World Inflation Waves, United States Inflation, Euro Zone Survival Risk and World Economic Slowdown
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011, 2012
Executive Summary
I World Inflation Waves
II United States Inflation
IIA Long-term US Inflation
IIB Current US Inflation
III World Financial Turbulence
IIIA Financial Risks
IIIB Appendix on Safe Haven Currencies
IIIC Appendix on Fiscal Compact
IIID Appendix on European Central Bank Large Scale Lender of Last Resort
IIIE Appendix Euro Zone Survival Risk
IIIF Appendix on Sovereign Bond Valuation
IV Global Inflation
V World Economic Slowdown
VA United States
VB Japan
VC China
VD Euro Area
VE Germany
VF France
VG Italy
VH United Kingdom
VI Valuation of Risk Financial Assets
VII Economic Indicators
VIII Interest Rates
IX Conclusion
References
Appendix I The Great Inflation
Executive Summary
ESI Economic Growth and Resolution of Italy’s Debt
Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common currency prevents Italy from devaluation to parity or the exchange rate that would permit export growth to promote internal economic activity that generates fiscal revenues for primary fiscal surplus, ensuring creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Data in Table ES-1 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU) are only 43.6 percent of the total. Exports to non-European Union area are growing at 15.2 percent in the 12 months ending in Nov while those to EMU are growing at 9.6 percent.
Table ES-1, Italy, Exports and Imports by Regions and Countries, % Share and 12 Months ∆%
| Exports | ∆% Jan-Nov 2011/ Jan-Nov 2010 | Imports | Imports | |
| EU | 57.3 | 9.5 | 54.8 | 6.9 |
| EMU 17 | 43.6 | 9.6 | 44.6 | 6.4 |
| France | 11.6 | 11.9 | 8.8 | 4.2 |
| Germany | 13.0 | 13.2 | 16.1 | 6.4 |
| Spain | 5.8 | 2.3 | 4.6 | 8.1 |
| UK | 5.2 | -1.0 | 2.7 | 9.4 |
| Non EU | 42.7 | 15.2 | 45.2 | 15.1 |
| Europe non EU | 12.0 | 24.4 | 10.3 | 20.2 |
| USA | 6.0 | 11.9 | 3.0 | 18.5 |
| China | 2.6 | 16.5 | 7.8 | 5.3 |
| OPEC | 5.3 | -1.3 | 9.5 | -0.4 |
| Total | 100.0 | 11.9 | 100.0 | 10.6 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: http://www.istat.it/it/archivio/50960
Growth rates of Italy’s trade and major products are provided in Table ES-2 for the period Jan-Nov 2011 relative to Jan-Nov 2010. Growth rates are high for the total and all segments with the exception of decline of durable goods imports of 6.4 percent. Capital goods exports increased 11.1 percent relative to a year earlier and intermediate products by 14.4 percent.
Table ES-2, Italy, Exports and Imports % Share of Products in Total and ∆%
| Exports | Exports | Imports | Imports | |
| Consumer | 29.5 | 9.4 | 25.3 | 8.0 |
| Durable | 6.3 | 4.7 | 3.5 | -6.4 |
| Non | 23.2 | 10.6 | 21.8 | 10.3 |
| Capital Goods | 32.4 | 11.1 | 22.4 | 1.3 |
| Inter- | 33.5 | 14.4 | 33.9 | 13.9 |
| Energy | 4.6 | 16.1 | 18.4 | 19.6 |
| Total ex Energy | 95.4 | 11.7 | 81.6 | 8.6 |
| Total | 100.0 | 11.9 | 100.0 | 10.6 |
Source: http://www.istat.it/it/archivio/50960
Table ES-3 provides Italy’s trade balance by product categories in Nov and Jan-Nov 2011. Italy’s trade balance excluding energy is a surplus of €30,523 in Jan-Nov 2011 but the energy trade balance is a deficit of €56,301 million. Italy has significant competitiveness in contrast with some other countries with debt difficulties.
Table ES-3, Italy, Trade Balance by Product Categories, € Millions
| Nov 2011 | Jan-Nov 2011 | |
| Consumer Goods | 877 | 7,361 |
| Durable | 876 | 9,256 |
| Nondurable | 1 | -1,896 |
| Capital Goods | 3,075 | 33,579 |
| Intermediate Goods | 78 | -10,417 |
| Energy | -5,610 | -56,301 |
| Total ex Energy | 4,030 | 30,523 |
| Total | -1,581 | -25,778 |
Source: http://www.istat.it/it/archivio/50960
Brazil faced in the debt crisis of 1982 a more complex policy mix. Between 1977 and 1983, Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.
ESII Euro Zone Credit Risks
Table ES-4 provides the consolidated financial statement of the Eurosystem on Dec 31, 2010 and Dec 28, 2011. Memo items provide the sum of lines 5, “lending to euro area credit institutions related to monetary policy operations denominated in euro,” and 7, “securities of euro area residents denominated in euro,” which has increased from €1,004,174 million on Dec 31, 2010 to €1,489,759 million on Dec 28, 2011. This sum is roughly what concerns Beim (2012Oct9) because of the probable exposure relative to capital to institutions and sovereigns with higher default risk. To be sure, there is no precise knowledge of the composition of the ECB portfolio of loans and securities with weights and analysis of the risks of components. Javier E. David, writing on Jan 16, 2012, on “The risks in ECB’s crisis moves,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204542404577158753459542024.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that the estimated debt of weakest euro zone sovereigns held by the ECB is €211 billion, with Greek debt in highest immediate default risk being only 17 percent of the total. Another unknown is whether there is high risk collateral in the €489 billion three-year loans to credit institutions at 1 percent interest rates. The potential risk is the need for recapitalization of the ECB that could find similar political hurdles as the bailout fund EFSF. There is no evidence that the ECB could not manage these risks.
Table ES-4, Consolidated Financial Statement of the Eurosytem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | |
| 1 Gold and other Receivables | 367,402 | 419,822 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 |
| 9 Other Assets | 278,719 | 336,574 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 |
| Memo Items | ||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 |
| Capital and Reserves | 78,143 | 81,481 |
Source: European Central Bank
http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html
http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html
ESIII World Inflation Waves
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 such as commodities 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. More technical discussion is in IF Appendix: Transmission of Unconventional Monetary Policy at http://cmpassocregulationblog.blogspot.com/2012/01/financial-risk-aversion-and-collapse-of.html.
Table ES-5 provides annual equivalent rates of inflation for producer price indexes followed in this blog. The behavior of the US producer price index in 2011 shows neatly four waves. (1) In Jan-Apr, without risk aversion, US producer prices rose at the annual equivalent rate of 17.3 percent. (2) After risk aversion, producer prices increased in the US at the annual equivalent rate of 0.8 percent in May-Jul. (3) From Jul to Sep, under alternating episodes of risk aversion, producer prices increased at the annual equivalent rate of 4.9 percent. (4) Under the pressure of risk aversion because of the European debt crisis US producer prices fell at the annual equivalent rate of 0.4 percent in Oct-Dec. 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 ES-5 for six countries (two for the UK) 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 returned since July, with alternating bouts of risk aversion. In the final months of the year producer price inflation collapsed because of the disincentive to exposures in commodity futures resulting from fears of resolution of the European debt crisis.
Table ES-5, Annual Equivalent Rates of Producer Price Indexes
| INDEX 2011 | AE ∆% |
| US Producer Price Index | |
| AE ∆% Oct-Dec | -0.4 |
| AE ∆% Jul-Sep | 4.9 |
| AE ∆% May-Jul | 0.8 |
| AE ∆% Jan-Apr | 17.3 |
| Japan Corporate Goods Price Index | |
| AE ∆% Jul-Dec | -1.6 |
| AE ∆% May-Jun | -1.2 |
| AE ∆% Jan-Apr | 7.1 |
| China Producer Price Index | |
| AE ∆% Jul-Dec | -3.1 |
| AE ∆% Jan-Jun | 20.4 |
| Germany Producer Price Index | |
| AE ∆% Oct-Dec | -0.4 |
| AE ∆% Jul-Sep | 2.8 |
| AE ∆% Jun-May | 1.2 |
| Jan-Apr | 7.1 |
| France Producer Price Index for the French Market | |
| AE ∆% Jul-Nov | 3.7 |
| 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 ∆% Oct-Dec | 0 |
| AE ∆% May-Sep | 2.4 |
| AE ∆% Jan-Apr | 12.0 |
| UK Input Prices | |
| AE ∆% Jul-Dec | -0.9 |
| 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/cgpi1112.pdf
http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778770.htm
http://www.insee.fr/en/themes/info-rapide.asp?id=25&date=20111223
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/index.html
http://www.istat.it/it/archivio/49093
Similar world inflation waves are in the behavior of consumer price indexes of six countries and the euro zone in Table ES-6. US consumer price inflation shows four waves in 2011. (1) Under risk appetite in Jan-Apr consumer prices increased at the annual equivalent rate of 7.5 percent. (2) Risk aversion caused the collapse of inflation to annual equivalent 2.0 percent in May-Jul. (3) Risk appetite drove the rate of consumer price inflation in the US to 4.9 percent in Jul-Sep. (4) Gloomier views of carry trades caused the collapse of inflation in Oct-Dec to annual equivalent minus 0.4 percent. There is similar behavior in all the other consumer price indexes in Table II-2. China’s CPI increased at annual equivalent 8.3 percent in Jan-Mar, 2.0 percent in Apr-Jun and 3.0 percent in Jul-Dec. The euro zone harmonized index of consumer prices (HICP) increased at annual equivalent 5.2 percent in Jan-Apr, minus 2.4 percent in May-Jul and 4.2 percent in Aug-Dec. The price indexes of the largest members of the euro zone, Germany, France and Italy, exhibit the same inflation waves. The United Kingdom CPI increased at annual equivalent 6.5 percent in Jan-Apr, falling to only 0.4 percent in May-Jul and then increasing at 4.7 percent in Aug-Dec
Table ES-6, Annual Equivalent Rates of Consumer Price Indexes
| Index 2011 | AE ∆% |
| US Consumer Price Index | |
| AE ∆% Oct-Dec | -0.4 |
| AE ∆% Jul-Sep | 4.9 |
| AE ∆% May-Jul | 2.0 |
| AE ∆% Jan-Apr | 7.5 |
| China Consumer Price Index | |
| AE ∆% Jul-Dec | 3.0 |
| AE ∆% Apr-Jun | 2.0 |
| AE ∆% Jan-Mar | 8.3 |
| Euro Zone Harmonized Index of Consumer Prices | |
| AE ∆% Aug-Dec | 4.2 |
| 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-Dec | 3.4 |
| AE ∆% May-Jul | -1.2 |
| AE ∆% Jan-Apr | 4.3 |
| Italy Consumer Price Index | |
| AE ∆% Jul-Dec | 3.0 |
| AE ∆% May-Jun | 1.2 |
| AE ∆% Jan-Apr | 4.9 |
| UK Consumer Price Index | |
| AE ∆% Aug-Dec | 4.7 |
| May-Jul | 0.4 |
| Jan-Apr | 6.5 |
Sources: http://www.bls.gov/cpi/data.htm
http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778750.htm
http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120112
http://www.istat.it/it/archivio/50340
http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/december-2011/index.html
Chart ES-1 provides 12-month percentage changes of the producer price index from 1960 to 2011. The distinguishing event in Chart II-7 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2011, which has much lower dimensions.
Chart ES-1, US, Producer Price Index, Finished Goods, 12-Month Percentage Change, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
I World Inflation Waves. 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.
3. 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.
4. 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. More technical discussion is in IF Appendix: Transmission of Unconventional Monetary Policy at http://cmpassocregulationblog.blogspot.com/2012/01/financial-risk-aversion-and-collapse-of.html.
Table I-1 provides annual equivalent rates of inflation for producer price indexes followed in this blog. The behavior of the US producer price index in 2011 shows neatly four waves. (1) In Jan-Apr, without risk aversion, US producer prices rose at the annual equivalent rate of 17.3 percent. (2) After risk aversion, producer prices increased in the US at the annual equivalent rate of 0.8 percent in May-Jul. (3) From Jul to Sep, under alternating episodes of risk aversion, producer prices increased at the annual equivalent rate of 4.9 percent. (4) Under the pressure of risk aversion because of the European debt crisis US producer prices fell at the annual equivalent rate of 0.4 percent in Oct-Dec. 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-1 for six countries (two for the UK) 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 returned since July, with alternating bouts of risk aversion. In the final months of the year producer price inflation collapsed because of the disincentive to exposures in commodity futures resulting from fears of resolution of the European debt crisis.
Table I-1, Annual Equivalent Rates of Producer Price Indexes
| INDEX 2011 | AE ∆% |
| US Producer Price Index | |
| AE ∆% Oct-Dec | -0.4 |
| AE ∆% Jul-Sep | 4.9 |
| AE ∆% May-Jul | 0.8 |
| AE ∆% Jan-Apr | 17.3 |
| Japan Corporate Goods Price Index | |
| AE ∆% Jul-Dec | -1.6 |
| AE ∆% May-Jun | -1.2 |
| AE ∆% Jan-Apr | 7.1 |
| China Producer Price Index | |
| AE ∆% Jul-Dec | -3.1 |
| AE ∆% Jan-Jun | 20.4 |
| Germany Producer Price Index | |
| AE ∆% Oct-Dec | -0.4 |
| AE ∆% Jul-Sep | 2.8 |
| AE ∆% Jun-May | 1.2 |
| Jan-Apr | 7.1 |
| France Producer Price Index for the French Market | |
| AE ∆% Jul-Nov | 3.7 |
| 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 ∆% Oct-Dec | 0 |
| AE ∆% May-Sep | 2.4 |
| AE ∆% Jan-Apr | 12.0 |
| UK Input Prices | |
| AE ∆% Jul-Dec | -0.9 |
| 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/cgpi1112.pdf
http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778770.htm
http://www.insee.fr/en/themes/info-rapide.asp?id=25&date=20111223
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/index.html
http://www.istat.it/it/archivio/49093
Similar world inflation waves are in the behavior of consumer price indexes of six countries and the euro zone in Table I-2. US consumer price inflation shows four waves in 2011. (1) Under risk appetite in Jan-Apr consumer prices increased at the annual equivalent rate of 7.5 percent. (2) Risk aversion caused the collapse of inflation to annual equivalent 2.0 percent in May-Jul. (3) Risk appetite drove the rate of consumer price inflation in the US to 4.9 percent in Jul-Sep. (4) Gloomier views of carry trades caused the collapse of inflation in Oct-Dec to annual equivalent minus 0.4 percent. There is similar behavior in all the other consumer price indexes in Table II-2. China’s CPI increased at annual equivalent 8.3 percent in Jan-Mar, 2.0 percent in Apr-Jun and 3.0 percent in Jul-Dec. The euro zone harmonized index of consumer prices (HICP) increased at annual equivalent 5.2 percent in Jan-Apr, minus 2.4 percent in May-Jul and 4.2 percent in Aug-Dec. The price indexes of the largest members of the euro zone, Germany, France and Italy, exhibit the same inflation waves. The United Kingdom CPI increased at annual equivalent 6.5 percent in Jan-Apr, falling to only 0.4 percent in May-Jul and then increasing at 4.7 percent in Aug-Dec
Table I-2, Annual Equivalent Rates of Consumer Price Indexes
| Index 2011 | AE ∆% |
| US Consumer Price Index | |
| AE ∆% Oct-Dec | -0.4 |
| AE ∆% Jul-Sep | 4.9 |
| AE ∆% May-Jul | 2.0 |
| AE ∆% Jan-Apr | 7.5 |
| China Consumer Price Index | |
| AE ∆% Jul-Dec | 3.0 |
| AE ∆% Apr-Jun | 2.0 |
| AE ∆% Jan-Mar | 8.3 |
| Euro Zone Harmonized Index of Consumer Prices | |
| AE ∆% Aug-Dec | 4.2 |
| 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-Dec | 3.4 |
| AE ∆% May-Jul | -1.2 |
| AE ∆% Jan-Apr | 4.3 |
| Italy Consumer Price Index | |
| AE ∆% Jul-Dec | 3.0 |
| AE ∆% May-Jun | 1.2 |
| AE ∆% Jan-Apr | 4.9 |
| UK Consumer Price Index | |
| AE ∆% Aug-Dec | 4.7 |
| May-Jul | 0.4 |
| Jan-Apr | 6.5 |
Sources: http://www.bls.gov/cpi/data.htm
http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778750.htm
http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120112
http://www.istat.it/it/archivio/50340
http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/december-2011/index.html
II United States Inflation. Monetary policy pursues symmetric inflation targets of maintaining core inflation of the index of personal consumption expenditures (core PCE) in an open interval of 2.00 percent. If inflation increases above 2.00 percent, the central bank could use restrictive monetary policy such as increases in interest rates to contain inflation in a tight range or interval around 2.00 percent. If inflation falls below 2 percent, the central bank could use restrictive monetary policy such as lowering interest rates to prevent inflation from falling too much below 2.00 percent. Currently, with about thirty million unemployed and underemployed, there may even be a policy bias to raise or at least ignore inflation, maintaining accommodation as a form of promoting full employment. There are two arguments in favor of symmetric inflation targets preventing inflation from falling to very low levels.
1. Room for interest rate policy. Nominal interest rates hardly ever fall below zero. In economic jargon, the floor of zero nominal interest rates is referred to as “the zero bound.” Symmetric targets are proposed to maintain a sufficiently high inflation rate such that interest rates can be lowered to promote economic activity when recession threatens. With inflation close to zero there is no room for lowering interest rates with policy tools.
2. Fear of Deflation. Inflation is a process of sustained increases in prices. Deflation is a process of sustained decreases in prices. The probability of deflation increases as inflation approximates zero. The influence of fear of deflation in monetary policy is discussed in Pelaez and Pelaez (International Financial Architecture (2005), 18-28, The Global Recession Risk (2007, 83-95).
Subsection IIA Long-term US Inflation evaluates long-term inflation in the US, concluding that there has not been deflation risk since World War II. Subsection IIB Current US Inflation finds no evidence in current inflation justifying fear of deflation.
IA Long-term US Inflation. Key percentage average yearly rates of the US economy on growth and inflation are provided in Table II-1 updated with release of new data. The choice of dates prevents the measurement of long-term potential economic growth because of two recessions from IQ2001 (Mar) to IVQ2001 (Nov) with decline of GDP of 0.4 percent and the drop in GDP of 5.1 percent in IVQ2007 (Dec) to IIQ2009 (June) (http://www.nber.org/cycles.html) followed with unusually low economic growth for an expansion phase after recession with the economy growing at the annual equivalent rate of 1.1 percent in the first three quarters of 2011 (http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable.html). Between 2000 and 2010, real GDP grew at the average rate of 1.6 percent per year, nominal GDP at 3.9 percent and the implicit deflator at 2.5 percent. The average rate of CPI inflation was 2.4 percent per year and 2.0 percent excluding food and energy. PPI inflation increased at 2.7 percent per year on average and at 1.6 percent excluding food and energy. There is also inflation in international trade. Import prices grew at 2.7 percent per year between 2000 and 2010 and 3.2 percent between 2000 and 2011. The commodity price shock is revealed by inflation of import prices of petroleum at 12.2 percent per year between 2000 and 2010 and at 13.5 percent between 2000 and 2011. The average growth rates of import prices excluding fuels are much lower at 1.9 percent for 2002 to 2010 and 2.1 percent for 2000 to 2011. Export prices rose at the average rate of 2.4 percent between 2000 and 2010 and at 2.6 percent from 2000 to 2011. What spared the US of sharper decade-long deterioration of the terms of trade, (export prices)/(import prices), was its diversification and competitiveness in agriculture. Agricultural export prices grew at the average yearly rate of 6.9 percent from 2000 to 2010 and at 6.3 percent from 2000 to 2011. US nonagricultural export prices rose at 2.1 percent per year in 2000 to 2010 and at 2.2 percent in 2000 to 2011. These dynamic growth rates are not similar to those for the economy of Japan where inflation was negative in seven of the 10 years in the 2000s.
Table II-1, US, Average Growth Rates of Real and Nominal GDP, Consumer Price Index, Producer Price Index and Import and Export Prices, Percent per Year
| Real GDP | 2000-2010: 1.6% |
| Nominal GDP | 2000-2010: 3.9% |
| Implicit Price Deflator | 2000-2010: 2.5% |
| CPI | 2000-2010: 2.4% |
| CPI ex Food and Energy | 2000-2010: 2.0% |
| PPI | 2000-2010: 2.7% |
| PPI ex Food and Energy | 2000-2010: 1.6% |
| Import Prices | 2000-2010: 2.7% |
| Import Prices of Petroleum and Petroleum Products | 2000-2010: 12.2% |
| Import Prices Excluding Fuels | 2002-2010: 1.9% |
| Export Prices | 2000-2010: 2.4% |
| Agricultural Export Prices | 2000-2010: 6.9% |
| Nonagricultural Export Prices | 2000-2010: 2.1% |
Note: rates for price indexes in the row beginning with “CPI” and ending in the row “Nonagricultural Export Prices” are for Dec 2000 to Dec 2010 and for Dec 2001 to Dec 2011. Import prices excluding fuels are not available before 2002.
Sources:
http://www.bea.gov/iTable/index_nipa.cfm http://www.bls.gov/ppi/data.htm
http://www.bls.gov/mxp/data.htm http://www.bls.gov/cpi/data.htm
Unconventional monetary policy of zero interest rates and large-scale purchases of long-term securities for the balance sheet of the central bank is proposed to prevent deflation. The data of CPI inflation of all goods and CPI inflation excluding food and energy for the past six decades show only one negative change by 0.4 percent in the CPI all goods annual index in 2009 but not one year of negative annual yearly change in the CPI excluding food and energy 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 II-1 provides US nominal GDP from 1980 to 2010. The only major bump in the chart occurred in the recession of IVQ2007 to IIQ2009. Tendency for deflation would be reflected in persistent bumps. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.5 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). The comparison of the global recession after 2007 with the Great Depression is entirely misleading.
Chart II-1, US, Nominal GDP 1980-2010
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Chart II-2 provides US real GDP from 1980 to 2010. Persistent deflation threatening real economic activity would also be reflected in the series of long-term growth of GDP. There is no such behavior in Chart II-2 except for periodic recessions in the US economy that have occurred throughout history.
Chart II-2, US, Real GDP 1980-2010
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Deflation would also be in evidence in long-term series of prices in the form of bumps. The GDP implicit deflator series in Chart II-3 from 1980 to 2010 shows rather dynamic behavior over time. The US economy is not plagued by deflation but by long-run inflation.
Chart II-3, US, GDP Implicit Price Deflator 1980-2010
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Chart II-4 provides percent change from preceding quarter in prices of GDP at seasonally-adjusted annual rates (SAAR) from 1980 to 2010. There is one case of negative change in IIQ2009. There has not been actual deflation or risk of deflation in the US that would justify unconventional monetary policy.
Chart II-4, Percent Change from Preceding Period in Prices for GDP Seasonally Adjusted at Annual Rates 1980-2011
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Chart II-5 provides percent change from preceding year in prices of GDP from 1980 to 2010. There was not one single year of deflation or risk of deflation in the past three decades.
Chart II-5, Percent Change from Preceding Year in Prices for Gross Domestic Product 1980-2010
Source: http://www.bea.gov/iTable/index_nipa.cfm
The producer price index of the US from 1960 to 2011 in Chart II-6 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.
Chart II-6, US, Producer Price Index, Finished Goods, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart II-7 provides 12-month percentage changes of the producer price index from 1960 to 2011. The distinguishing event in Chart II-7 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2011.
Chart II-7, US, Producer Price Index, Finished Goods, 12 Months Percentage Change, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The producer price index excluding food and energy from 1974, the first historical data of availability in the dataset of the Bureau of Labor Statistics (BLS), to 2011, shows similarly dynamic behavior as the overall index, as shown in Chart II-8. There is no evidence of persistent deflation in the US PPI.
Chart II-8, US Producer Price Index, Finished Goods Excluding Food and Energy, NSA, 1974-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart II-9 provides 12-month percentage rates of change of the finished goods index excluding food and energy. The dominating characteristic is the Great Inflation of the 1970s. The double hump illustrates how inflation may appear to be subdued and then returns with strength.
Chart II-9, US Producer Price Index, Finished Goods Excluding Food and Energy, 12 Month Percentage Change, NSA, 1974-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The producer price index of energy goods from 1974 to 2011 is provided in Chart II-10. The first jump occurred during the Great Inflation of the 1970s analyzed in various comments of this blog (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html) and in Appendix I. There is relative stability of producer prices after 1986 with another jump and decline in the late 1990s into the early 2000s. The episode of commodity price increases during a global recession in 2008 could only have happened with interest rates dropping toward zero, which stimulated the carry trade from zero interest rates to leveraged positions in commodity futures. Commodity futures exposures were dropped in the flight to government securities after Sep 2008. Commodity future exposures were created again when risk aversion diminished around Mar 2011 after the finding that US bank balance sheets did not have the toxic assets that were mentioned in proposing TARP in Congress (see Cochrane and Zingales 2009). Fluctuations in commodity prices and other risk financial assets originate in carry trade when risk aversion ameliorates.
Chart II-10, US, Producer Price Index, Finished Energy Goods, NSA, 1974-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart 1I-11 shows 12-month percentage change of the producer price index of finished energy goods from 1975 to 2011. This index is only available after 1974 and captures only one of the humps of energy prices during the Great Inflation. Fluctuations in energy prices have occurred throughout history in the US but without provoking deflation. Two cases are the decline of oil prices in 2001 to 2002 that has been analyzed by Barsky and Kilian (2004) and the collapse of oil prices from over $140/barrel with shock of risk aversion to the carry trade in Sep 2008.
Chart II-11, US, Producer Price Index, Finished Energy Goods, 12 Month Percentage Change, NSA, 1974-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart II-12 provides the consumer price index NSA from 1960 to 2011. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.
Chart II-12, US, Consumer Price Index, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart II-13 provides 12 month percentage changes of the consumer price index from 1960 to 2011. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.
Chart II-13, US, Consumer Price Index, All Items, 12- Month Percentage Change 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart II-14 provides the consumer price index excluding food and energy from 1960 to 2011. There is long-term inflation in the US without episodes of deflation.
Chart II-14, US, Consumer Price Index Excluding Food and Energy, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart II-15 provides 12 months percentage changes of the consumer price index excluding food and energy from 1960 to 2011. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.
Chart II-15, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1960-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The consumer price index of housing is provided in Chart II-16. There was also acceleration during the Great Inflation of the 1970s. The index flattens after the global recession in IVQ2007 to IIQ2009. Housing prices collapsed under the weight of construction of several times more housing than needed. Surplus housing originated in subsidies and artificially low interest rates in the shock of unconventional monetary policy in 2003 to 2004 in fear of deflation.
Chart II-16, US, Consumer Price Index Housing, NSA, 1967-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart II-17 provides 12 months percentage changes of the housing CPI. The Great Inflation also had extremely high rates of housing inflation. Housing is considered as potential hedge of inflation.
Chart II-17, US, Consumer Price Index, Housing, 12- Month Percentage Change, NSA, 1968-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
IIB Current US Inflation. Consumer price inflation has decelerated in recent months. Table II-2 provides the 12 months and annual equivalent rate for the months of Oct to Dec of the CPI and major segments. CPI inflation in the 12 months ending in Dec reached 3.0 percent and the annual equivalent rate Oct-Dec was minus 0.4 percent. These inflation rates fluctuate in accordance with inducement of risk appetite or frustration by risk aversion of carry trades from zero interest rates to commodity futures. Excluding food and energy, CPI inflation was 2.2 percent in the 12 months ending in Dec and 2.0 percent in annual equivalent in Oct-Dec. There is no deflation in the US economy that could justify further quantitative easing. Consumer food prices in the US have risen 4.7 percent in 12 months and at 1.6 percent in annual equivalent in Oct-Dec. Monetary policies stimulating carry trades of commodities that increase prices of food constitute a highly regressive tax on lower income families for whom food is a major portion of the consumption basket. Energy increased 10.3 percent in 12 months and at minus 17.9 percent in annual equivalent in Oct-Dec as the carry trade from zero interest rates to commodity futures was unwound during risk aversion originating in the European debt crisis. For lower income families, food and energy are a major part of the family budget. Inflation is not low or threatening deflation in annual equivalent in Oct-Dec in any of the categories in Table II-2 but simply reflecting waves of inflation originating in carry trades. An upward trend is determined by carry trades from zero interest rates to commodity futures positions with episodes of risk aversion causing fluctuations
Table II-2, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%
| ∆% 12 Months Dec 2011/Dec | ∆% Annual Equivalent Oct-Dec 2011 SA | |
| CPI All Items | 3.0 | -0.4 |
| CPI ex Food and Energy | 2.2 | 2.0 |
| Food | 4.7 | 1.6 |
| Food at Home | 6.0 | 0.9 |
| Food Away from Home | 2.9 | 2.4 |
| Energy | 6.6 | -17.9 |
| Gasoline | 9.9 | -26.2 |
| Fuel Oil | 10.3 | -26.2 |
| New Vehicles | 3.2 | -3.4 |
| Used Cars and Trucks | 4.0 | -6.5 |
| Medical Care Commodities | 3.5 | 5.1 |
| Apparel | 4.6 | 3.7 |
| Services Less Energy Services | 2.3 | 2.7 |
| Shelter | 1.9 | 2.1 |
| Transportation Services | 2.5 | 1.3 |
| Medical Care Services | 3.6 | 3.7 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/news.release/pdf/cpi.pdf
The weights of the CPI, US city average, are shown in Table II-3. Housing has a weight of 41.460 percent. The combined weight of housing and transportation is 58.768 percent or more than one half. The combined weight of housing, transportation and food and beverages is 73.56 percent of the US CPI.
Table II-3, US, Relative Importance, 2007-2008 Weights, of Components in the Consumer Price Index, US City Average, Dec 2010
| All Items | 100.000 |
| Food and Beverages | 14.792 |
| Food | 13.742 |
| Food at home | 7.816 |
| Food away from home | 5.926 |
| Housing | 41.460 |
| Shelter | 31.955 |
| Rent of primary residence | 5.925 |
| Owners’ equivalent rent | 24.905 |
| Apparel | 3.601 |
| Transportation | 17.308 |
| Private Transportation | 16.082 |
| New vehicles | 3.513 |
| Used cars and trucks | 2.055 |
| Motor fuel | 5.079 |
| Gasoline | 4.865 |
| Medical Care | 6.627 |
| Medical care commodities | 1.633 |
| Medical care services | 4.994 |
| Recreation | 6.293 |
| Education and Communication | 6.421 |
| Other Goods and Services | 3.497 |
Source:
US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart II-18 provides the US consumer price index for housing from 2001 to 2011. Housing prices rose sharply during the decade until the bump of the global recession and are increasing again in 2011 with some stabilization currently. The CPI excluding housing would likely show much higher inflation. Income remaining after paying for indispensable shelter has been compressed by the commodity carry trades resulting from unconventional monetary policy.
Chart II-18, US, Consumer Price Index, Housing, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart II-19 provides 12-month percentage changes of the housing CPI. Percentage changes collapsed during the global recession but have been rising into positive territory in 2011.
![clip_image034[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfiles1B7D457\image48.png "clip_image034[1]")
Chart II-19, US, Consumer Price Index, Housing, 12-Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
There have been four waves of consumer price inflation in the US in 2011 that are illustrated in Table II-4. The first wave occurred in Jan-Apr and was caused by the carry trade of commodity prices induced by unconventional monetary policy of zero interest rates. Cheap money at zero opportunity cost was channeled into financial risk assets, causing increases in commodity prices. The annual equivalent rate of increase of the all-items CPI in Jan-Apr was 7.5 percent and the CPI excluding food and energy increased at annual equivalent rate of 2.8 percent. The second wave occurred during the collapse of the carry trade from zero interest rates to exposures in commodity futures as a result of risk aversion in financial markets created by the sovereign debt crisis in Europe. The annual equivalent rate of increase of the all items CPI dropped to 2.0 percent in May-Jul but the annual equivalent rate of the CPI excluding food and energy increased to 3.2 percent. The third wave occurred in the form of increase of the CPI all items annual equivalent rate to 4.9 percent in Jul-Sep with the annual equivalent rate of the CPI excluding food and energy dropping to 2.0 percent. The fourth wave occurred in Oct-Dec with negative annual equivalent headline inflation of minus 0.4 percent and core inflation of 1.6 percent. The conclusion is that inflation accelerates and decelerates in unpredictable fashion that turns symmetric inflation targets in a source of destabilizing shocks to the financial system and eventually the overall economy.
Table II-4, US, Headline and Core CPI Inflation Monthly SA and 12 Months NSA ∆%
| All Items SA Month | All Items NSA 12 month | Core SA | Core NSA | |
| Dec | 0.0 | 3.0 | 0.1 | 2.2 |
| Nov | 0.0 | 3.4 | 0.2 | 2.2 |
| Oct | -0.1 | 3.5 | 0.1 | 2.1 |
| AE ∆% Oct-Dec | -0.4 | 1.6 | ||
| Sep | 0.3 | 3.9 | 0.1 | 2.0 |
| Aug | 0.4 | 3.8 | 0.2 | 2.0 |
| Jul | 0.5 | 3.6 | 0.2 | 1.8 |
| AE ∆% Jul-Sep | 4.9 | 2.0 | ||
| Jun | -0.2 | 3.6 | 0.3 | 1.6 |
| May | 0.2 | 3.6 | 0.3 | 1.5 |
| AE ∆% May-Jul | 2.0 | 3.2 | ||
| Apr | 0.4 | 3.2 | 0.2 | 1.3 |
| Mar | 0.5 | 2.7 | 0.1 | 1.2 |
| Feb | 0.5 | 2.1 | 0.2 | 1.1 |
| Jan | 0.4 | 1.6 | 0.2 | 1.0 |
| AE ∆% Jan-Apr | 7.5 | 2.8 | ||
| Dec 2010 | 0.4 | 1.5 | 0.1 | 0.8 |
| Nov | 0.1 | 1.1 | 0.1 | 0.8 |
| Oct | 0.2 | 1.2 | 0.0 | 0.6 |
| Sep | 0.2 | 1.1 | 0.0 | 0.8 |
| Aug | 0.2 | 1.1 | 0.1 | 0.9 |
| Jul | 0.3 | 1.2 | 0.1 | 0.9 |
| Jun | -0.2 | 1.1 | 0.1 | 0.9 |
| May | -0.1 | 2.0 | 0.1 | 0.9 |
| Apr | 0.0 | 2.2 | 0.0 | 0.9 |
| Mar | 0.0 | 2.3 | 0.0 | 1.1 |
| Feb | 0.0 | 2.1 | 0.1 | 1.3 |
| Jan | 0.1 | 2.6 | -0.1 | 1.6 |
Note: Core: excluding food and energy; AE: annual equivalent
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The behavior of the US consumer price index NSA from 2001 to 2011 is provided in Chart II-20. Inflation in the US is very dynamic without deflation risks that would justify symmetric inflation targets. The hump in 2008 originated in the carry trade from interest rates dropping to zero into commodity futures. There is no other explanation for the increase of oil prices toward $140/barrel during the global recession. The unwinding of the carry trade with the TARP announcement of toxic assets in banks channeled cheap money into government obligations (see Cochrane and Zingales 2009).
Chart II-20, US, Consumer Price Index, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart II-21 provides 12-month percentage changes of the consumer price index from 2001 to 2011. There was no deflation or threat of deflation from 2008 into 2009. Commodity prices collapsed during the panic of toxic assets in banks. When stress tests revealed US bank balance sheets in much stronger position, cheap money at zero opportunity cost exited government obligations and flowed into carry trades of risk financial assets. Increases in commodity prices drove again the all items CPI with interruptions during risk aversion originating in the sovereign debt crisis of Europe.
Chart II-21, US, Consumer Price Index, 12-Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The trend of increase of the consumer price index excluding food and industry in Chart II-22 does not reveal any threat of deflation that would justify symmetric inflation targets. There are mild oscillations in a neat upward trend.
Chart II-22, US, Consumer Price Index Excluding Food and Energy, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart II-23 provides 12 month percentage change of the consumer price index excluding food and energy. Past-year rates of inflation fell toward 1 percent from 2001 into 2003 as a result of the recession and the decline of commodity prices beginning before the recession with declines of real oil prices. Near zero interest rates with fed funds at 1 percent between Jun 2003 and Jun 2004 stimulated carry trades of all types, including in buying homes with subprime mortgages in expectation that low interest rates forever would increase home prices permanently, creating the equity that would permit the conversion of subprime mortgages into creditworthy mortgages (Gorton 2009EFM; see http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Inflation rose and then collapsed during the unwinding of carry trades and the housing debacle of the global recession. Carry trade into 2011 gave a new impulse to CPI inflation, all items and core. Symmetric inflation targets destabilize the economy by encouraging hunts for yields that inflate and deflate financial assets.
Chart II-23, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Headline and core producer price index are in Table II-5. The headline PPI fell 0.1 percent SA in Dec but the 12-month rate NSA fell to 4.8 percent. The core PPI SA increased 0.3 in Dec and rose 3.0 percent in 12 months. Analysis of annual equivalent rates of change shows four different waves. In the first wave, the absence of risk aversion from the sovereign risk crisis in Europe motivated the carry trade from zero interest rates into commodity futures that caused the average equivalent rate of 17.3 percent in the headline PPI in Jan-Apr and 5.3 percent in the core PPI. In the second wave, commodity futures prices collapsed in May with the return of risk aversion originating in the sovereign risk crisis of Europe. The annual equivalent rate of headline PPI inflation collapsed to 0.8 percent in May-Jul but the core annual equivalent inflation rate was much higher at 3.2 percent. In the third wave, headline PPI inflation resuscitated with annual equivalent 4.9 percent in Jul-Sep and core PPI inflation was 3.2 percent. Core PPI inflation has been persistent throughout 2011 and has jumped from around 1 percent in the first four months of 2010 to 3.0 percent in 12 months in Dec and 2.4 percent in annual equivalent rate in Jul-Dec. In the fourth wave, risk aversion originating in the lack of resolution of the European debt crisis caused unwinding of carry trades with annual equivalent headline PPI inflation of minus 0.4 percent in Oct-Dec but persistent core inflation of 1.6 percent. It is impossible to forecast PPI inflation and its relation to CPI inflation. “Inflation surprise” by monetary policy could be proposed to climb along a downward sloping Phillips curve, resulting in higher inflation but lower unemployment (see Kydland and Prescott 1977, Barro and Gordon 1983 and past comments of this blog http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). The architects of monetary policy would require superior inflation forecasting ability compared to forecasting naivety by everybody else. In practice, we are all naïve in forecasting inflation and other economic variables and events.
Table II-5, US, Headline and Core PPI Inflation Monthly SA and 12 Months NSA ∆%
| Finished | Finished | Finished Core SA | Finished Core NSA | |
| Dec 2011 | -0.1 | 4.8 | 0.3 | 3.0 |
| Nov | 0.3 | 5.7 | 0.1 | 2.9 |
| Oct | -0.3 | 5.9 | 0.0 | 2.8 |
| AE ∆% Oct-Dec | -0.4 | 1.6 | ||
| Sep | 0.7 | 6.9 | 0.0 | 2.5 |
| Aug | 0.2 | 6.6 | 0.2 | 2.7 |
| Jul | 0.3 | 7.1 | 0.6 | 2.7 |
| AE ∆% Jul-Sep | 4.9 | 3.2 | ||
| Jun | -0.3 | 6.9 | 0.3 | 2.3 |
| May | 0.1 | 7.1 | 0.1 | 2.1 |
| AE ∆% May-Jul | 0.8 | 3.2 | ||
| Apr | 0.8 | 6.6 | 0.3 | 2.3 |
| Mar | 0.7 | 5.6 | 0.3 | 2.0 |
| Feb | 1.5 | 5.4 | 0.2 | 1.8 |
| Jan | 1.0 | 3.6 | 0.5 | 1.6 |
| AE ∆% Jan-Apr | 17.3 | 5.3 | ||
| Dec 2010 | 0.9 | 3.8 | 0.2 | 1.4 |
| Nov | 0.5 | 3.4 | 0.0 | 1.2 |
| Oct | 0.6 | 4.3 | -0.3 | 1.6 |
| Sep | 0.3 | 3.9 | 0.2 | 1.6 |
| Aug | 0.6 | 3.3 | 0.1 | 1.3 |
| Jul | 0.1 | 4.1 | 0.2 | 1.5 |
| Jun | -0.3 | 2.7 | 0.1 | 1.1 |
| May | -0.2 | 5.1 | 0.2 | 1.3 |
| Apr | -0.1 | 5.4 | 0.1 | 0.9 |
| Mar | 0.7 | 5.9 | 0.2 | 0.9 |
| Feb | -0.4 | 4.2 | 0.0 | 1.0 |
| Jan | 1.1 | 4.5 | 0.3 | 1.0 |
Note: Core: excluding food and energy; AE: annual equivalent
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The US producer price index NSA from 2001 to 2011 is shown in Chart II-24. There are two episodes of decline of the PPI during recessions in 2001 and in 2008. Barsky and Kilian (2004) consider the 2001 episode as one in which real oil prices were declining when recession began. Recession and the fall of commodity prices instead of generalized deflation explain the behavior of US inflation in 2008.
Chart II-24, US, Producer Price Index, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Twelve-month percentage changes of the PPI NSA from 2001 to 2011 are shown in Chart II-25. It may be possible to forecast trends a few months in the future under adaptive expectations but turning points are almost impossible to anticipate especially when related to fluctuations of commodity prices in response to risk aversion. In a sense, monetary policy has been tied to behavior of the PPI in the negative 12 months rates in 2001 to 2003 and then again in 2009 to 2010. Monetary policy following deflation fears caused by commodity price fluctuations would introduce significant volatility and risks in financial markets and eventually in consumption and investment.
Chart II-25, US, Producer Price Index, 12-Month Percentage Change NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The US PPI excluding food and energy from 2001 to 2011 is shown in Chart II-26. There is here again a smooth trend of inflation instead of prolonged deflation as in Japan.
Chart II-26, US, Producer Price Index Excluding Food and Energy, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Twelve-month percentage changes of the producer price index excluding food and energy are shown in Chart II-27. Fluctuations replicate those in the headline PPI. There is an evident trend of increase of 12 months rates of core PPI inflation in 2011.
Chart II-27, US, Producer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
The US producer price index of energy goods from 2001 to 2011 is in Chart II-28. There is a clear upward trend with fluctuations that would not occur under persistent deflation.
Chart II-28, US, Producer Price Index Energy Goods, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Chart II-29 provides 12-month percentage changes of the producer price index of energy goods from 2001 to 2011. The episode of declining prices of energy goods in 2001 to 2002 is related to the analysis of decline of real oil prices by Barsky and Kilian (2004). Interest rates dropping to zero during the global recession explain the rise of the PPI of energy goods toward 30 percent. Bouts of risk aversion with policy interest rates held close to zero explain the fluctuations in the 12-month rates of the PPI of energy goods in the expansion phase of the economy. Symmetric inflation targets induce significant instability in inflation and interest rates with adverse effects on financial markets and the overall economy.
Chart II-29, US, Producer Price Index Energy Goods, 12- Month Percentage Change, NSA, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/ppi/data.htm
Table II-6 provides 12 month percentage changes of the CPI all items, CPI core and CPI housing from 2001 to 2011. There is no evidence in these data supporting symmetric inflation targets that would only induce greater instability in inflation, interest rates and financial markets. Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). The impact on the overall economy and the financial system of errors of policy are magnified by large-scale policy doses of trillions of dollars of quantitative easing and zero interest rates. The US economy has been experiencing financial repression as a result of negative real rates of interest in the past few years and programmed in monetary policy statements until 2013 or, for practical purposes, forever. The essential calculus of risk/return in capital budgeting and financial allocations has been distorted.
Table II-6, CPI All Items, CPI Core and CPI Housing, 12 Months Rates of Change, Dec NSA 2001-2011
| Nov | CPI All Items | CPI Core ex Food and Energy | CPI Housing |
| 2011 | 3.0 | 2.2 | 1.9 |
| 2010 | 1.5 | 0.8 | 0.3 |
| 2009 | 2.7 | 1.8 | -0.3 |
| 2008 | 0.1 | 1.8 | 2.4 |
| 2007 | 4.1 | 2.4 | 3.0 |
| 2006 | 2.5 | 2.6 | 3.3 |
| 2005 | 3.4 | 2.2 | 4.0 |
| 2004 | 3.3 | 2.2 | 3.0 |
| 2003 | 1.9 | 1.1 | 2.2 |
| 2002 | 2.4 | 1.9 | 2.4 |
| 2001 | 1.6 | 2.7 | 2.9 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
III World 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 provides current data and analysis. Subsection IIIA Financial Risks provides analysis of the evolution of valuations of risk assets during the week. There are various appendixes at the end of this section for convenience of reference of material related to the euro area debt crisis. Subsection IIIB Appendix on Safe Haven Currencies discusses arguments and measures of currency intervention. Subsection IIIC Appendix on Fiscal Compact provides analysis of the restructuring of the fiscal affairs of the European Union in the agreement of European leaders reached on Dec 9, 2011. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank. Appendix IIID Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis.
IIIA Financial Risks. The past four months have been characterized by financial turbulence, attaining unusual magnitude in the past few weeks. Table III-1, updated with every comment in this blog, provides beginning values on Fr Jan 13 and daily values throughout the week ending on Fri Jan 20 of several financial assets. Section VI 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 Jan 13 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 waves of 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 IIIC Appendix on Fiscal Compact.
The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.268/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jan 13, appreciating to USD 1.2664/EUR on Mon Jan 16, or by 0.1 percent. The dollar appreciated because fewer dollars, $1.2664, were required on Jan 16 to buy one euro than $1.268 on Jan 13. Table III-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 1.2664/EUR on Jan 16; 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 Jan 13, to the last business day of the current week, in this case Fri Jan 20, such as depreciation by 2.0 percent to USD 1.293/EUR by Jan 20; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (negative sign) by 2.0 percent from the rate of USD 1.268/EUR on Fri Jan 13 to the rate of USD 1.293/EUR on Fri Jan 20 {[(1.293/1.268) – 1]100 = 2.0% (rounding 1.972 to 2.0)} and appreciated by 0.2 percent from the rate of USD 1.2963 on Thu Jan 19 to USD 1.293/EUR on Fri Jan 20 {[(1.293/1.2963) -1]100 = -0.2%}. 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.
Table III-I, Weekly Financial Risk Assets Jan 16 to Jan 20, 2012
| Fri Jan 13, 2012 | M 16 | Tue 17 | W 18 | Thu 19 | Fr 20 |
| USD/EUR 1.268 0.3% | 1.2664 0.1% 0.1% | 1.2740 -0.5% -0.6% | 1.2857 -1.4% -0.9% | 1.2963 -2.2% -0.8% | 1.293 -2.0% 0.2% |
| JPY/ USD 76.952 0.0% | 76.7935 0.2% 0.2% | 76.8245 0.2% 0.0% | 76.7800 0.2% 0.0% | 77.1530 -0.3% -0.5% | 76.9563 0.0% 0.3% |
| CHF/ USD 0.9555 0.1% | 0.9546 0.1% 0.1% | 0.9494 0.6% 0.5% | 0.9397 1.6% 1.0% | 0.9323 2.4% 0.8% | 0.9341 2.2% -0.2% |
| CHF/ EUR 1.2076 0.6% | 1.2089 -0.1% -0.1% | 1.2096 -0.2% -0.1% | 1.2081 0.0% 0.1% | 1.2086 -0.1% 0.0% | 1.2083 -0.1% 0.0% |
| USD/ AUD 1.0321 0.9689 1.0% | 1.0307 0.9702 -0.1% -0.1% | 1.0378 0.9636 0.5% 0.7% | 1.0425 0.9592 1.0% 0.5% | 1.0424 0.9593 1.0% 0.0% | 1.048 0.9542 1.5% 0.5% |
| 10 Year T Note 1.869 | 1.86 | 1.86 | 1.89 | 1.98 | 2.026 |
| 2 Year T Note 0.225 | 0.22 | 0.22 | 0.23 | 0.23 | 0.242 |
| German Bond 2Y 0.15 10Y 1.77 | 2Y 0.15 10Y 1.77 | 2Y 0.18 10Y 1.79 | 2Y 0.20 10Y 1.78 | 2Y 0.21 10Y 1.86 | 2Y 0.21 10Y 1.93 |
| DJIA 12422.06 0.5% | 12422.06 -0.4% -0.4% | 12482.07 0.5% 0.5% | 12578.95 1.3% 0.8% | 12623.98 1.6% 0.4% | 12720.48 2.4% 0.8% |
| DJ Global 1841.21 1.6% | 1841.50 0.0% 0.0% | 1860.24 1.0% 1.0% | 1879.32 2.1% 1.0% | 1901.37 3.3% 1.2% | 1908.00 3.6% 0.3% |
| DJ Asia Pacific 1194.65 2.3% | 1183.85 -0.9% -0.9% | 1205.01 0.9% 1.8% | 1208.38 1.1% 0.3% | 1217.69 1.9% 0.8% | 1231.88 3.1% 1.2% |
| Nikkei 8500.02 1.3% | 8378.36 -1.4% -1.4% | 8466.40 -0.4% 1.1% | 8550.58 0.6% 1.0% | 8639.68 1.6% 1.0% | 8766.36 3.1% 1.5% |
| Shanghai 2244.58 3.8% | 2206.19 -1.7% -1.7% | 2298.38 2.4% 4.2% | 2266.38 1.0% -1.4% | 2296.08 2.3% 1.3% | 2319.12 3.3% 1.0% |
| DAX 6143.08 1.4% | 6220.01 1.3% 1.3% | 6332.93 3.1% 1.8% | 6354.57 3.4% 0.3% | 6416.26 4.4% 1.0% | 6404.39 4.3% -0.2% |
| DJ UBS Comm. 140.51 -1.4% | 140.51 -0.8% -0.8% | 141.48 0.7% 0.7% | 141.15 0.5% -0.2% | 141.59 0.8% 0.3% | 141.24 0.5% -0.2% |
| WTI $ B 99.26 -2.5% | 96.69 -2.6% -2.6% | 100.90 1.7% 4.4% | 100.89 1.6% 0.0% | 100.55 1.3% -0.3% | 98.46 -0.8% -2.1% |
| Brent $/B 111.14 -2.0% | 111.50 0.3% 0.3% | 111.70 0.5% 0.2% | 110.93 -0.2% -0.7% | 111.60 0.4% 0.6% | 110.21 -0.8% -1.2% |
| Gold $/OZ 1639.6 1.4% | 1643.7 0.3% 0.3% | 1652.2 0.8% 0.5% | 1661.5 1.3% 0.6% | 1657.6 1.1% -0.2% | 1666.5 1.6% 0.5% |
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
Table III-1 shows mixed results in valuations of risk financial assets in the week of Jan 9. 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 III-1 reflect alternating bouts of 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 observed in foreign exchange markets with daily trading of $4 trillion. The dollar has fluctuated in a tight range with hardly any changes except for appreciation of the Swiss franc by 2.2 percent relative to the dollar and depreciation by 0.1 percent relative to the euro. With stronger data in Asia favoring carry trades, the Australian dollar appreciated 1.5 percent.
Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing 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, falling to 1.871 percent on Fri Dec 30 and increasing to 1.957 percent on Jan 6 but falling again to 1.869 on Jan 13. More relaxed risk aversion is shown in the increase of the yield of the 10-year Treasury to 2.026 percent on Fri Jan 20, as shown in Table III-1. The 10-year Treasury yield is still at a level well below consumer price inflation of 3.0 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, increasing to 0.256 on Fri Jan 6 but falling to 0.225 on Jan 13. The yield of the two-year Treasury rose to 0.242 percent on Fri Dec 20 in an environment of more relaxed risk aversion, as shown in Table III-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 2.7 percent for the 12 months ending in Dec (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-17012012-AP/EN/2-17012012-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 and rising to 0.17 percent on Jan 6 and 0.15 percent on Jan 13. The yield of the two-year government bond of Germany increased to 0.21 percent in an environment of marginally more relaxed risk aversion, as shown in Table III-1. The yield of the ten-year German government bond has also collapsed from 2.15 percent on Dec 9 to 1.85 percent on Dec 16, rising to 1.96 percent on Dec 23, falling to 1.83 percent on Dec 30, which was virtually equal to the yield of 1.871 percent of the US ten-year Treasury note. The ten-year government bond of Germany traded at 1.85 percent on Jan 6 and at 1.77 percent on Jan 13, increasing to 1.93 percent on Jan 20, as shown in Table III-1. Safety overrides inflation-adjusted yield but there could be duration aversion. Turbulence has also affected the market for German sovereign bonds.
There was strong performance of equity indexes in Table III-1 during the week of Jan 20. Germany’s Dax rose 4.3 percent. DJIA gained 2.4 percent in the week of Fri Jan 20. Dow Global increased 3.6 percent in the week of Jan 20. China’s Shanghai Composite jumped 3.3 percent in the week with an increase of 2.4 percent on Jan 17 after release of strong economic data but that do not rule additional fiscal and monetary stimulus because of low inflation. Japan’s Nikkei Average increased 3.3 percent. Dow Asia Pacific rose 3.1 percent.
Financial risk assets increase during moderation of risk aversion in carry trades from zero interest rates and fall during increasing risk aversion. Commodities were mixed in the week of Jan 20. The DJ UBS Commodities Index increased 0.5 percent. WTI lost 0.8 percent and Brent also fell 0.8 percent. Gold gained 1.6 percent. Confrontation with Iran may be influencing oil and commodity prices.
The week has been dominated by rating actions of Standard & Poor’s Ratings Services (S&PRS) (2012Jan13) on 16 members of the European Monetary Union (EMU) or eurozone. The actions by S&PRS (2012Jan13) are of several types:
1. Downgrades by two notches of long-term credit ratings of Cyprus (from BBB/Watch/NegA-3+ to BB+/Neg/B), Italy (from A/Watch Neg/A-1 to BBB+/Neg/A-2), Portugal (from BBB-/Watch Neg/A-3 to BB/Neg/B) and Spain (from AA-/Watch Neg/A-1+ to A/Neg/A-1).
2. Downgrades by one notch of long-term credit ratings of Austria (from AAA/Watch Neg/A-1+ to AA+/Neg/A-1+), France (from AAA/Watch Neg/A-1+ to AA+/Neg A-1+), Malta (from A/Watch, Neg/A-1 to A-/Neg/A-2), Slovakia (from A+/Watch Neg/A-1 to A/Stable/A-1) and Slovenia (AA-/Watch Neg/A-1+ to A+/Neg/A-1).
3. Affirmation of long-term ratings of Belgium (AA/Neg/A-1+), Estonia (AA-/Neg/A-1+), Finland (AAA/Neg/A-1+), Germany (AAA/Stable/A-1+), Ireland (BBB+/Neg/A-2), Luxembourg (AAA/Neg/A-1+) and the Netherlands (AAA/Neg/A-1+) with removal from CreditWatch.
4. Negative outlook on the long-term credit ratings of Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain, meaning that S&PRS (2012Jan13) finds that the ratings of these sovereigns have a chance of at least 1-to-3 of downgrades in 2012 or 2013.
S&PRS (2012Jan13) finds that measures by European policymakers may not be sufficient to contain sovereign risks in the eurozone. The sources of stress according to S&PRS (2012Jan13) are:
1. Worsening credit environment
2. Increases in risk premiums for many eurozone borrowers
3. Simultaneous attempts at reducing debts by both eurozone governments and households
4. More limited perspectives of economic growth
5. Deepening and protracted division among Europe’s policymakers in agreeing to approaches to resolve the European debt crisis
There is now only one major country in the eurozone with AAA rating of its long-term debt by S&PRS (2012Jan13): Germany. IIIE Appendix Euro Zone Survival Risk analyzes the hurdle of financial bailouts of euro area members by the strength of the credit of Germany alone. The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is abouy $3531.6 billion. There is some simple “unpleasant bond arithmetic.” 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 about $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. Debt as percent of Germany’s GDP 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. Charles Forelle, writing on Jan 14, 2012, on “Downgrade hurts euro rescue fund,” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204409004577159210191567778.html), analyzes the impact of the downgrades on the European Financial Stability Facility (EFSF). The EFSF is a special purpose vehicle that has not capital but can raise funds to be used in bailouts by issuing AAA-rated debt. S&P may cut the rating of the EFSF to the new lowest rating of the six countries with AAA rating, which are now down to four with the downgrades of France and Austria. The other rating agencies Moody’s and Fitch have not taken similar action. On Jan, S&PRS (2012Jan16) did cut the long-term credit rating of the EFSF to AA+ and affirmed the short-term credit rating at A-+. The decision is derived from the reduction in credit rating of the countries guaranteeing the EFSF. In the view of S&PRS (2012Jan16), there are not sufficient credit enhancements after the reduction in the creditworthiness of the countries guaranteeing the EFSF. The decision could be reversed if credit enhancements were provided.
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. 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 are also critical in episodes of risk aversion. David Oakley, writing on Jan 3, 2012, on “Sovereign issues draw euro to crunch point,” published by the Financial Times (http://www.ft.com/intl/cms/s/0/63b9d7ca-2bfa-11e1-98bc-00144feabdc0.html#axzz1iLNRyEbs), estimates total euro area sovereign issues in 2012 at €794 billion, much higher than the long-term average of €670 billion. Oakley finds that the sovereign issues are: Italy €220 billion, France €197 billion, Germany €178 billion and Spain €81 billion. Bond auctions will test the resilience of the euro. Victor Mallet and Robin Wigglesworth, writing on Jan 12, 2012, on “Spain and Italy raise €22bn in debt sales,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/e22c4e28-3d05-11e1-ae07-00144feabdc0.html#axzz1j4euflAi), analyze debt auctions during the week. Spain placed €10 billion of new bonds with maturities in 2015 and 2016, which was twice the maximum planned for the auction. Italy placed €8.5 billion of one-year bills at average yield of 2.735 percent, which was less than one-half of the yield of 5.95 percent a month before. Italy also placed €3.5 billion of 136-day bills at 1.64 percent. There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20.
A combination of strong economic data in China analyzed in subsection VC and the realization of the widely expected downgrade could explain the strength of the European sovereign debt market. Emese Bartha, Art Patnaude and Nick Cawley, writing on January 17, 2012, on “European T-bills see solid demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204555904577166363369792848.html?mod=WSJPRO_hpp_LEFTTopStories), analyze successful auctions treasury bills by Spain and Greece. A day after the downgrade, the EFSF found strong demand on Jan 17 for its six-month debt auction at the yield of 0.2664 percent, which is about the same as sovereign bills of France with the same maturity.
There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20. Paul Dobson, Emma Charlton and Lucy Meakin, writing on Jan 20, 2012, on “Bonds show return of crisis once ECB loans expire,” published in Bloomberg (http://www.bloomberg.com/news/2012-01-20/bonds-show-return-of-crisis-once-ecb-loans-expire-euro-credit.html), analyze sovereign debt and analysis of market participants. Large-scale lending of last resort by the European Central Bank, considered in IIID Appendix on European Central Bank Large Scale Lender of Last Resort, provided ample liquidity in the euro zone for banks to borrow at 1 percent and lend at higher rates, including to government. Dobson, Charlton and Meakin trace the faster decline of yields of short-term sovereign debt relative to decline of yields of long-term sovereign debt. The significant fall of the spread of short relative to long yields could signal concern about the resolution of the sovereign debt while expanding lender of last resort operations have moderated relative short-term sovereign yields. Normal conditions would be attained if there is definitive resolution of long-term sovereign debt that would require fiscal consolidation in an environment of economic growth.
An important difference, according to Beim (2011Oct9), between large-scale buying of bonds by the central bank between the Federal Reserve of the US and the European Central Bank (ECB) is that the Fed and most banks do not buy local and state government obligations with lower creditworthiness. The European Monetary Union (EMU) that created the euro and the ECB did not include common fiscal policy and affairs. Thus, EMU cannot issue its own treasury obligations. The line “Reserve bank credit” in the Fed balance sheet for Jan 18, 2012, is $2901 billion of which $2600 billion consisting of $1652 billion US Treasury securities, $101 billion Federal agency debt securities and $847 billion mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The Fed has been careful in avoiding credit risk in its portfolio of securities. The 11 exceptional liquidity facilities of several trillion dollars created during the financial crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62) have not resulted in any losses. The Fed has used unconventional monetary policy without credit risk as in classical central banking.
Beim (2011Oct9, 6) argues:
“In short, the ECB system holds more than €1 trillion of debt of the banks and governments of the 17 member states. The state-by-state composition of this debt is not disclosed, but the events of the past year suggest that a disproportionate fraction of these assets are likely obligations of stressed countries. If a significant fraction of the €1 trillion were to be restructured at 40-60% discounts, the ECB would have a massive problem: who would bail out the ECB?
This is surely why the ECB has been so shrill in its antagonism to the slightest mention of default and restructuring. They need to maintain the illusion of risk-free sovereign debt because confidence in the euro itself is built upon it.”
Table II-2 provides the consolidated financial statement of the Eurosystem on Dec 31, 2010 and Dec 28, 2011. Memo items provide the sum of lines 5, “lending to euro area credit institutions related to monetary policy operations denominated in euro,” and 7, “securities of euro area residents denominated in euro,” which has increased from €1,004,174 million on Dec 31, 2010 to €1,489,759 million on Dec 28, 2011. This sum is roughly what concerns Beim (2012Oct9) because of the probable exposure relative to capital to institutions and sovereigns with higher default risk. To be sure, there is no precise knowledge of the composition of the ECB portfolio of loans and securities with weights and analysis of the risks of components. Javier E. David, writing on Jan 16, 2012, on “The risks in ECB’s crisis moves,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204542404577158753459542024.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that the estimated debt of weakest euro zone sovereigns held by the ECB is €211 billion, with Greek debt in highest immediate default risk being only 17 percent of the total. Another unknown is whether there is high risk collateral in the €489 billion three-year loans to credit institutions at 1 percent interest rates. The potential risk is the need for recapitalization of the ECB that could find similar political hurdles as the bailout fund EFSF.
Table II-2, Consolidated Financial Statement of the Eurosytem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | |
| 1 Gold and other Receivables | 367,402 | 419,822 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 |
| 9 Other Assets | 278,719 | 336,574 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 |
| Memo Items | ||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 |
| Capital and Reserves | 78,143 | 81,481 |
Source: European Central Bank
http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html
http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html
Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common currency prevents Italy from devaluation to parity or the exchange rate that would permit export growth to promote internal economic activity that generates fiscal revenues for primary fiscal surplus that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Data in Table II-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU) are only 43.6 percent of the total. Exports to non-European Union area are growing at 15.2 percent in the 12 months ending in Nov while those to EMU are growing at 9.6 percent.
Brazil faced in the debt crisis of 1982 a more complex policy mix. Between 1977 and 1983, Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.
Table II-3, Italy, Exports and Imports by Regions and Countries, % Share and 12 Months ∆%
| Exports | ∆% Jan-Nov 2011/ Jan-Nov 2010 | Imports | Imports | |
| EU | 57.3 | 9.5 | 54.8 | 6.9 |
| EMU 17 | 43.6 | 9.6 | 44.6 | 6.4 |
| France | 11.6 | 11.9 | 8.8 | 4.2 |
| Germany | 13.0 | 13.2 | 16.1 | 6.4 |
| Spain | 5.8 | 2.3 | 4.6 | 8.1 |
| UK | 5.2 | -1.0 | 2.7 | 9.4 |
| Non EU | 42.7 | 15.2 | 45.2 | 15.1 |
| Europe non EU | 12.0 | 24.4 | 10.3 | 20.2 |
| USA | 6.0 | 11.9 | 3.0 | 18.5 |
| China | 2.6 | 16.5 | 7.8 | 5.3 |
| OPEC | 5.3 | -1.3 | 9.5 | -0.4 |
| Total | 100.0 | 11.9 | 100.0 | 10.6 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: http://www.istat.it/it/archivio/50960
IIIB Appendix on Safe Haven Currencies. 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. 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).
IIIC Appendix on 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.
IIID Appendix on European Central Bank Large Scale Lender of Last Resort. 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.”
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.”
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.
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.
IIIE Appendix 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 III-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-4 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 III-4, World and Selected Regional and Country GDP and Fiscal Situation
| GDP 2010 | Primary Net Lending Borrowing | General Government Net Debt | |
| World | 62,911.2 | ||
| Euro Zone | 12,167.8 | -3.6 | 65.9 |
| Portugal | 229.2 | -6.3 | 88.7 |
| Ireland | 206.9 | -28.9 | 78.0 |
| Greece | 305.4 | -4.9 | 142.8 |
| Spain | 1,409.9 | -7.8 | 48.8 |
| Major Advanced Economies G7 | 31,716.9 | -6.5 | 76.5 |
| United States | 14,526.6 | -8.4 | 68.3 |
| UK | 2,250.2 | -7.7 | 67.7 |
| Germany | 3,286.5 | -1.2 | 57.6 |
| France | 2,562.7 | -4.9 | 76.5 |
| Japan | 5,458.8 | -8.1 | 117.2 |
| Canada | 1,577.0 | -4.9 | 32.2 |
| Italy | 2,055.1 | -0.3 | 99.4 |
| China | 5,878.3 | -2.3 | 33.8* |
| Cyprus | 23.2 | -5.3 | 61.6 |
*Gross Debt
Source: http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
The data in Table III-4 are used for some very simple calculations in Table III-5. The column “Net Debt USD Billions” in Table III-5 is generated by applying the percentage in Table III-4 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-5. 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 III-5, 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 III-4 for the current sovereign risk crisis in the euro zone. Table III-6 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Nov. German exports to other European Union members are 59.0 percent of total exports in Nov and 59.5 percent in Jan-Nov. Exports to the euro area are 39.7 percent in Nov and 39.9 percent in Jan-Nov. Exports to third countries are only 40.9 percent of the total in Nov and 40.5 percent in Jan-Nov. 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 III-6, Germany, Structure of Exports and Imports by Region, € Billions and ∆%
| Nov 2011 | 12 Months | Jan-Nov | Jan-Nov 2011/ | |
| Total | 94.9 | 8.3 | 976.0 | 12.1 |
| A. EU | 56.0 % 59.0 | 8.4 | 580.9 % 59.5 | 11.1 |
| Euro Area | 37.7 % 39.7 | 7.7 | 389.7 % 39.9 | 9.9 |
| Non-euro Area | 18.3 % 19.3 | 9.8 | 191.2 % 19.6 | 13.7 |
| B. Third Countries | 38.9 % 40.9 | 8.2 | 395.1 % 40.5 | 13.5 |
| Total Imports | 78.7 | 6.7 | 829.6 | 13.9 |
| C. EU Members | 50.6 % 64.3 | 10.6 | 526.7 % 63.5 | 14.7 |
| Euro Area | 35.1 % 44.6 | 8.8 | 369.4 % 44.5 | 13.8 |
| Non-euro Area | 15.5 % 19.7 | 15.1 | 157.3 % 18.9 | 17.0 |
| D. Third Countries | 28.0 % 35.6 | 0.2 | 302.9 % 36.5 | 12.4 |
Notes: Total Exports = A+B; Total Imports = C+D
IIIF 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:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+τ or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (5)
Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):
“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”
An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.
There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:
(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress
(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality
(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.
III Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table IV-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 IV-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 IV-1. Data for other countries in Table IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.
Table IV-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 1.5 | 3.0 | 5.7 | 8.6 |
| Japan | -0.7 | -0.5 | 1.3 | 4.5 |
| China | 8.9 | 4.1 | 1.7 | |
| UK | 0.5 | 4.2* | 4.8* output | 8.4 |
| Euro Zone | 1.4 | 2.7 | 5.3 | 10.3 |
| Germany | 3.0 | 2.8 | 5.2 | 5.5 |
| France | 1.6 | 2.7 | 5.6 | 9.8 |
| Nether-lands | 1.1 | 2.7 | 6.7 | 4.9 |
| Finland | 2.7 | 3.2 | 5.8 | 7.4 |
| Belgium | 1.8 | 3.7 | 5.7 | 7.2 |
| Portugal | -1.7 | 3.8 | 5.2 | 13.2 |
| Ireland | NA | 1.7 | 3.8 | 14.6 |
| Italy | NA | 3.7 | 4.5 | 8.6 |
| Greece | -5.2 | 2.8 | 7.2 | 18.8 |
| Spain | 0.8 | 2.9 | 6.3 | 22.9 |
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
CPI http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/december-2011/index.html
**Excluding food, beverage, tobacco and petroleum
Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html
Table IV-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 18.6 percent for unemployment/underemployment (see Table I-4 in http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html), 4.5 percent for Japan, 8.4 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in subsection VH) and 10.3 percent in the Euro Zone. Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 3.0 percent in the US, minus 0.2 percent for Japan, 2.7 percent for the Euro Zone and 4.2 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 III in this post and the earlier post http://cmpassocregulationblog.blogspot.com/2012/01/recovery-without-hiring-united-states.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/2012/01/recovery-without-hiring-united-states.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 Thirty Million Unemployed or Underemployed in http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.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 also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.”
There were no changes of direction in the meeting of the Federal Open Market Committee (FOMC) from Nov 1 to Nov 2, 2011. The FOMC released the statement as follows (http://www.federalreserve.gov/newsevents/press/monetary/20111102a.htm):
“For immediate release
Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year. Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has increased at a somewhat faster pace in recent months. Business investment in equipment and software has continued to expand, but investment in nonresidential structures is still weak, and the housing sector remains depressed. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.”
The FOMC also released the economic projections of governors of the Board of Governors of the Federal Reserve and Federal Reserve Banks presidents shown in Table IV-2. It is instructive to focus on 2012, as 2011 is 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 IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, November 2011
| ∆% GDP | UNEM % | ∆% PCE Inflation | ∆% Core PCE Inflation | |
| Central | ||||
| 2011 | 1.6 – 1.7 | 9.0 – 9.1 | 2.7 – 2.9 | 1.8 – 1.9 |
| 2012 | 2.5 – 2.9 | 8.5 – 8.7 | 1.4 – 2.0 | 1.5 – 2.0 |
| 2013 | 3.0 – 3.5 3.5 – 4.2 | 7.8 – 8.2 | 1.5 – 2.0 | 1.4 – 1.9 |
| 2014 | 3.0 – 3.9 | 6.8 – 7.7 | 1.5 – 2.0 | 1.5 – 2.0 |
| Longer Run | 2.4 – 2.7 | 5.2 – 6.0 | 1.7 – 2.0 | |
| Range | ||||
| 2011 | 1.6 – 1.8 | 8.9 – 9.1 | 2.5 – 3.3 | 1.7 – 2.0 |
| 2012 | 2.3 – 3.5 | 8.1 – 8.9 | 1.4 – 2.8 | 1.3 – 2.1 |
| 2013 | 2.7 – 4.0 | 7.5 – 8.4 | 1.4 – 2.5 | 1.4 – 2.1 |
| 2014 | 2.7 – 4.5 | 6.5 – 8.0 | 1.5 – 2.4 | 1.4 – 2.2 |
| Longer Run | 2.2 – 3.0 | 5.0 – 6.0 | 1.5 – 2.0 |
Notes: UEM: unemployment; PR: Projection
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20111102.pdf
There are two categories of responses in the Empire State Manufacturing Survey of the Federal Reserve Bank of New York (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html): current conditions and expectations for the next six months. There are responses in the survey for two types of prices: prices received or inputs of production and prices paid or sales prices of products. Table IV-3 provides the responses and indexes for the two categories and within them for the two types of prices from May to Jan of 2011. Current prices paid were rising at an accelerating rate in May but the rate of increase has dropped significantly as shown by the decline in the index from 68.89 in May to 22.47 in Oct and 18.29 in Nov but with increases to 24.42 in Dec and 26.37 in Jan. The index fell in every month from May to Aug and then again in Nov and Oct. The index of current prices received also fell sharply from 27.96 in May to 4.49 in Oct but rose to 6.10 in Nov to decline again in Dec to 3.49. The indexed jumped to 23.08 in Jan, meaning that prices are increasing at a rate similar to that in May. Responses of no change in prices received still dominate with 79.78 percent in Oct, 69.51 percent in Nov, 85.26 percent in Dec and 70.33 percent in Jan. In the expectations for the next six months, the index of prices paid also declined from 68.82 in May to 36.59 in Nov but rose to 56.98 in Dec with an increasing percentage of 59.30 percent of responses expecting rising prices. The index of expected prices paid fell slightly to 53.85 in Jan with 57.15 percent expecting higher prices paid. The index of expectations for the next six months of prices received has also fallen from 35.48 in May to 25.61 in Nov with 54.88 percent expecting no change in prices paid. In Dec, the index of prices paid rose again to 36.05 with 44.19 percent of respondents expecting price increases but fell to 30.77 in Jan with 39.56 percent of respondents expecting of prices received in the next six months.
Table IV-3, US, FRBNY Empire State Manufacturing Survey, Prices Paid and Prices Received, SA
| Higher | Same | Lower | Index | |
| Current | ||||
| Prices Paid | ||||
| May | 69.89 | 30.11 | 0.00 | 69.89 |
| Jun | 58.16 | 39.80 | 2.04 | 56.12 |
| Jul | 47.78 | 47.78 | 4.44 | 43.33 |
| Aug | 34.78 | 58.70 | 6.52 | 28.26 |
| Sep | 34.78 | 63.04 | 2.17 | 32.61 |
| Oct | 29.21 | 64.04 | 6.74 | 22.47 |
| Nov | 26.83 | 64.63 | 8.54 | 18.29 |
| Dec | 29.07 | 66.28 | 4.65 | 24.42 |
| Jan | 31.87 | 62.64 | 5.49 | 26.37 |
| Prices Received | ||||
| May | 33.33 | 61.29 | 5.38 | 27.96 |
| Jun | 17.35 | 76.53 | 6.12 | 11.22 |
| Jul | 14.44 | 76.67 | 8.89 | 5.56 |
| Aug | 15.22 | 71.74 | 13.04 | 2.17 |
| Sep | 17.39 | 73.91 | 8.70 | 8.70 |
| Oct | 12.36 | 79.78 | 7.87 | 4.49 |
| Nov | 18.29 | 69.51 | 12.20 | 6.10 |
| Dec | 10.47 | 85.26 | 6.98 | 3.49 |
| Jan | 26.37 | 70.33 | 3.30 | 23.08 |
| Six Months | ||||
| Prices Paid | ||||
| May | 70.97 | 26.88 | 2.15 | 68.82 |
| Jun | 58.16 | 38.78 | 3.06 | 55.10 |
| Jul | 56.67 | 37.78 | 5.56 | 51.11 |
| Aug | 46.74 | 48.91 | 4.35 | 42.39 |
| Sep | 54.35 | 44.57 | 1.09 | 53.26 |
| Oct | 47.19 | 46.07 | 6.74 | 40.45 |
| Nov | 42.68 | 51.22 | 6.10 | 36.59 |
| Dec | 59.30 | 38.37 | 2.33 | 56.98 |
| Jan | 57.14 | 39.56 | 3.30 | 53.85 |
| Prices Received | ||||
| May | 40.86 | 53.76 | 5.38 | 35.48 |
| Jun | 30.61 | 58.16 | 11.22 | 19.39 |
| Jul | 38.89 | 52.22 | 8.89 | 30.00 |
| Aug | 23.91 | 67.39 | 8.70 | 15.22 |
| Sep | 33.70 | 55.43 | 10.87 | 22.83 |
| Oct | 28.09 | 61.80 | 10.11 | 17.98 |
| Nov | 35.37 | 54.88 | 9.76 | 25.61 |
| Dec | 44.19 | 47.67 | 8.14 | 36.05 |
| Jan | 39.56 | 51.65 | 8.79 | 30.77 |
Source: http://www.newyorkfed.org/survey/empire/jan2012.pdfhttp://www.newyorkfed.org/survey/empire/dec2011.pdf
http://www.newyorkfed.org/survey/empire/nov2011.pdf
http://www.newyorkfed.org/survey/empire/sep2011.pdf
http://www.newyorkfed.org/survey/empire/july2011.pdf
http://www.newyorkfed.org/survey/empire/aug2011.pdf
Price indexes of the Federal Reserve Bank of Philadelphia Outlook Survey are provided in Table IV-4. As inflation waves throughout the world analyzed in section I World Inflation Waves, indexes of both current and expectations of future prices paid and received were quite high until May. Prices paid, or inputs, were more dynamic, reflecting carry trades from zero interest rates to commodity futures. All indexes softened after May with even decline of prices received in Aug during the first round of risk aversion. Current and future price indexes have increased again but not back to the levels in the beginning of 2011 because of risk aversion frustrating carry trades even under zero interest rates.
Table IV-4, US, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current and Future Prices Paid and Prices Received, SA
| Current Prices Paid | Current Prices Received | Future Prices Paid | Future Prices Received | |
| Jan 2012 | 31.6 | 9.4 | 53.0 | 23.4 |
| Dec 2011 | 30.4 | 10.3 | 49.4 | 26.4 |
| Nov | 25.9 | 6.2 | 41.0 | 28.1 |
| Oct | 23.5 | 1.6 | 44.8 | 27.2 |
| Sep | 25.0 | 3.9 | 37.8 | 22.0 |
| Aug | 20.1 | -6.0 | 40.2 | 20.1 |
| Jul | 30.2 | 3.9 | 44.2 | 12.7 |
| Jun | 32.8 | 5.2 | 30.5 | 4.1 |
| May | 46.4 | 16.3 | 53.4 | 27.0 |
| Apr | 54.4 | 23.0 | 55.4 | 33.5 |
| Mar | 59.8 | 19.3 | 63.6 | 34.8 |
| Feb | 63.2 | 17.5 | 67.8 | 35.9 |
| Jan | 51.9 | 14.5 | 62.8 | 36.0 |
Source: Federal Reserve Bank of Philadelphia
http://www.phil.frb.org/index.cfm
Inflation waves in the diffusion index of the Philadelphia Fed are quite clear in Chart IV-1 of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia. The index collapsed from the highs of the year that were driven by carry trades from zero interest rates to commodity futures and increased slightly again but under check by risk aversion from the European debt crisis.
Chart IV-1, Federal Reserve Bank of Philadelphia Business Outlook Survey Current Prices Paid Diffusion Index SA
Source: Federal Reserve Bank of Philadelphia
http://www.phil.frb.org/index.cfm
Chart IV-2 of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia provides the current diffusion index of prices received, which are prices of sales of products by companies. There is much less dynamism than in prices paid because commodity-rich inputs are only part of total costs. The high levels early in 2011 have not been realized again under the pressure on carry trades of risk financial assets from the European debt crisis
Chart IV-2, Federal Reserve Bank of Philadelphia Business Outlook Survey Current Prices Received Diffusion Index SA
Source: Federal Reserve Bank of Philadelphia
http://www.phil.frb.org/index.cfm
Inflation in advanced economies has been moderating at the producer price level with moderation of the commodity price shock. Table IV-5 provides the month and 12-month percentage rates of inflation of Japan’s corporate goods price index (CGPI). Inflation measured by the CGPI increased 0.1 percent in Dec and increased 1.3 percent in 12 months. Measured by 12-month rates, CGPI inflation has increased from minus 0.2 percent in Jul 2010 to a high of 2.8 percent in Jul 2011 and now to much lower 1.3 percent in Dec. Fiscal-year inflation for 2011 is 2.0 percent, which is the highest after declines in 2009 and 2010 but lower than 4.5 percent in the commodity shock driven by zero interest rates during the global recession in 2008. At the margin, annual equivalent inflation in the quarter Jul to Dec 2011 is minus 1.6 percent compared with annual equivalent inflation in Jan-Apr 2011 of 7.1 percent. Annual equivalent inflation in May-Jun 2011 was minus 1.2 percent. Moderation of commodity price increases after May 2011 has caused collapse of monthly inflation toward zero or less with 0.1 percent in Nov. The CGPI of Japan follows the same pattern of inflation waves. Inflation was relatively high in the first four months of 2011 driven by the carry trade from zero interest rates to commodity futures and other risk financial assets. Risk aversion influenced by the European sovereign debt crisis after May caused reversal of long positions in commodity futures and other risk financial assets, causing declines in prices of commodities and raw materials
Table IV-5, Japan Corporate Goods Price Index (CGPI) ∆%
| Month | Year | |
| Dec 2011 | 0.1 | 1.3 |
| Nov | 0.0 | 1.6 |
| Oct | -0.8 | 1.6 |
| Sep | -0.1 | 2.5 |
| Aug | -0.2 | 2.6 |
| Jul | 0.2 | 2.8 |
| AE ∆% Jul-Dec | -1.6 | |
| Jun | 0.0 | 2.5 |
| May | -0.2 | 2.2 |
| AE ∆% May-Jun | -1.2 | |
| Apr | 1.0 | 2.6 |
| Mar | 0.6 | 2.0 |
| Feb | 0.1 | 1.7 |
| Jan | 0.6 | 1.6 |
| AE ∆% Jan-Apr | 7.1 | |
| Dec 2010 | 0.4 | 1.2 |
| Nov | 0.0 | 0.9 |
| Oct | 0.2 | 0.9 |
| Sep | 0.0 | -0.1 |
| Aug | 0.0 | 0.0 |
| Jul | -0.1 | -0.2 |
| Fiscal Year | ||
| 2011 | 2.0 | |
| 2010 | -0.1 | |
| 2009 | -5.2 | |
| 2008 | 4.5 |
AE: annual equivalent
Source: http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1112.pdf
Further insight into inflation of the corporate goods price index (CGPI) of Japan is provided in Table IV-6. Manufactured products accounting for 91.9 percent of the products in the index fell 0.1 percent in Dec and increased 0.9 percent in 12 months. Petroleum and coal with weight of 5.4 percent rose 0.5 percent in Dec and increased 10.8 percent in 12 months. Japan exports manufactured products and imports raw materials and commodities such that the country’s terms of trade, or export prices relative to import prices, deteriorate during commodity price increases. In contrast, prices of machinery and equipment, with weight of 10.8 percent, were flat in Dec and fell 0.2 percent in 12 months. In general, most manufactured products experienced negative increases in prices while inflation rates were high in 12 months for products originating in raw materials and commodities. Ironically, unconventional monetary policy of zero interest rates and quantitative easing deteriorated the terms of trade of advanced economies.
Table IV-6, Japan, Corporate Goods Prices and Selected Components, % Weights, Month and 12 Months ∆%
| Dec 2011 | Weight | Month ∆% | 12 Month ∆% |
| Total | 1000.0 | 0.1 | 1.3 |
| Mfg Industry Products | 918.8 | -0.1 | 0.9 |
| Processed | 114.5 | 0.0 | 0.5 |
| Petroleum & Coal | 53.8 | 0.5 | 10.8 |
| Machinery & Equipment | 108.4 | 0.0 | -0.2 |
| Electric & Electronic | 129.0 | -0.3 | -3.8 |
| Electric Power, Gas & Water | 46.5 | 0.4 | 10.0 |
| Iron & Steel | 52.6 | -0.6 | 3.4 |
| Chemicals | 85.2 | -0.2 | 3.9 |
| Transport | 10.6 | -0.2 | -0.6 |
Source: http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1112.pdf
Percentage point contributions to change of the corporate goods price index (CGPI) in Dec 2011 are provided in Table IV-7 divided into the domestic, export and import segments. Petroleum and coal contributed 0.03 percentage points to domestic CGPI inflation of 0.1 percent while scrap and waste contributed 0.05 percentage points and agriculture, forestry & fishery contributed 0.04 percentage points. Electric power, gas and water contributed 0.02 percentage points and pulp, paper and related products also contributed 0.02 percentage points. The exports CGPI fell 0.3 percent on the basis of the contract currency and fell 0.1 percent on the basis of the yen with negative contributions of minus 0.17 percentage points by metals and related products, minus 0.11 percentage points by chemicals and related products and minus 0.05 percentage points by electric and electronic products. The imports CGPI increased 0.9 percent on the contract currency basis and 1.0 percent on the yen basis. The most important contributions were 0.99 percentage points by petroleum, coal and natural gas, minus 0.18 percentage points by metals and related products and 0.06 percentage points by general machinery and equipment and 0.03 percentage points by electric and electronic products.
Table IV-7, Japan, Percentage Point Contributions to Change of Corporate Goods Price Index
| Groups Dec 2011 | Contribution to Change Percentage Points |
| A. Domestic Corporate Goods Price Index | Monthly Change: |
| Scrap & Waste | 0.05 |
| Agriculture, Forestry & Fishery | 0.04 |
| Petroleum & Coal | 0.03 |
| Pulp, Paper & Related Products | 0.02 |
| Electric Power, Gas & Water | 0.02 |
| Chemicals & Related Products | -0.03 |
| Iron & Steel | -0.03 |
| Nonferrous Metals | -0.02 |
| B. Export Price Index | Monthly Change: -0.1% Yen basis |
| Metals & Related Products | -0.17 |
| Chemicals & Related Products | -0.11 |
| Electric & Electronic Products | -0.05 |
| Transportation Equipment | 0.06 |
| General Machinery & Equipment | 0.04 |
| C. Import Price Index | Monthly Change: 0.9 % contract currency basis 1.0% Yen basis |
| Petroleum, Coal & Natural Gas | 0.99 |
| General Machinery & Equipment | 0.06 |
| Electric & Electronic Products | 0.03 |
| Metals & Related Products | -0.18 |
Source: http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1112.pdf
Inflation in the euro zone measured by the harmonized index of consumer prices (HICP) in Table IV-8 is following three waves. In the first wave, inflation rose in Jan-Apr toward 3 percent in 12 months, with 2.8 percent in the twelve months ending in Apr. Annual equivalent inflation in Jan-Apr was 5.2 percent. In the second wave, inflation in May-Jul was equivalent to minus 2.4 percent for a full year and the 12 months rate stabilized between 2.5 percent and 2.7 percent. In the third wave, inflation in Aug-Dec rose to 4.2 percent in annual equivalent and settled at 2.7 percent in the 12 months ending in Dec.
Table IV-8, Euro Area Harmonized Index of Consumer Prices Month and 12 Months ∆%
| Month ∆% | 12 Months ∆% | |
| Dec 2011 | 0.3 | 2.7 |
| Nov | 0.1 | 3.0 |
| Oct | 0.3 | 3.0 |
| Sep | 0.8 | 3.0 |
| Aug | 0.2 | 2.5 |
| Aug-Dec | 4.2 | |
| Jul | -0.6 | 2.5 |
| Jun | 0.0 | 2.7 |
| May | 0.0 | 2.7 |
| AE ∆% May-Jul | -2.4 | |
| Apr | 0.6 | 2.8 |
| Mar | 1.4 | 2.7 |
| Feb | 0.4 | 2.4 |
| Jan | -0.7 | 2.3 |
| AE ∆% Jan-Apr | 5.2 | |
| Dec 2010 | 0.6 | 2.2 |
AE: annual equivalent
Inflation in the euro zone remained subdued around 2 percent in the first five years of the euro zone from 1999 to 2004, as shown in Table IV-9. Inflation climbed above 2.0 percent after 2005, peaking at 3.3 percent in 2008 with the surge in commodity prices but falling to 0.3 percent in 2009 with the collapse of commodity prices. Inflation climbed back to 2.7 percent in 2011.
Table IV-9, Euro Area, Yearly Percentage Change of Harmonized Index of Consumer Prices, ∆%
| Year | ∆% |
| 1999 | 1.2 |
| 2000 | 2.2 |
| 2001 | 2.4 |
| 2002 | 2.3 |
| 2003 | 2.1 |
| 2004 | 2.2 |
| 2005 | 2.2 |
| 2006 | 2.2 |
| 2007 | 2.1 |
| 2008 | 3.3 |
| 2009 | 0.3 |
| 2010 | 1.6 |
| 2011 | 2.7 |
Eurostat provides the decomposition in percentage point contributions of the rate of inflation of 2.7 percent in the 12 months in Dec 2011 relative to Dec 2010 shown in Table IV-10. Energy-rich components dominate the 12-month rate of inflation with percentage point contributions: 0.30 by fuel for transport, 0.15 by heating oil, 0.12 by gas and 0.12 by electricity. Table IV-10 only lists highest magnitudes of positive and negative contributions.
Table IV-10, Euro Area, Harmonized Index of Consumer Prices Sub-Indices with Most Important Impact %
| Dec 2011/ | Weight 2011 % | Rate ∆% | Impact |
| Positive Contribution | |||
| Fuel for Transport | 46.9 | 8.9 | 0.30 |
| Heating Oil | 9.5 | 18.9 | 0.15 |
| Gas | 16.7 | 10.0 | 0.12 |
| Electricity | 24.5 | 7.4 | 0.12 |
| Tobacco | 24.8 | 5.1 | 0.06 |
| Jewelry & Watches | 5.3 | 12.0 | 0.05 |
| Negative Contribution | |||
| Audio-Visual Equipment | 4.9 | -8.9 | -0.06 |
| IT Equipment | 5.0 | -10.0 | -0.06 |
| Cars | 39.3 | 1.0 | -0.07 |
| Rents | 59.8 | 1.4 | -0.08 |
| Vegetables | 15.8 | -4.6 | -0.12 |
| Telecom | 30.1 | -2.1 | -0.15 |
PP: percentage points
Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-17012012-AP/EN/2-17012012-AP-EN.PDF
Eurostat provides the decomposition in percentage point contributions of the rate of inflation of 0.3 percent in Dec 2011 relative to Nov 2011 shown in Table IV-11. The largest positive contributions originated in 0.18 percentage points from inflation of package holidays, 0.07 percentage points from accommodation services and 0.03 percentage points from rail transport, all related to year-end holidays. Several categories experienced price declines.
Table IV-11, Euro Area, Harmonized Index of Consumer Prices Sub-Indices with Most Important Impact %
| Dec 2011/ | Weight 2011 % | Rate ∆% | Impact Percentage Points |
| Positive Contribution | |||
| Package Holidays | 15.1 | 13.6 | 0.18 |
| Accommodation Services | 15.7 | 4.9 | 0.07 |
| Air Transport | 5.8 | 6.2 | 0.03 |
| Rail Transport | 4.9 | 1.6 | 0.01 |
| Gardens, Plants & Flowers | 6.6 | 1.3 | 0.01 |
| Fish | 10.4 | 0.9 | 0.01 |
| Negative Contribution | |||
| Recreational & Sporting Services | 10.7 | -0.4 | -0.01 |
| Electricity | 24.5 | -0.0 | -0.01 |
| Heating Oil | 9.5 | -0.8 | -0.01 |
| Telecom | 30.1 | -0.2 | -0.02 |
| Footwear | 13.8 | -0.9 | -0.02 |
| Fuels for Transport | 46.9 | -0.1 | -0.02 |
| Garments | 49.5 | -1.6 | -0.10 |
Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-17012012-AP/EN/2-17012012-AP-EN.PDF
The producer price index of Germany fell 0.4 percent in Dec relative to Nov and increased 4.0 percent in the 12 months ending in Dec, as shown in Table IV-12. The producer price index of Germany has similar four waves of inflation as in many other countries. In the first wave from Jan to Apr, the annual equivalent rate of producer price inflation was 7.1 percent, propelled by carry trades from zero interest rates to exposures in commodity futures in a mood of risk appetite. In the second wave in May and Jun, the annual equivalent rate of producer price inflation was only 1.2 percent because of the collapse of the carry trade in fear of risk from the European sovereign risk situation. In the third wave from Jul to Sep, annual-equivalent producer price inflation in Germany 2.8 percent with fluctuations in commodity prices resulting from perception of the sovereign risk crisis in Europe. In the fourth wave from Oct to Dec, annual equivalent inflation was minus 0.4 percent as financial markets were shocks with strong risk aversion. Annual data in the bottom of Table IV-12 show that the producer price index fell 5.2 percent in the 12 months ending in Dec 2009 as a result of the fall of commodity prices originating in risk aversion after the panic of 2008.
Table IV-12, Germany, Producer Price Index ∆%
| 12 Months ∆% NSA | Month ∆% Calendar and SA | |
| Dec 2011 | 4.0 | -0.4 |
| Nov | 5.2 | 0.1 |
| Oct | 5.3 | 0.2 |
| AE ∆% Oct-Dec | -0.4 | |
| Sep | 5.5 | 0.3 |
| Aug | 5.5 | -0.3 |
| Jul | 5.8 | 0.7 |
| AE ∆% Jul-Sep | 2.8 | |
| Jun | 5.6 | 0.1 |
| May | 6.1 | 0.0 |
| AE ∆% May-Jun | 1.2 | |
| Apr | 6.4 | 1.0 |
| Mar | 6.2 | 0.4 |
| Feb | 6.4 | 0.7 |
| Jan | 5.7 | 1.2 |
| AE ∆% Jan-Apr | 7.1 | |
| Dec 2010 | 5.3 | 0.7 |
| Nov | 4.4 | 0.2 |
| Oct | 4.3 | 0.5 |
| Sep | 3.9 | 0.5 |
| Aug | 3.2 | 0.1 |
| Jul | 3.7 | 0.7 |
| Jun | 1.7 | 0.5 |
| May | 0.9 | 0.2 |
| Apr | 0.6 | 0.6 |
| Mar | -1.5 | 0.6 |
| Feb | -2.9 | 0.1 |
| Jan | -3.4 | 0.4 |
| Dec 2009 | -5.2 | 0.2 |
| Dec 2008 | 4.0 | -0.2 |
| Dec 2007 | 1.9 | 0.4 |
| Dec 2006 | 4.2 | 0.2 |
| Dec 2005 | 4.8 | 0.2 |
| Dec 2004 | 2.9 | 0.2 |
| Dec 2003 | 1.8 | 0.0 |
Chart IV-3 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the producer price index of Germany from 2003 to 2011. Producer price inflation peaked in 2008 with the rise of commodity prices induced by the carry trade from zero interest rates to commodity futures. Prices then declined with the flight away from risk financial assets to government obligations after the financial panic in Sep 2008. With zero interest rates and no risk aversion, the carry trade pushed commodity future prices upwardly resulting in new rising trend of the producer price index. The right-hand side of the chart shows moderation and even decline in prices because of severe risk aversion frustrating carry trades from zero interest rates to commodity futures.
Chart IV-3, Germany, Index of Producer Prices for Industrial Products, 2005=100
Source: Statistiche Bundesamt Deutschland
Chart IV-4 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the unadjusted producer price index and trend. There is a clear upward trend of prices after the end of risk aversion with zero interest rates in 2009. The actual curve has fallen below trend in the current episode of severe risk aversion.
Chart IV-4, Germany, Producer Price Index, Non-adjusted Value and Trend, 2005=100
Source: Statistiche Bundesamt Deutschland
The Istituto Nazionale di Statistica of Italy released the second estimate of inflation of consumer prices in 2011. The wave of commodity price increases (http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_20.html) in the first four months of 2011 also influenced the surge of consumer price inflation in Italy shown in Table IV-13. Annual equivalent inflation in the first four months of 2011 was 4.9 percent. The crisis of confidence or risk aversion resulted in reversal of carry trades on commodity positions. Consumer price inflation in Italy was subdued in Jun and May at 0.1 percent for annual equivalent 1.2 percent. Annual equivalent inflation in the six months Jul-Dec jumped again to 3.0 percent.
Table IV-13, Italy, Consumer Price Index
| Month | 12 Months | |
| Dec | 0.4 | 3.3 |
| Nov 2011 | -0.1 | 3.3 |
| Oct | 0.6 | 3.4 |
| Sep | 0.0 | 3.0 |
| Aug | 0.3 | 2.8 |
| Jul | 0.3 | 2.7 |
| AE ∆% Jul-Dec | 3.0 | |
| Jun | 0.1 | 2.7 |
| May | 0.1 | 2.6 |
| AE ∆% May-Jun | 1.2 | |
| Apr | 0.5 | 2.6 |
| Mar | 0.4 | 2.5 |
| Feb | 0.3 | 2.4 |
| Jan | 0.4 | 2.1 |
| AE ∆% Jan-Apr | 4.9 | |
| Dec 2010 | 0.4 | 1.9 |
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/50340
Chart IV-5 of the Istituto Nazionale di Statistica of Italy shows 12 months percentage change of the consumer price index of Italy. The 12 month rates of consumer price inflation also show the acceleration in the beginning of 2011 followed by more moderate inflation and the resurgence after Jul. The final estimate for Dec shows stability at 3.3 percent in 12 months.
Chart IV-5, Italy, Consumer Prices 12 Months ∆%
Source: Istituto Nazionale di Statistica
Consumer price inflation in Italy by segments in Dec 2011 is provided in Table IV-14. Total consumer price inflation in Dec was 0.4 percent and 3.3 percent in 12 months. Inflation of goods was 0.2 percent and 3.8 percent in 12 months. Prices of durable goods fell 0.1 percent in Dec and increased only 0.8 percent in 12 months, as typical in most countries. Prices of energy goods jumped 1.7 percent in Dec and 13.7 percent in 12 months. Food prices increased only 0.1 percent in Dec and 2.9 percent in 12 months. Prices of services increased 0.4 percent and 2.5 percent in 12 months. Transport prices, also influenced by commodity prices, increased 1.6 percent in Dec and 5.0 percent in 12 months. Carry trades from zero interest rates to positions in commodity futures cause increases in commodity prices. Waves of inflation originate in periods when there is no risk aversion and commodity prices decline during periods of risk aversion.
Table IV-14, Italy, Consumer Price Index and Segments, Month and 12 Months ∆%
| Dec 2011 | Month ∆% | 12 Months ∆% |
| Total | 0.4 | 3.3 |
| I Goods | 0.2 | 3.8 |
| Food | 0.1 | 2.9 |
| Energy | 1.7 | 13.7 |
| Durable | -0.1 | 0.8 |
| Nondurable | 0.1 | 1.0 |
| II Services | 0.4 | 2.5 |
| Housing | 0.0 | 2.2 |
| Communications | 0.1 | 2.2 |
| Transport | 1.6 | 5.0 |
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/50340
Consumer price inflation in the UK in 2011 is shown in Table IV-15. CPI inflation in Dec rose to 0.4 percent from 0.2 percent in Nov after 0.6 percent in both Sep and Aug. The same three waves are present in UK CPI inflation. In the first wave in Jan-Apr, annual equivalent inflation was at a high 6.5 percent. In the second wave in May-Jul, annual equivalent inflation fell to only 0.4 percent. In the third wave in Jul-Nov, annual equivalent inflation has returned at 4.7 percent.
Table IV-15, UK, Consumer Price Index, Month and 12 Months ∆%
| Month ∆% | 12 Months ∆% | |
| Dec | 0.4 | 4.2 |
| Nov | 0.2 | 4.8 |
| Oct | 0.1 | 5.0 |
| Sep | 0.6 | 5.2 |
| Aug | 0.6 | 4.5 |
| AE ∆% Aug-Dec | 4.7 | |
| Jul | 0.0 | 4.4 |
| Jun | -0.1 | 4.2 |
| May | 0.2 | 4.5 |
| May-Jul | 0.4 | |
| Apr | 1.0 | 4.5 |
| Mar | 0.3 | 4.0 |
| Feb | 0.7 | 4.4 |
| Jan | 0.1 | 4.0 |
| AE ∆% Jan-Apr | 6.5 | |
| Dec 2010 | 1.0 | 3.7 |
| Nov | 0.4 | 3.3 |
| Oct | 0.3 | 3.2 |
| Sep | 0.0 | 3.1 |
| Aug | 0.5 | 3.1 |
| Jul | -0.2 | 3.1 |
| Jun | 0.1 | 3.2 |
| May | 0.2 | 3.4 |
| Apr | 0.6 | 3.7 |
| Mar | 0.6 | 3.4 |
| Feb | 0.4 | 3.0 |
| Jan | -0.2 | 3.5 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/december-2011/index.html
Inflation has been unusually high in the UK since 2006, as shown in Table IV-16. There were no rates of inflation close to 2.0 percent in the period from 1997 to 2004. Inflation has exceeded 2 percent since 2005, reaching 3.6 percent in 2008, 3.3 percent in 2010 and 4.5 percent in 2011.
Table IV-16, UK, Consumer Price Index, Annual ∆%
| 1997 | 1.8 |
| 1998 | 1.6 |
| 1999 | 1.3 |
| 2000 | 0.8 |
| 2001 | 1.2 |
| 2002 | 1.3 |
| 2003 | 1.4 |
| 2004 | 1.3 |
| 2005 | 2.1 |
| 2006 | 2.3 |
| 2007 | 2.3 |
| 2008 | 3.6 |
| 2009 | 2.2 |
| 2010 | 3.3 |
| 2011 | 4.5 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/december-2011/index.html
Table IV-17 provides the analysis of inflation in Dec by the UK Office for National Statistics. The drivers of monthly inflation of 0.4 percent were transport with 0.35 percentage points and food; nonalcoholic beverages with 0.16 percentage points; housing and household services with 0.02 percentage points; and furniture and household goods 0.06 percentage points. Contributions of percentage points to the 12 months rate of consumer price inflation of 4.2 are provided by the final two columns in Table IV-17. Housing and household services rose 7.9 percent in 12 months, contributing 1.01 percentage points. Transport rose 5.8 percent in 12 months, contributing 0.91 percentage points. There is only negative change of 0.7 percent in recreation and culture but with negligible impact on the index.
Table IV-17, UK, Consumer Price Index Month ∆% and Percentage Point Contribution by Components
| Dec 2011 | Month ∆% | Percentage Point Contribution | 12 Months ∆% | Percentage Point Contribution |
| CPI All Items | 0.4 | 4.2 | ||
| Food & Non-Alcoholic Beverages | 1.4 | 0.16 | 3.8 | 0.45 |
| Alcohol & Tobacco | -1.5 | -0.06 | 9.0 | 0.37 |
| Clothing & Footwear | -2.8 | -0.19 | 1.8 | 0.14 |
| Housing & Household Services | 0.2 | 0.02 | 7.9 | 1.01 |
| Furniture & Household Goods | 1.0 | 0.06 | 4.7 | 0.30 |
| Health | -0.2 | 0.00 | 3.2 | 0.08 |
| Transport | 2.2 | 0.35 | 5.8 | 0.91 |
| Communication | 1.3 | 0.03 | 6.6 | 0.17 |
| Recreation & Culture | 0.3 | 0.04 | -0.7 | -0.10 |
| Education | 0.0 | 0.00 | 5.1 | 0.09 |
| Restaurants & Hotels | 0.1 | 0.01 | 4.4 | 0.53 |
| Miscellaneous Goods & Services | 0.3 | 0.03 | 2.7 | 0.25 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/december-2011/index.html
© Carlos M. Pelaez, 2010, 2011, 2012
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