CMP Associates Regulation Blog: Financial Risk Aversion and Collapse of Valuations of Risk Financial Assets, World Financial Turbulence, Global Inflation and World Economic Slowdown

Financial Risk Aversion and Collapse of Valuations of Risk Financial Assets, World Financial Turbulence, Global Inflation and World Economic Slowdown

Carlos M. Pelaez

Executive Summary

I Financial Risk Aversion and Collapse of Valuations of Risk Financial Assets

IA Unconventional Monetary Policy

IB Financial Risk Aversion

IC Financial Risk Valuations

ID Global Inflation Waves

IE Summary

IF Appendix: Transmission of Unconventional Monetary Policy

IFi Theory

IFii Policy

IFiii Evidence

IFiv Unwinding Strategy

II World Financial Turbulence

IIIA Financial Risks

IIB Fiscal Compact

IIC European Central Bank Large Scale Lender of Last Resort

IID Euro Zone Survival Risk

IIE Appendix on Sovereign Bond Valuation

III Global Inflation

IV World Economic Slowdown

IVA United States

IVB Japan

IVC China

IVD Euro Area

IVE Germany

IVF France

IVG Italy

IVH United Kingdom

V Valuation of Risk Financial Assets

VI Economic Indicators

VII Interest Rates

VIII Conclusion

References

Appendix I The Great Inflation

Executive Summary

The critical fact of current world financial markets is the combination of “unconventional” monetary policy with intermittent shocks of financial risk aversion. There are two interrelated unconventional monetary policies. First, unconventional monetary policy consists of (1) reducing short-term policy interest rates toward the “zero bound” such as fixing the fed funds rate at 0 to ¼ percent by decision of the Federal Open Market Committee (FOMC) since Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). Second, unconventional monetary policy also includes a battery of measures to also reduce long-term interest rates of government securities and asset-backed securities such as mortgage-backed securities.

When inflation is low, the central bank lowers interest rates to stimulate aggregate demand in the economy, which consists of consumption and investment. When inflation is subdued and unemployment high, monetary policy would lower interest rates to stimulate aggregate demand, reducing unemployment. When interest rates decline to zero, unconventional monetary policy would consist of policies such as large-scale purchases of long-term securities to lower their yields. A major portion of credit in the economy is financed with long-term asset-backed securities. Loans for purchasing houses, automobiles and other consumer products are bundled in securities that in turn are sold to investors. Corporations borrow funds for investment by issuing corporate bonds. Loans to small businesses are also financed by bundling them in long-term bonds. Securities markets bridge the needs of higher returns by savers obtaining funds from investors that are channeled to consumers and business for consumption and investment. Lowering the yields of these long-term bonds could lower costs of financing purchases of consumer durables and investment by business. The essential mechanism of transmission from lower interest rates to increases in aggregate demand is portfolio rebalancing. Withdrawal of bonds in a specific maturity segment or directly in a bond category such as currently mortgage-backed securities causes reductions in yield that are equivalent to increases in the prices of the bonds. There can be secondary increases in purchases of those bonds in private portfolios in pursuit of their increasing prices. Lower yields translate into lower costs of buying homes and consumer durables such as automobiles and also lower costs of investment for business. There are two additional intended routes of transmission. (1) Unconventional monetary policy or its expectation can increase stock market valuations (Bernanke 2010WP). Increases in equities traded in stock markets can increase the wealth of consumers inducing increases in consumption. (2) Unconventional monetary policy causes devaluation of the dollar relative to other currencies than can cause increases in net exports of the US that increase aggregate economic activity (Yellen 2011AS).

Monetary policy can lower short-term interest rates quite effectively. Lowering long-term yields is somewhat more difficult. The critical issue is that monetary policy cannot ensure that increasing credit at low interest cost increases consumption and investment. There is a large variety of possible allocation of funds at low interest rates from consumption and investment to multiple risk financial assets. Monetary policy does not control how investors will allocate asset categories. A critical financial practice is to borrow at low short-term interest rates to invest in high-risk, leveraged financial assets. Investors may increase in their portfolios asset categories such as equities, emerging market equities, high-yield bonds, currencies, commodity futures and options and multiple other risk financial assets including structured products. If there is risk appetite, the carry trade from zero interest rates to risk financial assets will consist of short positions at short-term interest rates (or borrowing) and short dollar assets with simultaneous long positions in high-risk, leveraged financial assets such as equities, commodities and high-yield bonds. Low interest rates may induce increases in valuations of risk financial assets that may fluctuate in accordance with perceptions of risk aversion by investors and the public. During periods of muted risk aversion, carry trades from zero interest rates to exposures in risk financial assets cause temporary waves of inflation that may foster instead of preventing financial stability. During periods of risk aversion such as fears of disruption of world financial markets and the global economy resulting from collapse of the European Monetary Union, carry trades are unwound with sharp deterioration of valuations of risk financial assets.

McKinnon (1973) and Shaw (1974) argue that legal restrictions on financial institutions can be detrimental to economic development. “Financial repression” is the term used in the economic literature for these restrictions (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 81-6). Interest rate ceilings on deposits and loans have been commonly used. Chart ES1 provides savings as percent of disposable income or the US savings rate. There was a long-term downward sloping trend from 12 percent in the early 1980s to less than 2 percent in 2005-2006. The savings rate then rose during the contraction and also in the expansion. In 2011 the savings rate declined as consumption is financed with savings in part because of the disincentive or frustration of receiving a few pennies for every $10,000 of deposits in a bank. The objective of monetary policy is to reduce borrowing rates to induce consumption but it has collateral disincentive of reducing savings. The zero interest rate of monetary policy is a tax on saving. This tax is highly regressive, meaning that it affects the most people with lower income or wealth and retirees. The long-term decline of savings rates in the US has created a dependence on foreign savings to finance the deficits in the federal budget and the balance of payments. Financial repression also disrupts portfolio management and asset/liability management such as, for example, choosing assets to match benefits and income in pension funds and actually all management of financial institutions. Functions of finance such as allocating savings to long-term sound projects (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a) 30-42, Regulation of Banks and Finance (2009b), 37-44, 45-60) can be frustrated, constraining the volume of financial intermediation required for economic growth.

Chart ES1, US, Personal Savings as a Percentage of Disposable Personal Income, Quarterly, 1980-2011

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

The most critical source of risk aversion in international financial markets is the fear of unfavorable unwinding of the debt crisis in Europe. Section II World Financial Turbulence analyzes in detail the euro zone debt crisis. Fears originating in the euro zone debt crisis dominate wide oscillations in equity and bond markets that are transmitted worldwide.

Another major concern is the weakness of the expansion phase beginning in IIIQ2009 after the global recession from IVQ2007 to IIQ2009. Advanced economies are growing slowly with high levels of unemployment as followed in this blog in Section IV World Economic Slowdown.

Risk aversion is manifested in withdrawal of investments from financial assets to assets in currencies and government obligations of countries that are immune from risk at least in the medium term. Investment funds seeking refuge from risk are channeled to the US dollar, Japanese yen and Swiss franc. Government obligations such as US Treasury securities and German government securities are favored relative to higher risks in equities and fixed-income. When risk appetite returns, funds flow away from safe havens toward higher risks, depreciating the dollar and increasing valuations of risk financial assets.

Zero interest rates induce carry trades that magnify valuations of risk financial assets in the absence of risk aversion. In the presence of risk aversion, cheap money flows to the safety of the dollar, Japanese yen and Swiss franc and the government obligations of the United States and Germany.

Percentage changes of risk financial assets from the last day of the year relative to the last day of the earlier year are provided in Table ES1 from 2007 to 2011. The only gain for a major equity market in Table ES1 for 2011 is 5.5 percent for the DJIA. S&P 500 is better than other equity markets by remaining flat for 2011. With the exception of a drop of 8.4 percent of the European equity index STOXX 50, all declines of equity markets are in excess of 10 percent. China’s Shanghai Composite lost 21.7 percent. The equity index of Germany Dax fell 14.7 percent. The DJ UBS Commodities Index dropped 13.4 percent. Robin Wigglesworth, writing on Dec 30, 2011, on “$6.3tn wiped off markets in 2011,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/483069d8-32f3-11e1-8e0d-00144feabdc0.html#axzz1i2BE7OPa

), provides an estimate of $6.3 trillion erased from equity markets globally in 2011. The Congressional Budget Office (CBO2011Aug, 90) estimates US nominal GDP in 2011 at $15,238 billion. The loss in equity markets worldwide in 2011 of $6.3 trillion is equivalent to about 41 percent of US GDP or economic activity in 2011. Table ES1 also provides the exchange rate of number of US dollars (USD) required in buying a unit of euro (EUR), USD/EUR. The dollar appreciated 3.2 percent on the last day of trading in 2011 relative to the last day of trading in 2010.

Table ES1, Percentage Change of Year-end Values of Financial Assets Relative to Earlier Year-end Values 2007-2010

	2011	2010	2009	2008	2007
DJIA	5.5	11.0	18.8	-33.8	6.1
S&P 500	0.0	12.8	23.5	-38.5	3.1
NYSE Fin	-18.1	5.0	22.7	-53.6	-13.5
Dow Global	-13.7	4.6	30.8	-45.5	30.9
Dow Asia-Pacific	-17.6	15.9	36.4	-44.2	14.2
Nikkei Av	-17.3	-3.0	20.6	-42.9	-10.8
Shanghai	-21.7	-11.9	73.9	-65.2	104.9
STOXX 50	-8.4	-0.1	28.5	-44.6	-2.2
DAX	-14.7	16.1	23.8	-40.4	22.0
USD/EUR*	3.2	6.7	-2.9	4.7	-10.7
DJ UBS Com	-13.4	16.7	18.7	-36.6	11.2

*Negative sign is dollar devaluation; positive sign is dollar appreciation

Sources:

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

http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm

The other yearly percentage changes in Table ES1 are also revealing of the wide fluctuations in valuations of risk financial assets. To be sure, economic conditions and perceptions of the future do influence valuations of risk financial assets. It is also valid to contend that unconventional monetary policy magnifies fluctuations in these valuations inducing carry trades from zero interest rates to exposures with high leverage in risk financial assets such as equities, emerging equities, currencies, high-yield structured products and commodities futures and options. In fact, one of the alleged channels of transmission of unconventional monetary policy is through higher consumption induced by increases in wealth resulting from higher valuations of stock markets. Unconventional monetary policy could also result in magnification of values of risk financial assets beyond actual discounted future cash flows, creating financial instability. Separating all these effects in practice may be quite difficult because they are observed simultaneously while conclusive evidence would require contrasting what actually happened with the counterfactual of what would have happened in the absence of unconventional monetary policy and other effects. There is no certainty or evidence that unconventional policies attain their intended effects without risks of costly side effects. Yearly fluctuations of financial assets in Table ES1 are quite wide. In 2007, for example, the equity index Dow Global increased 30.9 percent while Dax gained 22.0 percent and the Shanghai Composite jumped 104.9 percent. The DJIA gained only 6.1 percent as recession began in IVQ2007. The flight to government obligations in 2008 (Cochrane and Zingales 2009, Cochrane 2011Jan) was equivalent to the astronomical declines of world equity markets and commodities. The flight from risk is also in evidence in the appreciation of the dollar by 4.7 percent in 2008 with unwinding carry trades and with renewed carry trades in the depreciation of the dollar by 2.9 percent in 2009. Recovery still continued in 2010 with shocks of the European debt crisis in the spring and in Nov. The flight from risk exposures dominated declines of valuations of risk financial assets in 2011.

Table ES2 is designed to provide a comparison of valuations of risk financial assets at the end of 2011 relative to valuations at the end of every year from 2006 to 2010. For example, the DJIA index is 5.5 percent higher at the end of 2011 relative to the valuation at the end of 2010 but is 2.3 percent below the valuation at the end of 2006 and 7.9 percent below the valuation at the end of 2007. It is higher by 39.2 percent relative to the depressed valuation at the end of 2008. Pre-recession valuations of 2006 and 2007 have not been recovered for all financial assets in Table ES2. With exception of gain by 5.5 percent by DJIA, all valuations of risk financial assets in Table ES2 are lower at the end of 2011 relative to their values at the end of 2010. Low valuations of risk financial assets are intimately related to risk aversion in international financial markets because of the European debt crisis, weakness and unemployment in advanced economies, fiscal imbalances and slowing growth in emerging economies.

Table ES2, Percentage Change of Year-end 2011 Values of Financial Assets Relative to Year-end Values 2006-2009

	2010	2009	2008	2007	2006
DJIA	5.5	17.2	39.2	-7.9	-2.3
S&P 500	0.0	12.8	39.2	-14.4	-11.7
NYSE Fin	-18.1	-13.9	5.6	-51.1	-57.7
Dow Global	-13.7	-9.7	18.0	-35.7	-15.8
Dow Asia-Pacific	-17.6	-4.5	30.3	-27.3	-16.9
Nikkei Av	-17.3	-19.8	-3.3	-44.8	-50.8
Shanghai	-21.7	-31.0	20.0	-58.2	-14.3
STOXX 50	-8.4	-8.5	17.6	-34.8	-36.2
DAX	-14.7	-1.0	22.6	-26.9	-10.8
USD/EUR*	3.2	9.7	7.0	11.4	1.9
DJ UBS Com	-13.4	1.1	20.0	-23.9	-15.4

*Negative sign is dollar devaluation; positive sign is dollar appreciation

Sources:

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

http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm

Unconventional monetary policy of zero interest rates and large-scale purchases of assets using the central bank’s balance sheet is designed to increase aggregate demand by stimulating consumption and investment. In practice, there is no control of how cheap money will be used. An alternative allocation of cheap money is through the carry trade from zero interest rates and short dollar positions to exposures in risk financial assets such as equities, commodities and so on. After a decade of unconventional monetary policy it may be prudent to return to normalcy so as to avoid adverse side effects of financial turbulence and inflation waves. Normal monetary policy would also encourage financial intermediation required for financing sound long-term projects that can stimulate economic growth and full utilization of resources.

There are collateral concerns about European banks. David Enrich and Sara Schaefer Muñoz, writing on Dec 28, on “European bank worry: collateral,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203899504577126430202451796.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the strain on bank funding from a squeeze in the availability of high-quality collateral as guarantee in funding. High-quality collateral includes government bonds and investment-grade non-government debt. There could be difficulties in funding for a bank without sufficient available high-quality collateral to offer in guarantee of loans. It is difficult to assess from bank balance sheets the availability of sufficient collateral to support bank funding requirements. There has been erosion in the quality of collateral as a result of the debt crisis and further erosion could occur. Perceptions of counterparty risk among financial institutions worsened the credit/dollar crisis of 2007 to 2009. The banking theory of Diamond and Rajan (2000, 2001a, 2001b) and the model of Diamond Dybvig (1983, 1986) provide the analysis of bank functions that explains the credit crisis of 2007 to 2008 (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 155-7, 48-52, Regulation of Banks and Finance (2009b), 52-66, 217-24). In fact, Rajan (2005, 339-41) anticipated the role of low interest rates in causing a hunt for yields in multiple financial markets from hedge funds to emerging markets and that low interest rates foster illiquidity. Rajan (2005, 341) argued:

“The point, therefore, is that common factors such as low interest rates—potentially caused by accommodative monetary policy—can engender excessive tolerance for risk on both sides of financial transactions.”

A critical function of banks consists of providing transformation services that convert illiquid risky loans and investment that the bank monitors into immediate liquidity such as unmonitored demand deposits. Credit in financial markets consists of the transformation of asset-backed securities (SRP) constructed with monitoring by financial institutions into unmonitored immediate liquidity by sale and repurchase agreements (SRP). In the financial crisis financial institutions distrusted the quality of their own balance sheets and those of their counterparties in SRPs. The financing counterparty distrusted that the financed counterparty would not repurchase the assets pledged in the SRP that could collapse in value below the financing provided. A critical problem was the unwillingness of banks to lend to each other in unsecured short-term loans. Emse Bartha, writing on Dec 28, on “Deposits at ECB hit high,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204720204577125913779446088.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that banks deposited €453.034 billion, or $589.72 billion, at the ECB on Dec 28, which is a record high in two consecutive days. The deposit facility is typically used by banks when they do prefer not to extend unsecured loans to other banks. In addition, banks borrowed €6.225 billion from the overnight facility on Dec 28, when in normal times only a few hundred million euro are borrowed. The collateral issues and the possible increase in counterparty risk occurred a week after large-scale lender of last resort by the ECB in the value of €489 billion in the prior week. The ECB may need to extend its lender of last resort operations.

I Financial Risk Aversion. The critical fact of current world financial markets is the combination of “unconventional” monetary policy with intermittent shocks of financial risk aversion. This section is divided in four subsections. IA Unconventional Monetary Policy discusses the objectives of unconventional monetary policy. IB Financial Risk Aversion considers the causes of risk aversion. IC Financial Risk Valuations analyzes yearly data on financial risk valuations since 2006. ID Global Inflation Waves discusses shocks to world inflation originating in carry trades from zero interest rates to commodity futures. IE Summary summarizes some conclusions. IF Appendix: Transmission of Unconventional Monetary Policy provides more technical discussion and references of unconventional monetary policy.

IA Unconventional Monetary Policy. There are two interrelated unconventional monetary policies. First, unconventional monetary policy consists of (1) reducing short-term policy interest rates toward the “zero bound” such as fixing the fed funds rate at 0 to ¼ percent by decision of the Federal Open Market Committee (FOMC) since Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm):

“The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.”

The FOMC reiterated the maintenance of the federal funds rate at 0 to ¼ percent for the foreseeable future as stated in the statement of the meeting on Dec 13, 2011 (http://www.federalreserve.gov/newsevents/press/monetary/20111213a.htm):

“The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

Second, unconventional monetary policy also includes a battery of measures to also reduce long-term interest rates of government securities and asset-backed securities such as mortgage-backed securities.

The objective of unconventional monetary policy is to implement the dual mandate of monetary policy of pursuing maximum employment and stable prices (http://www.federalreserve.gov/aboutthefed/mission.htm):

“The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.

Today, the Federal Reserve's duties fall into four general areas:

· conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates

· supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers

· maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

· providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system”

Monetary policy can lower short-term interest rates quite effectively. Lowering long-term yields is somewhat more difficult. The critical issue is that monetary policy cannot ensure that increasing credit at low interest cost increases consumption and investment. There is a large variety of possible allocation of funds at low interest rates from consumption and investment to multiple risk financial assets. Monetary policy does not control how investors will allocate asset categories. A critical financial practice is to borrow at low short-term interest rates to invest in high-risk, leveraged financial assets. Investors may increase in their portfolios asset categories such as equities, emerging market equities, high-yield bonds, currencies, commodity futures and options and multiple other risk financial assets including structured products. If there is risk appetite, the carry trade from zero interest rates to risk financial assets will consist of short short-term interest rates (or borrowing) and short dollar assets with simultaneous long positions in high-risk, leveraged financial assets such as equities, commodities and high-yield bonds. Low interest rates may induce increases in valuations of risk financial assets that may fluctuate in accordance with perceptions of risk aversion by investors and the public. During periods of muted risk aversion, carry trades from zero interest rates to exposures in risk financial assets cause temporary waves of inflation that may foster instead of preventing financial stability. During periods of risk aversion such as fears of disruption of world financial markets and the global economy resulting from collapse of the European Monetary Union, carry trades are unwound with sharp deterioration of valuations of risk financial assets.

McKinnon (1973) and Shaw (1974) argue that legal restrictions on financial institutions can be detrimental to economic development. “Financial repression” is the term used in the economic literature for these restrictions (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 81-6). Interest rate ceilings on deposits and loans have been commonly used. Chart I-1 provides savings as percent of disposable income or the US savings rate. There was a long-term downward sloping trend from 12 percent in the early 1980s to less than 2 percent in 2005-2006. The savings rate then rose during the contraction and also in the expansion. In 2011 the savings rate declined as consumption is financed with savings in part because of the disincentive or frustration of receiving a few pennies for every $10,000 of deposits in a bank. The objective of monetary policy is to reduce borrowing rates to induce consumption but it has collateral disincentive of reducing savings. The zero interest rate of monetary policy is a tax on saving. This tax is highly regressive, meaning that it affects the most people with lower income or wealth and retirees. The long-term decline of savings rates in the US has created a dependence on foreign savings to finance the deficits in the federal budget and the balance of payments. Financial repression also disrupts portfolio management and asset/liability management such as, for example, choosing assets to match benefits and income in pension funds and actually all management of financial institutions. Functions of finance such as allocating savings to long-term sound projects (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a) 30-42, Regulation of Banks and Finance (2009b), 37-44, 45-60) can be frustrated, constraining the volume of financial intermediation required for economic growth.

Chart I-1, US, Personal Savings as a Percentage of Disposable Personal Income, Quarterly, 1980-2011

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

IB Financial Risk Aversion. The most critical source of risk aversion in international financial markets is the fear of unfavorable unwinding of the debt crisis in Europe. Section II World Financial Turbulence analyzes in detail the euro zone debt crisis. Fears originating in the euro zone debt crisis dominate wide oscillations in equity and bond markets that are transmitted worldwide.

IC Financial Risk Valuations. Percentage changes of risk financial assets from the last day of the year relative to the last day of the earlier year are provided in Table I-1 from 2007 to 2011. The only gain for a major equity market in Table I-1 for 2011 is 5.5 percent for the DJIA. S&P 500 is better than other equity markets by remaining flat for 2011. With the exception of a drop of 8.4 percent of the European equity index STOXX 50, all declines of equity markets are in excess of 10 percent. China’s Shanghai Composite lost 21.7 percent. The equity index of Germany Dax fell 14.7 percent. The DJ UBS Commodities Index dropped 13.4 percent. Robin Wigglesworth, writing on Dec 30, 2011, on “$6.3tn wiped off markets in 2011,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/483069d8-32f3-11e1-8e0d-00144feabdc0.html#axzz1i2BE7OPa

), provides an estimate of $6.3 trillion erased from equity markets globally in 2011. The Congressional Budget Office (CBO2011Aug, 90) estimates US nominal GDP in 2011 at $15,238 billion. The loss in equity markets worldwide in 2011 of $6.3 trillion is equivalent to about 41 percent of US GDP or economic activity in 2011. Table I-1 also provides the exchange rate of number of US dollars (USD) required in buying a unit of euro (EUR), USD/EUR. The dollar appreciated 3.2 percent on the last day of trading in 2011 relative to the last day of trading in 2010.

Table I-1, Percentage Change of Year-end Values of Financial Assets Relative to Earlier Year-end Values 2007-2010

	2011	2010	2009	2008	2007
DJIA	5.5	11.0	18.8	-33.8	6.1
S&P 500	0.0	12.8	23.5	-38.5	3.1
NYSE Fin	-18.1	5.0	22.7	-53.6	-13.5
Dow Global	-13.7	4.6	30.8	-45.5	30.9
Dow Asia-Pacific	-17.6	15.9	36.4	-44.2	14.2
Nikkei Av	-17.3	-3.0	20.6	-42.9	-10.8
Shanghai	-21.7	-11.9	73.9	-65.2	104.9
STOXX 50	-8.4	-0.1	28.5	-44.6	-2.2
DAX	-14.7	16.1	23.8	-40.4	22.0
USD/EUR*	3.2	6.7	-2.9	4.7	-10.7
DJ UBS Com	-13.4	16.7	18.7	-36.6	11.2

*Negative sign is dollar devaluation; positive sign is dollar appreciation

Sources:

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

http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm

The other yearly percentage changes in Table I-1 are also revealing of the wide fluctuations in valuations of risk financial assets. To be sure, economic conditions and perceptions of the future do influence valuations of risk financial assets. It is also valid to contend that unconventional monetary policy magnifies fluctuations in these valuations inducing carry trades from zero interest rates to exposures with high leverage in risk financial assets such as equities, emerging equities, currencies, high-yield structured products and commodities futures and options. In fact, one of the alleged channels of transmission of unconventional monetary policy is through higher consumption induced by increases in wealth resulting from higher valuations of stock markets. Unconventional monetary policy could also result in magnification of values of risk financial assets beyond actual discounted future cash flows, creating financial instability. Separating all these effects in practice may be quite difficult because they are observed simultaneously while conclusive evidence would require contrasting what actually happened with the counterfactual of what would have happened in the absence of unconventional monetary policy and other effects. There is no certainty or evidence that unconventional policies attain their intended effects without risks of costly side effects. Yearly fluctuations of financial assets in Table I-1 are quite wide. In 2007, for example, the equity index Dow Global increased 30.9 percent while Dax gained 22.0 percent and the Shanghai Composite jumped 104.9 percent. The DJIA gained only 6.1 percent as recession began in IVQ2007. The flight to government obligations in 2008 (Cochrane and Zingales 2009, Cochrane 2011Jan) was equivalent to the astronomical declines of world equity markets and commodities. The flight from risk is also in evidence in the appreciation of the dollar by 4.7 percent in 2008 with unwinding carry trades and with renewed carry trades in the depreciation of the dollar by 2.9 percent in 2009. Recovery still continued in 2010 with shocks of the European debt crisis in the spring and in Nov. The flight from risk exposures dominated declines of valuations of risk financial assets in 2011.

Table I-2 is designed to provide a comparison of valuations of risk financial assets at the end of 2011 relative to valuations at the end of every year from 2006 to 2010. For example, the DJIA index is 5.5 percent higher at the end of 2011 relative to the valuation at the end of 2010 but is 2.3 percent below the valuation at the end of 2006 and 7.9 percent below the valuation at the end of 2007. It is higher by 39.2 percent relative to the depressed valuation at the end of 2008. Pre-recession valuations of 2006 and 2007 have not been recovered for all financial assets in Table I-2. With exception of gain by 5.5 percent of DJIA, all valuations of risk financial assets in Table I-2 are lower at the end of 2011 relative to their values at the end of 2010. Low valuations of risk financial assets are intimately related to risk aversion in international financial markets because of the European debt crisis, weakness and unemployment in advanced economies, fiscal imbalances and slowing growth in emerging economies.

Table I-2, Percentage Change of Year-end 2011 Values of Financial Assets Relative to Year-end Values 2006-2009

	2010	2009	2008	2007	2006
DJIA	5.5	17.2	39.2	-7.9	-2.3
S&P 500	0.0	12.8	39.2	-14.4	-11.7
NYSE Fin	-18.1	-13.9	5.6	-51.1	-57.7
Dow Global	-13.7	-9.7	18.0	-35.7	-15.8
Dow Asia-Pacific	-17.6	-4.5	30.3	-27.3	-16.9
Nikkei Av	-17.3	-19.8	-3.3	-44.8	-50.8
Shanghai	-21.7	-31.0	20.0	-58.2	-14.3
STOXX 50	-8.4	-8.5	17.6	-34.8	-36.2
DAX	-14.7	-1.0	22.6	-26.9	-10.8
USD/EUR*	3.2	9.7	7.0	11.4	1.9
DJ UBS Com	-13.4	1.1	20.0	-23.9	-15.4

*Negative sign is dollar devaluation; positive sign is dollar appreciation

Sources:

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

http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm

ID Global Inflation Waves. The analysis of world inflation in this blog reveals three waves of inflation of producer and consumer prices. In the first wave from Jan to Apr of 2011, lack of risk aversion channeled cheap money into commodity futures, causing worldwide increase in inflation. In the second wave in May and Jun, risk aversion because of the sovereign debt crisis in Europe caused unwinding of the carry trade into commodity futures with resulting decline in commodity prices and inflation. In the third wave since Aug, alternations of risk aversion revived carry trades of commodity futures with resulting higher and lower inflation.

Table I-3 provides annual equivalent rates of inflation for producer prices indexes followed in this blog. The behavior of the US producer price index in 2011 shows neatly three waves. In Jan-Apr, without risk aversion, US producer prices rose at the annual equivalent rate of 17.3 percent. After risk aversion, producer prices increased in the US at the annual equivalent rate of 0.8 percent in May-Jul. Since Jul, under alternating episodes of risk aversion, producer prices have increased at the annual equivalent rate of 2.9 percent. Resolution of the European debt crisis would result in jumps of valuations of risk financial assets. Increases in commodity prices would cause the same high producer-price inflation experienced in Jan-Apr. There are seven producer-price indexes in Table I-3 showing very similar behavior in 2011. Zero interest rates without risk aversion cause increases in commodity prices that in turn increase input and output prices. Producer price inflation rose during the first part of the year for the US, China, Germany, France, Italy and the UK when risk aversion was contained. With the increase in risk aversion in May and Jun, inflation moderated because carry trades were unwound. Producer price inflation has returned since July, with alternating bouts of risk aversion.

Table I-3, Annual Equivalent Rates of Producer Price Indexes

INDEX 2011	AE ∆%
US Producer Price Index
AE ∆% Jul-Nov	2.9
AE ∆% May-Jul	0.8
AE ∆% Jan-Apr	17.3
Japan Corporate Goods Price Index
AE ∆% Jul-Nov	-1.9
AE ∆% Jan-Apr	7.1
China Producer Price Index
AE ∆% Jul-Nov	-3.1
AE ∆% Jan-Jun	20.4
Germany Producer Price Index
AE ∆% Jul-Oct	4.6
AE ∆% Jun-May	1.2
Jan-Apr	7.1
France Producer Price Index for the French Market
AE ∆% Jul-Oct	3.4
AE ∆% May-Jun	-3.5
AE ∆% Jan-Apr	11.4
Italy Producer Price Index
AE ∆% Jul-Nov	1.4
AE ∆% Jun-May	-1.2
AE ∆% Jan-April	10.7
UK Output Prices
AE ∆% May-Nov	2.1
AE ∆% Jan-Apr	12.0
UK Input Prices
AE ∆% Jul-Nov	-0.1
AE ∆% May-Jun	-8.7
AE ∆% Jan-Apr	35.6

Sources: http://www.bls.gov/ppi/data.htm

http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1111.pdf

http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20111209_402771437.htm

http://www.insee.fr/en/themes/info-rapide.asp?id=25&date=20111130

http://www.istat.it/it/archivio/47110

http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/november-2011/index.html

Annual equivalent consumer price inflation in the US in Jan-Apr reached 7.5 percent as carry trades raised commodity futures, as shown in Table I-4. Return of risk aversion in May to Jul resulted in annual equivalent inflation of only 2.0 percent in May-Jul. Inflation then rose again in Jul-Oct to annual equivalent 3.3 percent with alternation of bouts of risk aversion and 2.7 in Jul-Nov. The three waves are neatly repeated in consumer price inflation for China, the euro zone, Germany, France, Italy and the UK. In the absence of risk aversion, zero interest rates with guidance now forever, induce carry trades that raise commodity prices, increasing prices.

Table I-4, Annual Equivalent Rates of Consumer Price Indexes

Index 2011	AE ∆%
US Consumer Price Index
AE ∆% Jul-Nov	2.7
AE ∆% May-Jul	2.0
AE ∆% Jan-Apr	7.5
China Consumer Price Index
AE ∆% Jul-Nov	2.9
AE ∆% Apr-Jun	2.0
AE ∆% Jan-Mar	8.3
Euro Zone Harmonized Index of Consumer Prices
AE ∆% Aug-Nov	4.3
AE ∆% May-Jul	-2.4
AE ∆% Jan-Apr	5.2
Germany Consumer Price Index
AE ∆% Jul-Dec	2.4
AE ∆% May-Jun	0.6
AE ∆% Feb-Apr	4.9
France Consumer Price Index
AE ∆% Aug-Nov	3.0
AE ∆% May-Jul	-1.2
AE ∆% Jan-Apr	4.3
Italy Consumer Price Index
AE ∆% Jul-Nov	2.7
AE ∆% May-Jun	1.2
AE ∆% Jan-Apr	4.9
UK Consumer Price Index
AE ∆% Aug-Nov	4.6
May-Jul	0.4
Jan-Apr	6.5

Sources: http://www.bls.gov/cpi/data.htm

http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20111209_402771439.htm

http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-15122011-AP/EN/2-15122011-AP-EN.PDF

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/12/PE11__456__611,templateId=renderPrint.psml

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20111213

http://www.istat.it/it/archivio/48180

http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/november-2011/index.html

IE Summary. Unconventional monetary policy of zero interest rates and large-scale purchases of assets using the central bank’s balance sheet is designed to increase aggregate demand by stimulating consumption and investment. In practice, there is no control of how cheap money will be used. An alternative allocation of cheap money is through the carry trade from zero interest rates and short dollar positions to exposures in risk financial assets such as equities, commodities and so on. After a decade of unconventional monetary policy it may be prudent to return to normalcy so as to avoid adverse side effects of financial turbulence and inflation waves. Normal monetary policy would also encourage financial intermediation required for financing sound long-term projects that can stimulate economic growth and full utilization of resources.

IF Appendix: Transmission of Unconventional Monetary Policy. Janet L. Yellen, Vice Chair of the Board of Governors of the Federal Reserve System, provides analysis of the policy of purchasing large amounts of long-term securities for the Fed’s balance sheet. The new analysis provides three channels of transmission of quantitative easing to the ultimate objectives of increasing growth and employment and increasing inflation to “levels of 2 percent or a bit less that most Committee participants judge to be consistent, over the long run, with the FOMC’s dual mandate” (Yellen 2011AS, 4, 7):

“There are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boost household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”

The new analysis by Yellen (2011AS) is considered below in four separate subsections: IFi Theory; IFii Policy; IFiii Evidence; and IFiv Unwinding Strategy.

IFi Theory. The transmission mechanism of quantitative easing can be analyzed in three different forms. (1) Portfolio choice theory. General equilibrium value theory was proposed by Hicks (1935) in analyzing the balance sheets of individuals and institutions with assets in the capital segment consisting of money, debts, stocks and productive equipment. Net worth or wealth would be comparable to income in value theory. Expected yield and risk would be the constraint comparable to income in value theory. Markowitz (1952) considers a portfolio of individual securities with mean μ_p and variance σ_p. The Markowitz (1952, 82) rule states that “investors would (or should” want to choose a portfolio of combinations of (μ_p, σ_p) that are efficient, which are those with minimum variance or risk for given expected return μ_p or more and maximum expected μ_p for given variance or risk or less. The more complete model of Tobin (1958) consists of portfolio choice of monetary assets by maximizing a utility function subject to a budget constraint. Tobin (1961, 28) proposes general equilibrium analysis of the capital account to derive choices of capital assets in balance sheets of economic units with the determination of yields in markets for capital assets with the constraint of net worth. A general equilibrium model of choice of portfolios was developed simultaneously by various authors (Hicks 1962; Treynor 1962; Sharpe 1964; Lintner 1965; Mossin 1966). If shocks such as by quantitative easing displace investors from the efficient frontier, there would be reallocations of portfolios among assets until another efficient point is reached. Investors would bid up the prices or lower the returns (interest plus capital gains) of long-term assets targeted by quantitative easing, causing the desired effect of lowering long-term costs of investment and consumption.

(2) General Equilibrium Theory. Bernanke and Reinhart (2004, 88) argue that “the possibility monetary policy works through portfolio substitution effects, even in normal times, has a long intellectual history, having been espoused by both Keynesians (James Tobin 1969) and monetarists (Karl Brunner and Allan Meltzer 1973).” Andres et al. (2004) explain the Tobin (1969) contribution by optimizing agents in a general-equilibrium model. Both Tobin (1969) and Brunner and Meltzer (1973) consider capital assets to be gross instead of perfect substitutes with positive partial derivatives of own rates of return and negative partial derivatives of cross rates in the vector of asset returns (interest plus principal gain or loss) as argument in portfolio balancing equations (see Pelaez and Suzigan 1978, 113-23). Tobin (1969, 26) explains portfolio substitution after monetary policy:

“When the supply of any asset is increased, the structure of rates of return, on this and other assets, must change in a way that induces the public to hold the new supply. When the asset’s own rate can rise, a large part of the necessary adjustment can occur in this way. But if the rate is fixed, the whole adjustment must take place through reductions in other rates or increases in prices of other assets. This is the secret of the special role of money; it is a secret that would be shared by any other asset with a fixed interest rate.”

Andrés et al. (2004, 682) find that in their multiple-channels model “base money expansion now matters for the deviations of long rates from the expected path of short rates. Monetary policy operates by both the expectations channel (the path of current and expected future short rates) and this additional channel. As in Tobin’s framework, interest rates spreads (specifically, the deviations from the pure expectations theory of the term structure) are an endogenous function of the relative quantities of assets supplied.”

The interrelation among yields of default-free securities is measured by the term structure of interest rates. This schedule of interest rates along time incorporates expectations of investors. (Cox, Ingersoll and Ross 1985). The expectations hypothesis postulates that the expectations of investors about the level of future spot rates influence the level of current long-term rates. The normal channel of transmission of monetary policy in a recession is to lower the target of the fed funds rate that will lower future spot rates through the term structure and also the yields of long-term securities. The expectations hypothesis is consistent with term premiums (Cox, Ingersoll and Ross 1981, 774-7) such as liquidity to compensate for risk or uncertainty about future events that can cause changes in prices or yields of long-term securities (Hicks 1939; see Cox, Ingersoll and Ross 1981, 784; Chung et al. 2011, 22).

(3) Preferred Habitat. Another approach is by the preferred-habitat models proposed by Culbertson (1957, 1963) and Modigliani and Sutch (1966). This approach is formalized by Vayanos and Vila (2009). The model considers investors or “clientele” who do not abandon their segment of operations unless there are extremely high potential returns and arbitrageurs who take positions to profit from discrepancies. Pension funds matching benefit liabilities would operate in segments above 15 years; life insurance companies operate around 15 years or more; and asset managers and bank treasury managers are active in maturities of less than 10 years (Ibid, 1). Hedge funds, proprietary trading desks and bank maturity transformation activities are examples of potential arbitrageurs. The role of arbitrageurs is to incorporate “information about current and future short rates into bond prices” (Ibid, 12). Suppose monetary policy raises the short-term rate above a certain level. Clientele would not trade on this information, but arbitrageurs would engage in carry trade, shorting bonds and investing at the short-term rate, in a “roll-up” trade, resulting in decline of bond prices or equivalently increases in yields. This is a situation of an upward-sloping yield curve. If the short-term rate were lowered, arbitrageurs would engage in carry trade borrowing at the short-term rate and going long bonds, resulting in an increase in bond prices or equivalently decline in yields, or “roll-down” trade. The carry trade is the mechanism by which bond yields adjust to changes in current and expected short-term interest rates. The risk premiums of bonds are positively associated with the slope of the term structure (Ibid, 13). Fama and Bliss (1987, 689) find with data for 1964-85 that “1-year expected returns for US Treasury maturities to 5 years, measured net of the interest rate on a 1-year bond, vary through time. Expected term premiums are mostly positive during good times but mostly negative during recessions.” Vayanos and Vila (2009) develop a model with two-factors, the short-term rate and demand or quantity. The term structure moves because of shocks of short-term rates and demand. An important finding is that demand or quantity shocks are largest for intermediate and long maturities while short-rate shocks are largest for short-term maturities.

IFii Policy. A simplified analysis could consider the portfolio balance equations A_ij = f(r, x) where A_ij is the demand for i = 1,2,∙∙∙n assets from j = 1,2, ∙∙∙m sectors, r the 1xn vector of rates of return, r_i, of n assets and x a vector of other relevant variables. Tobin (1969) and Brunner and Meltzer (1973) assume imperfect substitution among capital assets such that the own first derivatives of A_ij are positive, demand for an asset increases if its rate of return (interest plus capital gains) is higher, and cross first derivatives are negative, demand for an asset decreases if the rate of return of alternative assets increases. Theoretical purity would require the estimation of the complete model with all rates of return. In practice, it may be impossible to observe all rates of return such as in the critique of Roll (1976). Policy proposals by the Fed have been focused on the likely impact of withdrawals of stocks of securities in specific segments, that is, of effects of one or several specific rates of return among the n possible rates. There have been at least seven approaches on the role of monetary policy in purchasing long-term securities that have increased the classes of rates of return targeted by the Fed:

i. Suspension of Auctions of 30-year Treasury Bonds. Auctions of 30-year Treasury bonds were suspended between 2001 and 2005. This was Treasury policy not Fed policy. The effects were similar to those of quantitative easing: withdrawal of supply from the segment of 30-year bonds would result in higher prices or lower yields for close-substitute mortgage-backed securities with resulting lower mortgage rates. The objective was to encourage refinancing of house loans that would increase family income and consumption by freeing income from reducing monthly mortgage payments.

ii. Purchase of Long-term Securities by the Fed. Between Nov 2008 and Mar 2009 the Fed announced the intention of purchasing $1750 billion of long-term securities: $600 billion of agency mortgage-backed securities and agency debt announced on Nov 25 and $850 billion of agency mortgaged-backed securities and agency debt plus $300 billion of Treasury securities announced on Mar 18, 2009 (Yellen 2011AS, 5-6). The objective of buying mortgage-backed securities was to lower mortgage rates that would “support the housing sector” (Bernanke 2009SL). The FOMC statement on Dec 16, 2008 informs that: “over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and its stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant” (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). The Mar 18 statement of the FOMC explained that: “to provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities up to $1.25 trillion this year, and to increase its purchase of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months” (http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm). Policy changed to increase prices or reduce yields of mortgage-backed securities and Treasury securities with the objective of supporting housing markets and private credit markets by lowering costs of housing and long-term private credit.

iii. Portfolio Reinvestment. On Aug 10, 2010, the FOMC statement explains the reinvestment policy: “to help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in long-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature” (http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm). The objective of policy appears to be supporting conditions in housing and mortgage markets with slow transfer of the portfolio to Treasury securities that would support private-sector markets.

iv. Increasing Portfolio. As widely anticipated, the FOMC decided on Dec 3, 2010: “to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month” (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm). The emphasis appears to shift from housing markets and private-sector credit markets to the general economy, employment and preventing deflation.

v. Increasing Stock Market Valuations. Chairman Bernanke (2010WP) explained on Nov 4 the objectives of purchasing an additional $600 billion of long-term Treasury securities and reinvesting maturing principal and interest in the Fed portfolio. Long-term interest rates fell and stock prices rose when investors anticipated the new round of quantitative easing. Growth would be promoted by easier lending such as for refinancing of home mortgages and more investment by lower corporate bond yields. Consumers would experience higher confidence as their wealth in stocks rose, increasing outlays. Income and profits would rise and, in a “virtuous circle,” support higher economic growth. Bernanke (2000) analyzes the role of stock markets in central bank policy (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 99-100). Fed policy in 1929 increased interest rates to avert a gold outflow and failed to prevent the deepening of the banking crisis without which the Great Depression may not have occurred. In the crisis of Oct 19, 1987, Fed policy supported stock and futures markets by persuading banks to extend credit to brokerages. Collapse of stock markets would slow consumer spending.

vi. Devaluing the Dollar. Yellen (2011AS, 6) broadens the effects of quantitative easing by adding dollar devaluation: “there are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boosts household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”

vii. Let’s Twist Again Monetary Policy. The term “operation twist” grew out of the dance “twist” popularized by successful musical performer Chubby Chekker (http://www.youtube.com/watch?v=aWaJ0s0-E1o). Meulendyke (1998, 39) describes the coordination of policy by Treasury and the FOMC in the beginning of the Kennedy administration in 1961 (see Modigliani and Sutch 1966, 1967; http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html):

“In 1961, several developments led the FOMC to abandon its “bills only” restrictions. The new Kennedy administration was concerned about gold outflows and balance of payments deficits and, at the same time, it wanted to encourage a rapid recovery from the recent recession. Higher rates seemed desirable to limit the gold outflows and help the balance of payments, while lower rates were wanted to speed up economic growth.

To deal with these problems simultaneously, the Treasury and the FOMC attempted to encourage lower long-term rates without pushing down short-term rates. The policy was referred to in internal Federal Reserve documents as “operation nudge” and elsewhere as “operation twist.” For a few months, the Treasury engaged in maturity exchanges with trust accounts and concentrated its cash offerings in shorter maturities.

The Federal Reserve participated with some reluctance and skepticism, but it did not see any great danger in experimenting with the new procedure.

It attempted to flatten the yield curve by purchasing Treasury notes and bonds while selling short-term Treasury securities. The domestic portfolio grew by $1.7 billion over the course of 1961. Note and bond holdings increased by a substantial $8.8 billion, while certificate of indebtedness holdings fell by almost $7.4 billion (Table 2). The extent to which these actions changed the yield curve or modified investment decisions is a source of dispute, although the predominant view is that the impact on yields was minimal. The Federal Reserve continued to buy coupon issues thereafter, but its efforts were not very aggressive. Reference to the efforts disappeared once short-term rates rose in 1963. The Treasury did not press for continued Fed purchases of long-term debt. Indeed, in the second half of the decade, the Treasury faced an unwanted shortening of its portfolio. Bonds could not carry a coupon with a rate above 4 1/4 percent, and market rates persistently exceeded that level. Notes—which were not subject to interest rate restrictions—had a maximum maturity of five years; it was extended to seven years in 1967.”

As widely anticipated by markets, perhaps intentionally, the Federal Open Market Committee (FOMC) decided at its meeting on Sep 21 that it was again “twisting time” (http://www.federalreserve.gov/newsevents/press/monetary/20110921a.htm):

“Information received since the Federal Open Market Committee met in August indicates that economic growth remains slow. Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has been increasing at only a modest pace in recent months despite some recovery in sales of motor vehicles as supply-chain disruptions eased. Investment in nonresidential structures is still weak, and the housing sector remains depressed. However, business investment in equipment and software continues to expand. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate.”

IFiii Evidence. There are multiple empirical studies on the effectiveness of quantitative easing that have been covered in past posts such as (Andrés et al. 2004, D’Amico and King 2010, Doh 2010, Gagnon et al. 2010, Hamilton and Wu 2010). On the basis of simulations of quantitative easing with the FRB/US econometric model, Chung et al (2011, 28-9) find that:

”Lower long-term interest rates, coupled with higher stock market valuations and a lower foreign exchange value of the dollar, provide a considerable stimulus to real activity over time. Phase 1 of the program by itself is estimated to boost the level of real GDP almost 2 percent above baseline by early 2012, while the full program raises the level of real GDP almost 3 percent by the second half of 2012. This boost to real output in turn helps to keep labor market conditions noticeably better than they would have been without large scale asset purchases. In particular, the model simulations suggest that private payroll employment is currently 1.8 million higher, and the unemployment rate ¾ percentage point lower, that would otherwise be the case. These benefits are predicted to grow further over time; by 2012, the incremental contribution of the full program is estimated to be 3 million jobs, with an additional 700,000 jobs provided by the most recent phase of the program alone.”

An additional conclusion of these simulations is that quantitative easing may have prevented actual deflation. Empirical research is continuing.

IFiv Unwinding Strategy. Fed Vice-Chair Yellen (2011AS) considers four concerns on quantitative easing discussed below in turn. First, Excessive Inflation. Yellen (2011AS, 9-12) considers concerns that quantitative easing could result in excessive inflation because fast increases in aggregate demand from quantitative easing could raise the rate of inflation, posing another problem of adjustment with tighter monetary policy or higher interest rates. The Fed estimates significant slack of resources in the economy as measured by the difference of four percentage points between the high current rate of unemployment above 9 percent and the NAIRU (non-accelerating rate of unemployment) of 5.75 percent (Ibid, 2). Thus, faster economic growth resulting from quantitative easing would not likely result in upward trend of costs as resources are bid up competitively. The Fed monitors frequently slack indicators and is committed to maintaining inflation at a “level of 2 percent or a bit less than that” (Ibid, 13), say, in the narrow open interval (1.9, 2.1).

Second, Inflation and Bank Reserves. On Jan 12, the line “Reserve Bank credit” in the Fed balance sheet stood at $2450.6 billion, or $2.5 trillion, with the portfolio of long-term securities of $2175.7 billion, or $2.2 trillion, composed of $987.6 billion of notes and bonds, $49.7 billion of inflation-adjusted notes and bonds, $146.3 billion of Federal agency debt securities, and $992.1 billion of mortgage-backed securities; reserves balances with Federal Reserve Banks stood at $1095.5 billion, or $1.1 trillion (http://federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The concern addressed by Yellen (2011AS, 12-4) is that this high level of reserves could eventually result in demand growth that could accelerate inflation. Reserves would be excessively high relative to the levels before the recession. Reserves of depository institutions at the Federal Reserve Banks rose from $45.6 billion in Aug 2008 to $1084.8 billion in Aug 2010, not seasonally adjusted, multiplying by 23.8 times, or to $1038.2 billion in Nov 2010, multiplying by 22.8 times. The monetary base consists of the monetary liabilities of the government, composed largely of currency held by the public plus reserves of depository institutions at the Federal Reserve Banks. The monetary base not seasonally adjusted, or issue of money by the government, rose from $841.1 billion in Aug 2008 to $1991.1 billion or by 136.7 percent and to $1968.1 billion in Nov 2010 or by 133.9 percent (http://federalreserve.gov/releases/h3/hist/h3hist1.pdf). Policy can be viewed as creating government monetary liabilities that ended mostly in reserves of banks deposited at the Fed to purchase $2.1 trillion of long-term securities or assets, which in nontechnical language would be “printing money” (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). The marketable debt of the US government in Treasury securities held by the public stood at $8.7 trillion on Nov 30, 2010 (http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds112010.pdf). The current holdings of long-term securities by the Fed of $2.1 trillion, in the process of converting fully into Treasury securities, are equivalent to 24 percent of US government debt held by the public, and would represent 29.9 percent with the new round of quantitative easing if all the portfolio of the Fed, as intended, were in Treasury securities. Debt in Treasury securities held by the public on Dec 31, 2009, stood at $7.2 trillion (http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds122009.pdf), growing to Nov 30, 2010, by $1.5 trillion or by 20.8 percent. In spite of this growth of bank reserves, “the 12-month change in core PCE [personal consumption expenditures] prices dropped from about 2 ½ percent in mid-2008 to around 1 ½ percent in 2009 and declined further to less than 1 percent by late 2010” (Yellen 2011AS, 3). The PCE price index, excluding food and energy, is around 0.8 percent in the past 12 months, which could be, in the Fed’s view, too close for comfort to negative inflation or deflation. Yellen (2011AS, 12) agrees “that an accommodative monetary policy left in place too long can cause inflation to rise to undesirable levels” that would be true whether policy was constrained or not by “the zero bound on interest rates.” The FOMC is monitoring and reviewing the “asset purchase program regularly in light of incoming information” and will “adjust the program as needed to meet its objectives” (Ibid, 12). That is, the FOMC would withdraw the stimulus once the economy is closer to full capacity to maintain inflation around 2 percent. In testimony at the Senate Committee on the Budget, Chairman Bernanke stated that “the Federal Reserve has all the tools its needs to ensure that it will be able to smoothly and effectively exit from this program at the appropriate time” (http://federalreserve.gov/newsevents/testimony/bernanke20110107a.htm). The large quantity of reserves would not be an obstacle in attaining the 2 percent inflation level. Yellen (2011A, 13-4) enumerates Fed tools that would be deployed to withdraw reserves as desired: (1) increasing the interest rate paid on reserves deposited at the Fed currently at 0.25 percent per year; (2) withdrawing reserves with reverse sale and repurchase agreement in addition to those with primary dealers by using mortgage-backed securities; (3) offering a Term Deposit Facility similar to term certificates of deposit for member institutions; and (4) sale or redemption of all or parts of the portfolio of long-term securities. The Fed would be able to increase interest rates and withdraw reserves as required to attain its mandates of maximum employment and price stability.

Third, Financial Imbalances. Fed policy intends to lower costs to business and households with the objective of stimulating investment and consumption generating higher growth and employment. Yellen (2011A, 14-7) considers a possible consequence of excessively reducing interest rates: “a reasonable fear is that this process could go too far, encouraging potential borrowers to employ excessive leverage to take advantage of low financing costs and leading investors to accept less compensation for bearing risks as they seek to enhance their rates of return in an environment of very low yields. This concern deserves to be taken seriously, and the Federal Reserve is carefully monitoring financial indicators for signs of potential threats to financial stability.” Regulation and supervision would be the “first line of defense” against imbalances threatening financial stability but the Fed would also use monetary policy to check imbalances (Yellen 2011AS, 17).

Fourth, Adverse Effects on Foreign Economies. The issue is whether the now recognized dollar devaluation would promote higher growth and employment in the US at the expense of lower growth and employment in other countries.

II International Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) growth in China, Japan and world trade; (3) slow growth propelled by savings reduction in the US with high unemployment/underemployment; and (3) the outcome of the sovereign debt crisis in Europe. This section analyzes the events of the week culminating in the meeting of European leaders. Subsection IIA Financial Risks provides analysis of the evolution of valuations of risk assets during the week. Subsection IIB Fiscal Compact analysis the restructuring of the fiscal affairs of the European Union in the agreement of European leaders on Dec 9. Subsection IIC European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank. Subsection IID Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union. Subsection IIE Appendix on Sovereign Bond Valuation provides more technical analysis.

IIA Financial Risks. The past four months have been characterized by financial turbulence, attaining unusual magnitude in the past few weeks. Table II-1, updated with every comment in this blog, provides beginning values on Fr Dec 23 and daily values throughout the week ending on Fri Dec 30 of several financial assets. Section V Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Dec 23 and the percentage change in that prior week below the label of the financial risk asset. The first five asset rows provide five key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy but expanding into possibly France and Germany, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing inflation. The most important current shock is that resulting from the agreement by European leaders at their meeting on Dec 9 (European Council 2911Dec9), which is analyzed in the following subsection IIIB Fiscal Compact. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3044/EUR in the first row, first column in the block for currencies in Table II-1 for Fri Dec 23, depreciating to USD 1.3070/EUR on Tue Dec 27, or by 0.2 percent. The dollar depreciated because more dollars, $1.3070, were required on Dec 27 to buy one euro than $1.3044 on Dec 23. Table II-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3070/EUR on Dec 27; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Dec 23, to the last business day of the current week, in this case Fri Dec 30, such as appreciation by 0.8 to USD 1.2944/EUR by Dec 30; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (positive sign) by 0.8 percent from the rate of USD 1.3044/EUR on Fri Dec 23 to the rate of USD 1.2944/EUR on Fri Dec 30 {[(1.2944/1.3044) – 1]100 = -0.8%} and appreciated by 0.1 percent from the rate of USD 1.2963 on Thu Dec 29 to USD 1.2944/EUR on Fri Dec 30 {[(1.2944/1.2963) -1]100 = -0.1%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yield risk financial assets to the safety of dollar investments. When risk aversion declines, funds have been moving away from safe assets in dollars to risk financial assets.

II-1, Weekly Financial Risk Assets Dec 26 to Dec 30, 2011

Fri Dec 23, 2011

M 26

Tue 27

W 28

Thu 29

F 30

USD/EUR

1.3044

0.0%

1.3048

0.0%

1.3070

-0.2%

1.2937

0.8%

1.0%

1.2963

0.6%

-0.2%

1.2944

0.8%

0.1%

JPY/ USD

78.0875

-0.5%

78.0025

0.1%

77.8745

0.3%

0.2%

77.9218

0.2%

-0.1%

77.6203

0.6%

0.4%

76.887

1.5%

0.9%

CHF/ USD

0.9366

0.0%

0.9371

-0.1%

0.9343

0.2%

0.3%

0.9427

-0.7%

-0.9%

0.9400

-0.4%

0.3%

0.935

0.2%

0.5%

CHF/ EUR

1.2217

-0.1%

1.2227

-0.1%

1.2212

0.0%

0.1%

1.2197

0.2%

0.1%

1.2185

0.3%

0.1%

1.2152

0.5%

0.3%

USD/ AUD

1.0151

0.9851

1.9%

1.0161

0.9842

0.1%

1.0155

0.9847

0.0%

-0.1%

1.0091

0.9909

-0.6%

1.0142

0.9860

-0.1%

-0.5%

1.02

0.9804

0.5%

0.6%

10 Year

2.027

2.02

2.00

1.92

1.90

1.871

2 Year T Note

0.28

0.29

0.27

0.239

German Bond

2Y 0.23 10Y 1.96

2Y 0.17 10Y 1.92

2Y 0.17 10Y 1.89

2Y 0.16 10Y 1.84

2Y 0.14 10Y 1.83

DJIA

12294.00

3.6%

12294.00

0.0

1.0%

12291.35

0.0%

12151.41

-1.1%

12287.04

0.0%

1.1%

12217.56

-0.6%

DJ Global

1803.20

2.9%

1806.40

0.2%

1804.07

0.0%

-0.1%

1778.71

-1.4%

1795.80

-0.4%

1.0%

1801.60

-0.1%

0.4%

DJ Asia Pacific

1158.82

0.9%

1160.82

0.2%

1158.45

0.0%

-0.2%

1150.13

-0.7%

1150.67

-0.7%

0.1%

1161.94

0.3%

1.0%

Nikkei

8395.16

-0.1%

8479.34

1.0%

8440.56

0.5%

-0.5%

8423.62

0.4%

-0.2%

8398.89

0.0%

-0.3%

8455.35

0.7%

Shanghai

2204.78

-0.9%

2190.11

-0.7%

2166.21

-1.7%

-1.1%

2170.01

-1.6%

0.2%

2173.56

-1.4%

0.2%

2199.42

-0.2%

1.2%

DAX

5878.93

3.1%

5878.93

0.0%

5889.76

0.2%

5771.27

-1.8%

-2.0%

5848.78

-0.5%

1.3%

5898.35

0.3%

0.8%

DJ UBS

Comm.

141.20

3.1%

141.20

0.0%

142.13

0.7%

140.69

-0.4%

-1.0%

139.98

-0.9%

-0.5%

140.68

-0.4%

0.5%

WTI $ B

99.68

6.0%

99.78

0.1%

101.25

1.6%

1.5%

99.66

0.0%

-1.6%

99.68

0.0%

98.97

-0.8%

Brent $/B

107.96

4.1%

107.96

0.0%

109.03

1.0%

107.39

-0.5%

-1.5%

108.00

0.0%

0.6%

107.54

-0.4%

Gold $/OZ

1606.0

0.4%

1606.7

0.0%

1594.7

-0.7%

1555.1

-3.2%

-2.5%

1547.0

-3.7%

-0.5%

1564.7

-2.6%

1.1%

Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss

Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce

Sources: http://www.bloomberg.com/markets/

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

The flow of cash from safe havens to risk financial assets is processed by carry trades from zero interest rates that are frustrated by episodes of risk aversion or encouraged with return of risk appetite. Factors of risk appetite and risk aversion during the week of Dec 2 are important in understanding the financial environment before the meeting of European leaders on Dec 9. The frustration with the lack of evident resolution of the European sovereign debt crisis caused renewed risk aversion in the week of Dec 16. An impasse of risk aversion was experienced in the week of Dec 23 with some uncertainties on the implementation of the new agreement of European leaders.

· Bank Fears. European sovereign risk crises are closely linked to the exposures of regional banks to government debt. An important form of financial repression consists of changing the proportions of debt held by financial institutions toward higher shares in government debt. The financial history of Latin America, for example, is rich in such policies. Bailouts in the euro zone have sanctioned “bailing in” the private sector, which means that creditors such as banks will participate by “voluntary” reduction of the principal in government debt (see Pelaez and Pelaez, International Financial Architecture (2005), 163-202). David Enrich, Sara Schaeffer Muñoz and Patricia Knowsmann, writing on “European nations pressure own banks for loans,” on Nov 29, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204753404577066431341281676.html?mod=WSJPRO_hpp_MIDDLETopStories), provide important data and analysis on the role of banks in the European sovereign risk crisis. They assemble data from various sources showing that domestic banks hold 16.2 percent of Italy’s total government securities outstanding of €1,617.4 billion, 22.9 percent of Portugal’s total government securities of €103.9 billion and 12.3 percent of Spain’s total government securities of €535.3 billion. Capital requirements force banks to hold government securities to reduce overall risk exposure in balance sheets. Enrich, Schaeffer Muñoz and Knowsmann find information that governments are setting pressures on banks to acquire more government debt or at least to stop selling their holdings of government debt.

· Bond Auctions. Successive auctions of sovereign bonds of Italy and Spain improved in Dec 2011 as analyzed below. An important inflexion occurred on Nov 29. Jack Farchy, writing on “Italian bond sale boosts stock rally,” on Nov 29, 2011, published in the Financial Times (http://www.ft.com/intl/cms/s/0/2168664e-196b-11e1-92d8-00144feabdc0.html#axzz1f5gvxb00), informs on the boost to stock markets from the placement by Italy of the auction of €7.5 billion of bonds. Although the yields of 7.89 percent for three-year bonds and 7.56 percent for ten-year bonds were above the fear level of 7.0 percent, the euro gained 0.7 percent and stock markets rose. Success in the auction of bonds by Spain was an important turning point in the week of Dec 16. Emese Bartha , writing on Dec 15, on “Spain bonds sale goes smoothly,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204026804577099920841452332.html?mod=WSJPRO_hpp_LEFTTopStories), analyzes the strong demand for Spanish sovereign bonds. The target for the auction was to place between €2.5 and €3.5 billion of bonds maturing in Jan 2016 with coupon of 3.15 percent, bonds maturing in Apr 2020 with coupon of 4 percent and bonds maturing in Apr 2021 with coupon of 5.5 percent. Bartha informs that Spain placed bonds in value of €6.028 billion, around USD 7.83 billion. The bids reached €11.214 billion, or ratio of bids to actual sales of 1.86. Borrowing costs remained high with yield of 4.023 percent for the Jan 16 bonds versus 5.276 percent on Dec 1. Bloomberg finds yield of 0.61 percent for the four-year government bond of Germany and 0.89 percent for the five-year bond on Fri Dec 23 (http://www.bloomberg.com/markets/rates-bonds/government-bonds/germany/). Spain continues to make progress in placing its debt. Miles Johnson, writing on Dec 20, on “Spain’s short term debt yields tumble,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/1f57a9ba-2af9-11e1-8a38-00144feabdc0.html#axzz1gzoHXOj6), informs on the sharp reduction of short-term yields of Spanish debt. Spain placed €5.64 billion of short-term debt on Dec 20. The yield of the three-month security was 1.735 percent, compared with 5.11 percent of a similar auction in Nov, and the yield of the six-month security was 2.435 percent, compared with 5.227 per cent in the prior month. The newly-elected government in Spain intends to maintain the debt/GDP ratio below 60 percent; restrict the structural government deficit below 0.4 percent per year; and enhance bank balance sheets with recognition of losses in real estate loans. David Roman and Jonathan House, writing on Dec 30, on “Spain raises deficit forecast,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204720204577130382564753536.html?mod=WSJ_hp_LEFTWhatsNewsCollection), provide information on Spain’s austerity measures. The government of Spain announced on Dec 30 a new austerity package of €8.9 billion, or $11.54 billion. At the same time, the new government of Spain announced that the actual budget deficit in 2011 is likely to be around 8 percent instead of the planned 6 percent. The new package is designed to reduce the deficit to 3 percent of GDP by 2013 in compliance with European Union guidelines. Emese Bartha, writing on Dec 28, on “Italian funding costs slide,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204720204577126103208533754.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs of the success of the Italian Treasury in placing the entire auction of €9 billion, or $11.74 billion, of six-month treasury bills with average yield of 3.251 percent, much lower than the high in Nov for the euro period of six-month auction yield of 6.504 percent. The Italian Treasury also placed €1,733 billion of two-year zero coupon bonds at yield of 4.853 percent, which is lower than 7.814 percent in the prior month. Emese Bartha and Neelabh Chaturvedi, writing on Dec 29, on “Italy’s funding costs fall again,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204720204577128151842660474.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the sharp drop in the auction of three- and ten-year Italian government bonds. Markets improved with the announcement government measures with fiscal savings of €30 billion. The target of the auction was placing between €5 and €8 billion but €7.017 billion were actually placed. The yield of 5.62 percent of the bond maturing in Nov 2014 was much lower than the yield of 7.89 percent in the auction of Nov 29; the yield of 6.98 percent on the bond maturing in Mar 2022 was much lower than 7.56 percent in the prior auction. Ten-year government yields of Italian sovereign bonds remained just slightly above 7 percent during the week of Dec 30 with support from the European Central Bank to prevent higher yields. An important objective of the creation of the European Monetary Union (EMU) or euro zone was to lower borrowing costs throughout the members toward the yields of German bonds. Risk spreads of countries under sovereign risk pressure relative to yields of German government bonds have swelled to records in the history of the EMU.

· China Lowers Reserve Requirements. Yajun Zhang and Prudence Ho, writing on “China cuts reserve requirement ratio,” on Nov 30, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204012004577069804232647954.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the People’s Bank of China (PBOC), or Chinese central bank, announced the reduction of the reserve requirement of banks by 0.50 percentage points effective Dec 5. This is the first such reduction since Dec 2008. The PBOC increased the reserve requirement six times in 2011 and increased deposit rates five times since Oct 2010. Market participants are more hopeful that China will attain the elusive soft landing to lower inflation but with economic growth.

· Central Bank Dollar Swaps. The biggest boost to financial markets was provided by the return of central bank dollar swaps that were used during the financial crisis. The objective of the measure is to prevent deterioration of financial markets that could worsen the European sovereign debt crisis. The statement by the Federal Reserve is as follows (http://www.federalreserve.gov/newsevents/press/monetary/20111130a.htm):

“The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.

These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from December 5, 2011. The authorization of these swap arrangements has been extended to February 1, 2013. In addition, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank will continue to offer three-month tenders until further notice.

As a contingency measure, these central banks have also agreed to establish temporary bilateral liquidity swap arrangements so that liquidity can be provided in each jurisdiction in any of their currencies should market conditions so warrant. At present, there is no need to offer liquidity in non-domestic currencies other than the U.S. dollar, but the central banks judge it prudent to make the necessary arrangements so that liquidity support operations could be put into place quickly should the need arise. These swap lines are authorized through February 1, 2013.

Federal Reserve Actions
The Federal Open Market Committee has authorized an extension of the existing temporary U.S. dollar liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank through February 1, 2013. The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.

U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses.“

· European Central Bank. The European Central Bank (ECB) has been pressured to assist in the bailouts by acquiring sovereign debts. The ECB has been providing liquidity lines to banks under pressure and has acquired sovereign debts but not in the scale desired by authorities. In an important statement to the European Parliament, the President of the ECB Mario Draghi (2011Dec1) opened the possibility of further ECB actions but after a decisive “fiscal compact:”

“What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.

Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.

We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.

Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.

A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations.”

· French and Spanish Bond Auctions. Jack Farchy, writing on “French and Spanish auctions calm nerves,” on Dec 1, 2011, published in the Financial Times (http://www.ft.com/intl/cms/s/0/2168664e-196b-11e1-92d8-00144feabdc0.html#axzz1fIVz4kv1), analyzes the significant improvement in bond markets. Yields of government bonds of “peripheral countries” fell significantly and the yields of Italian government bonds fell below 7 percent. Spain placed the auction of €3.75 billion of government bonds and France placed €4.35 billion of government bonds.

· Brazilian Interest Rate Cut. The Banco Central do Brasil, Brazil’s central bank, lowered its policy rate SELIC for the third consecutive meeting of its monetary policy committee, COPOM (http://www.bcb.gov.br/textonoticia.asp?codigo=3268&IDPAI=NEWS):

“Copom reduces the Selic rate to 11.00 percent · 30/11/2011 7:47:00 PM

Brasília - Continuing the process of adjustment of monetary conditions, the Copom unanimously decided to reduce the Selic rate to 11.00 percent, without bias.

The Copom understands that, by promptly mitigating the effects stemming from a more restrictive global environment, a moderate adjustment in the basic rate level is consistent with the scenario of inflation convergence to the target in 2012.”

A worldwide easing movement by central banks contributed to the boom in valuation of risk financial assets. Much depends on the insistence of strong fiscal measures that were announced in the meeting of European leaders on Dec 9 but with doubts on implementation and effectiveness in the week of Dec 16. The risk impasse continued through the weeks of Dec 23 and Dec 30.

The combination of these policies explains the surge of valuations of risk financial assets in the weeks of Dec 2 and Dec 9. Table II-1 shows mixed results in valuations of risk financial assets in the week of Dec 30. Risk aversion returned in earlier weeks because of the uncertainties on rapidly moving political development in Greece, Italy, Spain and perhaps even in France and Germany. Most currency movements in Table II-1 reflect muted risk aversion because of continuing doubts on the success of the new agreement on Europe reached in the week of Dec 9. Risk aversion is probably best observed in foreign exchange markets with daily trading of $4 trillion instead of in relatively thin equity markets during year-end holidays. The dollar has remained virtually unchanged during three consecutive weeks, appreciating slightly relative to the euro in the week of Dec 30. Safe-haven currencies, such as the Swiss franc (CHF) and the Japanese yen (JPY) have been under threat of appreciation but also remained relatively unchanged. A characteristic of the global recession would be struggle for maintaining competitiveness by policies of regulation, trade and devaluation (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation War (2008c)). Appreciation of the exchange rate causes two major effects on Japan.

1. Trade. Consider an example with actual data (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-72). The yen traded at JPY 117.69/USD on Apr 2, 2007 and at JPY 102.77/USD on Apr 2, 2008, or appreciation of 12.7 percent. This meant that an export of JPY 10,000 to the US sold at USD 84.97 on Apr 2, 2007 [(JPY 10,000)/(USD 117.69/USD)], rising to USD 97.30 on Apr 2, 2008 [(JPY 10,000)/(JPY 102.77)]. If the goods sold by Japan were invoiced worldwide in dollars, Japanese’s companies would suffer a reduction in profit margins of 12.7 percent required to maintain the same dollar price. An export at cost of JPY 10,000 would only bring JPY 8,732 when converted at JPY 102.77 to maintain the price of USD 84.97 (USD 84.97 x JPY 102.77/USD). If profit margins were already tight, Japan would be uncompetitive and lose revenue and market share. The pain of Japan from dollar devaluation is illustrated by Table 58 in the Nov 6 comment of this blog (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html): The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 75.812/USD on Oct 28, 2011, for cumulative appreciation of 31.2 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Oct 28, 2011 (JPY 75.812) was 8.7 percent. The pain of Japan from dollar devaluation continues as illustrated by Table VI-6 in Section VI Valuation of Risk Financial Assets: The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 78.08/USD on Dec 23, 2011, for cumulative appreciation of 29.1 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Dec 23, 2011 (JPY 78.08) was 6.0 percent.

2. Foreign Earnings and Investment. Consider the case of a Japanese company receiving earnings from investment overseas. Accounting the earnings and investment in the books in Japan would also result in a loss of 12.7 percent. Accounting would show fewer yen for investment and earnings overseas.

There is a point of explosion of patience with dollar devaluation and domestic currency appreciation. Andrew Monahan, writing on “Japan intervenes on yen to cap sharp rise,” on Oct 31, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204528204577009152325076454.html?mod=WSJPRO_hpp_MIDDLETopStories), analyzes the intervention of the Bank of Japan, at request of the Ministry of Finance, on Oct 31, 2011. Traders consulted by Monahan estimate that the Bank of Japan sold JPY 7 trillion, about $92.31 billion, against the dollar, exceeding the JPY 4.5 trillion on Aug 4, 2011. The intervention caused an increase of the yen rate to JPY 79.55/USD relative to earlier trading at a low of JPY 75.31/USD. The JPY appreciated to JPY76.88/USD by Fri Nov 18 for cumulative appreciation of 3.4 percent from JPY 79.55 just after the intervention. The JPY appreciated another 0.3 percent in the week of Nov 18 but depreciated 1.1 percent in the week of Nov 25. There was mild depreciation of 0.3 percent in the week of Dec 2 that was followed by appreciation of 0.4 percent in the week of Dec 9. The JPY was virtually unchanged in the week of Dec 16 with depreciation of 0.1 percent but depreciated by 0.5 percent in the week of Dec 23, appreciating by 1.5 percent in the week of Dec 30 as shown in Table II-1. Historically, interventions in yen currency markets have been unsuccessful (Pelaez and Pelaez, The Global Recession Risk (2007), 107-109). Interventions are even more difficult currently with daily trading of some $4 trillion in world currency markets. Risk aversion with zero interest rates in the US diverts hot capital movements toward safe-haven currencies such as Japan, causing appreciation of the yen. Mitsuru Obe, writing on Nov 25, on “Japanese government bonds tumble,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204452104577060231493070676.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the increase in yields of the Japanese government bond with 10 year maturity to a high for one month of 1.025 percent at the close of market on Nov 25. Thin markets in after-hours trading may have played an important role in this increase in yield but there may have been an effect of a dreaded reduction in positions of bonds by banks under pressure of reducing assets. The report on Japan sustainability by the IMF (2011JSRNov23, 2), analyzes how rising yields could threaten Japan:

· “As evident from recent developments, market sentiment toward sovereigns with unsustainably large fiscal imbalances can shift abruptly, with adverse effects on debt dynamics. Should JGB yields increase, they could initiate an adverse feedback loop from rising yields to deteriorating confidence, diminishing policy space, and a contracting real economy.

· Higher yields could result in a withdrawal of liquidity from global capital markets, disrupt external positions and, through contagion, put upward pressure on sovereign bond yields elsewhere.”

Exchange rate controls by the Swiss National Bank (SNB) fixing the rate at a minimum of CHF 1.20/EUR (http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf) has prevented flight of capital into the Swiss franc. The Swiss franc remained unchanged relative to the USD in the week of Dec 23 and appreciated 0.2 percent in the week of Dec 30 relative to the USD and 0.5 percent relative to the euro, as shown in Table II-1. Risk aversion is evident in the depreciation of the Australian dollar by cumulative 2.5 percent in the week of Fr Dec 16 after no change in the week of Dec 9. In the week of Dec 23, the Australian dollar appreciated 1.9 percent, appreciating another 0.5 percent in the week of Dec 30 as shown in Table II-1. Risk appetite would be revealed by carry trades from zero interest rates in the US and Japan into high yielding currencies such as in Australia with appreciation of the Australian dollar (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4, Pelaez and Pelaez, Government Intervention in Globalization (2008c), 70-4).

Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing risk aversion is captured by decrease of the yield of the 10-year Treasury note from 2.326 percent on Oct 28 to 1.964 percent on Fri Nov 25, 2.065 on Dec 9 and collapse to 1.847 percent by Fr Dec 16. The yield of the 10-year Treasury rose from 1.81 percent on Mon Dec 19 to 2.027 percent on Fri Dec 23 and fell to 1.871 on Fri Dec 30, as shown in Table II-1, in a less relaxed mood of risk aversion. The 10-year Treasury yield is still at a level well below consumer price inflation of 3.4 percent in the 12 months ending in Nov (http://www.bls.gov/cpi/). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury with stable low yield of 0.226 percent on Dec 16 but rising to 0.28 percent on Dec 23 and then falling to 0.239 percent on Fri Dec 30, as shown in Table II-1. Investors are willing to sacrifice yield relative to inflation in defensive actions to avoid turbulence in valuations of risk financial assets but may be managing duration more carefully. During the financial panic of Sep 2008, funds moved away from risk exposures to government securities.

A similar risk aversion phenomenon occurred in Germany. The estimate of euro zone CPI inflation is at 3.0 percent for the 12 months ending in Nov (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-15122011-AP/EN/2-15122011-AP-EN.PDF) but the yield of the two-year German government bond fell from 0.32 percent on Dec 9 to 0.22 percent on Dec 16, virtually equal to the yield of the two-year Treasury note of the US and settled at 0.23 percent on Fri Dec 23, collapsing to 0.14 percent on Fri Dec 30 as shown in Table II-1. The yield of the 10-year German government bond has also collapsed from 2.15 percent on Dec 9 to 1.85 percent on Dec 16 but rising to 1.96 percent on Dec 23 but falling to 1.83 percent on Dec 30, which is virtually equal to the yield of 1.871 percent of the US 10-year Treasury note. Safety overrides inflation-adjusted yield but there could be duration aversion. Turbulence has also affected the market for German sovereign bonds. Emese Bartha, Art Patnaude and Nick Cawley, writing on “German bond auction falls flat,” on Nov 23, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204630904577055590007145230.html?mod=WSJPRO_hpp_LEFTTopStories), find decrease in risk appetite even for the highest quality financial assets in the euro zone. The auction of €6 billion of 10-year bunds on Nov 23 placed only €3.664 billion, or 60.7 percent. Although inflation of consumer prices in the UK at 5.0 percent exceeds euro zone inflation at 3.0 percent, David Oakley, Tracy Alloway, Alex Barker and Gerrit Wiesmann, writing on “UK borrowing costs drop below Germany,” on Nov 24, published in the Financial Times (http://www.ft.com/intl/cms/s/0/78994200-15c2-11e1-8db8-00144feabdc0.html#axzz1eWzvlRSp), inform that on Thu Nov 24 the UK 10-year gilt traded at 2.20 percent, which was lower than the yield of 2.23 percent of the German 10-year bond. Richard Milne, writing on “Italian bond yields rise above 8%,” on Nov 25, published in the Financial Times (http://www.ft.com/intl/cms/s/0/07079856-1754-11e1-b20e-00144feabdc0.html#axzz1eoXVrMVL), provides a quote of 8.13 percent for two-year Italian government bonds registered by Reuters’ data.

There was mixed performance of equity indexes in Table II-1 during the week of Dec 30. Germany’s Dax rose 1.3 percent on Thu Dec 29 and 0.8 percent on Fri Dec 30, gaining 0.3 percent in the week. DJIA fell 0.6 percent in the week of Fri Dec 30. Dow Global gained 1.4 percent in the week of Dec 9, lost 2.6 percent in the week of Dec 16, gained 2.9 percent in the week of Dec 23 but fell 0.1 percent in the week of Dec 30.

Financial risk assets increase during moderation of risk aversion in carry trades from zero interest rates and fall during increasing risk aversion. Commodities fell in the week of Dec 30. The DJ UBS Commodities Index lost 0.4 percent. WTI fell 0.8 percent, Brent dropped 0.4 percent and gold declined 2.6 percent.

IB Fiscal Compact. There are three types of actions in Europe to steer the euro zone away from the threats of fiscal and banking crises: (1) fiscal compact; (2) enhancement of stabilization tools and resources; and (3) bank capital requirements. The first two consist of agreements by the Euro Area Heads of State and government while the third one consists of measurements and recommendations by the European Banking Authority.

1. Fiscal Compact. The “fiscal compact” consists of (1) conciliation of fiscal policies and budgets within a “fiscal rule”; and (2) establishment of mechanisms of governance, monitoring and enforcement of the fiscal rule.

i. Fiscal Rule. The essence of the fiscal rule is that “general government budgets shall be balanced or in surplus” by compliance of members countries that “the annual structural deficit does not exceed 0.5% of nominal GDP” (European Council 2011Dec9, 3). Individual member states will create “an automatic correction mechanism that shall be triggered in the event of deviation” (European Council 2011Dec9, 3). Member states will define their automatic correction mechanisms following principles proposed by the European Commission. Those member states falling into an “excessive deficit procedure” will provide a detailed plan of structural reforms to correct excessive deficits. The European Council and European Commission will monitor yearly budget plans for consistency with adjustment of excessive deficits. Member states will report in anticipation their debt issuance plans. Deficits in excess of 3 percent of GDP and/or debt in excess of 60 percent of GDP will trigger automatic consequences.

ii. Policy Coordination and Governance. The euro area is committed to following common economic policy. In accordance, “a procedure will be established to ensure that all major economic policy reforms planned by euro area member states will be discussed and coordinated at the level of the euro area, with a view to benchmarking best practices” (European Council 2011Dec9, 5). Governance of the euro area will be strengthened with regular euro summits at least twice yearly.

2. Stabilization Tools and Resources. There are several enhancements to the bailouts of member states.

i. Facilities. The European Financial Stability Facility (EFSF) will use leverage and the European Central Bank as agent of its market operations. The European Stability Mechanism (ESM) or permanent bailout facility will be operational as soon as 90 percent of the capital commitments are ratified by member states. The ESM is planned to begin in Jul 2012.

ii. Financial Resources. The overall ceiling of the EFSF/ESM of €500 billion (USD 670 billion) will be reassessed in Mar 2012. Measures will be taken to maintain “the combined effective lending capacity of EUR 500 billion” (European Council 2011Dec9, 6). Member states will “consider, and confirm within 10 days, the provision of additional resources for the IMF of up to EUR 200 billion (USD 270 billion), in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. We are looking forward to parallel contributions from the international community” (European Council 2011Dec9, 6). Matthew Dalton and Matina Stevis, writing on Dec 20, 2011, on “Euro Zone Agrees to New IMF Loans,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204791104577107974167166272.html?mod=WSJPRO_hps_MIDDLESecondNews), inform that at a meeting on Dec 20, finance ministers of the euro-zone developed plans to contribute €150 billion in bilateral loans to the IMF as provided in the agreement of Dec 9. Bailouts “will strictly adhere to the well established IMF principles and practices.” There is a specific statement on private sector involvement and its relation to recent experience: “We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardized and identical Collective Action clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds” (European Council 2011Dec9, 6). Will there be again “unique and exceptional” conditions? The ESM is authorized to take emergency decisions with “a qualified majority of 85% in case the Commission and the ECB conclude that an urgent decision related to financial assistance is needed when the financial and economic sustainability of the euro area is threatened” (European Council 2011Dec9, 6).

3. Bank Capital. The European Banking Authority (EBA) finds that European banks have a capital shortfall of €114.7 billion (http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf). To avoid credit difficulties, the EBA recommends “that the credit institutions build a temporary capital buffer to reach a 9% Core Tier 1 ratio by 30 June 2012” (http://stress-test.eba.europa.eu/capitalexercise/EBA%20BS%202011%20173%20Recommendation%20FINAL.pdf 6). Patrick Jenkins, Martin Stabe and Stanley Pignal, writing on Dec 9, 2011, on “EU banks slash sovereign holdings,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/a6d2fd4e-228f-11e1-acdc-00144feabdc0.html#axzz1gAlaswcW), analyze the balance sheets of European banks released by the European Banking Authority. They conclude that European banks have reduced their holdings of riskier sovereign debt of countries in Europe by €65 billion from the end of 2010 to Sep 2011. Bankers informed that the European Central Bank and hedge funds acquired those exposures that represent 13 percent of their holdings of debt to Greece, Ireland, Italy, Portugal and Spain, which are down to €513 billion by the end of IIIQ2011.

IIIC European Central Bank. In the introductory statement to the press conference following the regularly-scheduled meeting of the European Central Bank (ECB), Draghi (2011Dec8) explains the decision to lower the policy rate (see also Draghi 2011Dec15):

“Based on its regular economic and monetary analyses, the Governing Council decided to lower the key ECB interest rates by 25 basis points, following the 25 basis point decrease on 3 November 2011. Inflation is likely to stay above 2% for several months to come, before declining to below 2%. The intensified financial market tensions are continuing to dampen economic activity in the euro area and the outlook remains subject to high uncertainty and substantial downside risks. In such an environment, cost, wage and price pressures in the euro area should remain modest over the policy-relevant horizon. At the same time, the underlying pace of monetary expansion remains moderate. Overall, it is essential for monetary policy to maintain price stability over the medium term, thereby ensuring a firm anchoring of inflation expectations in the euro area in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. Such anchoring is a prerequisite for monetary policy to make its contribution towards supporting economic growth and job creation in the euro area.”

What markets awaited came in the weaker form of temporary liquidity measures instead of the expectation of more aggressive bond buying by the ECB (Draghi 2011Dec8). These measures are termed as “non-standard:” (1) longer-term refinancing transactions with maturity of 36 months with the option of repayment after a year; (2) extension of collateral to new asset-backed securities; (3) reduction of the reserve ratio from 2 to 1 percent; and (4) discontinuance of fine-tuning in the final day of the maintenance period. Draghi (2011Dec8) reaffirmed the need for strong fiscal measures or compact in the euro zone (see also Draghi 2011Dec15):

“Turning to fiscal policies, all euro area governments urgently need to do their utmost to support fiscal sustainability in the euro area as a whole. A new fiscal compact, comprising a fundamental restatement of the fiscal rules together with the fiscal commitments that euro area governments have made, is the most important precondition for restoring the normal functioning of financial markets. Policy-makers need to correct excessive deficits and move to balanced budgets in the coming years by specifying and implementing the necessary adjustment measures. This will support public confidence in the soundness of policy actions and thus strengthen overall economic sentiment.

To accompany fiscal consolidation, the Governing Council has repeatedly called for bold and ambitious structural reforms. Going hand in hand, fiscal consolidation and structural reforms would strengthen confidence, growth prospects and job creation. Key reforms should be immediately carried out to help the euro area countries to improve competitiveness, increase the flexibility of their economies and enhance their longer-term growth potential. Labour market reforms should focus on removing rigidities and enhancing wage flexibility. Product market reforms should focus on fully opening up markets to increased competition.”

Draghi (2011Dec15) analyzed clearly the use of conventional lender of last resort monetary policy as decided by the Governing Council of the European Central Bank (see also ECB 2011MB, 5-9):

“Therefore, the Governing Council last week decided on three other measures, each of which provides additional support in order to bring the necessary monetary policy impulse to the real economy.

The current package should be felt tangibly in the financial sector and the real economy over the coming weeks and months. Of course, it comes against strong headwinds generated by deleveraging.

We established very long-term refinancing operations with a maturity of three years. This duration is a novelty in ECB monetary policy operations.

The extension of central bank credit provision to very long maturities is meant to give banks a longer horizon in their liquidity planning. It helps them to avoid rebalancing the maturities of their assets and liabilities through a downscaling of longer-term lending. Incidentally, we want to make it absolutely clear that in the present conditions where systemic risk is seriously hampering the functioning of the economy, we see no stigma attached to the use of central banking credit provisions: our facilities are there to be used.

Banks will be able to refinance term lending with the Eurosystem and thus preserve their long-term exposures to the real economy. After the first year, banks will have the option to terminate the operation. So they can flexibly adapt to changing liquidity conditions and a normalising market environment.

Our second measure will allow banks to use loans as collateral with the Eurosystem, thereby unfreezing a large portion of bank assets. It should also provide banks with an incentive to abstain from curtailing credit to the economy and to avoid fire-sales of other assets on their balance sheets.

The goal of these measures is to ensure that households and firms – and especially small and medium-sized enterprises – will receive credit as effectively as possible under the current circumstances. Of course, we have to screen the collateral carefully so as to protect our balance sheet.

The third measure we announced last week is to reduce the required reserves ratio from 2% to 1%. This measure frees up liquidity of the banking sector by about 100 billion euro. Along with other measures, this reduction in the reserve requirements should, too, help revive money market activity and lending.

You will notice that I referred repeatedly to small and medium-sized enterprises. The reason for drawing your attention to these businesses is that they are a significant part of our economy, accounting for about 70% of employment in the euro area and 60% of the turnover of all firms. We believe that the measures introduced last Thursday will provide support for this sector and indirectly also support much-needed investment, growth and employment.“

Draghi (2011Dec15) analyzes the fiscal compact as follows:

“We have now begun the process of re-designing Europe’s fiscal framework on three fronts.

The first lies with the countries concerned: they have to put their policies back on a sound footing. I believe that they are now on the right track and they are right in implementing budgetary consolidation resolutely. The unavoidable short-term contraction may be mitigated by the return of confidence. But in the medium term, sustainable growth can be achieved only by undertaking deep structural reforms that have been procrastinated for too long.

The second pillar of a response to the crisis consists of a re-design of the fiscal governance in the euro area, what I called the fiscal compact. The fiscal compact is a fundamental restatement of the rules to which national budgetary policies ought to be subject so as to gain credibility beyond doubt.

Last week’s summit committed to enshrine these rules in the primary legislation. They will foresee that the annual structural deficit should not exceed 0.5% of nominal GDP. Euro area Member States will implement such a rule in their national legal frameworks at a constitutional level, so that it is possible to avoid excessive deficits before they arise, rather than trying to control them after they have emerged. Prevention is better than cure.

Rules will also foresee an automatic correction mechanism in case of deviation. Moreover, the leaders agreed on a numerical benchmark for annual debt reduction to bring down debt levels. They also agreed to sanctions that will apply automatically to euro area Member States in breach of the 3% reference value for deficits.

The European Court of Justice may be asked to verify the implementation of these rules at national level.

Taken together, I believe that these decisions are capable of making public finances in the euro area credibly robust.

But restoring financial markets’ confidence also requires that investors be reassured that government debt will always be repaid and timely serviced. Greece will remain a unique case, and a credible stabilisation mechanism, a firewall, will be in place and can be activated when needed subject to proper conditionality. The leaders unambiguously agreed to assess the adequacy of the firewall by next March. Its objective is to address the threats to financial stability, and especially the risk of contagion between different sovereign debt markets.

The leaders decided to deploy the leveraging of the European Financial Stability Facility (EFSF) at the earliest opportunity. At the same time they agreed that the EFSF’s successor, the European Stability Mechanism, should come into force by July 2012.

It is crucial that the EFSF be fully equipped and be made operational as soon as possible. With this goal in mind, last Thursday, the Governing Council decided that the ECB would stand ready to act with its technical infrastructure and know-how as an agent for the EFSF in carrying out its market operations.”

An important statement of Draghi (2011Dec15) focuses on the role of central banking: “You all know that the statutes of the ECB inherited this important principle and that central bank independence and the credible pursuit of price stability go hand in hand.”

Draghi (2011Dec19) explains measures to ensure “access to funding markets” by euro zone banks:

§ “We have decided on three-year refinancing operations to support the supply of credit to the euro area economy. These measures address the risk that persistent financial markets tensions could affect the capacity of euro area banks to obtain refinancing over longer horizons.

§ Earlier, in October, the Governing Council had already decided to have two more refinancing operations with a maturity of around one year.

§ Also, it was announced then that in all refinancing operations until at least the first half of 2012 all liquidity demand by banks would be fully allotted at fixed rate.

§ Funding via the covered bonds market was also facilitated by the ECB deciding in October to introduce a new Covered Bond Purchase Programme of €40 billion.

§ Funding in US dollar is facilitated by lowering the pricing on the temporary US dollar liquidity swap arrangements.”

Lionel Barber and Ralph Atkins interviewed Mario Draghi on Dec 14 with the transcript published in the Financial Times on Dec 18 (http://www.ft.com/intl/cms/s/0/25d553ec-2972-11e1-a066-00144feabdc0.html#axzz1gzoHXOj6) as “FT interview transcript: Mario Draghi.” A critical question in the interview is if the new measures are a European version of quantitative easing. Draghi analyzes the difference between the measures of the European Central Bank (ECB) and quantitative easing such as in Japan, US and UK:

1. The measures are termed “non-standard” instead of “unconventional.” While quantitative easing attempts to lower the yield of targeted maturities, the three-year facility operates through the “bank channel.” Quantitative easing would not be feasible because the ECB is statutorily prohibited of funding central governments. The ECB would comply with its mandate of medium-term price stability.

2. There is a critical difference in the two programs. Quantitative easing has been used as a form of financial repression known as “directed lending.” For example, the purchase of mortgage-backed securities more recently or the suspension of the auctions of 30-year bonds in response to the contraction early in the 2000s has the clear objective of directing spending to housing. The ECB gives the banks entire discretion on how to use the funding within their risk/return decisions, which could include purchase of government bonds.

The question on the similarity of the ECB three-year lending facility and quantitative easing is quite valid. Tracy Alloway, writing on Oct 10, 2011, on “Investors worry over cheap ECB money side effects,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d2f87d16-f339-11e0-8383-00144feab49a.html#axzz1hAqMH1vn), analyzes the use of earlier long-term refinancing operations (LTRO) of the ECB. LTROs by the ECB in Jun, Sep and Dec 2009 lent €614 billion at 1 percent. Alloway quotes estimates of Deutsche Bank that banks used €442billion to acquire assets with higher yields. Carry trades developed from LTRO funds at 1 percent into liquid investments at a higher yield to earn highly profitable spreads. Alloway quotes estimates of Morgan Stanley that European debt of GIIPS (Greece, Ireland, Italy, Portugal and Spain) in European bank balance sheets is €700 billion. Tracy Alloway, writing on Dec 21, 2011, on “Demand for ECB loans rises to €489bn,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d6ddd0ae-2bbd-11e1-98bc-00144feabdc0.html#axzz1hAqMH1vn), informs that European banks borrowed the largest value of €489 billion in all LTROs of the ECB. Tom Fairless and David Cottle, writing on Dec 21, 2011, on “ECB sees record refinancing demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204464404577111983838592746.html?mod=WSJPRO_hpp_LEFTTopStories), inform that the first of three operations of the ECB lent €489.19 billion, or $639.96 billion, to 523 banks. Three such LTROs could add to $1.9 trillion, which is not far from the value of quantitative easing in the US of $2.5 trillion. Fairless and Cottle find that there could be renewed hopes that banks could use the LTROs to support euro zone bond markets. It is possible that there could be official moral suasion by governments on banks to increase their holdings of government bonds or at least not to sell existing holdings. Banks are not free to choose assets in evaluation of risk and returns. Floods of cheap money at 1 percent per year induce carry trades to high-risk assets and not necessarily financing of growth with borrowing and lending decisions constrained by shocks of confidence.

The LTROs of the ECB are not very different from the liquidity facilities of the Fed during the financial crisis. Kohn (2009Sep10) finds that the trillions of dollars in facilities provided by the Fed (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-64, Regulation of Banks and Finance (2009b), 224-7) could fall under normal principles of “lender of last resort” of central banks:

“The liquidity measures we took during the financial crisis, although unprecedented in their details, were generally consistent with Bagehot's principles and aimed at short-circuiting these feedback loops. The Federal Reserve lends only against collateral that meets specific quality requirements, and it applies haircuts where appropriate. Beyond the collateral, in many cases we also have recourse to the borrowing institution for repayment. In the case of the TALF, we are backstopped by the Treasury. In addition, the terms and conditions of most of our facilities are designed to be unattractive under normal market conditions, thus preserving borrowers' incentives to obtain funds in the market when markets are operating normally. Apart from a very small number of exceptions involving systemically important institutions, such features have limited the extent to which the Federal Reserve has taken on credit risk, and the overall credit risk involved in our lending during the crisis has been small.

In Ricardo's view, if the collateral had really been good, private institutions would have lent against it. However, as has been recognized since Bagehot, private lenders, acting to protect themselves, typically severely curtail lending during a financial crisis, irrespective of the quality of the available collateral.The central bank--because it is not liquidity constrained and has the infrastructure in place to make loans against a variety of collateral--is well positioned to make those loans in the interest of financial stability, and can make them without taking on significant credit risk, as long as its lending is secured by sound collateral. A key function of the central bank is to lend in such circumstances to contain the crisis and mitigate its effects on the economy.”

The Bagehot (1873) principle is that central banks should provide a safety net, lending to temporarily illiquid but solvent banks and not to insolvent banks (see Cline 2001, 2002; Pelaez and Pelaez, International Financial Architecture (2005), 175-8). Kohn (2009Apr18) characterizes “quantitative easing” as “large scale purchases of assets:”

“Another aspect of our efforts to affect financial conditions has been the extension of our open market operations to large-scale purchases of agency mortgage-backed securities (MBS), agency debt, and longer-term Treasury debt. We initially announced our intention to undertake large-scale asset purchases last November, when the federal funds rate began to approach its zero lower bound and we needed to begin applying stimulus through other channels as the economic contraction deepened. These purchases are intended to reduce intermediate- and longer-term interest rates on mortgages and other credit to households and businesses; those rates influence decisions about investments in long-lived assets like houses, consumer durable goods, and business capital. In ordinary circumstances, the typically quite modest volume of central bank purchases and sales of such assets has only small and temporary effects on their yields. However, the extremely large volume of purchases now underway does appear to have substantially lowered yields. The decline in yields reflects "preferred habitat" behavior, meaning that there is not perfect arbitrage between the yields on longer-term assets and current and expected short-term interest rates. These preferences are likely to be especially strong in current circumstances, so that long-term asset prices rise and yields fall as the Federal Reserve acquires a significant portion of the outstanding stock of securities held by the public.”

Non-standard ECB policy and unconventional Fed policy have a common link in the scale of implementation or policy doses. Direct lending by the central bank to banks is the function “large scale lender of last resort.” If there is moral suasion by governments to coerce banks into increasing their holdings of government bonds, the correct term would be financial repression.

An important additional measure discussed by Draghi (2011Nov19) is relaxation on the collateral pledged by banks in LTROs:

“Some banks’ access to refinancing operations may be restricted by lack of eligible collateral. To overcome this, a temporary expansion of the list of collateral has been decided. Furthermore, the ECB intends to enhance the use of bank loans as collateral in Eurosystem operations. These measures should support bank lending, by increasing the amount of assets on euro area banks’ balance sheets that can be used to obtain central bank refinancing.”

The financial reform of the United States around the proposal of a national bank by Alexander Hamilton (1780) to develop the money economy with specialization away from the barter economy is credited with creating the financial system that brought prosperity over a long period (see Pelaez 2008). Continuing growth and prosperity together with sound financial management earned the US dollar the role as reserve currency and the AAA rating of its Treasury securities. McKinnon (2011Dec18) analyzes the resolution of the European debt crisis by comparison with the reform of Alexander Hamilton. Northern states of the US had financed the revolutionary war with the issue of paper notes that were at risk of default by 1890. Alexander Hamilton proposed the purchase of the states’ paper notes by the Federal government without haircuts. McKinnon (2011Dec18) describes the conflicts before passing the assumption bill in 1790 for federal absorption of the debts of states. Other elements in the Hamilton reform consisted of creation of a market for US Treasury bonds by their use as paid-in capital in the First Bank of the United States. McKinnon (2011Dec18) finds growth of intermediation in the US by the branching of the First Bank of the United States throughout several states, accepting deposits to provide commercial short-term credit. The reform consolidated the union of states, fiscal credibility for the union and financial intermediation required for growth. The reform also introduced low tariffs and an excise tax on whisky to service the interest on the federal debt. Trade relations among members of the euro zone are highly important to economic activity. There are two lessons drawn by McKinnon (2011Dec18) from the experience of Hamilton for the euro zone currently. (1) The reform of Hamilton included new taxes for the assumption of debts of states with concrete provisions for their credibility. (2) Commercial lending was consolidated with a trusted bank both for accepting private deposits and for commercial lending, creating the structure of financial intermediation required for growth.

IIID Euro Zone Survival Risk. Charles Forelle and Stephen Fidler, writing on Dec 10, 2011, on “Questions place EU pact,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203413304577087562993283958.html?mod=WSJPRO_hpp_LEFTTopStories#project%3DEUSUMMIT121011%26articleTabs%3Darticle), provide data, information and analysis of the agreement of Dec 9. There are multiple issues centering on whether investors will be reassured that the measures have reduced the risks of European sovereign obligations. While the European Central Bank has welcomed the measures, it is not yet clear of its future role in preventing erosion of sovereign debt values.

Another complicating factor is whether there will be further actions on sovereign debt ratings. On Dec 5, 2011, four days before the conclusion of the meeting of European leaders, Standard & Poor’s (2011Dec5) placed the sovereign ratings of 15 members of the euro zone on “CreditWatch with negative implications.” S&P finds five conditions that trigger the action: (1) worsening credit conditions in the euro area; (2) differences among member states on how to manage the debt crisis in the short run and on measures to move toward enhanced fiscal convergence; (3) household and government debt at high levels throughout large parts of the euro area; (4) increasing risk spreads on euro area sovereigns, including those with AAA ratings; and (5) increasing risks of recession in the euro zone. S&P also placed the European Financial Stability Facility (EFSF) in CreditWatch with negative implications (http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245325307963). On Dec 9, 2011, Moody’s Investors Service downgraded the ratings of the three largest French banks (http://www.moodys.com/research/Moodys-downgrades-BNP-Paribass-long-term-ratings-to-Aa3-concluding--PR_232989 http://www.moodys.com/research/Moodys-downgrades-Credit-Agricole-SAs-long-term-ratings-to-Aa3--PR_233004 http://www.moodys.com/research/Moodys-downgrades-Socit-Gnrales-long-term-ratings-to-A1--PR_232986 ).

The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the following Subsection IIID Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30 the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent (see Table II-1). There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt of 120 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).

Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.

Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:

“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”

If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.

The prospects of survival of the euro zone are dire. Table II-2 is constructed with current IMF World Economic Outlook database for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2010.

Table II-2, World and Selected Regional and Country GDP and Fiscal Situation

	GDP 2010 USD Billions	Primary Net Lending Borrowing % GDP 2010	General Government Net Debt % GDP 2010
World	62,911.2
Euro Zone	12,167.8	-3.6	65.9
Portugal	229.2	-6.3	88.7
Ireland	206.9	-28.9	78.0
Greece	305.4	-4.9	142.8
Spain	1,409.9	-7.8	48.8
Major Advanced Economies G7	31,716.9	-6.5	76.5
United States	14,526.6	-8.4	68.3
UK	2,250.2	-7.7	67.7
Germany	3,286.5	-1.2	57.6
France	2,562.7	-4.9	76.5
Japan	5,458.8	-8.1	117.2
Canada	1,577.0	-4.9	32.2
Italy	2,055.1	-0.3	99.4
China	5,878.3	-2.3	33.8*
Cyprus	23.2	-5.3	61.6

*Gross Debt

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

The data in Table II-2 are used for some very simple calculations in Table II-3. The column “Net Debt USD Billions” in Table II-3 is generated by applying the percentage in Table II-2 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2010 is $3853.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3531.6 billion. There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-3. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.

Table II-3, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	8,018.6
B Germany	1,893.0		$7385.1 as % of $3286.5 =224.7% $5424.6 as % of $3286.5 =165.1%
C France	1,960.5
B+C	3,853.5	GDP $5849.2 Total Debt $7385.1 Debt/GDP: 126.3%
D Italy	2,042.8
E Spain	688.0
F Portugal	203.3
G Greece	436.1
H Ireland	161.4
Subtotal D+E+F+G+H	3,531.6

Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx

There is extremely important information in Table II-4 for the current sovereign risk crisis in the euro zone. Table II-4 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Oct. German exports to other European Union members are 58.7 percent of total exports in Oct and 59.6 percent in Jan-Oct. Exports to the euro area are 39.0 percent in Oct and 40.0 percent in Jan-Oct. Exports to third countries are only 41.3 percent of the total in Oct and 40.4 percent in Jan-Oct. There is similar distribution for imports. Economic performance in Germany is closely related to its high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone.

Table II-4, Germany, Structure of Exports and Imports by Region, € Billions and ∆%

	Oct 2011 € Billions	12 Months ∆%	Jan-Oct 2011 € Billions	Jan-Oct 2011/ Jan-Oct 2010 ∆%
Total Exports	89.2	3.8	881.1	12.5
A. EU Members	52.4 % 58.7	0.8	524.9 % 59.6	11.4
Euro Area	34.8 % 39.0	-0.4	352.1 % 40.0	10.2
Non-euro Area	17.7 % 19.8	3.1	172.7 % 19.6	14.0
B. Third Countries	36.8 % 41.3	8.3	356.2 % 40.4	14.1
Total Imports	77.6	8.6	750.7	14.6
C. EU Members	49.2 % 63.4	7.3	475.9 % 63.4	15.1
Euro Area	33.8 % 43.6	6.1	334.2 % 44.5	14.3
Non-euro Area	15.4 % 19.9	10.2	141.6 % 18.9	17.1
D. Third Countries	28.5 % 36.7	10.9	274.9 % 36.6	13.8

Notes: Total Exports = A+B; Total Imports = C+D

Source: http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/12/PE11__455__51,templateId=renderPrint.psml

IIE Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unpleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.

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

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

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

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

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

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

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

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

Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:

(M_t + B_t)/P_t = E_t∫(1/R_t_{, t+τ})s_t_+τdτ (4)

Equation (4) expresses the monetary, M_t, and debt, B_t, liabilities of the government, divided by the price level, P_t, in terms of the expected value discounted by the ex-post rate on government debt, R_t_{, t+τ}, of the future primary surpluses s_t_+τ, which are equal to T_t_+τ – G_t_+τ or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post R_t_{, t+τ}. The second equation of Cochrane (2011Jan, 5) is:

M_tV(i_t, ·) = P_tY_t (5)

Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):

“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”

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

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

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

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

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

III Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table III-1 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 (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table III-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table III-1. Data for other countries in Table III-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section IV World Economic Slowdown following with individual country and regional data tables.

Table III-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	1.5	3.4	5.7	8.6
Japan	-0.7	-0.5	1.7	4.5
China	9.1	4.2	2.7
UK	0.5	4.8* RPI 5.2	5.4* output 13.4* input 10.0**	8.3
Euro Zone	1.4	3.0	5.5	10.3
Germany	2.6	2.8	5.3	5.5
France	1.6	2.7	5.8	9.8
Nether-lands	1.1	2.7	6.8	4.8
Finland	2.7	3.2	5.8	7.8
Belgium	1.8	3.7	6.2	6.6
Portugal	-1.7	3.8	5.5	12.9
Ireland	NA	1.7	4.4	14.3
Italy	NA	3.7	4.7	8.5
Greece	-5.2	2.8	7.9	18.3
Spain	0.8	2.9	6.5	22.8

Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier

*Office for National Statistics

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/november-2011/index.html

CPI http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/november-2011/index.html

**Excluding food, beverage, tobacco and petroleum

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

Table III-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.5 percent in IIIQ2011 relative to IIIQ2010 (Table 8, p 11 in http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp3q11_3rd.pdf); Japan’s GDP fell 0.7 percent in IIIQ2011 relative to IIIQ2010 and contracted 1.7 percent in IIQ2011 relative to IIQ2010 because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 but grew at the seasonally-adjusted annual rate (SAAR) of 5.6 percent in IIIQ2011 (http://www.esri.cao.go.jp/jp/sna/sokuhou/kekka/gaiyou/main_1.pdf and see historical data in IIIB at http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial_11.html); the UK grew at 0.5 percent in IIIQ2011 relative to IIIQ2010 and 0.6 percent in IIIQ2011 relative to IIQ2011 (http://www.ons.gov.uk/ons/rel/naa2/quarterly-national-accounts/q3-2011/index.html); and the Euro Zone grew at 1.4 percent in IIIQ2011 relative to IIIQ2010 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-06122011-AP/EN/2-06122011-AP-EN.PDF). These are stagnating or “growth recession” rates, which are positive growth rates instead of contractions but insufficient to recover employment. The rates of unemployment are quite high: 8.6 percent in the US but 18.2 percent for unemployment/underemployment (see Table 3 in http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html), 4.5 percent for Japan, 8.3 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html) and 10.3 percent in the Euro Zone. Twelve months rates of inflation have been quite high, even when some are moderating at the margin: 3.4 percent in the US, minus 0.2 percent for Japan, 3.0 percent for the Euro Zone and 4.8 percent for the UK. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section II in this post and the earlier post http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable.html) (2) the tradeoff of growth and inflation in China; (3) slow growth by repression of savings with de facto interest rate controls (http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable.html), weak hiring (http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_20.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (see Section I Twenty Nine Million in Job Stress at http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see II Budget/Debt Quagmire in http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) the geopolitical events in the Middle East.

The Federal Open Market Committee (FOMC) did not change the course of monetary policy at its meeting on Dec 13 with the following statement (http://www.federalreserve.gov/newsevents/press/monetary/20111213a.htm):

“Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth. While indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but business fixed investment appears to be increasing less rapidly and the housing sector remains depressed. Inflation has moderated since earlier in the year, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.”

There were no changes of direction in the meeting of the Federal Open Market Committee (FOMC) from Nov 1 to Nov 2, 2011. The FOMC released the statement as follows (http://www.federalreserve.gov/newsevents/press/monetary/20111102a.htm):

“For immediate release

Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year. Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has increased at a somewhat faster pace in recent months. Business investment in equipment and software has continued to expand, but investment in nonresidential structures is still weak, and the housing sector remains depressed. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

The FOMC also released the economic projections of governors of the Board of Governors of the Federal Reserve and Federal Reserve Banks presidents shown in Table IV-2. It is instructive to focus on 2012, as 2011 is almost gone, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC. The first row for each year shows the projection introduced after the meeting of Nov 2 and the second row “Jun PR” the projection of the Jun meeting. There are three major changes in the view.

1. Growth “GDP ∆.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun to 2.5 to 2.9 percent in Nov.

2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun to 8.5 to 8.7 percent in Nov.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun to virtually the same of 1.4 to 2.0 percent in Nov.

Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun of 1.4 to 2.0 percent and the Nov projection of 1.5 to 2.0 percent.

Table III-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, November 2011

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2011 Jun PR	1.6 – 1.7 2.7 – 2.9	9.0 – 9.1 8.6 – 8.9	2.7 – 2.9 2.3 – 2.5	1.8 – 1.9 1.5 – 1.8
2012 Jun PR	2.5 – 2.9 3.3 – 3.7	8.5 – 8.7 7.8 – 8.2	1.4 – 2.0 1.5 – 2.0	1.5 – 2.0 1.4 – 2.0
2013 Jun PR	3.0 – 3.5 3.5 – 4.2	7.8 – 8.2 7.0 – 7.5	1.5 – 2.0 1.5 – 2.0	1.4 – 1.9 1.4 – 2.0
2014 Jun PR	3.0 – 3.9 NA	6.8 – 7.7 NA	1.5 – 2.0 NA	1.5 – 2.0 NA
Longer Run	2.4 – 2.7 2.5 – 2.8	5.2 – 6.0 5.2 – 5.6	1.7 – 2.0 1.7 – 2.0
Range
2011 Jun PR	1.6 – 1.8 2.5 – 3.0	8.9 – 9.1 8.4 – 9.1	2.5 – 3.3 2.1 – 3.5	1.7 – 2.0 1.5 – 2.3
2012 Jun PR	2.3 – 3.5 2.2 – 4.0	8.1 – 8.9 7.5 – 8.7	1.4 – 2.8 1.2 – 2.8	1.3 – 2.1 1.2 – 2.5
2013 Jun PR	2.7 – 4.0 3.0 – 4.5	7.5 – 8.4 6.5 – 8.3	1.4 – 2.5 1.3 – 2.5	1.4 – 2.1 1.3 – 2.5
2014 Jun PR	2.7 – 4.5 NA	6.5 – 8.0 NA	1.5 – 2.4 NA	1.4 – 2.2 NA
Longer Run	2.2 – 3.0 2.4 – 3.0	5.0 – 6.0 5.0 – 6.0	1.5 – 2.0 1.5 – 2.0

Notes: UEM: unemployment; PR: Projection

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20111102.pdf

Unconventional monetary policy of zero interest rates and quantitative easing has been used in Japan and now also in the US. Table III-3 provides the consumer price index of Japan, with inflation of minus 0.6 percent in Nov relative to Oct and minus 0.5 percent from Nov 2010 to Nov 2011. There is deflation in most of the 12 months rates in 2011 with the exception of Jul and Aug both with 0.2 percent and stability in Sep. There are eight years of deflation and one of zero inflation in the 12 months rate of inflation in Dec from 1995 to 2010. This experience is entirely different from that of the US that shows long-term inflation. It is difficult to justify unconventional monetary policy because of risks of deflation similar to those experienced in Japan.

Table III-3, Japan, Consumer Price Index, All Items ∆%

	∆% Month SA	∆% Month NSA	∆% 12 Months NSA
Nov 2011	-0.2	-0.6	-0.5
Oct	0.1	0.1	-0.2
Sep	-0.1	0.0	0.0
Aug	-0.3	0.1	0.2
Jul	0.3	0.0	0.2
Jun	-0.2	-0.2	-0.4
May	0.0	0.0	-0.4
Apr	-0.1	0.1	-0.4
Mar	-0.1	0.3	-0.5
Feb	0.1	0.0	-0.5
Jan	0.1	-0.1	-0.6
Dec 2010	-0.1	–0.3	0.0
Dec 2009			-1.7
Dec 2008			0.4
Dec 2007			0.7
Dec 2006			0.3
Dec 2005			-0.1
Dec 2004			0.2
Dec 2003			-0.4
Dec 2002			-0.3
Dec 2001			-1.2
Dec 2000			-0.2
Dec 1999			-1.1
Dec 1998			0.6
Dec 1997			1.8
Dec 1996			0.6
Dec 1995			-0.3
Dec 1994			0.7
Dec 1993			1.0
Dec 1992			1.2
Dec 1991			2.7
Dec 1990			3.8

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

http://www.e-stat.go.jp/SG1/estat/ListE.do?lid=000001084130

Unconventional monetary policy of zero interest rates and large-scale purchases of long-term securities for the balance sheet of the central bank is proposed to prevent deflation. The data of CPI inflation of all goods and CPI inflation excluding food and energy for the past six decades show only one negative change by 0.4 percent in the CPI all goods annual index in 2009 but not one year of negative annual yearly change in the CPI excluding food and energy measuring annual inflation (http://cmpassocregulationblog.blogspot.com/2011/08/world-financial-turbulence-global.html). Zero interest rates and quantitative easing are designed to lower costs of borrowing for investment and consumption, increase stock market valuations and devalue the dollar. In practice, the carry trade is from zero interest rates to a large variety of risk financial assets including commodities. Resulting commodity price inflation squeezes family budgets and deteriorates the terms of trade with negative effects on aggregate demand and employment. Excessive valuations of risk financial assets eventually result in crashes of financial markets with possible adverse effects on economic activity and employment.

Producer price inflation history in the past five decades does not provide evidence of deflation. The finished core PPI does not register even one single year of decline. The headline PPI experienced only six isolated cases of decline (http://cmpassocregulationblog.blogspot.com/2011/08/world-financial-turbulence-global.html):

-0.3 percent in 1963,

-1.4 percent in 1986,

-0.8 percent in 1986,

-0.8 percent in 1998,

-1.3 percent in 2001

-2.6 percent in 2009.

Deflation should show persistent cases of decline of prices and not isolated events. Fear of deflation in the US has caused a distraction of monetary policy. Symmetric inflation targets around 2 percent in the presence of multiple lags in effect of monetary policy and imperfect knowledge and forecasting are mostly unfeasible and likely to cause price and financial instability instead of desired price and financial stability.

Chart III-1 provides the consumer price index NSA from 1960 to 2011. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

Chart III-1, US, Consumer Price Index, All Items, NSA, 1960-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

Chart III-2 provides 12-month percentage changes of the consumer price index from 1960 to 2011. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.

Chart III-2, US, Consumer Price Index, All Items, NSA, 12- Month Percentage Change 1960-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

Chart III-3 provides the consumer price index excluding food and energy from 1960 to 2011. There is long-term inflation in the US without episodes of deflation.

Chart III-3, US, Consumer Price Index Excluding Food and Energy, NSA, 1960-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

Chart III-4 provides 12 months percentage changes of the consumer price index excluding food and energy from 1960 to 2011. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.

Chart III-4, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1960-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

More detail on the consumer price index of Japan in Nov is shown in Table III-4. Inflation in the 12 months ending in Nov has been driven by items rich in commodities such as 4.9 percent in fuel, light and water charges with monthly increase of 0.3 percent in the month of Nov. There is similar behavior in the preliminary estimate for Dec for the Ku Area of Tokyo with monthly inflation of fuel, light and water charges of 0.2 percent and 6.7 percent in 12 months. There is deflation in most of the items in the consumer price index with declines in Nov of: 0.8 percent goods, 0.4 percent services, 0.7 percent for CPI excluding imputed rent, 0.3 percent excluding fresh food and 0.4 percent excluding food, alcoholic beverages and energy.

Table III-4, Japan, Consumer Price Index, ∆%

2011	Nov/Oct ∆%	Year ∆%
CPI All Items	-0.6	-0.5
CPI Excluding Fresh Food	-0.3	-0.2
CPI Excluding Food, Alcoholic Beverages and Energy	-0.4	-1.1
CPI Goods	-0.8	-1.0
CPI Services	-0.4	-0.1
CPI Excluding Imputed Rent	-0.7	-0.6
CPI Fuel, Light, Water Charges	0.3	4.9
CPI Transport Communications	0.0	1.6
CPI Ku-Area Tokyo All Items	0.0	-0.4
Fuel, Light, Water Charges Ku Area Tokyo	0.2	6.7

Note: Ku-area Tokyo CPI data preliminary for Dec

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

The Statistiche Bundesamt Deutschland or Federal Statistical Agency of Germany estimates preliminarily that the consumer price index of Germany rose 2.3 percent in 2011 in relation to 2010. The preliminary estimate of the consumer price index in Dec is an increase of 2.1 percent relative to Dec 2010. CPI inflation in Dec is preliminarily estimated at 0.7 percent “mainly due to seasonal factors” (http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/12/PE11__487__611,templateId=renderPrint.psml). Consumer price inflation in Germany in Nov was flat and 2.4 percent in 12 months, as shown in Table III-5. Most inflation in Germany in 2011 has concentrated in three months: 0.4 percent in Jul, 0.5 percent in Mar and 0.5 percent in Feb. A quarter composed of those three months repeated for an entire year would result in annual equivalent inflation of 5.8 percent. Annual equivalent inflation in the quarter Jul-Nov was at the annual equivalent rate of 1.2 percent, which is lower than the 12-month rate of 2.4 percent in Nov. Annual equivalent inflation in Jul-Dec using the preliminary estimate is 2.4 percent.

Table III-5, Germany, Consumer Price Index ∆%

	12 Months ∆%	Month ∆%
Dec* 2011	2.1	0.7
Nov	2.4	0.0
Oct	2.5	0.0
Sep	2.6	0.1
Aug	2.4	0.0
Jul	2.4	0.4
AE ∆% Jul-Dec		2.4
Jun	2.3	0.1
May	2.3	0.0
AE ∆% May-Jun		0.6
Apr	2.4	0.2
Mar	2.1	0.5
Feb	2.1	0.5
Jan	2.0	-0.4
AE ∆% Jan-Apr		2.4
Dec 2010	1.7	1.0
Nov	1.5	0.1
Oct	1.3	0.1
Sep	1.3	-0.1
Aug	1.0	0.0
Annual Average ∆%
2010	1.1
2009	0.4
2008	2.6

*Based on preliminary information

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/12/PE11__487__611,templateId=renderPrint.psml

Source: Statistiche Bundesamt Deutschland

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/Content/Statistics/TimeSeries/EconomicIndicators/KeyIndicators/ConsumerPrices/liste__vpi,templateId=renderPrint.psml

Chart III-5, of the Statistiche Bundesamt Deutschland, or Federal Statistical Agency of Germany, provides the unadjusted consumer price index of Germany from 2003 to 2011. There is an evident acceleration in the form of sharper slope in the first months of 2011 and then a flattening in more recent months. If risk aversion declines, new carry trades from zero interest rates to commodity futures could again result in higher inflation.

Chart III-5, Germany, Consumer Price Index, Unadjusted, 2005=100

Source: Statistiche Bundesamt Deutschland

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/Content/Statistics/TimeSeries/EconomicIndicators/KeyIndicators/ConsumerPrices/liste__vpi,templateId=renderPrint.psml

Chart III-6 of the Statistiche Bundesamt Deutschland, or Federal Statistical Agency of Germany, provides the unadjusted consumer price index of Germany and trend from 2007 to 2011. Inflation moderated during the global recession but regained the sharper slope with the new carry trades from zero interest rates to commodity futures beginning in 2010.

Chart III-6, Germany, Consumer Price Index, Unadjusted and Trend, 2005=100

Source: Statistiche Bundesamt Deutschland

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/Content/Statistics/TimeSeries/EconomicIndicators/Prices/Content100/kpre510graf0.psml

Table III-6 provides the monthly and 12 months rate of inflation for segments of the consumer price index. Inflation excluding energy was flat in Nov and rose 1.4 percent in 12 months. Excluding household energy inflation was also flat in Nov and rose 1.4 percent in 12 months. High increases in Germany’s consumer prices in Nov were 4.4 percent in heating oil, 1.1 percent in household energy and 0.4 percent in nondurable consumer goods.

Table III-6, Germany, Consumer Price Index ∆%

Nov 2011	Weight	12 Months ∆%	Month ∆%
Total	1,000.00	2.4	0.0
Excluding heating oil and motor fuels	955.42	1.8	-0.1
Excluding household energy	940.18	1.9	0.0
Excluding Energy	904.81	1.4	0.0
Total Goods	493.00	3.7	0.3
Nondurable Consumer Goods	305.11	5.2	0.4
Medium-Term Life Consumer Goods	95.24	2.0	0.1
Durable Consumer Goods	92.65	0.0	0.0
Energy Components
Motor Fuels	35.37	11.3	-0.4
Household Energy	59.82	11.1	1.1
Heating Oil	9.21	28.5	4.4
Food	89.99	2.5	0.5

Source: http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/12/PE11__456__611,templateId=renderPrint.psml

Italy’s producer price inflation in Table III-7 also has the same waves in 2011 observed for many countries (http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_20.html). The annual equivalent producer price inflation in Jan-Apr was 10.7 percent, which was driven by increases in commodity prices resulting from the carry trades from zero interest rates to risk financial assets, in particular leveraged positions in commodities. Producer price inflation was minus 0.2 percent in Oct and rose 4.7 percent in 12 months but was 0.2 percent in Nov and rose 4.5 percent in 12 months. Producer price inflation moderated with decline by 0.2 percent in May and zero change in Jun. Annual equivalent consumer price inflation was 1.4 percent in Jul-Nov.

Table III-7, Italy, Industrial Prices, Internal Market

	Month ∆%	12 Months ∆%
Nov 2011	0.2	4.5
Oct	-0.2	4.7
Sep	0.2	4.7
Aug	0.1	4.8
Jul	0.3	4.9
AE ∆% Jul-Nov	1.4
Jun	0.0	4.6
May	-0.2	4.8
AE ∆% May-Jun	-1.2
Apr	0.7	5.6
Mar	0.8	6.2
Feb	0.7	5.8
Jan	1.2	5.3
AE ∆% Jan-Apr	10.7
Dec 2010	0.7	4.7
Year
2010		3.0
2009		-5.4
2008		5.9
2007		3.3
2006		5.2
2005		4.0
2004		2.7
2003		1.6
2002		0.2
2001		1.9

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/49093

Chart III-7 of the Istituto Nazionale di Statistica of Italy shows percentage changes in 12 months of Italy’s consumer price index. The commodity shock accelerated 12 months inflation rates that peaked in Mar. Inflation then fell but stabilized at a still relatively high level with slight decline in Nov.

Chart III-7, Italy, Producer Prices for the Internal Market 12 Months ∆%

Source: Istituto Nazionale di Statistica

http://www.istat.it/en/

Monthly and 12-month inflation of the producer price index of Italy and individual components is provided in Table III-8. Energy prices increased 1.4 percent in Nov and rose 10.8 percent in 12 months. Producer-price inflation is positive for all components in the month of Nov with exception of decline by 0.5 percent in intermediate goods. There is higher inflation in 12 months of 4.0 percent for nondurable goods than 2.5 percent for durable goods.

Table III-8, Italy, Industrial Prices, Internal Market, ∆%

	Nov 2011/ Oct 2011	Nov 2011/ Nov 2010
Total	0.2	4.5
Consumer Goods	0.3	3.6
Durable Goods	0.3	2.5
Nondurable	0.3	4.0
Intermediate	-0.5	3.5
Energy	1.4	10.8

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/49093

IV World Economic Slowdown. The JP Morgan Global All-Industry Output Index produced by JPMorgan and Markit in association with ISM and IFPSM registered improvement in Nov, increasing from the low of the recovery in Oct of 51.3 to 52.0 in Nov (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8909). There was acceleration in both manufacturing and nonmanufacturing in the US with composite activity growing at highest rhythm since Mar. Joseph Lupton, Global Economist at JPMorgan, finds that the combination of low employment and level of new orders could imply continuing global growth below trend in 2012. The JP Morgan Global Manufacturing PMI^™ produced by JP Morgan and Markit in association with ISM and IFPSM registered 49.6 in Nov compared with 49.9 in Oct, which means that global manufacturing is contracting at a faster rate (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8874). The JP Morgan Global Manufacturing PMI^™ fell for a third consecutive month. The proximity of the index to 50 suggests near stagnation of world manufacturing but it masks that growth in the US with share of 28.2 percent in the index was the sharpest in seven months. World manufacturing excluding the US fell at the fastest rhythm in 36 months (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8874). The table “World-Wide Factory Activity, by Country,” of Real Time Economics produced by WSJ Research and published in the Wall Street Journal on Dec 1 (http://blogs.wsj.com/economics/2011/12/01/world-wide-factory-activity-by-country-20/tab/interactive/) shows only six countries with manufacturing indexes above 50 in Nov: Canada (53.3), India (51.0), Russia (52.6), South Africa (51.6), Turkey (52.3) and the US (52.7). The HSBC Brazil Services PMI^TM compiled by Markit, combining manufacturing and services, registered 51.5 in Nov, which is higher than 51.3 in Oct (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8889). While the increase is moderate, André Loes, Chief Economist of HSBC in Brazil, finds that the index has been above the neutral point of 50 during 28 consecutive months and the increase in Nov is the fastest in six months (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8889). The HSBC Industrial Production PMI^™ for Brazil increased from 46.5 in Oct to 48.7 in Nov, which means contraction at a slower rate (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8846). Andre Loes, Chief Economist of HBSC in Brazil, finds that the index registered the highest level since Jun and the fastest rate of monthly change since Dec 2010 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8846). Inventory adjustment in response to expectations on the economy may have caused the decline of industrial production. Loes finds that if this interpretation is valid industry may improve performance in 2012.

IVA United States. The Manufacturing ISM Report on Business^® purchasing managers’ index jumped 1.9 percentage points from 50.8 in Oct to 52.7 in Nov, indicating continuing growth for 28 consecutive months but at slower rate of change (http://www.ism.ws/ISMReport/MfgROB.cfm). New orders, which are an indicator of future business, rose 4.3 percentage points, from 52.4 in Oct to 56.7 in Nov, indicating growth at a faster rate. The employment index fell 1.7 percentage points from 53.5 in Oct to 51.8 in Nov, indicating growth at slower rate of change. Prices paid or costs of inputs rose 4.0 percentage points from 41.0 in Oct to 45.0 in Oct, which is the second reading below 50 since May.

The nonmanufacturing index of the Institute for Supply Management^™ fell 0.9 percentage points in Nov to 52.0 from 52.9 in Oct. According to the IMS, the reading for Nov is the lowest since 50.7 in Jan 2010 (http://www.ism.ws/ISMReport/NonMfgROB.cfm). There are favorable aspects of the Nonmanufacturing ISM Report on Business^®: (1) business activity production increase by 2.4 percentage points from 53.8 in Oct to 56.2 in Nov; (2) new orders, indicating future activity, increased 0.6 percentage points from 52.4 in Oct to 53.0 in Nov; and new export orders increased 1.5 percentage points from 54.0 in Oct to 55.5 in Nov. Perhaps the most unfavorable aspect is the decline of employment by 4.4 percentage points from expansion at 53.3 in Oct to contraction at 48.9 in Nov. The establishment survey of the Bureau of Labor Statistics for Nov shows 92.199 million jobs in private service-providing activities in the US compared with 11.803 million jobs in manufacturing (Table B-1, page 29 http://www.bls.gov/news.release/pdf/empsit.pdf). Contraction of jobs in nonmanufacturing can affect many more workers than in manufacturing. Another unfavorable aspect is the increase in prices of 5.4 percentage points from 57.1 in Oct to 62.5 in Nov. Table USA provides the indicators for the US economy.

Table USA, US Economic Indicators

Consumer Price Index	Nov 12 months NSA ∆%: 3.4; ex food and energy ∆%: 2.2 Oct month ∆%: 0.0; ex food and energy ∆%: 0.2 Blog 12/18/11
Producer Price Index	Nov 12 months NSA ∆%: 5.7; ex food and energy ∆% 2.9 Oct month SA ∆% = 0.3; ex food and energy ∆%: 0.1 Blog 12/18/11
PCE Inflation	Nov 12 months NSA ∆%: headline 2.5; ex food and energy ∆% 1.7 Blog 12/27/11
Employment Situation	Household Survey: Nov Unemployment Rate SA 8.6% Blog calculation People in Job Stress Nov: 28.9 million NSA Establishment Survey: Nov Nonfarm Jobs 100,000; Private +120,000 jobs created Oct 12 months Average Hourly Earnings Inflation Adjusted ∆%: minus 1.6% Blog 12/04/11
Nonfarm Hiring	Nonfarm Hiring fell from 64.9 million in 2006 to 47.2 million in 2010 or by 17.7 million Private-Sector Hiring Oct 2011 4.091 million lower by 1.605 million than 5.696 million in Oct 2006 Blog 12/18/11
GDP Growth	BEA Revised National Income Accounts back to 2003 IQ2011 SAAR ∆%: 0.4 IIQ2011 SAAR ∆%: 1.3 IIIQ2011 SAAR ∆%: 1.8 First three quarters AE ∆% 1.2 Blog 12/27/11
Personal Income and Consumption	Nov month ∆% SA Real Disposable Personal Income (RDPI) 0.0 Nov month SA ∆% Real Personal Consumption Expenditures (RPCE): 0.2 12 months NSA ∆%: RDPI: -0.1; RPCE ∆%: 1.3 Blog 12/27/11
Quarterly Services Report	IIIQ11/IIQII SA ∆%: Information 0.6 Professional 0.8 Administrative 1.7 Hospitals -0.9 Blog 12/11/11
Employment Cost Index	IIIQ2011 SA ∆%: 0.3 Sep 12 months ∆%: 2.0 Blog 10/30/11
Industrial Production	NOV month SA ∆%: 0.2 Nov 12 months SA ∆%: 3.7 Capacity Utilization: 77.8 Blog 12/18/11
Productivity and Costs	Nonfarm Business Productivity IIIQ2011∆% SAAE 2.1; IIIQ2011/IIIQ2010 ∆% 0.9; Unit Labor Costs IIIQ2011 ∆% -2.5; IIIQ2011/IIIQ2010 ∆%: 0.4 Blog 12/04/11
New York Fed Manufacturing Index	General Business Conditions From 0.61 Nov to Dec 9.53 New Orders: From -2.07 Nov to minus 5.10 Dec Blog 12/18/11
Philadelphia Fed Business Outlook Index	General Index from 3.6 Nov to 10.3 Dec New Orders from 1.3 Nov to 9.7 Dec Blog 12/18/11
Manufacturing Shipments and Orders	Oct/Sep New Orders SA ∆%: minus 0.4; ex transport ∆%: 0.2 12 months Jan-Oct NSA ∆%: 12.3; ex transport ∆% 12.8 Blog 12/11/11
Durable Goods	Nov New Orders SA ∆%: 3.8; ex transport ∆%: 0.3 Jan-Nov months NSA New Orders ∆%: 9.5; ex transport ∆% : 9.1 Blog 12/27/11
Sales of New Motor Vehicles	Jan-Nov 2011 11.532 million; Jan-Oct 2011 10.444 million; Jan-Nov 2010 12.28 million. Nov SAAR 13.62 million, Oct SAAR 13.25, Nov 2010 SAAR 12.28 million Blog 12/04/11
Sales of Merchant Wholesalers	Jan-Oct 2011/2010 ∆%: Total 14.8; Durable Goods: 12.4; Nondurable Goods 16/7 Blog 12/11/11
Sales and Inventories of Manufacturers, Retailers and Merchant Wholesalers	Oct 11/Oct 10 NSA ∆%: Total Business 10.4; Manufacturers 11.0 Retailers 7.1; Merchant Wholesalers 12.8 Blog 12/18/11
Sales for Retail and Food Services	Jan-Nov 2011/Jan-Nov 2010 ∆%: Retail and Food Services: 7.8; Retail ∆% 8.1 Blog 12/18/11
Value of Construction Put in Place	Oct SAAR month SA ∆%: 0.8 Oct 12 months NSA: 0.3 Blog 12/04/11
Case-Shiller Home Prices	Oct 2011/Oct 2010 ∆% NSA: 10 Cities minus 3.0; 20 Cities: minus 3.4 ∆% Oct SA: 10 Cities minus 0.5 ; 20 Cities: minus 0.6 Blog 01/01/12
FHFA House Price Index Purchases Only	Oct SA ∆% -0.2; 12 month ∆%: minus 2.7 Blog 12/27/11
New House Sales	Nov month SAAR ∆%: 1.6 Jan-Nov 2011/Jan-Nov 2010 NSA ∆%: minus 6.1 Blog 12/27/11
Housing Starts and Permits	Nov Starts month SA ∆%: 9.3; Permits ∆%: 5.7 Jan-Nov 2011/2010 NSA ∆% Starts 2.1; Permits ∆% 1.9 Blog 12/27/11
Trade Balance	Balance Oct SA -$43,466 million versus Sep -$44,170 million Exports Oct SA ∆%: -0.8 Imports Oct SA ∆%: -0.9 Goods Exports Jan-Oct 2011/2010 NSA ∆%: 17.6 Good Imports Jan-Oct 2011/2010 NSA ∆%: 16.3 Blog 12/11/11
Export and Import Prices	Nov 12 months NSA ∆%: Imports 9.9; Exports 4.7 Blog 12/18/11
Consumer Credit	Oct ∆% annual rate: 3.7 Blog 12/11/11
Net Foreign Purchases of Long-term Treasury Securities	Oct Net Foreign Purchases of Long-term Treasury Securities: $4.8 billion Oct versus Sep $68.3 billion Major Holders of Treasury Securities: China $1134 billion; Japan $979 billion Blog 12/18/11
Treasury Budget	Fiscal Year 2012/2011 ∆%: Receipts 7.0; Outlays -5.9; Individual Income Taxes 16.0 Deficit Fiscal Year 2011 $1,298,80 million Deficit Fiscal Year 2012 Oct-Nov $315,474 million Blog 12/18/11
Flow of Funds	IIQ2011 ∆ since 2007 Assets -$6311B Real estate -$5111B Financial -$1490 Net Worth -$5802 Blog 09/18/11
Current Account Balance of Payments	IIIQ2011 -131B %GDP 2.9 Blog 12/18/11

Links to blog comments in Table USA: 12/27/11 http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable_27.html

12/18/2011 http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html

12/11/2011 II http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial_11.html

12/4/11 http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html

10/30/11 http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html

09/18/11 http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html

Table IVA-1 shows the euphoria of prices during the boom and the subsequent decline. House prices rose 96.0 percent in the 10-city composite of the Case-Shiller home price index and 81.2 percent in the 20-city composite between Oct 2000 and Oct 2005. Prices rose around 100 percent from Oct 2000 to Oct 2006, increasing 101.1 percent for the 10-city composite and almost doubled increasing by 86.7 percent for the 20-city composite. House prices rose 40.7 percent between Oct 2003 and Oct 2005 for the 10-city composite and 34.9 percent for the 20-city composite propelled by low fed funds rates of 1.0 percent between Jun 2003 and Jun 2004 and then only increasing by 0.25 basis points at every meeting of the Federal Open Market Committee (FOMC). Similarly, between Oct 2003 and Oct 2006 the 10-city index gained 44.3 percent and the 20-city increased 38.9 percent. House prices have fallen 31.4 percent since 2006 for the 10-city composite and 31.7 percent for the 20-city composite. Measuring house prices is quite difficult because of the lack of homogeneity that is typical of standardized commodities. In the 12 months ending in Oct 2011, house prices fell 3.0 percent in the 10-city composite and fell 3.4 percent in the 20-city composite in what has become a second round of decreases in prices of houses in the US. The final row in Table IVA-1 shows that house prices increased 37.9 percent between Oct 2000 and Oct 2011 for the 10-city composite and increased 27.5 percent for the 20-city composite. Standard & Poor’s Case-Shiller estimates that the declines from the peak in Jun/Jul 2006 to the values in Oct 2011 are minus 31.9 percent for the 10-city composite and minus 32.1 percent for the 20-city composite. House prices have recovered 2.4 percent for the 10-city composite from the low in Apr 2009 and 1.9 percent for the 20-city composite since the low in Mar 2011 recent (http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-Type&blobcol=urldocumentfile&blobtable=SPComSecureDocument&blobheadervalue2=inline%3B+filename%3Ddownload.pdf&blobheadername2=Content-Disposition&blobheadervalue1=application%2Fpdf&blobkey=id&blobheadername1=content-type&blobwhere=1245326665736&blobheadervalue3=abinary%3B+charset%3DUTF-8&blobnocache=true page 3).

Table IVA-1, US, Percentage Changes of Standard & Poor’s Case-Shiller Home Price Indices, Not Seasonally Adjusted, ∆%

	10-City Composite	20-City Composite
∆% Oct 2000 to Oct 2003	39.3	34.3
∆% Oct 2000 to Oct 2005	96.0	81.2
∆% Oct 2003 to Oct 2005	40.7	34.9
∆% Oct 2000 to Oct 2006	101.1	86.7
∆% Oct 2003 to Oct 2006	44.3	38.9
∆% Oct 2000 to Oct 2011	37.9	27.5
∆% Oct 2005 to Oct 2011	-29.7	-29.6
∆% Oct 2006 to Oct 2011	-31.4	-31.7
∆% Oct 2009 to Oct 2011	-2.9	-4.2
∆% Oct 2010 to Oct 2011	-3.0	-3.4
∆% Oct 2000 to Oct 2011	37.9	27.5

Source: http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----

With the exception of Apr, house prices seasonally-adjusted have declined in every month for both the 10-city and 20-city Case-Shiller composites, as shown in Table IVA-2. Without seasonal adjustment, house prices fell from Dec 2010 throughout Mar 2011 and then increased in every month from Apr to Aug but fell in both Sep and Oct. In Sep, house prices of the 10-city composite seasonally adjusted fell 0.5 percent and fell 0.7 percent for the 20-city composite. The not seasonally adjusted index registers declines of 0.5 percent in Sep and 1.1 percent in Oct for the 10-city composite and declines of 0.7 percent in Sep and 1.2 percent in Oct for the 20-city composite. Declining house prices cause multiple adverse effects of which two are quite evident. (1) There is a disincentive to buy houses in continuing price declines. (2) More mortgages could be losing fair market value relative to mortgage debt. Another possibility is a wealth effect that consumers restrain purchases because of the decline of their net worth in houses.

Table IVA-2, US, Monthly Percentage Change of S&P Case-Shiller Home Price Indices, Seasonally Adjusted, ∆%

	10-City Composite SA	10-City Composite NSA	20-City Composite SA	20-City Composite NSA
Oct 2011	-0.5	-1.1	-0.6	-1.2
Sep	-0.5	-0.5	-0.7	-0.7
Aug	-0.3	0.1	-0.4	0.1
Jul	-0.1	0.9	-0.1	0.9
Jun	-0.1	1.0	-0.1	1.1
May	-0.03	1.0	-0.04	1.1
Apr	0.5	0.6	0.5	0.6
Mar	-0.6	-0.9	-0.7	-1.0
Feb	-0.4	-1.3	-0.3	-1.2
Jan	-0.3	-1.1	-0.2	-1.1
Dec 2010	-0.3	-0.9	-0.3	-0.9

Source: http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----

VB Japan. The Markit/JMMA Purchasing Managers’ Index^™ (PMI^™) increased from 49.1 in Nov to 50.2 in Dec, which is above the contraction zone of 50 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8968). The index suggests only marginal growth. New export business fell in Dec with the contraction extending over ten months. There was marginal improvement in employment. Alex Hamilton, economist at Markit and author of the report finds better operating conditions in Japan’s manufacturing in Dec (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8968). The Markit Japan Services PMI^™ Composite Output Index fell 3.5 percentage points from 52.4 in Oct to 48.9 in Nov, meaning that private-sector activity has fallen into contraction territory (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8899). Alex Hamilton, economist at Markit and author of the report, finds that panelists view unfavorably the outlook of private-sector activity in the coming 12 months (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8899). The strong yen and weak world economic growth are beginning to affect manufacturing in Japan. The Markit/JMMA Japan Manufacturing PMI^TM registered 49.1 in Nov from 50.6 in Oct for the sharpest acceleration of decline of output since Apr after the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8837). Alex Hamilton, economist at Markit and author of the report, finds that weakening demand originated in the appreciated yen together with declining new orders from emerging Asia especially China (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8837). Table JPY provides the country data table for Japan.

Table JPY, Japan, Economic Indicators

Historical GDP and CPI	1981-2010 Real GDP Growth and CPI Inflation 1981-2010 Blog 07/31/11
Corporate Goods Prices	Nov ∆% 0.1 12 months ∆% 1.7 Blog 12/18/11
Consumer Price Index	Nov NSA ∆% minus 0.6 Nov 12 months NSA ∆% -0.5 Blog 01/01/12
Real GDP Growth	IIIQ2011 ∆%: 1.4 on IIQ2011; IIIQ2011 SAAR 5.6% ∆% from quarter a year earlier: -0.7 % Blog 12/11/11
Employment Report	Nov Unemployed 2.80 million Change in unemployed since last year: minus 380 thousand Unemployment rate: 4.5% Blog 01/01/12
All Industry Index	Oct month SA ∆% 0.8 12 months NSA ∆% 0.2 Blog 12/27/11
Industrial Production	Nov SA month ∆%: minus 2.6 12 months NSA ∆% minus 0.4 Blog 01/01/12
Machine Orders	Total Oct ∆% 3.2 Private ∆%: -9.2 Sep ∆% Excluding Volatile Orders -6.9 Blog 12/04/2011
Tertiary Index	Oct month SA ∆% 0.6 Oct 12 months NSA ∆% 0.5 Blog 12/18/2011
Wholesale and Retail Sales	Nov 12 months: Total ∆%: minus 2.5 Wholesale ∆%: minus 2.6 Retail ∆%: minus 2.3 Blog 01/01/12
Family Income and Expenditure Survey	Nov 12 months ∆% total nominal consumption minus 3.8, real minus 3.2 Blog 01/01/12
Trade Balance	Exports Nov 12 months ∆%: -4.5 Imports Nov 12 months ∆% 11.4 Blog 12/27/11

Links to blog comments in Table JPY:

12/27/11 http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable_27.html

12/18/11 http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html

12/11/2011 http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial.html

12/0411 http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html

07/31/11: http://cmpassocregulationblog.blogspot.com/2011/07/growth-recession-debt-financial-risk.html

Japan’s industrial production fell 2.6 percent in Nov relative to Oct and 4.0 percent relative to a year earlier, as shown in Table IVB-1. In Oct, industrial production increased 2.2 percent and 0.1 percent relative to a year earlier. The decline of 4.0 percent in Sep was revised to minus 3.3 percent and in 12 months also from minus 4.0 percent to minus 3.3 percent. Monthly industrial production had climbed in every month since the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011, with exception of Sep but fell again in Nov. Industrial production was higher in 12 months for the first month in Aug by 0.4 percent and again in Oct by 0.1 percent but is now 4.0 percent lower in Nov 2011 than a year earlier. Industrial production fell 21.9 percent in 2009 after falling 3.4 percent in 2008 but recovered 16.4 percent in 2010.

Table IVB-1, Japan, Industrial Production ∆%

	∆% Month SA	∆% 12 Months NSA
Nov 2011	-2.6	-4.0
Oct	2.2	0.1
Sep	-3.3	-3.3
Aug	0.6	0.4
Jul	0.4	-3.0
Jun	3.8	-1.7
May	6.2	-5.5
Apr	1.6	-13.6
Mar	-15.5	-13.1
Feb	1.8	2.9
Jan	0.0	4.6
Dec 2010	2.4	5.9
Calendar Year
2010		16.4
2009		-21.9
2008		-3.4

Source: http://www.meti.go.jp/statistics/tyo/iip/result/pdf/press/h2a1011j.pdf

The employment report for Japan in Nov is in Table IVB-2. The rate of unemployment fell from 4.6 percent in Jul to 4.1 percent in Sep but increased to 4.5 percent in Nov. The number unemployed has declined by 380 thousand, or 11.9 percent, relative to a year earlier.

Table IVB-2, Japan, Employment Report Nov 2011

Unemployed	2.80 million
Change since last year	-380 thousand; ∆% –11.9
Unemployment rate	4.5% SA 0.0 from ; 0.0 from prior month Oct; NSA 4.3%, –0.5 from earlier year
Population ≥ 15 years	110.4 million
Change since last year	∆% –0.1
Labor Force	65.4 million
Change since last year	∆% –0.5
Employed	62.6 million
Change since last year	% 0.1
Labor force participation rate	59.2
Change since last year	-0.2
Employment rate	56.7%
Change since last year	0.1

Source: http://www.stat.go.jp/english/data/roudou/154.htm

Japan, Statistics Bureau, Ministry of Internal Affairs and Communications

http://www.stat.go.jp/english/data/roudou/154.htm

Chart IVB-1 of Japan’s Statistics Bureau at the Ministry of Internal Affairs and Communications provides the unemployment rate of Japan from 2009 to 2011. The sharp decline in Sep is the best reading in 2011 but the rate increased in Oct and stabilized in Nov.

Chart IVB-1, Japan, Unemployment Rate 2008-2011

Source: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications

http://www.stat.go.jp/english/data/roudou/154.htm

During the “lost decade” of the 1990s from 1991 to 2002 (Pelaez and Pelaez, The Global Recession Risk (2007), 82-3), Japan’s GDP great at the average yearly rate of 1.0 percent, the CPI at 0.1 percent and the implicit deflator at minus 0.8 percent. Japan’s growth rate from the mid 1970s to 1992 was 4 percent (Ito 2004). Table IVB-3 provides Japan’s rates of unemployment, participation in labor force and employment for 1968, 1975, 1980 and 1985 and yearly from 1990 to 2010. The rate of unemployment jumped from 2.1 percent in 1991 to 5.4 percent in 2002, which was a year of global economic weakness. The participation rate dropped from 63.8 percent in 1992 to 61.2 percent in 2002 and the employment rate fell from 62.4 percent in 1992 to 57.9 percent in 2002. The rate of unemployment rose from 3.9 percent in 2007 to 5.1 percent in 2010 while the participation rate fell from 60.4 percent to 59.6 percent and the employment rate fell from 58.1 percent to 56.6 percent. The global recession adversely affected labor markets in advanced economies.

Table IVB-3, Japan, Rates of Unemployment, Participation in Labor Force and Employment, %

	Unemployment Rate	Participation Rate	Employment Rate
1968	1.2	65.9	65.1
1975	1.9	63.0	61.9
1980	2.0	63.3	62.0
1985	2.6	63.0	61.4
1990	2.1	63.3	61.9
1991	2.1	63.8	62.4
1992	2.2	64.0	62.6
1993	2.5	63.8	62.2
1994	2.9	63.8	61.8
1995	3.2	63.4	61.4
1996	3.4	63.5	61.4
1997	3.4	63.7	61.5
1998	4.1	63.3	60.7
1999	4.7	62.9	59.9
2000	4.7	62.4	59.5
2001	5.0	62.0	58.9
2002	5.4	61.2	57.9
2003	5.3	60.8	57.6
2004	4.7	60.4	57.6
2005	4.4	60.4	57.7
2006	4.1	60.4	57.9
2007	3.9	60.4	58.1
2008	4.0	60.2	57.8
2009	5.1	59.9	56.9
2010	5.1	59.6	56.6

Source: http://www.stat.go.jp/english/data/roudou/154.htm

The survey of household income and consumption of Japan in Table IVB-4 is showing noticeable improvement in Sep relative to earlier months, which can be appreciated in the chart in the link in parentheses but followed by decline in Nov (http://www.stat.go.jp/english/data/kakei/156.htm). Total consumption fell 3.2 percent in real terms in Nov and fell 3.8 percent in nominal terms. There are only a few segments of increasing consumption: clothing and footwear 5.6 percent, education 19.6 percent and transport and communications 0.1 percent in nominal terms. Household income, disposable income and consumption expenditures all fell in nominal and real terms in Nov 2011 relative to a year earlier.

Table IVB-4, Japan, Family Income and Expenditure Survey 12-months ∆% Relative to a Year Earlier

Nov 2011	Nominal	Real
Households of Two or More Persons
Total Consumption	-3.8	-3.2
Excluding Housing, Vehicles & Remittance		-4.0
Food	-0.8	0.4
Housing	-5.7	-5.6
Fuel, Light & Water Charges	-3.1	-7.6
Furniture & Household Utensils	-10.6	-4.8
Clothing & Footwear	5.6	5.6
Medical Care	-2.5	-1.3
Transport and Communications	0.1	-1.5
Education	19.8	19.6
Culture & Recreation	-24.4	-21.2
Other Consumption Expenditures	-1.3	-0.7*
Workers’ Households
Income	-1.6	-1.0
Disposable Income	-1.8	-1.2
Consumption Expenditures	-4.7	-4.1

*Real: nominal deflated by CPI excluding imputed rent

Source: http://www.stat.go.jp/english/data/kakei/156.htm

Japan is experiencing weak internal demand as in most advanced economies. Table IVB-5 provides Japan’s retail and wholesale sales. Retail sales fell 2.3 percent in Nov after increasing 1.9 percent in the 12 months ending in Oct and falling 1.1 percent in the 12 months ending in Sep. Retail sales have not recovered yet from the deep drops in Mar and Apr following the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Wholesale sales had been driving total sales but grew only 0.5 percent in Nov such that total sales fell 2.5 percent.

Table IVB-5, Japan, Wholesale and Retail Sales 12 Month ∆%

	Total	Wholesale	Retail
Nov 2011	-2.5	-2.6	-2.3
Oct	1.1	0.8	1.9
Sep	0.3	0.8	-1.1
Aug	3.1	5.2	-2.6
Jul	2.3	3.0	0.6
Jun	3.1	3.8	1.2
May	1.3	2.3	-1.3
Apr	-2.6	-1.7	-4.8
Mar	-1.3	1.2	-8.3
Feb	5.3	7.2	0.1
Jan	3.3	4.6	0.1
Dec 2010	3.5	5.7	-2.1
Calendar Year
2010	1.5	1.1	2.5
2009	-20.5	-25.6	-2.3
2008	1.2	1.5	0.3

Source: http://www.meti.go.jp/english/statistics/tyo/syoudou/index.html

IVC China. The HSBC Purchasing Managers’ Index^™ (PMI^™), compiled by Markit, summarizing conditions in China’s manufacturing rose from 47.7 in Nov to 48.7 in Dec, indicating marginally deteriorating business (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8969). Hongbin Qu, Chief Economist, China & Co-Head of Asian Economic Research at HSBC finds weakness in external demand that is causing slowdown in the economy (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8969), supporting fiscal and monetary policies that can avoid hard landing. Owen Fletcher, writing on Jan 1, on “Signs of strength in Chinese economy,” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203550304577133822170242612.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that China’s official purchasing managers’ index increased from 49.0 in Nov to expansion territory at 50.3 in Dec (http://professional.wsj.com/article/SB10001424052970203550304577133822170242612.html?mod=WSJ_hp_LEFTWhatsNewsCollection). The HSBC Composite Output Index for China, compiled by Markit, registered a decline from 52.6 in Oct to 48.9 in Nov (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8898). The composite index combined activity in manufacturing and services such that joint output has moved into contraction territory below 50. A favorable aspect in the index is growth of services employment at the fastest rate in five months, which could maintain demand at high levels. Hongbin Qu, Chief Economist, China & Co-Head of Asian Economic Research at HSBC, finds that policy could build on the growth of employment in services and the reduction of price pressures to ensure growth above 8 percent in 2012. The HSBC China Manufacturing PMI^™ compiled by Markit fell from 51.0 in Oct to 47.7 in Nov, which is the lowest in 32 months, indicating sharp deterioration of manufacturing in China (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8859). The good news in the index is the decline in average input costs for the first time in 16 months. The decline in new business was the prime reason for falling output but export business continued to increase. Hongbin Qu, Chief Economist, China & Co-head of Asian Economic Research at HSBC finds that the combination of weakening production and subdued inflation can lead to easing policies that may still ensure growth of 8 percent for China in 2012. The HSBC Flash China Manufacturing PMI^™, compiled by Markit, rose from 47.7 in Nov to 49.0 in Dec while the China Manufacturing Output index rose to 49.5 in Dec from 46.1 in Nov (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8932). Both indexes rose to two-month highs and indicate marginal contraction. Table CNY provides the country data table for China.

Table CNY, China, Economic Indicators

Price Indexes for Industry	Nov 12 months ∆%: 2.7 Jan-Nov ∆%: 6.4 Nov month ∆%: -0.7 Blog 12/11/11
Consumer Price Index	Nov month ∆%: -0.2 Nov 12 month ∆%: 4.2 Jan-Nov ∆%: 5.5 Blog 12/11/11
Value Added of Industry	Nov 12 month ∆%: 12.4 Jan-Nov 2011/Jan-Oct 2010 ∆%: 14.0 Blog 12/18/11
GDP Growth Rate	Year IIIQ2011 ∆%: 9.1 Quarter IIQ2011 ∆%: 2.2 Blog 10/23/11
Investment in Fixed Assets	Total Jan-Nov ∆%: 24.4 Jan-Nov ∆% real estate development: 29.9 Blog 12/18/11
Retail Sales	Nov month ∆%: 1.3 Nov 12 month ∆%: 17.3 Jan-Nov ∆%: 17.0 Blog 12/11/11
Trade Balance	Nov balance $14.52 billion Exports ∆% 13.8 Imports ∆% 22.1 Cumulative Nov: $138.55 billion Blog 12/11/11

Links to blog comments in Table CNY: 12/18/11 http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html

12/11/11 http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial_11.html

10/23/11 http://cmpassocregulationblog.blogspot.com/2011/10/properity-without-inflation-world.html

IVD Euro Area. The Markit Eurozone PMI^® Composite Output Index, combining manufacturing and services with high correlation with euro zone GDP, improved from 46.5 in Oct to 47.0 in Nov, meaning contraction of private-sector economic activity for the third consecutive month (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8887). The output of all big-four economies of the euro zone—Germany, France, Italy and Spain—contracted simultaneously for the first time since Jul 2009. Chris Williamson, Chief Economist at Markit, finds that the data in the index are consistent with economic contraction of the euro zone by 0.6 percent in IVQ2011 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8887). Italy’s GDP could decline by 1 percent in IVQ2011 with France and Spain contracting by 0.5 percent. Germany could experience a milder decline but manufacturing is falling with weakness in export orders. The Markit Eurozone Manufacturing PMI^® that is highly associated with euro zone manufacturing fell from 47.1 in Oct to 46.4 in Nov, which is the lowest reading in 28 months (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8840). Chris Williamson, Chief Economist at Markit, finds that production and new orders declined at the fastest rates since the first half of 2009 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8840). All individual indexes of countries in the report fell for the first time since the middle of 2009.

Table EUR provides the regional country data table for the euro zone. The Nov index is consistent with a rate of contraction of manufacturing output at 2 percent in the final quarter of 2011. The debt crisis has introduced significant uncertainty in regional business. The Markit Flash Eurozone PMI^® Composite Output Index rose to 47.9 in Dec from 47.0 in Nov, indicating milder contraction in the weakest quarter in the euro zone in two and half years (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8939). Table EUR provides the regional country data table for the euro zone.

Table EUR, Euro Area Economic Indicators

GDP	IIIQ2011 ∆% 0.2; IIIQ2011/IIIQ2010 ∆% 1.4 Blog 12/04/11
Unemployment	Oct 2011: 10.3% unemployment rate Oct 2011: 16.294 million unemployed Blog 12/04/11
HICP	Nov month ∆%: 0.1 12 months Nov ∆%: 3.0 Blog 12/18/11
Producer Prices	Euro Zone industrial producer prices Oct ∆%: 0.1 Oct 12 months ∆%: 5.5 Blog 12/04/11
Industrial Production	Oct month ∆%: -0.1 Sep 12 months ∆%: 1.3 Blog 12/18/11
Industrial New Orders	Sep month ∆%: minus 6.4 Sep 12 months ∆%: 1.6 Blog 12/04/11
Construction Output	Oct month ∆%: -1.4 Oct 12 months ∆%: -2.8 Blog 12/27/11
Retail Sales	Oct month ∆%: minus 0.4 Oct 12 months ∆%: minus 0.4 Blog 12/04/11
Confidence and Economic Sentiment Indicator	Sentiment 93.7 Nov 2011 down from 107 in Dec 2010 Confidence minus 20.4 Oct 2011 down from minus 11 in Dec 2010 Blog 12/04/11
Trade	Jan-Oct 2011/2010 Exports ∆%: 13.3 Imports ∆%: 13.8 Blog 12/18/11
HICP, Rate of Unemployment and GDP	Historical from 1999 to 2011 Blog 12/04/11 9/04/11

Links to blog comments in Table EUR:

12/27/11 http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html

12/04/11 http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html

09/04/11 http://cmpassocregulationblog.blogspot.com/2011/09/global-growth-standstill-recession.html

IVE Germany. The Markit Germany Composite Output Index, combining output of the manufacturing and service sectors, fell below the zone of 50.0 below zero for the first time since Jul 2009, registering 49.4 in Nov compared with 50.3 in Oct (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8876

). The decline in manufacturing production offset the Markit Germany Services Business Activity Index at 50.3 in Nov, which was lower than 50.6 in Oct. New work in services is experiencing the longest period of decline since the global recession in 2008 and 2009. Tim Moore, Senior Economist at Markit and author of the report, evaluates that stagnation may be the best outcome for the German economy in IVQ2011. The Markit/BME Germany Purchasing Managers’ Index^® (PMI^®) fell from 49.1 in Oct to 47.9 in Nov for the seventh consecutive month (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8860). The index registered the fastest deterioration of overall manufacturing since Jul 2009. While the declines in output and new orders were the fastest since Jun 2009, the rates of decline are much more benign than those experienced during the global recession of 2008 and 2009. Tim Moore, Senior Economist at Markit and author of the report, finds resilience in output of consumer goods that compensated for declines in manufacturing export orders (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8860). The Markit Flash Germany PMI^® Composite Output Index rose from 49.4 in Nov to 51.3 in Dec, for a four-month high, indicating return to expansion at a moderate rate (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8927).

Table DE, Germany, Economic Indicators

GDP	IIIQ2011 0.5 ∆%; III/Q2011/IIIQ2010 ∆% 2.5 Blog 11/27/11
Consumer Price Index	Dec month SA ∆%: 0.7 Dec 12 months ∆%: 2.1 Blog 01/01/12
Producer Price Index	Oct month ∆%: 0.1 12 months NSA ∆%: 5.2 Blog 12/27/11
Industrial Production	Oct month SA ∆%: minus 0.8 12 months NSA: 1.4 Blog 12/11/11
Machine Orders	Oct month ∆%: 5.2 Oct 12 months ∆%: 2.0 Blog 12/11/11
Retail Sales	Oct Month ∆% 0.7 12 Months ∆% -0.4 Blog 12/04/11
Employment Report	Employment Accounts: Oct Employed 12 months NSA ∆%: 2.9 Labor Force Survey: Aug Unemployment Rate: 5.2% Blog 12/04/11
Trade Balance	Exports Oct 12 month NSA ∆%: 3.8 Imports Oct 12 months NSA ∆%: 8.6 Exports Oct month SA ∆%: -3.6 percent; Imports Oct month SA minus 1.0 Blog 12/11/11

Links to blog comments in Table DE:

12/27/11 http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable_27.html

12/11/11 http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial_11.html

12/04/11 http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html

11/27/11 http://cmpassocregulationblog.blogspot.com/2011/11/us-growth-standstill-falling-real.html

IVF France. There was an improvement in the Markit France Services Activity Index for a two-month high from 44.6 in Oct to mild contraction at 49.6 in Nov that compensated the acceleration of decline in manufacturing. As a result the Markit France Composite Output Index, combining manufacturing and services, rose to a two-month high of 48.8 in Nov from 45.6 in Oct (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8906). Jack Kennedy, Senior Economist at Markit and author of the France Services PMI^®, finds that weak readings are suggesting contraction of the French economy in IVQ2011 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8906). Uncertainty from the euro zone debt crisis is driving down confidence in the service sector. The Markit France Manufacturing Purchasing Managers Index^® (PMI^®) fell to 47.3 in Nov from 48.5 in Oct, which is the lowest reading since Jun 2009 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8861). The index has been in the contraction zone below 50 during four consecutive months. New orders fell at the sharpest rate since Apr 2009 and have fallen during five consecutive months. Jack Kennedy, Senior Economist at Markit, and author of the France Manufacturing PMI^® find increasing weakness in domestic and export demand (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8861). The Markit Flash France PMI^® Composite Output Index increased from 48.8 in Nov to a three-month high at 49.8 in Dec (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8926). Table FR provides France’s country data table.

Table FR, France, Economic Indicators

CPI	Nov month ∆% 0.3 12 months ∆%: 2.5 12/18/11
PPI	Oct month ∆%: 0.4 Oct 12 months ∆%: 5.6 Blog 12/27/11
GDP Growth	IIIQ2011/IIQ2011 ∆%: 0.3 IIIQ2011/IIIQ2010 ∆%: 1.5 Blog 12/27/11
Industrial Production	Oct/Sep SA ∆%: Industrial Production 0.0; Manufacturing minus 0.0 Oct 12 months NSA ∆%: Industrial Production 2.3; Manufacturing 3.1 Blog 12/11/11
Industrial New Orders	Mfg Oct/Sep ∆% 0.3 YOY ∆% 5.0 Blog 12/27/11
Consumer Spending	Oct Manufactured Goods ∆%: 0.3 Oct 12 Months Manufactured Goods ∆%: minus 0.2 Blog 12/04/11
Employment	IIIQ2011 Unemployed 2.631 million Unemployment Rate: 9.3% Employment Rate: 63.8% Blog 12/04/11
Trade Balance	Oct Exports ∆%: month 0.5, 12 months 6.3 Oct Imports ∆%: month minus 0.3, 12 months 7.4 Blog 12/11/11
Confidence Indicators	Historical averages 100 Dec: France 92 Mfg Business Climate 94 Retail Trade 93 Services 91 Building 99 Household 79 Blog 12/18/11

Links to blog comments in Table FR:

12/27/11 http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable_27.html

12/18/11 http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html

12/11/11 http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial_11.html

12/04/11 http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html

IVG Italy. The Markit/ADACI Business Activity Index rose from 43.9 in Oct to 45.8 in Nov (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8900

). Business activity in Italian services has contracted during seven consecutive months. Phil Smith, economist at Markit and author of the Italy Services PMI^®, finds increasing evidence that the economy of Italy may have moved into recession during the second half of 2011 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8900). Cost inflation fell to the lowest since Feb 2010. The Markit/ADACI Italy Purchasing Managers’ Index^® (PMI^®) rose slightly from the 28-month low of 43.3 in Oct to 44.0 in Nov in the fourth month of deterioration of Italy’s manufacturing (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8842). The pace of decline of new business for Italy’s manufacturing continued at the two-and-a half year low registered in Oct and export business declined at the fastest rhythm since Aug 2009. Table IT provides the data table for Italy.

Table IT, Italy, Economic Indicators

Consumer Price Index	Nov month ∆%: -0.1 Nov 12 months ∆%: 3.3 Blog 12/18/11
Producer Price Index	Nov month ∆%: 0.2 Nov 12 months ∆%: 4.5 Blog 01/01/12
GDP Growth	IIIQ2011/IIIQ2010 SA ∆%: 0.2 IIIQ2011/IIQ2011 NSA ∆%: -0.2 Blog 12/27/11
Labor Report	Jul 2011 Participation rate 62% Employment ratio 56.9% Unemployment rate 8.0% Blog 09/04/11
Industrial Production	Oct month ∆%: minus 0.9 12 months ∆%: minus 4.2 Blog 12/11/11
Retail Sales	Oct month ∆%: -0.5 Oct 12 months ∆%: minus 1.5 Blog 12/27/11
Business Confidence	Mfg Dec 92.5, Aug 98.5 Construction Dec 80.1, Aug 77.3 Blog 01/01/12
Consumer Confidence	Consumer Confidence Dec 91.6, Nov 96.1 Economy Dec 77.2, Nov 83.1 Blog 12/27/11
Trade Balance	Balance Oct SA -€ 1965 million versus Sep -€ 1332 Exports Oct month SA ∆%: -3.2; Imports Oct month SA ∆%: -1.1 Exports 12 months NSA ∆%: 4.5 Imports 12 months NSA ∆%: -0.3 Blog 12/27/11

Links to blog comments in Table IT:

12/27/11 http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable_27.html

12/18/11 http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html

12/11/11 http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial_11.html

12/04/11 http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html

09/04/11 http://cmpassocregulationblog.blogspot.com/2011/09/global-growth-standstill-recession.html

Italy’s index of business confidence in manufacturing and construction is provided in Table IVG-1. There has been deterioration below the historical average of 100 since 98.5 in Aug with reading of 92.5 in Dec. Order books have fallen from minus 22 in Aug to minus 33 in Nov. There is mild improvement in construction with an increase of the index from 77.3 in Aug to 80.1 in Dec.

Table IVG-1, Italy, Index of Business Confidence in Manufacturing and Construction 2005=100

	Dec	Nov	Oct	Sep	Aug
Mfg Confidence	92.5	94.0	93.9	94.4	98.5
Order Books	-33	-31	-30	-28	-22
Stocks Finished Products	3	1	1	1	2
Production Expectation	0	2	0	-1	6
Construction Confidence	80.1	87.2	80.5	78.9	77.3
Order Books	-50	-42	-46	-50	-54
Employment	-16	-11	-19	-18	-17

Mfg: manufacturing

Source: http://www.istat.it/it/archivio/48960

IVH United Kingdom. The Markit/CIPS UK Services PMI^® finds a recurring pattern of weakness in manufacturing partly compensated by relatively stronger services. The Markit/CIPS Business Activity Index registered 52.1 in Nov, suggesting modest growth somewhat higher than 51.3 in Oct (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8903). The index has exceeded the no change zone of 50 in all the first ten months of 2011. Chris Williamson, Chief Economist at Markit, finds that the sharp drop of manufacturing combined with modest improvement in services suggests stagnation of the UK economy in IVQ2011 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8903).The Markit/CIPS UK Manufacturing Purchasing Managers’ Index^® (PMI^®) declined to 47.6 in Nov from the upwardly revised 47.8 in Oct for the lowest level since Jun 2009 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8853). There have been three consecutive monthly declines of manufacturing output in the UK and the rate of decline in Nov was the fastest in more than two-and-a-half year. Declining new orders determined the decline in output as a result of weak domestic and international markets. Table UK provides the data table for the United Kingdom.

Table UK, UK Economic Indicators


CPI	Nov month ∆%: 0.2 Nov 12 months ∆%: 5.0 Blog 12/18/11
Output/Input Prices	Output Prices: Nov 12 months NSA ∆%: 5.4; excluding food, petroleum ∆%: 3.2 Input Prices: Nov 12 months NSA ∆%: 13.4 Excluding ∆%: 10.0 Blog 12/11/11
GDP Growth	IIIQ2011 prior quarter ∆% 0.6; year earlier same quarter ∆%: 0.5 Blog 12/27/11
Industrial Production	Oct 2011/Oct 2010 NSA ∆%: Industrial Production minus 1.7; Manufacturing 0.3 Blog 12/11/11
Retail Sales	Nov month SA ∆%: -0.4 Oct 12 months ∆%: 0.7 Blog 12/18/11
Labor Market	Aug-Oct Unemployment Rate: 8.3% Blog 12/18/11
Trade Balance	Balance Oct minus ₤1,552 million Exports Oct ∆%: 5.8 Aug/Oct ∆%: 9.9 Imports Oct ∆%: -0.1 Aug/Oct ∆%: 7.2 Blog 12/11/11

Links to blog comments in Table UK:

12/27/11

http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable_27.html

12/18/11 http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html

12/11/11 http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial_11.html

12/04/11 http://cmpassocregulationblog.blogspot.com/2011/12/twenty-nine-million-in-job-stress.html

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/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html

Table V-1 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 unconventional monetary policy encouraging carry trades 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 V-1 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 of 8.6 percent by Fri Dec 30, 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, misallocating resources toward less productive economic activities and disrupting financial markets. The last row of Table V-1 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 V-1, 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	12/30 /2011
Rate	1.1423	1.5914	1.192	1.294
CNY/USD	01/03 2000	07/21 2005	7/15 2008	12/30 2011
Rate	8.2798	8.2765	6.8211	6.294
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://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata

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 V-2 extracts four rows of Table VI-I 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 V-4 below, the dollar has devalued again to USD 1.294/EUR or by 8.6 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 subsequently revaluing 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 6.294/USD on Fri Dec 30, 2011, or by an additional 7.7 percent, for cumulative revaluation of 23.9 percent. The Dow Jones Newswires informs on Oct 15 that the premier of China Wen Jiabao announced that the Chinese yuan will not be further appreciated to prevent adverse effects on exports (http://professional.wsj.com/article/SB10001424052970203914304576632790881396896.html?mod=WSJ_hp_LEFTWhatsNewsCollection). The policy appeared to be implemented because the rate of CNY 6.3838/USD on Oct 21, 2011, amounts to a small depreciation of 0.1 percent relative to the rate of CNY 6.379/USD a week earlier on Oct 14, 2011. Table V-2 now includes three last rows with the CNY/USD weekly rate. The final row of Table V-2 shows the percentage change from the prior week with positive signs for appreciation and negative signs for depreciation. In the week of Nov 11 there was no change but the CNY depreciated by 0.2 percent in the week of Nov 18 and by a further 0.4 percent in the week of Nov 25, for cumulative depreciation of 0.6 percent in the two weeks. In the week of Dec 2, revaluation returned with appreciation of 0.3 percent. In the week of Dec 9, there was minute depreciation of 0.1 percent. Revaluation continued with 0.3 percent in the week of Dec 16 and 0.2 percent in the week of Dec 23. Revaluation accelerated in the week of Dec 30 with appreciation of 0.7 percent. Meanwhile, the Senate of the US is proceeding with a bill on China’s trade that could create a confrontation but may not be approved by the entire Congress.

Table V-2, Dollar/Euro (USD/EUR) Exchange Rate and Chinese Yuan/Dollar (CNY/USD) Exchange Rate

USD/EUR	12/26/03	7/14/08	6/07/10	12/30 /2011
Rate	1.1423	1.5914	1.192	1.294
CNY/USD	01/03 2000	07/21 2005	7/15 2008	12/30 2011
Rate	8.2798	8.2765	6.8211	6.294
Weekly Rates	12/09/ 2011	12/16/ 2011	12/23/ 2011	12/30/ 2011
CNY/USD	6.3644	6.3484	6.3372	6.294
∆% from Earlier Week*	-0.1	0.3	0.2	0.7

*Negative sign is depreciation, positive sign is appreciation

Source: Table V-1 and same table in earlier blog posts.

Dollar devaluation did not eliminate the US current account deficit, which is projected by the International Monetary Fund (IMF) with the new database of Sep 2011 at 3.1 percent of GDP in 2011 and at 2.2 percent of GDP in 2015, as shown in Table V-3. Revaluation of the CNY has not reduced the current account surplus of China, which is projected by the IMF to increase from 5.2 percent of GDP in 2011 to 7.0 percent of GDP in 2015.

Table V-3, Fiscal Deficit, Current Account Deficit and Government Debt as % of GDP and 2011 Dollar GDP

	GDP $B 2011	FD %GDP 2011	CAD %GDP 2011	Debt %GDP 2011	FD%GDP 2015	CAD%GDP 2015	Debt %GDP 2015
US	15065	-7.9	-3.1	72.6	-3.1	-2.2	86.7
Japan	5855	-8.9	2.5	130.5	-8.4	2.4	160.0
UK	2481	-5.7	-2.7	72.9	0.4	-0.9	75.2
Euro	13355	-1.5	0.1	68.6	1.5	0.5	69.3
Ger	3629	0.4	5.0	56.9	2.1	4.7	55.3
France	2808	-3.4	-2.7	80.9	-2.5	0.6	83.9
Italy	2246	0.5	-3.5	100.4	4.5	-2.0	96.7
Can	1759	-3.7	-3.3	34.9	0.3	-2.6	35.1
China	6988	-1.6	5.2	22.2	0.1	7.0	12.9
Brazil	2518	3.2	-2.3	38.6	2.9	-3.2	34.1

Note: GER = Germany; Can = Canada; FD = fiscal deficit; CAD = current account deficit

FD is primary except total for China; Debt is net except gross for China

Source: http://www.imf.org/external/pubs/ft/weo/2011/02/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 V-1 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 now with realization of growth standstill recession. 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 driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion. Table V-4, 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.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 12/30/11,” which has been recently stalling or reversing amidst profound risk aversion. “Let’s twist again” monetary policy during the week of Sep 23 caused deep worldwide risk aversion and selloff of risk financial assets (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html). Monetary policy was designed to increase risk appetite but instead suffocated risk exposures. After the surge in the week of Dec 2, mixed performance of markets in the week of Dec 9, renewed risk aversion in the week of Dec 16, end-of-the-year relaxed risk aversion in thin markets in the weeks of Dec 23 and Dec 30 there are now only three financial values with negative change in valuation in column “∆% Trough to 12/23/11:” NYSE Financial minus 4.4 percent, Japan’s Nikkei Average minus 4.2 percent and Shanghai Composite minus 7.7 percent. Asia and financial entities are experiencing their own risk environments. The highest valuations are by US equities indexes: DJIA 26.1 percent and S&P 500 22.9 percent. Michael Mackenzie and Robin Wigglesworth, writing on Oct 21, 2011, on “Us earnings tell story of resilience,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/c44187d4-fb1f-11e0-bebe-00144feab49a.html#axzz1bVlVmY6d), analyze the strong earnings performance of US companies that explains the recovery of the DJIA by 26.9 percent from the trough and of the S&P 500 by 23.7 percent. Mackenzie and Wigglesworth quote S&P Capital IQ that a blended average of actual and forecast earnings on IIIQ2011 relative to IIIQ2010 could show growth of 14.6 percent. The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, all assets in the column “∆% Trough to 12/30/11” had double digit gains relative to the trough around Jul 2, 2010 but now most valuations show increases of less than 10 percent: Dow Global is 5.8 percent above the trough; Dow Asia Pacific is now higher by 1.5 percent; and Dax is 4.0 percent above the trough on May 25, 2010. Japan’s Nikkei Average is 4.2 percent below the trough on Aug 31, 2010 and 25.8 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 8455.35 on Fri Dec 30, which is 17.5 percent lower than 10,254.43 on Mar 11 on the date of the Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 8.6 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 12/30/2011” in Table V-4 shows mixed performance of risk financial assets in the week of Dec 30. There are still high uncertainties on European sovereign risks, US and world growth recession and China’s growth and inflation tradeoff. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table V-4 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 12/30/11” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Dec 2, 2011. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 12/30/11” but also relative to the peak in column “∆% Peak to 12/30/11.” There are now only two US equity indexes above the peak in Table V-4: DJIA 9.0 percent and S&P 500 3.3 percent. There are several indexes well below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 23.9 percent, Nikkei Average by 25.8 percent, Shanghai Composite by 30.5 percent, STOXX 50 by 12.6 percent, Dow Global by 13.7 percent and Dow Asia Pacific by 11.1 percent. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 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. The situation of risk financial assets has worsened.

Table V-4, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 12/30 /11	∆% Week 12/30/ 11	∆% Trough to 12/30 11
DJIA	4/26/ 10	7/2/10	-13.6	9.0	-0.6	26.1
S&P 500	4/23/ 10	7/20/ 10	-16.0	3.3	-0.6	22.9
NYSE Finance	4/15/ 10	7/2/10	-20.3	-23.9	-1.0	-4.4
Dow Global	4/15/ 10	7/2/10	-18.4	-13.7	-0.1	5.8
Asia Pacific	4/15/ 10	7/2/10	-12.5	-11.1	0.3	1.5
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-25.8	0.7	-4.2
China Shang.	4/15/ 10	7/02 /10	-24.7	-30.5	-0.2	-7.7
STOXX 50	4/15/10	7/2/10	-15.3	-12.6	1.3	3.2
DAX	4/26/ 10	5/25/ 10	-10.5	-6.9	0.3	4.0
Dollar Euro	11/25 2009	6/7 2010	21.2	14.5	0.8	-8.6
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	-3.0	-0.4	13.5
10-Year T Note	4/5/ 10	4/6/10	3.986	1.871

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

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 V-5 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. The last row of Table V-5 for Dec 30 shows that the S&P 500 is now 3.8 percent above the Apr 26, 2010 level and the DJIA is 9.0 percent above the level on Apr 26, 2010. Multiple rounds of risk aversion eroded the earlier gains, showing that risk aversion can destroy market value even with zero interest rates. Much the same as zero interest rates and quantitative easing have not had any effects in recovering economic activity while distorting financial markets and resource allocation.

Table V-5, Percentage Changes of DJIA and S&P 500 in Selected Dates

2010	∆% DJIA from prior date	∆% DJIA from Apr 26	∆% S&P 500 from prior date	∆% S&P 500 from Apr 26
Apr 26
May 6	-6.1	-6.1	-6.9	-6.9
May 26	-5.2	-10.9	-5.4	-11.9
Jun 8	-1.2	-11.3	2.1	-12.4
Jul 2	-2.6	-13.6	-3.8	-15.7
Aug 9	10.5	-4.3	10.3	-7.0
Aug 31	-6.4	-10.6	-6.9	-13.4
Nov 5	14.2	2.1	16.8	1.0
Nov 30	-3.8	-3.8	-3.7	-2.6
Dec 17	4.4	2.5	5.3	2.6
Dec 23	0.7	3.3	1.0	3.7
Dec 31	0.03	3.3	0.07	3.8
Jan 7	0.8	4.2	1.1	4.9
Jan 14	0.9	5.2	1.7	6.7
Jan 21	0.7	5.9	-0.8	5.9
Jan 28	-0.4	5.5	-0.5	5.3
Feb 4	2.3	7.9	2.7	8.1
Feb 11	1.5	9.5	1.4	9.7
Feb 18	0.9	10.6	1.0	10.8
Feb 25	-2.1	8.3	-1.7	8.9
Mar 4	0.3	8.6	0.1	9.0
Mar 11	-1.0	7.5	-1.3	7.6
Mar 18	-1.5	5.8	-1.9	5.5
Mar 25	3.1	9.1	2.7	8.4
Apr 1	1.3	10.5	1.4	9.9
Apr 8	0.03	10.5	-0.3	9.6
Apr 15	-0.3	10.1	-0.6	8.9
Apr 22	1.3	11.6	1.3	10.3
Apr 29	2.4	14.3	1.9	12.5
May 6	-1.3	12.8	-1.7	10.6
May 13	-0.3	12.4	-0.2	10.4
May 20	-0.7	11.7	-0.3	10.0
May 27	-0.6	11.0	-0.2	9.8
Jun 3	-2.3	8.4	-2.3	7.3
Jun 10	-1.6	6.7	-2.2	4.9
Jun 17	0.4	7.1	0.04	4.9
Jun 24	-0.6	6.5	-0.2	4.6
Jul 1	5.4	12.3	5.6	10.5
Jul 8	0.6	12.9	0.3	10.9
Jul 15	-1.4	11.4	-2.1	8.6
Jul 22	1.6	13.2	2.2	10.9
Jul 29	-4.2	8.4	-3.9	6.6
Aug 05	-5.8	2.1	-7.2	-1.0
Aug 12	-1.5	0.6	-1.7	-2.7
Aug 19	-4.0	-3.5	-4.7	-7.3
Aug 26	4.3	0.7	4.7	-2.9
Sep 02	-0.4	0.3	-0.2	-3.1
Sep 09	-2.2	-1.9	-1.7	-4.8
Sep 16	4.7	2.7	5.4	0.3
Sep 23	-6.4	-3.9	-6.5	-6.2
Sep 30	1.3	-2.6	-0.4	-6.7
Oct 7	1.7	-0.9	2.1	-4.7
Oct 14	4.9	3.9	5.9	1.0
Oct 21	1.4	5.4	1.1	2.2
Oct 28	3.6	9.2	3.8	6.0
Nov 04	-2.0	6.9	-2.5	3.4
Nov 11	1.4	8.5	0.8	4.3
Nov 18	-2.9	5.3	-3.8	0.3
Nov 25	-4.8	0.2	-4.7	-4.4
Dec 02	7.0	7.3	7.4	2.7
Dec 09	1.4	8.7	0.9	3.6
Dec 16	-2.6	5.9	-2.8	0.6
Dec 23	3.6	9.7	3.7	4.4
Dec 30	-0.6	9.0	-0.6	3.8

Source: http://professional.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3014

Table V-6, 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, large budget deficit of the federal government (http://professional.wsj.com/article/SB10001424052748703907004576279321350926848.html?mod=WSJ_hp_LEFTWhatsNewsCollection) and now zero interest rates indefinitely but with interruptions caused by risk aversion events. Such an event actually occurred in the week of Sep 23 reversing the devaluation of the dollar in the form of sharp appreciation of the dollar relative to other currencies from all over the world including the offshore Chinese yuan market. Column “Peak” in Table V-6 shows exchange rates during the crisis year of 2008. There was a flight to safety in dollar-denominated government assets as a result of the arguments in favor of TARP (Cochrane and Zingales 2009). This is evident in various exchange rates that depreciated sharply against the dollar such as the South African rand (ZAR) at the peak of depreciation of ZAR 11.578/USD on Oct 22, 2008, subsequently appreciating to the trough of ZAR 7.238/USD by Aug 15, 2010 but now depreciating by 10.4 percent to ZAR 8.076/USD on Dec 30, which is still 30.2 percent stronger than on Oct 22, 2008. An example from Asia is the Singapore Dollar (SGD) highly depreciated at the peak of SGD 1.553/USD on Mar 3, 2009 but subsequently appreciating by 13.2 percent to the trough of SGD 1.348/USD on Aug 9, 2010 but is now only 3.8 percent stronger at SGD 1.297/USD on Dec 30 relative to the trough of depreciation but still stronger by 16.5 percent relative to the peak of depreciation on Mar 3, 2009. Another example is the Brazilian real (BRL) that depreciated at the peak to BRL 2.43/USD on Dec 5, 2008 but appreciated 28.5 percent to the trough at BRL 1.737/USD on Apr 30, 2010, showing depreciation of 7.2 percent relative to the trough to BRL 1.862/USD on Dec 30 but still stronger by 23.4 percent relative to the peak on Dec 5, 2008. At one point in 2011 the Brazilian real traded at BRL 1.55/USD and in the week of Sep 23 surpassed BRL 1.90/USD in intraday trading for depreciation of more than 20 percent. The Banco Central do Brasil, Brazil’s central bank, lowered its policy rate SELIC for the third consecutive meeting of its monetary policy committee, COPOM (http://www.bcb.gov.br/textonoticia.asp?codigo=3268&IDPAI=NEWS):

“Copom reduces the Selic rate to 11.00 percent

30/11/2011 7:47:00 PM

Brasília - Continuing the process of adjustment of monetary conditions, the Copom unanimously decided to reduce the Selic rate to 11.00 percent, without bias.

Unconventional monetary policy of zero interest rates and quantitative easing creates trends such as the depreciation of the dollar followed by Table V-6 but with abrupt reversals during risk aversion. The main effects of unconventional monetary policy are on valuations of risk financial assets and not necessarily on consumption and investment or aggregate demand.

Table V-6, Exchange Rates

	Peak	Trough	∆% P/T	Dec 30, 2011	∆T Dec 30 2011	∆P Dec 30 2011
EUR USD	7/15 2008	6/7 2010		12/30 2011
Rate	1.59	1.192		1.294
∆%			-33.4		7.9	-22.9
JPY USD	8/18 2008	9/15 2010		12/30 2011
Rate	110.19	83.07		76.887
∆%			24.6		7.4	30.2
CHF USD	11/21 2008	12/8 2009		12/30 2011
Rate	1.225	1.025		0.935
∆%			16.3		8.8	23.7
USD GBP	7/15 2008	1/2/ 2009		12/30 2011
Rate	2.006	1.388		1.554
∆%			-44.5		10.7	-29.1
USD AUD	7/15 2008	10/27 2008		12/30 2011
Rate	1.0215	1.6639		1.02
∆%			-62.9		41.1	4.0
ZAR USD	10/22 2008	8/15 2010		12/30 2011
Rate	11.578	7.238		8.076
∆%			37.5		-10.4	30.2
SGD USD	3/3 2009	8/9 2010		12/30 2011
Rate	1.553	1.348		1.297
∆%			13.2		3.8	16.5
HKD USD	8/15 2008	12/14 2009		12/30 2011
Rate	7.813	7.752		7.767
∆%			0.8		-0.2	0.6
BRL USD	12/5 2008	4/30 2010		12/30 2011
Rate	2.43	1.737		1.862
∆%			28.5		-7.2	23.4
CZK USD	2/13 2009	8/6 2010		12/30 2011
Rate	22.19	18.693		19.713
∆%			15.7		-5.4	11.2
SEK USD	3/4 2009	8/9 2010		12/30 2011
Rate	9.313	7.108		6.886
∆%			23.7		3.1	26.1
CNY USD	7/20 2005	7/15 2008		12/30 2011
Rate	8.2765	6.8211		6.294
∆%			17.6		7.7	23.9

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://professional.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

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

Chart V-1 of the Board of Governors of the Federal Reserve System provides indexes of the dollar from 2010 to 2011. The dollar depreciates during episodes of risk appetite but appreciate during risk aversion as funds seek dollar-denominated assets in avoiding financial risk.

Chart V-1, Broad, Major Currency, and Other Important Trading Partners Indexes for the US Dollar

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/DataDownload/Chart.aspx?rel=H10&series=122e3bcb627e8e53f1bf72a1a09cfb81&lastObs=260&from=&to=&filetype=csv&label=include&layout=seriescolumn&pp=Download&names=%7bH10/H10/JRXWTFB_N.B,H10/H10/JRXWTFN_N.B,H10/H10/JRXWTFO_N.B%7d

Table V-7, 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 new coupons such as 2.0 percent in recent auctions (http://www.treasurydirect.gov/RI/OFAuctions?form=extended&cusip=912828RR3) are not comparable to prices in Table VI-7. 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. Monetary policy 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 Great East Japan Earthquake and Tsunami and now again by the sovereign risk doubts in Europe and the growth recession in the US and the world. The yield of 1.871 percent at the close of market on Fri Dec 30 would be equivalent to price of 106.8476 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price gain of 5.5 percent relative to the price on Nov 4, 2010, one day after the decision on the second program of quantitative easing, as shown in the last row of Table V-7. 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 Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 affecting Japan, recurring fears on European sovereign credit issues and worldwide risk aversion in the week of Sep 30 caused by “let’s twist again” monetary policy. The realization of a growth standstill recession is also influencing yields. Important causes of the earlier rise in yields shown in Table V-7 are expectations of rising inflation and US government debt estimated to exceed 70 percent of GDP in 2012 (http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html 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 Dec 28, 2011, the line “Reserve Bank credit” in the Fed balance sheet stood at $2909 billion, or $2.9 trillion, with portfolio of long-term securities of $2585 billion, or $2.6 trillion, consisting of $1576 billion Treasury nominal notes and bonds, $68 billion of notes and bonds inflation-indexed, $104 billion Federal agency debt securities and $837 billion mortgage-backed securities; reserve balances deposited with Federal Reserve Banks reached $1567 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 II World Financial Turbulence, has been affecting financial markets for several months. 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 V-7, 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
07/01/11	3.186	95.2281	-5.9
07/08/11	3.022	96.5957	-4.6
07/15/11	2.905	97.5851	-3.6
07/22/11	2.964	97.0847	-4.1
07/29/11	2.795	98.5258	-2.7
08/05/11	2.566	100.5175	-0.7
08/12/11	2.249	103.3504	2.1
08/19/11	2.066	105.270	3.7
08/26/11	2.202	103.7781	2.5
09/02/11	1.992	105.7137	4.4
09/09/11	1.918	106.4055	5.1
09/16/11	2.053	101.5434	0.3
09/23/11	1.826	107.2727	5.9
09/30/11	1.912	106.4602	5.1
10/07/11	2.078	104.9161	3.6
10/14/11	2.251	103.3323	2.0
10/21/11	2.220	103.6141	2.3
10/28/11	2.326	102.6540	1.4
11/04/11	2.066	105.0270	3.7
11/11/11	2.057	105.1103	3.8
11/18/11	2.003	105.6113	4.3
11/25/11	1.964	105.9749	4.7
12/02/11	2.042	105.2492	3.9
12/09/11	2.065	105.0363	3.7
12/16/11	1.847	107.0741	5.7
12/23/11	2.027	105.3883	4.1
12/30/11	1.871	106.8476	5.5

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://professional.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3000

VI Economic Indicators. Crude oil input in refineries increased 0.03 percent to 14,773 thousand barrels per day on average in the four weeks ending on Dec 23 from 14,768 thousand barrels per day in the four weeks ending on Dec 16, as shown in Table VI-1. The rate of capacity utilization in refineries continues at a relatively high level of 85.5 percent on Dec 23, 2011, which is slightly lower than 87.7 percent on Dec 24, 2010 and 85.6 percent on Dec 16, 2011. Imports of crude oil fell 0.2 percent from 8,564 thousand barrels per day on average in the four weeks ending on Dec 16 to 8,546 thousand barrels per day in the week of Dec 23. The Energy Information Administration (EIA) finds that “US crude oil imports averaged just under 9.0 million barrels per days last week [Dec 23], up by 1.4 million barrels per day from the previous week. Over the last four weeks, crude oil imports have averaged about 8.6 million barrels per days, 8 thousand barrels per day above the same four-week period last year” (http://www.eia.gov/pub/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/current/pdf/highlights.pdf 1). Slight increase in utilization in refineries but with imports increasing at the margin in the past week of Dec 23 resulted in increase of commercial crude oil stocks by 3.9 million barrels from 323.6 million barrels on Dec 16 to 327.5 million barrels on Dec 23. Motor gasoline production increased 0.6 percent from 9,312 thousand barrels per day in the week of Dec 16 to 9,366 thousand barrels per day on average in the week of Dec 23. Gasoline stocks declined 0.7 million barrels and stocks of fuel oil increased 1.3 million barrels. Supply of gasoline fell from 9,283 thousand barrels per day on Dec 24, 2010, to 8,761 thousand barrels per day on Dec 23, 2011, or by 5.6 percent, while fuel oil supply rose 3.9 percent. Part of the fall in consumption of gasoline is due to higher prices and part to the growth recession. Table VI-1 also shows increase in the WTI price of crude oil by 13.2 percent from Dec 17, 2010 to Dec 23, 2011. Gasoline prices rose 6.7 percent from Dec 27, 2010 to Dec 26, 2011. Increases in prices of crude oil and gasoline relative to a year earlier are moderating because year earlier prices are already reflecting the commodity price surge and commodity prices have been declining recently during worldwide risk aversion.

Table VI-1, US, Energy Information Administration Weekly Petroleum Status Report

Four Weeks Ending Thousand Barrels/Day	12/23/11	12/16/11	12/24/10
Crude Oil Refineries Input	14,773 Week ∆%: +0.03	14,768	14,933
Refinery Capacity Utilization %	85.5	85.6	87.7
Motor Gasoline Production	9,366 Week ∆%: +0.6	9,312	9,367
Distillate Fuel Oil Production	4,975 Week ∆%: +0.3	4,961	4,582
Crude Oil Imports	8,546 Week ∆%: -0.2	8,564	8,541
Motor Gasoline Supplied	8,761 ∆% 2011/2010= -5.6%	8,722	9,283
Distillate Fuel Oil Supplied	4,019 ∆% 2011/2010 = +3.9%	3,878	3,869
	12/23/11	12/16/11	12/24/10
Crude Oil Stocks Million B	327.5 ∆= +3.9 MB	323.6	339.4
Motor Gasoline Million B	217.7 ∆= -0.7 MB	218.4	214.9
Distillate Fuel Oil Million B	140.4 ∆= +1.3 MB	139.1	161.0
WTI Crude Oil Price $/B	99.61 ∆% 2011/2010 +13.2	93.53	88.02 (12/17/2010)
	12/26/11	12/19/11	12/27/10
Regular Motor Gasoline $/G	3.258 ∆% 2011/2010 +6.7	3.229	3.052

B: barrels; G: gallon

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

Chart VI-1 of the US Energy Information Administration shows the commercial stocks of crude oil of the US. There have been fluctuations around an upward trend since 2005. Crude oil stocks trended downwardly during a few weeks but with fluctuations.

Chart VI-1, US, Weekly Crude Oil Ending Stocks

Source: US Energy Information Administration

http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCESTUS1&f=W

Chart VI-2 of the US Energy Information Administration provides closer view of US crude oil stocks since Jun 2010. Crude oil stocks rose in a clear trend in 2011 but began to drop on a downward trend since May 2011. There is less need to stock oil after May with declining prices if it is anticipated that prices in future months may be lower. The final part of the chart shows the increase in oil stocks in the weeks of Nov 25 and Dec 2 and the declines in the weeks of Dec 9 and Dec 16 with an increase in the week of Dec 23.

Chart VI-2, US, Crude Oil Stocks

Source: US Energy Information Administration

http://www.eia.gov/petroleum/

Chart VI-3 of the US Energy Information Administration shows the price of WTI crude oil since the 1980s. Chart VI-3 captures commodity price shocks during the past decade. The costly mirage of deflation was caused by the decline in oil prices resulting from the recession of 2001. The upward trend after 2003 was promoted by the carry trade from near zero interest rates. The jump above $140/barrel during the global recession in 2008 can only be explained by the carry trade promoted by monetary policy of zero fed funds rate. After moderation of risk aversion, the carry trade returned with resulting sharp upward trend of crude prices.

Chart VI-3, US, Crude Oil Futures Contract

Source: US Energy Information Administration

http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D

There is significant difference between initial claims for unemployment insurance adjusted and not adjusted for seasonality provided in Table VI-2. Seasonally adjusted claims increased 15,000 from 366,000 on Dec 17 to 381,000 on Dec 24. Claims not adjusted for seasonality increased 69,261, from 421,103 on Dec 17 to 490,364 on Dec 24. There is strong seasonality in Dec.

Table VI-2, US, Initial Claims for Unemployment Insurance

2011	SA	NSA	4-week MA SA
Dec 24	381,000	490,364	375,000
Dec 17	366,000	421,103	380,750
Change	+15,000	+69,261	-5,750
Dec 10	368,000	435,863	388,250
Prior Year	404,000	525,710	419,750

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

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

Table VI-3 provides seasonally and not seasonally adjusted claims in the comparable week for the years from 2000 to 2011. Seasonally adjusted claims typically exceed claims not adjusted for seasonality. Claims not seasonally adjusted have declined from 719,691 on Dec 20, 2008 to 525,710 on Dec 25, 2010 and now to 490,364 on Dec 24, 2011. There is strong indication of significant decline in the level of layoffs in the US. Hiring has not recovered (http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_20.html).

Table VI-3, US, Unemployment Insurance Weekly Claims

	Not Seasonally Adjusted Claims	Seasonally Adjusted Claims
Dec 23, 2000	481,720	364,000
Dec 22, 2001	529,570	416,000
Dec 21, 2002	483,449	394,000
Dec 20, 2003	424,192	354,000
Dec 25, 2004	446,699	320,000
Dec 24, 2005	433,397	320,000
Dec 23, 2006	425,357	323,000
Dec 22, 2007	456,280	355,000
Dec 20, 2008	719,691	584,000
Dec 26, 2009	561.852	465,000
Dec 25, 2010	525,710	404,000
Dec 24, 2011	490,364	381,000

Source: http://www.workforcesecurity.doleta.gov/unemploy/claims.asp

VII Interest Rates. It is quite difficult to measure inflationary expectations because they tend to break abruptly from past inflation. There could still be an influence of past and current inflation in the calculation of future inflation by economic agents. Table VII-1 provides inflation of the CPI. In Jul-Nov 2011, CPI inflation for all items seasonally adjusted was 2.7 percent in annual equivalent, that is, compounding inflation in Jul-Nov and assuming it would be repeated for a full year. In the 12 months ending in Nov, CPI inflation of all items not seasonally adjusted was 3.4 percent. The second row provides the same measurements for the CPI of all items excluding food and energy: 2.2 percent in 12 months and 1.9 percent in annual equivalent. Bloomberg provides the yield curve of US Treasury securities (http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/). The lowest yield is 0.01 percent for three months, 0.06 percent for six months, 0.10 percent for 12 months, 0.24 percent for two years, 0.35 percent for three years, 0.83 percent for five years, 1.34 percent for seven years, 1.88 percent for ten years and 2.89 percent for 30 years. The Irving Fisher definition of real interest rates is approximately the difference between nominal interest rates, which are those estimated by Bloomberg, and the rate of inflation expected in the term of the security, which could behave as in Table VII-1. Real interest rates in the US have been negative during substantial periods in the past decade while monetary policy pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

“Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”

Negative real rates of interest distort calculations of risk and returns from capital budgeting by firms, through lending by financial intermediaries to decisions on savings, housing and purchases of households. Inflation on near zero interest rates misallocates resources away from their most productive uses and creates uncertainty of the future path of adjustment to higher interest rates that inhibit sound decisions.

Table VII-1, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%

	∆% 12 Months Nov 2011/Nov 2010 NSA	∆% Annual Equivalent Jul-Nov 2011 SA
CPI All Items	3.4	2.7
CPI ex Food and Energy	2.2	1.9

Source: http://www.bls.gov/news.release/pdf/cpi.pdf

VII Conclusion. The US economy is in growth standstill at an annual equivalent rate in the first three quarters of 1.1 percent primarily driven by drawing on savings. Real disposable income is falling. There are around 29 million people in the US unemployed or underemployed. Real wages are falling. There is no exit from unemployment, underemployment and falling real wages because of the collapse of hiring. The euro is fighting for survival. Inflation has occurred in three waves in 2011 with higher inflation induced by carry trades from zero interest rates to commodity futures when there is subdued risk aversion. Inflation declined in the middle of the year because of unwinding carry trades as a result of financial risk aversion originating in the sovereign debt crisis of Europe. Unconventional monetary policy of zero interest rates and large-scale purchases of assets using the central bank’s balance sheet is designed to increase aggregate demand by stimulating consumption and investment. In practice, there is no control of how cheap money will be used. An alternative allocation of cheap money is through the carry trade from zero interest rates and short dollar positions to exposures in risk financial assets such as equities, commodities and so on. After a decade of unconventional monetary policy it may be prudent to return to normalcy so as to avoid adverse side effects of financial turbulence and inflation waves. Normal monetary policy would also encourage financial intermediation required for financing sound long-term projects that can stimulate economic growth and full utilization of resources. (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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Appendix I. The Great Inflation

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 I1 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 I1 cannot be explained without taking into account the increase in the fed funds rate that reached 22.36 percent on Jul 22, 1981 (http://www.federalreserve.gov/releases/h15/data.htm) in the Volcker Fed that 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. This interpretation is consistent with the case of the 24 emerging market economies analyzed by Reinhart and Rogoff (2010GTD, 4), concluding that “higher debt levels are associated with significantly higher levels of inflation in emerging markets. Median inflation more than doubles (from less than seven percent to 16 percent) as debt rises from the low (0 to 30 percent) range to above 90 percent. Fiscal dominance is a plausible interpretation of this pattern.”

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 I1, 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). TableI1 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 I1, US Annual Rate of Growth of GDP and CPI and Unemployment Rate 1960-1982

	∆% GDP	∆% CPI	UNE
1960	2.5	1.4	6.6
1961	2.3	0.7	6.0
1962	6.1	1.3	5.5
1963	4.4	1.6	5.5
1964	5.8	1.0	5.0
1965	6.4	1.9	4.0
1966	6.5	3.5	3.8
1967	2.5	3.0	3.8
1968	4.8	4.7	3.4
1969	3.1	6.2	3.5
1970	0.2	5.6	6.1
1971	3.4	3.3	6.0
1972	5.3	3.4	5.2
1973	5.8	8.7	4.9
1974	-0.6	12.3	7.2
1975	-0.2	6.9	8.2
1976	5.4	4.9	7.8
1977	4.6	6.7	6.4
1978	5.6	9.0	6.0
1979	3.1	13.3	6.0
1980	-0.3	12.5	7.2
1981	2.5	8.9	8.5
1982	-1.9	3.8	10.8
1983	4.5	3.8	8.3
1984	7.2	3.9	7.3
1985	4.1	3.8	7.0
1986	3.5	1.1	6.6
1987	3.2	4.4	5.7
1988	4.1	4.4	5,3
1989	3.6	4.6	5.4
1990	1.9	6.1	6.3

Note: GDP: Gross Domestic Product; CPI: consumer price index; UNE: rate of unemployment; CPI and UNE are at year end instead of average to obtain a complete series

Source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

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

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

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

There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table I2 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 I2 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 I2, 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

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Financial Risk Aversion and Collapse of Valuations of Risk Financial Assets, World Financial Turbulence, Global Inflation and World Economic Slowdown

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