CMP Associates Regulation Blog

Chart ES2 provides 12-month percentage changes of the consumer price index from 1960 to 2012. 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 ES2, US, Consumer Price Index, All Items, 12- Month Percentage Change 1960-2012

Source: US Bureau of Labor Statistics

http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120209_402782975.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.

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).

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 five waves. (1) In Jan-Apr, without risk aversion, US producer prices rose at the annual equivalent rate of 9.7 percent. (2) After risk aversion, producer prices increased in the US at the annual equivalent rate of 1.2 percent in May-Jul. (3) From Jul to Sep, under alternating episodes of risk aversion, producer prices increased at the annual equivalent rate of 6.6 percent. (4) Under the pressure of risk aversion because of the European debt crisis US producer prices fell at the annual equivalent rate of 0.8 percent in Oct-Dec. (5) From Dec 2011 to Jan 2012, US producer prices were flat at annual equivalent rate. 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. Zero interest rates without risk aversion cause increases in commodity prices that in turn increase input and output prices. Producer price inflation rose at very high rates 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 2011-2012	AE ∆%
US Producer Price Index
AE ∆% Dec-Jan	0.0
AE ∆% Oct-Dec	-0.8
AE ∆% Jul-Sep	6.6
AE ∆% May-Jul	1.2
AE ∆% Jan-Apr	9.7
Japan Corporate Goods Price Index
AE ∆% Dec-Jan	0.6
AE ∆% Jul-Dec	-1.6
AE ∆% May-Jun	-1.2
AE ∆% Jan-Apr	7.1
China Producer Price Index
AE ∆% Dec-Jan	-2.4
AE ∆% Jul-Dec	-3.9
AE ∆% Jan-Jun	20.4
Germany Producer Price Index
AE ∆% Dec-Jan	1.2
AE ∆% Oct-Dec	-0.4
AE ∆% Jul-Sep	2.8
AE ∆% Jun-May	0.6
AE ∆% Jan-Apr	10.3
France Producer Price Index for the French Market
AE ∆% Oct-Dec	3.2
AE ∆% Jul-Sep	2.4
AE ∆% May-Jun	-3.5
AE ∆% Jan-Apr	11.4
Italy Producer Price Index
AE ∆% Oct-Dec	0.8
AE ∆% Jul-Sep	2.4
AE ∆% Jun-May	-1.2
AE ∆% Jan-April	10.7
UK Output Prices
AE ∆% Nov-Jan	2.0
AE ∆% Oct-Dec	0.0
AE ∆% May-Sep	1.5
AE ∆% Jan-Apr	12.0
UK Input Prices
AE ∆% Dec-Jan	1.2
AE ∆% Jul-Dec	-0.5
AE ∆% May-Jun	-8.7
AE ∆% Jan-Apr	35.6

Sources:

http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/january-2012/index.html

http://www.insee.fr/en/themes/info-rapide.asp?id=25&date=20120131

http://www.istat.it/it/archivio/51905

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 five waves. (1) Under risk appetite in Jan-Apr consumer prices increased at the annual equivalent rate of 4.9 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. (5) Consumer price inflation resuscitated with increased risk appetite at annual equivalent of 1.2 percent in Dec 2011 to Jan 2012. 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, 3.0 percent in Jul-Dec and resuscitated at 11.3 percent annual equivalent in Dec 2011 to Jan 2012. 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. UK consumer prices increased at 0.6 percent annual equivalent from Dec 2011 to Jan 2012.

Table I-2, Annual Equivalent Rates of Consumer Price Indexes

Index 2011-2012	AE ∆%
US Consumer Price Index
AE ∆% Dec-Jan	1.2
AE ∆% Oct-Dec	-0.4
AE ∆% Jul-Sep	4.9
AE ∆% May-Jul	2.0
AE ∆% Jan-Apr	4.9
China Consumer Price Index
AE ∆% Dec-Jan	11.3
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 ∆% Dec-Jan	1.8
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 ∆% Oct-Jan	3.7
AE ∆% Jul-Sep	2.4
AE ∆% May-Jun	1.2
AE ∆% Jan-Apr	4.9
UK Consumer Price Index
AE ∆% Dec-Jan	0.6
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/t20120209_402782970.htm

http://epp.eurostat.ec.europa.eu/tgm/refreshTableAction.do?tab=table&plugin=1&pcode=teicp000&language=en

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2012/02/PE12__048__611,templateId=renderPrint.psml

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120112

http://www.istat.it/it/archivio/52552

http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/january-2012/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. Subsection IIC Import Export Prices analyzes inflation in US international trade.

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 1.6 percent IVQ2011 relative to IVQ2010 (http://cmpassocregulationblog.blogspot.com/2012/01/mediocre-economic-growth-financial.html). Between 2000 and 2011, real GDP grew at the average rate of 1.6 percent per year, nominal GDP at 3.9 percent and the implicit deflator at 2.3 percent. The average rate of CPI inflation was 2.5 percent per year and 2.0 percent excluding food and energy. PPI inflation increased at 3.0 percent per year on average and at 1.7 percent excluding food and energy. There is also inflation in international trade. Import prices grew at 3.2 percent per year between 2000 and 2011 and also at 3.2 percent between 2000 and 2012. The commodity price shock is revealed by inflation of import prices of petroleum increasing at 13.4 percent per year between 2000 and 2011 and at 13.6 percent between 2000 and 2012. The average growth rates of import prices excluding fuels are much lower at 1.3 percent for 2002 to 2011 and also 2.1 percent for 2000 to 2012. Export prices rose at the average rate of 2.6 percent between 2000 and 2011 and at 2.4 percent from 2000 to 2012. 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 6.3 percent from 2000 to 2011 and at 6.1 percent from 2000 to 2012. US nonagricultural export prices rose at 2.2 percent per year from 2000 to 2011 and at 2.1 percent from 2000 to 2012. 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	2000-2011: 1.6%
Nominal GDP	2000-2011: 3.9%
Implicit Price Deflator	2000-2011: 2.3%
CPI	2000-2011: 2.5% 2000-2012: 2.5%
CPI ex Food and Energy	2000-2011: 2.0% 2000-2012: 2.0%
PPI	2000-2011: 3.0% 2000-2012: 3.0%
PPI ex Food and Energy	2000-2011: 1.7% 2000-2012: 1.7%
Import Prices	2000-2011: 3.2% 2000-2012: 3.2%
Import Prices of Petroleum and Petroleum Products	2000-2011: 13.4% 2000-2012: 13.6%
Import Prices Excluding Petroleum	2000-2011: 1.3% 2000-2012: 1.3%
Import Prices Excluding Fuels	2002-2011: 2.1% 2002-2012: 1.9%
Export Prices	2000-2011: 2.6% 2000-2012: 2.4%
Agricultural Export Prices	2000-2011: 6.3% 2000-2012: 6.1%
Nonagricultural Export Prices	2000-2011: 2.2% 2000-2012: 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 2011 and for Jan 2000 to Jan 2012. 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 1980-2011

Source: US Bureau of Economic Analysis

Chart II-2 provides US real GDP from 1980 to 2011. 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 1980-2011

Source: US Bureau of Economic Analysis

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 2011 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 1980-2011

Source: US Bureau of Economic Analysis

Chart II-4 provides percent change from preceding quarter in prices of GDP at seasonally-adjusted annual rates (SAAR) from 1980 to 2011. 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

Chart II-5 provides percent change from preceding year in prices of GDP from 1980 to 2011. 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 1980-2011

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

The producer price index of the US from 1960 to 2012 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, 1960-2012

Source: US Bureau of Labor Statistics

Chart II-7 provides 12-month percentage changes of the producer price index from 1960 to 2012. 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 2012.

Chart II-7, US, Producer Price Index, Finished Goods, 12-Month Percentage Change, NSA, 1960-2012

Source: US Bureau of Labor Statistics

The producer price index excluding food and energy from 1974 to 2012, the first historical date of availability in the dataset of the Bureau of Labor Statistics (BLS), 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, 1973-2012

Source: US Bureau of Labor Statistics

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, 1974-2012

Source: US Bureau of Labor Statistics

The producer price index of energy goods from 1974 to 2012 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 occurred 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, 1974-2012

Source: US Bureau of Labor Statistics

Chart 1I-11 shows 12-month percentage change of the producer price index of finished energy goods from 1975 to 2012. 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, 1974-2012

Source: US Bureau of Labor Statistics

Chart II-12 provides the consumer price index NSA from 1960 to 2012. 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, 1960-2012

Source: US Bureau of Labor Statistics

Chart II-13 provides 12-month percentage changes of the consumer price index from 1960 to 2012. 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 1960-2012

Source: US Bureau of Labor Statistics

Chart II-14 provides the consumer price index excluding food and energy from 1960 to 2012. There is long-term inflation in the US without episodes of deflation.

Chart II-14, US, Consumer Price Index Excluding Food and Energy, NSA, 1960-2012

Source: US Bureau of Labor Statistics

Chart II-15 provides 12-month percentage changes of the consumer price index excluding food and energy from 1960 to 2012. 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, 1960-2012

Source: US Bureau of Labor Statistics

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, 1967-2012

Source: US Bureau of Labor Statistics

Chart II-17 provides 12-month 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, 1968-2012

Source: US Bureau of Labor Statistics

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

IIB Current US Inflation. Consumer price inflation has decelerated in recent months. Table II-2 provides 12-month and annual equivalent percentage changes for the months of Nov 2011 to Jan 2012 of the CPI and major segments. The final column provides inflation from Dec 2011 to Jan 2012, which annualizes at 2.4 percent. CPI inflation in the 12 months ending in Jan reached 2.9 percent and the annual equivalent rate Nov-Jan was 1.2 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 2.3 percent in the 12 months ending in Jan and 2.0 percent in annual equivalent in Nov-Jan. There is no deflation in the US economy that could justify further quantitative easing. Consumer food prices in the US have risen 4.4 percent in 12 months and at 2.0 percent in annual equivalent in Nov-Jan. 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 6.1 percent in 12 months and at minus 6.2 percent in annual equivalent in Nov-Jan 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 Nov-Jan 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 Jan 2012/Jan 2011 NSA	∆% Annual Equivalent Nov 2011 to Jan 2012 SA	∆% Jan/Dec
CPI All Items	2.9	1.2	0.2
CPI ex Food and Energy	2.3	2.0	0.2
Food	4.4	2.0	0.2
Food at Home	5.3	0.8	0.0
Food Away from Home	3.1	3.7	0.4
Energy	6.1	-6.2	0.2
Gasoline	9.7	-8.2	0.9
Fuel Oil	12.1	13.0	1.4
New Vehicles	3.2	-1.6	0.0
Used Cars and Trucks	3.2	-8.1	-1.0
Medical Care Commodities	3.2	4.1	0.6
Apparel	4.7	5.3	0.9
Services Less Energy Services	2.3	2.4	0.2
Shelter	2.0	2.4	0.2
Transportation Services	2.1	0.4	0.0
Medical Care Services	3.7	4.1	0.2

Source: US Bureau of Labor Statistics

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

Chart II-18 provides the US consumer price index for housing from 2001 to 2012. Housing prices rose sharply during the decade until the bump of the global recession and increased 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, 2001-2012

Source: US Bureau of Labor Statistics

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.

Chart II-19, US, Consumer Price Index, Housing, 12-Month Percentage Change, NSA, 2001-2012

Source: US Bureau of Labor Statistics

There have been five 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 4.9 percent and the CPI excluding food and energy increased at annual equivalent rate of 2.4 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 2.4 percent in May-Jul but the annual equivalent rate of the CPI excluding food and energy increased to 3.0 percent. The third wave occurred in the form of increase of the CPI all-items annual equivalent rate to 3.7 percent in Jul-Sep with the annual equivalent rate of the CPI excluding food and energy dropping to 2.4 percent. The fourth wave occurred in Oct-Dec with negative annual equivalent headline inflation of 0.4 percent and core inflation of 2.4 percent. In the fifth wave from Dec 2011 to Jan 2012, consumer price inflation rose at annual-equivalent rate of 1.2 percent and 2.4 percent for core pries. 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 Month	Core NSA 12 months
Jan 2012	0.2	2.9	0.2	2.3
Dec 2011	0.0	3.0	0.2	2.2
AE ∆% Dec-Jan	1.2		2.4
Nov	0.1	3.4	0.2	2.2
Oct	0.0	3.5	0.2	2.1
AE ∆% Oct-Dec	0.4		2.4
Sep	0.3	3.9	0.1	2.0
Aug	0.3	3.8	0.3	2.0
Jul	0.3	3.6	0.2	1.8
AE ∆% Jul-Sep	3.7		2.4
Jun	0.1	3.6	0.2	1.6
May	0.3	3.6	0.3	1.5
AE ∆% May-Jul	2.4		3.0
Apr	0.4	3.2	0.2	1.3
Mar	0.5	2.7	0.2	1.2
Feb	0.4	2.1	0.2	1.1
Jan	0.3	1.6	0.2	1.0
AE ∆% Jan-Apr	4.9		2.4
Dec 2010	0.5	1.5	0.1	0.8
Nov	0.2	1.1	0.1	0.8
Oct	0.4	1.2	0.0	0.6
Sep	0.2	1.1	0.1	0.8
Aug	0.2	1.1	0.1	0.9
Jul	0.3	1.2	0.1	0.9
Jun	0.0	1.1	0.1	0.9
May	-0.1	2.0	0.1	0.9
Apr	-0.1	2.2	0.0	0.9
Mar	0.0	2.3	0.1	1.1
Feb	0.0	2.1	0.1	1.3
Jan	0.2	1.6	0.0	1.6

Note: Core: excluding food and energy; AE: annual equivalent

Source: US Bureau of Labor Statistics

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, 2001-2012

Source: US Bureau of Labor Statistics

Chart II-21 provides 12-month percentage changes of the consumer price index from 2001 to 2012. 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, 2001-2012

Source: US Bureau of Labor Statistics

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, 2001-2012

Source: US Bureau of Labor Statistics

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, 2001-2012

Source: US Bureau of Labor Statistics

Headline and core producer price index are in Table II-5. The headline PPI increased 0.1 percent SA in Jan but the 12-month rate NSA fell from 4.8 percent in Dec to 4.1 percent in Jan. The core PPI SA increased 0.4 in Jan and rose 3.0 percent in 12 months. Analysis of annual equivalent rates of change shows five 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 13.1 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 1.2 percent in May-Jul but the core annual equivalent inflation rate was much higher at 3.0 percent. In the third wave, headline PPI inflation resuscitated with annual equivalent at 6.6 percent in Jul-Sep and core PPI inflation at 4.1 percent. Core PPI inflation has been persistent throughout 2011 and has jumped from annual equivalent at 2.4 percent in the first four months of 2010 to 4.1 percent in 12 months in Jan 2012 and 2.6 percent in annual equivalent rate in Jul-Jan. 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 0.8 percent in Oct-Dec but persistent core inflation of 1.2 percent. In the fifth wave from Dec 2011 to Jan 2012, annual equivalent inflation was flat for the headline index but 4.3 percent for the core index excluding food and energy. 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 Goods SA Month	Finished Goods NSA 12 months	Finished Core SA Month	Finished Core NSA 12 months
Jan 2012	0.1	4.1	0.4	3.0
Dec 2011	-0.1	4.8	0.3	3.0
AE ∆% Dec-Jan	0.0		4.3
Nov	0.2	5.7	0.1	2.9
Oct	-0.3	5.9	-0.1	2.8
AE ∆% Oct-Dec	-0.8		1.2
Sep	0.9	7.0	0.3	2.8
Aug	0.2	6.6	0.2	2.7
Jul	0.5	7.1	0.5	2.7
AE ∆% Jul-Sep	6.6		4.1
Jun	0.1	6.9	0.3	2.3
May	0.1	7.1	0.2	2.1
AE ∆% May-Jul	1.2		3.0
Apr	0.7	6.6	0.3	2.3
Mar	0.5	5.6	0.3	2.0
Feb	1.1	5.4	0.2	1.8
Jan	0.8	3.6	0.5	1.6
AE ∆% Jan-Apr	9.7		4.0
Dec 2010	0.9	3.8	0.2	1.4
Nov	0.4	3.4	-0.1	1.2
Oct	0.8	4.3	-0.2	1.6
Sep	0.4	3.9	0.2	1.6
Aug	0.7	3.3	0.2	1.3
Jul	0.2	4.1	0.2	1.5
Jun	-0.2	2.7	0.1	1.1
May	-0.2	5.1	0.3	1.3
Apr	-0.1	5.4	0.1	0.9
Mar	0.5	5.9	0.2	0.9
Feb	-0.6	4.2	0.0	1.0
Jan	1.0	4.5	0.3	1.0

Note: Core: excluding food and energy; AE: annual equivalent

Source: US Bureau of Labor Statistics

The US producer price index NSA from 2001 to 2012 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, 2001-2012

Source: US Bureau of Labor Statistics

Twelve-month percentage changes of the PPI NSA from 2001 to 2012 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-month 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, 2001-2012

Source: US Bureau of Labor Statistics

The US PPI excluding food and energy from 2001 to 2012 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, 2001-2012

Source: US Bureau of Labor Statistics

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 and in the firth month of 2012.

Chart II-27, US, Producer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2001-2012

Source: US Bureau of Labor Statistics

The US producer price index of energy goods from 2001 to 2012 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 Finished Energy Goods, NSA, 2001-2012

Source: US Bureau of Labor Statistics

Chart II-29 provides 12-month percentage changes of the producer price index of energy goods from 2001 to 2012. 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, 2001-2012

Source: US Bureau of Labor Statistics

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-Month Percentage Change2, NSA 2001-2012

Jan	CPI All Items	CPI Core ex Food and Energy	CPI Housing
2012	2.9	2.3	1.9
2011	1.6	1.0	0.4
2010	2.6	1.6	-0.5
2009	0.0	1.7	2.2
2008	4.3	2.5	3.0
2007	2.1	2.7	3.0
2006	4.0	2.1	4.3
2005	3.0	2.3	3.0
2004	1.9	1.1	2.2
2003	2.6	1.9	2.6
2002	1.1	2.6	2.0
2001	3.7	2.6	4.9

Source: US Bureau of Labor Statistics

IIC Import Export Prices. Chart IIC-1 provides prices of total US imports 2001-2012. Prices fell during the contraction of 2001. Import price inflation accelerated after unconventional monetary policy of near zero interest rates in 2003-2004 and quantitative easing by withdrawing supply with the suspension of 30-year Treasury bond auctions. Slow pace of adjusting fed funds rates from 1 percent by increments of 25 basis points in 17 consecutive meetings of the Federal Open Market Committee (FOMC) between Jun 2004 and Jun 2006 continued to give impetus to carry trades. The reduction of fed funds rates toward zero in 2008 fueled a spectacular hunt for yields that caused commodity price inflation in the middle of a global recession. After risk aversion in 2009 because of the announcement of TARP (Troubled Asset Relief Program) creating anxiety on “toxic assets” in bank balance sheets (see Cochrane and Zingales 2009), prices collapsed after unwinding carry trades. Renewed price increases returned with zero interest rates and quantitative easing. Monetary policy impulses in massive doses have driven inflation and valuation of risk financial assets in wide fluctuations over a decade.

Chart IIC-1, US, Prices of Total US Imports 2001=100, 2001-2012

Chart IIC-2 provides 12-month percentage changes of prices of total US imports from 2001 to 2012. The only plausible explanation for the wide oscillations is by the carry trade from unconventional monetary policy. Import prices jumped in 2008 during deep and protracted global recession driven by carry trades from zero interest rates to long, leveraged positions in commodity futures. Carry trades were unwound during the financial panic in the final quarter of 2008 that resulted in flight to government obligations. Import prices jumped again in 2009 with subdued risk aversion because US banks did not have unsustainable toxic assets. Import prices then fluctuated as carry trades were resumed during periods of risk appetite and unwound during risk aversion resulting from the European debt crisis.

Chart IIC-2, US, Prices of Total US Imports, 12-Month Percentage Changes, 2001-2012

Chart IIC-3 provides prices of US imports from 1982 to 2012. There is no similar episode to that of the increase of commodity prices in 2008 during a protracted and deep global recession with subsequent collapse during a flight into government obligations. Trade prices have been driven by carry trades created by unconventional monetary policy in the past decade.

Chart IIC-3, US, Prices of Total US Imports, 2001=100, 1982-2012

Chart IIC-4 provides 12-month percentage changes of US total imports from 1982 to 2012. There have not been wide consecutive oscillations as the ones during the global recession of IVQ2007 to IIQ2009.

Chart IIC-4, US, Prices of Total US Imports, 12-Month Percentage Changes, 1982-2012

Chart IIC-5 provides the index of US export prices from 2001 to 2012. Import and export prices have been driven by impulses of unconventional monetary policy in massive doses. The most recent segment in Chart IIC-5 shows declining trend resulting from a combination of the world economic slowdown and the decline of commodity prices as carry trade exposures are unwound because of risk aversion to the sovereign debt crisis in Europe.

Chart IIC-5, US, Prices of Total US Exports, 2001=100, 2001-2012

Chart IIC-6 provides prices of US total exports from 1982 to 2012. The rise before the global recession from 2003 to 2008, driven by carry trades, is also unique in the series.

Chart IIC-6, US, Prices of Total US Exports, 2001=100, 1982-2012

Chart IIC-7 provides 12-month percentage changes of total US exports from 1982 to 2012. The uniqueness of the oscillations around the global recession of IVQ2007 to IIQ2009 is clearly revealed

Chart IIC-7, US, Prices of Total US Exports, 12-Month Percentage Changes, 1982-2012

Twelve-month percentage changes of US prices of exports and imports are provided in Table IIC-1. Import prices have been driven since 2003 by unconventional monetary policy of near zero interest rates influencing commodity prices according to moods of risk aversion. In a global recession without risk aversion until the panic of Sep 2008 with flight to government obligations, import prices rose 13.6 percent in the twelve months ending in Jan 2008 and fell 12.5 percent in the 12 months ending in Jan 2009 when risk aversion developed in 2008 until mid 2009. Import prices rose again sharply in 2010 by 11.4 percent and in 2011 until May in the presence of zero interest rates with relaxed mood of risk aversion. There is similar behavior of prices of imports ex fuels, exports and exports ex agricultural goods but less pronounced than for commodity-rich prices dominated by carry trades from zero interest rates

Table IIC-1, US, Twelve-Month Percentage Rates of Change of Prices of Exports and Imports

	Imports	Imports Ex Fuels	Exports	Exports Non-Ag
Jan 2012	7.1	2.9	2.5	3.0
Jan 2011	5.6	3.4	7.0	5.4
Jan 2010	11.4	1.3	3.5	3.3
Jan 2009	-12.5	-0.3	-3.4	-2.7
Jan 2008	13.6	3.5	6.8	4.9
Jan 2007	0.0	2.8	4.1	3.3
Jan 2006	8.7	0.9	2.7	2.6
Jan 2005	5.7	3.0	4.0	5.1
Jan 2004	2.2	1.5	2.6	1.6
Jan 2003	5.8	0.1	1.4	1.0
Jan 2002	-8.9	NA	-2.8	-2.9
Jan 2001	2.8	NA	1.1	0.9

Source: http://www.bls.gov/mxp/data.htm#

Chart IIC-8 shows the US monthly import price index of all commodities excluding fuels from 2001 to 2011. All curves of nominal values follow the same behavior under the influence of unconventional monetary policy. Zero interest rates without risk aversion result in jumps of nominal values and zero interest rates while under strong risk aversion there are declines of nominal values.

Chart IIC-8, US, Import Price Index All Commodities Excluding Fuels, 2001=100, 2001-2012

Source: US Bureau of Labor Statistics

Chart IIC-9 provides 12-month percentage changes of the US import price index excluding fuels between 2001 and 2012. There is the same behavior of carry trades driving up without risk aversion and down with risk aversion prices of raw materials, commodities and food in international trade during the global recession of IVQ2007 to IIQ2009 and in previous and subsequent periods.

Chart IIC-9, US, Import Price Index All Commodities Excluding Fuels, 12-Month Percentage Changes, 2002-2012

Source: US Bureau of Labor Statistics

Chart IIC-10 provides the monthly US import price index ex petroleum from 2001 to 2012. Prices including or excluding commodities follow the same fluctuations and trends originating in impulses of unconventional monetary policy of zero interest rates.

Chart IIC-10, US, Import Price Index ex Petroleum, 2001=100, 2001-2012

Source: US Bureau of Labor Statistics

Chart IIC-11 provides the US import price index ex petroleum from 1982 to 2012. There is the same unique hump in 2008 caused by carry trades from zero interest rates to prices of commodities and raw materials.

Chart IIC-11, US, Import Price Index ex Petroleum, 2001=100, 1982-2012

Source: US Bureau of Labor Statistics

Chart IIC-12 provides 12-month percentage changes of the import price index ex petroleum from 1986 to 2012. The oscillations caused by the carry trade in increasing prices of commodities and raw materials without risk aversion and subsequently decreasing them during risk aversion are quite unique.

Chart IIC-12, US, Import Price Index ex Petroleum, 12-Month Percentage Changes, 1986-2012

Source: US Bureau of Labor Statistics

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

Chart IIC-13 of the US Energy Information Administration provides the price of the crude oil futures contract from 1985 to 2012. There is the same hump in 2008 as in all charts caused by the common factor of carry trades from zero interest rates to commodity futures positions with risk appetite and subsequent decline when carry trades were unwound during shocks of risk aversion.

Chart IIC-13, US, Crude Oil Futures Contract

Source: US Energy Information Administration

The price index of US imports of petroleum and petroleum products in shown in Chart IIC-14. There is similar behavior of the curves all driven by the same impulses of monetary policy.

Chart IIC-14, US, Import Price Index of Petroleum and Petroleum Products, 2001=100, 2001-2012

Source: US Bureau of Labor Statistics

Chart IIC-15 provides the price index of petroleum and petroleum products from 1982 to 2012. The rise in prices during the global recession in 2008 and the decline after the flight to government obligations is unique in the history of the series. Increases in prices of trade in petroleum and petroleum products were induced by carry trades and declines by unwinding carry trades in flight to government obligations.

Chart IIC-15, US, Import Price Index of Petroleum and Petroleum Products, 2001=100, 1982-2012

Source: US Bureau of Labor Statistics

Chart IIC-16 provides 12-month percentage changes of the price index of US imports of petroleum and petroleum products from 1982 to 2012. There were wider oscillations in this index from 1999 to 2001 (see Barsky and Killian 2004 for an explanation).

Chart IIC-16, US, Import Price Index of Petroleum and Petroleum Products, 12-Month Percentage Changes, 1982-2012

Source: US Bureau of Labor Statistics

The price index of US exports of agricultural commodities is in Chart IIC-17 from 2001 to 2012. There are similar fluctuations and trends as in all other price index originating in unconventional monetary policy repeated over a decade. The most recent segment in 2011 has declining trend in a new flight from risk resulting from the sovereign debt crisis in Europe.

Chart IIC-17, US, Exports Price Index of Agricultural Commodities, 2001=100, 2001-2012

Source: US Bureau of Labor Statistics

Chart IIC-18 provides the price index of US exports of agricultural commodities from 1982 to 2012. The increase in 2008 in the middle of deep, protracted contraction was induced by unconventional monetary policy. The decline from 2008 into 2009 was caused by unwinding carry trades in a flight to government obligations. The increase into 2011 and current pause were also induced by unconventional monetary policy in waves of increases during relaxed risk aversion and declines during unwinding of positions because of aversion to financial risk.

Chart IIC-18, US, Exports Price Index of Agricultural Commodities, 2001=100, 1982-2012

Source: US Bureau of Labor Statistics

Chart IIC-19 provides 12-month percentage changes of the index of US exports of agricultural commodities from 1986 to 2012. The wide swings in 2008, 2009 and 2011 are only explained by unconventional monetary policy inducing carry trades from zero interest rates to commodity futures and reversals during risk aversion.

Chart IIC-19, US, Exports Price Index of Agricultural Commodities, 12-Month Percentage Changes, 1986-2012

Source: US Bureau of Labor Statistics

Chart IIC-20 shows the export price index of nonagricultural commodities from 2001 to 2012. Unconventional monetary policy of zero interest rates drove price behavior during the past decade. Policy has been based on the myth of stimulating the economy by climbing the negative slope of an imaginary short-term Phillips curve.

Chart IIC-20, US, Exports Price Index of Nonagricultural Commodities, 2001=100, 2001-2012

Source: US Bureau of Labor Statistics

Chart IIC-21 provides a longer perspective of the price index of US nonagricultural commodities from 1982 to 2012. Increases and decreases around the global contraction after 2007 were caused by carry trade induced by unconventional monetary policy.

Chart IIC-21, US, Exports Price Index of Nonagricultural Commodities, 2001=100, 1982-2012

Source: US Bureau of Labor Statistics

Finally, Chart IIC-22 provides 12-month percentage changes of the price index of US exports of nonagricultural commodities from 1986 to 2012. The wide swings before, during and after the global recession beginning in 2007 were caused by carry trades induced by unconventional monetary policy.

Chart IIC-22, US, Exports Price Index of Nonagricultural Commodities, 12-Month Percentage Changes, 1986-2012

Source: US Bureau of Labor Statistics

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

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. Some of this material is updated in Subsection IIIA when new data are available and then maintained in the appendixes for future reference until updated again in Subsection IIIA. 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 IIIE 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 half year has been characterized by financial turbulence, attaining unusual magnitude in recent months. Table III-1, updated with every comment in this blog, provides beginning values on Fr Feb 10 and daily values throughout the week ending on Fri Feb 17 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 Feb 10 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. European leaders reached a new agreement on Jan 30 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/127631.pdf).

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.319/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Feb 10, appreciating to USD 1.3130/EUR on Tue Feb 14, or by 0.5 percent. The dollar was flat, or zero change, from Fri Feb 10 to Mon Feb 13. The dollar appreciated because fewer dollars, $1.3130, were required on Feb 14 to buy one euro than $1.319 on Feb 10. 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 1.3130/EUR on Feb 14; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Feb 10, to the last business day of the current week, in this case Fri Feb 17, such as appreciation by 0.2 percent to USD 1.3140/EUR by Feb 17; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (denoted by positive sign) by 0.4 percent from the rate of USD 1.319/EUR on Fri Feb 10 to the rate of USD 1.3140/EUR on Fri Feb 17 {[(1.3140/1.319) – 1]100 = -0.4%} and depreciated (denoted by negative sign) by 0.5 percent from the rate of USD 1.3067 on Wed Feb 15 to USD 1.3135/EUR on Thu Feb 16 {[(1.3135/1.3067) -1]100 = 0.5%}. 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 yielding 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.

III-I, Weekly Risk Financial Assets Feb 13 to Feb 17, 2012

Fri Feb 10, 2012

M 13

Tue 14

W 15

Thu 16

Fr 17

USD/EUR

1.319

-0.2%

1.3192

0.0%

1.3130

0.5%

1.3067

0.9%

0.5%

1.3135

0.4%

-0.5%

1.3140

0.4%

0.0%

JPY/ USD

77.595

-1.3%

77.5693

0.0%

78.4028

-1.0%

78.3663

-1.0%

0.0%

78.8955

-1.7%

-0.7%

79.52

-2.5%

-0.8%

CHF/ USD

0.9174

0.2%

0.9164

0.1%

0.9188

-0.2%

-0.3%

0.9234

-0.7%

-0.5%

0.9188

-0.2%

0.5%

0.918

-0.1%

0.1%

CHF/ EUR

1.2089

-0.1%

1.2088

0.0%

1.2076

0.1%

1.2067

0.2%

0.1%

1.2069

0.2%

0.0%

1.2089

0.0%

-0.2%

USD/ AUD

1.067

0.9372

-1.0%

1.0733

0.9317

0.6%

1.0686

0.9358

0.1%

-0.4%

1.0698

0.9348

0.2%

0.1%

1.0755

0.9298

0.8%

0.5%

1.071

0.9337

0.4%

-0.4%

10 Year T Note

1.974

1.98

1.94

1.93

1.98

2.00

2 Year T Note

0.274

0.29

0.27

0.29

0.292

German Bond

2Y 0.24 10Y 1.91

2Y 0.26 10Y 1.93

2Y 0.24 10Y 1.90

2Y 0.21 10Y 1.86

2Y 0.24 10Y 1.90

2Y 0.25 10Y 1.92

DJIA

12801.23

-0.5%

12874.04

0.6%

12878.28

0.6%

0.0%

12780.95

-0.2%

-0.8%

12904.08

0.8%

1.0%

12949.87

1.2%

0.4%

DJ Global

1964.70

-0.6%

1978.52

0.7%

1964.71

0.0%

-0.7%

1966.90

0.1%

1969.85

0.3%

0.2%

1989.39

1.3%

1.00

DJ Asia Pacific

1279.54

0.5%

1288.49

0.7%

1280.94

0.1%

-0.6%

1302.91

1.8%

1.7%

1288.12

0.7%

-1.1%

1298.19

1.5%

0.8%

Nikkei

8947.17

1.3%

8999.18

0.6%

9052.07

1.2%

0.6%

9260.34

3.5%

2.3%

9238.10

3.3%

-0.2%

9384.17

4.9%

1.6%

Shanghai

2351.98

0.9%

2351.85

0.0%

2344.77

-0.3%

2366.70

0.6%

0.9%

2356.86

0.2%

-0.4%

2357.18

0.2%

0.0

DAX

6692.96

-1.1%

6738.47

0.7%

6728.19

0.5%

-0.2%

6757.94

1.0%

0.4%

6751.96

0.9%

-0.1%

6848.03

2.3%

1.4%

DJ UBS

Comm.

144.89

-0.4%

145.28

0.3%

144.92

0.0%

-0.2%

144.70

-0.1%

145.21

0.2%

0.3%

145.76

0.6%

0.4%

WTI $ B

98.94

1.2%

100.55

1.6%

100.94

2.0%

0.3%

102.02

3.1%

1.1%

102.30

3.4%

0.3%

104.06

5.2%

1.7%

Brent $/B

117.57

2.7%

117.42

-0.1%

117.76

0.2%

0.3%

119.10

1.3%

1.1%

120.16

2.2%

0.9%

119.94

2.0%

-0.2%

Gold $/OZ

1722.6

-0.3%

1724.3

0.1%

1721.5

-0.1%

-0.2%

1730.0

0.4%

0.5%

1730.2

0.4%

0.0%

1725.2

0.1%

-0.3%

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

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

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

Table III-1 shows changes in valuations of risk financial assets in the week of Feb 13 to Feb 17 that were affected by the continuing impasse on the negotiation of the bailout for Greece. 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, 2011 and the new agreement reached on Jan 30, 2012. Risk aversion is observed in foreign exchange markets with daily trading of around $4 trillion. The dollar had fluctuated in a tight range with hardly any changes but depreciated after advanced guidance by the Federal Open Market Committee (FOMC) that fed funds rates may remain at 0 to ¼ percent until the latter part of 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20120125a.htm http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf).

The JPY depreciated 2.5 percent during the week largely because of strong new measures by the Bank of Japan. The Policy Board of the Bank of Japan decided three important measures of enhancing monetary easing at the meeting held on Feb 14, 2012 (Bank of Japan 2012EME, 2012PSG and 2012APP). First, the Bank of Japan (2012Feb14EME, 2012Feb14PSG) adopted a “price stability goal” for the “medium term” of 2 percent of the “year-on-year rate of change of the CPI” with the immediate goal of inflation of 1 percent. Japan’s CPI inflation in the 12 months ending in Dec was minus 0.2 percent. Second, the Bank of Japan (2012Feb14EME, 1-2) will conduct “virtually zero interest rate policy” by maintaining “the uncollateralized overnight call rate at around 0 to 0.1 percent.” Third, the Bank of Japan (20012Feb13EME, 2014Feb14APP) is increasing the size of its quantitative easing:

“The Bank increases the total size of the Asset Purchase Program by about 10 trillion yen, from about 55 trillion yen to about 65 trillion yen. The increase in the Program is earmarked for the purchase of Japanese government bonds. By fully implementing the Program including the additional expansion decided today, by the end of 2012, the amount outstanding of the Program will be increased by about 22 trillion yen from the current level of around 43 trillion yen.”

IIIB Appendix on Safe Haven Currencies analyzes the burden on the Japanese economy of yen appreciation. Policy rates close to zero by major central banks in the world together with quantitative easing tend to depreciate currencies. Monetary policy is an indirect form of currency intervention.

The Swiss franc was mostly unchanged, depreciating 0.1 percent to USD 0.918/USD relative to the dollar and remaining unchanged relative to the euro at CHF 1.2089/EUR. The Australian dollar appreciated to USD 1.071/AUD on Feb 17 for cumulative appreciation of 0.4 percent relative to the USD. The AUD is considered a commodity carry trade currency.

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 ten-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 ten-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 ten-year Treasury to 2.026 percent on Fri Jan 20 but renewed aversion with decline to 1.893 percent on Jan 27 and 1.923 on Feb 3. As shown in Table III-1, the ten-year Treasury yield rose to 1.974 on Fri Feb 10 and marginally to 2.00 percent on Feb 17. The ten-year Treasury yield is still at a level well below consumer price inflation of 2.9 percent in the 12 months ending in Dec (see section II United States Inflation). 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 Jan 20 in an environment of more relaxed risk aversion but fell to 0.215 on Fri Jan 27 in another shock of aversion, standing at 0.234 on Feb 3. As shown in Table III-1, the two-year Treasury yield rose to 0.274 percent on Fri Feb 10 and marginally to 0.292 on Fri Feb 17. 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 flash estimate of euro zone CPI inflation is at 2.7 percent for the 12 months ending in Jan 2012 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-01022012-AP/EN/2-01022012-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 on Jan 20 but fell to 0.19 percent on Jan 27 and 0.20 percent on Feb 3. As shown in Table III-1, the yield of the two-year German government bond increased to 0.24 percent on Fri Feb 10 and marginally to 0.25 percent on Fri Feb 17. 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 but falling to 1.86 percent on Jan 27 and rising to 1.93 percent on Feb 10. As shown in Table III-1, the yield of the ten-year government bond of Germany settled at 1.91 percent on Fri Feb 10 and remained almost unchanged at 1.92 percent on Fri Feb 17. 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 Feb 17. Germany’s Dax rose 2.3 percent with optimism on closing the Greek bailout. DJIA gained 1.2 percent in the week of Feb 17 and Dow Global gained 1.3 percent. Japan’s Nikkei Average jumped 4.9 percent because of the measures of enhancing monetary easing by the Bank of Japan. Dow Asia Pacific rose 1.5 percent.

Financial risk assets increase during moderation of risk aversion in carry trades from zero interest rates and fall during increasing risk aversion. Commodities gained in the week of Feb 17. During the week of Feb 17, DJ UBS Commodities Index rose 0.6 percent; WTI jumped 5.2 percent but Brent increased 2.0 percent; and gold gained only 0.1 percent.

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. Newly available data in Table III-1A 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 the non-European Union area are growing at 14.9 percent in Jan-Dec 2011 relative to Jan-Dec 2010 while those to EMU are growing at 8.7 percent.

Table III-1A, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%

	Exports % Share	∆% Jan-Dec 2011/ Jan-Dec 2010	Imports % Share	Imports ∆% Jan-Dec 2011/ Jan-Dec 2010
EU	57.3	8.8	54.8	5.8
EMU 17	43.6	8.7	44.6	5.4
France	11.6	11.2	8.8	3.7
Germany	13.0	12.4	16.1	5.7
Spain	5.8	1.4	4.6	6.0
UK	5.2	-0.2	2.7	6.8
Non EU	42.7	14.9	45.2	12.6
Europe non EU	12.0	23.3	10.3	18.0
USA	6.0	12.4	3.0	17.0
China	2.6	16.2	7.8	1.8
OPEC	5.3	-1.1	9.5	-1.4
Total	100.0	11.4	100.0	8.9

Notes: EU: European Union; EMU: European Monetary Union (euro zone)

Table III-1B provides Italy’s trade balance by regions and countries. Italy has a trade deficit of €12,461 million with the 17 countries of the euro zone (EMU 17). Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €5505 million with Europe non European Union and of €9823 million with the US. There is significant rigidity in the trade deficits of €19,302 million with China and €16,701 million with oil exporting countries (OPEC).

Table III-1B, Italy, Trade Balance by Regions and Countries, Millions of Euro

Regions and Countries	Trade Balance Dec 2011 Millions of Euro	Trade Balance Jan-Dec 2011 Millions of Euro
EU	-577	-2,747
EMU 17	-1,565	-12,461
France	703	10,284
Germany	-1,451	-12,999
Spain	145	2,130
UK	703	6,848
Non EU	2,024	-21,586
Europe non EU	1,042	5,505
USA	1,082	9,823
China	-853	-19,302
OPEC	-1,014	-16,701
Total	1,447	-24,333

Notes: EU: European Union; EMU: European Monetary Union (euro zone)

Growth rates of Italy’s trade and major products are provided in Table III-1C for the period Jan-Dec 2011 relative to Jan-Dec 2010. Growth rates are high for the total and all segments with the exception of decline of durable goods imports of 6.0 percent. Capital goods exports increased 10.7 percent relative to a year earlier and intermediate products 13.9 percent

Table III-1C, Italy, Exports and Imports % Share of Products in Total and ∆%

	Exports Share %	Exports ∆% Jan-Dec 2011/ Jan-Dec 2010	Imports Share %	Imports ∆% Jan-De 2011/ Jan-Nov 2010
Consumer Goods	29.5	9.1	25.3	7.8
Durable	6.3	4.2	3.5	-6.0
Non Durable	23.2	10.4	21.8	6.2
Capital Goods	32.4	10.7	22.4	0.8
Inter- mediate Goods	33.5	13.9	33.9	10.8
Energy	4.6	12.8	18.4	16.8
Total ex Energy	95.4	11.3	81.6	7.1
Total	100.0	11.4	100.0	8.9

Table III-1D provides Italy’s trade balance by product categories in Dec and Jan-De 2011. Italy’s trade balance excluding energy is a surplus of €37,060 in Jan-Dec 2011 but the energy trade balance is a deficit of €61,394 million. Italy has significant competitiveness in contrast with some other countries with debt difficulties.

Table III-1D, Italy, Trade Balance by Product Categories, € Millions

	Dec 2011	Jan-Dec 2011
Consumer Goods	935	8,305
Durable	950	10,205
Nondurable	-15	-1,900
Capital Goods	4,358	37,927
Intermediate Goods	1,255	-9,172
Energy	-5,102	-61,394
Total ex Energy	6,549	37,060
Total	1,447	-24,333

http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html

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 VII 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. Markets have 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 VD 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.

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 ).

Improving equity markets and strength of the euro appear related to developments in sovereign debt negotiations and markets. Alkman Granitsas and Costas Paris, writing on Jan 29, 2012, on “Greek debt deal, new loan agreement to finish next week,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204573704577189021923288392.html?mod=WSJPRO_hpp_LEFTTopStories), inform that Greece and its private creditors were near finishing a deal of writing off €100 billion, about $132 billion, of Greece’s debt depending on the conversations between Greece, the euro area and the IMF on the new bailout. An agreement had been reached in Oct 2011 for a new package of fresh money in the amount of €130 billion to fill needs through 2015 but was contingent on haircuts reducing Greece’s debt from 160 percent of GDP to 120 percent of GDP. The new bailout would be required to prevent default by Greece of €14.4 billion maturing on Mar 20, 2012. There has been increasing improvement of sovereign bond yields. Italy’s ten-year bond yield fell from over 6.30 percent on Jan 20, 2012 to slightly above 5.90 percent on Jan 27. Spain’s ten-year bond yield fell from slightly above 5.50 percent on Jan 20 to just below 5 percent on Jan 27.

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 25, 2012, is $2902 billion of which $2570 billion consisting of $1565 billion US Treasury notes and bonds, $68 billion inflation-indexed bonds and notes, $101 billion Federal agency debt securities and $836 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 III-2 provides the consolidated financial statement of the Eurosystem on Dec 31, 2010 and Dec 28, 2011 and an update for Feb 10, 2012. 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 a recurring issue of whether the ECB should accept a haircut on its portfolio of Greek bonds of €40 billion acquired at discounts from face value. An article on “Haircut for the ECB? Not so fast,” published by the Wall Street Journal on Jan 28, 2012 (http://blogs.wsj.com/davos/2012/01/28/haircut-for-the-ecb-not-so-fast/), informs of the remarks by Mark Carney, Governor of the Bank of Canada and President of the Financial Stability Board (FSB) (http://www.financialstabilityboard.org/about/overview.htm), expressing what appears to be correct doctrine that there could conceivably be haircuts for official debt but that such a decision should be taken by governments and not by central banks.

Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR

	Dec 31, 2010	Dec 28, 2011	Feb 10, 2012
1 Gold and other Receivables	367,402	419,822	423,446
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	245,107
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	100,629
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	23,936
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	787,255
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	70,338
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	624,299
8 General Government Debt Denominated in Euro	34,954	33,928	31,176
9 Other Assets	278,719	336,574	349,598
TOTAL ASSETS	2,004, 432	2,733,235	2,665,784
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,411,554
Capital and Reserves	78,143	81,481	81,877

Source: European Central Bank

http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html

http://www.ecb.int/press/pr/wfs/2012/html/fs120214.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. Newly available data in Table III-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 the non-European Union area are growing at 14.9 percent in Jan-Dec 2011 relative to Jan-Dec 2010 while those to EMU are growing at 8.7 percent.

Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%

	Exports % Share	∆% Jan-Dec 2011/ Jan-Dec 2010	Imports % Share	Imports ∆% Jan-Dec 2011/ Jan-Dec 2010
EU	57.3	8.8	54.8	5.8
EMU 17	43.6	8.7	44.6	5.4
France	11.6	11.2	8.8	3.7
Germany	13.0	12.4	16.1	5.7
Spain	5.8	1.4	4.6	6.0
UK	5.2	-0.2	2.7	6.8
Non EU	42.7	14.9	45.2	12.6
Europe non EU	12.0	23.3	10.3	18.0
USA	6.0	12.4	3.0	17.0
China	2.6	16.2	7.8	1.8
OPEC	5.3	-1.1	9.5	-1.4
Total	100.0	11.4	100.0	8.9

Notes: EU: European Union; EMU: European Monetary Union (euro zone)

Table III-4 provides Italy’s trade balance by regions and countries. Italy has a trade deficit of €12,461 million with the 17 countries of the euro zone (EMU 17). Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €5505 million with Europe non European Union and of €9823 million with the US. There is significant rigidity in the trade deficits of €19,302 million with China and €16,701 million with oil exporting countries (OPEC).

Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro

Regions and Countries	Trade Balance Dec 2011 Millions of Euro	Trade Balance Jan-Dec 2011 Millions of Euro
EU	-577	-2,747
EMU 17	-1,565	-12,461
France	703	10,284
Germany	-1,451	-12,999
Spain	145	2,130
UK	703	6,848
Non EU	2,024	-21,586
Europe non EU	1,042	5,505
USA	1,082	9,823
China	-853	-19,302
OPEC	-1,014	-16,701
Total	1,447	-24,333

Notes: EU: European Union; EMU: European Monetary Union (euro zone)

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Dec 2011 relative to Jan-Dec 2010. Growth rates are high for the total and all segments with the exception of decline of durable goods imports of 6.0 percent. Capital goods exports increased 10.7 percent relative to a year earlier and intermediate products 13.9 percent

Table III-5, Italy, Exports and Imports % Share of Products in Total and ∆%

	Exports Share %	Exports ∆% Jan-Dec 2011/ Jan-Dec 2010	Imports Share %	Imports ∆% Jan-De 2011/ Jan-Nov 2010
Consumer Goods	29.5	9.1	25.3	7.8
Durable	6.3	4.2	3.5	-6.0
Non Durable	23.2	10.4	21.8	6.2
Capital Goods	32.4	10.7	22.4	0.8
Inter- mediate Goods	33.5	13.9	33.9	10.8
Energy	4.6	12.8	18.4	16.8
Total ex Energy	95.4	11.3	81.6	7.1
Total	100.0	11.4	100.0	8.9

Table III-6 provides Italy’s trade balance by product categories in Dec and Jan-De 2011. Italy’s trade balance excluding energy is a surplus of €37,060 in Jan-Dec 2011 but the energy trade balance is a deficit of €61,394 million. Italy has significant competitiveness in contrast with some other countries with debt difficulties.

Table III-6, Italy, Trade Balance by Product Categories, € Millions

	Dec 2011	Jan-Dec 2011
Consumer Goods	935	8,305
Durable	950	10,205
Nondurable	-15	-1,900
Capital Goods	4,358	37,927
Intermediate Goods	1,255	-9,172
Energy	-5,102	-61,394
Total ex Energy	6,549	37,060
Total	1,447	-24,333