 2008.
Table 21, Germany, Producer Price Index ∆%
| 12 Months ∆% NSA | Month ∆% Calendar and SA | |
| Oct 2011 | 5.3 | 0.3 |
| Sep | 5.5 | 0.4 |
| Aug | 5.5 | 0.1 |
| Jul | 5.8 | 0.7 |
| AE ∆% Jul-Oct | 4.6 | |
| Jun | 5.6 | 0.1 |
| May | 6.1 | 0.1 |
| AE ∆% Jun-May | 1.2 | |
| Apr | 6.4 | 0.7 |
| Mar | 6.2 | 0.3 |
| Feb | 6.4 | 0.8 |
| Jan | 5.7 | 0.6 |
| AE ∆% Jan-Apr | 7.1 | |
| Dec 2010 | 5.3 | 0.8 |
| Nov | 4.4 | 0.3 |
| Oct | 4.3 | 0.5 |
| Sep | 3.9 | 0.5 |
| Aug | 3.2 | 0.1 |
| Jul | 3.7 | 0.7 |
| Jun | 1.7 | 0.5 |
| May | 0.9 | 0.2 |
| Apr | 0.6 | 0.6 |
| Mar | -1.5 | 0.6 |
| Feb | -2.9 | 0.1 |
| Jan | -3.4 | 0.4 |
| Dec 2009 | -5.2 | 0.2 |
| Dec 2008 | 4.0 | -0.2 |
| Dec 2007 | 1.9 | 0.4 |
| Dec 2006 | 4.2 | 0.2 |
| Dec 2005 | 4.8 | 0.2 |
| Dec 2004 | 2.9 | 0.2 |
| Dec 2003 | 1.8 | 0.0 |
Chart 30 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the producer price index of Germany from 2003 to 2011. Producer price inflation peaked in 2008 with the rise of commodity prices induced by the carry trade from zero interest rates to commodity futures. Prices then declined with the flight away from risk financial assets to government obligations after the financial panic in Sep 2008. With zero interest rates and no risk aversion, the carry trade pushed commodity future prices upwardly resulting in new rising trend of the producer price index.
Chart 30, Germany, Index of Producer Prices for Industrial Products, 2005=100
Source: Statistiche Bundesamt Deutschland
Chart 31 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the unadjusted producer price index and trend. There is a clear upward trend of prices after the end of risk aversion with zero interest rates in 2009.
Chart 31, Germany, Producer Price Index, Non-adjusted Value and Trend, 2005=100
Source: Statistiche Bundesamt Deutschland
The consumer price index of Italy in Table 22 also exhibits the same three waves of inflation worldwide induced by carry trades driven by unconventional monetary policy of zero interest rates. In the first wave in Jan-Apr, annual equivalent inflation was 4.9 percent. In the second wave in May-Jun, annual equivalent inflation was 1.2 percent. In the third wave in Jul-Oct, annual equivalent inflation has returned at 3.7 percent.
Table 22, Italy, Consumer Price Index
| Month | 12 Months | |
| Oct 2011 | 0.6 | 3.4 |
| Sep | 0.0 | 3.0 |
| Aug | 0.3 | 2.8 |
| Jul | 03 | 2.7 |
| AE ∆% Jul-Oct | 3.7 | |
| Jun | 0.1 | 2.7 |
| May | 0.1 | 2.6 |
| AE ∆% May-Jun | 1.2 | |
| Apr | 0.5 | 2.6 |
| Mar | 0.4 | 2.5 |
| Feb | 0.3 | 2.4 |
| Jan | 0.4 | 2.1 |
| AE ∆% Jan-Apr | 4.9 | |
| Dec 2010 | 0.4 | 1.9 |
Source: http://www.istat.it/it/archivio/45391
Chart 32 of Italy’s Istituto Nazionale di Statistica confirms an upward trend of inflation. Zero interest rates with alternating bouts of risk aversion results in an upward trend of inflation.
Chart 32, Italy, Consumer Prices 12 Months ∆%
Source: Istituto Nazionale di Statistica http://www.istat.it/en/
Consumer price inflation in the UK in 2011 is shown in Table 23. CPI inflation in Oct fell to 0.1 percent from 0.6 percent in both Sep and Aug. The same three waves are present in UK CPI inflation. In the first wave in Jan-Apr, annual equivalent inflation was at a high 6.5 percent. In the second wave in May-Jul, annual equivalent inflation fell to only 0.4 percent. In the third wave in Jul-Aug, annual equivalent inflation has returned at 5.3 percent.
Table 23, UK, Consumer Price Index, Month and 12 Months ∆%
| Month ∆% | 12 Months ∆% | |
| Oct 2011 | 0.1 | 5.0 |
| Sep | 0.6 | 5.2 |
| Aug | 0.6 | 4.5 |
| AE ∆% Jul-Aug | 5.3 | |
| Jul | 0.0 | 4.4 |
| Jun | -0.1 | 4.2 |
| May | 0.2 | 4.5 |
| May-Jul | 0.4 | |
| Apr | 1.0 | 4.5 |
| Mar | 0.3 | 4.0 |
| Feb | 0.7 | 4.4 |
| Jan | 0.1 | 4.0 |
| AE ∆% Jan-Apr | 6.5 | |
| Dec 2010 | 1.0 | 3.7 |
| Nov | 0.4 | 3.3 |
| Oct | 0.3 | 3.2 |
| Sep | 0.0 | 3.1 |
| Aug | 0.5 | 3.1 |
| Jul | -0.2 | 3.1 |
| Jun | 0.1 | 3.2 |
| May | 0.2 | 3.4 |
| Apr | 0.6 | 3.7 |
| Mar | 0.6 | 3.4 |
| Feb | 0.4 | 3.0 |
| Jan | -0.2 | 3.5 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/october-2011/index.html
Inflation has been unusually high in the UK since 2006, as shown in Table 24. There were no rates of inflation close to 2.0 percent in the period from 1997 to 2004. Inflation has exceeded 2 percent since 2005, reaching 3.6 percent in 2008 and 3.3 percent in 2010.
Table 24, UK, Consumer Price Index, Annual ∆%
| 1997 | 1.8 |
| 1998 | 1.6 |
| 1999 | 1.3 |
| 2000 | 0.8 |
| 2001 | 1.2 |
| 2002 | 1.3 |
| 2003 | 1.4 |
| 2004 | 1.3 |
| 2005 | 2.1 |
| 2006 | 2.3 |
| 2007 | 2.3 |
| 2008 | 3.6 |
| 2009 | 2.2 |
| 2010 | 3.3 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/october-2011/index.html
Table 25 provides the analysis of the monthly rate of inflation in Oct by the UK Office for National Statistics. The drivers of monthly inflation of 0.1 percent were clothing and footwear with contribution of 0.05 percentage points; housing and household services with contribution of 0.08 percentage points; recreation and culture with 0.10 percentage points; and education with 0.05 percentage points. Transport fell 0.7 percent in Sep with contribution of minus 0.11 percentage points and food and nonalcoholic beverages fell 0.9 percent with negative contribution of 0.10 percentage points. Contributions of percentage points to the 12 months rate of consumer price inflation of 5.0 provided by the UK Office for National Statistics are also in Table 25. Housing and household services rose 9.1 percent in 12 months, contributing 1.16 percentage points. Transport rose 7.7 percent in 12 months, contributing 1.23 percentage points. There is only negative change of 0.5 percent in recreation and culture but with negligible impact on the index.
Table 25, UK, Consumer Price Index Month ∆% and Percentage Point Contribution by Components
| Oct 2011 | Month ∆% | Percentage Point Contribution | 12 Months ∆% | Percentage Point Contribution |
| CPI All Items | 0.1 | 5.0 | ||
| Food & Non-Alcoholic Beverages | -0.9 | -0.10 | 5.0 | 0.56 |
| Alcohol & Tobacco | 0.0 | 0.00 | 9.1 | 0.38 |
| Clothing & Footwear | 0.8 | 0.0.5 | 3.6 | 0.26 |
| Housing & Household Services | 0.6 | 0.08 | 9.1 | 1.16 |
| Furniture & Household Goods | -0.6 | -0.04 | 5.7 | 0.36 |
| Health | 0.1 | 0.00 | 3.0 | 0.07 |
| Transport | -0.7 | -0.11 | 7.7 | 1.23 |
| Communication | -0.1 | 0.00 | 4.8 | 0.13 |
| Recreation & Culture | 0.7 | 0.10 | -0.5 | -0.07 |
| Education | 2.7 | 0.05 | 5.1 | 0.09 |
| Restaurants & Hotels | 0.0 | 0.00 | 4.5 | 0.55 |
| Miscellaneous Goods & Services | 0.4 | 0.04 | 2.8 | 0.27 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/october-2011/index.html
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