Recovery without Hiring, Continuance of Maturity Extension Twist Policy, World Financial Turbulence and Economic Slowdown
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011, 2012
Executive Summary
I Recovery without Hiring
IA Hiring Collapse
IB Labor Underutilization
IC Ten Fewer Full-time Jobs
ID Youth Unemployment
II Twist Again Extension
IIA Extension of Let’s Twist Again Policy
IIB Twist Objectives
IIC Appendix: Operation Twist
IIC1 Operation Twist
IIC2 Transmission of Quantitative Easing
IIC2i Theory
IIC2ii Policy
IIC2iii Evidence
IIC2iv Unwinding Strategy
III World Financial Turbulence
IIIA Financial Risks
IIIB Appendix on Safe Haven Currencies
IIIC Appendix on Fiscal Compact
IIID Appendix on European Central Bank Large Scale Lender of Last Resort
IIIE Appendix Euro Zone Survival Risk
IIIF Appendix on Sovereign Bond Valuation
IIIG Appendix on Deficit Financing of Growth and the Debt Crisis
IIIGA Monetary Policy with Deficit Financing of Economic Growth
IIIGB Adjustment during the Debt Crisis of the 1980s
IV Global Inflation
V World Economic Slowdown
VA United States
VB Japan
VC China
VD Euro Area
VE Germany
VF France
VG Italy
VH United Kingdom
VI Valuation of Risk Financial Assets
VII Economic Indicators
VIII Interest Rates
IX Conclusion
References
Appendix I The Great Inflation
Executive Summary
ESI Recovery without Hiring. Professor Edward P. Lazear (2012Jan19) at Stanford University finds that recovery of hiring in the US to peaks attained in 2007 requires an increase of hiring by 30 percent while hiring levels have increased by only 4 percent since Jan 2009. The high level of unemployment with low level of hiring reduces the statistical probability that the unemployed will find a job. According to Lazear (2012Jan19), the probability of finding a new job currently is about one third of the probability of finding a job in 2007. Improvements in labor markets have not increased the probability of finding a new job. Lazear (2012Jan19) quotes an essay coauthored with James R. Spletzer forthcoming in the American Economic Review on the concept of churn. A dynamic labor market occurs when a similar amount of workers is hired as those who are separated. This replacement of separated workers is called churn, which explains about two-thirds of total hiring. Typically, wage increases received in a new job are higher by 8 percent. Lazear (2012Jan19) argues that churn has declined 35 percent from the level before the recession in IVQ2007. Because of the collapse of churn there are no opportunities in escaping falling real wages by moving to another job. As this blog argues, there are meager chances of escaping unemployment because of the collapse of hiring and those employed cannot escape falling real wages by moving to another job (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). Lazear and Spletzer (2012Mar, 1) argue that reductions of churn reduce the operational effectiveness of labor markets. Churn is part of the allocation of resources or in this case labor to occupations of higher marginal returns. The decline in churn can harm static and dynamic economic efficiency. Losses from decline of churn during recessions can affect an economy over the long-term by preventing optimal growth trajectories because resources are not used in the occupations where they provide highest marginal returns. Lazear and Spletzer (2012Mar 7-8) conclude that: “under a number of assumptions, we estimate that the loss in output during the recession [of 2007 to 2009] and its aftermath resulting from reduced churn equaled $208 billion. On an annual basis, this amounts to about .4% of GDP for a period of 3½ years.”
There are two additional facts discussed below: (1) there are about ten million fewer full-time jobs currently than before the recession of 2008 and 2009; and (2) the extremely high and rigid rate of youth unemployment is denying an early start to young people ages 16 to 24 years.
An important characteristic of the current fractured labor market of the US is the closing of the avenue for exiting unemployment and underemployment normally available through dynamic hiring. Another avenue that is closed is the opportunity for advancement in moving to new jobs that pay better salaries and benefits again because of the collapse of hiring in the United States. Those who are unemployed or underemployed cannot find a new job even accepting lower wages and no benefits. The employed cannot escape declining inflation-adjusted earnings and shorter workweeks because there is no hiring. The objective of this section is to analyze hiring and labor underutilization in the United States.
An appropriate measure of job stress is considered by Blanchard and Katz (1997, 53):
“The right measure of the state of the labor market is the exit rate from unemployment, defined as the number of hires divided by the number unemployed, rather than the unemployment rate itself. What matters to the unemployed is not how many of them there are, but how many of them there are in relation to the number of hires by firms.”
The natural rate of unemployment and the similar NAIRU are quite difficult to estimate in practice (Ibid; see Ball and Mankiw 2002).
The Bureau of Labor Statistics (BLS) created the Job Openings and Labor Turnover Survey (JOLTS) with the purpose that (http://www.bls.gov/jlt/jltover.htm#purpose):
“These data serve as demand-side indicators of labor shortages at the national level. Prior to JOLTS, there was no economic indicator of the unmet demand for labor with which to assess the presence or extent of labor shortages in the United States. The availability of unfilled jobs—the jobs opening rate—is an important measure of tightness of job markets, parallel to existing measures of unemployment.”
The BLS collects data from about 16,000 US business establishments in nonagricultural industries through the 50 states and DC. The data are released monthly and constitute an important complement to other data provided by the BLS (see also Lazear and Spletzer 2012Mar, 6-7).
Hiring in the nonfarm sector (HNF) has declined from 69.4 million in 2004 to 50.1 million in 2011 or by 19.3 million while hiring in the private sector (HP) has declined from 59.5 million in 2006 to 46.9 million in 2011 or by 12.6 million, as shown in Table ESI-1. The ratio of nonfarm hiring to employment (RNF) has fallen from 47.2 in 2005 to 38.1 in 2011 and in the private sector (RHP) from 52.1 in 2006 to 42.9 in 2011. The collapse of hiring in the US has not been followed by dynamic labor markets because of the low rate of economic growth of 2.4 percent in the first eleven quarters of expansion from IIIQ2009 to IQ2012 compared with 6.2 percent in prior cyclical expansions (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html).
Table ESI-1, US, Annual Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US and Percentage of Total Employment
| HNF | Rate RNF | HP | Rate HP | |
| 2001 | 62,948 | 47.8 | 58,825 | 53.1 |
| 2002 | 58,583 | 44.9 | 54,759 | 50.3 |
| 2003 | 56,451 | 43.4 | 53,056 | 48.9 |
| 2004 | 69,367 | 45.9 | 56,617 | 51.6 |
| 2005 | 63,150 | 47.2 | 59,372 | 53.1 |
| 2006 | 63,773 | 46.9 | 59,494 | 52.1 |
| 2007 | 62,421 | 45.4 | 58,035 | 50.3 |
| 2008 | 55,166 | 40.3 | 51,606 | 45.2 |
| 2009 | 46,398 | 35.5 | 43,052 | 39.8 |
| 2010 | 48,647 | 37.5 | 44,826 | 41.7 |
| 2011 | 50,083 | 38.1 | 46,869 | 42.9 |
Source: http://www.bls.gov/jlt/data.htm
Chart ESI-1 provides the yearly levels of total nonfarm hiring (NFH) in Table ESI-1. The fall of hiring during the contraction of 2007 to 2009 was much stronger than in the shallow recession of 2001 with GDP contraction of only 0.4 percent from Mar 2001 (IQ2001) to Dec 2001 (IVQ 2001) compared with 5.1 percent contraction in the much longer recession from Dec 2007 (IVQ2007) to Jun 2009 (IIQ2009) (http://www.nber.org/cycles/cyclesmain.html). Recovery is tepid.
Chart ESI-1, US, Level Total Nonfarm Hiring (HNF), Yearly, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Chart ESI-2 shows the ratio or rate of nonfarm hiring to employment (RNF) that also fell much more in the recession of 2007 to 2009 than in the shallow recession of 2001. Recovery is weak.
Chart ESI-2, US, Rate Total Nonfarm Hiring (HNF), Yearly, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Yearly percentage changes of total nonfarm hiring (HNF) are provided in Table ESI-2. There were much milder declines in 2002 of 6.9 percent and 3.6 percent in 2003 followed by strong rebounds of 6.9 percent in 2004 and 4.6 percent in 2005. In contrast, the contractions of nonfarm hiring in the recession after 2007 were much sharper in percentage points: 2.1 in 2007, 11.6 in 2008 and 15.9 percent in 2009. On a yearly basis, nonfarm hiring grew 4.8 percent in 2010 relative to 2009 and 3.0 percent in 2011.
Table ESI-2, US, Annual Total Nonfarm Hiring (HNF), Yearly Percentage Change, 2001-2011
| Year | Annual |
| 2002 | -6.9 |
| 2003 | -3.6 |
| 2004 | 6.9 |
| 2005 | 4.6 |
| 2006 | 1.0 |
| 2007 | -2.1 |
| 2008 | -11.6 |
| 2009 | -15.9 |
| 2010 | 4.8 |
| 2011 | 3.0 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Chart ESI-3 plots yearly percentage changes of nonfarm hiring. Percentage declines after 2007 were quite sharp.
Chart ESI-3, US, Annual Total Nonfarm Hiring (HNF), Yearly Percentage Change, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Total private hiring (HP) yearly data are provided in Chart ESI-4. There has been sharp contraction of total private hiring in the US and only milder recovery in 2011 than in 2010.
Chart ESI-4, US, Total Private Hiring, Yearly, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Chart ESI-5 plots the rate of total private hiring relative to employment (RHP). The rate collapsed during the global recession after 2007 with insufficient recovery.
Chart ESI-5, US, Rate Total Private Hiring, Yearly, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Total nonfarm hiring (HNF), total private hiring (HP) and their respective rates are provided for the month of Apr in the years from 2001 to 2012 in Table ESI-3. Hiring numbers are in thousands. There is some recovery in HNF from 4223 thousand (or 4.2 million) in Apr 2009 to 4334 thousand in Apr 2011 and 4447 thousand in Apr 2012 for cumulative gain of 5.3 percent. The levels in Apr 2010 and Apr 2012 are coincidentally equal at 4447 thousand. HP rose from 3920 thousand in Apr 2009 to 4140 thousand in Apr 2011 and 4244 thousand in Apr 2012 for cumulative gain of 8.3 percent. HNF has fallen from 5859 in Apr 2005 to 4447 in Apr 2012 or by 24.1 percent. HP has fallen from 5630 in Apr 2006 to 4244 in Apr 2012 or by 24.6 percent. The labor market continues to be fractured, failing to provide an opportunity to exit from unemployment/underemployment or to find an opportunity for advancement away from declining inflation-adjusted earnings.
Table ESI-3, US, Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US in Thousands and in Percentage of Total Employment Not Seasonally Adjusted
| HNF | Rate RNF | HP | Rate HP | |
| 2001 Apr | 6016 | 4.6 | 5750 | 5.2 |
| 2002 Apr | 5556 | 4.3 | 5309 | 4.9 |
| 2003 Apr | 5132 | 4.0 | 4922 | 4.6 |
| 2004 Apr | 5692 | 4.3 | 5466 | 5.0 |
| 2005 Apr | 5859 | 4.4 | 5630 | 5.1 |
| 2006 Apr | 5568 | 4.1 | 5309 | 4.7 |
| 2007 Apr | 5646 | 4.1 | 5368 | 4.7 |
| 2008 Apr | 5347 | 3.9 | 5120 | 4.5 |
| 2009 Apr | 4223 | 3.2 | 3920 | 3.6 |
| 2010 Apr | 4447 | 3.4 | 4186 | 3.9 |
| 2011 Apr | 4334 | 3.3 | 4140 | 3.8 |
| 2012 Apr | 4447 | 3.3 | 4244 | 3.8 |
Source: US Bureau of Labor Statistics http://www.bls.gov/jlt/data.htm
Chart ESI-6 provides total nonfarm hiring on a monthly basis from 2001 to 2012. Nonfarm hiring rebounded in early 2010 but then fell and stabilized at a lower level than the early peak not-seasonally adjusted (NSA) in 2010 of 4786 in May. Nonfarm hiring fell again in Dec 2011 to 3038 from 3844 in Nov and to revised 3633 in Feb 2012, increasing to 4127 in Mar 2012 and 4447 in Apr 2012. Chart ESI-6 provides seasonally-adjusted (SA) monthly data. The number of seasonally-adjusted hires in Aug 2011 was 4221 thousand, increasing to revised 4444 thousand in Feb 2012, or 5.3 percent, but falling to revised 4335 thousand in Mar 2012 and 4157 in Apr 2012, or cumulative decline of 1.1 percent relative to Aug 2011. The number of hires not seasonally adjusted was 4655 in Aug 2011, falling to 3038 in Dec but increasing to 4072 in Jan 2012, falling again to 3580 in Feb 2012 and increasing to 4117 in Mar 2012. The number of nonfarm hiring not seasonally adjusted fell by 34.7 percent from 4655 in Aug 2011 to 3038 in Dec 2011 in a yearly-repeated seasonal pattern.
Chart ESI-6, US, Total Nonfarm Hiring (HNF), 2001-2012 Month SA
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Similar behavior occurs in the rate of nonfarm hiring plot in Chart ESI-7. Recovery in early 2010 was followed by decline and stabilization at a lower level but with stability in monthly SA estimates of 3.2 in Sep 2011 to 3.2 in Jan 2012 and 3.3 in both Feb and Mar 2012, falling to 3.1 in Apr 2012. The rate not seasonally adjusted fell from 3.7 in Jun 2011 to 2.3 in Dec, climbing to 3.1 in Jan 2012 but falling to revised 2.8 in Feb 2012 and increasing to 3.1 in Mar 2012 and 3.3 in Apr 2012. Rates of nonfarm hiring NSA were in the range of 2.8 (Dec) to 4.5 (Jun) in 2006.
Chart ESI-7, US, Rate Total Nonfarm Hiring, Month SA 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
There is only milder improvement in total private hiring shown in Chart ESI-8. Hiring private (HP) rose in 2010 followed by stability and renewed increase in 2011. The number of private hiring seasonally adjusted fell from 4002 thousand in Sep 2011 to 3889 in Dec or by 2.8 percent, increasing to 3945 in Jan 2012 or decline by 1.4 relative to the level in Sep 2011 but moving to revised 4128 in Feb 2012 for increase of 3.1 percent relative to Sep 2011, revised 4041 in Mar 2012 for increase of 1.0 percent relative to 4002 in Sep 2011 but decrease to 3882 in Apr 2012 or decline of 3.0 percent relative to Sep 2011. The number of private hiring not seasonally adjusted fell from 4130 in Sep 2011 to 2856 in Dec or by 30.8 percent, reaching 3782 in Jan 2012 or decline of 8.4 percent relative to Sep 2011 and 4244 in Apr 2012 or increase of 2.8 percent relative to Sep 2011. Companies do not hire in the latter part of the year that explains the high seasonality in year-end employment data. For example, NSA private hiring fell from 4934 in Sep 2006 to 3635 in Dec 2006 or by 26.3 percent. Private hiring NSA data are useful in showing the huge declines from the period before the global recession. In Jul 2006 private hiring NSA was 5555, declining to 4293 in Jul 2011 or by 22.7 percent. The conclusion is that private hiring in the US is more than 20 percent below the hiring before the global recession. The main problem in recovery of the US labor market has been the low rate of growth of 2.4 percent in the eleven quarters of expansion of the economy from IIIQ2009 to IQ2012 compared with average 6.2 percent in prior expansions from contractions (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The US missed the opportunity to recover employment as in past cyclical expansions from contractions.
Chart ESI-8, US, Total Private Hiring Month SA 2011-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Chart ESI-9 shows similar behavior in the rate of private hiring. The rate in 2011 in monthly SA data has not risen significantly above the peak in 2010. The rate seasonally adjusted fell from 3.6 in Sep 2011 to 3.5 in Dec 2011, increasing to 3.6 in Jan 2012 and 3.7 in Feb 2012 but falling to 3.5 in Apr 2012. The rate not seasonally adjusted (NSA) fell from 3.8 in Sep 2011 to 2.6 in Dec 2011, increasing to revised 3.5 in Jan 2012 but falling to 3.1 in Feb 2012 and then increasing to 3.6 in Mar 2012 and 3.8 in Apr 2012. The NSA rate of private hiring fell from 4.9 in Jun 2006 to 3.6 in Jun 2009 but recovery was insufficient to only 4.1 in Jun 2011.
Chart ESI-9, US, Rate Total Private Hiring Month SA 2011-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
The JOLTS report of the Bureau of Labor Statistics also provides total nonfarm job openings (TNF JOB), TNF JOB rate and TNF LD (layoffs and discharges) shown in Table ESI-4 for the month of Apr from 2001 to 2012. The final column provides annual TNF LD for the years from 2001 to 2011. Nonfarm job openings fell from a peak of 4962 in Apr 2007 to 3665 in Apr 2012 or by 26.1 percent while the rate dropped from 3.5 to 2.7. Nonfarm layoffs and discharges (TNF LD) rose from 1672 in Apr 2006 to 2422 in Apr 2009 or by 44.9 percent. The yearly data show layoffs and discharges rising from 21.2 million in 2006 to 26.8 million in 2009 or by 26.4 percent.
Table ESI-4, US, Job Openings and Total Separations, Thousands NSA
| TNF JOB | TNF JOB | TNF LD | TNF LD | |
| Apr 2001 | 5262 | 3.8 | 1849 | 24499 |
| Apr 2002 | 3808 | 2.8 | 1798 | 22922 |
| Apr 2003 | 3529 | 2.6 | 1819 | 23294 |
| Apr 2004 | 3985 | 2.9 | 1844 | 22802 |
| Apr 2005 | 4571 | 3.3 | 1751 | 22185 |
| Apr 2006 | 4940 | 3.5 | 1672 | 21157 |
| Apr 2007 | 4962 | 3.5 | 1776 | 22142 |
| Apr 2008 | 4306 | 3.0 | 1758 | 24166 |
| Apr 2009 | 2511 | 1.9 | 2422 | 26783 |
| Apr 2010 | 3402 | 2.6 | 1586 | 21784 |
| Apr 2011 | 3273 | 2.4 | 1486 | 20718 |
| Apr 2012 | 3665 | 2.7 | 1594 |
Notes: TNF JOB: Total Nonfarm Job Openings; LD: Layoffs and Discharges
Source: US Bureau of Labor Statistics http://www.bls.gov/jlt/data.htm
Chart ESI-10 shows monthly job openings rising from the trough in 2009 to a high in the beginning of 2010. Job openings then stabilized into 2011 but have surpassed the peak of 3057 in Nov 2010 with 3416 seasonally adjusted in Apr 2012, which is lower by 2.4 percent than 3501 in Sep 2011 and lower by 8.7 percent relative to 3741 in Mar 2012. Job openings recovered in Dec 2011 at 3540 but fell into Jan 2012 to 3477. The high of job openings not seasonally adjusted in 2010 was 3221 in Oct 2010 that was surpassed by 3659 in Oct 2011, increasing to 3722 in Mar 2012, declining marginally to 3665 in Apr 2012. The level of job openings not seasonally adjusted fell to 2912 in Nov 2011 or by 17.9 percent relative to 3546 in Sep 2011. There is here again the strong seasonality of year-end labor data. Job openings NSA fell from 4678 in Oct 2006 to 2547 in Oct 2009 or by 45.6 percent, recovering to 3221 in Oct 2010 or by 31.1 percent, which is still 21.8 percent lower at 3659 in Oct 2011 relative to Oct 2006. The level of job openings of 3665 in Apr 2011 NSA is lower by 26.1 percent relative to 4962 in Apr 2007. Again, the main problem in recovery of the US labor market has been the low rate of growth of 2.4 percent in the eleven quarters of expansion of the economy since IIIQ2009 compared with average 6.2 percent in prior expansions from contractions (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The US missed the opportunity to recover employment as in past cyclical expansions from contractions.
Chart ESI-10, US Job Openings, Thousands NSA, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
The rate of job openings in Chart ESI-11 shows similar behavior. The rate seasonally adjusted rose from 2.1 percent in Jan 2011 to 2.6 percent in Dec 2011. The rate not seasonally adjusted rose from the high of 2.6 in Apr 2010 to 2.7 in Jul 2011 and 2.7 in both Mar 2012 and Apr 2012. The rate of job openings NSA fell from 3.5 in Apr 2006 to 1.9 in Apr 2009, recovering insufficiently to 2.7 in Apr 2012.
Chart ESI-11, US, Rate of Job Openings, Thousands NSA, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
ESII Ten Million Fewer Full-Time Jobs. There is strong seasonality in US labor markets around the end of the year. The number employed part-time for economic reasons because they could not find full-time employment fell from 9.270 million in Sep 2011 to 8.098 million in May 2012, seasonally adjusted, or decline of 1.172 million in eight months, as shown in Table ESII-1. The number employed full-time increased from 112.479 million in Sep 2011 to 115.290 million in Mar 2012 or 2.811 million but then fell to 111.478 million in Apr 2012 or 1.001 million fewer full-time employed than in Sep 2011. There is a jump in the level of full-time SA to 114.212 or 2.734 million relative to Apr 2012. The number of employed part-time for economic reasons actually increased without seasonal adjustment from 8.271 million in Nov 2011 to 8.428 million in Dec 2011 or by 157,000 and then to 8.918 million in Jan 2012 or by an additional 490,000 for cumulative increase from Nov 2011 to Jan 2012 of 647,000. The level of employed part-time for economic reasons then fell from 8.918 million in Jan 2012 to 7.867 million in Mar 2012 or by 1.0151 million and to 7.694 million in Apr 2012 or 1.224 million fewer relative to Jan 2012. In May, the number employed part-time for economic reasons increased to 7.837 million SA or 143,000 more than in Apr 2012. The number employed full time without seasonal adjustment fell from 113.138 million in Nov 2011 to 113.050 million in Dec 2011 or by 88,000 and fell further to 111.879 in Jan 2012 for cumulative decrease of 1.259 million. The number employed full-time not seasonally adjusted fell from 113.138 million in Nov 2011 to 112.587 million in Feb 2012 or by 551.000 but increased to 113.916 in Mar 2012 or increase by 778,000 compared with the level in Nov 2011 and further increased to 113.999 in Apr 2012 or 861,000 more than in Nov 2011 and then to 114.634 million in May 2012 or 1.496 million relative to Nov 2011. Comparisons over long periods require use of NSA data. The number with full-time jobs fell from a high of 123.219 million in Jul 2007 to 108.770 million in Jan 2010 or by 14.449 million. The number with full-time jobs in May 2012 is 114.634 million, which is lower by 8.6 million relative to the peak of 123.219 million in Jul 2007. There appear to be around 10 million less full-time jobs in the US than before the global recession. Growth at 2.4 percent on average in the eleven quarters of expansion from IIIQ2009 to IQ2012 compared with 6.2 percent on average in expansions from postwar cyclical contractions is the main culprit of the fractured US labor market (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html).
Table ESII-1, US, Employed Part-time for Economic Reasons, Thousands, and Full-time, Millions
| Part-time Thousands | Full-time Millions | |
| Seasonally Adjusted | ||
| May 2012 | 8,098 | 114.212 |
| Apr 2012 | 7,853 | 111.478 |
| Mar 2012 | 7,672 | 115.290 |
| Feb 2012 | 8,119 | 114.408 |
| Jan 2012 | 8,230 | 113.845 |
| Dec 2011 | 8,098 | 113.765 |
| Nov 2011 | 8,469 | 113.212 |
| Oct 2011 | 8,790 | 112.841 |
| Sep 2011 | 9,270 | 112.479 |
| Aug 2011 | 8,787 | 112.406 |
| Not Seasonally Adjusted | ||
| May 2012 | 7,837 | 114.634 |
| Apr 2012 | 7,694 | 113.999 |
| Mar 2012 | 7,867 | 113.916 |
| Feb 2012 | 8,455 | 112.587 |
| Jan 2012 | 8,918 | 111.879 |
| Dec 2011 | 8,428 | 113.050 |
| Nov 2011 | 8,271 | 113.138 |
| Oct 2011 | 8,258 | 113.456 |
| May 2011 | 8,270 | 112.618 |
| Apr 2011 | 8,425 | 111.844 |
| Mar 2011 | 8,737 | 111.186 |
| Feb 2011 | 8,749 | 110.731 |
| Jan 2011 | 9,187 | 110.373 |
| Dec 2010 | 9,205 | 111.207 |
| Nov 2010 | 8,670 | 111.348 |
| Oct 2010 | 8,408 | 112.342 |
| May 2010 | 8,513 | 112.809 |
| Apr 2010 | 8,921 | 111.391 |
| Mar 2010 | 9,343 | 109.877 |
| Feb 2010 | 9,282 | 109.100 |
| Jan 2010 | 9,290 | 108.777 (low) |
| Dec 2009 | 9,354 (high) | 109.875 |
| May 2009 | 8,785 | 113.083 |
| Apr 2009 | 8,648 | 112.746 |
| Mar 2009 | 9,305 | 112.215 |
| Feb 2009 | 9,170 | 112.947 |
| Jan 2009 | 8,829 | 113.815 |
| May 2008 | 5,096 | 120.809 |
| Apr 2008 | 5,071 | 120.027 |
| Mar 2008 | 5,038 | 119.875 |
| Feb 2008 | 5,114 | 119.452 |
| Jan 2008 | 5,340 | 119.322 |
| Jul 2007 | 4,516 | 123.219 (high) |
| May 2007 | 4,315 | 120.846 |
| Apr 2007 | 4,205 | 119.609 |
| Mar 2007 | 4,384 | 119.640 |
| Feb 2007 | 4,417 | 119.041 |
| Jan 2007 | 4,726 | 119.094 |
| Sep 2006 | 3,735 (low) | 120.780 |
| May 2006 | 3,968 | 118.925 |
| Apr 2006 | 3,787 | 118.559 |
| Mar 2006 | 4,097 | 117.693 |
| Feb 2006 | 4,403 | 116.823 |
| Jan 2006 | 4,597 | 116.395 |
Source: US Bureau of Labor Statistics http://www.bls.gov/cps/data.htm
People lose their marketable job skills after prolonged unemployment and find increasing difficulty in finding another job. Chart ESII-1 shows the sharp rise in unemployed over 27 weeks and stabilization at an extremely high level.
Chart ESII-1, US, Number Unemployed for 27 Weeks or Over, Thousands SA Month 2001-2011
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Another segment of U6 consists of people marginally attached to the labor force who continue to seek employment but less frequently on the frustration there may not be a job for them. Chart ESII-2 shows the sharp rise in people marginally attached to the labor force after 2007 and subsequent stabilization.
Chart ESII-2, US, Marginally Attached to the Labor Force, NSA Month 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart ESII-3 reveals the fracture in the US labor market. The number of workers with full-time jobs not-seasonally-adjusted rose with fluctuations from 2002 to a peak in 2007, collapsing during the global recession. The terrible state of the job market is shown in the segment from 2009 to 2012 with fluctuations around the typical behavior of a stationary series: there is no improvement in the United States in creating full-time jobs.
Chart ESII-3, US, Full-time Employed, Thousands, NSA, 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
ESIII Youth Unemployment. The United States is experiencing high youth unemployment as in European economies. Table ESIII-1 provides the employment level for ages 16 to 24 years of age estimated by the Bureau of Labor Statistics. On an annual basis, youth employment fell from 20.041 million in 2006 to 17.362 million in 2011 or 2.679 million fewer youth jobs. During the seasonal peak months of youth employment in the summer from Jun to Aug, youth employment has fallen by more than two million jobs. There are two hardships behind these data. First, young people cannot find employment after finishing high-school and college, reducing prospects for achievement in older age. Second, students with more modest means cannot find employment to keep them in college.
Table ESIII-1, US, Employment Level 16-24 Years, Thousands, NSA
| Year | Feb | Mar | Apr | May | Annual |
| 2001 | 19745 | 19800 | 19778 | 19648 | 20088 |
| 2002 | 19074 | 19091 | 19108 | 19484 | 19683 |
| 2003 | 18880 | 18709 | 18873 | 19032 | 19351 |
| 2004 | 18841 | 18752 | 19184 | 19237 | 19630 |
| 2005 | 18670 | 18989 | 19071 | 19356 | 19770 |
| 2006 | 19182 | 19291 | 19406 | 19769 | 20041 |
| 2007 | 19415 | 19538 | 19368 | 19457 | 19875 |
| 2008 | 18546 | 18745 | 19161 | 19254 | 19202 |
| 2009 | 17606 | 17564 | 17739 | 17588 | 17601 |
| 2010 | 16412 | 16587 | 16764 | 17039 | 17077 |
| 2011 | 16638 | 16898 | 16970 | 17045 | 17362 |
| 2012 | 17150 | 17301 | 17387 | 17681 |
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart ESIII-1 provides US employment level ages 16 to 24 years from 2002 to 2012. Employment level is sharply lower in Apr 2012 relative to the peak in 2007.
Chart ESIII-1, US, Employment Level 16-24 Years, Thousands SA, 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Table ESIII-2 provides US unemployment level ages 16 to 24 years. The number unemployed ages 16 to 24 years increased from 2342 thousand in 2007 to 3634 thousand in 2011 or by 1.292 million. This situation may persist for many years.
Table ESIII-2, US, Unemployment Level 16-24 Years, Thousands NSA
| Year | Feb | Mar | Apr | May | Annual |
| 2001 | 2258 | 2253 | 2095 | 2171 | 2371 |
| 2002 | 2731 | 2822 | 2515 | 2568 | 2683 |
| 2003 | 2740 | 2601 | 2572 | 2838 | 2746 |
| 2004 | 2631 | 2588 | 2387 | 2684 | 2638 |
| 2005 | 2787 | 2520 | 2398 | 2619 | 2521 |
| 2006 | 2433 | 2216 | 2092 | 2254 | 2353 |
| 2007 | 2230 | 2096 | 2074 | 2203 | 2342 |
| 2008 | 2480 | 2347 | 2196 | 2952 | 2830 |
| 2009 | 3457 | 3371 | 3321 | 3851 | 3760 |
| 2010 | 3888 | 3748 | 3803 | 3854 | 3857 |
| 2011 | 3696 | 3520 | 3365 | 3628 | 3634 |
| 2012 | 3507 | 3294 | 3175 | 3438 |
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart ESIII-2 provides the unemployment level ages 16 to 24 from 2002 to 2012. The level rose sharply from 2007 to 2010 with tepid improvement into 2012.
Chart ESIII-2, US, Unemployment Level 16-24 Years, Thousands SA, 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Table ESIII-3 provides the rate of unemployment of young peoples in ages 16 to 24 years. The annual rate jumped from 10.5 percent in 2007 to 18.4 percent in 2010 and 17.3 percent in 2011. During the seasonal peak in Jul 2011 the rate of youth unemployed was 18.1 percent compared with 10.8 percent in Jun 2007.
Table ESIII-3, US, Unemployment Rate 16-24 Years, Thousands, NSA
| Year | Feb | Mar | Apr | May | Annual |
| 2001 | 10.3 | 10.2 | 9.6 | 10.0 | 10.6 |
| 2002 | 12.5 | 12.9 | 11.6 | 11.6 | 12.0 |
| 2003 | 12.7 | 12.2 | 12.0 | 13.0 | 12.4 |
| 2004 | 12.3 | 12.1 | 11.1 | 12.2 | 11.8 |
| 2005 | 13.0 | 11.7 | 11.2 | 11.9 | 11.3 |
| 2006 | 11.3 | 10.3 | 9.7 | 10.2 | 10.5 |
| 2007 | 10.3 | 9.7 | 9.7 | 10.2 | 10.5 |
| 2008 | 11.8 | 11.1 | 10.3 | 13.3 | 12.8 |
| 2009 | 16.4 | 16.1 | 15.8 | 18.0 | 17.6 |
| 2010 | 19.2 | 18.4 | 18.5 | 18.4 | 18.4 |
| 2011 | 18.2 | 17.2 | 16.5 | 17.5 | 17.3 |
| 2012 | 17.0 | 16.0 | 15.4 | 16.3 |
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart ESIII-4 provides the BLS estimate of the not-seasonally-adjusted rate of youth unemployment for ages 16 to 24 years from 2002 to 2012. The rate of youth unemployment increased sharply during the global recession of 2008 and 2009 but has failed to drop to earlier lower levels during the eleven quarters of expansion of the economy since IIIQ2009.
Chart ESIII-4, US, Unemployment Rate 16-24 Years, Thousands, NSA, 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart ESIII-5 provides longer perspective with the rate of youth unemployment in ages 16 to 24 years from 1948 to 2012. The rate of youth unemployment rose to 20 percent during the contractions of the early 1980s and also during the contraction of the global recession in 2008 and 2009. The data illustrate again the claim in this blog that the contractions of the early 1980s are the valid framework for comparison with the global recession of 2008 and 2009 instead of misleading comparisons with the 1930s. During the initial phase of recovery, the rate of youth unemployment 16 to 24 years NSA fell from 18.9 percent in Jun 1983 to 14.5 percent in Jun 1984 while the rate of youth unemployment 16 to 24 years was nearly the same during the expansion after IIIQ2009: 19.9 percent in Jun 2009, 20.0 percent in Jun 2010 and 18.9 percent in Jun 2011. The NSA rate of unemployment 16-24 years of age is 16.3 percent for May 2012. The difference originates in the vigorous seasonally-adjusted annual equivalent average rate of GDP growth of 5.7 percent during the recovery from IQ1983 to IVQ1985 compared with 2.4 percent on average during the first eleven quarters of expansion from IIIQ2009 to IQ2012 (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The fractured US labor market denies an early start for young people.
Chart ESIII-5, US, Unemployment Rate 16-24 Years, Percent NSA, 1948-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
ESIV Projections of the US Economy. Table ESIV-1 provides economic projections of governors of the Board of Governors of the Federal Reserve and regional presidents of Federal Reserve Banks released at the meeting of Jun 20, 2012. The Fed releases the data with careful explanations (http://www.federalreserve.gov/newsevents/press/monetary/20120620b.htm). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IQ2012 is analyzed in a prior blog post together with the PCE inflation data from the report on personal income and outlays (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The Bureau of Economic Analysis (BEA) provides the second estimate of IQ2012 GDP with the third estimate to be released on Jun 28 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed in this blog as soon as available (for the latest report for Apr see http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm and http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The next report on “Personal Income and Outlays” for May will be released at 8:30 AM on Jun 29, 2012. PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog (the May report is analyzed at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The report for Jun will be released on July 6, 2012 (http://www.bls.gov/cps/). “Longer term projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf).
It is instructive to focus on 2012, as 2013, 2014 and longer term are too far away, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Jun 20, 2012, and the second row “PR” the projection of the Apr 25, 2012 meeting. There are three major changes in the view.
1. Growth “∆% GDP.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun 2011 to 2.5 to 2.9 percent in Nov 2011 and 2.2 to 2.7 percent at the Jan 25 meeting but increased it to 2.4 to 2.9 percent at the Apr 25, 2012 meeting, reducing it to 1.9 to 2.4 percent at the Jun 20, 2012 meeting.
2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun 2011 to 8.5 to 8.7 percent in Nov 2011 but has reduced it to 8.2 to 8.5 percent at the Jan 25 meeting and further down to 7.8 to 8.0 percent at the Apr 25, 2012 meeting but increased it to 8.0 to 8.2 percent at the Jun 20, 2012 meeting.
3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun 2011 to virtually the same of 1.4 to 2.0 percent in Nov 2011 but has reduced it to 1.4 to 1.8 percent at the Jan 25 meeting but increased it to 1.9 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.2 to 1.7 percent at the Jun 20, 2012 meeting.
4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun 2011 of 1.4 to 2.0 percent and the Nov 2011 projection of 1.5 to 2.0 percent, which has been reduced slightly to 1.5 to 1.8 percent at the Jan 25 meeting but increased to 1.8 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.7 to 2.0 percent at the Jun 20, 2012 meeting.
Table ESIV-1, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, June 2012 and April 2012
| ∆% GDP | UNEM % | ∆% PCE Inflation | ∆% Core PCE Inflation | |
| Central | ||||
| 2012 Apr PR | 1.9 to 2.4 2.4 to 2.9 | 8.0 to 8.2 7.8 to 8.0 | 1.2 to 1.7 1.9 to 2.0 | 1.7 to 2.0 1.8 to 2.0 |
| 2013 | 2.2 to 2.8 | 7.5 to 8.0 | 1.5 to 2.0 | 1.6 to 2.0 1.7 to 2.0 |
| 2014 | 3.0 to 3.5 | 7.0 to 7.7 | 1.5 to 2.0 | 1.6 to 2.0 |
| Longer Run Apr PR | 2.3 to 2.5 2.3 to 2.6 | 5.2 to 6.0 5.2 to 6.0 | 2.0 2.0 | |
| Range | ||||
| 2012 | 1.6 to 2.5 | 7.8 to 8.4 | 1.2 to 2.0 | 1.7 to 2.0 |
| 2013 | 2.2 to 3.5 | 7.0 to 8.1 | 1.5 to 2.1 | 1.4 to 2.1 |
| 2014 | 2.8 to 4.0 | 6.3 to 7.7 | 1.5 to 2.2 | 1.5 to 2.2 |
| Longer Run Apr PR | 2.2 to 3.0 2.2 to 3.0 | 4.9 to 6.3 4.9 to 6.0 | 2.0 2.0 |
Notes: UEM: unemployment; PR: Projection
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf
ESV Maturity Extension Program. The Federal Reserve Bank of New York (FRBNY) provides a “Statement Regarding Continuation of the Maturity Extension Program” with the directions to the FRBNY’s Open Market Trading Desk (the Desk) (http://www.newyorkfed.org/markets/opolicy/operating_policy_120620.html):
“Specifically, the Desk was directed to purchase Treasury securities with remaining maturities of 6 to 30 years and to sell or redeem an equal par value of Treasury securities with remaining maturities of approximately 3 years or less. The continuation of the maturity extension program will proceed at the current pace and result in the purchase, as well as the sale and redemption, of about $267 billion in Treasury securities by the end of 2012. The FOMC also directed the Desk to continue reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities (MBS) in agency MBS, and to suspend, for the duration of the maturity extension program, rolling over maturity Treasury securities into new issues at auction.”
The distribution of the purchases of securities will be as follows: 32 percent for maturities from 6 to 8 years, 32 percent for maturities from 8 to 10 years, 4 percent for maturities from 10 to 20 years, 29 percent from maturities from 20 to 30 years and 3 percent for maturities of TIPS (Treasury Inflation-Protected Securities http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm) from 6 to 30 years.
The purchase of long-term Treasury securities would displace demand for long-term Treasury securities upward and to the right. The price of long-term Treasury securities would increase, which is equivalent to a reduction of yields of long-term Treasury securities. Most credit currently is provided by securitized banking without which the economy would probably not grow as rapidly as permitted by labor, capital, resources and technology. The bank is also an intermediary between investors (savers) and borrowers (debtors). Investors give cash to the bank in exchange for collateral, such as securities, that is not insured by the government (see Gorton and Metrick 2010SB, Figure 2, 45). The securities are “pledged” by the bank to the investors in guarantee of repayment of the cash. The bank in turn gives cash to direct lenders that provide it to homebuyers who pledge the home with a mortgage loan. The direct lenders receive the cash provided to the homebuyers by transferring the mortgage to the dealer bank. Mortgages of the similar maturity and credit quality are agglutinated or “bundled” into a residential mortgage-backed security (RMBS) and sold or “distributed” to investors in the market.
The part of securitization banking analyzed by Gorton and Metrick (2010SB, Figure 6, Securitization, 41) consists of the critical transactions that surfaced during the beginning of the credit/dollar crisis. Banks fund by receiving cash from investors in exchange for collateral that is not insured by the FDIC. With the mortgages received in exchange for the cash, the bank creates RMBS that in some cases are transferred to a special purpose vehicle, variously called structured investment vehicles (SIV) and conduits in Europe. The securities are divided in tranches with credit risk from AAA to investment grade BBB and an unrated equity tranche to which the manager of the securities allocates the first losses and when exhausted losses are allocated beginning with the lower-rated tranches until reaching AAA in ascending hierarchy of credit rating. The SIV is actually an off-balance sheet vehicle of a bank that provides its AAA rating to obtain lower-cost financing. The SIV generated cash by issuing asset-backed commercial paper (ABCP) with guarantees of the securities. The SIV financed the ABCP in the short-term SRP (sales and repurchase agreement) market, obtaining the funds to purchase the securities from the bank that in turn financed the direct lender and ultimately the homebuyer. The bank provided a desk letter of comfort that it would provide liquidity to the SIV in cases of failure to roll over or refinance SRPs to ensure AAA rating for the ABCP of the SIV that allowed low-cost SRP financing. The SIV then sold asset-backed securities (ABS) to investors with the securities bundled by the bank. The SIV also created collateralized debt obligations (CDO) with the same tranches from AAA to unrated equity layer and the same process of loss absorption beginning with the unrated equity layer and climbing in the rating ladder to the AAA tranche. The CDO is sold to investors. The purpose of the tranches is to create diverse products catering to the risk appetite of investors, with pension funds buying AAA tranches and hedge funds acquiring BBB. The tranches also include credit default swaps (CDS). This process of credit risk transfer was analyzed by the Joint Forum of the Basel Committee on Banking Supervision, International Organization of Securities Commissions and the International Association of Supervisors (2004). Credit risk transfer consists of pulverizing credit in small transactions distributed to many investors in order to diminish concentrations of risk in large financial institutions that could cause systemic crises (see Pelaez and Pelaez, International Financial Architecture (2005), 134-54).
Maturity extension of the Treasury yield curve by open-market purchases of the Desk of the FRBNY intend to lower yields of ABS that fund wholesale credit for consumption and investment. Lower yields of ABS reduce the costs of borrowing for consumption and investment that can increase aggregate demand. Table ESV-1 provides US GDP and its components in billions of dollars and percentage share for IQ2012. US GDP at seasonally-adjusted annual rate was $15,454.0 billion. The share of PCE in IQ2012 GDP was $11,009.5 billion or 71.2 percent. The share of gross private domestic investment in IQ2012 GDP was $2,046.5 billion or 13.2 percent. The sum of PCE and gross private domestic investment is aggregate demand. Maturity extension intends to lower costs of borrowing for consumption and investment to increase aggregate demand that would accelerate growth and hiring.
Table ESV-1, US, GDP Seasonally-Adjusted at Annual Rates and Percentage Shares, Billions of Dollars and %
| IQ2012 SAAR Billions of Dollars | IQ2012 Percentage Shares | |
| GDP | 15,454.0 | 100.0 |
| PCE | 11,009.5 | 71.2 |
| Goods | 3,788.3 | 24.5 |
| Durable | 1,232.2 | 8.0 |
| Nondurable | 2,556.1 | 16.5 |
| Services | 7,221.2 | 46.7 |
| Gross Private Domestic Investment | 2,046.5 | 13.2 |
| Fixed Investment | 1,970.3 | 12.7 |
| NRFI | 1,609.3 | 10.4 |
| RFI | 361.0 | 2.3 |
| Change in Private | 76.2 | 0.5 |
| Net Exports of Goods and Services | -620.1 | -4.0 |
| Exports | 2,168.3 | 14.0 |
| Goods | 1,527.0 | 9.9 |
| Services | 641.3 | 4.1 |
| Imports | 2,788.5 | 18.0 |
| Goods | 2,341.3 | 15.1 |
| Services | 447.2 | 2.9 |
| Government | 3,018.2 | 19.5 |
| Federal | 1,218.8 | 7.9 |
| State and Local | 1,799.4 | 11.6 |
PCE: personal consumption expenditures; NRFI: nonresidential fixed investment; RFI: residential fixed investment
Source: http://www.bea.gov/iTable/index_nipa.cfm
The task of monetary policy is to accelerate growth of the aggregate of consumption and investment is the US economy, about $13,056.0 billion, or $13.1 trillion. The first step of transmission of monetary policy consists of lowering yields of ABS securities. Pozsar et al (2012RFeb, 7-9) provide a gross measurement of “shadow banking” liabilities including those relating to securitization, such as ABS, Mortgage-backed Securities (MBS) and other liabilities of Government-Sponsored Enterprises (GSE) that include Fannie and Freddie, plus money market activities such as sale and repurchase agreements (SRP), commercial paper and liabilities of money market funds. The net measure tries to avoid double counting. The gross measure of shadow banking reached around $22 trillion in 2007 and contracted sharply during the financial crisis and global recession. A complete measure following the analysis of Pozsar et al (20012RFeb) would have to include not only liabilities in the US but also in international markets. Success of maturity extension and quantitative easing also requires igniting credit through the traditional banking system. McKinsey & Co. (2007) measures a broad aggregate financial stock consisting of equities, bonds, loans and deposits, measured at $51 trillion in 2005 for the US, $38 trillion for the euro area and $20 trillion for Japan. McKinsey & Co. (2007) finds that in the ten years to 2005 the financial stock of the US grew at the average yearly rate of 6.5 percent, which was lower than 8.5 percent for the UK. The US lost competitive advantage in finance during a prolonged period (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 168-79, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 160-6). Recession financial regulation typically accentuates loss of competitiveness and financial disintermediation, creating obstacles to growth (for financial regulation, see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), Regulation of Banks and Finance (2009b)).
Residential construction is one of the multiple sectors that would have to be influenced by monetary policy for success in increasing aggregate demand. The report of the US Census Bureau for Apr 2012 places the value of construction put in place in the US of $820,662 million, seasonally-adjusted at annual rate, of which $262,328 in residential construction or 32.0 percent and $558,334 million in nonresidential construction or 68.0 percent (http://www.census.gov/construction/c30/pdf/release.pdf, Table 1; see http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html). Table ESV-2 provides data of the Federal Housing Finance Agency (FHFA), regulator of Fannie Mae and Freddie Mac, with stock of mortgages outstanding in the US of $11,387,6767 million in 2010.
The US Treasury measures total public debt outstanding in the US at $15,779.6 billion of which $4,747.1 billion in intergovernmental holdings and $11,032.5 billion in debt held by the public (http://www.treasurydirect.gov/NP/BPDLogin?application=np). The Bank for International Settlements (BIS) measures international debt securities of developed countries of all types of issuers at $26,661.7 billion in Sep 2011 of which $7,396.2 billion by the United States (http://www.bis.org/publ/qtrpdf/r_qa1112.pdf). Total issues of international money market instruments in Sep 2011 are measured by BIS at $980.1 billion in Sep 2011 (http://www.bis.org/publ/qtrpdf/r_qa1112.pdf). International bonds and notes outstanding in Sep 2011 reached $28,795.8 billion (http://www.bis.org/publ/qtrpdf/r_qa1112.pdf). Measuring the market value of derivatives relevant to successful monetary policy is more arduous (http://www.bis.org/publ/otc_hy1205.pdf).
Table ESV-2, United States, Residential Mortgage Debt Outstanding, Millions of Dollars
| Fannie Mae | Freddie Mac | Combined Enterprises | Residential Mortgage Debt Outstanding | |
| 1990 | $404,703 | $338,217 | $742,920 | $2,893,729 |
| 1991 | $484,267 | $386,209 | $870,476 | $3,058,425 |
| 1992 | $582,563 | $441,410 | $1,023,973 | $3,212,681 |
| 1993 | $662,167 | $494,727 | $1,156,894 | $3,368,360 |
| 1994 | $708,402 | $533,484 | $1,241,886 | $3,546,131 |
| 1995 | $766,741 | $566,469 | $1,333,210 | $3,719,233 |
| 1996 | $835,225 | $610,820 | $1,446,045 | $3,954,526 |
| 1997 | $895,816 | $640,406 | $1,536,222 | $4,200,416 |
| 1998 | $1,051,658 | $733,360 | $1,785,018 | $4,590,489 |
| 1999 | $1,203,086 | $862,326 | $2,065,412 | $5,055,445 |
| 2000 | $1,316,844 | $968,399 | $2,285,243 | $5,508,592 |
| 2001 | $1,579,398 | $1,150,723 | $2,730,121 | $6,102,611 |
| 2002 | $1,840,218 | $1,297,081 | $3,137,299 | $6,896,266 |
| 2003 | $2,209,388 | $1,397,630 | $3,607,018 | $7,797,171 |
| 2004 | $2,325,256 | $1,505,531 | $3,830,787 | $8,872,741 |
| 2005 | $2,336,807 | $1,684,546 | $4,021,353 | $10,049,205 |
| 2006 | $2,506,482 | $1,826,720 | $4,333,202 | $11,163,068 |
| 2007 | $2,846,812 | $2,102,676 | $4,949,488 | $11,954,031 |
| 2008 | $3,081,655 | $2,207,476 | $5,289,131 | $11,906,478 |
| 2009 | $3,202,041 | $2,250,539 | $5,452,580 | $11,707,666 |
| 2010* | $3,156,192 | $2,164,859 | $5,321,051 | $11,387,676 |
Source: Federal Housing Finance Agency (FHFA)http://fhfa.gov/Default.aspx?Page=70
ESVI Flight to Government Securities of the United States, Germany and Japan. There was significant improvement in ten-year yields of bonds of the government of Italy, declining to 5.770 percent on Fri Jun 22 from yields exceeding 6 percent, and of ten-year yields of bonds of the government of Spain, declining to 6.3580 percent on Fri Jun 22 from earlier yields exceeding 7 percent (http://professional.wsj.com/mdc/public/page/2_3022-govtbonds.html?mod=mdc_bnd_pglnk). 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 and the two- and ten-year government bonds of Germany. Table ESVI-1 provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.676 percent on Jun 22, 2012 while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.58 percent. The yield of the two-year government bond of Germany fell from 0.65 percent on Aug 26, 2011, to 0.01 percent on Jun 1, 2012, as investors fled euro area risks to the safety of liabilities of the government of Germany, and increased marginally to 0.07 percent on Jun 15, 2012. The combination of multiple risks in the world economy and finance caused heightened risk aversion in the week of Jun 1, 2012, with the ten-year Treasury yield collapsing to 1.454, level experienced during the Treasury-Fed agreement of the 1940s, while the two-year government bond of Germany fell to 0.01 percent and even negative and 0.00 percent and the ten-year government bond of Germany collapsing to 1.17 percent. There was relaxation of risk aversion in the week of Jun 8 with increase of the yield of the ten-year Treasury to 1.635 percent and of the two-year government bond of Germany to 0.04 percent and the ten-year to 1.33 percent, which are still at levels of extreme flight from risk. Fears on Greece, Spain and Italy resulted in renewed risk aversion with yields on Jun 15, 2012 at levels of flight to safety but more relaxed yields in the week of Jun 22, 2012. The US dollar strengthened significantly from USD 1.450/EUR on Aug 26, 2011, to USD 1.2518/EUR on May 25, 2919, or by 13.7 percent, and further to USD 1.2435/EUR on Jun 1, 2012, or by 14.2 percent. The USD revalued by 0.7 percent to USD 1.2517 on Jun 8, 2012, depreciated 1 percent on Jun 15 to USD 1.2640/EUR but appreciated by 0.6 percent on Jun 22. The dollar peaked at USD 1.192/EUR on Jun 7, 2010, during the first round of the European sovereign risk crisis, but is now only 5.5 percent weaker at USD 1.2570/EUR on Jun 22, 2012. Under zero interest rates for the monetary policy rate of the US, or fed funds rate, carry trades ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield is still at a level well below consumer price inflation of 1.7 percent in the 12 months ending in May (see subsection IB United States Inflation http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.html and ealier http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html) and the expectation of higher inflation if risk aversion diminishes. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury.
A similar risk aversion phenomenon occurred in Germany. Eurostat confirmed euro zone CPI inflation is at 2.4 percent for the 12 months ending in May 2012 but jumping 1.3 percent in the month of Mar (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-14062012-BP/EN/2-14062012-BP-EN.PDF and Section IV http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.html) but the yield of the two-year German government bond fell from 0.65 percent on Aug 19, 2011 to 0.05 percent on May 25, 2012, 0.01 percent on Jun 1, 2012, 0.04 percent on Jun 8, 0.07 percent on Jun 15 and 0.14 percent on Jun 22, while the ten-year yield fell from 2.16 percent on Aug 26, 2011 to 1.37 percent on May 25, 2012 and then to 1.17 percent on Jun 1, 2012, 1.33 percent on Jun 8, 1.44 percent on Jun 15 and 1.58 percent on Jun 22 , as shown in Table ESVI-1. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.
Table ESVI-1, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate
| US 2Y | US 10Y | DE 2Y | DE 10Y | USD/ EUR | |
| 6/22/12 | 0.309 | 1.676 | 0.14 | 1.58 | 1.2570 |
| 6/15/12 | 0.272 | 1.584 | 0.07 | 1.44 | 1.2640 |
| 6/8/12 | 0.268 | 1.635 | 0.04 | 1.33 | 1.2517 |
| 6/1/12 | 0.248 | 1.454 | 0.01 | 1.17 | 1.2435 |
| 5/25/12 | 0.291 | 1.738 | 0.05 | 1.37 | 1.2518 |
| 5/18/12 | 0.292 | 1.714 | 0.05 | 1.43 | 1.2780 |
| 5/11/12 | 0.248 | 1.845 | 0.09 | 1.52 | 1.2917 |
| 5/4/12 | 0.256 | 1.876 | 0.08 | 1.58 | 1.3084 |
| 4/6/12 | 0.31 | 2.058 | 0.14 | 1.74 | 1.3096 |
| 3/30/12 | 0.335 | 2.214 | 0.21 | 1.79 | 1.3340 |
| 3/2/12 | 0.29 | 1.977 | 0.16 | 1.80 | 1.3190 |
| 2/24/12 | 0.307 | 1.977 | 0.24 | 1.88 | 1.3449 |
| 1/6/12 | 0.256 | 1.957 | 0.17 | 1.85 | 1.2720 |
| 12/30/11 | 0.239 | 1.871 | 0.14 | 1.83 | 1.2944 |
| 8/26/11 | 0.20 | 2.202 | 0.65 | 2.16 | 1.450 |
| 8/19/11 | 0.192 | 2.066 | 0.65 | 2.11 | 1.4390 |
| 6/7/10 | 0.74 | 3.17 | 0.49 | 2.56 | 1.192 |
| 3/5/09 | 0.89 | 2.83 | 1.19 | 3.01 | 1.254 |
| 12/17/08 | 0.73 | 2.20 | 1.94 | 3.00 | 1.442 |
| 10/27/08 | 1.57 | 3.79 | 2.61 | 3.76 | 1.246 |
| 7/14/08 | 2.47 | 3.88 | 4.38 | 4.40 | 1.5914 |
| 6/26/03 | 1.41 | 3.55 | NA | 3.62 | 1.1423 |
Note: DE: Germany
Source:
http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
http://www.federalreserve.gov/releases/h15/data.htm
http://www.ecb.int/stats/money/long/html/index.en.html
ESVII Stagnation of Real Disposable Income. Table ESVII-1 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IVQ1985 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IVQ1985, GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.5 percent at the annual equivalent rate of 4.3 percent; RDPI per capita increased 11.5 percent at the annual equivalent rate of 3.4 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. Second, in the 11 quarters of the current cyclical expansion from IIIQ2009 to IQ2012, GDP increased 6.7 percent at the annual equivalent rate of 2.4 percent; real disposable personal income (RDPI) increased 2.5 percent at the annual equivalent rate of 0.9 percent; RDPI per capita increased 0.3 percent at the annual equivalent rate of 0.1 percent; and population increased 2.1 percent at the annual equivalent rate of 0.8 percent. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing.
Table ESVII-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2011, %
| # Quarters | ∆% | ∆% Annual Equivalent | |
| IQ1983 to IVQ1985 | 13 | ||
| GDP | 19.6 | 5.7 | |
| RDPI | 14.5 | 4.3 | |
| RDPI Per Capita | 11.5 | 3.4 | |
| Population | 2.7 | 0.8 | |
| IIIQ2009 to IQ2012 | 11 | ||
| GDP | 6.7 | 2.4 | |
| RDPI | 2.5 | 0.9 | |
| RDPI per Capita | 0.3 | 0.1 | |
| Population | 2.1 | 0.8 |
RDPI: Real Disposable Personal Income
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
ESVIII Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/fmu/eng/2012/01/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/pubs/ft/fm/2012/update/01/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider a summary of global economic and financial risks, which are analyzed in detail in the comments of this blog in Section VI Valuation of Risk Financial Assets, Table VI-4.
Economic risks include the following:
1. China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. The growth rate of GDP of China in the first quarter of 2012 of 1.8 percent is equivalent to 7.4 percent per year.
2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 28.4 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically-low hiring and declining real wages.
3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
4. World Inflation Waves. Inflation continues in repetitive waves globally (see Section I Inflation Waves at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html).
A list of financial uncertainties includes:
1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.
2. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies.
3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.
4. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
5. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).
6. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion.
It is in this context of economic and financial uncertainties that decisions on portfolio choices of risk financial assets must be made. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table VI-1 in the text after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China now complicated by political developments, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion or the “sharp shifts in risk appetite” of Blanchard (2012WEOApr, XIII). Table ESVIII-1, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 6/22/12,” which has been recently stalling or reversing amidst profound risk aversion. “Let’s twist again” monetary policy during the week of Sep 23 caused deep worldwide risk aversion and selloff of risk financial assets (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html). Monetary policy was designed to increase risk appetite but instead suffocated risk exposures. There has been rollercoaster fluctuation in risk aversion and financial risk asset valuations: surge in the week of Dec 2, mixed performance of markets in the week of Dec 9, renewed risk aversion in the week of Dec 16, end-of-the-year relaxed risk aversion in thin markets in the weeks of Dec 23 and Dec 30, mixed sentiment in the weeks of Jan 6 and Jan 13 2012 and strength in the weeks of Jan 20, Jan 27 and Feb 3 followed by weakness in the week of Feb 10 but strength in the weeks of Feb 17 and 24 followed by uncertainty on financial counterparty risk in the weeks of Mar 2 and Mar 9. All financial values have fluctuated with events such as the surge in the week of Mar 16 on favorable news of Greece’s bailout even with new risk issues arising in the week of Mar 23 but renewed risk appetite in the week of Mar 30 because of the end of the quarter and the increase in the firewall of support of sovereign debts in the euro area. New risks developed in the week of Apr 6 with increase of yields of sovereign bonds of Spain and Italy, doubts on Fed policy and weak employment report. Asia and financial entities are experiencing their own risk environments. Financial markets were under stress in the week of Apr 13 because of the large exposure of Spanish banks to lending by the European Central Bank and the annual equivalent growth rate of China’s GDP of 7.4 percent in IQ2012 [(1.018)4]. There was strength again in the week of Apr 20 because of the enhanced IMF firewall and Spain placement of debt, continuing into the week of Apr 27. Risk aversion returned in the week of May 4 because of the expectation of elections in Europe and the new trend of deterioration of job creation in the US. Europe’s sovereign debt crisis and the fractured US job market continued to influence risk aversion in the week of May 11. Politics in Greece and banking issues in Spain were important factors of sharper risk aversion in the week of May 18. Risk aversion continued during the week of May 25 and exploded in the week of Jun 1. Expectations of stimulus by central banks caused valuation of risk financial assets in the week of Jun 8 and in the week of Jun 15. Expectations of major stimulus were frustrated by minor continuance of maturity extension policy in the week of Jun 22 together with doubts on the silent bank run in highly indebted euro area member countries. The highest valuations in column “∆% Trough to 6/22/12” are by US equities indexes: DJIA 30.5 percent and S&P 500 30.6 percent, driven by stronger earnings and economy in the US than in other advanced economies but with doubts on the relation of business revenue to the weakening economy and fractured job market. The DJIA reached 13,331.77 in intraday trading on Mar 16, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 6/22/12” had double digit gains relative to the trough around Jul 2, 2010 but now most valuations of equity indexes show increase of less than 10 percent: China’s Shanghai Composite is 5.1 percent below the trough; STOXX 50 of Europe is 1.9 percent above the trough; Japan’s Nikkei Average is 0.3 percent below the trough; DJ Asia Pacific TSM is 1.9 percent above the trough; Dow Global is 5.2 percent above the trough; and NYSE Financial is 2.9 percent above the trough. DJ UBS Commodities is 3.5 percent above the trough. DAX is 10.5 percent above the trough. Japan’s Nikkei Average is 0.3 percent below the trough on Aug 31, 2010 and 22.8 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 8798.35 on Fri Jun 22, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 14.2 percent lower than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 5.5 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 6/22/12” in Table ESVIII-1 shows that there were increases of valuations of risk financial assets in the week of Jun 22, 2012 such as 0.1 percent for DJ Asia Pacific, 2.7 percent for Nikkei Average and 0.9 percent for STOXX 50. DJ UBS Commodities fell 0.4 percent. Other valuations also increased such as 0.3 percent for NYSE Financial, 0.2 percent for Dow Global and 0.5 percent for DAX. The DJIA lost 1.0 percent and S&P 500 declined 0.6 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table ESVIII-1 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 6/22/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Jun 22, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 6/22/12” but also relative to the peak in column “∆% Peak to 6/22/12.” There are now only two equity indexes above the peak in Table ESVIII-1: DJIA 12.8 percent and S&P 500 9.7 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 18.0 percent, Nikkei Average by 22.8 percent, Shanghai Composite by 28.6 percent, DJ Asia Pacific by 10.8 percent, STOXX 50 by 13.7 percent, DAX by 1.1 percent and Dow Global by 14.1 percent. DJ UBS Commodities Index is now 11.6 percent below the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.
Table ESVIII-1, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 6/22 /12 | ∆% Week 6/22/ 12 | ∆% Trough to 6/22 12 | |
| DJIA | 4/26/ | 7/2/10 | -13.6 | 12.8 | -1.0 | 30.5 |
| S&P 500 | 4/23/ | 7/20/ | -16.0 | 9.7 | -0.6 | 30.6 |
| NYSE Finance | 4/15/ | 7/2/10 | -20.3 | -18.0 | 0.3 | 2.9 |
| Dow Global | 4/15/ | 7/2/10 | -18.4 | -14.1 | 0.2 | 5.2 |
| Asia Pacific | 4/15/ | 7/2/10 | -12.5 | -10.8 | 0.1 | 1.9 |
| Japan Nikkei Aver. | 4/05/ | 8/31/ | -22.5 | -22.8 | 2.7 | -0.3 |
| China Shang. | 4/15/ | 7/02 | -24.7 | -28.6 | -2.0 | -5.1 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -13.7 | 0.9 | 1.9 |
| DAX | 4/26/ | 5/25/ | -10.5 | -1.1 | 0.5 | 10.5 |
| Dollar | 11/25 2009 | 6/7 | 21.2 | 16.9 | 0.6 | -5.5 |
| DJ UBS Comm. | 1/6/ | 7/2/10 | -14.5 | -11.6 | -0.4 | 3.5 |
| 10-Year T Note | 4/5/ | 4/6/10 | 3.986 | 1.676 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
I Recovery without Hiring. Professor Edward P. Lazear (2012Jan19) at Stanford University finds that recovery of hiring in the US to peaks attained in 2007 requires an increase of hiring by 30 percent while hiring levels have increased by only 4 percent since Jan 2009. The high level of unemployment with low level of hiring reduces the statistical probability that the unemployed will find a job. According to Lazear (2012Jan19), the probability of finding a new job currently is about one third of the probability of finding a job in 2007. Improvements in labor markets have not increased the probability of finding a new job. Lazear (2012Jan19) quotes an essay coauthored with James R. Spletzer forthcoming in the American Economic Review on the concept of churn. A dynamic labor market occurs when a similar amount of workers is hired as those who are separated. This replacement of separated workers is called churn, which explains about two-thirds of total hiring. Typically, wage increases received in a new job are higher by 8 percent. Lazear (2012Jan19) argues that churn has declined 35 percent from the level before the recession in IVQ2007. Because of the collapse of churn there are no opportunities in escaping falling real wages by moving to another job. As this blog argues, there are meager chances of escaping unemployment because of the collapse of hiring and those employed cannot escape falling real wages by moving to another job (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). Lazear and Spletzer (2012Mar, 1) argue that reductions of churn reduce the operational effectiveness of labor markets. Churn is part of the allocation of resources or in this case labor to occupations of higher marginal returns. The decline in churn can harm static and dynamic economic efficiency. Losses from decline of churn during recessions can affect an economy over the long-term by preventing optimal growth trajectories because resources are not used in the occupations where they provide highest marginal returns. Lazear and Spletzer (2012Mar 7-8) conclude that: “under a number of assumptions, we estimate that the loss in output during the recession [of 2007 to 2009] and its aftermath resulting from reduced churn equaled $208 billion. On an annual basis, this amounts to about .4% of GDP for a period of 3½ years.”
There are two additional facts discussed below: (1) there are about ten million fewer full-time jobs currently than before the recession of 2008 and 2009; and (2) the extremely high and rigid rate of youth unemployment is denying an early start to young people ages 16 to 24 years. There are four subsections. IA Hiring Collapse provides the data and analysis on the weakness of hiring in the United States economy. IB Labor Underutilization provides the measures of labor underutilization of the Bureau of Labor Statistics (BLS). Statistics on the decline of full-time employment are in IC Ten Million Fewer Full-time Jobs. ID Youth Unemployment provides the data on high unemployment of ages 16 to 24 years.
IA Hiring Collapse. An important characteristic of the current fractured labor market of the US is the closing of the avenue for exiting unemployment and underemployment normally available through dynamic hiring. Another avenue that is closed is the opportunity for advancement in moving to new jobs that pay better salaries and benefits again because of the collapse of hiring in the United States. Those who are unemployed or underemployed cannot find a new job even accepting lower wages and no benefits. The employed cannot escape declining inflation-adjusted earnings because there is no hiring. The objective of this section is to analyze hiring and labor underutilization in the United States.
An appropriate measure of job stress is considered by Blanchard and Katz (1997, 53):
“The right measure of the state of the labor market is the exit rate from unemployment, defined as the number of hires divided by the number unemployed, rather than the unemployment rate itself. What matters to the unemployed is not how many of them there are, but how many of them there are in relation to the number of hires by firms.”
The natural rate of unemployment and the similar NAIRU are quite difficult to estimate in practice (Ibid; see Ball and Mankiw 2002).
The Bureau of Labor Statistics (BLS) created the Job Openings and Labor Turnover Survey (JOLTS) with the purpose that (http://www.bls.gov/jlt/jltover.htm#purpose):
“These data serve as demand-side indicators of labor shortages at the national level. Prior to JOLTS, there was no economic indicator of the unmet demand for labor with which to assess the presence or extent of labor shortages in the United States. The availability of unfilled jobs—the jobs opening rate—is an important measure of tightness of job markets, parallel to existing measures of unemployment.”
The BLS collects data from about 16,000 US business establishments in nonagricultural industries through the 50 states and DC. The data are released monthly and constitute an important complement to other data provided by the BLS (see also Lazear and Spletzer 2012Mar, 6-7).
Hiring in the nonfarm sector (HNF) has declined from 69.4 million in 2004 to 50.1 million in 2011 or by 19.3 million while hiring in the private sector (HP) has declined from 59.5 million in 2006 to 46.9 million in 2011 or by 12.6 million, as shown in Table I-1. The ratio of nonfarm hiring to employment (RNF) has fallen from 47.2 in 2005 to 38.1 in 2011 and in the private sector (RHP) from 52.1 in 2006 to 42.9 in 2011. The collapse of hiring in the US has not been followed by dynamic labor markets because of the low rate of economic growth of 2.4 percent in the first eleven quarters of expansion from IIIQ2009 to IQ2012 compared with 6.2 percent in prior cyclical expansions (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html).
Table I-1, US, Annual Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US and Percentage of Total Employment
| HNF | Rate RNF | HP | Rate HP | |
| 2001 | 62,948 | 47.8 | 58,825 | 53.1 |
| 2002 | 58,583 | 44.9 | 54,759 | 50.3 |
| 2003 | 56,451 | 43.4 | 53,056 | 48.9 |
| 2004 | 69,367 | 45.9 | 56,617 | 51.6 |
| 2005 | 63,150 | 47.2 | 59,372 | 53.1 |
| 2006 | 63,773 | 46.9 | 59,494 | 52.1 |
| 2007 | 62,421 | 45.4 | 58,035 | 50.3 |
| 2008 | 55,166 | 40.3 | 51,606 | 45.2 |
| 2009 | 46,398 | 35.5 | 43,052 | 39.8 |
| 2010 | 48,647 | 37.5 | 44,826 | 41.7 |
| 2011 | 50,083 | 38.1 | 46,869 | 42.9 |
Source: http://www.bls.gov/jlt/data.htm
Chart I-1 provides the yearly levels of total nonfarm hiring (NFH) in Table I-1. The fall of hiring during the contraction of 2007 to 2009 was much stronger than in the shallow recession of 2001 with GDP contraction of only 0.4 percent from Mar 2001 (IQ2001) to Dec 2001 (IVQ 2001) compared with 5.1 percent contraction in the much longer recession from Dec 2007 (IVQ2007) to Jun 2009 (IIQ2009) (http://www.nber.org/cycles/cyclesmain.html). Recovery is tepid.
Chart I-1, US, Level Total Nonfarm Hiring (HNF), Yearly, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Chart I-2 shows the ratio or rate of nonfarm hiring to employment (RNF) that also fell much more in the recession of 2007 to 2009 than in the shallow recession of 2001. Recovery is weak.
Chart I-2, US, Rate Total Nonfarm Hiring (HNF), Yearly, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Yearly percentage changes of total nonfarm hiring (HNF) are provided in Table I-2. There were much milder declines in 2002 of 6.9 percent and 3.6 percent in 2003 followed by strong rebounds of 6.9 percent in 2004 and 4.6 percent in 2005. In contrast, the contractions of nonfarm hiring in the recession after 2007 were much sharper in percentage points: 2.1 in 2007, 11.6 in 2008 and 15.9 percent in 2009. On a yearly basis, nonfarm hiring grew 4.8 percent in 2010 relative to 2009 and 3.0 percent in 2011.
Table I-2, US, Annual Total Nonfarm Hiring (HNF), Yearly Percentage Change, 2001-2011
| Year | Annual |
| 2002 | -6.9 |
| 2003 | -3.6 |
| 2004 | 6.9 |
| 2005 | 4.6 |
| 2006 | 1.0 |
| 2007 | -2.1 |
| 2008 | -11.6 |
| 2009 | -15.9 |
| 2010 | 4.8 |
| 2011 | 3.0 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Chart I-3 plots yearly percentage changes of nonfarm hiring. Percentage declines after 2007 were quite sharp.
![clip_image006[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfiles3274BA0\image3.png "clip_image006[1]")
Chart I-3, US, Annual Total Nonfarm Hiring (HNF), Yearly Percentage Change, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Total private hiring (HP) yearly data are provided in Chart I-4. There has been sharp contraction of total private hiring in the US and only milder recovery in 2011 than in 2010.
![clip_image008[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfiles3274BA0\image15.png "clip_image008[1]")
Chart I-4, US, Total Private Hiring, Yearly, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Chart I-5 plots the rate of total private hiring relative to employment (RHP). The rate collapsed during the global recession after 2007 with insufficient recovery.
Chart I-5, US, Rate Total Private Hiring, Yearly, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Total nonfarm hiring (HNF), total private hiring (HP) and their respective rates are provided for the month of Apr in the years from 2001 to 2012 in Table I-3. Hiring numbers are in thousands. There is some recovery in HNF from 4223 thousand (or 4.2 million) in Apr 2009 to 4334 thousand in Apr 2011 and 4447 thousand in Apr 2012 for cumulative gain of 5.3 percent. The levels in Apr 2010 and Apr 2012 are coincidentally equal at 4447 thousand. HP rose from 3920 thousand in Apr 2009 to 4140 thousand in Apr 2011 and 4244 thousand in Apr 2012 for cumulative gain of 8.3 percent. HNF has fallen from 5859 in Apr 2005 to 4447 in Apr 2012 or by 24.1 percent. HP has fallen from 5630 in Apr 2006 to 4244 in Apr 2012 or by 24.6 percent. The labor market continues to be fractured, failing to provide an opportunity to exit from unemployment/underemployment or to find an opportunity for advancement away from declining inflation-adjusted earnings.
Table I-3, US, Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US in Thousands and in Percentage of Total Employment Not Seasonally Adjusted
| HNF | Rate RNF | HP | Rate HP | |
| 2001 Apr | 6016 | 4.6 | 5750 | 5.2 |
| 2002 Apr | 5556 | 4.3 | 5309 | 4.9 |
| 2003 Apr | 5132 | 4.0 | 4922 | 4.6 |
| 2004 Apr | 5692 | 4.3 | 5466 | 5.0 |
| 2005 Apr | 5859 | 4.4 | 5630 | 5.1 |
| 2006 Apr | 5568 | 4.1 | 5309 | 4.7 |
| 2007 Apr | 5646 | 4.1 | 5368 | 4.7 |
| 2008 Apr | 5347 | 3.9 | 5120 | 4.5 |
| 2009 Apr | 4223 | 3.2 | 3920 | 3.6 |
| 2010 Apr | 4447 | 3.4 | 4186 | 3.9 |
| 2011 Apr | 4334 | 3.3 | 4140 | 3.8 |
| 2012 Apr | 4447 | 3.3 | 4244 | 3.8 |
Source: US Bureau of Labor Statistics http://www.bls.gov/jlt/data.htm
Chart I-6 provides total nonfarm hiring on a monthly basis from 2001 to 2012. Nonfarm hiring rebounded in early 2010 but then fell and stabilized at a lower level than the early peak not-seasonally adjusted (NSA) in 2010 of 4786 in May. Nonfarm hiring fell again in Dec 2011 to 3038 from 3844 in Nov and to revised 3633 in Feb 2012, increasing to 4127 in Mar 2012 and 4447 in Apr 2012. Chart I-6 provides seasonally-adjusted (SA) monthly data. The number of seasonally-adjusted hires in Aug 2011 was 4221 thousand, increasing to revised 4444 thousand in Feb 2012, or 5.3 percent, but falling to revised 4335 thousand in Mar 2012 and 4157 in Apr 2012, or cumulative decline of 1.1 percent relative to Aug 2011. The number of hires not seasonally adjusted was 4655 in Aug 2011, falling to 3038 in Dec but increasing to 4072 in Jan 2012, falling again to 3580 in Feb 2012 and increasing to 4117 in Mar 2012. The number of nonfarm hiring not seasonally adjusted fell by 34.7 percent from 4655 in Aug 2011 to 3038 in Dec 2011 in a yearly-repeated seasonal pattern.
![clip_image012[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfiles3274BA0\image23.png "clip_image012[1]")
Chart I-6, US, Total Nonfarm Hiring (HNF), 2001-2012 Month SA
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Similar behavior occurs in the rate of nonfarm hiring plot in Chart I-7. Recovery in early 2010 was followed by decline and stabilization at a lower level but with stability in monthly SA estimates of 3.2 in Sep 2011 to 3.2 in Jan 2012 and 3.3 in both Feb and Mar 2012, falling to 3.1 in Apr 2012. The rate not seasonally adjusted fell from 3.7 in Jun 2011 to 2.3 in Dec, climbing to 3.1 in Jan 2012 but falling to revised 2.8 in Feb 2012 and increasing to 3.1 in Mar 2012 and 3.3 in Apr 2012. Rates of nonfarm hiring NSA were in the range of 2.8 (Dec) to 4.5 (Jun) in 2006.
Chart I-7, US, Rate Total Nonfarm Hiring, Month SA 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
There is only milder improvement in total private hiring shown in Chart I-8. Hiring private (HP) rose in 2010 followed by stability and renewed increase in 2011. The number of private hiring seasonally adjusted fell from 4002 thousand in Sep 2011 to 3889 in Dec or by 2.8 percent, increasing to 3945 in Jan 2012 or decline by 1.4 relative to the level in Sep 2011 but moving to revised 4128 in Feb 2012 for increase of 3.1 percent relative to Sep 2011, revised 4041 in Mar 2012 for increase of 1.0 percent relative to 4002 in Sep 2011 but decrease to 3882 in Apr 2012 or decline of 3.0 percent relative to Sep 2011. The number of private hiring not seasonally adjusted fell from 4130 in Sep 2011 to 2856 in Dec or by 30.8 percent, reaching 3782 in Jan 2012 or decline of 8.4 percent relative to Sep 2011 and 4244 in Apr 2012 or increase of 2.8 percent relative to Sep 2011. Companies do not hire in the latter part of the year that explains the high seasonality in year-end employment data. For example, NSA private hiring fell from 4934 in Sep 2006 to 3635 in Dec 2006 or by 26.3 percent. Private hiring NSA data are useful in showing the huge declines from the period before the global recession. In Jul 2006 private hiring NSA was 5555, declining to 4293 in Jul 2011 or by 22.7 percent. The conclusion is that private hiring in the US is more than 20 percent below the hiring before the global recession. The main problem in recovery of the US labor market has been the low rate of growth of 2.4 percent in the eleven quarters of expansion of the economy from IIIQ2009 to IQ2012 compared with average 6.2 percent in prior expansions from contractions (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The US missed the opportunity to recover employment as in past cyclical expansions from contractions.
Chart I-8, US, Total Private Hiring Month SA 2011-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Chart I-9 shows similar behavior in the rate of private hiring. The rate in 2011 in monthly SA data has not risen significantly above the peak in 2010. The rate seasonally adjusted fell from 3.6 in Sep 2011 to 3.5 in Dec 2011, increasing to 3.6 in Jan 2012 and 3.7 in Feb 2012 but falling to 3.5 in Apr 2012. The rate not seasonally adjusted (NSA) fell from 3.8 in Sep 2011 to 2.6 in Dec 2011, increasing to revised 3.5 in Jan 2012 but falling to 3.1 in Feb 2012 and then increasing to 3.6 in Mar 2012 and 3.8 in Apr 2012. The NSA rate of private hiring fell from 4.9 in Jun 2006 to 3.6 in Jun 2009 but recovery was insufficient to only 4.1 in Jun 2011.
Chart I-9, US, Rate Total Private Hiring Month SA 2011-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
The JOLTS report of the Bureau of Labor Statistics also provides total nonfarm job openings (TNF JOB), TNF JOB rate and TNF LD (layoffs and discharges) shown in Table I-4 for the month of Apr from 2001 to 2012. The final column provides annual TNF LD for the years from 2001 to 2011. Nonfarm job openings fell from a peak of 4962 in Apr 2007 to 3665 in Apr 2012 or by 26.1 percent while the rate dropped from 3.5 to 2.7. Nonfarm layoffs and discharges (TNF LD) rose from 1672 in Apr 2006 to 2422 in Apr 2009 or by 44.9 percent. The yearly data show layoffs and discharges rising from 21.2 million in 2006 to 26.8 million in 2009 or by 26.4 percent.
Table I-4, US, Job Openings and Total Separations, Thousands NSA
| TNF JOB | TNF JOB | TNF LD | TNF LD | |
| Apr 2001 | 5262 | 3.8 | 1849 | 24499 |
| Apr 2002 | 3808 | 2.8 | 1798 | 22922 |
| Apr 2003 | 3529 | 2.6 | 1819 | 23294 |
| Apr 2004 | 3985 | 2.9 | 1844 | 22802 |
| Apr 2005 | 4571 | 3.3 | 1751 | 22185 |
| Apr 2006 | 4940 | 3.5 | 1672 | 21157 |
| Apr 2007 | 4962 | 3.5 | 1776 | 22142 |
| Apr 2008 | 4306 | 3.0 | 1758 | 24166 |
| Apr 2009 | 2511 | 1.9 | 2422 | 26783 |
| Apr 2010 | 3402 | 2.6 | 1586 | 21784 |
| Apr 2011 | 3273 | 2.4 | 1486 | 20718 |
| Apr 2012 | 3665 | 2.7 | 1594 |
Notes: TNF JOB: Total Nonfarm Job Openings; LD: Layoffs and Discharges
Source: US Bureau of Labor Statistics http://www.bls.gov/jlt/data.htm
Chart I-10 shows monthly job openings rising from the trough in 2009 to a high in the beginning of 2010. Job openings then stabilized into 2011 but have surpassed the peak of 3057 in Nov 2010 with 3416 seasonally adjusted in Apr 2012, which is lower by 2.4 percent than 3501 in Sep 2011 and lower by 8.7 percent relative to 3741 in Mar 2012. Job openings recovered in Dec 2011 at 3540 but fell into Jan 2012 to 3477. The high of job openings not seasonally adjusted in 2010 was 3221 in Oct 2010 that was surpassed by 3659 in Oct 2011, increasing to 3722 in Mar 2012, declining marginally to 3665 in Apr 2012. The level of job openings not seasonally adjusted fell to 2912 in Nov 2011 or by 17.9 percent relative to 3546 in Sep 2011. There is here again the strong seasonality of year-end labor data. Job openings NSA fell from 4678 in Oct 2006 to 2547 in Oct 2009 or by 45.6 percent, recovering to 3221 in Oct 2010 or by 31.1 percent, which is still 21.8 percent lower at 3659 in Oct 2011 relative to Oct 2006. The level of job openings of 3665 in Apr 2011 NSA is lower by 26.1 percent relative to 4962 in Apr 2007. Again, the main problem in recovery of the US labor market has been the low rate of growth of 2.4 percent in the eleven quarters of expansion of the economy since IIIQ2009 compared with average 6.2 percent in prior expansions from contractions (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The US missed the opportunity to recover employment as in past cyclical expansions from contractions.
Chart I-10, US Job Openings, Thousands NSA, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
The rate of job openings in Chart I-11 shows similar behavior. The rate seasonally adjusted rose from 2.1 percent in Jan 2011 to 2.6 percent in Dec 2011. The rate not seasonally adjusted rose from the high of 2.6 in Apr 2010 to 2.7 in Jul 2011 and 2.7 in both Mar 2012 and Apr 2012. The rate of job openings NSA fell from 3.5 in Apr 2006 to 1.9 in Apr 2009, recovering insufficiently to 2.7 in Apr 2012.
![clip_image022[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfiles3274BA0\image81.png "clip_image022[1]")
Chart I-11, US, Rate of Job Openings, Thousands NSA, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Total separations are shown in Chart I-12. Separations are much lower in 2012 than before the global recession.
Chart I-12, US, Total Separations, Month SA, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Yearly total separations are shown in Chart I-13. Separations are much lower in 2011 than before the global recession.
Chart I-13, US, Total Separations, Annual, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Table I-5 provides total nonfarm total separations from 2001 to 2011. Separations fell from 61.6 million in 2006 to 47.6 million in 2010 or by 14.0 million and 48.2 million in 2011 or by 13.4 million.
Table I-5, US, Total Nonfarm Total Separations, Thousands, 2001-2011
| Year | Annual |
| 2001 | 64765 |
| 2002 | 59190 |
| 2003 | 56487 |
| 2004 | 58340 |
| 2005 | 60733 |
| 2006 | 61565 |
| 2007 | 61162 |
| 2008 | 58601 |
| 2009 | 51527 |
| 2010 | 47641 |
| 2011 | 48242 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Monthly data of layoffs and discharges reach a peak in early 2009, as shown in Chart I-14. Layoffs and discharges dropped sharply with the recovery of the economy in 2010 and 2011 once employers reduced their job count to what was required for cost reductions and loss of business.
Chart I-14, US, Total Nonfarm Layoffs and Discharges, Monthly SA, 2011-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Layoffs and discharges in Chart I-15 rose sharply to a peak in 2009. There was pronounced drop into 2010 and 2011.
Chart I-15, US, Total Nonfarm Layoffs and Discharges, Annual, 2001-2011
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
Table I-6 provides annual nonfarm layoffs and discharges from 2001 to 2011. Layoffs and discharges peaked at 26.8 million in 2009 and then fell to 20.7 million in 2011, by 6.1 million, or 22.8 percent.
Table I-6, US, Total Nonfarm Layoffs and Discharges, 2001-2011
| Year | Annual |
| 2001 | 24499 |
| 2002 | 22922 |
| 2003 | 23294 |
| 2004 | 22802 |
| 2005 | 22185 |
| 2006 | 21157 |
| 2007 | 22142 |
| 2008 | 24166 |
| 2009 | 26783 |
| 2010 | 21784 |
| 2011 | 20718 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/jlt/data.htm
IB Labor Underutilization. The Bureau of Labor Statistics also provides alternative measures of labor underutilization shown in Table I-7. The most comprehensive measure is U6 that consists of total unemployed plus total employed part time for economic reasons plus all marginally attached workers as percent of the labor force. U6 not seasonally annualized has risen from 8.2 percent in 2006 to 14.3 in Apr 2012.
Table I-7, US, Alternative Measures of Labor Underutilization NSA %
| U1 | U2 | U3 | U4 | U5 | U6 | |
| 2012 | ||||||
| May | 4.7 | 4.3 | 7.9 | 8.4 | 9.3 | 14.3 |
| Apr | 4.8 | 4.3 | 7.7 | 8.3 | 9.1 | 14.1 |
| Mar | 4.9 | 4.8 | 8.4 | 8.9 | 9.7 | 14.8 |
| Feb | 4.9 | 5.1 | 8.7 | 9.3 | 10.2 | 15.6 |
| Jan | 4.9 | 5.4 | 8.8 | 9.4 | 10.5 | 16.2 |
| 2011 | ||||||
| Dec | 4.8 | 5.0 | 8.3 | 8.8 | 9.8 | 15.2 |
| Nov | 4.9 | 4.7 | 8.2 | 8.9 | 9.7 | 15.0 |
| Oct | 5.0 | 4.8 | 8.5 | 9.1 | 10.0 | 15.3 |
| Sep | 5.2 | 5.0 | 8.8 | 9.4 | 10.2 | 15.7 |
| Aug | 5.2 | 5.1 | 9.1 | 9.6 | 10.6 | 16.1 |
| Jul | 5.2 | 5.2 | 9.3 | 10.0 | 10.9 | 16.3 |
| Jun | 5.1 | 5.1 | 9.3 | 9.9 | 10.9 | 16.4 |
| May | 5.5 | 5.1 | 8.7 | 9.2 | 10.0 | 15.4 |
| Apr | 5.5 | 5.2 | 8.7 | 9.2 | 10.1 | 15.5 |
| Mar | 5.7 | 5.8 | 9.2 | 9.7 | 10.6 | 16.2 |
| Feb | 5.6 | 6.0 | 9.5 | 10.1 | 11.1 | 16.7 |
| Jan | 5.6 | 6.2 | 9.8 | 10.4 | 11.4 | 17.3 |
| Dec 2010 | 5.4 | 5.9 | 9.1 | 9.9 | 10.7 | 16.6 |
| 2011 | 5.3 | 5.3 | 8.9 | 9.5 | 10.4 | 15.9 |
| 2010 | 5.7 | 6.0 | 9.6 | 10.3 | 11.1 | 16.7 |
| 2009 | 4.7 | 5.9 | 9.3 | 9.7 | 10.5 | 16.2 |
| 2008 | 2.1 | 3.1 | 5.8 | 6.1 | 6.8 | 10.5 |
| 2007 | 1.5 | 2.3 | 4.6 | 4.9 | 5.5 | 8.3 |
| 2006 | 1.5 | 2.2 | 4.6 | 4.9 | 5.5 | 8.2 |
| 2005 | 1.8 | 2.5 | 5.1 | 5.4 | 6.1 | 8.9 |
| 2004 | 2.1 | 2.8 | 5.5 | 5.8 | 6.5 | 9.6 |
| 2003 | 2.3 | 3.3 | 6.0 | 6.3 | 7.0 | 10.1 |
| 2002 | 2.0 | 3.2 | 5.8 | 6.0 | 6.7 | 9.6 |
| 2001 | 1.2 | 2.4 | 4.7 | 4.9 | 5.6 | 8.1 |
| 2000 | 0.9 | 1.8 | 4.0 | 4.2 | 4.8 | 7.0 |
Note: LF: labor force; U1, persons unemployed 15 weeks % LF; U2, job losers and persons who completed temporary jobs %LF; U3, total unemployed % LF; U4, total unemployed plus discouraged workers, plus all other marginally attached workers; % LF plus discouraged workers; U5, total unemployed, plus discouraged workers, plus all other marginally attached workers % LF plus all marginally attached workers; U6, total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons % LF plus all marginally attached workers
Source: US Bureau of Labor Statistics http://www.bls.gov/cps/data.htm
Monthly seasonally adjusted measures of labor underutilization are provided in Table I-8. U6 climbed from 16.2 percent in Aug 2011 to 16.4 percent in Sep 2011 and then fell to 14.8 percent in May 2012. Unemployment is an incomplete measure of the stress in US job markets. A different calculation in this blog is provided by using the participation rate in the labor force before the global recession. This calculation shows 28.4 million in job stress of unemployment/underemployment in May 2012, not seasonally adjusted, corresponding to 17.6 percent of the labor force (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html Table I-4).
Table I-8, US, Alternative Measures of Labor Underutilization SA %
| May 2011 | Apr 2011 | Mar 2012 | Feb 2012 | Jan 2012 | Dec 2011 | Nov | Oct 2011 | |
| U1 | 4.6 | 4.5 | 4.6 | 4.8 | 4.9 | 5.0 | 5.0 | 5.1 |
| U2 | 4.5 | 4.4 | 4.5 | 4.7 | 4.7 | 4.9 | 4.9 | 5.1 |
| U3 | 8.2 | 8.1 | 8.2 | 8.3 | 8.3 | 8.5 | 8.7 | 8.9 |
| U4 | 8.7 | 8.7 | 8.7 | 8.9 | 8.9 | 9.1 | 9.3 | 9.5 |
| U5 | 9.6 | 9.5 | 9.6 | 9.8 | 9.9 | 10.0 | 10.2 | 10.4 |
| U6 | 14.8 | 14.5 | 14.5 | 14.9 | 15.1 | 15.2 | 15.6 | 16.0 |
Note: LF: labor force; U1, persons unemployed 15 weeks % LF; U2, job losers and persons who completed temporary jobs %LF; U3, total unemployed % LF; U4, total unemployed plus discouraged workers, plus all other marginally attached workers; % LF plus discouraged workers; U5, total unemployed, plus discouraged workers, plus all other marginally attached workers % LF plus all marginally attached workers; U6, total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons % LF plus all marginally attached workers
Source: http://www.bls.gov/cps/data.htm
Chart I-16 provides U6 on a monthly basis from 2001 to 2012. There was a steep climb from 2007 into 2009 and then this measure of unemployment and underemployment stabilized at that high level but declined into 2012. The low of U16 NSA was 7.9 percent in Dec 2006 and the peak was 17.2 percent in Oct 2009. The low NSA was 7.6 percent in Oct 2006 and the peak was 17.1 percent in Dec 2009.
Chart I-16, US, U6, total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons % LF plus all marginally attached workers as % of Labor Force, Month, SA, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart I-17 provides the number employed part-time for economic reasons or who cannot find full-time employment. There are sharp declines at the end of 2009, 2010 and 2011.
Chart I-17, US, Working Part-time for Economic Reasons
Thousands, Month SA 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
There is strong seasonality in US labor markets around the end of the year. The number employed part-time for economic reasons because they could not find full-time employment fell from 9.270 million in Sep 2011 to 8.098 million in May 2012, seasonally adjusted, or decline of 1.172 million in eight months, as shown in Table I-9. The number employed full-time increased from 112.479 million in Sep 2011 to 115.290 million in Mar 2012 or 2.811 million but then fell to 111.478 million in Apr 2012 or 1.001 million fewer full-time employed than in Sep 2011. There is a jump in the level of full-time SA to 114.212 or 2.734 million relative to Apr 2012. The number of employed part-time for economic reasons actually increased without seasonal adjustment from 8.271 million in Nov 2011 to 8.428 million in Dec 2011 or by 157,000 and then to 8.918 million in Jan 2012 or by an additional 490,000 for cumulative increase from Nov 2011 to Jan 2012 of 647,000. The level of employed part-time for economic reasons then fell from 8.918 million in Jan 2012 to 7.867 million in Mar 2012 or by 1.0151 million and to 7.694 million in Apr 2012 or 1.224 million fewer relative to Jan 2012. In May, the number employed part-time for economic reasons increased to 7.837 million SA or 143,000 more than in Apr 2012. The number employed full time without seasonal adjustment fell from 113.138 million in Nov 2011 to 113.050 million in Dec 2011 or by 88,000 and fell further to 111.879 in Jan 2012 for cumulative decrease of 1.259 million. The number employed full-time not seasonally adjusted fell from 113.138 million in Nov 2011 to 112.587 million in Feb 2012 or by 551.000 but increased to 113.916 in Mar 2012 or increase by 778,000 compared with the level in Nov 2011 and further increased to 113.999 in Apr 2012 or 861,000 more than in Nov 2011 and then to 114.634 million in May 2012 or 1.496 million relative to Nov 2011. Comparisons over long periods require use of NSA data. The number with full-time jobs fell from a high of 123.219 million in Jul 2007 to 108.770 million in Jan 2010 or by 14.449 million. The number with full-time jobs in May 2012 is 114.634 million, which is lower by 8.6 million relative to the peak of 123.219 million in Jul 2007. There appear to be around 10 million less full-time jobs in the US than before the global recession. Growth at 2.4 percent on average in the eleven quarters of expansion from IIIQ2009 to IQ2012 compared with 6.2 percent on average in expansions from postwar cyclical contractions is the main culprit of the fractured US labor market (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html).
Table I-9, US, Employed Part-time for Economic Reasons, Thousands, and Full-time, Millions
| Part-time Thousands | Full-time Millions | |
| Seasonally Adjusted | ||
| May 2012 | 8,098 | 114.212 |
| Apr 2012 | 7,853 | 111.478 |
| Mar 2012 | 7,672 | 115.290 |
| Feb 2012 | 8,119 | 114.408 |
| Jan 2012 | 8,230 | 113.845 |
| Dec 2011 | 8,098 | 113.765 |
| Nov 2011 | 8,469 | 113.212 |
| Oct 2011 | 8,790 | 112.841 |
| Sep 2011 | 9,270 | 112.479 |
| Aug 2011 | 8,787 | 112.406 |
| Not Seasonally Adjusted | ||
| May 2012 | 7,837 | 114.634 |
| Apr 2012 | 7,694 | 113.999 |
| Mar 2012 | 7,867 | 113.916 |
| Feb 2012 | 8,455 | 112.587 |
| Jan 2012 | 8,918 | 111.879 |
| Dec 2011 | 8,428 | 113.050 |
| Nov 2011 | 8,271 | 113.138 |
| Oct 2011 | 8,258 | 113.456 |
| May 2011 | 8,270 | 112.618 |
| Apr 2011 | 8,425 | 111.844 |
| Mar 2011 | 8,737 | 111.186 |
| Feb 2011 | 8,749 | 110.731 |
| Jan 2011 | 9,187 | 110.373 |
| Dec 2010 | 9,205 | 111.207 |
| Nov 2010 | 8,670 | 111.348 |
| Oct 2010 | 8,408 | 112.342 |
| May 2010 | 8,513 | 112.809 |
| Apr 2010 | 8,921 | 111.391 |
| Mar 2010 | 9,343 | 109.877 |
| Feb 2010 | 9,282 | 109.100 |
| Jan 2010 | 9,290 | 108.777 (low) |
| Dec 2009 | 9,354 (high) | 109.875 |
| May 2009 | 8,785 | 113.083 |
| Apr 2009 | 8,648 | 112.746 |
| Mar 2009 | 9,305 | 112.215 |
| Feb 2009 | 9,170 | 112.947 |
| Jan 2009 | 8,829 | 113.815 |
| May 2008 | 5,096 | 120.809 |
| Apr 2008 | 5,071 | 120.027 |
| Mar 2008 | 5,038 | 119.875 |
| Feb 2008 | 5,114 | 119.452 |
| Jan 2008 | 5,340 | 119.322 |
| Jul 2007 | 4,516 | 123.219 (high) |
| May 2007 | 4,315 | 120.846 |
| Apr 2007 | 4,205 | 119.609 |
| Mar 2007 | 4,384 | 119.640 |
| Feb 2007 | 4,417 | 119.041 |
| Jan 2007 | 4,726 | 119.094 |
| Sep 2006 | 3,735 (low) | 120.780 |
| May 2006 | 3,968 | 118.925 |
| Apr 2006 | 3,787 | 118.559 |
| Mar 2006 | 4,097 | 117.693 |
| Feb 2006 | 4,403 | 116.823 |
| Jan 2006 | 4,597 | 116.395 |
Source: US Bureau of Labor Statistics http://www.bls.gov/cps/data.htm
People lose their marketable job skills after prolonged unemployment and find increasing difficulty in finding another job. Chart I-18 shows the sharp rise in unemployed over 27 weeks and stabilization at an extremely high level.
![clip_image024[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfiles3274BA0\image4.png "clip_image024[1]")
Chart I-18, US, Number Unemployed for 27 Weeks or Over, Thousands SA Month 2001-2011
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Another segment of U6 consists of people marginally attached to the labor force who continue to seek employment but less frequently on the frustration there may not be a job for them. Chart I-19 shows the sharp rise in people marginally attached to the labor force after 2007 and subsequent stabilization.
Chart I-19, US, Marginally Attached to the Labor Force, NSA Month 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
IC Ten Million Fewer Full-time Jobs. Chart I-20 reveals the fracture in the US labor market. The number of workers with full-time jobs not-seasonally-adjusted rose with fluctuations from 2002 to a peak in 2007, collapsing during the global recession. The terrible state of the job market is shown in the segment from 2009 to 2012 with fluctuations around the typical behavior of a stationary series: there is no improvement in the United States in creating full-time jobs.
Chart I-20, US, Full-time Employed, Thousands, NSA, 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
ID Youth Unemployment. The United States is experiencing high youth unemployment as in European economies. Table I-10 provides the employment level for ages 16 to 24 years of age estimated by the Bureau of Labor Statistics. On an annual basis, youth employment fell from 20.041 million in 2006 to 17.362 million in 2011 or 2.679 million fewer youth jobs. During the seasonal peak months of youth employment in the summer from Jun to Aug, youth employment has fallen by more than two million jobs. There are two hardships behind these data. First, young people cannot find employment after finishing high-school and college, reducing prospects for achievement in older age. Second, students with more modest means cannot find employment to keep them in college.
Table I-10, US, Employment Level 16-24 Years, Thousands, NSA
| Year | Feb | Mar | Apr | May | Annual |
| 2001 | 19745 | 19800 | 19778 | 19648 | 20088 |
| 2002 | 19074 | 19091 | 19108 | 19484 | 19683 |
| 2003 | 18880 | 18709 | 18873 | 19032 | 19351 |
| 2004 | 18841 | 18752 | 19184 | 19237 | 19630 |
| 2005 | 18670 | 18989 | 19071 | 19356 | 19770 |
| 2006 | 19182 | 19291 | 19406 | 19769 | 20041 |
| 2007 | 19415 | 19538 | 19368 | 19457 | 19875 |
| 2008 | 18546 | 18745 | 19161 | 19254 | 19202 |
| 2009 | 17606 | 17564 | 17739 | 17588 | 17601 |
| 2010 | 16412 | 16587 | 16764 | 17039 | 17077 |
| 2011 | 16638 | 16898 | 16970 | 17045 | 17362 |
| 2012 | 17150 | 17301 | 17387 | 17681 |
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart I-21 provides US employment level ages 16 to 24 years from 2002 to 2012. Employment level is sharply lower in Apr 2012 relative to the peak in 2007.
Chart I-21, US, Employment Level 16-24 Years, Thousands SA, 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Table I-11 provides US unemployment level ages 16 to 24 years. The number unemployed ages 16 to 24 years increased from 2342 thousand in 2007 to 3634 thousand in 2011 or by 1.292 million. This situation may persist for many years.
Table I-11, US, Unemployment Level 16-24 Years, Thousands NSA
| Year | Feb | Mar | Apr | May | Annual |
| 2001 | 2258 | 2253 | 2095 | 2171 | 2371 |
| 2002 | 2731 | 2822 | 2515 | 2568 | 2683 |
| 2003 | 2740 | 2601 | 2572 | 2838 | 2746 |
| 2004 | 2631 | 2588 | 2387 | 2684 | 2638 |
| 2005 | 2787 | 2520 | 2398 | 2619 | 2521 |
| 2006 | 2433 | 2216 | 2092 | 2254 | 2353 |
| 2007 | 2230 | 2096 | 2074 | 2203 | 2342 |
| 2008 | 2480 | 2347 | 2196 | 2952 | 2830 |
| 2009 | 3457 | 3371 | 3321 | 3851 | 3760 |
| 2010 | 3888 | 3748 | 3803 | 3854 | 3857 |
| 2011 | 3696 | 3520 | 3365 | 3628 | 3634 |
| 2012 | 3507 | 3294 | 3175 | 3438 |
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart I-22 provides the unemployment level ages 16 to 24 from 2002 to 2012. The level rose sharply from 2007 to 2010 with tepid improvement into 2012.
Chart I-22, US, Unemployment Level 16-24 Years, Thousands SA, 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Table I-12 provides the rate of unemployment of young peoples in ages 16 to 24 years. The annual rate jumped from 10.5 percent in 2007 to 18.4 percent in 2010 and 17.3 percent in 2011. During the seasonal peak in Jul 2011 the rate of youth unemployed was 18.1 percent compared with 10.8 percent in Jun 2007.
Table I-12, US, Unemployment Rate 16-24 Years, Thousands, NSA
| Year | Feb | Mar | Apr | May | Annual |
| 2001 | 10.3 | 10.2 | 9.6 | 10.0 | 10.6 |
| 2002 | 12.5 | 12.9 | 11.6 | 11.6 | 12.0 |
| 2003 | 12.7 | 12.2 | 12.0 | 13.0 | 12.4 |
| 2004 | 12.3 | 12.1 | 11.1 | 12.2 | 11.8 |
| 2005 | 13.0 | 11.7 | 11.2 | 11.9 | 11.3 |
| 2006 | 11.3 | 10.3 | 9.7 | 10.2 | 10.5 |
| 2007 | 10.3 | 9.7 | 9.7 | 10.2 | 10.5 |
| 2008 | 11.8 | 11.1 | 10.3 | 13.3 | 12.8 |
| 2009 | 16.4 | 16.1 | 15.8 | 18.0 | 17.6 |
| 2010 | 19.2 | 18.4 | 18.5 | 18.4 | 18.4 |
| 2011 | 18.2 | 17.2 | 16.5 | 17.5 | 17.3 |
| 2012 | 17.0 | 16.0 | 15.4 | 16.3 |
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart I-23 provides the BLS estimate of the not-seasonally-adjusted rate of youth unemployment for ages 16 to 24 years from 2002 to 2012. The rate of youth unemployment increased sharply during the global recession of 2008 and 2009 but has failed to drop to earlier lower levels during the eleven quarters of expansion of the economy since IIIQ2009.
Chart I-23, US, Unemployment Rate 16-24 Years, Thousands, NSA, 2001-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
Chart I-24 provides longer perspective with the rate of youth unemployment in ages 16 to 24 years from 1948 to 2012. The rate of youth unemployment rose to 20 percent during the contractions of the early 1980s and also during the contraction of the global recession in 2008 and 2009. The data illustrate again the claim in this blog that the contractions of the early 1980s are the valid framework for comparison with the global recession of 2008 and 2009 instead of misleading comparisons with the 1930s. During the initial phase of recovery, the rate of youth unemployment 16 to 24 years NSA fell from 18.9 percent in Jun 1983 to 14.5 percent in Jun 1984 while the rate of youth unemployment 16 to 24 years was nearly the same during the expansion after IIIQ2009: 19.9 percent in Jun 2009, 20.0 percent in Jun 2010 and 18.9 percent in Jun 2011. The NSA rate of unemployment 16-24 years of age is 16.3 percent for May 2012. The difference originates in the vigorous seasonally-adjusted annual equivalent average rate of GDP growth of 5.7 percent during the recovery from IQ1983 to IVQ1985 compared with 2.4 percent on average during the first eleven quarters of expansion from IIIQ2009 to IQ2012 (see table II-5 in http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The fractured US labor market denies an early start for young people.
Chart I-24, US, Unemployment Rate 16-24 Years, Percent NSA, 1948-2012
Sources: US Bureau of Labor Statistics
http://www.bls.gov/cps/data.htm
II Twist Again Extension. The term “operation twist” grew out of the dance “twist” popularized by successful musical performer Chubby Chekker (http://www.youtube.com/watch?v=aWaJ0s0-E1o). Meulendyke (1998, 39) describes the coordination of policy by Treasury and the FOMC in the beginning of the Kennedy administration in 1961:
“In 1961, several developments led the FOMC to abandon its “bills only” restrictions. The new Kennedy administration was concerned about gold outflows and balance of payments deficits and, at the same time, it wanted to encourage a rapid recovery from the recent recession. Higher rates seemed desirable to limit the gold outflows and help the balance of payments, while lower rates were wanted to speed up economic growth.
To deal with these problems simultaneously, the Treasury and the FOMC attempted to encourage lower long-term rates without pushing down short-term rates. The policy was referred to in internal Federal Reserve documents as “operation nudge” and elsewhere as “operation twist.” For a few months, the Treasury engaged in maturity exchanges with trust accounts and concentrated its cash offerings in shorter maturities.
At the meeting on Sep 21, 2011, the Federal Open Market Committee (FOMC) decided (http://www.federalreserve.gov/newsevents/press/monetary/20110921a.htm):
“To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”
At the meeting on Jun 24-25, 2012, the FOMC decided to extend maturity lengthening of its portfolio of securities (http://www.federalreserve.gov/newsevents/press/monetary/20120125a.htm):
“The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.”
This section provides analysis of maturity lengthening of the portfolio of securities held by the central bank. Subsection IIA Extension of Let’s Twist Again Policy provides details of the decision and the forecasts on which it was based. IIB Twist Objectives analyzes the objectives of maturity lengthening of central bank portfolios of securities. Subsection IIC Appendix: Operation Twist provides survey of the technical literature on maturity lengthening.
IIA Extension of Let’s Twist Again Policy. The Federal Reserve Bank of New York (FRBNY) provides a “Statement Regarding Continuation of the Maturity Extension Program” with the directions to the FRBNY’s Open Market Trading Desk (the Desk) (http://www.newyorkfed.org/markets/opolicy/operating_policy_120620.html):
“Specifically, the Desk was directed to purchase Treasury securities with remaining maturities of 6 to 30 years and to sell or redeem an equal par value of Treasury securities with remaining maturities of approximately 3 years or less. The continuation of the maturity extension program will proceed at the current pace and result in the purchase, as well as the sale and redemption, of about $267 billion in Treasury securities by the end of 2012. The FOMC also directed the Desk to continue reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities (MBS) in agency MBS, and to suspend, for the duration of the maturity extension program, rolling over maturity Treasury securities into new issues at auction.”
The distribution of the purchases of securities will be as follows: 32 percent for maturities from 6 to 8 years, 32 percent for maturities from 8 to 10 years, 4 percent for maturities from 10 to 20 years, 29 percent from maturities from 20 to 30 years and 3 percent for maturities of TIPS (Treasury Inflation-Protected Securities http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm) from 6 to 30 years.
At the press conference following the FOMC meeting, Chairman Bernanke summarized the view of the 19 participants of the FOMC, consisting of 12 regional presidents of Federal Reserve Banks, and 7 members of the Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20120620.pdf):
“In conjunction with today’s meetings [Jun 20, 2012], FOMC participants submitted their individual economic projections and policy assessments for the years 2012 to 2014 and over the longer run. These projections are important inputs to the Committee’s deliberations. Incoming information suggests that the economy continues to expand at a moderate pace in the face of headwinds generated by the situation in Europe, a still-depressed housing market, tight credit for some borrowers, and fiscal restraint at the federal, state, and local levels. Business and household spending are increasing at rates consistent with moderate economic growth, though household spending appears to be rising at a somewhat slower pace than earlier this year. Employment gains have been smaller in recent months and the unemployment rate at 8.2 percent remains elevated. In light of these developments, Committee participants have generally marked down their projections for economic growth, but most still see the economy as expanding at a moderate pace over coming quarters and the picking up gradually.”
Table II-1 provides economic projections of governors of the Board of Governors of the Federal Reserve and regional presidents of Federal Reserve Banks released at the meeting of Jun 20, 2012. The Fed releases the data with careful explanations (http://www.federalreserve.gov/newsevents/press/monetary/20120620b.htm). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IQ2012 is analyzed in a prior blog post together with the PCE inflation data from the report on personal income and outlays (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The Bureau of Economic Analysis (BEA) provides the second estimate of IQ2012 GDP with the third estimate to be released on Jun 28 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed in this blog as soon as available (for the latest report for Apr see http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm and http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The next report on “Personal Income and Outlays” for May will be released at 8:30 AM on Jun 29, 2012. PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog (the May report is analyzed at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The report for Jun will be released on July 6, 2012 (http://www.bls.gov/cps/). “Longer term projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf).
It is instructive to focus on 2012, as 2013, 2014 and longer term are too far away, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Jun 20, 2012, and the second row “PR” the projection of the Apr 25, 2012 meeting. There are three major changes in the view.
1. Growth “∆% GDP.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun 2011 to 2.5 to 2.9 percent in Nov 2011 and 2.2 to 2.7 percent at the Jan 25 meeting but increased it to 2.4 to 2.9 percent at the Apr 25, 2012 meeting, reducing it to 1.9 to 2.4 percent at the Jun 20, 2012 meeting.
2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun 2011 to 8.5 to 8.7 percent in Nov 2011 but has reduced it to 8.2 to 8.5 percent at the Jan 25 meeting and further down to 7.8 to 8.0 percent at the Apr 25, 2012 meeting but increased it to 8.0 to 8.2 percent at the Jun 20, 2012 meeting.
3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun 2011 to virtually the same of 1.4 to 2.0 percent in Nov 2011 but has reduced it to 1.4 to 1.8 percent at the Jan 25 meeting but increased it to 1.9 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.2 to 1.7 percent at the Jun 20, 2012 meeting.
4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun 2011 of 1.4 to 2.0 percent and the Nov 2011 projection of 1.5 to 2.0 percent, which has been reduced slightly to 1.5 to 1.8 percent at the Jan 25 meeting but increased to 1.8 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.7 to 2.0 percent at the Jun 20, 2012 meeting.
Table II-1, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, June 2012 and April 2012
| ∆% GDP | UNEM % | ∆% PCE Inflation | ∆% Core PCE Inflation | |
| Central | ||||
| 2012 Apr PR | 1.9 to 2.4 2.4 to 2.9 | 8.0 to 8.2 7.8 to 8.0 | 1.2 to 1.7 1.9 to 2.0 | 1.7 to 2.0 1.8 to 2.0 |
| 2013 | 2.2 to 2.8 | 7.5 to 8.0 | 1.5 to 2.0 | 1.6 to 2.0 1.7 to 2.0 |
| 2014 | 3.0 to 3.5 | 7.0 to 7.7 | 1.5 to 2.0 | 1.6 to 2.0 |
| Longer Run Apr PR | 2.3 to 2.5 2.3 to 2.6 | 5.2 to 6.0 5.2 to 6.0 | 2.0 2.0 | |
| Range | ||||
| 2012 | 1.6 to 2.5 | 7.8 to 8.4 | 1.2 to 2.0 | 1.7 to 2.0 |
| 2013 | 2.2 to 3.5 | 7.0 to 8.1 | 1.5 to 2.1 | 1.4 to 2.1 |
| 2014 | 2.8 to 4.0 | 6.3 to 7.7 | 1.5 to 2.2 | 1.5 to 2.2 |
| Longer Run Apr PR | 2.2 to 3.0 2.2 to 3.0 | 4.9 to 6.3 4.9 to 6.0 | 2.0 2.0 |
Notes: UEM: unemployment; PR: Projection
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf
Another important decision at the FOMC meeting on Jan 25, 2012, is formal specification of the goal of inflation of 2 percent per year but without specific goal for unemployment (http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm):
“Following careful deliberations at its recent meetings, the Federal Open Market Committee (FOMC) has reached broad agreement on the following principles regarding its longer-run goals and monetary policy strategy. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.
The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.
Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.
The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier.
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. ”
The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; 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). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.
The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table II-2 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 2012, 2013, 2014 and the in the longer term. Table II-2 is inferred from a chart provided by the FOMC with the number of participants expecting the target of fed funds rate (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf). There are 16 participants expecting the rate to remain at 0 to ¼ percent in 2012 and only three to be higher. Not much change is expected in 2013 either with 13 participants anticipating the rate at the current target of 0 to ¼ percent and only six expecting higher rates. The rate would still remain at 0 to ¼ percent in 2014 for six participants with five expecting the rate to be in the range of 0.5 to 1 percent and five participants expecting rates from 1 to 2.0 percent but only three with rates exceeding 2.0 percent. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014.
Table II-2, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012
| 0 to 0.25 | 0.5 to 1.0 | 1.0 to 1.5 | 1.0 to 2.0 | 2.0 to 3.0 | 3.0 to 4.5 | |
| 2012 | 16 | 3 | ||||
| 2013 | 13 | 2 | 3 | 1 | ||
| 2014 | 6 | 5 | 5 | 3 | ||
| Longer Run | 19 |
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf
Additional information is provided in Table II-3 with the number of participants expecting increasing interest rates in the years from 2012 to 2015. It is evident from Table II-3 that the prevailing view in the FOMC is for interest rates to continue at low levels in future years. This view is consistent with the economic projections of low economic growth, relatively high unemployment and subdued inflation provided in Table II-1.
Table II-3, US, Views of Appropriate Year of Increasing Target Federal Funds Rate of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012
| Appropriate Year of Increasing Target Fed Funds Rate | Number of Participants |
| 2012 | 3 |
| 2013 | 3 |
| 2014 | 7 |
| 2015 | 6 |
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf
IIB Twist Objectives. The purchase of long-term Treasury securities would displace demand for long-term Treasury securities upward and to the right. The price of long-term Treasury securities would increase, which is equivalent to a reduction of yields of long-term Treasury securities. Most credit currently is provided by securitized banking without which the economy would probably not grow as rapidly as permitted by labor, capital, resources and technology. The bank is also an intermediary between investors (savers) and borrowers (debtors). Investors give cash to the bank in exchange for collateral, such as securities, that is not insured by the government (see Gorton and Metrick 2010SB, Figure 2, 45). The securities are “pledged” by the bank to the investors in guarantee of repayment of the cash. The bank in turn gives cash to direct lenders that provide it to homebuyers who pledge the home with a mortgage loan. The direct lenders receive the cash provided to the homebuyers by transferring the mortgage to the dealer bank. Mortgages of the similar maturity and credit quality are agglutinated or “bundled” into a residential mortgage-backed security (RMBS) and sold or “distributed” to investors in the market.
The part of securitization banking analyzed by Gorton and Metrick (2010SB, Figure 6, Securitization, 41) consists of the critical transactions that surfaced during the beginning of the credit/dollar crisis. Banks fund by receiving cash from investors in exchange for collateral that is not insured by the FDIC. With the mortgages received in exchange for the cash, the bank creates RMBS that in some cases are transferred to a special purpose vehicle, variously called structured investment vehicles (SIV) and conduits in Europe. The securities are divided in tranches with credit risk from AAA to investment grade BBB and an unrated equity tranche to which the manager of the securities allocates the first losses and when exhausted losses are allocated beginning with the lower-rated tranches until reaching AAA in ascending hierarchy of credit rating. The SIV is actually an off-balance sheet vehicle of a bank that provides its AAA rating to obtain lower-cost financing. The SIV generated cash by issuing asset-backed commercial paper (ABCP) with guarantees of the securities. The SIV financed the ABCP in the short-term SRP (sales and repurchase agreement) market, obtaining the funds to purchase the securities from the bank that in turn financed the direct lender and ultimately the homebuyer. The bank provided a desk letter of comfort that it would provide liquidity to the SIV in cases of failure to roll over or refinance SRPs to ensure AAA rating for the ABCP of the SIV that allowed low-cost SRP financing. The SIV then sold asset-backed securities (ABS) to investors with the securities bundled by the bank. The SIV also created collateralized debt obligations (CDO) with the same tranches from AAA to unrated equity layer and the same process of loss absorption beginning with the unrated equity layer and climbing in the rating ladder to the AAA tranche. The CDO is sold to investors. The purpose of the tranches is to create diverse products catering to the risk appetite of investors, with pension funds buying AAA tranches and hedge funds acquiring BBB. The tranches also include credit default swaps (CDS). This process of credit risk transfer was analyzed by the Joint Forum of the Basel Committee on Banking Supervision, International Organization of Securities Commissions and the International Association of Supervisors (2004). Credit risk transfer consists of pulverizing credit in small transactions distributed to many investors in order to diminish concentrations of risk in large financial institutions that could cause systemic crises (see Pelaez and Pelaez, International Financial Architecture (2005), 134-54).
Maturity extension of the Treasury yield curve by open-market purchases of the Desk of the FRBNY intend to lower yields of ABS that fund wholesale credit for consumption and investment. Lower yields of ABS reduce the costs of borrowing for consumption and investment that can increase aggregate demand. Table II-4 provides US GDP and its components in billions of dollars and percentage share for IQ2012. US GDP at seasonally-adjusted annual rate was $15,454.0 billion. The share of PCE in IQ2012 GDP was $11,009.5 billion or 71.2 percent. The share of gross private domestic investment in IQ2012 GDP was $2,046.5 billion or 13.2 percent. The sum of PCE and gross private domestic investment is aggregate demand. Maturity extension intends to lower costs of borrowing for consumption and investment to increase aggregate demand that would accelerate growth and hiring.
Table II-4, US, GDP Seasonally-Adjusted at Annual Rates and Percentage Shares, Billions of Dollars and %
| IQ2012 SAAR Billions of Dollars | IQ2012 Percentage Shares | |
| GDP | 15,454.0 | 100.0 |
| PCE | 11,009.5 | 71.2 |
| Goods | 3,788.3 | 24.5 |
| Durable | 1,232.2 | 8.0 |
| Nondurable | 2,556.1 | 16.5 |
| Services | 7,221.2 | 46.7 |
| Gross Private Domestic Investment | 2,046.5 | 13.2 |
| Fixed Investment | 1,970.3 | 12.7 |
| NRFI | 1,609.3 | 10.4 |
| RFI | 361.0 | 2.3 |
| Change in Private | 76.2 | 0.5 |
| Net Exports of Goods and Services | -620.1 | -4.0 |
| Exports | 2,168.3 | 14.0 |
| Goods | 1,527.0 | 9.9 |
| Services | 641.3 | 4.1 |
| Imports | 2,788.5 | 18.0 |
| Goods | 2,341.3 | 15.1 |
| Services | 447.2 | 2.9 |
| Government | 3,018.2 | 19.5 |
| Federal | 1,218.8 | 7.9 |
| State and Local | 1,799.4 | 11.6 |
PCE: personal consumption expenditures; NRFI: nonresidential fixed investment; RFI: residential fixed investment
Source: http://www.bea.gov/iTable/index_nipa.cfm
Contributions to the rate of growth of GDP in percentage points (PP) are provided in Table II-5. Aggregate demand, personal consumption expenditures (PCE) and gross private domestic investment (GDI) were much stronger during the expansion phase in IQ1983 to IIQ1984 than in IIIQ2009 to IQ2012. GDI provided the impulse of growth in 1983 and 1984, which has not been the case from 2009 to 2012. The investment decision in the US economy has been frustrated in the current cyclical expansion. Growth of GDP in IQ2012 of 1.9 percent at seasonally-adjusted annual rate (SAAR) consisted of positive contributions of 1.90 percentage points of personal consumption expenditures (PCE) + 0.81 percentage points of gross domestic investment (GDI) but with significant part originating in inventory change of 0.21 percentage points (∆ PI) minus 0.08 percentage points of net exports (net trade or exports less imports) minus 0.78 percentage points of government consumption expenditures and gross investment (GOV). Growth in IVQ2010 was driven mainly by increase in private inventories of 1.81 percentage points.
Table II-5, US, Contributions to the Rate of Growth of GDP in Percentage Points
| GDP | PCE | GDI | ∆ PI | Trade | GOV | |
| 2012 | ||||||
| I | 1.9 | 1.90 | 0.81 | 0.21 | -0.08 | -0.78 |
| 2011 | ||||||
| I | 0.4 | 1.47 | 0.47 | 0.32 | -0.34 | -1.23 |
| II | 1.3 | 0.49 | 0.79 | -0.28 | 0.24 | -0.18 |
| III | 1.8 | 1.24 | 0.17 | -1.35 | 0.43 | -0.02 |
| IV | 3.0 | 1.47 | 2.59 | 1.81 | -0.26 | -0.84 |
| 2010 | ||||||
| I | 3.9 | 1.92 | 3.25 | 3.10 | -0.97 | -0.26 |
| II | 3.8 | 2.05 | 2.92 | 0.79 | -1.94 | 0.77 |
| III | 2.5 | 1.85 | 1.14 | 0.86 | -0.68 | 0.20 |
| IV | 2.3 | 2.48 | -0.91 | -1.79 | 1.37 | -0.58 |
| 2009 | ||||||
| I | -6.7 | -1.02 | -7.76 | -2.66 | 2.44 | -0.33 |
| II | -0.7 | -1.28 | -2.84 | -0.58 | 2.21 | 1.21 |
| III | 1.7 | 1.66 | 0.35 | 0.21 | -0.59 | 0.28 |
| IV | 3.8 | 0.33 | 3.51 | 3.93 | 0.15 | -0.18 |
| 1982 | ||||||
| I | -6.4 | 1.62 | -7.50 | -5.47 | -0.49 | -0.03 |
| II | 2.2 | 0.90 | -0.05 | 2.35 | 0.84 | 0.50 |
| III | -1.5 | 1.92 | -0.72 | 1.15 | -3.31 | 0.57 |
| IV | 0.3 | 4.64 | -5.66 | -5.48 | -0.10 | 1.44 |
| 1983 | ||||||
| I | 5.1 | 2.54 | 2.20 | 0.94 | -0.30 | 0.63 |
| II | 9.3 | 5.22 | 5.87 | 3.51 | -2.54 | 0.75 |
| III | 8.1 | 4.66 | 4.30 | 0.60 | -2.32 | 1.48 |
| IV | 8.5 | 4.20 | 6.84 | 3.09 | -1.17 | -1.35 |
| 1984 | ||||||
| I | 8.0 | 2.35 | 7.15 | 5.07 | -2.37 | 0.86 |
| II | 7.1 | 3.75 | 2.44 | -0.30 | -0.89 | 1.79 |
| III | 3.9 | 2.02 | 1.67 | 0.21 | -0.36 | 0.62 |
| IV | 3.3 | 3.38 | -1.26 | -2.50 | -0.58 | 1.75 |
| 1985 | ||||||
| I | 3.8 | 4.34 | -2.38 | -2.94 | 0.91 | 0.95 |
| II | 3.4 | 2.35 | 1.24 | 0.35 | -2.01 | 1.85 |
| III | 6.4 | 4.91 | -0.68 | -0.16 | -0.01 | 2.18 |
| IV | 3.1 | 0.54 | 2.72 | 1.45 | -0.68 | 0.50 |
Note: PCE: personal consumption expenditures; GDI: gross private domestic investment; ∆ PI: change in private inventories; Trade: net exports of goods and services; GOV: government consumption expenditures and gross investment; – is negative and no sign positive
GDP: percent change at annual rate; percentage points at annual rates
Source: http://www.bea.gov/iTable/index_nipa.cfm
Table II-6 provides the data required for broader comparison of the cyclical expansions from IQ1983 to IVQ1985 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IVQ1985, GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.5 percent at the annual equivalent rate of 4.3 percent; RDPI per capita increased 11.5 percent at the annual equivalent rate of 3.4 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. Second, in the 11 quarters of the current cyclical expansion from IIIQ2009 to IQ2012, GDP increased 6.7 percent at the annual equivalent rate of 2.4 percent; real disposable personal income (RDPI) increased 2.5 percent at the annual equivalent rate of 0.9 percent; RDPI per capita increased 0.3 percent at the annual equivalent rate of 0.1 percent; and population increased 2.1 percent at the annual equivalent rate of 0.8 percent. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing.
Table II-6, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2011, %
| # Quarters | ∆% | ∆% Annual Equivalent | |
| IQ1983 to IVQ1985 | 13 | ||
| GDP | 19.6 | 5.7 | |
| RDPI | 14.5 | 4.3 | |
| RDPI Per Capita | 11.5 | 3.4 | |
| Population | 2.7 | 0.8 | |
| IIIQ2009 to IQ2012 | 11 | ||
| GDP | 6.7 | 2.4 | |
| RDPI | 2.5 | 0.9 | |
| RDPI per Capita | 0.3 | 0.1 | |
| Population | 2.1 | 0.8 |
RDPI: Real Disposable Personal Income
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
A widely prevailing view of the limited scope and lack of effects on real economic activity of operation twist is provided by Blinder (2000, 1097):
“If the overnight (nominal) interest rate is zero, but other interest rates are not, the central bank can use open market operations in longer-dated securities to try to drive down longer-term interest rates. But here we encounter a problem analogous to the one that bedevils foreign exchange intervention: If the pure expectations theory of the term structure holds and short rates are expected to remain (approximately) zero for a while, then intermediate-term rates will be (approximately) zero, too. And, to bring down truly long rates, the bank would have to convince the market that the zero-interest-rate period would last many years!
Fortunately, the pure expectations theory does not hold. At a minimum, long rates include a variable term premium (often called a risk premium) which is potentially manipulable by changing the relative supplies of longs and shorts. But note that open market purchases of long bonds by the central bank are equivalent to open market purchases of bills plus a "twist" operation that sells bills and buys bonds. Most of us are skeptical that such twist operations have dramatic effects on the yield curve, much less on economic activity. America's "Operation Twist" of the 1960s is widely remembered as a failure, but that may be because the scale of the operation was so small. Once again, the message may be: Think big.”
The term “big” is not exaggerated. The task of monetary policy is to accelerate growth of the aggregate of consumption and investment is the US economy, about $13,056.0 billion, or $13.1 trillion. The first step of transmission of monetary policy consists of lowering yields of ABS securities. Pozsar et al (2012RFeb, 7-9) provide a gross measurement of “shadow banking” liabilities including those relating to securitization, such as ABS, Mortgage-backed Securities (MBS) and other liabilities of Government-Sponsored Enterprises (GSE) that include Fannie and Freddie, plus money market activities such as sale and repurchase agreements (SRP), commercial paper and liabilities of money market funds. The net measure tries to avoid double counting. The gross measure of shadow banking reached around $22 trillion in 2007 and contracted sharply during the financial crisis and global recession. A complete measure following the analysis of Pozsar et al (20012RFeb) would have to include not only liabilities in the US but also in international markets. Success of maturity extension and quantitative easing also requires igniting credit through the traditional banking system. McKinsey & Co. (2007) measures a broad aggregate financial stock consisting of equities, bonds, loans and deposits, measured at $51 trillion in 2005 for the US, $38 trillion for the euro area and $20 trillion for Japan. McKinsey & Co. (2007) finds that in the ten years to 2005 the financial stock of the US grew at the average yearly rate of 6.5 percent, which was lower than 8.5 percent for the UK. The US lost competitive advantage in finance during a prolonged period (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 168-79, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 160-6). Recession financial regulation typically accentuates loss of competitiveness and financial disintermediation, creating obstacles to growth (for financial regulation, see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), Regulation of Banks and Finance (2009b)).
Residential construction is one of the multiple sectors that would have to be influenced by monetary policy for success in increasing aggregate demand. The report of the US Census Bureau for Apr 2012 places the value of construction put in place in the US of $820,662 million, seasonally-adjusted at annual rate, of which $262,328 in residential construction or 32.0 percent and $558,334 million in nonresidential construction or 68.0 percent (http://www.census.gov/construction/c30/pdf/release.pdf, Table 1; see http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html). Table II-7 provides data of the Federal Housing Finance Agency (FHFA), regulator of Fannie Mae and Freddie Mac, with stock of mortgages outstanding in the US of $11,387,6767 million in 2010.
Table II-7, United States, Residential Mortgage Debt Outstanding, Millions of Dollars
| Fannie Mae | Freddie Mac | Combined Enterprises | Residential Mortgage Debt Outstanding | |
| 1990 | $404,703 | $338,217 | $742,920 | $2,893,729 |
| 1991 | $484,267 | $386,209 | $870,476 | $3,058,425 |
| 1992 | $582,563 | $441,410 | $1,023,973 | $3,212,681 |
| 1993 | $662,167 | $494,727 | $1,156,894 | $3,368,360 |
| 1994 | $708,402 | $533,484 | $1,241,886 | $3,546,131 |
| 1995 | $766,741 | $566,469 | $1,333,210 | $3,719,233 |
| 1996 | $835,225 | $610,820 | $1,446,045 | $3,954,526 |
| 1997 | $895,816 | $640,406 | $1,536,222 | $4,200,416 |
| 1998 | $1,051,658 | $733,360 | $1,785,018 | $4,590,489 |
| 1999 | $1,203,086 | $862,326 | $2,065,412 | $5,055,445 |
| 2000 | $1,316,844 | $968,399 | $2,285,243 | $5,508,592 |
| 2001 | $1,579,398 | $1,150,723 | $2,730,121 | $6,102,611 |
| 2002 | $1,840,218 | $1,297,081 | $3,137,299 | $6,896,266 |
| 2003 | $2,209,388 | $1,397,630 | $3,607,018 | $7,797,171 |
| 2004 | $2,325,256 | $1,505,531 | $3,830,787 | $8,872,741 |
| 2005 | $2,336,807 | $1,684,546 | $4,021,353 | $10,049,205 |
| 2006 | $2,506,482 | $1,826,720 | $4,333,202 | $11,163,068 |
| 2007 | $2,846,812 | $2,102,676 | $4,949,488 | $11,954,031 |
| 2008 | $3,081,655 | $2,207,476 | $5,289,131 | $11,906,478 |
| 2009 | $3,202,041 | $2,250,539 | $5,452,580 | $11,707,666 |
| 2010* | $3,156,192 | $2,164,859 | $5,321,051 | $11,387,676 |
Source: Federal Housing Finance Agency (FHFA)http://fhfa.gov/Default.aspx?Page=70
Table II-8 provides the combined and individual shares of Fannie Mae, Freddie Mac and in residential mortgage debt outstanding since 1990. The combined share increased from 25.7 percent in 1990 to 46.7 percent in 2010.
Table II-8, United States, Enterprise Share of Residential Mortgage Debt Outstanding, %
| Enterprise Share of | |||
| Residential Mortgage Debt Outstanding | |||
| Combined Enterprise Share | Fannie Mae Share | Freddie Mac Share | |
| 1990 | 25.7% | 14.0% | 11.7% |
| 1991 | 28.5% | 15.8% | 12.6% |
| 1992 | 31.9% | 18.1% | 13.7% |
| 1993 | 34.3% | 19.7% | 14.7% |
| 1994 | 35.0% | 20.0% | 15.0% |
| 1995 | 35.8% | 20.6% | 15.2% |
| 1996 | 36.6% | 21.1% | 15.4% |
| 1997 | 36.6% | 21.3% | 15.2% |
| 1998 | 38.9% | 22.9% | 16.0% |
| 1999 | 40.9% | 23.8% | 17.1% |
| 2000 | 41.5% | 23.9% | 17.6% |
| 2001 | 44.7% | 25.9% | 18.9% |
| 2002 | 45.5% | 26.7% | 18.8% |
| 2003 | 46.3% | 28.3% | 17.9% |
| 2004 | 43.2% | 26.2% | 17.0% |
| 2005 | 40.0% | 23.3% | 16.8% |
| 2006 | 38.8% | 22.5% | 16.4% |
| 2007 | 41.4% | 23.8% | 17.6% |
| 2008 | 44.4% | 25.9% | 18.5% |
| 2009 | 46.6% | 27.3% | 19.2% |
| 2010 | 46.7% | 27.7% | 19.0% |
Source: Federal Housing Finance Agency (FHFA)http://fhfa.gov/Default.aspx?Page=70
FHFA data for single-family mortgage originations are provided in Table II-9. In IIQ2011, single-family originations reached $10,395,472. Influencing even the relatively lower value of residential construction in the US requires a relatively “big” monetary impulse.
Table II-9, United States, Single-Family Mortgage Originations
| Single-Family Mortgages | |
| 1990 | $2,606,304 |
| 1991 | $2,774,317 |
| 1992 | $2,941,747 |
| 1993 | $3,100,671 |
| 1994 | $3,277,919 |
| 1995 | $3,445,383 |
| 1996 | $3,668,416 |
| 1997 | $3,902,568 |
| 1998 | $4,259,017 |
| 1999 | $4,683,043 |
| 2000 | $5,106,580 |
| 2001 | $5,658,549 |
| 2002 | $6,413,247 |
| 2003 | $7,240,069 |
| 2004 | $8,271,414 |
| 2005 | $9,386,635 |
| 2006 | $10,458,168 |
| 2007 | $11,169,427 |
| 2008 | $11,068,190 |
| 2009 | $10,867,662 |
| 2010 | $10,524,042 |
| 2011 Q1 | $10,449,675 |
| 2011 Q2 | $10,395,472 |
Source: Federal Housing Finance Agency (FHFA)http://fhfa.gov/Default.aspx?Page=70
The US Treasury measures total public debt outstanding in the US at $15,779.6 billion of which $4,747.1 billion in intergovernmental holdings and $11,032.5 billion in debt held by the public (http://www.treasurydirect.gov/NP/BPDLogin?application=np). The Bank for International Settlements (BIS) measures international debt securities of developed countries of all types of issuers at $26,661.7 billion in Sep 2011 of which $7,396.2 billion by the United States (http://www.bis.org/publ/qtrpdf/r_qa1112.pdf). Total issues of international money market instruments in Sep 2011 are measured by BIS at $980.1 billion in Sep 2011 (http://www.bis.org/publ/qtrpdf/r_qa1112.pdf). International bonds and notes outstanding in Sep 2011 reached $28,795.8 billion (http://www.bis.org/publ/qtrpdf/r_qa1112.pdf). Measuring the market value of derivatives relevant to successful monetary policy is more arduous (http://www.bis.org/publ/otc_hy1205.pdf).
Chairman Bernanke provides sober assessment of monetary policy (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20120620.pdf, 6-7):
“As I’ve said many times, monetary policy is not a panacea. Monetary policy by itself is not going to solve our economic problems. We welcome help and support from any other part of the government, from other economic policy makers. I wouldn’t accept the proposition, though, that the Fed has no more ammunition. I do think that our tools, while they are nonstandard, still can create more accommodative financial conditions, can still provide support for the economy, can still help us return to a more normal economic situation. That being said again, any other support that is forthcoming, any other economic policies that are undertaken that are helpful in terms of making our economy stronger are welcome. But I do think that monetary policy still does have some capacity to strengthen the economy by easing financial conditions.”
An alternative approach emphasizes long-term monetary policy rules instead of optimization intermittently by discretionary authorities (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html. Section VI Valuation of Risk Financial Assets follows carry trades.
IIC Appendix: Operation Twist. Meulendyke (1998, 39) describes the coordination of policy by Treasury and the FOMC in the beginning of the Kennedy administration in 1961:
“In 1961, several developments led the FOMC to abandon its “bills only” restrictions. The new Kennedy administration was concerned about gold outflows and balance of payments deficits and, at the same time, it wanted to encourage a rapid recovery from the recent recession. Higher rates seemed desirable to limit the gold outflows and help the balance of payments, while lower rates were wanted to speed up economic growth.
To deal with these problems simultaneously, the Treasury and the FOMC attempted to encourage lower long-term rates without pushing down short-term rates. The policy was referred to in internal Federal Reserve documents as “operation nudge” and elsewhere as “operation twist.” For a few months, the Treasury engaged in maturity exchanges with trust accounts and concentrated its cash offerings in shorter maturities.
The Federal Reserve participated with some reluctance and skepticism, but it did not see any great danger in experimenting with the new procedure.
It attempted to flatten the yield curve by purchasing Treasury notes and bonds while selling short-term Treasury securities. The domestic portfolio grew by $1.7 billion over the course of 1961. Note and bond holdings increased by a substantial $8.8 billion, while certificate of indebtedness holdings fell by almost $7.4 billion (Table 2). The extent to which these actions changed the yield curve or modified investment decisions is a source of dispute, although the predominant view is that the impact on yields was minimal. The Federal Reserve continued to buy coupon issues thereafter, but its efforts were not very aggressive. Reference to the efforts disappeared once short-term rates rose in 1963. The Treasury did not press for continued Fed purchases of long-term debt. Indeed, in the second half of the decade, the Treasury faced an unwanted shortening of its portfolio. Bonds could not carry a coupon with a rate above 4 1/4 percent, and market rates persistently exceeded that level. Notes—which were not subject to interest rate restrictions—had a maximum maturity of five years; it was extended to seven years in 1967.”
The term “operation twist” grew out of the dance “twist” popularized by successful musical performer Chubby Chekker (http://www.youtube.com/watch?v=aWaJ0s0-E1o). Financial markets had been widely anticipating the return of Chubby Chekker’s “twisting time” or “let’s twist again” monetary policy perhaps even during the two-day meeting of the FOMC scheduled for Sep 20 to Sep 21 (http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm#9662)..
The limited effects of operation twist were analyzed by Modigliani and Stuch (1966, 1967) with empirical estimation methods of their time in the 1960s. Swanson (2011Mar) provides analysis and measurement using current state of the art estimation methods.
Swanson (2011Mar) analyzes the policy mechanics of operation twist. President Kennedy faced two policy challenges after assuming office in Jan 1961: (1) international financial funds flowed in pursuit of higher short-term interest rates in Europe relative to those in the US that were restricted by prohibition of payment of interest on demand deposits and ceilings of interest on time deposits as provided by the Banking Act of 1933 and implemented by Regulation Q (for Regulation Q see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 74-5); and (2) the US was recovering from strong recession that lasted from IIQ1960 (Apr) to IQ1961 (Feb) (http://www.nber.org/cycles/cyclesmain.html). The objective of operation twist was maintaining stable or increasing short-term interest rates to prevent financial funds from flowing away from the US into Europe while simultaneously reducing long-term interest rates to stimulate investment and consumption, or aggregate demand. President Kennedy announced coordination of Treasury and FOMC policy as follows:
1. Treasury. The US Treasury would increase the issuance of short term securities while at the same time reduce the issuance of long-term securities. The desired effects of this policy would be in two forms:
i. The increase in the issuance of short-term Treasury securities would displace the supply curve of short-term securities downward and to the right. Assuming stable demand, the price of short-term Treasury securities would fall, which is equivalent to an increase in short-term interest rates that would prevent net outflows of capital from the US. There is a critical assumption here that capital flows among nations are determined by short-term interest rate differentials
ii. The reduction in the supply of long-term Treasury securities would cause displacement of the supply curve upward and to the left. Assuming stable demand, the price of long-term securities increases, which is equivalent to reducing yields of long-term securities
2. Federal Open Market Committee (FOMC). The FOMC would decide to sell short-term securities and buy long-term securities with the following desired effects:
i. The sale of short-term Treasury securities could displace the supply curve downwardly and to the right. Assuming stable demand, the price of short-term Treasury securities would fall, which is equivalent to an increase in short-term rates of Treasury securities designed to prevent net outflows of international capital from the US
ii. The purchase of long-term Treasury securities would displace demand for long-term Treasury securities upward and to the right. The price of long-term Treasury securities would increase, which is equivalent to a reduction of yields of long-term Treasury securities
A widely prevailing view of the limited scope and lack of effects on real economic activity of operation twist is provided by Blinder (2000, 1097):
“If the overnight (nominal) interest rate is zero, but other interest rates are not, the central bank can use open market operations in longer-dated securities to try to drive down longer-term interest rates. But here we encounter a problem analogous to the one that bedevils foreign exchange intervention: If the pure expectations theory of the term structure holds and short rates are expected to remain (approximately) zero for a while, then intermediate-term rates will be (approximately) zero, too. And, to bring down truly long rates, the bank would have to convince the market that the zero-interest-rate period would last many years!
Fortunately, the pure expectations theory does not hold. At a minimum, long rates include a variable term premium (often called a risk premium) which is potentially manipulable by changing the relative supplies of longs and shorts. But note that open market purchases of long bonds by the central bank are equivalent to open market purchases of bills plus a "twist" operation that sells bills and buys bonds. Most of us are skeptical that such twist operations have dramatic effects on the yield curve, much less on economic activity. America's "Operation Twist" of the 1960s is widely remembered as a failure, but that may be because the scale of the operation was so small. Once again, the message may be: Think big.”
Swanson (2011Mar, 5) provides evidence that operation twist was comparable in size to quantitative easing two (QE2). Operation twist was on the order of $8.8 billion while QE2 was $600 billion but nominal values are misleading as operation twist was equivalent to 1.7 percent of GDP, which is not insignificant relative to 4.1 percent of GDP for QE2. Operation twist was equivalent to 4.7 percent of US Treasury debt, which is not insignificant relative to 7.0 percent for QE2. Operation twist was equivalent to 4.5 percent of US agency-guaranteed debt, which is higher than 3.7 percent for QE2. Finally, operation twist was coordinated with Treasury whereas this was not the case of QE2.
The limited size of operation twist is related to the findings of Modigliani and Sutch (1966, 196) that:
“1. The expectation model can account remarkably well for the relation between short- and long-term rates in the United States. Furthermore, the prevailing expectations of long-term rates involve a blending of extrapolation of very recent changes and regression toward a long term normal level.
2. There is no evidence that the maturity structure of the federal debt, or changes in this structure, exert a significant, lasting or transient, influence on the relation between the two rates.
3. The spread between long and short rates in the government market since the inception of Operation Twist was on the average some twelve base points below what one might infer from the pre-Operation Twist relation. This discrepancy seems to be largely attributable to the successive increase in the ceiling rate under Regulation Q which enabled the newly invented CD's to exercise their maximum influence.
4. Any effects, direct or indirect, of Operation Twist in narrowing the spread which further study might establish, are most unlikely to exceed some ten to twenty base points a reduction that can be considered moderate at best.”
Swanson (2011Mar, 31-2) finds with modern state of the art estimation methods that operation twist reduced yields of long-term US treasury securities by 15 basis points:
“The present paper has reexamined Operation Twist using a modern high-frequency event-study approach, which avoids the problems with lower-frequency methods discussed above. In contrast to Modigliani and Sutch, we find that Operation Twist had a highly statistically significant impact on longer-term Treasury yields. However, consistent with those authors, we find that the size of the effect was moderate, amounting to about 15 basis points. This estimate is also consistent with the lower end of the range of estimates of Treasury supply effects in the literature.”
The effects of quantitative easing or operation twist of 15 basis points are comparable to those of tightening of the fed funds rate by 100 basis points, as measured by Gürkaynak, Sack and Swanson (2005, 84):
“In particular, we estimate that a 1 percentage point surprise tightening in the federal funds rate leads, on average, to a 4.3 percent decline in the S&P 500 and increases of 49, 28, and 13 bp in two-, five-, and ten-year Treasury yields, respectively.”
There is another operational factors of the “let’s twist again” monetary policy. Swanson (2011Mar) also reminds that lowering long-term yields in a new twist of the yield curve does not require increasing short-term rates as in the part of operation twist policy designed to prevent net capital outflows of the US. The desk of the Federal Reserve Bank of New York can continue to implement the target of fed funds rate of 0 to ¼ percent.
The crucial issue here is if lowering the yields of long-term Treasury securities would have any impact on investment and consumption or aggregate demand. The decline of long-term yields of Treasury securities would have to cause decline of yields of asset-backed securities used to securitize loans for investment by firms and purchase of durable goods by consumers. The decline in costs of investment and consumption of durable goods would ultimately have to result in higher investment and consumption.
This appendix is divided into two subsections: IIC1 Operation Twist that reviews the analysis of lowering long-term yields; and IIC2 that reviews the analysis of quantitative easing.
IIC1 Operation Twist. Swanson finds three disadvantages in the time series approach of Modigliani and Sutch who relied on estimation methods available in the mid 1960s. (1) Treasury yields are very sensitive to expectations of inflation and the future path of fed funds rates that are not captured by quarterly data but are isolated in high-frequency observations. (2) The magnitudes of changes in yields by small numbers of basis points would have to be statistically insignificant relative to high standard errors of regressions. (3) There are multiple macroeconomic factors affecting Treasury yields preventing identification of the effects of policy that may not be present in high-frequency observations.
The method used by Swanson is that of event studies popularized by the efficient market hypothesis. Under rational expectations, asset prices incorporate all available information after the announcement (Samuelson 1965; Fama 1970). Swanson identifies six events of which five provide the information to reject the null hypothesis that changes in net supply of long-term bonds do not have effects on Treasury yields of any maturity. The alternative hypothesis is that changes in supply affect yields of Treasury securities.
IIC2 Transmission of Quantitative Easing. Janet L. Yellen, Vice Chair of the Board of Governors of the Federal Reserve System, provides analysis of the policy of purchasing large amounts of long-term securities for the Fed’s balance sheet. The new analysis provides now three channels of transmission of quantitative easing to the ultimate objectives of increasing growth and employment and increasing inflation to “levels of 2 percent or a bit less that most Committee participants judge to be consistent, over the long run, with the FOMC’s dual mandate” (Yellen 2011AS, 4, 7):
“There are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boost household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”
The new analysis by Yellen (2011AS) is considered below in four separate subsections: IIC2i Theory; IIC2ii Policy; IIC2iii Evidence; and IIC2iv Unwinding Strategy.
IIC2i Theory. The transmission mechanism of quantitative easing can be analyzed in three different forms. (1) Portfolio choice theory. General equilibrium value theory was proposed by Hicks (1935) in analyzing the balance sheets of individuals and institutions with assets in the capital segment consisting of money, debts, stocks and productive equipment. Net worth or wealth would be comparable to income in value theory. Expected yield and risk would be the constraint comparable to income in value theory. Markowitz (1952) considers a portfolio of individual securities with mean μp and variance σp. The Markowitz (1952, 82) rule states that “investors would (or should”) want to choose a portfolio of combinations of (μp, that are efficient, which are those with minimum variance or risk for given expected return μp or more and maximum expected μp for given variance or risk or less. The more complete model of Tobin (1958) consists of portfolio choice of monetary assets by maximizing a utility function subject to a budget constraint. Tobin (1961, 28) proposes general equilibrium analysis of the capital account to derive choices of capital assets in balance sheets of economic units with the determination of yields in markets for capital assets with the constraint of net worth. A general equilibrium model of choice of portfolios was developed simultaneously by various authors (Hicks 1962; Treynor 1962; Sharpe 1964; Lintner 1965; Mossin 1966). If shocks such as by quantitative easing displace investors from the efficient frontier, there would be reallocations of portfolios among assets until another efficient point is reached. Investors would bid up the prices or lower the returns (interest plus capital gains) of long-term assets targeted by quantitative easing, causing the desired effect of lowering long-term costs of investment and consumption.
(2) General Equilibrium Theory. Bernanke and Reinhart (2004, 88) argue that “the possibility monetary policy works through portfolio substitution effects, even in normal times, has a long intellectual history, having been espoused by both Keynesians (James Tobin 1969) and monetarists (Karl Brunner and Allan Meltzer 1973).” Andres et al. (2004) explain the Tobin (1969) contribution by optimizing agents in a general-equilibrium model. Both Tobin (1969) and Brunner and Meltzer (1973) consider capital assets to be gross instead of perfect substitutes with positive partial derivatives of own rates of return and negative partial derivatives of cross rates in the vector of asset returns (interest plus principal gain or loss) as argument in portfolio balancing equations (see Pelaez and Suzigan 1978, 113-23). Tobin (1969, 26) explains portfolio substitution after monetary policy:
“When the supply of any asset is increased, the structure of rates of return, on this and other assets, must change in a way that induces the public to hold the new supply. When the asset’s own rate can rise, a large part of the necessary adjustment can occur in this way. But if the rate is fixed, the whole adjustment must take place through reductions in other rates or increases in prices of other assets. This is the secret of the special role of money; it is a secret that would be shared by any other asset with a fixed interest rate.”
Andrés et al. (2004, 682) find that in their multiple-channels model “base money expansion now matters for the deviations of long rates from the expected path of short rates. Monetary policy operates by both the expectations channel (the path of current and expected future short rates) and this additional channel. As in Tobin’s framework, interest rates spreads (specifically, the deviations from the pure expectations theory of the term structure) are an endogenous function of the relative quantities of assets supplied.”
The interrelation among yields of default-free securities is measured by the term structure of interest rates. This schedule of interest rates along time incorporates expectations of investors. (Cox, Ingersoll and Ross 1985). The expectations hypothesis postulates that the expectations of investors about the level of future spot rates influence the level of current long-term rates. The normal channel of transmission of monetary policy in a recession is to lower the target of the fed funds rate that will lower future spot rates through the term structure and also the yields of long-term securities. The expectations hypothesis is consistent with term premiums (Cox, Ingersoll and Ross 1981, 774-7) such as liquidity to compensate for risk or uncertainty about future events that can cause changes in prices or yields of long-term securities (Hicks 1939; see Cox, Ingersoll and Ross 1981, 784; Chung et al. 2011, 22).
(3) Preferred Habitat. Another approach is by the preferred-habitat models proposed by Culbertson (1957, 1963) and Modigliani and Sutch (1966). This approach is formalized by Vayanos and Vila (2009). The model considers investors or “clientele” who do not abandon their segment of operations unless there are extremely high potential returns and arbitrageurs who take positions to profit from discrepancies. Pension funds matching benefit liabilities would operate in segments above 15 years; life insurance companies operate around 15 years or more; and asset managers and bank treasury managers are active in maturities of less than 10 years (Ibid, 1). Hedge funds, proprietary trading desks and bank maturity transformation activities are examples of potential arbitrageurs. The role of arbitrageurs is to incorporate “information about current and future short rates into bond prices” (Ibid, 12). Suppose monetary policy raises the short-term rate above a certain level. Clientele would not trade on this information, but arbitrageurs would engage in carry trade, shorting bonds and investing at the short-term rate, in a “roll-up” trade, resulting in decline of bond prices or equivalently increases in yields. This is a situation of an upward-sloping yield curve. If the short-term rate were lowered, arbitrageurs would engage in carry trade borrowing at the short-term rate and going long bonds, resulting in an increase in bond prices or equivalently decline in yields, or “roll-down” trade. The carry trade is the mechanism by which bond yields adjust to changes in current and expected short-term interest rates. The risk premiums of bonds are positively associated with the slope of the term structure (Ibid, 13). Fama and Bliss (1987, 689) find with data for 1964-85 that “1-year expected returns for US Treasury maturities to 5 years, measured net of the interest rate on a 1-year bond, vary through time. Expected term premiums are mostly positive during good times but mostly negative during recessions.” Vayanos and Vila (2009) develop a model with two-factors, the short-term rate and demand or quantity. The term structure moves because of shocks of short-term rates and demand. An important finding is that demand or quantity shocks are largest for intermediate and long maturities while short-rate shocks are largest for short-term maturities.
IIA2ii Policy. A simplified analysis could consider the portfolio balance equations Aij = f(r, x) where Aij is the demand for i = 1,2,∙∙∙n assets from j = 1,2, ∙∙∙m sectors, r the 1xn vector of rates of return, ri, of n assets and x a vector of other relevant variables. Tobin (1969) and Brunner and Meltzer (1973) assume imperfect substitution among capital assets such that the own first derivatives of Aij are positive, demand for an asset increases if its rate of return (interest plus capital gains) is higher, and cross first derivatives are negative, demand for an asset decreases if the rate of return of alternative assets increases. Theoretical purity would require the estimation of the complete model with all rates of return. In practice, it may be impossible to observe all rates of return such as in the critique of Roll (1976). Policy proposals by the Fed have been focused on the likely impact of withdrawals of stocks of securities in specific segments, that is, of effects of one or several specific rates of return among the n possible rates. There have been six approaches on the role of monetary policy in purchasing long-term securities that have increased the classes of rates of return targeted by the Fed:
i. Suspension of Auctions of 30-year Treasury Bonds. Auctions of 30-year Treasury bonds were suspended between 2001 and 2005. This was Treasury policy not Fed policy. The effects were similar to those of quantitative easing: withdrawal of supply from the segment of 30-year bonds would result in higher prices or lower yields for close-substitute mortgage-backed securities with resulting lower mortgage rates. The objective was to encourage refinancing of house loans that would increase family income and consumption by freeing income from reducing monthly mortgage payments.
ii. Purchase of Long-term Securities by the Fed. Between Nov 2008 and Mar 2009 the Fed announced the intention of purchasing $1750 billion of long-term securities: $600 billion of agency mortgage-backed securities and agency debt announced on Nov 25 and $850 billion of agency mortgaged-backed securities and agency debt plus $300 billion of Treasury securities announced on Mar 18, 2009 (Yellen 2011AS, 5-6). The objective of buying mortgage-backed securities was to lower mortgage rates that would “support the housing sector” (Bernanke 2009SL). The FOMC statement on Dec 16, 2008 informs that: “over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and its stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant” (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). The Mar 18 statement of the FOMC explained that: “to provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities up to $1.25 trillion this year, and to increase its purchase of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months” (http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm). Policy changed to increase prices or reduce yields of mortgage-backed securities and Treasury securities with the objective of supporting housing markets and private credit markets by lowering costs of housing and long-term private credit.
iii. Portfolio Reinvestment. On Aug 10, 2010, the FOMC statement explains the reinvestment policy: “to help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in long-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature” (http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm). The objective of policy appears to be supporting conditions in housing and mortgage markets with slow transfer of the portfolio to Treasury securities that would support private-sector markets.
iv. Increasing Portfolio. As widely anticipated, the FOMC decided on Dec 3, 2010: “to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month” (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm). The emphasis appears to shift from housing markets and private-sector credit markets to the general economy, employment and preventing deflation.
v. Increasing Stock Market Valuations. Chairman Bernanke (2010WP) explained on Nov 4 the objectives of purchasing an additional $600 billion of long-term Treasury securities and reinvesting maturing principal and interest in the Fed portfolio. Long-term interest rates fell and stock prices rose when investors anticipated the new round of quantitative easing. Growth would be promoted by easier lending such as for refinancing of home mortgages and more investment by lower corporate bond yields. Consumers would experience higher confidence as their wealth in stocks rose, increasing outlays. Income and profits would rise and, in a “virtuous circle,” support higher economic growth. Bernanke (2000) analyzes the role of stock markets in central bank policy (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 99-100). Fed policy in 1929 increased interest rates to avert a gold outflow and failed to prevent the deepening of the banking crisis without which the Great Depression may not have occurred. In the crisis of Oct 19, 1987, Fed policy supported stock and futures markets by persuading banks to extend credit to brokerages. Collapse of stock markets would slow consumer spending.
vi. Devaluing the Dollar. Yellen (2011AS, 6) broadens the effects of quantitative easing by adding dollar devaluation: “there are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boosts household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”
IIC2iii Evidence. There are multiple empirical studies on the effectiveness of quantitative easing that have been covered in past posts such as (Andrés et al. 2004, D’Amico and King 2010, Doh 2010, Gagnon et al. 2010, Hamilton and Wu 2010). On the basis of simulations of quantitative easing with the FRB/US econometric model, Chung et al (2011, 28-9) find that:
”Lower long-term interest rates, coupled with higher stock market valuations and a lower foreign exchange value of the dollar, provide a considerable stimulus to real activity over time. Phase 1 of the program by itself is estimated to boost the level of real GDP almost 2 percent above baseline by early 2012, while the full program raises the level of real GDP almost 3 percent by the second half of 2012. This boost to real output in turn helps to keep labor market conditions noticeably better than they would have been without large scale asset purchases. In particular, the model simulations suggest that private payroll employment is currently 1.8 million higher, and the unemployment rate ¾ percentage point lower, that would otherwise be the case. These benefits are predicted to grow further over time; by 2012, the incremental contribution of the full program is estimated to be 3 million jobs, with an additional 700,000 jobs provided by the most recent phase of the program alone.”
An additional conclusion of these simulations is that quantitative easing may have prevented actual deflation. Empirical research is continuing.
IIC2iv Unwinding Strategy. Fed Vice-Chair Yellen (2011AS) considers four concerns on quantitative easing discussed below in turn. First, Excessive Inflation. Yellen (2011AS, 9-12) considers concerns that quantitative easing could result in excessive inflation because fast increases in aggregate demand from quantitative easing could raise the rate of inflation, posing another problem of adjustment with tighter monetary policy or higher interest rates. The Fed estimates significant slack of resources in the economy as measured by the difference of four percentage points between the high current rate of unemployment above 9 percent and the NAIRU (non-accelerating rate of unemployment) of 5.75 percent (Ibid, 2). Thus, faster economic growth resulting from quantitative easing would not likely result in upward rise of costs as resources are bid up competitively. The Fed monitors frequently slack indicators and is committed to maintaining inflation at a “level of 2 percent or a bit less than that” (Ibid, 13), say, in the narrow open interval (1.9, 2.1).
Second, Inflation and Bank Reserves. On Jan 12, the line “Reserve Bank credit” in the Fed balance sheet stood at $2450,6 billion, or $2.5 trillion, with the portfolio of long-term securities of $2175.7 billion, or $2.2 trillion, composed of $987.6 billion of notes and bonds, $49.7 billion of inflation-adjusted notes and bonds, $146.3 billion of Federal agency debt securities, and $992.1 billion of mortgage-backed securities; reserves balances with Federal Reserve Banks stood at $1095.5 billion, or $1.1 trillion (http://federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The concern addressed by Yellen (2011AS, 12-4) is that this high level of reserves could eventually result in demand growth that could accelerate inflation. Reserves would be excessively high relative to the levels before the recession. Reserves of depository institutions at the Federal Reserve Banks rose from $45.6 billion in Aug 2008 to $1084.8 billion in Aug 2010, not seasonally adjusted, multiplying by 23.8 times, or to $1038.2 billion in Nov 2010, multiplying by 22.8 times. The monetary base consists of the monetary liabilities of the government, composed largely of currency held by the public plus reserves of depository institutions at the Federal Reserve Banks. The monetary base not seasonally adjusted, or issue of money by the government, rose from $841.1 billion in Aug 2008 to $1991.1 billion or by 136.7 percent and to $1968.1 billion in Nov 2010 or by 133.9 percent (http://federalreserve.gov/releases/h3/hist/h3hist1.pdf). Policy can be viewed as creating government monetary liabilities that ended mostly in reserves of banks deposited at the Fed to purchase $2.1 trillion of long-term securities or assets, which in nontechnical language would be “printing money” (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). The marketable debt of the US government in Treasury securities held by the public stood at $8.7 trillion on Nov 30, 2010 (http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds112010.pdf). Holdings of long-term securities by the Fed of $2.1 trillion, in the process of converting fully into Treasury securities, are equivalent to 24 percent of US government debt held by the public, and would represent 29.9 percent with the new round of quantitative easing if all the portfolio of the Fed, as intended, were in Treasury securities. Debt in Treasury securities held by the public on Dec 31, 2009, stood at $7.2 trillion (http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds122009.pdf), growing to Nov 30, 2010, by $1.5 trillion or by 20.8 percent. In spite of this growth of bank reserves, “the 12-month change in core PCE [personal consumption expenditures] prices dropped from about 2 ½ percent in mid-2008 to around 1 ½ percent in 2009 and declined further to less than 1 percent by late 2010” (Yellen 2011AS, 3). The PCE price index, excluding food and energy, is around 0.8 percent in the past 12 months, which could be, in the Fed’s view, too close for comfort to negative inflation or deflation. Yellen (2011AS, 12) agrees “that an accommodative monetary policy left in place too long can cause inflation to rise to undesirable levels” that would be true whether policy was constrained or not by “the zero bound on interest rates.” The FOMC is monitoring and reviewing the “asset purchase program regularly in light of incoming information” and will “adjust the program as needed to meet its objectives” (Ibid, 12). That is, the FOMC would withdraw the stimulus once the economy is closer to full capacity to maintain inflation around 2 percent. In testimony at the Senate Committee on the Budget, Chairman Bernanke stated that “the Federal Reserve has all the tools its needs to ensure that it will be able to smoothly and effectively exit from this program at the appropriate time” (http://federalreserve.gov/newsevents/testimony/bernanke20110107a.htm). The large quantity of reserves would not be an obstacle in attaining the 2 percent inflation level. Yellen (2011A, 13-4) enumerates Fed tools that would be deployed to withdraw reserves as desired: (1) increasing the interest rate paid on reserves deposited at the Fed currently at 0.25 percent per year; (2) withdrawing reserves with reverse sale and repurchase agreement in addition to those with primary dealers by using mortgage-backed securities; (3) offering a Term Deposit Facility similar to term certificates of deposit for member institutions; and (4) sale or redemption of all or parts of the portfolio of long-term securities. The Fed would be able to increase interest rates and withdraw reserves as required to attain its mandates of maximum employment and price stability.
Third, Financial Imbalances. Fed policy intends to lower costs to business and households with the objective of stimulating investment and consumption generating higher growth and employment. Yellen (2011A, 14-7) considers a possible consequence of excessively reducing interest rates: “a reasonable fear is that this process could go too far, encouraging potential borrowers to employ excessive leverage to take advantage of low financing costs and leading investors to accept less compensation for bearing risks as they seek to enhance their rates of return in an environment of very low yields. This concern deserves to be taken seriously, and the Federal Reserve is carefully monitoring financial indicators for signs of potential threats to financial stability.” Regulation and supervision would be the “first line of defense” against imbalances threatening financial stability but the Fed would also use monetary policy to check imbalances (Yellen 2011AS, 17).
Fourth, Adverse Effects on Foreign Economies. The issue is whether the now recognized dollar devaluation would promote higher growth and employment in the US at the expense of lower growth and employment in other countries.
III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) growth in China with political development, Japan and world trade; (3) slow growth propelled by savings reduction in the US with high unemployment/underemployment, falling wages and hiring collapse; 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. Subsection IIIG Appendix on Deficit Financing of Growth and the Debt Crisis provides analysis of proposals to finance growth with budget deficits together with experience of the economic history of Brazil.
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 Jun 15 and daily values throughout the week ending on Fri Jun 22 of various 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 Jun 15 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Jun 15, 2012”, first row “USD/EUR 1.2640 -1.0%,” provides the information that the US dollar (USD) depreciated 1.0 percent to USD 1.2640/EUR in the week ending on Fri Jun 15 relative to the exchange rate on Fri Jun 8. 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 1.2640/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jun 15, appreciating to USD 1.2572/EUR on Mon Jun 18, or by 0.5 percent. The dollar appreciated because fewer dollars, $1.2572, were required on Mon Jun 18 to buy one euro than $1.2640 on Jun 15. 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 such as 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 1.2572/EUR on Jun 18; 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 Jun 15, to the last business day of the current week, in this case Fri Jun 22, such as appreciation by 0.6 percent to USD 1.2570/EUR by Jun 22; 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 0.6 percent from the rate of USD 1.2640/EUR on Fri Jun 15 to the rate of USD 1.2570/EUR on Fri Jun 22 {[(1.2570/1.2640) – 1]100 = -0.6%} and depreciated (denoted by negative sign) by 0.2 percent from the rate of USD 1.2544 on Thu Jun 21 to USD 1.2570/EUR on Fri Jun 22 {[(1.2570/1.2544) -1]100 = 0.2%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher 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, depreciating the dollar.
Table III-I, Weekly Financial Risk Assets Jun 18 to Jun 22, 2012
| Fri Jun 15, 2012 | M 18 | Tue 19 | W 20 | Thu 21 | Fr 22 |
| USD/EUR 1.2640 -1.0% | 1.2572 0.5% 0.5% | 1.2686 -0.4% -0.9% | 1.2704 -0.5% -0.1% | 1.2544 0.8% 1.3% | 1.2570 0.6% -0.2% |
| JPY/ USD 78.71 0.9% | 79.12 -0.5% -0.5% | 78.95 -0.3% 0.2% | 79.49 -1.0% -0.7% | 80.27 -2.0% -1.0% | 80.43 -2.2% -0.2% |
| CHF/ USD 0.9502 1.0% | 0.9553 -0.5% -0.5% | 0.9467 0.4% 0.9% | 0.9454 0.5% 0.1% | 0.9574 -0.8% -1.3% | 0.9553 -0.5% 0.2% |
| CHF/ EUR 1.2010 0.0% | 1.2010 0.0% 0.0% | 1.2009 0.0% 0.0% | 1.2011 0.0% 0.0% | 1.2010 0.0% 0.0% | 1.2010 0.0% 0.0% |
| USD/ AUD 1.0081 0.9919 1.6% | 1.0119 0.9882 0.4% 0.4% | 1.0192 0.9812 1.1% 0.7% | 1.0199 0.9805 1.1% 0.1% | 1.0039 0.9961 -0.4% -1.6% | 1.0065 0.9935 -0.2% 0.3% |
| 10 Year T Note 1.584 | 1.57 | 1.62 | 1.65 | 1.62 | 1.676 |
| 2 Year T Note 0.272 | 0.28 | 0.29 | 0.31 | 0.30 | 0.309 |
| German Bond 2Y 0.07 10Y 1.44 | 2Y 0.03 10Y 1.41 | 2Y 0.09 10Y 1.53 | 2Y 0.15 10Y 1.61 | 2Y 0.10 10Y 1.53 | 2Y 0.14 10Y 1.58 |
| DJIA 12767.17 1.7% | 12741.82 -0.2% -0.2% | 12837.33 0.5% 0.8% | 12824.39 0.5% -0.1% | 12573.57 -1.5% -2.0% | 12640.78 -1.0% 0.5% |
| DJ Global 1789.12 1.7% | 1793.32 0.2% 0.2% | 1816.97 1.6% 1.3% | 1824.14 2.0% 0.4% | 1795.87 0.4% -1.6% | 1792.14 0.2% -0.2% |
| DJ Asia Pacific 1165.39 2.2% | 1181.26 1.4% 1.4% | 1180.40 1.3% -0.1% | 1190.01 2.1% 0.8% | 1179.52 1.2% -0.9% | 1166.29 0.1% -1.1% |
| Nikkei 8569.32 1.3% | 8721.02 1.8% 1.8% | 8655.87 1.0% -0.8% | 8752.31 2.1% 1.1% | 8824.07 3.0% 0.8% | 8798.35 2.7% -0.3% |
| Shanghai 2306.85 1.1% | 2316.05 0.4% 0.4% | 2300.79 -0.3% -0.7% | 2292.88 -0.6% -0.3% | 2260.88 -2.0% -1.4% | 2260.88 -2.0% -1.4% |
| DAX 6229.41 1.6% | 6248.20 0.3% 0.3% | 6363.36 2.1% 1.8% | 6392.13 2.6% 0.5% | 6343.13 1.8% -0.8% | 6263.25 0.5% -1.3% |
| DJ UBS Comm. 128.79 0.0% | 130.13 1.0% 1.0% | 131.45 2.1% 1.0% | 130.41 1.3% -0.8% | 127.83 -0.7% -2.0% | 128.27 -0.4% 0.3% |
| WTI $ B 84.05 -0.4% | 82.99 -1.3% -1.3% | 84.18 0.2% 1.4% | 81.09 -3.5% -3.7% | 78.24 -6.9% -3.5% | 80.16 -4.6% 2.5% |
| Brent $/B 97.60 -2.3% | 95.77 -1.9% -1.9% | 95.93 -1.7% 0.2% | 92.59 -5.1% -3.5% | 89.28 -8.5% -3.6% | 91.48 -6.3% 2.5% |
| Gold $/OZ 1628.1 2.1% | 1628.8 0.0% 0.0% | 1619.0 -0.6% -0.6% | 1608.1 -1.2% -0.7% | 1566.6 -3.8% -2.6% | 1572.7 -3.4% 0.4% |
Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss
Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce
Sources: http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
The declaration of the meeting of G20 leaders at Los Cabos on Jun 19 addressed the financial stability of Europe as follows (see the G20 University of Toronto information service http://www.g20.utoronto.ca/2012/2012-0619-loscabos.html):
“Against the background of renewed market tensions, Euro Area members of the G20 will take all necessary measures to safeguard the integrity and stability of the area, improve the functioning of financial markets and break the feedback loop between sovereigns and banks. We welcome the significant actions taken since the last summit by the Euro Area to support growth, ensure financial stability and promote fiscal responsibility as a contribution to the G20 framework for strong, sustainable and balanced growth. In this context, we welcome Spain’s plan to recapitalize its banking system and the Eurogroup’s announcement of support for Spain’s financial restructuring authority. The adoption of the Fiscal Compact and its ongoing implementation, together with growth-enhancing policies and structural reform and financial stability measures, are important steps towards greater fiscal and economic integration that lead to sustainable borrowing costs. The imminent establishment of the European Stability Mechanism is a substantial strengthening of the European firewalls. We fully support the actions of the Euro Area in moving forward with the completion of the Economic and Monetary Union. Towards that end, we support the intention to consider concrete steps towards a more integrated financial architecture, encompassing banking supervision, resolution and recapitalization, and deposit insurance. Euro Area members will foster intra Euro Area adjustment through structural reforms to strengthen competitiveness in deficit countries and to promote demand and growth in surplus countries. The European Union members of the G20 are determined to move forward expeditiously on measures to support growth including through completing the European Single Market and making better use of European financial means, such as the European Investment Bank (EIB), pilot project bonds, and structural and cohesion funds, for more targeted investment, employment, growth and competitiveness, while maintaining the firm commitment to implement fiscal consolidation to be assessed on a structural basis. We look forward to the Euro Area working in partnership with the next Greek government to ensure they remain on the path to reform and sustainability within the Euro Area.”
The Concluding Statement of the IMF Mission on the 2012 Article IV Consultation with the Euro Area proposes full banking union (http://www.imf.org/external/np/ms/2012/062112.htm):
“The immediate priority is concrete action toward a banking union for the euro area. The proposed EU framework for harmonized national bank resolution processes is a necessary first step. But it needs to go further. A deposit guarantee scheme needs to be established at the regional level to help break the links between domestic banks and their sovereigns, and support depositor confidence. A common bank resolution authority is also needed. It should be backed by a common resolution fund to ensure burden sharing and to limit fiscal costs. These efforts should be supported by a common supervisory and macro-prudential framework to forestall further financial fragmentation. While a banking union is desirable at the EU27 level, it is critical for the euro 17.”
The definition of “banking panic” by Calomiris and Gorton (1991, 112) during the Great Depression in the US is:
“A banking panic occurs when bank debt holders at all or many banks in the banking system suddenly demand that banks convert their debt claims into cash (at par) to such an extent that the banks suspend convertibility of their debt into cash, or in the case of the United States, act collectively to avoid suspension of convertibility by issuing clearing house loan certificates.”
The financial panic during the credit crisis and global recession consisted of a run on the sale and repurchase agreements (SRP) of structured investment products (http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Cochrane and Zingales (2009) argue that the initial proposal for the Troubled Asset Relief Program (TARP) instead of the failure of Lehman Bros caused the flight into the dollar and Treasury securities. Washington Mutual experienced a silent run in the form of internet withdrawals. The current silent run in the euro area is from banks with challenged balance sheets in highly indebted member countries to banks and government securities in countries with stronger fiscal affairs. The analysis of the IMF 2012 Article IV Consultation focuses on this key policy priority of reversing the silent run on challenged euro area banks.
Jonathan House, writing on “Spanish banks need as much as €62 billion in new capital,” on Jun 21, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702304765304577480062972372858.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that two independent studies estimate the needs new capital of Spain’s banks at €62, billion, around $78.8 billion, which will be used by the government of Spain in the request for financial assistance from the European Union during the meeting with finance ministers.
The European Central Bank (ECB) announced changes in acceptable collateral for refinancing (http://www.ecb.int/press/pr/date/2012/html/pr120622.en.html):
“On 20 June 2012 the Governing Council of the European Central Bank (ECB) decided on additional measures to improve the access of the banking sector to Eurosystem operations in order to further support the provision of credit to households and non-financial corporations.
The Governing Council has reduced the rating threshold and amended the eligibility requirements for certain asset-backed securities (ABSs). It has thus broadened the scope of the measures to increase collateral availability which were introduced on 8 December 2011 and which remain applicable.
In addition to the ABSs that are already eligible for use as collateral in Eurosystem operations, the Eurosystem will consider the following ABSs as eligible:
1. Auto loan, leasing and consumer finance ABSs and ABSs backed by commercial mortgages (CMBSs) which have a second-best rating of at least “single A” [1] in the Eurosystem’s harmonised credit scale, at issuance and at all times subsequently. These ABSs will be subject to a valuation haircut of 16%.
2. Residential mortgage-backed securities (RMBSs), securities backed by loans to small and medium-sized enterprises (SMEs), auto loan, leasing and consumer finance ABSs and CMBSs which have a second-best rating of at least “triple B” [2] in the Eurosystem’s harmonised credit scale, at issuance and at all times subsequently. RMBSs, securities backed by loans to SMEs, and auto loan, leasing and consumer finance ABSs would be subject to a valuation haircut of 26%, while CMBSs would be subject to a valuation haircut of 32%.
The risk control framework with higher haircuts applicable to the newly eligible ABS aims at ensuring risk equalisation across asset classes and maintaining the risk profile of the Eurosystem.
The newly eligible ABSs must also satisfy additional requirements which will be specified in the legal act to be adopted Thursday, 28 June 2012. The measures will take effect as soon as the relevant legal act enters into force.”
There was significant improvement in ten-year yields of bonds of the government of Italy, declining to 5.770 percent on Fri Jun 22 from yields exceeding 6 percent, and of ten-year yields of bonds of the government of Spain, declining to 6.3580 percent on Fri Jun 22 from earlier yields exceeding 7 percent (http://professional.wsj.com/mdc/public/page/2_3022-govtbonds.html?mod=mdc_bnd_pglnk). 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 and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.676 percent on Jun 22, 2012 while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.58 percent. The yield of the two-year government bond of Germany fell from 0.65 percent on Aug 26, 2011, to 0.01 percent on Jun 1, 2012, as investors fled euro area risks to the safety of liabilities of the government of Germany, and increased marginally to 0.07 percent on Jun 15, 2012. The combination of multiple risks in the world economy and finance caused heightened risk aversion in the week of Jun 1, 2012, with the ten-year Treasury yield collapsing to 1.454, level experienced during the Treasury-Fed agreement of the 1940s, while the two-year government bond of Germany fell to 0.01 percent and even negative and 0.00 percent and the ten-year government bond of Germany collapsing to 1.17 percent. There was relaxation of risk aversion in the week of Jun 8 with increase of the yield of the ten-year Treasury to 1.635 percent and of the two-year government bond of Germany to 0.04 percent and the ten-year to 1.33 percent, which are still at levels of extreme flight from risk. Fears on Greece, Spain and Italy resulted in renewed risk aversion with yields on Jun 15, 2012 at levels of flight to safety but more relaxed yields in the week of Jun 22, 2012. The US dollar strengthened significantly from USD 1.450/EUR on Aug 26, 2011, to USD 1.2518/EUR on May 25, 2919, or by 13.7 percent, and further to USD 1.2435/EUR on Jun 1, 2012, or by 14.2 percent. The USD revalued by 0.7 percent to USD 1.2517 on Jun 8, 2012, depreciated 1 percent on Jun 15 to USD 1.2640/EUR but appreciated by 0.6 percent on Jun 22. The dollar peaked at USD 1.192/EUR on Jun 7, 2010, during the first round of the European sovereign risk crisis, but is now only 5.5 percent weaker at USD 1.2570/EUR on Jun 22, 2012. Under zero interest rates for the monetary policy rate of the US, or fed funds rate, carry trades ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield is still at a level well below consumer price inflation of 1.7 percent in the 12 months ending in May (see subsection IB United States Inflation http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.html and ealier http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html) and the expectation of higher inflation if risk aversion diminishes. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury.
A similar risk aversion phenomenon occurred in Germany. Eurostat confirmed euro zone CPI inflation is at 2.4 percent for the 12 months ending in May 2012 but jumping 1.3 percent in the month of Mar (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-14062012-BP/EN/2-14062012-BP-EN.PDF and Section IV http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.html) but the yield of the two-year German government bond fell from 0.65 percent on Aug 19, 2011 to 0.05 percent on May 25, 2012, 0.01 percent on Jun 1, 2012, 0.04 percent on Jun 8, 0.07 percent on Jun 15 and 0.14 percent on Jun 22, while the ten-year yield fell from 2.16 percent on Aug 26, 2011 to 1.37 percent on May 25, 2012 and then to 1.17 percent on Jun 1, 2012, 1.33 percent on Jun 8, 1.44 percent on Jun 15 and 1.58 percent on Jun 22 , as shown in Table III-1A. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.
Table III-1A, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate
| US 2Y | US 10Y | DE 2Y | DE 10Y | USD/ EUR | |
| 6/22/12 | 0.309 | 1.676 | 0.14 | 1.58 | 1.2570 |
| 6/15/12 | 0.272 | 1.584 | 0.07 | 1.44 | 1.2640 |
| 6/8/12 | 0.268 | 1.635 | 0.04 | 1.33 | 1.2517 |
| 6/1/12 | 0.248 | 1.454 | 0.01 | 1.17 | 1.2435 |
| 5/25/12 | 0.291 | 1.738 | 0.05 | 1.37 | 1.2518 |
| 5/18/12 | 0.292 | 1.714 | 0.05 | 1.43 | 1.2780 |
| 5/11/12 | 0.248 | 1.845 | 0.09 | 1.52 | 1.2917 |
| 5/4/12 | 0.256 | 1.876 | 0.08 | 1.58 | 1.3084 |
| 4/6/12 | 0.31 | 2.058 | 0.14 | 1.74 | 1.3096 |
| 3/30/12 | 0.335 | 2.214 | 0.21 | 1.79 | 1.3340 |
| 3/2/12 | 0.29 | 1.977 | 0.16 | 1.80 | 1.3190 |
| 2/24/12 | 0.307 | 1.977 | 0.24 | 1.88 | 1.3449 |
| 1/6/12 | 0.256 | 1.957 | 0.17 | 1.85 | 1.2720 |
| 12/30/11 | 0.239 | 1.871 | 0.14 | 1.83 | 1.2944 |
| 8/26/11 | 0.20 | 2.202 | 0.65 | 2.16 | 1.450 |
| 8/19/11 | 0.192 | 2.066 | 0.65 | 2.11 | 1.4390 |
| 6/7/10 | 0.74 | 3.17 | 0.49 | 2.56 | 1.192 |
| 3/5/09 | 0.89 | 2.83 | 1.19 | 3.01 | 1.254 |
| 12/17/08 | 0.73 | 2.20 | 1.94 | 3.00 | 1.442 |
| 10/27/08 | 1.57 | 3.79 | 2.61 | 3.76 | 1.246 |
| 7/14/08 | 2.47 | 3.88 | 4.38 | 4.40 | 1.5914 |
| 6/26/03 | 1.41 | 3.55 | NA | 3.62 | 1.1423 |
Note: DE: Germany
Source:
http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
http://www.federalreserve.gov/releases/h15/data.htm
http://www.ecb.int/stats/money/long/html/index.en.html
Equity indexes in Table III-1 were mixed in the week of Jun 22. Germany’s Dax gained 0.5 percent while DJIA fell 1.0 percent in the week of Jun 22 and Dow Global increased 0.2 percent. Japan’s Nikkei Average increased 2.7 percent. Dow Asia Pacific TSM increased 0.1 percent in the week of Jun 22 while Shanghai Composite fell 2.0 percent.
Commodities were weak during the week of Jun 8, 2012, as shown in Table III-1. The DJ UBS Commodities Index fell 0.4 percent. WTI fell 4.6 percent while Brent decreased 6.3 percent. Gold fell 3.4 percent.
Risk aversion during the week of Mar 2, 2012, was dominated by the long-term refinancing operations (LTRO) of the European Central Bank. LTROs and related principles are analyzed in subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort. First, as analyzed by David Enrich, writing on “ECB allots €529.5 billion in long-term refinancing operations,” published on Feb 29, 2012 by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203986604577252803223310964.html?mod=WSJ_hp_LEFTWhatsNewsCollection), the ECB provided a second round of three-year loans at 1.0 percent to about 800 banks. The earlier round provided €489 billion to more than 500 banks. Second, the ECB sets the fixed-rate for main refinancing operations at 1.00 percent and the overnight deposit facility at 0.25 percent (http://www.ecb.int/home/html/index.en.html) for negative spread of 75 basis points. That is, if a bank borrows at 1.0 percent for three years through the LTRO and deposits overnight at the ECB, it incurs negative spread of 75 basis points. An alternative allocation could be to lend for a positive spread to other banks. Richard Milne, writing on “Banks deposit record cash with ECB,” on Mar 2, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/9798fd36-644a-11e1-b30e-00144feabdc0.html#axzz1nxeicB6H), provides important information and analysis that banks deposited a record €776.9 billion at the ECB on Fri Mar 2 at interest receipt of 0.25 percent, just two days after receiving €529.5 billion of LTRO loans at interest cost of 1.0 percent. The main issue here is whether there is ongoing perceptions of high risks in counterparties in financial transactions that froze credit markets in 2008 (see Pelaez and Pelaez, Regulation of Banks and Finance (2009a), 57-60, 217-27, Financial Regulation after the Global Recession (2009b), 155-67). Richard Milne and Mary Watkins, writing on “European finance: the leaning tower of perils,” on Mar 27, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/82205f6e-7735-11e1-baf3-00144feab49a.html#axzz1qOqWaqF2), raise concerns that the large volume of LTROs can create future problems for banks and the euro area. An important issue is if the cheap loans at 1 percent for three-year terms finance the carry trade into securities of the governments of banks. Balance sheets of banks may be stressed during future sovereign-credit events. Sam Jones, writing on “ECB liquidity fuels high stakes hedging,” on Apr 4, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/cb74d63a-7e75-11e1-b009-00144feab49a.html#axzz1qyDYxLjS), analyzes unusually high spreads in government bond markets in Europe that could have been caused by LTROs. There has been active relative value arbitrage of these spreads similar to the strategies of Long-Term Capital Management (LTCM) of capturing high spreads in mortgage-backed securities jointly with hedges in Treasury securities (on LTCM see Pelaez and Pelaez, International Financial Architecture (2005), 108-12, 87-9, The Global Recession Risk (2007) 12-3, 102, 176, Globalization and the State, Vol. I (2008a), 59-64).
Table III-1B provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increasing from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,206,289 million on Jun 15, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,809,605 million in the statement of Jun 15.
Table III-1B, Consolidated Financial Statement of the Eurosystem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | Jun 15, 2012 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 432,701 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 246,521 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 48,160 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 17,612 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 1,206,289 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 191,721 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 603,316 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 30,587 |
| 9 Other Assets | 278,719 | 336,574 | 250,398 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 3,027,305 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 1,809,605 |
| Capital and Reserves | 78,143 | 81,481 | 85,748 |
Source: European Central Bank
http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html
http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html
http://www.ecb.int/press/pr/wfs/2012/html/fs120619.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.
The members of the European Monetary Union (EMU), or euro area, established the European Financial Stability Facility (EFSF), on May 9, 2010, to (http://www.efsf.europa.eu/about/index.htm):
- “Provide loans to countries in financial difficulties
- Intervene in the debt primary and secondary markets. Intervention in the secondary market will be only on the basis of an ECB analysis recognising the existence of exceptional financial market circumstances and risks to financial stability
- Act on the basis of a precautionary programme
- Finance recapitalisations of financial institutions through loans to governments”
The EFSF will be replaced by the permanent European Stability Mechanism (ESM) in 2013. On Mar 30, 2012, members of the euro area reached an agreement providing for sufficient funding required in rescue programs of members countries facing funding and fiscal difficulties and the transition from the EFSF to the ESM. The agreement of Mar 30, 2012 of the euro area members provides for the following (http://www.consilium.europa.eu/media/1513204/eurogroup_statement_30_march_12.pdf):
· Acceleration of ESM paid-in capital. The acceleration of paid-in capital for the ESM provides for two tranches paid in 2012, in July and Oct; another two tranches in 2013; and a final tranche in the first half of 2014. There could be acceleration of paid-in capital is required to maintain a 15 percent relation of paid-in capital and the outstanding issue of the ESM
· ESM Operation and EFSF transition. ESM will assume all new rescue programs beginning in Jul 2012. EFSF will administer programs begun before initiation of ESM activities. There will be a transition period for the EFSF until mid 2013 in which it can engage in new programs if required to maintain the full lending limit of €500 billion.
· Increase of ESM/EFSF lending limit. The combined ceiling of the ESM and EFSF will be increased to €700 billion to facilitate operation of the transition of the EFSF to the ESM. The ESM lending ceiling will be €500 billion by mid 2013. The combined lending ceiling of the ESM and EFSF will continue to €700 billion
· Prior lending. The bilateral Greek loan facility of €53 billion and €49 billion of the EFSF have been paid-out in supporting programs of countries: “all together the euro area is mobilizing an overall firewall of approximately EUR 800 billion, more than USD 1 trillion” (http://www.consilium.europa.eu/media/1513204/eurogroup_statement_30_march_12.pdf)
· Bilateral IMF contributions. Members of the euro area have made commitments of bilateral contributions to the IMF of €150 billion
A key development in the bailout of Greece is the approval by the Executive Board of the International Monetary Fund (IMF) on Mar 15, 2012, of a new four-year financing in the value of €28 billion to be disbursed in equal quarterly disbursements (http://www.imf.org/external/np/tr/2012/tr031512.htm). The sovereign debt crisis of Europe has moderated significantly with the elimination of immediate default of Greece. New economic and financial risk factors have developed, which are covered in VI Valuation of Risk Financial Assets and V World Economic Slowdown.
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 an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increasing from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,206,289 million on Jun 15, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,809,605 million in the statement of Jun 17.
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 | Jun 15, 2012 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 432,701 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 246,521 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 48,160 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 17,612 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 1,206,289 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 191,721 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 603,316 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 30,587 |
| 9 Other Assets | 278,719 | 336,574 | 250,398 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 3,027,305 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 1,809,605 |
| Capital and Reserves | 78,143 | 81,481 | 85,748 |
Source: European Central Bank
http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html
http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html
http://www.ecb.int/press/pr/wfs/2012/html/fs120619.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 euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate 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 42.7 percent of the total. Exports to the non-European Union area are growing at 8.0 percent in Apr 2012 relative to Apr 2011 while those to EMU are falling at 0.5 percent.
Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%
| Apr 2012 | Exports | ∆% Jan-Apr 2012/ Jan-Apr 2011 | Imports | Imports |
| EU | 56.0 | 0.5 | 53.3 | -7.6 |
| EMU 17 | 42.7 | -0.5 | 43.2 | -7.1 |
| France | 11.6 | 0.6 | 8.3 | -4.7 |
| Germany | 13.1 | 3.3 | 15.6 | -10.3 |
| Spain | 5.3 | -9.3 | 4.5 | -9.9 |
| UK | 4.7 | 8.9 | 2.7 | -16.4 |
| Non EU | 44.0 | 8.0 | 46.7 | -3.7 |
| Europe non EU | 13.3 | 12.4 | 11.1 | -4.7 |
| USA | 6.1 | 7.9 | 3.3 | 5.4 |
| China | 2.7 | -10.7 | 7.3 | -22.3 |
| OPEC | 4.7 | 18.2 | 8.6 | 20.1 |
| Total | 100.0 | 3.7 | 100.0 | -5.7 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/64824
Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €325 million with the 17 countries of the euro zone (EMU 17) in Apr and deficit of €667 million in Jan-Apr. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €2469 million in Jan-Apr with Europe non European Union and of €3415 million with the US. There is significant rigidity in the trade deficits in Jan-Apr of €5187 million with China and €8039 million with members of the Organization of Petroleum Exporting Countries (OPEC).
Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro
| Regions and Countries | Trade Balance Apr 2012 Millions of Euro | Trade Balance Cumulative Jan-Apr 2012 Millions of Euro |
| EU | 702 | 3,434 |
| EMU 17 | -325 | -667 |
| France | 848 | 3,820 |
| Germany | -521 | -1,882 |
| Spain | 93 | 834 |
| UK | 715 | 2,855 |
| Non EU | -904 | -7,052 |
| Europe non EU | 605 | 2,469 |
| USA | 1,279 | 3,415 |
| China | -1,076 | -5,187 |
| OPEC | -1,877 | -8,039 |
| Total | -202 | -3,617 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/64824
Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Mar 2012 relative to Mar 2011. Growth rates of imports are negative with the exception of energy. The higher rate of growth of exports of 3.7 percent relative to imports of minus 5.7 percent may reflect weak demand in Italy with GDP declining during three consecutive quarters from IIIQ2011 through IQ2012.
Table III-5, Italy, Exports and Imports % Share of Products in Total and ∆%
| Exports | Exports | Imports | Imports | |
| Consumer | 28.9 | 4.7 | 25.0 | -2.8 |
| Durable | 5.9 | 0.8 | 3.0 | -9.8 |
| Non | 23.0 | 5.7 | 22.0 | -1.8 |
| Capital Goods | 32.2 | 1.9 | 20.8 | -13.9 |
| Inter- | 34.3 | 2.6 | 34.5 | -13.0 |
| Energy | 4.7 | 17.3 | 19.7 | 13.0 |
| Total ex Energy | 95.3 | 3.0 | 80.3 | -10.2 |
| Total | 100.0 | 3.7 | 100.0 | -5.7 |
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/64824
Table III-6 provides Italy’s trade balance by product categories in Apr 2012 and cumulative Jan-Apr 2012. Italy’s trade balance excluding energy generated surplus of €5351 million in Apr 2012 and €19,377 million in Jan-Apr 2012 but the energy trade balance created deficit of €5553 million in Apr 2012 and €22,994 million in Jan-Apr 2012. The overall deficit in Apr 2012 was €202 million but there was an overall deficit of €3617 million in Jan-Apr 2012. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.
Table III-6, Italy, Trade Balance by Product Categories, € Millions
| Mar 2012 | Cumulative Jan-Mar 2012 | |
| Consumer Goods | 788 | 4,286 |
| Durable | 867 | 3,510 |
| Nondurable | -80 | 776 |
| Capital Goods | 4,452 | 14,072 |
| Intermediate Goods | 112 | 1,019 |
| Energy | -5,553 | -22,994 |
| Total ex Energy | 5,351 | 19,377 |
| Total | -202 | -3,617 |
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/64824
Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.
The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the following Subsection IIID Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30 the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent. There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt of 120 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).
Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.
Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:
“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”
If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.
The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2010.
Table III-7, World and Selected Regional and Country GDP and Fiscal Situation
| GDP 2012 | Primary Net Lending Borrowing | General Government Net Debt | |
| World | 69,660 | ||
| Euro Zone | 12,586 | -0.5 | 70.3 |
| Portugal | 221 | 0.1 | 110.9 |
| Ireland | 210 | -4.4 | 102.9 |
| Greece | 271 | -1.0 | 153.2 |
| Spain | 1,398 | -3.6 | 67.0 |
| Major Advanced Economies G7 | 34,106 | -4.8 | 88.3 |
| United States | 15,610 | -6.1 | 83.7 |
| UK | 2,453 | -5.3 | 84.2 |
| Germany | 3,479 | 1.0 | 54.1 |
| France | 2,712.0 | -2.2 | 83.2 |
| Japan | 5,981 | -8.9 | 135.2 |
| Canada | 1,805 | -3.1 | 35.4 |
| Italy | 2,067 | 2.9 | 102.3 |
| China | 7992 | -1.3* | 22.0** |
*Net Lending/borrowing**Gross Debt
Source: http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weoselgr.aspx
The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2012 is $4138.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3927.8 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8066.3 billion, which would be equivalent to 130.3 percent of their combined GDP in 2012. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 231.9 percent if including debt of France and 167.0 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.
Table III-8, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %
| Net Debt USD Billions | Debt as % of Germany Plus France GDP | Debt as % of Germany GDP | |
| A Euro Area | 8,847.9 | ||
| B Germany | 1,882.1 | $8066.3 as % of $3479 =231.9% $5809.9 as % of $3479 =167.0% | |
| C France | 2,256.4 | ||
| B+C | 4,138.5 | GDP $6,191.0 Total Debt $8066.3 Debt/GDP: 130.3% | |
| D Italy | 2,114.5 | ||
| E Spain | 936.7 | ||
| F Portugal | 245.3 | ||
| G Greece | 415.2 | ||
| H Ireland | 216.1 | ||
| Subtotal D+E+F+G+H | 3,927.8 |
Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx
There is extremely important information in Table III-1C for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Apr 2012. German exports to other European Union (EU) members are 57.9 percent of total exports in Apr 2012 and 58.3 percent in Jan-Apr 2012. Exports to the euro area are 38.0 percent in Apr and 38.8 percent in Jan-Apr. Exports to third countries are 42.1 percent of the total in Apr and 41.7 percent in Jan-Mar. There is similar distribution for imports. Economic performance in Germany is closely related to its high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone. Germany could benefit from depreciation of the euro because of its high share in exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.
Table III-9, Germany, Structure of Exports and Imports by Region, € Billions and ∆%
| Apr 2012 | Apr 12-Month | Jan–Apr 2012 € Billions | Jan-Apr 2012/ | |
| Total | 87.1 | 3.4 | 363.1 | 5.2 |
| A. EU | 50.5 % 57.9 | -1.1 | 211.6 % 58.3 | 1.4 |
| Euro Area | 33.1 % 38.0 | -3.6 | 140.7 % 38.8 | -0.1 |
| Non-euro Area | 17.3 % 19.9 | 4.1 | 70.9 % 19.5 | 4.6 |
| B. Third Countries | 36.7 % 42.1 | 10.3 | 151.4 % 41.7 | 11.0 |
| Total Imports | 72.7 | -1.0 | 303.2 | 3.3 |
| C. EU Members | 46.3 % 63.7 | -1.1 | 192.0 % 63.3 | 3.4 |
| Euro Area | 32.8 % 45.1 | -0.6 | 135.1 % 44.6 | 3.3 |
| Non-euro Area | 13.5 % 18.6 | -2.3 | 56.9 % 18.8 | 3.7 |
| D. Third Countries | 26.5 % 36.5 | -0.7 | 113.3 % 37.4 | 3.1 |
Notes: Total Exports = A+B; Total Imports = C+D
Source:
Statistiche Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/06/PE12_195_51.html;jsessionid=9AA93AFFD978CD2C25BE7CA368BD0690.cae1
IIIF Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unpleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.
First, Unpleasant Monetarist Arithmetic. Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:
D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (1)
Equation (1) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,
{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:
N(t+1) = (1+n)N(t), n>-1 (2)
The per capita form of the budget constraint is obtained by dividing (1) by N(t) and rearranging:
B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (3)
On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.
Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+τ or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (5)
Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):
“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”
An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.
There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:
(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress
(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality
(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.
IIIG Appendix on Deficit Financing of Growth and the Debt Crisis. This section is divided into two subsections. Subsection IIIGA Monetary Policy with Deficit Financing of Economic Growth analyzes proposals to promote economic growth with government deficits financed by monetary policy. Subsection IIIGB Adjustment during the Debt Crisis of the 1980s provides the routes of adjustment of Brazil during the debt crisis after 1983.
IIIGA Monetary Policy with Deficit Financing of Economic Growth. The advice of Bernanke (2000, 159-161, 165) to the Bank of Japan (BOJ) to reignite growth and employment in the economy consisted of zero interest rates and commitment to a high inflation target as proposed by Krugman (1999):
“I agree that this approach would be helpful, in that it would give private decision makers more information about the objectives of monetary policy. In particular, a target in the 3-4 percent range for inflation to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime but also that it intends to make up some of the ‘price-level gap’ created by 8 years of zero or negative inflation. In stating an inflation target of, say, 3-4 percent, the BOJ would be giving the direction in which it will attempt to move the economy. The important question, of course, is whether a determined Bank of Japan would be able to depreciate the yen. I am not aware of any previous historical episode, including the period of very low interest rates in the 1930s, in which a central bank has been unable to devaluate its currency. There is strong presumption that vigorous intervention by the BOJ, together with appropriate announcements to influence market expectations, could drive down the value of the yen significantly. Further, there seems little reason not to try this strategy. The ‘worst’ that could happen would be that the BOJ would greatly increase its holdings of reserve assets. Perhaps not all of those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. Franklin D. Roosevelt was elected president of the United States in 1932 with the mandate to get the country out of the Depression. In the end, his most effective actions were the same ones that Japan needs to take—namely, rehabilitation of the banking system and devaluation of the currency.”
Bernanke (2002) also finds devaluation to be a powerful policy instrument to move the economy away from deflation and weak economic and financial conditions:
“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”
Krugman (2012Apr24) finds that this advice of then Professor Bernanke (2000) is relevant to current monetary policy in the US. The relevance would be in a target of inflation in the US of 4 percent, which was the rate prevailing in the late years of the Reagan Administration. The liquidity trap is defined by Krugman (1998, 141) “as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.” The adversity of the liquidity trap in terms of weakness in output and employment can be viewed as an economy experiencing deflation that cannot be contained by increases in the monetary base, or currency held by the public plus reserves held by banks at the central bank. The argument of monetary neutrality is that an increase in money throughout all future periods will increase prices by the same proportion. According to Krugman (1998, 142), the liquidity trap occurs because the public does not expect that the central bank will continue the monetary expansion once inflation returns to a certain level. Expectations are critical in explaining the liquidity trap and have been shaped by the continued fight against inflation by central banks during several decades with the possible exception of Japan beginning with the lost decade when deflation became the relevant policy concern. In this framework, monetary policy is ineffectual if perceived by the public as temporary. Credible monetary policy is perceived by the public as permanent deliberate increase in prices or output: “if the central bank can credibly promise to be irresponsible—that is, convince the market that it will in fact allow prices to rise sufficiently—it can bootstrap the economy out of the trap” (Krugman 1998, 161).
Fed Chairman Bernanke (2012Apr25, 7-8) argues that there is no conflict between his advice to the Bank of Japan as Princeton Professor Bernanke (2000) and current monetary policy by the Federal Open Market Committee (FOMC):
“So there’s this view circulating [Princeton Professor Paul Krugman at http://www.nytimes.com/2012/04/29/magazine/chairman-bernanke-should-listen-to-professor-bernanke.html?pagewanted=all] that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies. That is absolutely incorrect. Our—my views and our policies today are completely consistent with the views that I held at that time. I made two points at that time to the Bank of Japan. The first was that I believe that a determined central bank could and should work to eliminate deflation—that is, falling prices. The second point that I made was that when short-term interest rates hit zero, the tools of a central bank are no longer—are not exhausted, there are still other things that the central bank can do to create additional accommodation. Now, looking at the current situation in United States, we are not in deflation. When deflation became a significant risk in late 2010, or at least a modest risk in late 2010, we used additional balance sheet tools to help return inflation close to the 2 percent target. Likewise, we have been aggressive and creative in using non-federal-funds-rate-centered tools to achieve additional accommodation for the U.S. economy. So the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation, and, clearly, when you’re in deflation and in recession, then both sides of your mandates, so to speak, are demanding additional accommodation. In this case, it’s—we are not in deflation, we have an inflation rate that’s close to our objective. Now, why don’t we do more? Well, first I would again reiterate that we are doing a great deal; policy is extraordinarily accommodative. We—and I won’t go through the list again, but you know all the things that we have done to try to provide support to the economy. I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction—a slightly increased pace of reduction in the unemployment rate? The view of the Committee is that that would be very reckless. We have—we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been be able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.”
Chairman Bernanke (2012Apr 25, 10-11) explains current FOMC policy:
“So it’s not a ceiling, it’s a symmetric objective, and we attempt to bring inflation close to 2 percent. And in particular, if inflation were to jump for whatever reason—and we don’t have, obviously don’t have perfect control of inflation—we’ll try to return inflation to 2 percent at a pace which takes into account the situation with respect to unemployment. The risk of higher inflation—you say 2½ percent; well, 2½ percent expected change might involve a distribution of outcomes, some of which might be much higher than 2½ percent. And the concern we have is that if inflation were to run well above 2 percent for a protracted period, that the credibility and the well-anchored inflation expectations, which are such a valuable asset of the Federal Reserve, might become eroded, in which case we would in fact have less rather than more flexibility to use accommodative monetary policy to achieve our employment goals. I would cite to you, just as an example, if you look at Vice Chair Yellen’s paper, which she gave—or speech, which she gave a couple of weeks ago, where she described a number of ways of looking at the late 2014 guidance. She showed there some so-called optimal policy rules that come from trying to get the best possible outcomes from our quantitative econometric models, and what you see, if you look at that, is that the best possible outcomes, assuming perfect certainty, assuming perfect foresight—very unrealistic assumptions—still involve inflation staying quite close to 2 percent. So there is no presumption even in our econometric models that you need inflation well above target in order to make progress on unemployment.”
In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in the US. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:
“In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”
In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.
Proposals for higher inflation target of 4 percent for FOMC monetary policy are based on the view that interest rates are too high in real terms because the nominal rate is already at zero and cannot be lowered further. Rajan (2012May8) argues that higher inflation targets by the FOMC need not increase aggregate demand as proposed in those policies because of various factors:
· Pension Crisis. Baby boomers close to retirement calculate that their savings are not enough at current interest rates and may simply save more. Many potential retirees are delaying retirement in order to save what is required to provide for comfortable retirement.
· Regional Income and Debt Disparities. Unemployment, indebtedness and income growth differ by regions in the US. It is not feasible to relocate demand around the country such that decreases in real interest rates may not have aggregate demand effects.
· Inflation Expectations. Rajan (2012May) argues that there is not much knowledge about how people form expectations. Increasing the FOMC target to 4 percent could erode control of monetary policy by the central bank. More technical analysis of this issue, which could be merely repetition of inflation surprise in the US Great Inflation of the 1970s, is presented in Appendix IIA.
· Frictions. Keynesian economics is based on rigidities of wages and benefits in economic activities but there may be even more important current inflexibilities such as moving when it is not possible to sell and buy a house.
Thomas J. Sargent and William L. Silber, writing on “The challenges of the Fed’s bid for transparency,” on Mar 20, published in the Financial Times (http://www.ft.com/intl/cms/s/0/778eb1ce-7288-11e1-9c23-00144feab49a.html#axzz1pexRlsiQ), analyze the costs and benefits of transparency by the Fed. In the analysis of Sargent and Silber (2012Mar20), benefits of transparency by the Fed will exceed costs if the Fed is successful in conveying to the public what policies would be implemented and how forcibly in the presence of unforeseen economic events. History has been unkind to policy commitments. The risk in this case is if the Fed would postpone adjustment because of political pressures as has occurred in the past or because of errors of evaluation and forecasting of economic and financial conditions. Both political pressures and errors abounded in the unhappy stagflation of the 1970s also known as the US Great Inflation (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB). The challenge of the Fed, in the view of Sargent and Silber 2012Mar20), is to convey to the public the need to deviate from the commitment to interest rates of zero to ¼ percent because conditions have changed instead of unwarranted inaction or policy changes. Errors have abounded such as a critical cause of the global recession pointed by Sargent and Silber (2012Mar20): “While no president is known to have explicitly pressurized Mr. Bernanke’s predecessor, Alan Greenspan, he found it easy to maintain low interest rates for too long, fuelling the credit boom and housing bubble that led to the financial crisis in 2008.” Sargent and Silber (2012Mar20) also find need of commitment of fiscal authorities to consolidation needed to attain sustainable path of debt. Further analysis is provided in Appendix IIA Inflation Surprise and Appendix IIB Unpleasant Monetarist Arithmetic at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html.
According to an influential school of thought, the interrelation of growth and inflation in Latin America is complex, preventing analysis of whether inflation promotes or restricts economic growth (Seers 1962, 191). In this view, there are multiple structural factors of inflation. Successful economic policy requires a development program that ameliorates structural weaknesses. Policy measures in developed countries are not transferable to developing economies.
In extensive research and analysis, Kahil (1973) finds no evidence of the role of structural factors in Brazilian inflation from 1947 to 1963. In fact, Kahil (1973, 329) concludes:
“The immediate causes of the persistent and often violent rise in prices, with which Brazil was plagued from the last month of 1948 to the early months of 1964, are pretty obvious: large and generally growing public deficits, together with too rapid an expansion of bank credit in the first years and, later, exaggerated and more and more frequent increases in the legal minimum wages.”
Kahil (1973, 334) analyzes the impact of inflation on the economy and society of Brazil:
“The real incomes of the various social classes alternately suffered increasingly frequent and sharp fluctuations: no sooner had a group succeeded in its struggle to restore its real income to some previous peak than it witnessed its erosion with accelerated speed; and it soon became apparent to all that the success of any important group in raising its real income, through government actions or by other means, was achieved only by reducing theirs. Social harmony, the general climate of euphoria, and also enthusiasm for government policies, which had tended to prevail until the last months of 1958, gave way in the following years of galloping inflation to intense political and social conflict and to profound disillusionment with public policies. By 1963 when inflation reached its runaway stage, the economy had ceased to grow, industry and transport were convulsed by innumerable strikes, and peasants were invading land in the countryside; and the situation further worsened in the first months of 1964.”
Professor Nathiel H. Leff (1975) at Columbia University identified another important contribution of Kahil (1975, Chapter IV“The supply of capital,” 127-185) of key current relevance to current proposals to promote economic growth and employment by raising inflation targets:
“Contrary to the assertions of some earlier writers on this topic, Kahil concludes that inflation did not lead to accelerated capital formation in Brazil.”
In econometric analysis of Brazil’s inflation from 1947 to 1980, Barbosa (1987) concludes:
“The most important result, based on the empirical evidence presented here, is that in the long run inflation is a monetary phenomenon. It follows that the most challenging task for Brazilian society in the near future is to shape a monetary-fiscal constitution that precludes financing much of the budget deficits through the inflation tax.”
Experience with continuing fiscal deficits and money creation tend to show accelerating inflation. Table III-10 provides average yearly rates of growth of two definitions of the money stock, M1, and M2 that adds also interest-paying deposits. The data were part of a research project on the monetary history of Brazil using the NBER framework of Friedman and Schwartz (1963, 1970) and Cagan (1965) as well as the institutional framework of Rondo E. Cameron (1967, 1972) who inspired the research (Pelaez 1974, 1975, 1976a,b, 1977, 1979, Pelaez and Suzigan 1978, 1981). The data were also used to test the correct specification of money and income following Sims (1972; see also Williams et al. 1976) as well as another test of orthogonality of money demand and supply using covariance analysis. The average yearly rates of inflation are high for almost any period in 1861-1970, even when prices were declining at 1 percent in 19th century England, and accelerated to 27.1 percent in 1945-1970. There may be concern in an uncontrolled deficit monetized by sharp increases in base money. The Fed may have desired to control inflation at 2 percent after lowering the fed funds rate to 1 percent in 2003 but inflation rose to 4.1 percent in 2007. There is not “one hundred percent” confidence in controlling inflation because of the lags in effects of monetary policy impulses and the equally important lags in realization of the need for action and taking of action and also the inability to forecast any economic variable. Romer and Romer (2004) find that a one percentage point tightening of monetary policy is associated with a 4.3 percent decline in industrial production. There is no change in inflation in the first 22 months after monetary policy tightening when it begins to decline steadily, with decrease by 6 percent after 48 months (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 102). Even if there were one hundred percent confidence in reducing inflation by monetary policy, it could take a prolonged period with adverse effects on economic activity. Certainty does not occur in economic policy, which is characterized by costs that cannot be anticipated.
Table III-10, Brazil, Yearly Growth Rates of M1, M2, Nominal Income (Y), Real Income (y), Real Income per Capita (y/n) and Prices (P)
| M1 | M2 | Y | y | y/N | P | |
| 1861-1970 | 9.3 | 6.2 | 10.2 | 4.6 | 2.4 | 5.8 |
| 1861-1900 | 5.4 | 5.9 | 5.9 | 4.4 | 2.6 | 1.6 |
| 1861-1913 | 4.7 | 4.7 | 5.3 | 4.4 | 2.4 | 0.1 |
| 1861-1929 | 5.5 | 5.6 | 6.4 | 4.3 | 2.3 | 2.1 |
| 1900-1970 | 13.9 | 13.9 | 15.2 | 4.9 | 2.6 | 10.3 |
| 1900-1929 | 8.9 | 8.9 | 10.8 | 4.2 | 2.1 | 6.6 |
| 1900-1945 | 8.6 | 9.1 | 9.2 | 4.3 | 2.2 | 4.9 |
| 1920-1970 | 17.8 | 17.3 | 19.4 | 5.3 | 2.8 | 14.1 |
| 1920-1945 | 8.3 | 8.7 | 7.5 | 4.3 | 2.2 | 3.2 |
| 1920-1929 | 5.4 | 6.9 | 11.1 | 5.3 | 3.3 | 5.8 |
| 1929-1939 | 8.9 | 8.1 | 11.7 | 6.3 | 4.1 | 5.4 |
| 1945-1970 | 30.3 | 29.2 | 33.2 | 6.1 | 3.1 | 27.1 |
Note: growth rates are obtained by regressions of the natural logarithms on time. M1 and M2 definitions of the money stock; Y nominal GDP; y real GDP; y/N real GDP per capita; P prices.
Source: See Pelaez and Suzigan (1978), 143; M1 and M2 from Pelaez and Suzigan (1981); money income and real income from Contador and Haddad (1975) and Haddad (1974); prices by the exchange rate adjusted by British wholesale prices until 1906 and then from Villela and Suzigan (1973); national accounts after 1947 from Fundação Getúlio Vargas.
Chart III-1 shows in semi-logarithmic scale from 1861 to 1970 in descending order two definitions of income velocity, money income, M1, M2, an indicator of prices and real income.
Chart III-1, Brazil, Money, Income and Prices 1861-1970.
Source: © Carlos Manuel Pelaez and Wilson Suzigan. 1981. História Monetária do Brasil Segunda Edição. Coleção Temas Brasileiros. Brasília: Universidade de Brasília, 21.
Table III-11 provides yearly percentage changes of GDP, GDP per capita, base money, prices and the current account in millions of dollars during the acceleration of inflation after 1947. There was an explosion of base money or the issue of money and three waves of inflation identified by Kahil (1973). Inflation accelerated together with issue of money and political instability from 1960 to 1964. There must be a role for expectations in inflation but there is not much sound knowledge and measurement as Rajan (2012May8) argues. There have been inflation waves documented in periodic comments in this blog (see Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html). The risk is ignition of adverse expectations at the crest of one of worldwide inflation waves. Lack of credibility of the commitment by the FOMC to contain inflation could ignite such perverse expectations. Deficit financing of economic growth can lead to inflation and financial instability.
Table III-11, Brazil, GDP, GDP per Capita, Base Money, Prices and Current Account of the Balance of Payments, ∆% and USD Millions, 1947-1971
| GDP ∆% | GDP per Capita ∆% | Base Money ∆% | Prices ∆% | Current USD Millions | |
| 1947 | 2.4 | 0.1 | -1.4 | 14.0 | 162 |
| 1948 | 7.4 | 4.9 | 4.6 | 7.6 | -24 |
| 1949 | 6.6 | 4.2 | 14.5 | 4.0 | -74 |
| 1950 | 6.5 | 4.0 | 23.0 | 10.0 | 52 |
| 1951 | 5.9 | 2.9 | 15.3 | 21.9 | -291 |
| 1952 | 8.7 | 5.6 | 17.7 | 10.2 | -615 |
| 1953 | 2.5 | -0.5 | 15.5 | 12.1 | 16 |
| 1954 | 10.1 | 6.9 | 23.4 | 31.0 | -203 |
| 1955 | 6.9 | 3.8 | 18.0 | 14.0 | 17 |
| 1956 | 3.2 | 0.2 | 16.9 | 21.6 | 194 |
| 1957 | 8.1 | 4.9 | 30.5 | 13.9 | -180 |
| 1958 | 7.7 | 4.6 | 26.1 | 10.4 | -253 |
| 1959 | 5.6 | 2.5 | 32.3 | 37.7 | -154 |
| 1960 | 9.7 | 6.5 | 42.4 | 27.6 | -410 |
| 1961 | 10.3 | 7.1 | 54.4 | 36.1 | 115 |
| 1962 | 5.3 | 2.2 | 66.4 | 54.1 | -346 |
| 1963 | 1.6 | -1.4 | 78.4 | 75.2 | -244 |
| 1964 | 2.9 | -0.1 | 82.5 | 89.7 | 40 |
| 1965 | 2.7 | -0.6 | 67.6 | 62.0 | 331 |
| 1966 | 4.4 | 1.5 | 25.8 | 37.9 | 153 |
| 1967 | 4.9 | 2.0 | 33.9 | 28.7 | -245 |
| 1968 | 11.2 | 8.1 | 31.4 | 25.2 | 32 |
| 1969 | 9.9 | 6.9 | 22.4 | 18.2 | 549 |
| 1970 | 8.9 | 5.8 | 20.2 | 20.7 | 545 |
| 1971 | 13.3 | 10.2 | 29.8 | 22.0 | 530 |
Sources: Fundação Getúlio Vargas, Banco Central do Brasil and Pelaez and Suzigan (1981). Carlos Manuel Pelaez, História Econômica do Brasil: Um Elo entre a Teoria e a Realidade Econômica. São Paulo: Editora Atlas, 1979, 94.
IIIGB Adjustment during the Debt Crisis of the 1980s. Economic and financial risks in the euro area are increasingly being dominated by analytical and political disagreement on conflicts of fiscal adjustment, financial stability, economic growth and employment. Political development is beginning to push for alternative paths of policy. Blanchard (2012WEOApr) and Draghi (2012May3) provide analysis of appropriate directions of policy.
Blanchard (2012WEOApr) finds that interest rates close to zero in advanced economies have not induced higher economic growth because of two main factors—fiscal consolidation and deleveraging—that restrict economic growth in the short-term. First, Blanchard (2012WEOApr, XIII) finds that assuming a multiplier of unity of the fiscal deficit on GDP, decrease of the cyclically-adjusted deficit of advanced economies by 1 percent would reduce economic growth by one percentage point. Second, deleveraging by banks, occurring mainly in Europe, tightens credit supply with similar reduction of euro area economic growth by one percentage point in 2012. The baseline of the World Economic Outlook (WEO) of the IMF (2012WEOApr) for Apr 2012 incorporates both effects, which results in weak economic growth, in particular in Europe, and prolonged unemployment. An important analysis by Blanchard (2012WEOApr, XIII) is that “financial uncertainty, together with sharp shifts in risk appetite, has led to volatile capital flows.” Blanchard (2012WEOApr) still finds that the greatest vulnerability is another profound crisis in Europe (ECB). Crisis prevention should buttress the resilience of affected countries during those shifts in risk appetite. The role of the enhanced firewall of the IMF, European Union (EU) and European Central Bank is gaining time during which countries could engage in fiscal consolidation and structural reforms that would diminish the shifts in risk appetite, preventing devastating effects of financial crises. Volatility in capital flows is equivalent to volatility of valuations of risk financial assets. The challenge to the policy mix consists in balancing the adverse short-term effects of fiscal consolidation and deleveraging with the beneficial long-term effects of eliminating the vulnerability to shocks of risk aversion. Blanchard (2012WEOApr) finds that policy should seek short-term credibility while implementing measures that restrict the path of expenditures together with simultaneous development of institutions and rules that constrain deficits and spending in the future. There is similar policy challenge in deleveraging banks, which is required for sound lending institutions, but without causing an adverse credit crunch. Advanced economies face a tough policy challenge of increasing demand and potential growth.
The President of the European Central Bank (ECB) Mario Draghi (2012May3) also outlines the appropriate policy mix for successful adjustment:
“It is of utmost importance to ensure fiscal sustainability and sustainable growth in the euro area. Most euro area countries made good progress in terms of fiscal consolidation in 2011. While the necessary comprehensive fiscal adjustment is weighing on near-term economic growth, its successful implementation will contribute to the sustainability of public finances and thereby to the lowering of sovereign risk premia. In an environment of enhanced confidence in fiscal balances, private sector activity should also be fostered, supporting private investment and medium-term growth.
At the same time, together with fiscal consolidation, growth and growth potential in the euro area need to be enhanced by decisive structural reforms. In this context, facilitating entrepreneurial activities, the start-up of new firms and job creation is crucial. Policies aimed at enhancing competition in product markets and increasing the wage and employment adjustment capacity of firms will foster innovation, promote job creation and boost longer-term growth prospects. Reforms in these areas are particularly important for countries which have suffered significant losses in cost competitiveness and need to stimulate productivity and improve trade performance.
In this context, let me make a few remarks on the adjustment process within the euro area. As we know from the experience of other large currency areas, regional divergences in economic developments are a normal feature. However, considerable imbalances have accumulated in the last decade in several euro area countries and they are now in the process of being corrected.
As concerns the monetary policy stance of the ECB, it has to be focused on the euro area. Our primary objective remains to maintain price stability over the medium term. This is the best contribution of monetary policy to fostering growth and job creation in the euro area.
Addressing divergences among individual euro area countries is the task of national governments. They must undertake determined policy actions to address major imbalances and vulnerabilities in the fiscal, financial and structural domains. We note that progress is being made in many countries, but several governments need to be more ambitious. Ensuring sound fiscal balances, financial stability and competitiveness in all euro area countries is in our common interest.”
Economic policy during the debt crisis of 1983 may be useful in analyzing the options of the euro area. Brazil successfully combined fiscal consolidation, structural reforms to eliminate subsidies and devaluation to parity. Brazil’s terms of trade, or export prices relative to import prices, deteriorated by 47 percent from 1977 to 1983 (Pelaez 1986, 46). Table III-12 provides selected economic indicators of the economy of Brazil from 1970 to 1985. In 1983, Brazil’s inflation was 164.9 percent, GDP fell 3.2 percent, idle capacity in manufacturing reached 24.0 percent and Brazil had an unsustainable foreign debt. US money center banks would have had negative capital if loans to emerging countries could have been marked according to loss given default and probability of default (for credit risk models see Pelaez and Pelaez (2005), International Financial Architecture, 134-54). Brazil’s current account of the balance of payments shrank from $16,310 million in 1982 to $6,837 million in 1983 because of the abrupt cessation of foreign capital inflows with resulting contraction of Brazil’s GDP by 3.2 percent. An important part of adjustment consisted of agile coordination of domestic production to cushion the impact of drastic reduction in imports. In 1984, Brazil had a surplus of $45 million in current account, the economy grew at 4.5 percent and inflation was stabilized at 232.9 percent.
Table III-12, Brazil, Selected Economic Indicators 1970-1985
| Inflation ∆% | GDP Growth ∆% | Idle Capacity in MFG % | BOP Current Account USD MM | |
| 1985 | 223.4 | 7.4 | 19.8 | -630 |
| 1984 | 232.9 | 4.5 | 22.6 | 45 |
| 1983 | 164.9 | -3.2 | 24.0 | -6,837 |
| 1982 | 94.0 | 0.9 | 15.2 | -16,310 |
| 1981 | 113.0 | -1.6 | 12.3 | -11,374 |
| 1980 | 109.2 | 7.2 | 3.5 | -12,886 |
| 1979 | 55.4 | 6.4 | 4.1 | -10,742 |
| 1978 | 38.9 | 5.0 | 3.3 | -6,990 |
| 1977 | 40.6 | 5.7 | 3.2 | -4,037 |
| 1976 | 40.4 | 9.7 | 0.0 | -6,013 |
| 1975 | 27.8 | 5.4 | 3.0 | -6,711 |
| 1974 | 29.1 | 9.7 | 0.1 | -7,122 |
| 1973 | 15.4 | 13.6 | 0.3 | -1,688 |
| 1972 | 17.7 | 11.1 | 6.5 | -1,489 |
| 1971 | 21.5 | 12.0 | 9.8 | -1,307 |
| 1970 | 19.3 | 8.8 | 12.2 | -562 |
Source: Carlos 21.5Manuel Pelaez, O Cruzado e o Austral: Análise das Reformas Monetárias do Brasil e da Argentina. São Paulo, Editora Atlas, 1986, 86.
Chart III-2 provides the tortuous Phillips Circuit of Brazil from 1963 to 1987. There were no reliable consumer price index and unemployment data in Brazil for that period. Chart III-2 used the more reliable indicator of inflation, the wholesale price index, and idle capacity of manufacturing as a proxy of unemployment in large urban centers.
Chart III-2, Brazil, Phillips Circuit 1963-1987
Source:
©Carlos Manuel Pelaez, O Cruzado e o Austral: Análise das Reformas Monetárias do Brasil e da Argentina. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.
A key to success in stabilizing an economy with significant risk aversion is finding parity of internal and external interest rates. Brazil implemented fiscal consolidation and reforms that are advisable in explosive foreign debt environments. In addition, Brazil had the capacity to find parity in external and internal interest rates to prevent capital flight and disruption of balance sheets (for analysis of balance sheets, interest rates, indexing, devaluation, financial instruments and asset/liability management in that period see Pelaez and Pelaez (2007), The Global Recession Risk: Dollar Devaluation and the World Economy, 178-87). Table III-13 provides monthly percentage changes of inflation, devaluation and indexing and the monthly percent overnight interest rate. Parity was attained by means of a simple inequality:
Cost of Domestic Loan ≥ Cost of Foreign Loan
This ordering was attained in practice by setting the domestic interest rate of the overnight interest rate plus spread higher than indexing of government securities with lower spread than loans in turn higher than devaluation plus spread of foreign loans. Interest parity required equality of inflation, devaluation and indexing. Brazil devalued the cruzeiro by 30 percent in 1983 because the depreciation of the German mark DM relative to the USD had eroded the competitiveness of Brazil’s products in Germany and in competition with German goods worldwide. The database of the Board of Governors of the Federal Reserve System quotes DM 1.7829/USD on Mar 3 1980 and DM 2.4425/USD on Mar 15, 1983 (http://www.federalreserve.gov/releases/h10/hist/dat89_ge.htm) for devaluation of 37.0 percent. Parity of costs and rates of domestic and foreign loans and assets required ensuring that there would not be appreciation of the exchange rate, inducing capital flight in expectation of future devaluation that would have reversed stabilization. One of the main problems of adjustment of members of the euro area with high debts is that they cannot adjust the exchange rate because of the common euro currency. This is not an argument in favor of breaking the euro area because there would be also major problems of adjustment such as exiting the euro in favor of a new Drachma in the case of Greece. Another hurdle of adjustment in the euro area is that Brazil could have moved swiftly to adjust its economy in 1983 but the euro area has major sovereignty and distribution of taxation hurdles in moving rapidly.
Table III-13, Brazil, Inflation, Devaluation, Overnight Interest Rate and Indexing, Percent per Month, 1984
| 1984 | Inflation IGP ∆% | Devaluation ∆% | Overnight Interest Rate % | Indexing ∆% |
| Jan | 9.8 | 9.8 | 10.0 | 9.8 |
| Feb | 12.3 | 12.3 | 12.2 | 12.3 |
| Mar | 10.0 | 10.1 | 11.3 | 10.0 |
| Apr | 8.9 | 8.8 | 10.1 | 8.9 |
| May | 8.9 | 8.9 | 9.8 | 8.9 |
| Jun | 9.2 | 9.2 | 10.2 | 9.2 |
| Jul | 10.3 | 10.2 | 11.9 | 10.3 |
| Aug | 10.6 | 10.6 | 11.0 | 10.6 |
| Sep | 10.5 | 10.5 | 11.9 | 10.5 |
| Oct | 12.6 | 12.6 | 12.9 | 12.6 |
| Nov | 9.9 | 9.9 | 10.9 | 9.9 |
| Dec | 10.5 | 10.5 | 11.5 | 10.5 |
Source: Carlos Manuel Pelaez, O Cruzado e o Austral: Análise das Reformas Monetárias do Brasil e da Argentina. São Paulo, Editora Atlas, 1986, 86.
IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table IV-1, updated with every blog comment, provides the latest annual data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of sovereign risk issues (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table IV-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table IV-1. Data for other countries in Table IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.
Table IV-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 2.0 | 1.7 | 1.9 | 8.2 |
| Japan | 2.8 | 0.4 | -0.5 | 4.6 |
| China | 8.9 | 3.0 | -1.4 | |
| UK | -0.1 | 2.8* | 2.8* output | 8.2 |
| Euro Zone | -0.1 | 2.4 | 2.6 | 11.0 |
| Germany | 1.2 | 2.2 | 2.4 | 5.4 |
| France | 0.3 | 2.3 | 2.7 | 10.2 |
| Nether-lands | -1.3 | 2.5 | 3.0 | 5.2 |
| Finland | 1.7 | 3.1 | 2.3 | 7.6 |
| Belgium | 0.5 | 2.6 | 2.0 | 7.4 |
| Portugal | -2.2 | 2.7 | 3.6 | 15.2 |
| Ireland | NA | 1.9 | 3.1 | 14.2 |
| Italy | -1.3 | 3.5 | 2.5 | 10.2 |
| Greece | -6.2 | 0.9 | 5.2 | NA |
| Spain | -0.4 | 1.9 | 3.1 | 24.3 |
Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier
*Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/may-2012/index.html **Core
PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/may-2012/index.html
Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html
Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 2.0 percent in IQ2012 relative to IQ2011 (Table 8, p 11 in http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp1q12_adv.pdf See Section II Mediocre Economic Growth at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html and earlier http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment.html). Japan’s GDP fell 0.6 percent in IVQ2011 relative to IVQ2010 and contracted 1.8 percent in IIQ2011 relative to IIQ2010 because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 but grew at the seasonally-adjusted annual rate (SAAR) of 7.8 percent in IIIQ2011, increasing at the SAAR of 0.1 percent in IVQ 2011 and 4.7 percent in IQ2012 (see Section VB at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html); the UK grew at minus 0.1 percent in IQ2012 relative to IQ2011 and GDP fell 0.3 percent in IQ2012 relative to IVQ2011 (see Section VB http://cmpassocregulationblog.blogspot.com/2012/05/world-financial-turbulence-global_27.html); and the Euro Zone grew at 0.0 percent in both IQ2012 relative to IVQ2011 and fell 0.1 percent in IQ2012 relative to IQ2011 (see Section VD http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities_10.html and http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-06062012-AP/EN/2-06062012-AP-EN.PDF). These are stagnating or “growth recession” rates, which are positive or about nil growth rates instead of contractions but insufficient to recover employment. The rates of unemployment are quite high: 8.2 percent in the US but 17.6 percent for unemployment/underemployment or job stress of 28.4 million (see Table I-4 in Section I at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html and earlier http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/thirty-million-unemployed-or.html), 4.6 percent for Japan (see Section VB http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment_29.html), 8.2 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in Subsection VH and earlier at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy_20.html) and 11.0 percent in the Euro Zone (section VD http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html and earlier http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight_06.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.7 percent in the US, 0.4 percent for Japan, 3.0 percent for China, 2.4 percent for the Euro Zone and 2.8 percent for the UK (see Section IV and earlier http://cmpassocregulationblog.blogspot.com/2012/05/world-financial-turbulence-global_27.html). Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section III in this post and the earlier post http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.html); (2) the tradeoff of growth and inflation in China now with change in growth strategy to domestic consumption instead of investment and political developments in a decennial transition; (3) slow growth by repression of savings with de facto interest rate controls (see section I http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html and earlier http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment.html), weak hiring with the loss of 10 million full-time jobs (see section I and earlier http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-hiring-ten-million.html and http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (see Section I Twenty Eight Million Unemployed or Underemployed http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see IV Budget/Debt Quagmire in http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) geopolitical events in the Middle East.
In the effort to increase transparency, the Federal Open Market Committee (FOMC) provides both economic projections of its participants and views on future paths of the policy rate that in the US is the federal funds rate or interest on interbank lending of reserves deposited at Federal Reserve Banks. These projections and views are discussed initially followed with appropriate analysis.
The statement of the FOMC at the conclusion of its meeting on Apr 25, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20120620a.htm):
“Release Date: June 20, 2012
For immediate release
Information received since the Federal Open Market Committee met in April suggests that the economy has been expanding moderately this year. However, growth in employment has slowed in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending appears to be rising at a somewhat slower pace than earlier in the year. Despite some signs of improvement, the housing sector remains depressed. Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities. Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
There are several important issues in this statement.
1. Mandate. The FOMC pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):
“Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”
2. Extending Average Maturity of Holdings of Securities. The statement of Apr 25, 2012, invokes the mandate that inflation is subdued but employment below maximum such that further accommodation is required. Accommodation consists of low interest rates. The new “Operation Twist” (http://cmpassocregulationblog.blogspot.com/2011_09_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html) or restructuring the portfolio of securities of the Fed by selling short-dated securities and buying long-term securities has the objective of reducing long-term interest rates. Lower interest rates would stimulate consumption and investment, or aggregate demand, increasing the rate of economic growth and thus reducing stress in job markets. Policy now focuses on improving conditions in real estate by attempting to reduce mortgage rates: “The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.”
3. Continuing Maturity Extension Program. This program is discussed in Section II Twist Again Extension. The statement affirms: “The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities. Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative.”
4. Target of Fed Funds Rate. The FOMC continues to maintain the target of fed funds rate at 0 to ¼ percent.
5. Advance Guidance. The FOMC increases transparency by advising on the expectation of the future path of fed funds rate. This guidance is the view that conditions such as “low rates of resource utilization and a subdued outlook for inflation over the medium run are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”
6. Monitoring and Policy Focus. The FOMC reconsiders its policy continuously in accordance with available information: “The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
These policy statements are carefully crafted to express the intentions of the FOMC. The main objective of the statements is to communicate as clearly and firmly as possible the intentions of the FOMC to fulfill its dual mandate. During periods of low inflation and high unemployment and underemployment such as currently the FOMC may be more biased toward measures that stimulate the economy to reduce underutilization of workers and other productive resources. The FOMC also is vigilant about inflation and ready to change policy in the effort to attain its dual mandate.
Table IV-2 provides economic projections of governors of the Board of Governors of the Federal Reserve and regional presidents of Federal Reserve Banks released at the meeting of Jun 20, 2012. The Fed releases the data with careful explanations (http://www.federalreserve.gov/newsevents/press/monetary/20120620b.htm). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IQ2012 is analyzed in a prior blog post together with the PCE inflation data from the report on personal income and outlays (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The Bureau of Economic Analysis (BEA) provides the second estimate of IQ2012 GDP with the third estimate to be released on Jun 28 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed in this blog as soon as available (for the latest report for Apr see http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm and http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The next report on “Personal Income and Outlays” for May will be released at 8:30 AM on Jun 29, 2012. PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog (the May report is analyzed at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). The report for Jun will be released on July 6, 2012 (http://www.bls.gov/cps/). “Longer term projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf).
It is instructive to focus on 2012, as 2013, 2014 and longer term are too far away, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Jun 20, 2012, and the second row “PR” the projection of the Apr 25, 2012 meeting. There are three major changes in the view.
1. Growth “∆% GDP.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun 2011 to 2.5 to 2.9 percent in Nov 2011 and 2.2 to 2.7 percent at the Jan 25 meeting but increased it to 2.4 to 2.9 percent at the Apr 25, 2012 meeting, reducing it to 1.9 to 2.4 percent at the Jun 20, 2012 meeting.
2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun 2011 to 8.5 to 8.7 percent in Nov 2011 but has reduced it to 8.2 to 8.5 percent at the Jan 25 meeting and further down to 7.8 to 8.0 percent at the Apr 25, 2012 meeting but increased it to 8.0 to 8.2 percent at the Jun 20, 2012 meeting.
3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun 2011 to virtually the same of 1.4 to 2.0 percent in Nov 2011 but has reduced it to 1.4 to 1.8 percent at the Jan 25 meeting but increased it to 1.9 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.2 to 1.7 percent at the Jun 20, 2012 meeting.
4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun 2011 of 1.4 to 2.0 percent and the Nov 2011 projection of 1.5 to 2.0 percent, which has been reduced slightly to 1.5 to 1.8 percent at the Jan 25 meeting but increased to 1.8 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.7 to 2.0 percent at the Jun 20, 2012 meeting.
Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, June 2012 and April 2012
| ∆% GDP | UNEM % | ∆% PCE Inflation | ∆% Core PCE Inflation | |
| Central | ||||
| 2012 Apr PR | 1.9 to 2.4 2.4 to 2.9 | 8.0 to 8.2 7.8 to 8.0 | 1.2 to 1.7 1.9 to 2.0 | 1.7 to 2.0 1.8 to 2.0 |
| 2013 | 2.2 to 2.8 | 7.5 to 8.0 | 1.5 to 2.0 | 1.6 to 2.0 1.7 to 2.0 |
| 2014 | 3.0 to 3.5 | 7.0 to 7.7 | 1.5 to 2.0 | 1.6 to 2.0 |
| Longer Run Apr PR | 2.3 to 2.5 2.3 to 2.6 | 5.2 to 6.0 5.2 to 6.0 | 2.0 2.0 | |
| Range | ||||
| 2012 | 1.6 to 2.5 | 7.8 to 8.4 | 1.2 to 2.0 | 1.7 to 2.0 |
| 2013 | 2.2 to 3.5 | 7.0 to 8.1 | 1.5 to 2.1 | 1.4 to 2.1 |
| 2014 | 2.8 to 4.0 | 6.3 to 7.7 | 1.5 to 2.2 | 1.5 to 2.2 |
| Longer Run Apr PR | 2.2 to 3.0 2.2 to 3.0 | 4.9 to 6.3 4.9 to 6.0 | 2.0 2.0 |
Notes: UEM: unemployment; PR: Projection
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf
Another important decision at the FOMC meeting on Jan 25, 2012, is formal specification of the goal of inflation of 2 percent per year but without specific goal for unemployment (http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm):
“Following careful deliberations at its recent meetings, the Federal Open Market Committee (FOMC) has reached broad agreement on the following principles regarding its longer-run goals and monetary policy strategy. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.
The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.
Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.
The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier.
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. ”
The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; 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). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.
The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table IV-3 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 2012, 2013, 2014 and the in the longer term. Table IV-3 is inferred from a chart provided by the FOMC with the number of participants expecting the target of fed funds rate (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf). There are 16 participants expecting the rate to remain at 0 to ¼ percent in 2012 and only three to be higher. Not much change is expected in 2013 either with 13 participants anticipating the rate at the current target of 0 to ¼ percent and only six expecting higher rates. The rate would still remain at 0 to ¼ percent in 2014 for six participants with five expecting the rate to be in the range of 0.5 to 1 percent and five participants expecting rates from 1 to 2.0 percent but only three with rates exceeding 2.0 percent. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014.
Table IV-3, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012
| 0 to 0.25 | 0.5 to 1.0 | 1.0 to 1.5 | 1.0 to 2.0 | 2.0 to 3.0 | 3.0 to 4.5 | |
| 2012 | 16 | 3 | ||||
| 2013 | 13 | 2 | 3 | 1 | ||
| 2014 | 6 | 5 | 5 | 3 | ||
| Longer Run | 19 |
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf
Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2012 to 2015. It is evident from Table IV-4 that the prevailing view in the FOMC is for interest rates to continue at low levels in future years. This view is consistent with the economic projections of low economic growth, relatively high unemployment and subdued inflation provided in Table IV-2.
Table IV-4, US, Views of Appropriate Year of Increasing Target Federal Funds Rate of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012
| Appropriate Year of Increasing Target Fed Funds Rate | Number of Participants |
| 2012 | 3 |
| 2013 | 3 |
| 2014 | 7 |
| 2015 | 6 |
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf
Price indexes of the Federal Reserve Bank of Philadelphia Outlook Survey are provided in Table IV-5. As inflation waves throughout the world (analyzed in http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.html), indexes of both current and expectations of future prices paid and received were quite high until May 2011. Prices paid, or inputs, were more dynamic, reflecting carry trades from zero interest rates to commodity futures. All indexes softened after May 2001 with even decline of prices received in Aug during the first round of risk aversion. Current and future price indexes have increased again but not back to the levels in the beginning of 2011 because of risk aversion frustrating carry trades even under zero interest rates. In Jun 2012, the index of current prices received was minus 6.9 percent, indicating contraction of prices received, while the index of current prices paid fell from 22.5 in Apr to minus 2.8 in Jun, indicating moderate contraction. The index of future prices paid increased from 35.2 percent in Apr 2012 to 37.8 in May but falling to 20.1 in Jun, indicating lower expectation of increases in prices paid or prices of inputs while the index of future prices received fell from 20.4 percent in Apr 2012 to 7.7 percent in May and 13.5 in Jun, indicating softness in expected future prices received or sales prices.
Table IV-5, US, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current and Future Prices Paid and Prices Received, SA
| Current Prices Paid | Current Prices Received | Future Prices Paid | Future Prices Received | |
| Jun 2012 | -2.8 | -6.9 | 20.1 | 13.5 |
| May | 5.0 | -4.5 | 37.8 | 7.7 |
| Apr | 22.5 | 9.4 | 35.2 | 20.4 |
| Mar | 18.7 | 8.4 | 39.4 | 25.6 |
| Feb | 38.7 | 15.0 | 50.4 | 32.0 |
| Jan | 31.8 | 11.2 | 52.7 | 23.8 |
| Dec 2011 | 30.4 | 10.3 | 49.4 | 26.4 |
| Nov | 25.9 | 6.2 | 41.0 | 28.1 |
| Oct | 23.5 | 1.6 | 44.8 | 27.2 |
| Sep | 25.0 | 3.9 | 37.8 | 22.0 |
| Aug | 20.1 | -6.0 | 40.2 | 20.1 |
| Jul | 30.2 | 3.9 | 44.2 | 12.7 |
| Jun | 32.8 | 5.2 | 30.5 | 4.1 |
| May | 46.4 | 16.3 | 53.4 | 27.0 |
| Apr | 54.4 | 23.0 | 55.4 | 33.5 |
| Mar | 59.8 | 19.3 | 63.6 | 34.8 |
| Feb | 63.2 | 17.5 | 67.8 | 35.9 |
| Jan | 51.9 | 14.5 | 62.8 | 36.0 |
Source: Federal Reserve Bank of Philadelphia http://www.philadelphiafed.org/index.cfm
Chart IV-1, Federal Reserve Bank of Philadelphia Business Outlook Survey Current Prices Paid Diffusion Index SA
Source: Federal Reserve Bank of Philadelphia
http://www.phil.frb.org/index.cfm
Chart IV-2 of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia provides the current diffusion index of prices received, which are prices of sales of products by companies. There is much less dynamism than in prices paid because commodity-rich inputs are only part of total costs. The high levels early in 2011 have not been realized again under the pressure on carry trades of risk financial assets from the European debt crisis and the index crossed again downward into the contraction zone below 0.
Chart IV-2, Federal Reserve Bank of Philadelphia Business Outlook Survey Current Prices Received Diffusion Index SA
Source: Federal Reserve Bank of Philadelphia
http://www.phil.frb.org/index.cfm
The producer price index of Germany fell 0.3 percent in May relative to Apr and increased 2.1 percent in the 12 months ending in May, as shown in Table IV-6. The producer price index of Germany has similar waves of inflation as in many other countries (http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.html). In the first wave from Jan to Apr 2011, the annual equivalent rate of producer price inflation was 10.4 percent, propelled by carry trades from zero interest rates to exposures in commodity futures in a mood of risk appetite. In the second wave in May and Jun 2011, the annual equivalent rate of producer price inflation was only 0.6 percent because of the collapse of the carry trade in fear of risks of European sovereign debt. In the third wave from Jul to Sep 2011, annual-equivalent producer price inflation in Germany was 2.8 percent with fluctuations in commodity prices resulting from perceptions of the sovereign risk crisis in Europe. In the fourth wave from Oct to Nov 2011, annual equivalent inflation was 1.8 percent as financial markets were shocked with strong risk aversion. In the fifth wave from Dec 2011 to Jan 2012, annual equivalent inflation was at 1.2 percent. In the sixth wave, annual equivalent inflation increased to 6.2 percent in Feb-Mar 2012 and 4.9 percent in Feb-Apr. In the seventh wave, annual equivalent inflation was minus 3.5 percent in May 2012. Annual data in the bottom of Table IV-6 show that the producer price index fell 5.2 percent in the 12 months ending in Dec 2009 as a result of the fall of commodity prices originating in risk aversion after the panic of 2008.
Table IV-6, Germany, Index of Producer Prices for Industrial Products ∆%
| 12 Months ∆% NSA | Month ∆% Calendar and SA | |
| May 2012 | 2.1 | -0.3 |
| AE ∆% May | -3.5 | |
| Apr | 2.4 | 0.2 |
| Mar | 3.3 | 0.6 |
| Feb | 3.2 | 0.4 |
| AE ∆% Feb-Apr | 4.9 | |
| Jan | 3.4 | 0.6 |
| Dec 2011 | 4.0 | -0.4 |
| AE ∆% Dec-Jan | 1.2 | |
| Nov | 5.2 | 0.1 |
| Oct | 5.3 | 0.2 |
| AE ∆% Oct-Nov | 1.8 | |
| Sep | 5.5 | 0.3 |
| Aug | 5.5 | -0.3 |
| Jul | 5.8 | 0.7 |
| AE ∆% Jul-Sep | 2.8 | |
| Jun | 5.6 | 0.1 |
| May | 6.1 | 0.0 |
| AE ∆% May-Jun | 0.6 | |
| Apr | 6.4 | 1.0 |
| Mar | 6.2 | 0.4 |
| Feb | 6.4 | 0.7 |
| Jan | 5.7 | 1.2 |
| AE ∆% Jan-Apr | 10.4 | |
| Dec 2010 | 5.3 | 0.7 |
| Nov | 4.4 | 0.2 |
| Oct | 4.3 | 0.4 |
| Sep | 3.9 | 0.3 |
| Aug | 3.2 | 0.0 |
| Jul | 3.7 | 0.5 |
| Jun | 1.7 | 0.6 |
| May | 0.9 | 0.3 |
| Apr | 0.6 | 0.8 |
| Mar | -1.5 | 0.7 |
| Feb | -2.9 | 0.0 |
| Jan | -3.4 | 0.8 |
| Dec 2009 | -5.2 | -0.1 |
| Dec 2008 | 4.0 | -0.8 |
| Dec 2007 | 1.9 | -0.1 |
| Dec 2006 | 4.2 | 0.1 |
| Dec 2005 | 4.8 | 0.3 |
| Dec 2004 | 2.9 | 0.1 |
| Dec 2003 | 1.8 | 0.0 |
| Dec 2002 | 0.5 | 0.1 |
| Dec 2001 | 0.1 | -0.2 |
Source: https://www.destatis.de/EN/PressServices/Press/pr/2012/06/PE12_210_61241.html;jsessionid=0CB77C7988F7FA1404D1DF860EA86B9F.cae1 https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html
Chart IV-3 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the producer price index of Germany from 2003 to 2012. Producer price inflation peaked in 2008 with the rise of commodity prices induced by the carry trade from zero interest rates to commodity futures. Prices then declined with the flight away from risk financial assets to government obligations after the financial panic in Sep 2008. With zero interest rates and no risk aversion, the carry trade pushed commodity future prices upwardly resulting in new rising trend of the producer price index. The right-hand side of the chart shows moderation and even decline in prices because of severe risk aversion frustrating carry trades from zero interest rates to commodity futures but then return of risk appetite with another surge of the index in annual equivalent rate at 6.2 percent in Feb-Mar 2012 and 4.9 percent annual equivalent in Feb-Apr 2012 but decline of 0.3 percent in May 2012 at annual equivalent rate of minus 3.5 percent.
Chart IV-3, Germany, Index of Producer Prices for Industrial Products, 2005=100
Source: Statistiche Bundesamt Deutschland
https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html
Chart IV-4 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the unadjusted producer price index and trend. There is a clear upward trend of prices after the end of risk aversion with zero interest rates in 2009. The actual curve fell below trend in the current episode of severe risk aversion but rose again in Feb-Apr 2012, falling in May 2012.
Chart IV-4, Germany, Producer Price Index, Non-adjusted Value and Trend, 2005=100
Source: Statistiche Bundesamt Deutschland
https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html
Consumer price inflation in the UK is shown in Table IV-7. The CPI index fell 0.1 percent in May. The same inflation waves (http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.html) are present in UK CPI inflation. In the first wave in Jan-Apr 2011, annual equivalent inflation was at a high 6.5 percent. In the second wave in May-Jul, annual equivalent inflation fell to only 0.4 percent. In the third wave in Aug-Dec 2011, annual equivalent inflation returned at 4.6 percent. In the fourth wave in Dec 2011 to Jan 2012, annual equivalent inflation was minus 0.6 percent because of decline of 0.5 percent in Jan 2012. In the fifth wave, annual equivalent inflation increased to 6.2 percent in Feb-Apr 2012. In the seventh wave, annual equivalent inflation was minus 1.2 percent in May 2012.
Table IV-7, UK, Consumer Price Index All Items, Month and 12-Month ∆%
| Month ∆% | 12 Months ∆% | |
| May 2012 | -0.1 | 2.8 |
| AE ∆% May | -1.2 | |
| Apr | 0.6 | 3.0 |
| Mar | 0.3 | 3.5 |
| Feb | 0.6 | 3.4 |
| AE ∆% Feb-Apr | 6.2 | |
| Jan | -0.5 | 3.6 |
| Dec 2011 | 0.4 | 4.2 |
| AE ∆% Dec-Jan | -0.6 | |
| Nov | 0.2 | 4.8 |
| Oct | 0.1 | 5.0 |
| Sep | 0.6 | 5.2 |
| Aug | 0.6 | 4.5 |
| AE ∆% Aug-Dec | 4.6 | |
| Jul | 0.0 | 4.4 |
| Jun | -0.1 | 4.2 |
| May | 0.2 | 4.5 |
| May-Jul | 0.4 | |
| Apr | 1.0 | 4.5 |
| Mar | 0.3 | 4.0 |
| Feb | 0.7 | 4.4 |
| Jan | 0.1 | 4.0 |
| AE ∆% Jan-Apr | 6.5 | |
| Dec 2010 | 1.0 | 3.7 |
| Nov | 0.4 | 3.3 |
| Oct | 0.3 | 3.2 |
| Sep | 0.0 | 3.1 |
| Aug | 0.5 | 3.1 |
| Jul | -0.2 | 3.1 |
| Jun | 0.1 | 3.2 |
| May | 0.2 | 3.4 |
| Apr | 0.6 | 3.7 |
| Mar | 0.6 | 3.4 |
| Feb | 0.4 | 3.0 |
| Jan | -0.2 | 3.5 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/may-2012/index.html
Inflation has been unusually high in the UK since 2006, as shown in Table IV-8. There were no rates of inflation close to 2.0 percent in the period from 1997 to 2004. Inflation has exceeded 2 percent since 2005, reaching 3.6 percent in 2008, 3.3 percent in 2010 and 4.5 percent in 2011.
Table IV-8, UK, Consumer Price Index, Annual ∆%
| 1997 | 1.8 |
| 1998 | 1.6 |
| 1999 | 1.3 |
| 2000 | 0.8 |
| 2001 | 1.2 |
| 2002 | 1.3 |
| 2003 | 1.4 |
| 2004 | 1.3 |
| 2005 | 2.1 |
| 2006 | 2.3 |
| 2007 | 2.3 |
| 2008 | 3.6 |
| 2009 | 2.2 |
| 2010 | 3.3 |
| 2011 | 4.5 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/may-2012/index.html
Table IV-9 provides the analysis of inflation in Apr 2012 by the UK Office for National Statistics. The positive drivers of monthly inflation of 0.1 percent are 0.05 percentage points of restaurants and hotels and equal 0.04 percentage points of food and alcoholic beverages and furniture and household goods. Transportation subtracted 0.13 percentage points and recreation and culture subtracted 0.05 percentage points. Contributions of percentage points to the 12-month rate of consumer price inflation of 2.8 percent are provided by the final two columns in Table IV-9. Housing and household services rose 6.2 percent in 12 months, contributing 0.80 percentage points. There were equal contributions of 0.38 percentage points by food and nonalcoholic beverages and restaurants and hotels. Transportation rose 1.7 percent in 12 months, contributing 0.27 percentage points. There is only negative change of 0.7 percent in recreation and culture but with negligible impact on the index of deducting 0.10 percentage points.
Table IV-9, UK, Consumer Price Index Month ∆% and Percentage Point Contribution by Components
| May 2012 | Month ∆% | Percentage Point Contribution | 12 Months ∆% | Percentage Point Contribution |
| CPI All Items | -0.1 | 2.8 | ||
| Food & Non-Alcoholic Beverages | 0.3 | 0.04 | 3.3 | 0.38 |
| Alcohol & Tobacco | -0.1 | 0.00 | 4.8 | 0.20 |
| Clothing & Footwear | -0.1 | -0.01 | 1.6 | 0.12 |
| Housing & Household Services | -0.1 | -0.01 | 6.2 | 0.80 |
| Furniture & Household Goods | 0.6 | 0.04 | 3.9 | 0.24 |
| Health | 0.0 | 0.00 | 3.3 | 0.08 |
| Transport | -0.8 | -0.13 | 1.7 | 0.27 |
| Communication | 0.8 | 0.02 | 4.1 | 0.11 |
| Recreation & Culture | -0.4 | -0.05 | -0.7 | -0.10 |
| Education | 0.0 | 0.00 | 5.1 | 0.09 |
| Restaurants & Hotels | 0.4 | 0.05 | 3.3 | 0.38 |
| Miscellaneous Goods & Services | 0.0 | 0.00 | 2.1 | 0.20 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/may-2012/index.html
© Carlos M. Pelaez, 2010, 2011, 2012
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