Financial Risk Aversion, Slow Growth, Budget/Debt Quagmire and Global Inflation
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011
Executive Summary
I Financial Risk Aversion
II Slow Growth
IIA Third Estimate of IQ2011 GDP
IIB Growth Forecasts
III Budget/Debt Quagmire
IIIA CBO Long-term Budget Outlook
IIIB Timing of Reducing the Fiscal Stimulus
IIIC Composition of Policy Measures
IV Global Inflation
V Valuation of Risk Financial Assets
VI Interest Rates
VII Conclusion
References
Executive Summary
There are three events that significantly influence financial markets and economic activity, which are analyzed in this comment. European sovereign risks have caused since April 2010 the strongest shocks of financial risk aversion after the flight to government securities in September 2008. This is a crucial week with two legislative votes on the Greek austerity program that are required for release of the bailout tranche with which Greece can avoid default of maturing bonds in July. Major financial institutions are exposed to Greek sovereign debts. Total exposures of European financial institutions to sovereign risks in doubt are about two trillion dollars. A Greek default could raise interest costs for other countries in need of foreign loans. The world financial system is linked in multiple ways. The “troika” of the European Union, European Central Bank and International Monetary Fund agreed on proposed measures of fiscal adjustment by Greece that require the approval of parliament. Downgrades of credit ratings of lenders could by itself also create adverse repercussions throughout the world financial system. More definitive solutions could be found by bridging Greece to a more favorable financial environment.
The Congressional Budget Office (CBO) released a new long-term budget outlook. In the extended-baseline scenario, debt held by the public increases from 69 percent of GDP in 2011, much higher than 40 percent of GDP in 2008, to 76 percent of GDP in 2021 and 84 percent of GDP in 2035. Albert Einstein is attributed phrases such as “compound interest is the greatest mathematical discovery of all time” and “the most powerful force in the universe is compound interest.” An important aspect of the baseline-scenario is that interest payments on the debt held by the public increase from 1.4 percent of GDP in 2011 to 3.4 percent of GDP in 2021 and to 4.1 percent of GDP in 2035. An important distinguishing characteristic of the alternative fiscal scenario is the much sharper increase in debt held by the public from 69 percent of GDP in 2011 to 101 percent of GDP in 2021 and 187 percent of GDP in 2035. Accordingly, interest payments on the debt jump from 1.4 percent of GDP in 2011 to 8.9 percent of GDP in 2035. In contrast with the extended-baseline scenario, the alternative fiscal scenario fixes revenue as percent of GDP at 18.4 percent after 2035. It has been almost impossible for the US federal government to tax more than 20 percent of GDP. The critical risk of US debt according to the CBO is that in a fiscal crisis “investors become unwilling to finance all of a government’s borrowing needs unless they are compensated with very high interest rates; as a result, the interest rates on government debt rise suddenly and sharply relative to rates of return on other assets” (CBO 2011LTBO, 34). There are two strands of thought proposed by prominent economists on how to deal with the debt issue, growth and employment, which are discussed in terms of multiple contributions. (1) The timing of exit from the fiscal programs is reconciled with the need to recover economic growth and employment creation. (2) The composition of measures of fiscal adjustment is reconciled with the need for economic growth and employment creation. These two strands of thought illustrate the technical approaches that can guide political conciliation of views.
The Annual Report of the Bank for International Settlements (BIS) for 2010/2011 warns about a third extremely important policy need (http://www.bis.org/publ/arpdf/ar2011e1.pdf 5):
“But controlling inflation in the long term will require policy tightening. And with short-term inflation up, that means a quicker normalisation of policy rates. Expectations that short-term interest rates would rise contributed to the increase in long-term bond yields seen until early 2011.”
Inflation is not only a phenomenon in emerging economies growing more rapidly. Slack is not a good predictor of historical inflation events. There is inflation throughout the world economy, including advanced economies. Policy rates should be adjusted to normal levels that can guide again risk/return decisions.
I Financial Risk Aversion. The past seven weeks have been characterized by unusual financial turbulence. Table 1, updated with every comment in this blog, provides beginning values on Jun 20 and daily values throughout the week ending on Jun 24. All data are for New York time at 5 PM. The first three rows provide three key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. The dollar appreciated by 0.8 percent relative to the euro with cumulative appreciation occurring mostly after Wed Jun 22 because of the fears of default in Greece with adverse repercussions in sovereign debts of other countries in Europe’s “periphery” as well as in “core countries” through exposures of banks. The week was characterized by major events such as the confidence vote on the Prime Minister of Greece on Thu Jun 21, which alleviated risk aversion as shown by depreciation of the dollar by cumulative 0.7 percent by Wed Jun 22. Leaders of the European Union pledged required assistance to Greece that must pass two laws on required fiscal adjustment and its implementation to receive a tranche of bailout funds in Jul that would avoid default on debt obligations. These events are discussed in detail after analysis of the data in Table 1. The Japanese yen depreciated during the week finally reaching JPY 80.39/USD by Fri Jun 24, which is still quite strong as the currency is used as safe haven from world risks while fears of another Japanese and G7 intervention subsided. The Swiss franc appreciated 1.2 percent during the week, reaching CHF 0.8380/USD on Fri Jun 24, which could be a signal of risk aversion by funds fleeing temporarily to safe haven in a strong deposit and investment market.
Table 1, Daily Valuation of Risk Financial Assets
| Jun 20 | Jun 21 | Jun 22 | Jun 23 | Jun 24 | |
| USD/ | 1.4302 0.03% | 1.4402 -0.7% | 1.4348 -0.3% | 1.4254 0.4% | 1.4190 0.8% |
| JPY/ | 80.29 -0.4% | 80.2045 -0.3% | 80.337 -0.4% | 80.5295 -0.7% | 80.39 -0.5% |
| CHF/ | 0.8465 0.2% | 0.8404 0.9% | 0.8396 1.0% | 0.8388 1.1% | 0.8380 1.2% |
| 10 Year Yield | 2.95 | 2.98 | 2.98 | 2.91 | 2.872 |
| 2 Year Yield | 0.37 | 0.37 | 0.37 | 0.34 | 0.338 |
| 10 Year | 2.96 | 2.98 | 2.94 | 2.87 | 2.83 |
| DJIA | 0.63% 0.63% | 1.55% 1.91% | 0.88% -0.66% | 0.38% -0.49% | -0.58% -0.96% |
| DJ Global | -0.15% -0.15% | 1.48% 1.63% | 1.27% -0.21% | -0.15% -1.41% | -0.38% -0.23% |
| DAX | -0.19% -0.19% | 1.69% 1.89% | 1.59% -0.10% | -0.20% -1.77% | -0.59% -0.39% |
| DJ Asia Pacific | -0.44% -0.44% | 0.74% 1.19% | 1.65% 0.90% | 0.76% -0.88% | 1.87% 1.11% |
| WTI $/b | 93.41 0.35% 0.35% | 93.700 0.67% 0.31% | 94.580 1.61% 0.94% | 91.860 -1.31% -2.88% | 91.130 -2.09% -0.79% |
| Brent $/b | 111.77 -1.28% -1.28% | 110.360 -2.53% -1.26% | 113.530 0.27% 2.87% | 108.120 -4.51% -4.77% | 105.550 -6.77% -2.38% |
| Gold $/ounce | 1541.50 0.12% 0.12% | 1547.30 0.50% 0.38% | 1551.40 0.77% 0.27% | 1521.80 -1.16% -1.91% | 1502.90 -2.38% -1.24% |
Note: For the exchange rates the percentage is the cumulative change since Fri the prior week; for the exchange rates appreciation is a positive percentage and depreciation a negative percentage; USD: US dollar; JPY: Japanese Yen; CHF: Swiss Franc; AUD: Australian dollar; B: barrel; for the four stock indexes and prices of oil and gold the upper line is the percentage change since the past week and the lower line the percentage change from the prior day;
Source: http://noir.bloomberg.com/intro_markets.html
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
The three sovereign bond yields in Table 1 capture risk aversion in the flight to the safety of US Treasury securities and German securities. The 2-year US Treasury note is highly attractive because of minimal duration or sensitivity to price change and its yield continued declining for a sustained period to 0.338 percent per year on Fri Jun 24. Much the same is true of the 10-year Treasury note and the 10-year bond of the government of Germany, falling to 2.872 percent for the 10-year Treasury note and to 2.83 percent for the 10-year government bond of Germany. Section V Valuation of Risk Financial Assets provides more details and comparisons of performance in peaks and troughs.
The upper line in the stock indexes in Table 1 measures the percentage cumulative change since the closing level in the prior week on Jun 3 and the lower line measures the daily percentage change. E. S. Browning, writing on Jun 11 in the Wall Street Journal on “Stocks swoon, worry rises” (http://professional.wsj.com/article/SB10001424052702304259304576377970959834268.html?mod=WSJ_hp_LEFTWhatsNewsCollection), correctly attributes the new round of risk aversion to concerns about slowing growth in the US, doubts on European sovereign risks and slowing growth in Asia. The DJIA had accumulated a decline of 6.7 percent in six weeks, or 1.1 percent on average, from the high level in Apr to Jun 10. Section IV Valuation of Risk Financial Assets tracks financial risk and opportunities with emphasis on the European sovereign risk issues that developed between Apr and Jul 2010 and recurred in Nov 2010 with Ireland and now after Mar with Portugal followed by a showdown with Greece. The revealing chart in the WSJ Browning article (http://professional.wsj.com/article/SB10001424052702304259304576377970959834268.html?mod=WSJ_hp_LEFTWhatsNewsCollection) shows that the DJIA last declined during six consecutive weeks in 2002. The DJIA fell 0.58 percent in the week of Jun 24 in Table 1, which is the seventh decline in the past eight weeks. The DJIA has declined from 12810.54 on Fri Apr 29 to 11934.58 on Fri June 24 or by 6.8 percent. The S&P 500 has declined in seven of the past eight weeks from 1363.61 on Fri Apr 29 to 1268.45 on Fri Jun 24 (http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata) or by 6.9 percent. The DJ Global Index fell 0.58 percent in the week of Jun 24 and has lost 9.5 percent between Apr 29 and Jun 24. The DAX index of Germany lost 0.59 percent in the week of Jun 24 and has lost 5.2 percent since Apr 29. The Dow Asia Pacific TSM actually gained 1.87 percent in the week of Jun 24 but has lost 5.0 percent since Apr 29. Japan’s all industry index rose 1.5 percent in Apr, showing strong recovery (http://www.meti.go.jp/statistics/tyo/zenkatu/result-2/pdf/hv37913_201104j.pdf), which lifted Asian stock markets. Section V Valuation of Risk Financial Assets provides more details and comparisons of performance in peaks and troughs.
The final block of data in Table 1 shows the collapse of oil prices by 2.1 percent for WTI and 6.8 percent for Brent as a result of the planned release of oil from the strategic reserves of 27 countries. The collapse of oil prices was caused by the announcement on Jun 23 by the Energy Information Agency (EIA) of the US that the International Energy Agency (IEA) had agreed to release 60 million barrels of oil from the strategic reserves of the US and 27 other member countries of the IEA (http://www.eia.gov/todayinenergy/detail.cfm?id=1950). The release will be at the rate of 2 million barrels per day over the next month. The US is making available 30 million barrels and the other 27 members of the IEA the remaining 30 million barrels. Keith Johnson and Guy Chazan writing on Jun 24 on “World oil reserves tapped” in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303339904576403570929000178.html?mod=WSJ_hp_LEFTWhatsNewsCollection) argue that the impact of the release is more psychological than physical because the 60 million barrels are equivalent to less than one day of world consumption of crude oil and around three days of US consumption of crude oil. The daily impact of two million barrels released is minimal. Gold prices also declined by 2.4 percent during the week. Risk aversion has been dominating valuations of risk financial assets in an evident flight to quality but in much milder scale than during the credit/dollar crisis and global recession after 2007.
The combination of debt/GDP ratio of about 150 percent, yields of two year bonds fluctuating between 20 and 30 percent, negative primary budget deficit and unfavorable foreign funding environment lead Feldstein (2011Jun22) to the conclusion that Greece’s default is inevitable. The important issue is when and how to default. An immediate default of Greece could have adverse effects on foreign funding of other euro zone members such as Ireland, Portugal and Spain. Generalized default could impair the balance sheets of major European banks. At a meeting of the European Systemic Risk Board, the President of the European Central Bank (ECB), Jean-Claude Trichet, declared that the relation of banks to sovereign debts poses the most important risk to the European Union’s financial stability (see Jeff Black and Gabi Thesing, “Trichet says risk signals ‘red’ as crisis threatens banks,” Bloomberg, Jun 23 http://noir.bloomberg.com/apps/news?pid=20601087&sid=acuWqe_1VG80&pos=1). An effective plan could create a transition period during which banks would be able to improve their balance sheets to write down unsound sovereign debts and exposures to countries in debt difficulties. A possible solution analyzed by Feldstein (2011Jun22) consists of aligning the interest of creditor and debtors with three ingredients: (1) interest capitalization and new loans may be attractive to banks to avoid default of their debtors; (2) ECB would accept new loans as collateral for loans but not debt restructured in default; and (3) peer pressure on banks and various creditors could reveal the advantages of avoiding defaults. These three ingredients could provide an incentive for banks and creditors to engage in the “voluntary” approach to providing new loans. The ECB or other probable investors could acquire the new loans. The objective is to improve the balance sheets of banks by debt reduction and increased capital to the point at which they can sustain the loss from sovereign debt default. The process would be similar to the Brady Plan that reduced the debt of Latin American countries in the 1980s to manageable levels (see for example Krugman 1994 in vast literature on the debt crisis of the 1980s). Feldstein (2011Jun22) finds that a difficulty in the sovereigns of Europe is that because of the single currency they cannot devalue their currencies to generate trade surpluses that could promote growth and resulting fiscal adjustment as it occurred with, for example, Brazil that devalued in 1983 to compensate for the loss of competitiveness to Germany, benefitting from the boom in world trade in 1984.
Aaron Kirchfeld and Elena Logutenkova provide important information and analysis on Greek potential default in an article on Jun 20 for Bloomberg on “Greek default spells ‘havoc’ for banks a year after bailout” (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a9NUZxaO9Fq8). Data of the Bank for International Settlements (BIS) for year-end 2010 measure that banks in Europe have exposure of almost $2 trillion to Portugal, Ireland, Spain and Italy. There are four important elements of risk provided by Kirchfeld and Logutenkova: (1) A Swiss rating agency, Independent Credit View, estimates that 33 of the largest banks in Europe require additional capital of $347 billion by the end of 2012 to increase capital to 10 per cent of risk-weighted assets from 9.1 percent in 2010; (2) stress tests by Standard & Poor’s released in Mar estimate that European banks may require €250 billion of new capital if there were stress of high interest rates and strong economic contraction; (3) French banks, according to BIS data, have the highest exposure to Greece with $56.7 billion that includes $15 billion of sovereign debt at the end of 2010 while the exposure of French banks to Ireland, Italy and Spain reaches $589.8 billion; and (4) the exposure of German banks to Greece is only $22.7 billion but the exposure to Ireland, Italy, Portugal and Spain reaches $498.8 billion and the joint exposure of French and German banks is equivalent to 60 percent of Greece’s obligations to banks. Kirchfeld and Logutenkova identify a chain of reactions to default by Greece: (1) refinancing costs of Ireland, Portugal and Spain could increase, preventing efforts to continue fiscal adjustment and probably provoking more defaults; (2) banks with precarious balance sheets located in other countries could experience funding stress while other banks could suffer erosion of their capital base because of deductions for defaults; (3) there would be flight of risk capital away from stock exchanges and euro-denominated assets to safe havens such as dollar-denominated Treasury securities, deposits in Switzerland and similar assets perceived with lower risk; and (4) in the worst scenario there would be a flight away from private debt into government securities as in Sep of 2008.
It is conceivable that default may not be required for major global stress and that all that is needed is downgrading of credit ratings of banks in anticipation of default risk. Such a process could well be underway. Michael Mackenzie and Nicole Bullock in an article on Jun 24 on “Flight from money market funds exposed to EU banks” published by the Financial Times (http://www.ft.com/intl/cms/s/0/eceac008-9e75-11e0-9469-00144feabdc0.html#axzz1QHWSaYiU) inform the reduction of exposures by US banks to their European counterparties. Mackenzie and Bullock quote data from the Investment Company Institute. Taxable non-government funds experienced withdrawal of $51.3 billion from $1120.27 billion on Jun 8 to $1069.02 billion on Jun 22 (“Money market mutual fund assets,” Jun 23, Investor Company Institute http://www.ici.org/research/stats/mmf/mm_06_23_11). McKenzie and Bullock remind that institutional withdrawals are relatively low compared with withdrawals of $400 billion from US money market funds after the Lehman Sep 2008 collapse. McKenzie and Bullock quote Fitch that 40 percent of assets of money market funds are issued by the 15 largest banks of which ten are European banks that account for 30 percent of total money market fund assets. Matt Phillips, Elena Berton and Sebastian Moffett writing on Jun 16 in an article on “French banks warned on their Greek debt” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702304186404576386872909695108.html
) inform the warnings to three large French banks by Moody’s Investors Service that their credit ratings could be downgraded. Javier E. David writing on Jun 17 in the Europe Business News of the Wall Street Journal on “Moody’s puts Italy’s rating on watch” (http://professional.wsj.com/article/SB10001424052702303635604576392112978533044.html
) informs the decision by Moody’s Investors Service to place Italy on notice that its sovereign debt rating is in danger because of sluggish economic growth, increasing interest rates, weak plan of fiscal consolidation and the effects of the euro zone debt crisis. A Market Comment by Dow Jones Newswires on Jun 24, “Milan stocks end lower, dragged down by banks” (http://professional.wsj.com/article/TPDJI0000020110624e76o00108.html) informs that the FTSE MIB stock index of Milan fell 1.6 percent on Fri Jun 24 because of sharp declines in the stock values of three Italian banks. Trading was temporarily suspended pending an investigation. Martin Vaughan and Art Patnaude in an article on May 24 on “Moody’s: Greek default may hit Europe ratings” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702304520804576342562248452484.html
) inform that Moody’s Investors Service may downgrade Greece and maybe other European countries if there is some form of default by Greece. Such an event could have strong repercussions for the creditworthiness of European institutions.
James G. Neuger in an article on Jun 23 on “EU pledges to meet Greece’s July needs” published by Bloomberg (http://www.bloomberg.com/news/2011-06-23/greece-faces-renewed-pressure-to-pass-deficit-cuts-as-eu-s-leaders-meet.html) informs that leaders of the European Union promised to take all necessary measures to provide financing for Greece in Jul. Maria Petrakis writing on Jun 23 on “Greece’s additional budget cuts backed by EU-IMF” published by Bloomberg (http://www.bloomberg.com/news/2011-06-23/greece-sets-solidarity-levy-on-wages.html) informs that the European Union and the IMF approved the austerity measures to be taken by Greece to obtain the release of a tranche of the bailout package of 2010 in order to avoid default on €6.6 billion of Greek bonds maturing in Jul. There are two legislative decisions required by Greece from its parliament on the approval of the austerity measures, to be voted in the week of Jun 27, and subsequently on the form of their implementation. The measures include new income tax rates and the sale of €50 billion of state assets. There are two political tests of the bailout plans. (1) The population of the bailed out countries must support the measures, avoiding troubled political events. (2) The electorate in the countries providing bailout resources must support the contributions to the rescue programs. Laura Stevens writing on Jun 25 on “Germans, prizing virtues of savings, find euro bailouts hard to swallow” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702304569504576406014281865254.html?mod=WSJPRO_hps_MIDDLESecondNews) informs that Germany has become quite frugal with the average savings rate in 2010 at 11.5 percent, based on data by the OECD, compared with 5.7 percent for the US and an average spending increase of 12 percent on earnings in Greece in 2008. The difference in saving and spending habits may explain the hurdles found by leaders in countries funding the bailouts in obtaining support from their constituencies.
Markit’s flash estimate of euro zone purchasing managers indexes (PMI) show deceleration of growth (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jun/EZ_Flash_ENG_1107_PR.pdf). The flash estimate of the euro zone manufacturing PMI fell from 54.6 in May to 52.0 in Jun, which is an 18-month low. The flash estimate of manufacturing PMI output fell from 55.2 in May to 52.4 in Jun, which is a 21-month low. The flash estimate of services PMI business activity fell from 56.0 in May to 54.2 in Jun, which is a 6-month low. The flash estimate of euro zone PMI composite output index, which is a weighted average of manufacturing output and services business, fell from 55.8 in May to 53.6 in Jun, which is a 20-month low. The PMI periphery output index excluding France and Germany registered the first fall since Nov 2009 and the fastest rate of rate decline since Sep 2009. The Markit PMI® for Germany suggests that GDP growth decelerated from 1.5 percent in IQ2011 to 1.0 percent in IIQ2011 (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jun/PMI%20and%20IFO%20surveys_11_06_24.pdf).
The HSBC flash manufacturing PMI® of China compiled by Markit (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jun/CN_Manufacturing_ENG_1107_PR_FLASH.pdf) fell from 51.6 in May to 50.1 in Jun, bordering stagnation, and the Flash China Manufacturing output index fell from 51.6 in May to 50.0 in Jun, both of which are at 11-mont lows. The indexes are consistent with a growth rate of GDP of 9.3 percent (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jun/CN_NOTE_23_06_11.pdf).
One of the factors restraining inflation in the US has been the purchase of apparel and related products such as shoes from China at relatively stable or even declining prices over time. John Hilsenrath, Laurie Burkitt and Elizabeth Holmes, writing on Jun 21 on “Change in China hits US purse,” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303499204576387774214424658.html
) show how this bliss may be ending. Imported-goods prices are increasing and beginning to affect inflation. Hilsenrath, Burkitt and Holmes find declines of apparel consumer prices in the US in 13 of the pasts 17 years. Apparel consumer prices rose 1.0 percent in the 12 months ending in May 2011 and 2.1 percent in annual equivalent rate in the first five months of 2011. Apparel prices rose at the 3.6 percent annual equivalent rate in the quarter Mar to May 2011 and 1.2 percent in the month of May (see Table 10 in http://www.bls.gov/news.release/pdf/cpi.pdf). Hilsenrath, Burkitt and Holmes analyze important cost increases in China such as cotton prices and labor that is not as abundant and cheap as before. Since 2005, China has been following a policy of revaluation of the Chinese yuan (CNY) relative to the US dollar (USD) from CNY 8.2765/USD on Jul 21, 2005 to CNY 6.4750/USD on Jun 24, 2011, or revaluation by 21.8 percent. The intent of the policy is to make goods produced in other countries cheaper than Chinese-produced goods both in the internal market of China and in those of other countries. Invoicing in dollars by China would result in a loss of CNY receipts. A good sold for USD 1 in 2005 would bring CNY 8.2765 but a good sold for USD 1 currently would bring only CNY 6.4710, for a loss of 21.8 percent of CNY revenue. Profit margins were also eroded by inflation. It becomes increasingly difficult for China to maintain fixed invoiced dollar prices. The Premier of China, Wen Jiabao (2011Jun23), writing on Jun 23 on “How China plans to reinforce the global recovery” published by the Financial Times (http://www.ft.com/intl/cms/s/0/e3fe038a-9dc9-11e0-b30c-00144feabdc0.html#axzz1QHWSaYiU) argues that China pursued a policy of stimulating demand to maintain sound growth during the global recession while continuing reforms to improve the wellbeing of the population and the country’s development. Premier Jiabao finds that inflation can be controlled and expects it to decline continuously.
II Slow Growth. Subsection IIA Third Estimate of IQ2011 GDP analyzes the third release of the national accounts for the first quarter and subsection IIB Growth Forecasts provides the new forecasts by the Board of Governors of the Federal Reserve Bank and the members of the Federal Open Market Committee.
IIA Third Estimate of IQ2011 GDP. Historical parallels are instructive but have all the limitations of empirical research in economics. The more instructive comparisons are not with the Great Depression of the 1930s but rather with the recessions in the 1950s, 1970s and 1980s.
The growth rate and job creation in the expansion of the economy away from recession are subpar in the current expansion compared to others in the past. Four recessions are initially considered, following the reference dates of the National Bureau of Economic Research (NBER) (http://www.nber.org/cycles/cyclesmain.html ): IIQ1953-IIQ1954, IIIQ1957-IIQ1958, IIIQ1973-IQ1975 and IQ1980-IIIQ1980. The data for the earlier contractions illustrate that the growth rate and job creation in the current expansion are inferior. The sharp contractions of the 1950s and 1970s are considered in Table 2, showing the Bureau of Economic Analysis (BEA) quarter-to-quarter, seasonally adjusted (SA), yearly-equivalent growth rates of GDP. The recovery from the recession of 1953 consisted of four consecutive quarters of high percentage growth rates from IIIQ1954 to IIIQ1955: 4.6, 8.3, 12.0, 6.8 and 5.4. The recession of 1957 was followed by four consecutive high percentage growth rates from IIIQ1958 to IIQ1959: 9.7, 9.7, 8.3 and 10.5. The recession of 1973-1975 was followed by high percentage growth rates from IIQ1975 to IIQ1976: 6.9, 5.3, 9.4 and 3.0.
Table 2, Quarterly Growth Rates of GDP, % Annual Equivalent SA
| IQ | IIQ | IIIQ | IVQ | |
| 1953 | 7.7 | 3.1 | -2.4 | -6.2 |
| 1954 | -1.9 | 0.5 | 4.6 | 8.3 |
| 1955 | 12.0 | 6.8 | 5.4 | 2.3 |
| 1957 | 2.5 | -1.0 | 3.9 | -4.1 |
| 1958 | -10.4 | 2.5 | 9.7 | 9.7 |
| 1959 | 8.3 | 10.5 | -0.5 | 1.4 |
| 1973 | 10.6 | 4.7 | -2.1 | 3.9 |
| 1974 | 3.5 | 1.0 | -3.9 | 6.9 |
| 1975 | -4.8 | 3.1 | 6.9 | 5.3 |
| 1976 | 9.4 | 3.0 | 2.0 | 2.9 |
| 1979 | 0.7 | 0.4 | 2.9 | 1.1 |
| 1980 | 1.3 | -7.9 | -0.7 | 7.6 |
The NBER dates another recession in 1980 that lasted about half a year. If the two recessions from IQ1980s to IIIQ1980 and IIIQ1981 to IVQ1982 are combined, the impact on lost GDP is comparable to the revised 4.1 percent drop of the recession from IVQ2007 to IIQ2009. The recession in 1981-1982 is quite similar on its own to the 2007-2009 recession. Table 3 provides the BEA quarterly growth rates of GDP in SA yearly equivalents for the recessions of 1981-1982 and 2007 to 2009. There were four quarters of contraction in 1981-1982 ranging in rate from -1.5 percent to -6.4 percent and five quarters of contraction in 2007-2009 ranging in rate from -0.7 percent to -6.8 percent. The striking difference is that in the first seven quarters of expansion from IQ1983 to IIIQ1984, shown in Table 3 in relief, GDP grew at the high quarterly percentage growth rate of 5.1, 9.3, 8.1, 8.5, 7.1, 3.9 and 3.3 while the percentage growth rate in the first seven quarters from IIIQ2009 to IQ2011, shown in relief in Table 3, was mediocre: 1.6, 5.0, 3.7, 1.7, 2.6, 3.1 and 1.8. The data in this and the following tables incorporate the third estimate of IQ2011 by the BEA, with the growth of GDP at 1.8 percent. Inventory change contributed to initial growth but was rapidly replaced by growth in investment and demand in 1983. The key difference may be found in the negative incentive to business and household investment and business hiring from the structural shock to business models resulting from legislative restructurings and regulation with alleged benefits in the long-term but adverse short-term growth and jobs effects.
Table 3, Quarterly Growth Rates of GDP, % Annual Equivalent SA
| Q | 1981 | 1982 | 1983 | 1984 | 2008 | 2009 | 2010 |
| I | 8.6 | -6.4 | 5.1 | 7.1 | -0.7 | -4.9 | 3.7 |
| II | -3.2 | 2.2 | 9.3 | 3.9 | 0.6 | -0.7 | 1.7 |
| III | 4.9 | -1.5 | 8.1 | 3.3 | -4.0 | 1.6 | 2.6 |
| IV | -4.9 | 0.3 | 8.5 | 5.4 | -6.8 | 5.0 | 3.1 |
| 1985 | 2011 | ||||||
| I | 3.8 | 1.9 | |||||
| II | 3.4 | ||||||
| III | 6.4 | ||||||
| IV | 3.1 |
Source:
http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp1q11_2nd.pdf
http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf
The contributions to the rate of growth of GDP in percentage points (PP) are provided in Table 4. Aggregate demand, personal consumption expenditures (PCE) and gross private domestic investment (GDI) were much stronger during the expansion phase in IQ1983 to IIQ1984 than in IIIQ2009 to IQ2011. In an article for the WSJ, Feldstein (2011Jun8) argues that US economic growth will be subpar in the best conditions with continuing high levels of unemployment and underemployment. Feldstein (2011Jun8) analyzes the decline in the rate of growth of GDP from 3.2 percent in IVQ2010 (fourth quarter of 2010) to 1.8 percent in IQ2011. Table 4 shows that he decomposition of the rate of growth of GDP of 1.9 percent in IQ2011, which now attributes 1.31 percentage points to change in inventories (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html). GDP data are seasonally-adjusted quarterly growth rates expressed in annual equivalent. The argument by Feldstein (2011Jun8) is that growth of final sales after deducting inventory change was only 0.6 percent, which is equivalent to growth of only 0.15 percent in the quarter ((1.006)1/4 or 0.6 percent discounted four quarterly periods). This argument is still valid with the third estimate of GDP growth of 1.9 percent in IQ2011 and of contribution of 1.31 PP by inventory change. The economy stalled. Inventory accumulation cannot sustain economic growth that requires increasing demand in investment and consumption. Business only invests when sales increase. Consumers need to see their income growing and the evidence is that real disposable income stagnated in the first four months of 2011 (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html). Real wages are falling, 44 million people struggle with food stamps, hiring has collapsed and between 24 and 30 million people are unemployed or underemployed (http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html). Feldstein (2011Jun8) also finds significant weakness in short-term economic indicators, which are analyzed in this blog weekly.
Table 4, Contributions to the Rate of Growth of GDP in Percentage Points
| GDP | PCE | GDI | ∆ PI | Trade | GOV | |
| 2011 | ||||||
| I | 1.9 | 1.52 | 1.46 | 1.31 | 0.14 | -1.20 |
| 2010 | ||||||
| I | 3.7 | 1.33 | 3.04 | 2.64 | -0.31 | -0.32 |
| II | 1.7 | 1.54 | 2.88 | 0.82 | -3.50 | 0.80 |
| III | 2.6 | 1.67 | 1.80 | 1.61 | -1.70 | 0.79 |
| IV | 3.1 | 2.79 | -2.61 | -3.42 | 3.27 | -0.34 |
| 2009 | ||||||
| I | -4.9 | -0.34 | -6.80 | -1.09 | 2.88 | -0.61 |
| II | -0.7 | -1.12 | -2.30 | -1.03 | 1.47 | 1.24 |
| III | 1.6 | 1.41 | 1.22 | 1.10 | -1.37 | 0.33 |
| IV | 5.0 | 0.69 | 2.70 | 2.83 | 1.90 | -0.28 |
| 1982 | ||||||
| I | -6.4 | 1.62 | -7.50 | -5.47 | -0.49 | -0.03 |
| II | -2.2 | 0.90 | -0.05 | 2.35 | 0.84 | 0.50 |
| III | -1.5 | 1.92 | -0.72 | 1.15 | -3.31 | 0.57 |
| IV | 0.3 | 4.64 | -5.66 | -5.48 | -0.10 | 1.44 |
| 1983 |
|
|
|
|
|
|
| I | 5.1 | 2.54 | 2.20 | 0.94 | -0.30 | 0.63 |
| II | 9.3 | 5.22 | 5.87 | 3.51 | -2.54 | 0.75 |
| III | 8.1 | 4.66 | 4.30 | 0.60 | -2.32 | 1.48 |
| IV | 8.5 | 4.20 | 6.84 | 3.09 | -1.17 | -1.35 |
| 1984 | ||||||
| I | 8.0 | 2.35 | 7.15 | 5.07 | -2.37 | 0.86 |
| II | 7.1 | 3.75 | 2.44 | -0.30 | -0.89 | 1.79 |
| III | 3.9 | 2.02 | -0.89 | 0.21 | -0.36 | 0.62 |
| IV | 3.3 | 3.38 | 1.79 | -2.50 | -0.58 | 1.75 |
| 1985 | ||||||
| I | 3.8 | 4.34 | -2.38 | -2.94 | 0.91 | 0.95 |
Note: PCE: personal consumption expenditures; GDI: gross private domestic investment; ∆ PI: change in private inventories; Trade: net exports of goods and services; GOV: government consumption expenditures and gross investment; – is negative and no sign positive
GDP: percent change at annual rate; percentage points at annual rates
Source:
http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp1q11_2nd.pdf
http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf
Table 5 provides more detailed information on the causes of the deceleration of GDP growth from 3.1 percent in IVQ2010 to 1.9 percent in IQ2011. The Bureau of Economic Analysis (BEA) finds three source of contribution to GDP growth in IQ2011: (1) growth of PCE by 2.2 percent; (2) growth of exports by 7.6 percent; (3) positive contribution of private inventory investment of 1.31 PP; and (4) growth of nonresidential fixed investment (NRI) by 2.0 percent. The factors that contributed to reduction of growth in IQ2011 were: (1) decline in residential fixed investment by 2.0 percent; (2) increase of imports by 5.1 percent, which are a deduction to GDP growth; and (3) contraction of federal and state/local government or combined government (GOV) by 5.8 percent. There are three sources causing deceleration of growth: (1) deceleration of nonresidential fixed investment (NRFI) from 7.7 percent to 2.0 percent; (2) deceleration of PCE growth from 4.0 percent in IVQ2010 to 2.2 percent in IQ2011 (with durable goods growth declining from 21.1 percent in IVQ2010 to 9.3 percent in IQ2011; (3) change of growth of 3.3 percent of RFI in IVQ2010 to -2.0 percent in IQ2011; (4) acceleration of decline of government consumption and expenditures (GOV) from minus 1.7 percent to minus 5.8 percent with federal government consumption and expenditures decelerating from minus 0.3 percent to minus 8.1 percent, caused by decline in defense expenditures by -11.7 percent, and state/local from minus 2.6 percent to minus 3.2 percent.
Table 5, Percentage Seasonally Adjusted Annual Equivalent Quarterly Rates of Increase, %
| IVQ2010 | IQ2011 | |
| GDP | 3.1 | 1.9 |
| PCE | 4.0 | 2.2 |
| Durable Goods | 21.1 | 9.3 |
| NRFI | 7.7 | 2.0 |
| RFI | 3.3 | -2.0 |
| Exports | 8.6 | 7.6 |
| Imports | -12.6 | 5.1 |
| GOV | -1.7 | -5.8 |
| Federal GOV | -0.3 | -8.1 |
| State/Local GOV | -2.6 | -4.2 |
| ∆ PI (PP) | -3.42 | 1.31 |
| Gross Domestic Purchases | -0.2 | 1.7 |
| Prices Gross Domestic Purchases | 2.1 | 3.9 |
| Prices of GDP | 0.4 | 2.0 |
| Prices of GDP Excluding Food and Energy | 1.2 | 2.4 |
| Prices of PCE | 1.7 | 3.9 |
| Prices of PCE Excluding Food and Energy | 0.4 | 1.6 |
| Prices of Market Based PCE | 1.8 | 3.9 |
| Prices of Market Based PCE Excluding Food and Energy | 0.3 | 1.2 |
| Real Disposable Personal Income | 0.3 | 0.2 |
| Personal Savings As % Disposable Income | 5.4 | 5.1 |
Note: PCE: personal consumption expenditures; NRFI: nonresidential fixed investment; RFI: residential fixed investment; GOV: government consumption expenditures and gross investment; ∆ PI: change in
private inventories; GDP - ∆ PI: final sales of domestic product; PP: percentage points; Personal savings rate: savings as percent of disposable income
Source:
http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp1q11_2nd.pdf
http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf
http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_adv.pdf
Table 6 shows the percentage point (PP) contributions to the annual levels in the earlier recessions 1958-1959, 1975-1976, 1982-1983 and 2009 and 2010. The most striking contrast is in the rates of growth of annual GDP in the expansion phases of 7.2 percent in 1959, 4.5 percent in 1983 followed by 7.2 percent in 1984 and 4.1 percent in 1985 but only 2.9 percent in 2010 after six consecutive quarters of growth. The annual levels also show much stronger growth of PCEs in the expansions after the earlier contractions. PCEs contributed 1.26 PPs to GDP growth in 2010 of which 0.99 PP in goods and 0.27 PP in services. GDI deducted 3.24 PPs of GDP growth in 2009 of which -2.69 PPs by fixed investment and -0.55 PP of ∆PI and added 1.87 PPs to GDI in 2010 of which 0.48 PPs of fixed investment and 1.40 of ∆PI. Trade, or exports of goods and services net of imports, contributed 1.13 PPs in 2009 of which exports deducted 1.18 PPs and imports added 2.32 PPs. In 2010, trade deducted 0.49 PP with exports contributing 1.34 PPs and imports deducting 1.83 PPs. In 2009, Government added 0.32 PP of which 0.43 PP by the federal government and -0.11 PP by state and local government; in 2010, government added 0.21 PP of which 0.39 PP by the federal government with state and local government deducting 0.18 PP.
Table 6, Percentage Point Contributions to the Annual Growth Rate of GDP
| GDP | PCE | GDI | ∆ PI | Trade | GOV | |
| 1958 | -0.9 | 0.54 | -1.25 | -0.18 | -0.89 | 0.70 |
| 1959 | 7.2 | 3.61 | 2.80 | 0.86 | 0.00 | 0.76 |
| 1975 | -0.2 | 1.40 | -2.98 | -1.27 | 0.89 | 0.48 |
| 1976 | 5.4 | 3.51 | 2.84 | 1.41 | -1.08 | 0.10 |
| 1982 | -1.9 | 0.86 | -2.55 | -1.34 | -0.60 | 0.35 |
| 1983 | 4.5 | 3.65 | -1.45 | 0.29 | -1.35 | 0.76 |
| 1984 | 7.2 | 3.43 | 4.63 | 1.95 | -1.58 | 0.70 |
| 1985 | 4.1 | 3.32 | -0.17 | -1.06 | -0.42 | 1.41 |
| 2009 | -2.6 | -0.84 | -3.24 | -0.55 | 1.13 | 0.32 |
| 2010 | 2.9 | 1.26 | 1.87 | 1.40 | -0.49 | 0.21 |
http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf
IIB Growth Forecasts. DeLong (2011May21) finds a restrictive macroeconomic environment. Economic growth will be insufficient to reduce the gap of actual relative to potential output. As a result, the economy is not likely to generate sufficient hiring so that the population/employment ratio, or number of people employed, will not climb back promptly to the levels before the recession. In 2006, the employment population ratio was 62.9 percent but it has declined to 58.5 percent by May 2011 (see Table 2 in http://cmpassocregulationblog.blogspot.com/2011/06/unemployment-and-underemployment-of-24.html). There are 26 to 30 million in job stress and decline in hiring by 17 million per year clouds hopes of those unemployed or seeking improvement by changing jobs. DeLong (2011May21) believes the situation will remain restrictive for a long period.
Table 7 provides the forecast of Federal Reserve Board Members and Federal Reserve Bank Presidents used at the meeting of the Federal Open Market Committee (FOMC) meeting on Jun 22. The forecast of growth for 2011 in Apr was for an increase in real GDP in 2011 between 3.1 and 3.3 percent. Table 7 shows that this forecast has been reduced to 2.7 to 2.9 percent for 2011. The forecast for the rate of unemployment in Apr was 8.4 to 8.7 percent but it has been increased from 8.6 to 8.9 percent. Short-term indicators of the economy point to reduction of the rate of growth in IIQ2011. The Statement of the FOMC on Jun 22 states (http://www.federalreserve.gov/newsevents/press/monetary/20110622a.htm):
“Also, recent labor market indicators have been weaker than anticipated. The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan. Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.”
There is supporting evidence for the FOMC view in the May Fed report on industrial production and capacity utilization in the US (http://www.federalreserve.gov/releases/g17/current/):
“Industrial production edged up 0.1 percent in May, the second consecutive month with little or no gain. Revisions to total industrial production in months before May were small. In May, manufacturing production rose 0.4 percent after having fallen 0.5 percent in April. The output of motor vehicles and parts has been held down in the past two months because of supply chain disruptions following the earthquake in Japan. Excluding motor vehicles and parts, manufacturing output advanced 0.6 percent in May and edged down 0.1 percent in April; the decrease in April in part reflected production lost because of tornadoes in the South at the end of the month. Outside of manufacturing, the output of mines increased 0.5 percent in May, while the output of utilities fell 2.8 percent. At 93.0 percent of its 2007 average, total industrial production in May was 3.4 percent above its year-earlier level. Capacity utilization for total industry was flat at 76.7 percent, a rate 3.7 percentage points below its average from 1972 to 2010.”
The good news is that resilience of Japan augurs but strong rebound in industry that will contribute to elimination the disruptions of the supply chain (see more details on industry and economic indicators in http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html
Table 7, Central Tendency Forecasts of the FOMC, %
| ∆% Real GDP | Unemployment Rate % | |
| 2011 | 2.7 to 2.9 | 8.6 to 8.9 |
| 2012 | 3.3 to 3.7 | 7.8 to 8.2 |
| 2013 | 3.5 to 4.2 | 7.0 to 7.5 |
| Longer Run | 2.5 to 2.8 | 5.2 to 5.6 |
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20110622.pdf
III Budget/Debt Quagmire. The nonpartisan Congressional Budget Office (CBO) has released its yearly long-term budget outlook (CBO 2011JunLTBO). The CBO warns of the risks of a fiscal crisis in the US as follows (CBO 2011JunLTBO, 34):
“A rising level of government debt would have another significant negative consequence. Combined with an unfavorable long-term budget outlook, it would increase the probability of a fiscal crisis for the United States. In such a crisis, investors become unwilling to finance all of a government’s borrowing needs unless they are compensated with very high interest rates; as a result, the interest rates on government debt rise suddenly and sharply relative to rates of return on other assets. Unfortunately, there is no way to predict with any confidence whether and when such a crisis might occur in the United States. In particular, there is no identifiable tipping point of debt relative to GDP that indicates a crisis is likely or imminent. All else being equal, however, the larger the debt, the greater the risk of such a crisis.”
Section IIIA CBO Long-term Budget Outlook considers the new projections by the CBO. There is an active policy debate of which two strands are considered in separate subsections. IIIB Timing of Reducing the Fiscal Stimulus deals with contributions of the need for fiscal stimulus in the short-term for growth and employment purposes while providing for fiscal adjustment in the medium term that could avoid the undesirable fiscal crisis. IIIC Composition of Policy Measures analyzes fiscal stimulus in different ways and tries to blend policies for long-term growth and employment with near-term policy incentives and measures to solve the growth and employment deficiencies.
IIIA CBO Long-term Budget Outlook. According to the CBO (2011BEOJ, 4):
“The deficits that will accumulate under current law will push federal debt held by the public to significantly higher levels. Just two years ago, debt held by the public was less than $6 trillion, or about 40 percent of GDP; at the end of fiscal year 2010, such debt was roughly $9 trillion, or 62 percent of GDP, and by the end of 2021, it is projected to climb to $18 trillion, or 77 percent of GDP. With such a large increase in debt, plus an expected increase in interest rates as the economic recovery strengthens, interest payments on the debt are poised to skyrocket over the next decade. CBO projects that the government’s annual spending on net interest will more than double between 2011 and 2021 as a share of GDP, increasing from 1.5 percent to 3.3 percent.”
Table 8 provides the budget outlook of the CBO (2011BEOJ, 2011PBM) for 2011 to 2021. Two critical issues relating to the budget quagmire of the US are revealed by these projections: (1) the ratio of outlays to GDP is projected at 24.1 percent of GDP in 2011 and at 23.5 percent for 2012 to 2021; and (2) the debt/GDP ratio remains above 70 percent after 2012 and is projected at 75.6 percent in 2021. Revenue in the projections of the CBO (2011BEOJ, 2; 2011PBM, 20) is 19.9 percent of GDP, facing the historical ceiling of 20 percent. Adjustment would require reduction of expenditures or outlays closer to 20 percent to eliminate permanent deficits. The rise of the debt/GDP ratio poses doubts of whether yields of US Treasury securities could incorporate a risk premium to reflect increasing difficulty in placing new debt to finance the deficits and refinance existing debt.
Table 8, CBO Budget Outlook 2011-2021
| Out | Out | Deficit | Deficit | Debt | Debt | |
| 2010 | 3,456 | 23.8 | 1,294 | 8.9 | 9,019 | 62.1 |
| 2011 | 3,629 | 24.1 | 1,399 | 9.3 | 10,363 | 68.9 |
| 2012 | 3,639 | 23.2 | 1,081 | 6.9 | 11,516 | 73.4 |
| 2013 | 3,779 | 23.0 | 692 | 4.2 | 12,311 | 75.1 |
| 2014 | 3,954 | 22.9 | 513 | 3.0 | 12,919 | 74.9 |
| 2015 | 4,180 | 23.0 | 538 | 3.0 | 13,554 | 74.5 |
| 2016 | 4,460 | 23.3 | 635 | 3.3 | 14,282 | 74.6 |
| 2017 | 4,661 | 23.3 | 590 | 2.9 | 14,964 | 74.7 |
| 2018 | 4,856 | 23.2 | 585 | 2.8 | 15,640 | 74.7 |
| 2019 | 5,148 | 23.6 | 665 | 3.0 | 16,393 | 75.0 |
| 2020 | 5,412 | 23.7 | 710 | 3.1 | 17,192 | 75.3 |
| 2021 | 5,680 | 23.9 | 729 | 3.1 | 18,008 | 75.6 |
| 2012 | 45,770 | 23.3 | 6,737 | 3.4 |
Note: Out = outlays
Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/SummaryforWeb.pdf
http://www.cbo.gov/ftpdocs/121xx/doc12103/2011-03-18-APB-PreliminaryReport.pdf
The CBO (2011LTBO) extends the projections of the US budget beyond the ten-year window considered in Table 8 in terms of two scenarios. First, Table 9 provides projections of the budget and debt for the “extended-baseline scenario,” which is based on the following assumptions (CBO 2011LTBO, 2):
“The current-law assumption of the extended-baseline scenario implies that many adjustments that lawmakers have routinely made in the past—such as changes to the AMT and to the Medicare program’s payments to physicians—will not be made again. Because of the structure of current tax law, federal revenues would grow significantly faster than GDP over the long run under this scenario, ultimately rising well above the levels that U.S. taxpayers have seen in the past.”
Table 9, CBO Long-term Budget Outlook Extended-Baseline Scenario, % of GDP
| 2011 | 2021 | 2035 | |
| Spending | 24.1 | 23.9 | 27.4 |
| Primary | 22.7 | 20.5 | 23.3 |
| SS | 4.8 | 5.3 | 6.1 |
| Medicare | 3.7 | 4.1 | 5.9 |
| Medicaid | 1.9 | 2.8 | 3.5 |
| Other | 12.3 | 8.3 | 7.8 |
| Interest | 1.4 | 3.4 | 4.1 |
| Revenues | 14.8 | 20.8 | 23.2 |
| Deficit | –9.3 | -3.1 | -4.2 |
| Primary | –7.9 | 0.3 | -0.1 |
| Debt | 69 | 76 | 84 |
Primary spending is spending other than interest payments. Primary deficit or surplus is revenue less primary spending.
Source: http://www.cbo.gov/ftpdocs/122xx/doc12212/06-21-Long-Term_Budget_Outlook.pdf
The scenarios require assumptions about economic variables, in particular “real wage growth for workers covered by social security, growth in consumer price index, nominal wage growth for workers covered by social security, average real annual interest rate, average annual unemployment rate and real GDP” (CBO 2011LTBO Excel worksheet). Table 9 provides spending divided in primary spending and interest payments and the resulting concepts of primary balance equal to revenue less primary spending and total balance or revenue less total spending. Debt held by the public increases from 69 percent of GDP in 2011, much higher than 40 percent of GDP in 2008, to 76 percent of GDP in 2021 and 84 percent of GDP in 2035. Albert Einstein is attributed phrases such as “compound interest is the greatest mathematical discovery of all time” and “the most powerful force in the universe is compound interest.” An important aspect of Table 9 is that interest payments on the debt held by the public increase from 1.4 percent of GDP in 2011 to 3.4 percent of GDP in 2021 and to 4.1 percent of GDP in 2035. Spending on categories other than social security, Medicare and Medicaid shrinks from 12.3 percent of GDP in 2011 to 8.3 percent of GDP in 2021 and to 7.8 percent in 2035. Correspondingly, the combined share of social security, Medicare and Medicaid in spending increases from 10.4 percent of GDP in 2011 to 15.5 percent of GDP in 2035 with combined Medicare and Medicaid explaining most of the increase with a jump from 5.6 percent of GDP to 9.4 percent of GDP while social security only increases its share from 4.8 percent of GDP in 2011 to 6.1 percent in 2035. Revenue as a percent of GDP has been on average 18.6 percent in the past 40 years and there is skepticism if it can increase above 20 percent. The alternative-baseline scenario in Table 9 projects revenue as percent of GDP at 20 percent of GDP in 2015 and 2016 and then exceeding 20 percent permanently, rising to 30.6 percent of GDP in 2085 (see the Excel spreadsheet accompanying CBO 2011LTBO).
Second, Table 10 provides fiscal projections under an alternative fiscal scenario, which is based on the following assumptions (CBO 2011LTBO, 2):
“The alternative fiscal scenario embodies several changes to current law that would continue certain tax and spending policies that people have grown accustomed to (because the policies are in place now or have been in place recently). Versions of some of the changes assumed in the scenario—such as those related to the tax cuts originally enacted in 2001, the AMT, certain other tax provisions, and Medicare’s payments to physicians—have regularly been enacted in the past and are widely expected to be made in some form over the next few years. After 2021, the alternative fiscal scenario also incorporates modifications to several provisions of current law that might be difficult to sustain for a long period. Thus, the scenario includes changes to certain restraints on the growth of spending for Medicare and to indexing provisions that would slow the growth of federal subsidies for health insurance coverage. In addition, the scenario includes unspecified changes in tax law that would keep revenues constant as a share of GDP after 2021.”
Table 10, CBO Long-term Budget Outlook Alternative Fiscal Scenario, % of GDP
| 2011 | 2021 | 2035 | |
| Spending | 24.1 | 25.9 | 33.9 |
| Primary | 22.7 | 21.5 | 25.0 |
| SS | 4.8 | 5.3 | 6.1 |
| Medicare | 3.7 | 4.3 | 6.7 |
| Medicaid | 1.9 | 2.8 | 3.7 |
| Other | 12.3 | 9.1 | 8.5 |
| Interest | 1.4 | 4.4 | 8.9 |
| Revenues | 14.8 | 18.4 | 18.4 |
| Deficit | -9.3 | -7.5 | -15.5 |
| Primary | -7.9 | -3.1 | -6.6 |
| Debt | 69 | 101 | 187 |
Primary spending is spending other than interest payments. Primary deficit or surplus is revenue less primary spending.
Source: http://www.cbo.gov/ftpdocs/122xx/doc12212/06-21-Long-Term_Budget_Outlook.pdf
An important distinguishing characteristic of the alternative fiscal scenario in Table 10 is the much sharper increase in debt held by the public from 69 percent of GDP in 2011 to 101 percent of GDP in 2021 and 187 percent of GDP in 2035. Accordingly, interest payments on the debt jump from 1.4 percent of GDP in 2011 to 8.9 percent of GDP in 2035. In contrast with the extended-baseline scenario, the alternative fiscal scenario fixes revenue as percent of GDP at 18.4 percent after 2035.
Fiscal projections by the CBO incorporate a host of assumptions on demographic variables, such as the rate of growth and consumption of the US population, economic variables, interest rates, labor market factors, real GDP and earnings per worker. The CBO (2011LTBO) analyzes how the performance of the economy would be affected by an increase in debt held by the public over 76 percent of GDP, which is used as benchmark economic conditions. A Solow-type model (after Solow 1956, 1989; see Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), 11-16) is used for measuring effects on the economy of fiscal policies under the two scenarios. The method is discussed in CBO (2011PBB, Appendix A, 31-7). The calculations by the CBO (2011LTO, 28-31) are shown in Table 11. The impact is much softer on GDP than on GNP because “the change in GDP does not reflect the increased future outflow of profits and interest generated by the additional capital inflow” (CBO 2011LTO, 28). The striking result in Table 11 is the sharp reduction of GNP by 2035 of 6.7 percentage points to 17.6 percentage points over what it would be under the benchmark debt level of 76 percent and of GDP from 2.4 percentage points to 9.9 percentage points.
Table 11, Effects on GNP and GDP of Fiscal Policies in CBO’s Scenarios in Percentage Difference from Benchmark Level
| 2025 | 2035 | |
| Extended Baseline | ||
| GNP | -0.2 to –0.4 | -0.5 to –1.6 |
| GDP | (-0.05 to 0.05 to –0,2 | -0.2 to –1.3 |
| Alternative Fiscal | ||
| GNP | -2.2 to –5.7 | -6.8 to –17.6 |
| GDP | -0.4 to –3.1 | -2.4 to –9.9 |
Source: http://www.cbo.gov/ftpdocs/122xx/doc12212/06-21-Long-Term_Budget_Outlook.pdf
IIIB Timing of Reducing Fiscal Stimulus. There is a difficult decision on when to withdraw the fiscal stimulus that could have adverse consequences on current growth and employment analyzed by Krugman (2011Jun18). CBO (2011JunLTBO, Chapter 2) considers the timing of withdrawal as well as the equally tough problems that result from not taking prompt action to prevent a possible debt crisis in the future. Krugman (2011Jun18) refers to Eggertsson and Krugman (2010) on the possible contractive effects of debt. The world does not become poorer as a result of debt because an individual’s asset is another’s liability. Past levels of credit may become unacceptable by credit tightening, such as during a financial crisis. Debtors are forced into deleveraging, which results in expenditure reduction, but there may not be compensatory effects by creditors who may not be in need of increasing expenditures. The economy could be pushed toward the lower bound of zero interest rates, or liquidity trap, remaining in that threshold of deflation and high unemployment.
Analysis of debt can lead to the solution of the timing of when to cease stimulus by fiscal spending (Krugman 2011Jun18). Excessive debt caused the financial crisis and global recession and it is difficult to understand how more debt can recover the economy. Krugman (2011Jun18) argues that the level of debt is not important because one individual’s asset is another individual’s liability. The distribution of debt is important when economic agents with high debt levels are encountering different constraints than economic agents with low debt levels. The opportunity for recovery may exist in borrowing by some agents that can adjust the adverse effects of past excessive borrowing by other agents. As Krugman (2011Jun18, 20) states:
“Suppose, in particular, that the government can borrow for a while, using the borrowed money to buy useful things like infrastructure. The true social cost of these things will be very low, because the spending will be putting resources that would otherwise be unemployed to work. And government spending will also make it easier for highly indebted players to pay down their debt; if the spending is sufficiently sustained, it can bring the debtors to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen. The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can – and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.”
Besides operational issues, the consideration of this argument would require specifying and measuring two types of gains and losses from this policy: (1) the benefits in terms of growth and employment currently; and (2) the costs of postponing the adjustment such as in the exercise by CBO (2011JunLTO, 28-31) in Table 11. It may be easier to analyze the costs and benefits than actual measurement.
An analytical and empirical approach is followed by Blinder and Zandi (2010), using the Moody’s Analytics model of the US economy with four different scenarios: (1) baseline with all policies used; (2) counterfactual including all fiscal stimulus policies but excluding financial stimulus policies; (3) counterfactual including all financial stimulus policies but excluding fiscal stimulus; and (4) a scenario excluding all policies. The scenario excluding all policies is an important reference or the counterfactual of what would have happened if the government had been entirely inactive. A salient feature of the work by Blinder and Zandi (2010) is the consideration of both fiscal and financial policies. There was probably more activity with financial policies than with fiscal policies. Financial policies included the Fed balance sheet, 11 facilities of direct credit to illiquid segments of financial markets, interest rate policy, the Financial Stability Plan including stress tests of banks, the Troubled Asset Relief Program (TARP) and others (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 157-67; Regulation of Banks and Finance (2009a), 224-7).
Blinder and Zandi (2010, 4) find that:
“In the scenario that excludes all the extraordinary policies, the downturn continues into 2011. Real GDP falls a stunning 7.4% in 2009 and another 3.7% in 2010 (see Table 3). The peak-to-trough decline in GDP is therefore close to 12%, compared to an actual decline of about 4%. By the time employment hits bottom, some 16.6 million jobs are lost in this scenario—about twice as many as actually were lost. The unemployment rate peaks at 16.5%, and although not determined in this analysis, it would not be surprising if the underemployment rate approached one-fourth of the labor force. The federal budget deficit surges to over $2 trillion in fiscal year 2010, $2.6 trillion in fiscal year 2011, and $2.25 trillion in FY 2012. Remember, this is with no policy response. With outright deflation in prices and wages in 2009-2011, this dark scenario constitutes a 1930s-like depression.”
The conclusion by Blinder and Zandi (2010) is that if the US had not taken massive fiscal and financial measures the economy could have suffered far more during a prolonged period. There are still a multitude of questions that cloud understanding of the impact of the recession and what would have happened without massive policy impulses. Some effects are quite difficult to measure. An important argument by Blinder and Zandi (2010) is that this evaluation of counterfactuals is relevant to the need of stimulus if economic conditions worsened again.
Blinder (2011Apr19) argues that spending cuts in the House Budget Committee (HBC) plan have adverse redistributive consequences. The reduction of expenditures would weaken significantly Medicare, which is the health insurance of elderly poor and middle-class people. There would be additional restrictions of Medicaid, which is the health insurance of the poor. Simultaneously, Blinder (2011Apr19) argues that taxes would be lowered for upper income brackets.
There are three arguments of analysis of government spending and the economy and a proposal of stimulating the economy by Blinder (2011Jun21). (1) There is no destruction of jobs or adverse effects in deficit financing of government spending. Government fiscal policy according to Blinder (2011Jun21) consisted of actual spending of $600 billion together with tax cuts of approximately $200 billion. In a simple Keynesian model income creation by increasing government spending through the positive multiplier of government expenditures could be offset by income destruction through the negative multiplier of tax increases. There could still be a balanced budget multiplier effect. (2) The “crowding out” effect consists of government spending and debt sales that lower the prices of government securities or equivalently increase their yields, which results in increases in the borrowing costs of the private sector. Blinder (2011Jun20) argues that interest rates have been at historically low levels and at the moment long-term yields are even declining. Government spending would not be competing with private spending in the current economy with significant idle capacity. (3) There is an argument that large deficits undermine business confidence, resulting in restrained investment. Blinder (2011Jun20) finds that this argument is logically possible but that there is no evidence. For example, Blinder recalls that real GDP has been growing at the annual rate of 2.3 percent in the past four quarters but business spending on investment and software has soared by 14.7 percent. The recommendation by Blinder (2011Jun20) considers that there is an immense deficit problem and that its adjustment is desirable earlier than later. The recommendation would blend the need to adjust the deficit with required job creation. A tax credit would be given to companies adding workers to their payrolls while a sound deficit-reduction plan would be enacted immediately.
If uncertainty restricted investment by the private sector, it would be reflected in adverse expectations in credit markets, foreign exchange and equities in stock exchanges, as argued by DeLong (2011May12). There would be a return of the so-called “bond vigilantes,” or higher required yields by bond investors because of large deficits and growing debt in the hands of the public but DeLong (2011May12) argues that bond yields have not reflected such uncertainties. At the moment, other risk factors in the world economy may dominate credit, foreign exchange and stock markets.
The business cycle in the US is interpreted by Summers (2011Jun12) as recessions resulting from tighter monetary policy to curb inflation that resulted from excessive confidence which increased asset values. The current situation is one of constrained demand with idle productive capacity and fractured labor markets. In past expansions after recessions the rate of economic growth jumped to 6 percent annual equivalent, eliminating idle productive capacity and unemployment. Expansions occurred when lower inflation and interest rates encouraged confidence, borrowing and lending. Summers (2011Jun12) finds that the greatest threat to the US today is a “lost decade” as in Japan in the 1990s, that is, a long period of low or nil rates of growth of the economy. Thus, near-term acceleration of economic growth is a policy priority in the fiscal debate. The appropriate blend of policy is to include short-term growth together with medium-term fiscal austerity. One possible measure would be to extend to employers the payroll tax cut. There would be an opportunity at the moment in long-term interest rates of government debt below 3 percent to create infrastructure required for long-term economic growth. Infrastructure construction would absorb part of the unemployment in construction that has reached about 20 percent. Summers (2011Jun12) also favors delaying monetary policy tightening to combat inflation and excessive asset valuations while at the same time enforcing strictly the Dodd-Frank act. Other important policies would be to continue the President’s export drive and regulatory relaxation.
IIIC Composition of Policy Measures. There are other views on how to blend fiscal austerity measures with policies to promote growth of the economy. The objective of the combined monetary and fiscal stimulus is to turn around the economy, creating the conditions for the private sector to grow and create jobs. The calculation of the government stimulus by Mark Pittman and Bob Ivry at Bloomberg declined from $12.8 trillion committed and $4.2 trillion used by Mar 2009 to $11.6 trillion committed and $3.0 trillion used by Sep 2009 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahys015DzWXc# see Pelaez and Pelaez, Regulation of Banks and Finance (2009b) 224-7, Financial Regulation after the Global Recession (2009a), 157-70). The Federal Reserve total commitment by Sep 2009 was $5.9 trillion, or 50.8 percent of the total, and the use was $1.6 trillion, or 53 percent of the total. Even the most optimistic are beginning to realize that the combined stimulus did not work as intended.
The fiscal stimulus was provided by the American Recovery and Reinvestment Act of 2009 (ARRA) that was designed: “(1) to preserve and create jobs and promote economic recovery; (2) to assist those most impacted by the recession; (3) to provide investments needed to increase economic efficiency by spurring technological advances in science and health; (4) to invest in transportation, environmental protection, and other infrastructure that will provide long-term economic benefits; (5) to stabilize State and local government budgets, in order to minimize and avoid reductions in essential services and counterproductive state and local tax increases” (http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h1enr.pdf). The economic rationale for ARRA was that a “stimulus package” of $757 billion would increase GDP by 3.7 percent by IVQ2010 over what it would have been without that stimulus, increasing jobs by 3,675,000 over what would have been payroll employment without the package (Romer and Bernstein 2009, 4). These effects of the stimulus would result from the estimate that additional “government purchases” by 1 percent of GDP increase or “multiply” output by 1.51 times by the fifth quarter after the purchases (Ibid, 12). The policy debate has focused on the actual size of the multiplier of government purchases that would explain the impact on output of ARRA (Cogan and Taylor 2010Oct, 2010 Dec, 2011Jan). Commerce Department data show that government purchases increased by 3 percent of the $862 billion ARRA stimulus package or by $24 billion; infrastructure spending increased by only $4 billion; and these spending and purchases are negligible relative to GDP of the US of around $14.5 trillion (Cogan and Taylor 2010Dec). State and local government purchases have remained below their 2008 levels, that is, failing to increase after ARRA. Cogan and Taylor (2010Dec) conclude that ARRA grants did not have statistically significant effects on purchases by state and local government: even if the multiplier was 1.5 there was not enough multiplicand in the form of government purchases. The conclusion is that limited effects of ARRA instead of insufficient volume of stimulus explain the failure of the fiscal stimulus.
Schultz et al (2010) find theory and evidence in support of long-term policies instead of temporary policies. An important reason is the uncertainty created by temporary policies as investors, consumers and business delay decisions. One example of deviation toward temporary, adverse policies provided by Schultz et al (2010) was the lowering of the interest rates to 1 percent from Jun 2003 to Jun 2004, or monetary policies maintaining interest rates at extremely low levels for a long time period. At the same time, federal housing policies permitted mortgages to buy homes with nearly equal loan to value ratios, or almost zero down payments by the borrower. A separate loan was provided for the down payments in “piggy-back” mortgages such that there was an effective loan to value ratio of unity, or no equity infusion by the mortgage debtor. Another example is found in temporary tax rebates instead of permanent tax reductions that would really stimulate the economy over the long term. The recommendation of Schultz et al (2010) is to reduce the deficit and control the debt by reducing spending and not by tax increases.
Government spending in 2000 was 18.2 percent of GDP and 19.6 percent of GDP in 2007 but the average in the past three years has been 24.4 percent of GDP, as shown by Taylor (2011Apr22). It has not been feasible to tax more than 20 percent of GDP in the US (see Becker, Schultz and Taylor 2011Apr4). Thus, slowing growth of the national debt requires reducing spending to what can be paid with current taxes or around 20 percent of GDP. Otherwise, the yearly deficit would continue to add to the national debt with rising share of interest payments in spending. Taylor (2011Apr22) calculates the second White House Budget (WHB) proposal of Apr 13 for the next decade, finding that spending is lower in proportion of GDP, over 22 percent by 2021, than in the original WHB proposal of Feb 14 of 24.2 percent in 2021. There is the issue of whether the debt would become unsustainable, meaning that there could be risk premium on yields of Treasury securities. An additional issue raised by Taylor (2011Apr22) is that if investment increases because of lower government expenditures and slower growth of government debt, government spending of 19 to 20 percent of higher economic activity or GDP would provide more dollar resources for provision of public goods by the government.
There is ongoing bipartisan negotiation on reducing the deficit, which is welcomed by Boskin (2011Jun 20). There are several principles recommended by Boskin (2011Jun 20) on how to reduce the deficit. (1) Research on large fiscal policy programs in OECD countries between 1970 and 2007 by Alesina and Ardagna (2010) finds that large fiscal programs of stimulus are more successful when based on tax cuts than using spending increases and also more likely to promote economic growth (see Alesina 2011WB). In cases of large fiscal adjustments, such as the ones faced by the US and other advanced economies, reliance on spending reduction is more likely to be successful than increases in taxes in reducing deficits and debt/GDP ratios. An additional result is that fiscal adjustments based on spending reductions are more likely to result in recessions than those based on tax increases. Boskin (2011Jun20) finds that deficit reduction and control of the debt/GDP ratio may be more effective by reducing spending instead of increasing taxes. (2) There are past examples of programs of controlling spending that could not be enforced. Boskin (2011Jun20) recalls the reduction of taxes by President Reagan in 1981 that was to be followed with spending reduction that was not enforceable. Full employment laws are another historical effort in the US that could not be implemented (see DeLong 1996; and an earlier comment of this blog http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html): (i) Employment Law of 1946, Title 15, Chapter 21 § 1021(a) (http://www.law.cornell.edu/uscode/15/1021.html http://uscode.house.gov/download/pls/15C21.txt http://www.eric.ed.gov/PDFS/ED164974.pdf); and (ii) The Full Employment and Balanced Growth Act of 1978, Public Law 95-523 of Oct 27, 1978 (http://www.eric.ed.gov/PDFS/ED164974.pdf). (3) Baseline scenarios, in the opinion of Boskin (2011Jun20), can incorporate budget increases in taxes and spending. (4) Another common problem in all policy is unintended consequences such as analyzed by Kydland and Prescott (1977). Models based on past econometric structures may provide misleading measurements in the structure during policy implementation (Lucas 1976). (5) Policy should consider meaningful portions of the budget but political restrictions may create difficult barriers.
A lower rate of growth of 1 percent per year during a generation can result in a difference of 25 percent in per capita income, as argued by Meltzer (2011Jun15) on the basis of data by the OECD. Policy should avoid long-term low rates of growth and permanently high unemployment. The solution of the current low growth and high unemployment environment, according to Meltzer (2011Jun15) could be attained by policies such as those of Presidents Kennedy and Reagan of lowering permanently marginal income tax rates while simultaneously reducing the constraints of oppressive regulation.
IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 12 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). CPI inflation stabilized in China at 5.3 percent in the 12 months ending in Apr relative to 5.4 percent in the 12 months ending in Mar. Food prices in China soared by 11.7 percent in Mar after 11.0 percent in Feb, 10.3 percent in Jan and 9.6 percent in Dec (http://www.ft.com/cms/s/0/69aa5fcc-670d-11e0-8d88-00144feab49a.html#axzz1J7CmnPhC). Food prices rose 11.5 percent in China in the 12 months ending in Apr relative to 11 percent in the first quarter of 2011 relative to 2010 as analyzed by Jamil Anderlini in the Financial Times (“China inflation edges lower to 5.3%” http://www.ft.com/cms/s/0/09a22246-7b75-11e0-ae56-00144feabdc0.html#axzz1LqpStZfj). Jamil Anderlini writing in the Financial Times (“Inflation in China hits 34-month high,” Jun 14 http://www.ft.com/intl/cms/s/0/dda66798-9630-11e0-8256-00144feab49a.html#axzz1P401vEUE) informs that food prices rose 11.7 percent in May 2011 relative to a year earlier, exceeding 11.5 percent in the 12 months ending in Apr. Jason Dean in the Wall Street Journal (“Chinese inflation speeds up,” WSJ Jun 14 http://professional.wsj.com/article/SB10001424052702303714704576382593374669206.html?mod=WSJPRO_hpp_LEFTTopStories) finds that CPI inflation of 5.5 percent in the 12 months ending in May 2011 is the highest rate since 6.3 percent in Jul 2008. Industrial output rose 13.3 percent in China in May 2011 relative to May 2010, almost equal to 13.4 percent in Apr while fixed investment rose 25.8 percent in the first five months of 2011 relative to the same period in 2010 compared with 25.4 percent in Jan-Apr. The money stock M2 rose 15.1 percent in May relative to a year earlier. New loans in local currency rose CNY (Chinese yuan) 740 billion in Apr (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aolyrQHuzo4o&pos=4) but new loans in local currency rose only CNY 551.6 billion in May 2011 relative to Apr 2010 (Jamil Anderlini writing in the Financial Times (“Inflation in China hits 34-month high,” Jun 14 http://www.ft.com/intl/cms/s/0/dda66798-9630-11e0-8256-00144feab49a.html#axzz1P401vEUE). The People’s Bank of China increased the reserve requirement by 0.5 percent to 21.5 percent effective Jun 20 (Bloomberg News, “China raises bank reserve requirements as inflation quickens,” http://noir.bloomberg.com/apps/news?pid=20601087&sid=aae70h91sWhY&pos=3). China has raised interest rates four times since Sep, raising the reserve requirements on banks and appreciating the CNY relative to the USD by 1.6 percent in 2011. Authorities in China are highly concerned about inflation because of its impact on social stability and fears of a forced landing of the economy.
Table 12, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 2.9 | 3.6 | 7.3 | 9.1 |
| Japan | -0.7*** | 0.3 | 2.2 | 4.7 |
| China | 9.7 | 5.5 | 6.8 | |
| UK | 1.8 | 4.5* | 5.3* output | 7.7 |
| Euro Zone | 2.5 | 2.7 | 6.7 | 9.9 |
| Germany | 4.8 | 2.4 | 6.4 | 6.1 |
| France | 2.2 | 2.2 | 6.4 | 9.4 |
| Nether-lands | 3.2 | 2.4 | 11.7 | 4.2 |
| Finland | 5.8 | 3.4 | 8.5 | 8.0 |
| Belgium | 3.0 | 3.1 | 10.6 | 7.7 |
| Portugal | -0.7 | 3.7 | 6.5 | 12.6 |
| Ireland | -1.0 | 1.2 | 5.0 | 14.7 |
| Italy | 1.0 | 3.0 | 5.5 | 8.1 |
| Greece | -4.8 | 3.1 | 7.9 | 15.1 |
| Spain | 0.8 | 3.4 | 7.3 | 20.7 |
Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier
*Office for National Statistics
PPI http://www.statistics.gov.uk/pdfdir/ppi0611.pdf
CPI http://www.statistics.gov.uk/pdfdir/cpi0611.pdf
** Excluding food, beverage, tobacco and petroleum
http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-04042011-AP/EN/4-04042011-AP-EN.PDF
***Change from IQ2011 relative to IQ2010 http://www.esri.cao.go.jp/jp/sna/sokuhou/kekka/gaiyou/main_1.pdf
Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html
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 I Risk Aversion in this post 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 http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/05/mediocre-growth-world-inflation.html http://cmpassocregulationblog.blogspot.com/2011_03_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/02/mediocre-growth-raw-materials-shock-and.html), weak hiring (http://cmpassocregulationblog.blogspot.com/2011/03/slow-growth-inflation-unemployment-and.html and section III Hiring Collapse in http://cmpassocregulationblog.blogspot.com/2011/04/fed-commodities-price-shocks-global.html ) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (http://cmpassocregulationblog.blogspot.com/2011/05/job-stress-of-24-to-30-million-falling.html http://cmpassocregulationblog.blogspot.com/2011/04/twenty-four-to-thirty-million-in-job_03.html http://cmpassocregulationblog.blogspot.com/2011/03/unemployment-and-undermployment.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the earthquake and tsunami affecting Japan that is having repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) the geopolitical events in the Middle East.
Table 13 provides the forecasts of the Federal Reserve Board Members and Federal Reserve Bank Presidents for the FOMC meeting in Jun. Inflation by the price index of personal consumption expenditures (PCE) was forecast for 2011 in the Apr meeting of the FOMC between 2.1 to 2.8 percent. Table 12 shows that the interval has narrowed to PCE headline inflation of between 2.3 and 2.5 percent. The FOMC focuses on core PCE inflation, which excludes food and energy. The Apr forecast of core PCE inflation was an interval between 1.3 and 1.6 percent. Table 13 shows the revision of this forecast in Jun to a higher interval between 1.5 and 1.8 percent. The Statement of the FOMC meeting on Jun 22 analyzes inflation as follows (http://www.federalreserve.gov/newsevents/press/monetary/20110622a.htm):
“Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate 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 for an extended period.”
Table 13, Forecasts of PCE Inflation and Core PCE Inflation by the FOMC, %
| PCE Inflation | Core PCE Inflation | |
| 2011 | 2.3 to 2.5 | 1.5 to 1.8 |
| 2012 | 1.5 to 2.0 | 1.4 to 2.0 |
| 2013 | 1.5 to 2.0 | 1.4 to 2.0 |
| Longer Run | 1.7 to 2.0 |
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20110622.pdf
Inflation and unemployment in the period 1966 to 1985 is analyzed by Cochrane (2011Jan, 23) by means of a Phillips circuit joining points of inflation and unemployment. Chart 1 for Brazil in Pelaez (1986, 94-5) was reprinted in The Economist in the issue of Jan 17-23, 1987 as updated by the author. Cochrane (2011Jan, 23) argues that the Phillips circuit shows the weakness in Phillips curve correlation. The explanation is by a shift in aggregate supply, rise in inflation expectations or loss of anchoring. The case of Brazil in Chart 1 cannot be explained without taking into account that the increase in the fed funds rate to 22 percent in 1981 in the Volcker Fed precipitated the stress on a foreign debt bloated by financing balance of payments deficits with bank loans in the 1970s; the loans were used in projects, many of state-owned enterprises with low present value in long gestation. The combination of the insolvency of the country because of debt higher than its ability of repayment and the huge government deficit with declining revenue as the economy contracted caused adverse expectations on inflation and the economy. The reading of the Phillips circuits of the 1970s by Cochrane (2011Jan, 25) is doubtful about the output gap and inflation expectations:
“So, inflation is caused by ‘tightness’ and deflation by ‘slack’ in the economy. This is not just a cause and forecasting variable, it is the cause, because given ‘slack’ we apparently do not have to worry about inflation from other sources, notwithstanding the weak correlation of [Phillips circuits]. These statements [by the Fed] do mention ‘stable inflation expectations. How does the Fed know expectations are ‘stable’ and would not come unglued once people look at deficit numbers? As I read Fed statements, almost all confidence in ‘stable’ or ‘anchored’ expectations comes from the fact that we have experienced a long period of low inflation (adaptive expectations). All these analyses ignore the stagflation experience in the 1970s, in which inflation was high even with ‘slack’ markets and little ‘demand, and ‘expectations’ moved quickly. They ignore the experience of hyperinflations and currency collapses, which happen in economies well below potential.”
Chart 1, Brazil, Phillips Circuit 1963-1987
©Carlos Manuel Pelaez, O cruzado e o austral. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.
DeLong (1997, 247-8) shows that the 1970s were the only peacetime period of inflation in the US without parallel in the prior century. The price level in the US drifted upward since 1896 with jumps resulting from the two world wars: “on this scale, the inflation of the 1970s was as large an increase in the price level relative to drift as either of this century’s major wars” (DeLong, 1997, 248). Monetary policy focused on accommodating higher inflation, with emphasis solely on the mandate of promoting employment, has been blamed as deliberate or because of model error or imperfect measurement for creating the Great Inflation (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). As DeLong (1997) shows, the Great Inflation began in the mid 1960s, well before the oil shocks of the 1970s (see also the comment to DeLong 1997 by Taylor 1997, 276-7). Table 14 provides the change in GDP, CPI and the rate of unemployment from 1960 to 1990. There are three waves of inflation (1) in the second half of the 1960s; (2) from 1973 to 1975; and (3) from 1978 to 1981. In one of his multiple important contributions to understanding the Great Inflation, Meltzer (2005) distinguishes between one-time price jumps, such as by oil shocks, and a “maintained” inflation rate. Meltzer (2005) uses a dummy variable to extract the one-time oil price changes, resulting in a maintained inflation rate that was never higher than 8 to 10 percent in the 1970s. There is revealing analysis of the Great Inflation and its reversal by Meltzer (2005, 2010a, 2010b).
Table 14, US Annual Rate of Growth of GDP and CPI and Unemployment Rate 1960-1982
| ∆% GDP | ∆% CPI | UNE | |
| 1960 | 2.5 | 1.4 | 6.6 |
| 1961 | 2.3 | 0.7 | 6.0 |
| 1962 | 6.1 | 1.3 | 5.5 |
| 1963 | 4.4 | 1.6 | 5.5 |
| 1964 | 5.8 | 1.0 | 5.0 |
| 1965 | 6.4 | 1.9 | 4.0 |
| 1966 | 6.5 | 3.5 | 3.8 |
| 1967 | 2.5 | 3.0 | 3.8 |
| 1968 | 4.8 | 4.7 | 3.4 |
| 1969 | 3.1 | 6.2 | 3.5 |
| 1970 | 0.2 | 5.6 | 6.1 |
| 1971 | 3.4 | 3.3 | 6.0 |
| 1972 | 5.3 | 3.4 | 5.2 |
| 1973 | 5.8 | 8.7 | 4.9 |
| 1974 | -0.6 | 12.3 | 7.2 |
| 1975 | -0.2 | 6.9 | 8.2 |
| 1976 | 5.4 | 4.9 | 7.8 |
| 1977 | 4.6 | 6.7 | 6.4 |
| 1978 | 5.6 | 9.0 | 6.0 |
| 1979 | 3.1 | 13.3 | 6.0 |
| 1980 | -0.3 | 12.5 | 7.2 |
| 1981 | 2.5 | 8.9 | 8.5 |
| 1982 | -1.9 | 3.8 | 10.8 |
| 1983 | 4.5 | 3.8 | 8.3 |
| 1984 | 7.2 | 3.9 | 7.3 |
| 1985 | 4.1 | 3.8 | 7.0 |
| 1986 | 3.5 | 1.1 | 6.6 |
| 1987 | 3.2 | 4.4 | 5.7 |
| 1988 | 4.1 | 4.4 | 5,3 |
| 1989 | 3.6 | 4.6 | 5.4 |
| 1990 | 1.9 | 6.1 | 6.3 |
Note: GDP: Gross Domestic Product; CPI: consumer price index; UNE: rate of unemployment; CPI and UNE are at year end instead of average to obtain a complete series
Source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
http://www.bls.gov/web/empsit/cpseea01.htm
http://data.bls.gov/pdq/SurveyOutputServlet
There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table 15 when monetary policy pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table 15 shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.
Table 15, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994
| 1994 | FF | 30Y | 30P | 10Y | 10P | MOR | CPI |
| Jan | 3.00 | 6.29 | 100 | 5.75 | 100 | 7.06 | 2.52 |
| Feb | 3.25 | 6.49 | 97.37 | 5.97 | 98.36 | 7.15 | 2.51 |
| Mar | 3.50 | 6.91 | 92.19 | 6.48 | 94.69 | 7.68 | 2.51 |
| Apr | 3.75 | 7.27 | 88.10 | 6.97 | 91.32 | 8.32 | 2.36 |
| May | 4.25 | 7.41 | 86.59 | 7.18 | 88.93 | 8.60 | 2.29 |
| Jun | 4.25 | 7.40 | 86.69 | 7.10 | 90.45 | 8.40 | 2.49 |
| Jul | 4.25 | 7.58 | 84.81 | 7.30 | 89.14 | 8.61 | 2.77 |
| Aug | 4.75 | 7.49 | 85.74 | 7.24 | 89.53 | 8.51 | 2.69 |
| Sep | 4.75 | 7.71 | 83.49 | 7.46 | 88.10 | 8.64 | 2.96 |
| Oct | 4.75 | 7.94 | 81.23 | 7.74 | 86.33 | 8.93 | 2.61 |
| Nov | 5.50 | 8.08 | 79.90 | 7.96 | 84.96 | 9.17 | 2.67 |
| Dec | 6.00 | 7.87 | 81.91 | 7.81 | 85.89 | 9.20 | 2.67 |
Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months
Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.t
Table 16, updated with every blog comment, provides in the second column the yield at the close of market of the 10-year Treasury note on the date in the first column. The price in the third column is calculated with the coupon of 2.625 percent of the 10-year note current at the time of the second round of quantitative easing after Nov 3, 2010 and the final column “∆% 11/04/10” calculates the percentage change of the price on the date relative to that of 101.2573 at the close of market on Nov 4, 2010, one day after the decision on quantitative easing by the Fed on Nov 3, 2010. Prices with the new coupon of 3.63 percent in recent auctions (http://www.treasurydirect.gov/instit/annceresult/press/preanre/2011/2011.htm) are not comparable to prices in Table 16. The highest yield in the decade was 5.510 percent on May 1, 2001 that would result in a loss of principal of 22.9 percent relative to the price on Nov 4. The Fed has created a “duration trap” of bond prices. Duration is the percentage change in bond price resulting from a percentage change in yield or what economists call the yield elasticity of bond price. Duration is higher the lower the bond coupon and yield, all other things constant. This means that the price loss in a yield rise from low coupons and yields is much higher than with high coupons and yields. Intuitively, the higher coupon payments offset part of the price loss. Prices/yields of Treasury securities were affected by the combination of Fed purchases for its program of quantitative easing and also by the flight to dollar-denominated assets because of geopolitical risks in the Middle East, subsequently by the tragic earthquake and tsunami in Japan and now again by the sovereign risk doubts in Europe. The yield of 2.872 percent at the close of market on Fr Jun 24, 2011, would be equivalent to price of 97.8662 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 3.3 percent relative to the price on Nov 4, 2010, one day after the decision on the second program of quantitative easing. If inflation accelerates, yields of Treasury securities may rise sharply. Yields are not observed without special yield-lowering effects such as the flight into dollars caused by the events in the Middle East, continuing purchases of Treasury securities by the Fed, the tragic earthquake and tsunami affecting Japan and recurring fears on European sovereign credit issues. Important causes of the rise in yields shown in Table 16 are expectations of rising inflation and US government debt estimated to exceed 70 percent of GDP in 2012 (http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html), rising from 40.8 percent of GDP in 2008, 53.5 percent in 2009 (Table 2 in http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html) and 69 percent in 2011. On Jun 15, 2011, the line “Reserve Bank credit” in the Fed balance sheet stood at $2841 billion, or $2.8 trillion, with portfolio of long-term securities of $2606 billion, or $2.6 trillion, consisting of $1509 billion Treasury nominal notes and bonds, $65 billion of notes and bonds inflation-indexed, $118 billion Federal agency debt securities and $914 billion mortgage-backed securities; reserve balances deposited with Federal Reserve Banks reached $1594 billion or $1.6 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). There is no simple exit of this trap created by the highest monetary policy accommodation in US history together with the highest deficits and debt in percent of GDP since World War II. Risk aversion from various sources, discussed in section I, has been affecting financial markets for several weeks. The risk is that in a reversal of risk aversion that has been typical in this cyclical expansion of the economy yields of Treasury securities may back up sharply.
Table 16, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note
| Date | Yield | Price | ∆% 11/04/10 |
| 05/01/01 | 5.510 | 78.0582 | -22.9 |
| 06/10/03 | 3.112 | 95.8452 | -5.3 |
| 06/12/07 | 5.297 | 79.4747 | -21.5 |
| 12/19/08 | 2.213 | 104.4981 | 3.2 |
| 12/31/08 | 2.240 | 103.4295 | 2.1 |
| 03/19/09 | 2.605 | 100.1748 | -1.1 |
| 06/09/09 | 3.862 | 89.8257 | -11.3 |
| 10/07/09 | 3.182 | 95.2643 | -5.9 |
| 11/27/09 | 3.197 | 95.1403 | -6.0 |
| 12/31/09 | 3.835 | 90.0347 | -11.1 |
| 02/09/10 | 3.646 | 91.5239 | -9.6 |
| 03/04/10 | 3.605 | 91.8384 | -9.3 |
| 04/05/10 | 3.986 | 88.8726 | -12.2 |
| 08/31/10 | 2.473 | 101.3338 | 0.08 |
| 10/07/10 | 2.385 | 102.1224 | 0.8 |
| 10/28/10 | 2.658 | 99.7119 | -1.5 |
| 11/04/10 | 2.481 | 101.2573 | - |
| 11/15/10 | 2.964 | 97.0867 | -4.1 |
| 11/26/10 | 2.869 | 97.8932 | -3.3 |
| 12/03/10 | 3.007 | 96.7241 | -4.5 |
| 12/10/10 | 3.324 | 94.0982 | -7.1 |
| 12/15/10 | 3.517 | 92.5427 | -8.6 |
| 12/17/10 | 3.338 | 93.9842 | -7.2 |
| 12/23/10 | 3.397 | 93.5051 | -7.7 |
| 12/31/10 | 3.228 | 94.3923 | -6.7 |
| 01/07/11 | 3.322 | 94.1146 | -7.1 |
| 01/14/11 | 3.323 | 94.1064 | -7.1 |
| 01/21/11 | 3.414 | 93.4687 | -7.7 |
| 01/28/11 | 3.323 | 94.1064 | -7.1 |
| 02/04/11 | 3.640 | 91.750 | -9.4 |
| 02/11/11 | 3.643 | 91.5319 | -9.6 |
| 02/18/11 | 3.582 | 92.0157 | -9.1 |
| 02/25/11 | 3.414 | 93.3676 | -7.8 |
| 03/04/11 | 3.494 | 92.7235 | -8.4 |
| 03/11/11 | 3.401 | 93.4727 | -7.7 |
| 03/18/11 | 3.273 | 94.5115 | -6.7 |
| 03/25/11 | 3.435 | 93.1935 | -7.9 |
| 04/01/11 | 3.445 | 93.1129 | -8.0 |
| 04/08/11 | 3.576 | 92.0635 | -9.1 |
| 04/15/11 | 3.411 | 93.3874 | -7.8 |
| 04/22/11 | 3.402 | 93.4646 | -7.7 |
| 04/29/11 | 3.290 | 94.3759 | -6.8 |
| 05/06/11 | 3.147 | 95.5542 | -5.6 |
| 05/13/11 | 3.173 | 95.3387 | -5.8 |
| 05/20/11 | 3.146 | 95.5625 | -5.6 |
| 05/27/11 | 3.068 | 96.2089 | -4.9 |
| 06/03/11 | 2.990 | 96.8672 | -4.3 |
| 06/10/11 | 2.973 | 97.0106 | -4.2 |
| 06/17/11 | 2.937 | 97.3134 | -3.9 |
| 06/24/11 | 2.872 | 97.8662 | -3.3 |
Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates and the coupon of 2.625% on 11/04/10
Source:
http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3020
V Valuation of Risk Financial Assets. The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html
Table 17 shows the phenomenal impulse to valuations of risk financial assets originating in the initial shock of near zero interest rates in 2003-2004 with the fed funds rate at 1 percent, in fear of deflation that never materialized, and quantitative easing in the form of suspension of the auction of 30-year Treasury bonds to lower mortgage rates. World financial markets were dominated by monetary and housing policies in the US. Between 2002 and 2008, the DJ UBS Commodity Index rose 165.5 percent largely because of the unconventional monetary policy encouraging carry trade from low US interest rates to long leveraged positions in commodities, exchange rates and other risk financial assets. The charts of risk financial assets show sharp increase in valuations leading to the financial crisis and then profound drops that are captured in Table 17 by percentage changes of peaks and troughs. The first round of quantitative easing and near zero interest rates depreciated the dollar relative to the euro by 39.3 percent between 2003 and 2008, with revaluation of the dollar by 25.1 percent from 2008 to 2010 in the flight to dollar-denominated assets in fear of world financial risks and then devaluation of the dollar by 19.0 percent by Fri Jun 24, 2011. Dollar devaluation is a major vehicle of monetary policy in reducing the output gap that is implemented in the probably erroneous belief that devaluation will not accelerate inflation. The last row of Table 17 shows CPI inflation in the US rising from 1.9 percent in 2003 to 4.1 percent in 2007 even as monetary policy increased the fed funds rate from 1 percent in Jun 2004 to 5.25 percent in Jun 2006.
Table 17 Volatility of Assets
| DJIA | 10/08/02-10/01/07 | 10/01/07-3/4/09 | 3/4/09- 4/6/10 | |
| ∆% | 87.8 | -51.2 | 60.3 | |
| NYSE Financial | 1/15/04- 6/13/07 | 6/13/07- 3/4/09 | 3/4/09- 4/16/07 | |
| ∆% | 42.3 | -75.9 | 121.1 | |
| Shanghai Composite | 6/10/05- 10/15/07 | 10/15/07- 10/30/08 | 10/30/08- 7/30/09 | |
| ∆% | 444.2 | -70.8 | 85.3 | |
| STOXX EUROPE 50 | 3/10/03- 7/25/07 | 7/25/07- 3/9/09 | 3/9/09- 4/21/10 | |
| ∆% | 93.5 | -57.9 | 64.3 | |
| UBS Com. | 1/23/02- 7/1/08 | 7/1/08- 2/23/09 | 2/23/09- 1/6/10 | |
| ∆% | 165.5 | -56.4 | 41.4 | |
| 10-Year Treasury | 6/10/03 | 6/12/07 | 12/31/08 | 4/5/10 |
| % | 3.112 | 5.297 | 2.247 | 3.986 |
| USD/EUR | 6/26/03 | 7/14/08 | 6/07/10 | 06/24 |
| Rate | 1.1423 | 1.5914 | 1.192 | 1.419 |
| CNY/USD | 01/03 | 07/21 | 7/15 | 06/24 2011 |
| Rate | 8.2798 | 8.2765 | 6.8211 | 6.4750 |
| New House | 1963 | 1977 | 2005 | 2009 |
| Sales 1000s | 560 | 819 | 1283 | 375 |
| New House | 2000 | 2007 | 2009 | 2010 |
| Median Price $1000 | 169 | 247 | 217 | 203 |
| 2003 | 2005 | 2007 | 2010 | |
| CPI | 1.9 | 3.4 | 4.1 | 1.5 |
Sources: http://online.wsj.com/mdc/page/marketsdata.html
http://www.census.gov/const/www/newressalesindex_excel.html
http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm
Table 17A extracts four rows of Table 24 with the Dollar/Euro (USD/EUR) exchange rate and Chinese Yuan/Dollar (CNY/USD) exchange rate that reveal pursuit of exchange rate policies resulting from monetary policy in the US and capital control/exchange rate policy in China. The ultimate intentions are the same: promoting internal economic activity at the expense of the rest of the world. The easy money policy of the US was deliberately or not but effectively to devalue the dollar from USD 1.1423/EUR on Jun 26, 2003 to USD 1.5914/EUR on Jul 14, 2008, or by 39.3 percent. The flight into dollar assets after the global recession caused revaluation to USD 1.192/EUR on Jun 7, 2010, or by 25.1 percent. After the temporary interruption of the sovereign risk issues in Europe from Apr to Jul, 2010, shown in Table 19 below, the dollar has devalued again to USD 1.419/EUR or by 19.0 percent. Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment. China fixed the CNY to the dollar for a long period at a highly undervalued level of around CNY 8.2765/USD until it revalued to CNY 6.8211/USD until Jun 7, 2010, or by 17.6 percent and after fixing it again to the dollar, revalued to CNY 6.4750/USD on Fri Jun 24, 2011, or by an additional 5.1 percent, for cumulative revaluation of 21.8 percent.
Table 17A, Dollar/Euro (USD/EUR) Exchange Rate and Chinese Yuan/Dollar (CNY/USD) Exchange Rate
| USD/EUR | 6/26/03 | 7/14/08 | 6/07/10 | 06/24 |
| Rate | 1.1423 | 1.5914 | 1.192 | 1.419 |
| CNY/USD | 01/03 | 07/21 | 7/15 | 06/24 2011 |
| Rate | 8.2798 | 8.2765 | 6.8211 | 6.4750 |
Source: Table 17.
Dollar devaluation did not eliminate the US current account deficit, which is projected by the International Monetary Fund (IMF) at 3.2 percent of GDP in 2011 and also in 2012, as shown in Table 18. Revaluation of the CNY has not reduced the current account surplus of China, which is projected by the IMF to increase from 5.7 percent of GDP in 2011 to 6.3 percent of GDP in 2012.
Table 18, Fiscal Deficit, Current Account Deficit and Government Debt as % of GDP and 2011 Dollar GDP
| GDP $B | FD %GDP 2011 | CAD %GDP 2011 | Debt %GDP 2011 | FD%GDP 2012 | CAD%GDP 2012 | Debt %GDP 2012 | |
| US | 15227 | -10.6 | -3.2 | 64.8 | -10.8 | -3.2 | 72.4 |
| Japan | 5821 | -9.9 | 2.3 | 127.8 | -8.4 | 2.3 | 135.1 |
| UK | 2471 | -8.6 | -2.4 | 75.1 | -6.9 | -1.9 | 78.6 |
| Euro | 12939 | -4.4 | 0.03 | 66.9 | -3.6 | 0.05 | 68.2 |
| Ger | 3519 | -2.3 | 5.1 | 54.7 | -1.5 | 4.6 | 54.7 |
| France | 2751 | -6.0 | -2.8 | 77.9 | -5.0 | -2.7 | 79.9 |
| Italy | 2181 | -4.3 | -3.4 | 100.6 | -3.5 | -2.9 | 100.4 |
| Can | 1737 | -4.6 | -2.8 | 35.1 | -2.8 | -2.6 | 36.3 |
| China | 6516 | -1.6 | 5.7 | 17.1 | -0.9 | 6.3 | 16.3 |
| Brazil | 2090 | -2.4 | -2.6 | 39.9 | -2.6 | -2.9 | 39.4 |
Note: GER = Germany; Can = Canada; FD = fiscal deficit; CAD = current account deficit
Source: http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table 17 above after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets with fluctuations provoked by events of risk aversion. Table 19, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough” and the sharp recovery after around Jul 2010 in the last column “∆% Trough to 06/24/11” with all risk financial assets in the range from 8.2 percent for European stocks to 25.6 percent for the DAX equity index of Germany. Japan has significantly improved performance rising 9.7 percent above the trough. The dollar devalued by 19.0 percent and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 6/24/2011” shows the sharp fall of many risk financial assets, with the exception of increase by 3.9 percent of the Shanghai stock index of China and 3.5 percent by the Japanese Nikkei Average. Japan’s all industry index rose 1.5 percent in Apr, showing strong recovery (http://www.meti.go.jp/statistics/tyo/zenkatu/result-2/pdf/hv37913_201104j.pdf). The Dow Global lost 0.4 percent with strength in Asia but weakness in Europe and the US. The DJ UBS Commodity Index lost 2.2 percent in the week in large part because of the release of strategic reserves by the US and 27 other members of the IEA. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with caution instead of more aggressive risk exposures. There is a fundamental change in Table 19 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2011. That change is best perceived in the column “∆% Peak to 6/24/11” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event. Most financial risk assets had gained not only relative to the trough as shown in column “∆% Trough to 6/24/11” but also relative to the peak in column “∆% Peak to 6/24/11.” There are multiple indexes below the peak: NYSE Finance by 11.6 percent, Dow Global by 2.2 percent, Nikkei Average by 15.0 percent but mostly because of the earthquake/tsunami, Shanghai Composite by 13.2 percent and STOXX 50 by 8.3 percent. The only gainers relative to the peak in Apr 2010 are: DAX by 12.5 percent, Asia Pacific by 3.6 percent, S&P 500 by 4.2 percent, DJIA by 6.2 percent and the DJ UBS Commodities Index by 7.2 percent. The factors of risk aversion have adversely affected the performance of financial risk assets. The performance relative to the peak in Apr is more important than the performance relative to the trough around early Jul because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. Aggressive tightening of monetary policy to maintain the credibility of inflation not rising above 2 percent—in contrast with timid “measured” policy during the adjustment in Jun 2004 to Jun 2006 after the earlier round of near zero interest rates—may cause another credit/dollar crisis and stress on the overall world economy. The choices may prove tough and will magnify effects on financial variables because of the corner in which policy has been driven by aggressive impulses that have resulted in the fed funds rate of 0 to ¼ percent and holdings of long-term securities close to 30 percent of Treasury securities in circulation.
Table 19, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 6/ 24/11 | ∆% Week 6/ | ∆% Trough to 6/ | |
| DJIA | 4/26/ | 7/2/10 | -13.6 | 6.5 | -0.6 | 23.2 |
| S&P 500 | 4/23/ | 7/20/ | -16.0 | 4.2 | -0.2 | 24.0 |
| NYSE Finance | 4/15/ | 7/2/10 | -20.3 | -11.6 | -1.2 | 10.9 |
| Dow Global | 4/15/ | 7/2/10 | -18.4 | -2.2 | -0.4 | 19.9 |
| Asia Pacific | 4/15/ | 7/2/10 | -12.5 | 3.6 | 1.9 | 18.3 |
| Japan Nikkei Aver. | 4/05/ | 8/31/ | -22.5 | -15.0 | 3.5 | 9.7 |
| China Shang. | 4/15/ | 7/02 | -24.7 | -13.2 | 3.9 | 15.2 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -8.3 | -1.1 | 8.2 |
| DAX | 4/26/ | 5/25/ | -10.5 | 12.5 | -0.6 | 25.6 |
| Dollar | 11/25 2009 | 6/7 | 21.2 | 6.2 | 0.8 | -19,0 |
| DJ UBS Comm. | 1/6/ | 7/2/10 | -14.5 | 7.2 | -2.2 | 25.4 |
| 10-Year Tre. | 4/5/ | 4/6/10 | 3.986 | 2.872 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://online.wsj.com/mdc/page/marketsdata.html.
Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. Table 20 shows a gain by Apr 29, 2011 in the DJIA of 14.3 percent and of the S&P 500 of 12.5 percent since Apr 26, 2010, around the time when sovereign risk issues in Europe began to be acknowledged in financial risk asset valuations. There were still fluctuations. Reversals of valuations are possible during aggressive changes in interest rate policy. The stock market of the US then entered a period of six consecutive weekly declines interrupted by a week of advance and then another decline in the week of Jun 24. In the week of May 6, return of risk aversion, resulted in moderation of the valuation of the DJIA to 12.8 percent and that of the S&P 500 to 10.6 percent. There was further loss of dynamism in the week of May 13 with the DJIA reducing its gain to 12.4 percent and the S&P 500 to 10.4 percent. Further declines lowered the gain to 11.7 percent in the DJIA and to 10.0 in the S&P 500 by Fri May 20. By Fri May 27 the gains were further reduced to 11.0 percent for the DJIA and 9.8 percent for the S&P 500. In the fifth consecutive week of declines in the week of Fri June 3, the DJIA fell 2.3 percent, reducing the cumulative gain to 8.4 percent, and the S&P 500 also lost 2.3 percent, resulting in cumulative gain of 7.3 percent. The DJIA lost another 1.6 percent and the S&P 500 also 2.2 percent in the week of Jun 10, reducing the cumulative gain to 6.7 percent for the DJIA and of 4.9 percent for the S&P 500. The DJIA gained 0.4 percent in the week of Jun 17, to break the round of six consecutive weekly declines, rising 7.1 percent relative to Apr 26, 2010, while the S&P moved sideways by 0.04 percent, with gain of 4.9 percent relative to Apr 26, 2010. In the week of Jun 24, the DJIA lost 0.6 percent and the S&P lost 0.2 percent. The DJIA has lost 6.8 percent between Apr 29 and Jun 10, 2011, and the S&P 500 lost 6.9 percent.
Table 20, Percentage Changes of DJIA and S&P 500 in Selected Dates
| 2010 | ∆% DJIA from earlier date | ∆% DJIA from | ∆% S&P 500 from earlier date | ∆% S&P 500 from |
| Apr 26 | ||||
| May 6 | -6.1 | -6.1 | -6.9 | -6.9 |
| May 26 | -5.2 | -10.9 | -5.4 | -11.9 |
| Jun 8 | -1.2 | -11.3 | 2.1 | -12.4 |
| Jul 2 | -2.6 | -13.6 | -3.8 | -15.7 |
| Aug 9 | 10.5 | -4.3 | 10.3 | -7.0 |
| Aug 31 | -6.4 | -10.6 | -6.9 | -13.4 |
| Nov 5 | 14.2 | 2.1 | 16.8 | 1.0 |
| Nov 30 | -3.8 | -3.8 | -3.7 | -2.6 |
| Dec 17 | 4.4 | 2.5 | 5.3 | 2.6 |
| Dec 23 | 0.7 | 3.3 | 1.0 | 3.7 |
| Dec 31 | 0.03 | 3.3 | 0.07 | 3.8 |
| Jan 7 | 0.8 | 4.2 | 1.1 | 4.9 |
| Jan 14 | 0.9 | 5.2 | 1.7 | 6.7 |
| Jan 21 | 0.7 | 5.9 | -0.8 | 5.9 |
| Jan 28 | -0.4 | 5.5 | -0.5 | 5.3 |
| Feb 4 | 2.3 | 7.9 | 2.7 | 8.1 |
| Feb 11 | 1.5 | 9.5 | 1.4 | 9.7 |
| Feb 18 | 0.9 | 10.6 | 1.0 | 10.8 |
| Feb 25 | -2.1 | 8.3 | -1.7 | 8.9 |
| Mar 4 | 0.3 | 8.6 | 0.1 | 9.0 |
| Mar 11 | -1.0 | 7.5 | -1.3 | 7.6 |
| Mar 18 | -1.5 | 5.8 | -1.9 | 5.5 |
| Mar 25 | 3.1 | 9.1 | 2.7 | 8.4 |
| Apr 1 | 1.3 | 10.5 | 1.4 | 9.9 |
| Apr 8 | 0.03 | 10.5 | -0.3 | 9.6 |
| Apr 15 | -0.3 | 10.1 | -0.6 | 8.9 |
| Apr 22 | 1.3 | 11.6 | 1.3 | 10.3 |
| Apr 29 | 2.4 | 14.3 | 1.9 | 12.5 |
| May 6 | -1.3 | 12.8 | -1.7 | 10.6 |
| May 13 | -0.3 | 12.4 | -0.2 | 10.4 |
| May 20 | -0.7 | 11.7 | -0.3 | 10.0 |
| May 27 | -0.6 | 11.0 | -0.2 | 9.8 |
| Jun 3 | -2.3 | 8.4 | -2.3 | 7.3 |
| Jun 10 | -1.6 | 6.7 | -2.2 | 4.9 |
| Jun 17 | 0.4 | 7.1 | 0.04 | 4.9 |
| Jun 24 | -0.6 | 6.5 | -0.2 | 4.6 |
Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004
Table 21, updated with every post, shows that exchange rate valuations affect a large variety of countries, in fact, almost the entire world, in magnitudes that cause major problems for domestic monetary policy and trade flows. Dollar devaluation is expected to continue because of zero fed funds rate, expectations of rising inflation and the large budget deficit of the federal government (http://professional.wsj.com/article/SB10001424052748703907004576279321350926848.html?mod=WSJ_hp_LEFTWhatsNewsCollection) but with interruptions caused by risk aversion events.
Table 21, Exchange Rates
| Peak | Trough | ∆% P/T | Jun 24 2011 | ∆% T Jun 24 2011 | ∆% P Jun 24 2011 | |
| EUR USD | 7/15 | 6/7 2010 | 6/24 2011 | |||
| Rate | 1.59 | 1.192 | 1.419 | |||
| ∆% | -33.4 | 15.9 | -12.1 | |||
| JPY USD | 8/18 | 9/15 | 6/24 2011 | |||
| Rate | 110.19 | 83.07 | 80.39 | |||
| ∆% | 24.6 | 3.2 | 27.0 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 6/24 2011 | |||
| Rate | 1.225 | 1.025 | 0.838 | |||
| ∆% | 16.3 | 18.2 | 31.6 | |||
| USD GBP | 7/15 | 1/2/ 2009 | 6/24 2011 | |||
| Rate | 2.006 | 1.388 | 1.596 | |||
| ∆% | -44.5 | 13.0 | -25.7 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 6/24 | |||
| Rate | 1.0215 | 1.6639 | 1.049 | |||
| ∆% | -62.9 | 42.7 | 6.7 | |||
| ZAR USD | 10/22 2008 | 8/15 | 6/24 2011 | |||
| Rate | 11.578 | 7.238 | 6.894 | |||
| ∆% | 37.5 | 4.8 | 40.5 | |||
| SGD USD | 3/3 | 8/9 | 6/24 | |||
| Rate | 1.553 | 1.348 | 1.238 | |||
| ∆% | 13.2 | 8.2 | 20.3 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 6/24 | |||
| Rate | 7.813 | 7.752 | 7.788 | |||
| ∆% | 0.8 | -0.5 | 0.3 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 6/24 2011 | |||
| Rate | 2.43 | 1.737 | 1.591 | |||
| ∆% | 28.5 | 8.4 | 34.5 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 6/24 | |||
| Rate | 22.19 | 18.693 | 17.169 | |||
| ∆% | 15.7 | 8.2 | 22.6 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 6/24 2011 | |||
| Rate | 9.313 | 7.108 | 6.494 | |||
| ∆% | 23.7 | 8.6 | 30.3 | |||
| CNY USD | 7/20 2005 | 7/15 | 6/24 | |||
| Rate | 8.2765 | 6.8211 | 6.4750 | |||
| ∆% | 17.6 | 5.1 | 21.8 |
Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; CNY: Chinese yuan; P: peak; T: trough
Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation
Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000
http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm
http://markets.ft.com/ft/markets/currencies.asp
VI Economic Indicators. The advance report on durable goods manufacturers’ shipments and new orders in Table 22 shows stronger performance in May relative to Apr after the disappointing numbers in Apr/Mar but sound numbers in Mar/Feb. Durable goods data are among the most volatile and difficult to interpret short-term economic indicators. An important source of volatility is large value items such as aircraft. Investors and traders were concerned with sovereign risk issues on Fri Jun 24 when the report was released together with the third estimate of IQ2011 GDP.
Table 22, Durable Goods Manufacturers’ Shipments and New Orders, SA, %
| May/Apr ∆% | Apr/Mar ∆% | Mar/Feb ∆% | |
| Total | |||
| S | 0.3 | -1.4 | 3.1 |
| NO | 1.9 | -2.7 | 4.6 |
| Excluding Transport | |||
| S | 0.5 | -0.7 | 2.5 |
| NO | 0.6 | -0.4 | 2.6 |
| Excluding Defense | |||
| S | 0.4 | -1.3 | 3.2 |
| NO | 1.9 | -2.9 | 4.2 |
| Transport Equipment | |||
| S | -0.4 | -3.8 | 5.1 |
| NO | 5.8 | -9.4 | 10.6 |
| Motor Vehicles | |||
| S | 0.6 | -5.3 | 6.9 |
| NO | 0.6 | -5.3 | 6.6 |
| Nondefense Aircraft | |||
| S | -2.4 | -2.0 | 2.5 |
| NO | 36.5 | -29.0 | 2.3 |
| Capital Goods | |||
| S | 0.8 | -2.0 | 3.6 |
| NO | 5.6 | -5.4 | 6.1 |
Note: S: shipments; NO: new orders; Transport: transportation
Source: http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf
Durable goods manufacturers’ shipments and new orders, not seasonally adjusted, grew rapidly when comparing the first five months of 2011 relative to the first five months of 2010, shown in Table 23. The data are not adjusted for changes in prices such that there might be inflation behind double-digit growth.
Table 23, Durable Goods Manufacturers’ Shipments and New Orders, NSA, %
| Jan-May 2011/Jan-May 2010 ∆% | |
| Total | |
| S | 7.5 |
| NO | 9.7 |
| Excluding Transport | |
| S | 8.6 |
| NO | 9.5 |
| Excluding Defense | |
| S | 9.6 |
| NO | 11.3 |
| Transport Equipment | |
| S | 4.4 |
| NO | 10.2 |
| Motor Vehicles | |
| S | 11.7 |
| NO | 12.0 |
| Nondefense Aircraft | |
| S | 4.7 |
| NO | 10.5 |
| Capital Goods | |
| S | 4.6 |
| NO | 9.4 |
Note: S: shipments; NO: new orders; Transport: transportation
Source: http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf
Sales of new homes SA at annual equivalent rate rose strongly by 8.9 percent in Mar and 6.5 percent in Apr but fell 2.1 percent in May, as shown in Table 24. The first two months of the year were disappointing for real estate even adjusted for seasonality.
Table 24, Sales of New Homes at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %
| SA Annual Rate Thousands | ∆% | |
| Jan | 310 | -6.3 |
| Feb | 281 | -9.4 |
| Mar | 306 | 8.9 |
| Apr | 326 | 6.5 |
| May | 319 | -2.1 |
Source: http://www.census.gov/const/newressales.pdf
The housing sector continues to be depressed relative to the prior year and the peak in 2005 to 2006. Table 25 shows that new home sales not seasonally adjusted fell 13.6 percent in Jan-May 2011 relative to the same period in 2010, 72.9 percent relative to the same period in 2006 and 76.6 percent relative to the same period in 2005.
Table 25, Sales of New Homes Not Seasonally Adjusted, Thousands and %
| Not Seasonally Adjusted Thousands | |
| Jan-May 2011 | 132 |
| Jan-May 2010 | 153 |
| ∆% | -13.6* |
| Jan-May 2006 | 487 |
| ∆% Jan-May 2011 | -72.9 |
| Jan-May 2005 | 564 |
| ∆% Jan-May 2011 | -76.6 |
*Computed using unrounded data
Source: http://www.census.gov/const/newressales.pdf
http://www.census.gov/const/newressales_200705.pdf
http://www.census.gov/const/newressales_200605.pdf
The Federal Housing Finance Agency (FHFA) House Price Index in Table 26 provided a surprise in the form of increase in house prices from Mar into Apr. The 12 months ending in Apr show decline in house prices of 5.7 percent. The index is 19.3 percent below the Apr 2007 peak and about the same level as in Jan 2004.
Table 26, Federal Housing Finance Agency (FHFA) House Price Index
| Mar/Apr | 12 Months Apr 2011 | |
| ∆% | 0.8 | -5.7 |
Note: US FHFA House Price Index is 19.3 percent below the Apr 2007 peak and about the same level as in Jan 2004
Source: http://www.fhfa.gov/webfiles/21604/MonthlyHPI62211F.pdf
The index of existing home sales of the National Association of Realtors dropped 3.8 percent seasonally adjusted in May relative to Apr and fell 15.3 percent in May 2011 relative to May 2010 (http://www.realtor.org/press_room/news_releases/2011/06/may_decline). The comparison relative to the year before is biased by the surge in sales provoked by the effort to buy before the expiration of the home buyer tax credit.
The Energy Information Administration Weekly Petroleum Status Report is summarized in Table 27. Crude oil stocks fell to 363.8 million barrels in the week of Jun 17 from 365.6 million in the week of Jun 10 and are lower by 1.3 barrels than in the week of Jun 18, 2010. The world crude oil price rose to $113.61/barrel in the week of Jun 17 from $112.26/barrel in the week of Jun 10, but is 53.8 percent higher than $73.85/barrel in the week of Jun 18, 2010. The price of regular motor gasoline of $3.652/gallon on Jun 20, 2011 was 33.1 percent higher than $2.743/gallon on Jun 21, 2010. These data are released for the prior week so that they do not include the significant decline in fuel prices in the week of Jun 24 following the announcement of release into the market of 60 million barrels of oil from the strategic reserves of the US and 27 member countries of the IEA. It is yet to be seen if the release of oil in the strategic reserves will have more than an initial impact because the total is equivalent to only one day of world consumption and the release is by 2 million barrels per day over one month.
Table 27, Energy Information Administration Weekly Petroleum Status Report
| Week Ending 06/17/11 | Week Ending 06/10/11 | Week Ending 06/18/10 | |
| Crude Oil Stocks Million B | 363.8 | 365.6 | 365.1 |
| Crude Oil Imports Thousand Barrels/Day | 8,942 | 8,963 | 9,667 |
| Motor Gasoline Million B | 214.6 | 215.1 | 217.6 |
| Distillate Fuel Oil Million B | 142.0 | 140.8 | 156.9 |
| World Crude Oil Price $/B | 113.61 | 112.26 | 73.85 |
| 06/20/11 | 06/13/11 | 06/21/10 | |
| Regular Motor Gasoline $/G | 3.652 | 3.713 | 2.743 |
B: barrels; G: gallon
Initial claims for unemployment insurance seasonally adjusted rose 9000 to reach 429,000 in the week of Jun 18 from 420,000 in the week of Jun 11, as shown in Table 28. Claims not seasonally adjusted fell 5683 to reach 394,925 in the week of May 18 from 400,608 in the week of Jun 11. The labor market is not showing improvement with claims around 400,000, seasonally adjusted or not.
Table 28, Initial Claims for Unemployment Insurance
| SA | NSA | 4-week MA SA | |
| Jun 18 | 429,000 | 394,925 | 426,250 |
| Jun 11 | 420,000 | 400,608 | 426,250 |
| Change | 9,000 | -5,683 | 0 |
| Jun 4 | 430,000 | 366,816 | 424,750 |
| Prior Year | 463,000 | 427,080 | 466,250 |
Note: SA: seasonally adjusted; NSA: not seasonally adjusted; MA: moving average
Source: http://www.dol.gov/opa/media/press/eta/ui/current.htm
VII Interest Rates. The US yield curve shows mostly negative percentage yields throughout most maturities under almost any expectation of inflation: 0.01 3-months, 0.07 6-months, 0.14 12-months, 0.33 2-years, 0.56 3-years, 1.38 5-years, 2.11 7-years, 2.86 10-years and 4.18 30-years. Negative real rates of interest prevent sound calculations of risk/returns such as capital budgeting, decisions on purchasing consumer durables and nearly every important financial and economic decision. There is also significant risk exposure if inflation accelerates and/or risk aversion declines.
VIII Conclusion. The Annual Report of the Bank for International Settlements (BIS) for 2010/2011 warns about an extremely important policy need (http://www.bis.org/publ/arpdf/ar2011e1.pdf 5):
“But controlling inflation in the long term will require policy tightening. And with short-term inflation up, that means a quicker normalisation of policy rates. Expectations that short-term interest rates would rise contributed to the increase in long-term bond yields seen until early 2011.”
Inflation is not only a phenomenon in emerging economies growing more rapidly. Slack is not a good predictor of historical inflation events. There is inflation throughout the world economy, including advanced economies. Policy rates should be adjusted to normal levels that can guide again risk/return decisions.
(Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)
http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
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© Carlos M. Pelaez, 2010, 2011
