Sunday, August 19, 2012

World Inflation Waves, Loss of Dynamism of the United States Economy, Financial Risks and World Economic Slowdown with Global Recession Risk: PartI

 

World Inflation Waves, Loss of Dynamism of the United States Economy, Financial Risks and World Economic Slowdown with Global Recession Risk

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011, 2012

Executive Summary

I World Inflation Waves

I World Inflation Waves

IA Appendix: Transmission of Unconventional Monetary Policy

IAi Theory

IAii Policy

IAiii Evidence

IAiv Unwinding Strategy

II United States Inflation

IIA Long-term US Inflation

IIB Current US Inflation

III World Financial Turbulence

IIIA Financial Risks

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

IIID Appendix on European Central Bank Large Scale Lender of Last Resort

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

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

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

1. Unconventional monetary policy or its expectation can increase stock market valuations (Bernanke 2010WP). Increases in equities traded in stock markets can augment perceptions of the wealth of consumers inducing increases in consumption.

2. Unconventional monetary policy causes devaluation of the dollar relative to other currencies, which can cause increases in net exports of the US that increase aggregate economic activity (Yellen 2011AS).

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

Table ESI-1 provides annual equivalent rates of inflation for producer price indexes followed in this blog. The behavior of the US producer price index in 2011 and into 2012 shows neatly multiple waves. (1) In Jan-Apr 2011, without risk aversion, US producer prices rose at the annual equivalent rate of 9.7 percent. (2) After risk aversion, producer prices increased in the US at the annual equivalent rate of 1.2 percent in May-Jun 2011. (3) From Jul to Sep 2011, under alternating episodes of risk aversion, producer prices increased at the annual equivalent rate of 6.6 percent. (4) Under the pressure of risk aversion because of the European debt crisis US producer prices fell at the annual equivalent rate of minus 1.2 percent in Oct-Nov 2011. (5) From Dec 2011 to Jan 2012, US producer prices rose at the annual equivalent rate of 1.2 percent with relaxed risk aversion and commodity-price increases at the margin. (6) Inflation of producer prices returned with 1.2 percent annual equivalent in Feb-Mar 2012. (7) With return of risk aversion from the European debt crisis, producer prices fell at the annual equivalent rate of 7.0 percent in Apr-Jun 2012. (8) New positions in commodity futures even with continuing risk aversion caused annual equivalent inflation of 2.4 percent in Jun-Jul 2012. Resolution of the European debt crisis if there is not an unfavorable growth event with political development in China would result in jumps of valuations of risk financial assets. Increases in commodity prices would cause the same high producer price inflation experienced in Jan-Apr 2011. There are nine producer-price indexes in Table ESI-1 for seven countries (two for the UK) and one region (euro area) showing very similar behavior. Zero interest rates without risk aversion cause increases in commodity prices that in turn increase input and output prices. Producer price inflation rose at very high rates during the first part of 2011 for the US, Japan, China, Euro Area, Germany, France, Italy and the UK when risk aversion was contained. With the increase in risk aversion in May and Jun, inflation moderated because carry trades were unwound. Producer price inflation returned after July 2011, with alternating bouts of risk aversion. In the final months of the year producer price inflation collapsed because of the disincentive to exposures in commodity futures resulting from fears of resolution of the European debt crisis. There is renewed worldwide inflation in the early part of 2012 with subsequent collapse because of another round of sharp risk aversion. Unconventional monetary policy fails in stimulating the overall real economy, merely introducing undesirable instability as monetary authorities cannot control allocation of floods of money at zero interest rates to carry trades into risk financial assets.  

Table ESI-1, Annual Equivalent Rates of Producer Price Indexes

INDEX 2011-2012

AE ∆%

US Producer Price Index

 

AE  ∆% Jun-Jul 2012

2.4

AE  ∆% Apr-May 2012

-7.0

AE  ∆% Feb-Mar 2012

1.2

AE  ∆% Dec 2011-Jan-2012

1.2

AE  ∆% Oct-Nov 2011

-1.2

AE ∆% Jul-Sep 2011

6.6

AE ∆% May-Jun 2011

1.2

AE ∆% Jan-Apr 2011

9.7

Japan Corporate Goods Price Index

 

AE ∆%  May-Jul 2012

-6.2

AE ∆%  Feb-Apr 2012

3.3

AE ∆% Dec 2011-Jan 2012

-0.6

AE ∆% Jul-Nov 2011

-2.2

AE ∆% May-Jun 2011

-1.2

AE ∆% Jan-Apr 2011

5.9

Euro Zone Industrial Producer Prices

 

AE ∆% Apr-Jun 2012

-3.9

AE ∆% Jan-Mar 2012

8.3

AE ∆% Oct-Dec 2011

0.8

AE ∆% Jul-Sep

2.0

AE ∆% May-Jun

-1.2

AE ∆% Jan-Apr

12.0

China Producer Price Index

 

AE ∆% May-Jul 2012

-7.3

AE ∆% Feb-Apr 2012

2.4

AE ∆% Dec 2011-Jan 2012

-2.4

AE ∆% Jul-Nov 2011

-3.1

AE ∆% Jan-Jun 2011

6.4

Germany Producer Price Index

 

AE ∆% May-Jul 2012

-2.8 NSA 1.2 SA

AE ∆% Feb-Apr 2012

4.9 NSA 0.8 SA

AE ∆% Dec 2011-Jan 2012

1.2 NSA 0.0 SA

AE ∆% Oct-Nov 2011

1.8 NSA 3.7 SA

AE ∆% Jul-Sep 2011

2.8 NSA 4.9 SA

AE ∆% May-Jun 2011

0.6 NSA 3.0 SA

AE ∆% Jan-Apr 2011

10.4 NSA 6.5 SA

France Producer Price Index for the French Market

 

AE ∆% Apr-Jun 2012

-7.7

AE ∆% Jan-Mar 2012

8.3

AE ∆% Oct-Dec 2011

2.4

AE ∆% Jul-Sep 2011

2.8

AE ∆% May-Jun 2011

-3.5

AE ∆% Jan-Apr 2011

11.4

Italy Producer Price Index

 

AE ∆% May-Jun 2012

-2.4

AE ∆% Mar-Apr 2012

4.3

AE ∆% Jan-Feb 2012

7.4

AE ∆% Nov 2011-Jan 2012

4.5

AE ∆% Oct-Dec 2011

0.4

AE ∆% Jul-Sep 2011

2.4

AE ∆% May-Jun 2011

-1.2

AE ∆% Jan-April 2011

10.7

UK Output Prices

 

AE ∆% May-Jul 2012

-3.5

AE ∆% Feb-Apr 2012

7.9

AE ∆% Nov 2011-Jan-2012

1.6

AE ∆% May-Oct 2011

2.0

AE ∆% Jan-Apr 2011

12.0

UK Input Prices

 

AE ∆% Jul 2012

16.8

AE ∆% Apr-Jun 2012

-24.4

AE ∆% Jan-Mar 2012

18.1

AE ∆% Nov-Dec 2011

-1.2

AE ∆% May-Oct 2011

-3.1

AE ∆% Jan-Apr 2011

35.6

AE: Annual Equivalent

Sources:

http://www.bls.gov/ppi/

http://www.boj.or.jp/en/

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

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

https://www.destatis.de/EN/Homepage.html

http://www.insee.fr/en/default.asp

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

http://www.ons.gov.uk/ons/index.html

Similar world inflation waves are in the behavior of consumer price indexes of six countries and the euro zone in Table ESI-2. US consumer price inflation shows similar waves. (1) Under risk appetite in Jan-Apr 2011 consumer prices increased at the annual equivalent rate of 4.9 percent. (2) Risk aversion caused the collapse of inflation to annual equivalent 2.8 percent in May-Jul 2011. (3) Risk appetite drove the rate of consumer price inflation in the US to 3.7 percent in Jul-Sep 2011. (4) Gloomier views of carry trades caused the collapse of inflation in Oct-Nov 2011 to annual equivalent 0.6 percent. (5) Consumer price inflation resuscitated with increased risk appetite at annual equivalent of 1.2 percent in Dec 2011 to Jan 2012. (6) Consumer price inflation returned at 2.8 percent annual equivalent in Feb-Apr 2012. (7) Under renewed risk aversion, annual equivalent consumer price inflation in the US is minus 1.2 percent in May-Jul 2012. There is similar behavior in all the other consumer price indexes in Table ESI-2. China’s CPI increased at annual equivalent 8.3 percent in Jan-Mar 2011, 2.0 percent in Apr-Jun, 2.9 percent in Jul-Dec and resuscitated at 5.8 percent annual equivalent in Dec 2011 to Mar 2012, declining to minus 2.7 percent in Apr-Jul 2012. The euro zone harmonized index of consumer prices (HICP) increased at annual equivalent 5.2 percent in Jan-Apr 2011, minus 2.4 percent in May-Jul, 4.3 percent in Aug-Dec, minus 3.0 percent in Dec 2011-Jan 2012 and then 9.6 percent in Feb-Apr 2012, falling to minus 2.8 percent annual equivalent in May-Jul 2012. The price indexes of the largest members of the euro zone, Germany, France and Italy, and the euro zone as a whole, exhibit the same inflation waves. The United Kingdom CPI increased at annual equivalent 6.5 percent in Jan-Apr 2011, falling to only 0.4 percent in May-Jul and then increasing at 4.6 percent in Aug-Nov. UK consumer prices fell at 0.6 percent annual equivalent in Dec 2011 to Jan 2012 but increased at 6.2 percent annual equivalent from Feb to Apr 2012. In May-Jun 2012, with renewed risk aversion, UK consumer prices fell at the annual equivalent rate of minus 3.0 percent. Inflation returned at 1.2 percent annual equivalent in Jul 2012.

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

Index 2011-2012

AE ∆%

US Consumer Price Index

 

AE ∆% May-Jul 2012

-1.2

AE ∆% Feb-Apr 2012

2.8

AE ∆% Dec 2011-Jan  2012

1.2

AE ∆% Oct-Nov 2011

0.6

AE ∆% Jul-Sep 2011

3.7

AE ∆% May-Jul 2011

2.8

AE ∆% Jan-Apr 2011

4.9

China Consumer Price Index

 

AE ∆% Apr-Jul 2012

-2.7

AE ∆% Dec 2011-Mar 2012

5.8

AE ∆% Jul-Nov 2011

2.9

AE ∆% Apr-Jun 2011

2.0

AE ∆% Jan-Mar 2011

8.3

Euro Zone Harmonized Index of Consumer Prices

 

AE ∆% May-Jul 2012

-2.8

AE ∆% Feb-Apr 2012

9.6

AE ∆% Dec 2011-Jan 2012

-3.0

AE ∆% Aug-Dec 2011

4.3

AE ∆% May-Jul 2011

-2.4

AE ∆% Jan-Apr 2011

5.2

Germany Consumer Price Index

 

AE ∆% Jul 2012

4.9 NSA 2.4 SA

AE ∆% May-Jun 2012

-1.8 NSA 0.0 SA

AE ∆% Feb-Apr 2012

4.9 NSA 2.4 SA

AE ∆% Dec 2011-Jan 2012

1.8 NSA 1.2 SA

AE ∆% Jul-Nov 2011

1.2 NSA 2.2 SA

AE ∆% May-Jun 2011

0.6 NSA 2.4 SA

AE ∆% Feb-Apr 2011

4.9 NSA 2.4 SA

France Consumer Price Index

 

AE ∆% May-Jul 2012

-2.0

AE ∆% Feb-Apr 2012

5.3

AE ∆% Dec 2011-Jan 2012

0.0

AE ∆% Aug-Nov 2011

2.7

AE ∆% May-Jul 2011

-0.8

AE ∆% Jan-Apr 2011

4.3

Italy Consumer Price Index

 

AE ∆% May-Jul 2012

1.2

AE ∆% Feb-Apr 2012

5.7

AE ∆% Dec 2011-Jan 2012

4.3

AE ∆% Oct-Nov 2011

3.0

AE ∆% Jul-Sep 2011

2.4

AE ∆% May-Jun 2011

1.2

AE ∆% Jan-Apr 2011

4.9

UK Consumer Price Index

 

AE ∆% Jul 2012

1.2

AE ∆% May-Jun 2012

-3.0

AE ∆% Feb-Apr 2012

6.2

AE ∆% Dec 2011-Jan 2012

-0.6

AE ∆% Aug-Nov 2011

4.6

AE ∆% May-Jul 2011

0.4

AE ∆% Jan-Apr 2011

6.5

AE: Annual Equivalent

Sources:

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

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

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

https://www.destatis.de/EN/Homepage.html

http://www.insee.fr/en/default.asp

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

http://www.ons.gov.uk/ons/index.html

ESII Maximizing Interest Payments by Taxpayers on Government Debt. Table ESII-1 provides the maturity distribution and average length in months of marketable interest-bearing debt held by the private investors from 2007 to Mar 2012. Total debt increased from $3635 billion in 2007 to $8609 billion in Mar 2012 or increase by 136.8 percent. There are two concerns with the maturity distribution of US debt. (1) Growth of debt is moving total debt to the point of saturation in investors’ portfolio. In a new environment of risk appetite and nonzero fed funds rates with economic growth at historical trend of around 3 percent, yields on risk financial assets are likely to increase. Placement of new debt may require increasing interest rates in an environment of continuing placement of debt by the US Treasury without strong fiscal constraints. (2) Refinancing of maturing debt is likely to occur in an environment of higher interest rates, exerting pressure on future fiscal budgets. In Mar 2012, $2821 billion or 32.8 percent of outstanding debt held by investors matures in less than a year and $3477 billion or 40.3 percent of total debt matures in one to five years. Debt maturing in five years or less adds to 6298 billion or 73.2 percent of total outstanding debt held by investors of $8609 billion. This historical episode may be remembered as one in which the US managed its government debt with short-dated instruments during record low long-dated yields and on the verge of fiscal pressures on all interest rates, which kind of maximizes over time interest payments on government debt by taxpayers that is precisely the opposite of the objective of sound debt management and taxpayer welfare.

Table ESII-1, Maturity Distribution and Average Length in Months of Marketable Interest-Bearing Public Debt Held by Private Investors, Billions of Dollars

End of Fiscal Year or Month

2007

2008

2009

2010

2011

Mar 2012

Total*

3635

4745

6229

7676

7951

8609

<1 Year

1176

2042

2605

2480

2504

2821

1-5 Years

1310

1468

2075

2956

3085

3477

5-10 Years

678

719

995

1529

1544

1498

10-20 Years

292

352

351

341

309

284

>20 Years

178

163

204

371

510

528

Average
Months

58

49

49

57

60

57

*Amount Outstanding Privately Held

Source: United States Treasury. 2012Jun. Treasury Bulletin. Washington, DC, Jun 2012.

ESIII World Economic Slowdown. Table ESIII-1 provides the latest available estimates of GDP for the regions and countries followed in this blog for IQ2012 and IIQ2012. Growth is weak throughout most of the world. Japan’s GDP increased 1.3 percent in IQ2012 and 2.9 percent relative to a year earlier but part of the jump could be the low level a year earlier because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan is experiencing difficulties with the overvalued yen because of worldwide capital flight originating in zero interest rates with risk aversion in an environment of softer growth of world trade. Japan’s GDP grew 0.3 percent in IIQ2012 at the seasonally adjusted annual rate (SAAR) of 1.4 percent, which is much lower than 5.5 percent in IQ2012. Growth of 3.5 percent in IIQ2012 in Japan relative to IIQ2011 has effects of the low level of output because of Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. China grew at 1.8 percent in IIQ2012, which annualizes to 7.4 percent. Xinhuanet informs that Premier Wen Jiabao considers the need for macroeconomic stimulus, arguing that “we should continue to implement proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). Premier Wen elaborates that “the country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). China’s GDP grew 7.6 percent in IIQ2012 relative to IQ2011. Growth rates of GDP of China in a quarter relative to the same quarter a year earlier have been declining from 2011 to 2012. GDP was flat in the euro area in IQ2012 and also in IQ2012 relative to a year earlier. Euro area GDP contracted 0.2 percent IIQ2012 and fell 0.4 percent relative to a year earlier. Germany’s GDP increased 0.5 percent in IQ2012 and 1.7 percent relative to a year earlier. In IIQ2012, Germany’s GDP increased 0.3 percent and 0.5 percent relative to a year earlier. Growth of US GDP in IQ2012 was 0.5 percent, at SAAR of 2.0 percent and higher by 2.4 percent relative to IQ2011. US GDP increased 0.4 percent in IIQ2012, 2.0 percent at SAAR and 2.2 percent relative to a year earlier (Section I Mediocre and Decelerating United States Economic Growth http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery.html) but with substantial underemployment and underemployment (Section I http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real.html) and weak hiring (Section I http://cmpassocregulationblog.blogspot.com/2012/08/recovery-without-hiring-ten-million.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-hiring-ten-million.html). UK GDP fell 0.7 percent in IIQ2012, declining 0.8 percent relative to IIQ2011. In IQ2011, UK GDP fell 0.3 percent, declining 0.2 percent relative to a year earlier. Italy has experienced decline of GDP in four consecutive quarters from IIIQ2011 to IIQ2012. Italy’s GDP fell 0.7 percent in IIQ2012 and declined 2.5 percent relative to IIQ2011.

Table ESIII-1, Percentage Changes of GDP Quarter on Prior Quarter and on Same Quarter Year Earlier, ∆%

 

IQ2012/IVQ2011

IQ2012/IQ2011

United States

QOQ: 0.5        SAAR: 2.0

2.4

Japan

QOQ: 1.3

SAAR: 5.5

2.9

China

1.8

8.1

Euro Area

0.0

0.0

Germany

0.5

1.7

France

0.0

0.3

Italy

-0.8

-1.4

United Kingdom

-0.3

-0.2

 

IIQ2012/IQ2012

IIQ2012/IIQ2011

United States

QOQ: 0.4         SAAR: 1.5

2.2

Japan

QOQ: 0.3
SAAR: 1.4

3.5

China

1.8

7.6

Euro Area

-0.2

-0.4

Germany

0.3

0.5

France

0.0

0.3

Italy

-0.7

-2.5

United Kingdom

-0.7

-0.8

QOQ: Quarter relative to prior quarter; SAAR: seasonally adjusted annual rate

Source: Country Statistical Agencies

http://www.bea.gov/national/index.htm#gdp http://www.esri.cao.go.jp/en/sna/sokuhou/sokuhou_top.html http://www.stats.gov.cn/enGliSH/

ESIV The Loss of Dynamism of the United States. Lucas (2001May) estimates US economic growth in the long-term and about 2 percent in per capita terms. There are displacements from this trend caused by events such as wars and recessions but the economy then returns to trend. Historical US GDP data exhibit remarkable growth: Lucas (2011May) estimates an increase of US real income per person by a factor of 12 in the period from 1870 to 2010. The explanation of this remarkable growth experience by Lucas (2012) is that government provided stability and education while elements of “free-market capitalism” were an important driver of long-term growth and prosperity. The analysis is sharpened by comparison with the long-term growth experience of G7 countries (US, UK, France, Germany, Canada, Italy and Japan) and Spain from 1870 to 2010. Countries benefitted from “common civilization” and “technology” to “catch up” with the early growth leaders of the US and UK, eventually growing at a faster rate. Significant part of this catch up occurred after World War II. Lucas (2011May) finds that the catch up stalled in the 1970s. The analysis of Lucas (2011May) is that the 20-40 percent gap that developed originated in differences in relative taxation and regulation that discouraged savings and work incentives in comparison with the US. A larger welfare state, according to Lucas (2011May), could be the cause of the 20-40 percent gap. Cobet and Wilson (2002) provide estimates of output per hour and unit labor costs in national currency and US dollars for the US, Japan and Germany from 1950 to 2000 (see Pelaez and Pelaez, The Global Recession Risk (2007), 137-44). The average yearly rate of productivity change from 1950 to 2000 was 2.9 percent in the US, 6.3 percent for Japan and 4.7 percent for Germany while unit labor costs in USD increased at 2.6 percent in the US, 4.7 percent in Japan and 4.3 percent in Germany. From 1995 to 2000, output per hour increased at the average yearly rate of 4.6 percent in the US, 3.9 percent in Japan and 2.6 percent in Germany while unit labor costs in US fell at minus 0.7 percent in the US, 4.3 percent in Japan and 7.5 percent in Germany. There was increase in productivity growth in the G7 in Japan and France in the second half of the 1990s but significantly lower than the acceleration of 1.3 percentage points per year in the US. Long-term economic growth and prosperity are measured by the key indicators of growth of real income per capita, or what is earned per person after inflation. A refined concept would include real disposable income per capita, or what is earned per person after inflation and taxes.

Table ESIV-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 12 quarters of the current cyclical expansion from IIIQ2009 to IIQ2012, GDP increased 6.75 percent at the annual equivalent rate of 2.2 percent; real disposable personal income (RDPI) increased 3.8 percent at the annual equivalent rate of 1.2 percent; RDPI per capita increased 1.4 percent at the annual equivalent rate of 0.5 percent; and population increased 2.3 percent at the annual equivalent rate of 0.8 percent. Third, since the beginning of the recession in IVQ2007 to IIQ2012, GDP increased 1.7 percent, or barely above the level before the recession; real disposable personal income increased 3.5 percent; population increased 3.7 percent; and real disposable personal income per capita is 0.2 percent lower than the level before the recession. 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 ESIV-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

12

   

GDP

 

6.75

2.2

RDPI

 

3.8

1.2

RDPI per Capita

 

1.4

0.5

Population

 

2.3

0.8

IVQ2007 to IIQ2012

19

   

GDP

 

1.7

 

RDPI

 

3.5

 

RDPI per Capita

 

-0.2

 

Population

 

3.7

 

RDPI: Real Disposable Personal Income

Source: US Bureau of Economic Analysis

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

ESV Flight to Government Securities of the United States and Germany. Yields on sovereign debt backed up again with the yield of the ten-year government bond of Spain rising sharply to 7.224 percent on Fri Jul 20 while the yield of the ten-year government bond of Italy increased to 6.158 percent but eased again on Fri Jul 27 on the expectations of massive government support with the yield of the ten-year government bond of Spain falling to 6.731 percent and the yield of the ten-year government bond of Italy dropping to 5.956 percent. The ten-year government bond of Spain was quoted at yield of 6.827 percent on Fri Aug 3 and the ten-year government bond of Italy was quoted at 6.064 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The ten-year government bond of Spain was quoted at 6.868 percent on Aug 10, declining to 6.447 percent on Aug 17, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10 to 5.709 percent on Aug 17. Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table ESV-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 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. Under increasing risk appetite, the yield of the ten-year Treasury rose to 1.544 on Jul 27, 2012 and 1.569 percent on Aug 3, 2012, while the yield of the ten-year Government bond of Germany rose to 1.40 percent on Jul 27 and 1.42 percent on Aug 3. Yields have been on an increasing trend with the US ten-year note at 1.814 percent on Aug 17 and the German ten-year bond at 1.50 percent. The US dollar strengthened significantly from USD 1.450/EUR on Aug 26, 2011, to USD 1.2158 on Jul 20, 2012, or by 16.2 percent, but depreciated to USD 1.2320/EUR on Jul 27, 2012 and 1.2387 on Aug 3, 2012 in expectation of massive support of highly indebted euro zone members. Doubts returned at the end of the week of Aug 10, 2012 with appreciation to USD 1.2290/EUR and decline of the yields of the two-year government bond of Germany to -0.07 percent and of the ten-year to 1.38 percent. On Aug 17, the US dollar depreciated by 0.4 percent to USD 1.2335/EUR and the ten-year bond of Germany yielded -0.04 percent. 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 around consumer price inflation of 1.4 percent in the 12 months ending in Jul (see subsection II United States Inflation and earlier at http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.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. The lower part of Table ESV-1 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 ESV-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

8/17/12

0.2888

1.814

-0.04

1.50

1.2335

8/10/12

0.267

1.658

-0.07

1.38

1.2290

8/3/12

0.242

1.569

-0.02

1.42

1.2387

7/27/12

0.244

1.544

-0.03

1.40

1.2320

7/20/12

0.207

1.459

-0.07

1.17

1.2158

7/13/12

0.24

1.49

-0.04

1.26

1.2248

7/6/12

0.272

1.548

-0.01

1.33

1.2288

6/29/12

0.305

1.648

0.12

1.58

1.2661

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.bundesbank.de/Navigation/EN/Statistics/Time_series_databases/Macro_economic_time_series/macro_economic_time_series_node.html?anker=GELDZINS

http://www.ecb.int/stats/money/long/html/index.en.html

Chart ESV-1 of the Board of Governors of the Federal Reserve System provides the ten-year and two-year Treasury constant maturity yields. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe.

clip_image002

Chart ESV-1, US, Ten-Year and Two-Year Treasury Constant Maturity Yields Jan 2, 2001-Aug 16, 2012

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h15/update/

ESVI Exchange Rate Confrontations. The Dow Jones Newswires informs on Oct 15 that the premier of China Wen Jiabao announced that the Chinese yuan will not be further appreciated to prevent adverse effects on exports (http://professional.wsj.com/article/SB10001424052970203914304576632790881396896.html?mod=WSJ_hp_LEFTWhatsNewsCollection). Bob Davis and Lingling Wei, writing on “China shifts course, lets Yuan drop,” on Jul 25, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444840104577548610131107868.html?mod=WSJPRO_hpp_LEFTTopStories), find that China is depreciating the CNY relative to the USD in an effort to diminish the impact of appreciation of the CNY relative to the EUR. Table ESVI-1 provides the CNY/USD rate from Oct 28, 2011 to Aug 17, 2012 in selected intervals. The CNY/USD revalued by 0.9 percent from Oct 28, 2012 to Apr 27, 2012. The CNY was virtually unchanged relative to the USD by Aug 17, 2012 to CNY 6.3589/USD from the rate of CNY 6.3588/USD on Oct 28, 2011. Meanwhile, the Senate of the US is proceeding with a bill on China’s trade that could create a confrontation but may not be approved by the entire Congress.

Table ESVI-1, Renminbi Yuan US Dollar Rate

 

CNY/USD

∆% from 10/28/2011

8/17/12

6.3589

0.0

8/10/12

6.3604

0.0

8/3/12

6.3726

-0.2

7/27/12

6.3818

-0.4

7/20/12

6.3750

-0.3

7/13/12

6.3868

-0.4

7/6/12

6.3658

-0.1

6/29/12

6.3552

0.1

6/22/12

6.3650

-0.1

6/15/12

6.3678

-0.1

6/8/2012

6.3752

-0.3

6/1/2012

6.3708

-0.2

4/27/2012

6.3016

0.9

3/23/2012

6.3008

0.9

2/3/2012

6.3030

0.9

12/30/2011

6.2940

1.0

11/25/2011

6.3816

-0.4

10/28/2011

6.3588

-

Source:

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

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

Chart ESVI-1 of the Board of Governors of the Federal Reserve System provides the CNY/USD exchange rate from Aug 17, 2003 to Aug 9, 2012 together with US recession dates in shaded areas. China fixed the CNY/USD date for a long period as shown in the horizontal segment from 2000 to 2005. There was systematic revaluation of 17.6 percent from CNY 8.2765 on Jul 21, 2005 to CNY 6.8211 on Jul 15, 2008. China fixed the CNY/USD rate until Jun 7, 2010, to avoid adverse effects on its economy from the global recession, which is shown as a horizontal segment from 2009 until mid 2010. China then continued the policy of appreciation of the CNY relative to the USD with oscillations until the beginning of 2012 when the rate began to move sideways followed by a final upward slope of devaluation that is measured in Table ESVI-1 but virtually disappeared in the rate of CNY 6.3589/USD on Aug 17, 2012. Revaluation of the CNY relative to the USD by 23.2 percent by Aug 17, 2012 has not reduced the trade surplus of China but reversal of the policy of revaluation could result in international confrontation. The upward slope in the final segment on the right of Chart ESVI-I is measured as virtually stability in Table ESVI-1.

clip_image004

Chart ESVI-1, Chinese Yuan (CNY) per US Dollar (US), Aug 17, 2000-Aug 9, 2012

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/datadownload/Choose.aspx?rel=H10

ESVII 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 second 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 28.6 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 http://cmpassocregulationblog.blogspot.com/2012/06/destruction-of-three-trillion-dollars.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 ESVII-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 8/17/12,” 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, 2011, 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], which was repeated in IIQ2012. 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. There was a major rally of valuations of risk financial assets in the week of Jun 29 with the announcement of new measures on bank resolutions by the European Council. New doubts surfaced in the week of Jul 6, 2012 on the implementation of the bank resolution mechanism and on the outlook for the world economy because of interest rate reductions by the European Central, Bank of England and People’s Bank of China. Risk appetite returned in the week of July 13 in relief that economic data suggests continuing high growth in China but fiscal and banking uncertainties in Spain spread to Italy in the selloff of July 20, 2012. Mario Draghi (2012Jul26), president of the European Central Bank, stated: “But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” This statement caused return of risk appetite, driving upward valuations of risk financial assets worldwide. Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html). Risk appetite continued in the week of Aug 3, 2012, in expectation of purchases of sovereign bonds by the ECB. Growth of China’s exports by 1.0 percent in the 12 months ending in Jul 2012 released in the week of Aug 10, 2012, together with doubts on the purchases of bonds by the ECB injected a mild dose of risk aversion. There was optimism on the resolution of the European debt crisis on Aug 17, 2011. The highest valuations in column “∆% Trough to 8/17/12” are by US equities indexes: DJIA 37.0 percent and S&P 500 38.7 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 8/17/12” had double digit gains relative to the trough around Jul 2, 2010 but now many valuations of equity indexes show increase of less than 10 percent: China’s Shanghai Composite is 11.2 percent below the trough; Japan’s Nikkei Average is 3.8 percent above the trough; DJ Asia Pacific TSM is 7.4 percent above the trough; Dow Global is 11.2 percent above the trough; STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 12.2 percent above the trough; and NYSE Financial is 8.2 percent above the trough. DJ UBS Commodities is 15.4 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 24.2 percent above the trough. Japan’s Nikkei Average is 3.8 percent above the trough on Aug 31, 2010 and 19.6 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 9162.50 on Fri Aug 17, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 10.6 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 3.5 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 8/17/12” in Table ESVII-1 shows that there were increases of valuations of risk financial assets in the week of Aug 17, 2012 such as 1.4 percent for DAX, 0.6 percent for STOXX 50, 1.5 percent for NYSE Financial, 0.3 percent DJ Asia Pacific TSM, 3.0 percent Japan’s Nikkei Average and 0.7 percent for Dow Global. DJ UBS Commodities decreased 0.1 percent. China’s Shanghai Composite fell 2.5 percent. The DJIA increased 0.5 percent and S&P 500 increased 0.9 percent. The USD depreciated 0.4 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 ESVII-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 8/17/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Aug 17, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 8/17/12” but also relative to the peak in column “∆% Peak to 8/17/12.” There are now only three equity indexes above the peak in Table ESVII-1: DJIA 18.5 percent, S&P 500 16.5 percent and DAX 11.2 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 13.8 percent, Nikkei Average by 19.6 percent, Shanghai Composite by 33.2 percent, DJ Asia Pacific by 6.0 percent, STOXX 50 by 5.0 percent and Dow Global by 9.3 percent. DJ UBS Commodities Index is now 1.3 percent below the peak. The US dollar strengthened 18.5 percent relative to 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 ESVII-1, Stock Indexes, Commodities, Dollar and 10-Year Treasury  

 

Peak

Trough

∆% to Trough

∆% Peak to 8/17/

/12

∆% Week 8/17/12

∆% Trough to 8/17/

12

DJIA

4/26/
10

7/2/10

-13.6

18.5

0.5

37.0

S&P 500

4/23/
10

7/20/
10

-16.0

16.5

0.9

38.7

NYSE Finance

4/15/
10

7/2/10

-20.3

-13.8

1.5

8.2

Dow Global

4/15/
10

7/2/10

-18.4

-9.3

0.7

11.2

Asia Pacific

4/15/
10

7/2/10

-12.5

-6.0

0.3

7.4

Japan Nikkei Aver.

4/05/
10

8/31/
10

-22.5

-19.6

3.0

3.8

China Shang.

4/15/
10

7/02
/10

-24.7

-33.2

-2.5

-11.2

STOXX 50

4/15/10

7/2/10

-15.3

-5.0

0.6

12.2

DAX

4/26/
10

5/25/
10

-10.5

11.2

1.4

24.2

Dollar
Euro

11/25 2009

6/7
2010

21.2

18.5

-0.4

-3.5

DJ UBS Comm.

1/6/
10

7/2/10

-14.5

-1.3

-0.1

15.4

10-Year T Note

4/5/
10

4/6/10

3.986

1.814

   

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 World Inflation Waves. This section provides analysis and data on world inflation waves. The general framework is provided in Subsection I World Inflation Waves. IA Appendix: Transmission of Unconventional Monetary Policy provides more technical analysis. II United States Inflation analyzes inflation in the United States in two subsections: IIA Long-term US Inflation and IIB Current US Inflation.

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

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

3. Unconventional monetary policy or its expectation can increase stock market valuations (Bernanke 2010WP). Increases in equities traded in stock markets can augment perceptions of the wealth of consumers inducing increases in consumption.

4. Unconventional monetary policy causes devaluation of the dollar relative to other currencies, which can cause increases in net exports of the US that increase aggregate economic activity (Yellen 2011AS).

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

Table I-1 provides annual equivalent rates of inflation for producer price indexes followed in this blog. The behavior of the US producer price index in 2011 and into 2012 shows neatly multiple waves. (1) In Jan-Apr 2011, without risk aversion, US producer prices rose at the annual equivalent rate of 9.7 percent. (2) After risk aversion, producer prices increased in the US at the annual equivalent rate of 1.2 percent in May-Jun 2011. (3) From Jul to Sep 2011, under alternating episodes of risk aversion, producer prices increased at the annual equivalent rate of 6.6 percent. (4) Under the pressure of risk aversion because of the European debt crisis US producer prices fell at the annual equivalent rate of minus 1.2 percent in Oct-Nov 2011. (5) From Dec 2011 to Jan 2012, US producer prices rose at the annual equivalent rate of 1.2 percent with relaxed risk aversion and commodity-price increases at the margin. (6) Inflation of producer prices returned with 1.2 percent annual equivalent in Feb-Mar 2012. (7) With return of risk aversion from the European debt crisis, producer prices fell at the annual equivalent rate of 7.0 percent in Apr-Jun 2012. (8) New positions in commodity futures even with continuing risk aversion caused annual equivalent inflation of 2.4 percent in Jun-Jul 2012. Resolution of the European debt crisis if there is not an unfavorable growth event with political development in China would result in jumps of valuations of risk financial assets. Increases in commodity prices would cause the same high producer price inflation experienced in Jan-Apr 2011. There are nine producer-price indexes in Table I-1 for seven countries (two for the UK) and one region (euro area) showing very similar behavior. Zero interest rates without risk aversion cause increases in commodity prices that in turn increase input and output prices. Producer price inflation rose at very high rates during the first part of 2011 for the US, Japan, China, Euro Area, Germany, France, Italy and the UK when risk aversion was contained. With the increase in risk aversion in May and Jun, inflation moderated because carry trades were unwound. Producer price inflation returned after July 2011, with alternating bouts of risk aversion. In the final months of the year producer price inflation collapsed because of the disincentive to exposures in commodity futures resulting from fears of resolution of the European debt crisis. There is renewed worldwide inflation in the early part of 2012 with subsequent collapse because of another round of sharp risk aversion. Unconventional monetary policy fails in stimulating the overall real economy, merely introducing undesirable instability as monetary authorities cannot control allocation of floods of money at zero interest rates to carry trades into risk financial assets.  

Table I-1, Annual Equivalent Rates of Producer Price Indexes

INDEX 2011-2012

AE ∆%

US Producer Price Index

 

AE  ∆% Jun-Jul 2012

2.4

AE  ∆% Apr-May 2012

-7.0

AE  ∆% Feb-Mar 2012

1.2

AE  ∆% Dec 2011-Jan-2012

1.2

AE  ∆% Oct-Nov 2011

-1.2

AE ∆% Jul-Sep 2011

6.6

AE ∆% May-Jun 2011

1.2

AE ∆% Jan-Apr 2011

9.7

Japan Corporate Goods Price Index

 

AE ∆%  May-Jul 2012

-6.2

AE ∆%  Feb-Apr 2012

3.3

AE ∆% Dec 2011-Jan 2012

-0.6

AE ∆% Jul-Nov 2011

-2.2

AE ∆% May-Jun 2011

-1.2

AE ∆% Jan-Apr 2011

5.9

Euro Zone Industrial Producer Prices

 

AE ∆% Apr-Jun 2012

-3.9

AE ∆% Jan-Mar 2012

8.3

AE ∆% Oct-Dec 2011

0.8

AE ∆% Jul-Sep

2.0

AE ∆% May-Jun

-1.2

AE ∆% Jan-Apr

12.0

China Producer Price Index

 

AE ∆% May-Jul 2012

-7.3

AE ∆% Feb-Apr 2012

2.4

AE ∆% Dec 2011-Jan 2012

-2.4

AE ∆% Jul-Nov 2011

-3.1

AE ∆% Jan-Jun 2011

6.4

Germany Producer Price Index

 

AE ∆% May-Jul 2012

-2.8 NSA 1.2 SA

AE ∆% Feb-Apr 2012

4.9 NSA 0.8 SA

AE ∆% Dec 2011-Jan 2012

1.2 NSA 0.0 SA

AE ∆% Oct-Nov 2011

1.8 NSA 3.7 SA

AE ∆% Jul-Sep 2011

2.8 NSA 4.9 SA

AE ∆% May-Jun 2011

0.6 NSA 3.0 SA

AE ∆% Jan-Apr 2011

10.4 NSA 6.5 SA

France Producer Price Index for the French Market

 

AE ∆% Apr-Jun 2012

-7.7

AE ∆% Jan-Mar 2012

8.3

AE ∆% Oct-Dec 2011

2.4

AE ∆% Jul-Sep 2011

2.8

AE ∆% May-Jun 2011

-3.5

AE ∆% Jan-Apr 2011

11.4

Italy Producer Price Index

 

AE ∆% May-Jun 2012

-2.4

AE ∆% Mar-Apr 2012

4.3

AE ∆% Jan-Feb 2012

7.4

AE ∆% Nov 2011-Jan 2012

4.5

AE ∆% Oct-Dec 2011

0.4

AE ∆% Jul-Sep 2011

2.4

AE ∆% May-Jun 2011

-1.2

AE ∆% Jan-April 2011

10.7

UK Output Prices

 

AE ∆% May-Jul 2012

-3.5

AE ∆% Feb-Apr 2012

7.9

AE ∆% Nov 2011-Jan-2012

1.6

AE ∆% May-Oct 2011

2.0

AE ∆% Jan-Apr 2011

12.0

UK Input Prices

 

AE ∆% Jul 2012

16.8

AE ∆% Apr-Jun 2012

-24.4

AE ∆% Jan-Mar 2012

18.1

AE ∆% Nov-Dec 2011

-1.2

AE ∆% May-Oct 2011

-3.1

AE ∆% Jan-Apr 2011

35.6

AE: Annual Equivalent

Sources:

http://www.bls.gov/ppi/

http://www.boj.or.jp/en/

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

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

https://www.destatis.de/EN/Homepage.html

http://www.insee.fr/en/default.asp

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

http://www.ons.gov.uk/ons/index.html

Similar world inflation waves are in the behavior of consumer price indexes of six countries and the euro zone in Table I-2. US consumer price inflation shows similar waves. (1) Under risk appetite in Jan-Apr 2011 consumer prices increased at the annual equivalent rate of 4.9 percent. (2) Risk aversion caused the collapse of inflation to annual equivalent 2.8 percent in May-Jul 2011. (3) Risk appetite drove the rate of consumer price inflation in the US to 3.7 percent in Jul-Sep 2011. (4) Gloomier views of carry trades caused the collapse of inflation in Oct-Nov 2011 to annual equivalent 0.6 percent. (5) Consumer price inflation resuscitated with increased risk appetite at annual equivalent of 1.2 percent in Dec 2011 to Jan 2012. (6) Consumer price inflation returned at 2.8 percent annual equivalent in Feb-Apr 2012. (7) Under renewed risk aversion, annual equivalent consumer price inflation in the US is minus 1.2 percent in May-Jul 2012. There is similar behavior in all the other consumer price indexes in Table I-2. China’s CPI increased at annual equivalent 8.3 percent in Jan-Mar 2011, 2.0 percent in Apr-Jun, 2.9 percent in Jul-Dec and resuscitated at 5.8 percent annual equivalent in Dec 2011 to Mar 2012, declining to minus 2.7 percent in Apr-Jul 2012. The euro zone harmonized index of consumer prices (HICP) increased at annual equivalent 5.2 percent in Jan-Apr 2011, minus 2.4 percent in May-Jul, 4.3 percent in Aug-Dec, minus 3.0 percent in Dec 2011-Jan 2012 and then 9.6 percent in Feb-Apr 2012, falling to minus 2.8 percent annual equivalent in May-Jul 2012. The price indexes of the largest members of the euro zone, Germany, France and Italy, and the euro zone as a whole, exhibit the same inflation waves. The United Kingdom CPI increased at annual equivalent 6.5 percent in Jan-Apr 2011, falling to only 0.4 percent in May-Jul and then increasing at 4.6 percent in Aug-Nov. UK consumer prices fell at 0.6 percent annual equivalent in Dec 2011 to Jan 2012 but increased at 6.2 percent annual equivalent from Feb to Apr 2012. In May-Jun 2012, with renewed risk aversion, UK consumer prices fell at the annual equivalent rate of minus 3.0 percent. Inflation returned at 1.2 percent annual equivalent in Jul 2012.

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

Index 2011-2012

AE ∆%

US Consumer Price Index

 

AE ∆% May-Jul 2012

-1.2

AE ∆% Feb-Apr 2012

2.8

AE ∆% Dec 2011-Jan  2012

1.2

AE ∆% Oct-Nov 2011

0.6

AE ∆% Jul-Sep 2011

3.7

AE ∆% May-Jul 2011

2.8

AE ∆% Jan-Apr 2011

4.9

China Consumer Price Index

 

AE ∆% Apr-Jul 2012

-2.7

AE ∆% Dec 2011-Mar 2012

5.8

AE ∆% Jul-Nov 2011

2.9

AE ∆% Apr-Jun 2011

2.0

AE ∆% Jan-Mar 2011

8.3

Euro Zone Harmonized Index of Consumer Prices

 

AE ∆% May-Jul 2012

-2.8

AE ∆% Feb-Apr 2012

9.6

AE ∆% Dec 2011-Jan 2012

-3.0

AE ∆% Aug-Dec 2011

4.3

AE ∆% May-Jul 2011

-2.4

AE ∆% Jan-Apr 2011

5.2

Germany Consumer Price Index

 

AE ∆% Jul 2012

4.9 NSA 2.4 SA

AE ∆% May-Jun 2012

-1.8 NSA 0.0 SA

AE ∆% Feb-Apr 2012

4.9 NSA 2.4 SA

AE ∆% Dec 2011-Jan 2012

1.8 NSA 1.2 SA

AE ∆% Jul-Nov 2011

1.2 NSA 2.2 SA

AE ∆% May-Jun 2011

0.6 NSA 2.4 SA

AE ∆% Feb-Apr 2011

4.9 NSA 2.4 SA

France Consumer Price Index

 

AE ∆% May-Jul 2012

-2.0

AE ∆% Feb-Apr 2012

5.3

AE ∆% Dec 2011-Jan 2012

0.0

AE ∆% Aug-Nov 2011

2.7

AE ∆% May-Jul 2011

-0.8

AE ∆% Jan-Apr 2011

4.3

Italy Consumer Price Index

 

AE ∆% May-Jul 2012

1.2

AE ∆% Feb-Apr 2012

5.7

AE ∆% Dec 2011-Jan 2012

4.3

AE ∆% Oct-Nov 2011

3.0

AE ∆% Jul-Sep 2011

2.4

AE ∆% May-Jun 2011

1.2

AE ∆% Jan-Apr 2011

4.9

UK Consumer Price Index

 

AE ∆% Jul 2012

1.2

AE ∆% May-Jun 2012

-3.0

AE ∆% Feb-Apr 2012

6.2

AE ∆% Dec 2011-Jan 2012

-0.6

AE ∆% Aug-Nov 2011

4.6

AE ∆% May-Jul 2011

0.4

AE ∆% Jan-Apr 2011

6.5

AE: Annual Equivalent

Sources:

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

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

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

https://www.destatis.de/EN/Homepage.html

http://www.insee.fr/en/default.asp

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

http://www.ons.gov.uk/ons/index.html

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

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

The new analysis by Yellen (2011AS) is considered below in four separate subsections: IAi Theory; IAii Policy; IAiii Evidence; and IAiv Unwinding Strategy.

IFi Theory. The transmission mechanism of quantitative easing can be analyzed in three different forms. (1) Portfolio choice theory. General equilibrium value theory was proposed by Hicks (1935) in analyzing the balance sheets of individuals and institutions with assets in the capital segment consisting of money, debts, stocks and productive equipment. Net worth or wealth would be comparable to income in value theory. Expected yield and risk would be the constraint comparable to income in value theory. Markowitz (1952) considers a portfolio of individual securities with mean μp and variance σp. The Markowitz (1952, 82) rule states that “investors would (or should” want to choose a portfolio of combinations of (μp, σp) 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 1935; 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.

IAii 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 at least seven approaches on the role of monetary policy in purchasing long-term securities that have increased the classes of rates of return targeted by the Fed:

(1) 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.

(2) 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, 2009, 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.

(3) 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.

(4) 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.

(5) 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.

(6) 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.”

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

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

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

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

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

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

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

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

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

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

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

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

The FOMC decided at its meeting on Jun 20, 2012, to continue “Let’s Twist Again” monetary policy until the end of 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120620a.htm http://www.newyorkfed.org/markets/opolicy/operating_policy_120620.html):

“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.”

IAiii 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.

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

Second, Inflation and Bank Reserves. On Jan 12, 2012, the line “Reserve Bank credit” in the Fed balance sheet stood at $2450.6 billion, or $2.5 trillion, with the portfolio of long-term securities of $2175.7 billion, or $2.2 trillion, composed of $987.6 billion of notes and bonds, $49.7 billion of inflation-adjusted notes and bonds, $146.3 billion of Federal agency debt securities, and $992.1 billion of mortgage-backed securities; reserves balances with Federal Reserve Banks stood at $1095.5 billion, or $1.1 trillion (http://federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The concern addressed by Yellen (2011AS, 12-4) is that this high level of reserves could eventually result in demand growth that could accelerate inflation. Reserves would be excessively high relative to the levels before the recession. Reserves of depository institutions at the Federal Reserve Banks rose from $45.6 billion in Aug 2008 to $1084.8 billion in Aug 2010, not seasonally adjusted, multiplying by 23.8 times, or to $1038.2 billion in Nov 2010, multiplying by 22.8 times. The monetary base consists of the monetary liabilities of the government, composed largely of currency held by the public plus reserves of depository institutions at the Federal Reserve Banks. The monetary base not seasonally adjusted, or issue of money by the government, rose from $841.1 billion in Aug 2008 to $1991.1 billion or by 136.7 percent and to $1968.1 billion in Nov 2010 or by 133.9 percent (http://federalreserve.gov/releases/h3/hist/h3hist1.pdf). Policy can be viewed as creating government monetary liabilities that ended mostly in reserves of banks deposited at the Fed to purchase $2.1 trillion of long-term securities or assets, which in nontechnical language would be “printing money” (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). The marketable debt of the US government in Treasury securities held by the public stood at $8.7 trillion on Nov 30, 2010 (http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds112010.pdf). The current holdings of long-term securities by the Fed of $2.1 trillion, in the process of converting fully into Treasury securities, are equivalent to 24 percent of US government debt held by the public, and would represent 29.9 percent with the new round of quantitative easing if all the portfolio of the Fed, as intended, were in Treasury securities. Debt in Treasury securities held by the public on Dec 31, 2009, stood at $7.2 trillion (http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds122009.pdf), growing on Nov 30, 2010, to $1.5 trillion or by 20.8 percent. In spite of this growth of bank reserves, “the 12-month change in core PCE [personal consumption expenditures] prices dropped from about 2 ½ percent in mid-2008 to around 1 ½ percent in 2009 and declined further to less than 1 percent by late 2010” (Yellen 2011AS, 3). The PCE price index, excluding food and energy, is around 0.8 percent in the past 12 months, which could be, in the Fed’s view, too close for comfort to negative inflation or deflation. Yellen (2011AS, 12) agrees “that an accommodative monetary policy left in place too long can cause inflation to rise to undesirable levels” that would be true whether policy was constrained or not by “the zero bound on interest rates.” The FOMC is monitoring and reviewing the “asset purchase program regularly in light of incoming information” and will “adjust the program as needed to meet its objectives” (Ibid, 12). That is, the FOMC would withdraw the stimulus once the economy is closer to full capacity to maintain inflation around 2 percent. In testimony at the Senate Committee on the Budget, Chairman Bernanke stated that “the Federal Reserve has all the tools its needs to ensure that it will be able to smoothly and effectively exit from this program at the appropriate time” (http://federalreserve.gov/newsevents/testimony/bernanke20110107a.htm). The large quantity of reserves would not be an obstacle in attaining the 2 percent inflation level. Yellen (2011A, 13-4) enumerates Fed tools that would be deployed to withdraw reserves as desired: (1) increasing the interest rate paid on reserves deposited at the Fed currently at 0.25 percent per year; (2) withdrawing reserves with reverse sale and repurchase agreement in addition to those with primary dealers by using mortgage-backed securities; (3) offering a Term Deposit Facility similar to term certificates of deposit for member institutions; and (4) sale or redemption of all or parts of the portfolio of long-term securities. The Fed would be able to increase interest rates and withdraw reserves as required to attain its mandates of maximum employment and price stability.

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

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

II United States Inflation. Monetary policy pursues symmetric inflation targets of maintaining core inflation of the index of personal consumption expenditures (core PCE) in an open interval of 2.00 percent. If inflation increases above 2.00 percent, the central bank could use restrictive monetary policy such as increases in interest rates to contain inflation in a tight range or interval around 2.00 percent. If inflation falls below 2 percent, the central bank could use restrictive monetary policy such as lowering interest rates to prevent inflation from falling too much below 2.00 percent. Currently, with about thirty million unemployed and underemployed (http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html) and depressed hiring (http://cmpassocregulationblog.blogspot.com/2012/08/recovery-without-hiring-ten-million.html), there may even be a policy bias to raise or at least ignore inflation, even with falling real wages, maintaining accommodation as a form of promoting full employment. There are two arguments in favor of symmetric inflation targets preventing inflation from falling to very low levels.

1. Room for interest rate policy. Nominal interest rates hardly ever fall below zero. In economic jargon, the floor of zero nominal interest rates is referred to as “the zero bound.” Symmetric targets are proposed to maintain a sufficiently high inflation rate such that interest rates can be lowered to promote economic activity when recession threatens. With inflation close to zero there is no room for lowering interest rates with policy tools.

2. Fear of Deflation. Inflation is a process of sustained increases in prices. Deflation is a process of sustained decreases in prices. The probability of deflation increases as inflation approximates zero. The influence of fear of deflation in monetary policy is discussed in Pelaez and Pelaez (International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-95).

Subsection IIA Long-term US Inflation evaluates long-term inflation in the US, concluding that there has not been deflation risk since World War II. Subsection IIB Current US Inflation finds no evidence in current inflation justifying fear of deflation.

IIA Long-term US Inflation. Key percentage average yearly rates of the US economy on growth and inflation are provided in Table II-1 updated with release of new data. The choice of dates prevents the measurement of long-term potential economic growth because of two recessions from IQ2001 (Mar) to IVQ2001 (Nov) with decline of GDP of 0.4 percent and the drop in GDP of 5.1 percent in IVQ2007 (Dec) to IIQ2009 (June) (http://www.nber.org/cycles.html) followed with unusually low economic growth for an expansion phase after recession with the economy growing at 2.2 percent from IIQ2011 to IIQ2012 and annual equivalent in the four quarters of 2011 and first two quarters of 2012 at 1.9 percent (http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery.html). Cumulative GDP growth in the first two quarters of 2012 was 0.87 percent, which is equivalent to 1.75 percent per year. Between 2000 and 2011, real GDP grew at the average rate of 1.6 percent per year, nominal GDP at 3.9 percent and the implicit deflator at 2.3 percent. Between 2000 and 2012, the average rate of CPI inflation was 2.4 percent per year and 2.0 percent excluding food and energy. PPI inflation increased at 2.8 percent per year on average from 2000 to 2012 and at 1.8 percent excluding food and energy. There is also inflation in international trade. Import prices grew at 3.3 percent per year between 2000 and 2012. The commodity price shock is revealed by inflation of import prices of petroleum increasing at 13.4 percent per year between 2000 and 2011 and at 11.0 percent between 2000 and 2012. The average growth rates of import prices excluding fuels are much lower at 2.1 percent for 2002 to 2011 and 1.9 percent for 2000 to 2012. Export prices rose at the average rate of 2.7 percent between 2000 and 2011 and at 2.4 percent from 2000 to 2012. What spared the US of sharper decade-long deterioration of the terms of trade, (export prices)/(import prices), was its diversification and competitiveness in agriculture. Agricultural export prices grew at the average yearly rate of 7.1 percent from 2000 to 2011 and at 6.8 percent from 2000 to 2012. US nonagricultural export prices rose at 2.3 percent per year from 2000 to 2011 and at 1.9 percent from 2000 to 2012. The share of petroleum imports in US trade far exceeds that of agricultural exports. Unconventional monetary policy inducing carry trades in commodities has deteriorated US terms of trade, prices of exports relative to prices of imports, tending to restrict growth of US aggregate real income. These dynamic inflation rates are not similar to those for the economy of Japan where inflation was negative in seven of the 10 years in the 2000s

Table II-1, US, Average Growth Rates of Real and Nominal GDP, Consumer Price Index, Producer Price Index and Import and Export Prices, Percent per Year

Real GDP

2000-2011: 1.6%

Nominal GDP

2000-2011: 3.9%

Implicit Price Deflator

2000-2011: 2.3%

CPI

2000-2011: 2.5%
2000-2012: 2.4%

CPI ex Food and Energy

2000-2011: 2.0%
2000-2012: 2.0%

PPI

2000-2011: 3.0%
2000-2012: 2.8%

PPI ex Food and Energy

2000-2011: 1.7%
2000-2012: 1.8%

Import Prices

2000-2011: 3.3%
2000-2012: 2.7%

Import Prices of Petroleum and Petroleum Products

2000-2011: 13.4%
2000-2012: 11.0%

Import Prices Excluding Petroleum

2000-2011: 1.4%
2000-2012: 1.2%

Import Prices Excluding Fuels

2002-2011: 2.1%
2002-2012:  1.9%

Export Prices

2000-2011: 2.7%
2000-2012: 2.4%

Agricultural Export Prices

2000-2011: 7.1%
2000-2012: 6.8%

Nonagricultural Export Prices

2000-2011: 2.3%
2000-2012: 1.9%

Note: rates for price indexes in the row beginning with “CPI” and ending in the row “Nonagricultural Export Prices” are for Jul 2000 to Jul 2011 and for Jul 2000 to Jul 2012 using not seasonally adjusted indexes. Import prices excluding fuels are not available before 2002.

Sources: http://www.bea.gov/iTable/index_nipa.cfm http://www.bls.gov/data/

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

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

-0.3 percent in 1963,

-1.4 percent in 1986,

-0.8 percent in 1986,

-0.8 percent in 1998,

-1.3 percent in 2001

-2.6 percent in 2009.

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

Chart II-1 provides US nominal GDP from 1980 to 2010. The only major bump in the chart occurred in the recession of IVQ2007 to IIQ2009 with revised cumulative decline of GDP of 4.7 percent. Tendency for deflation would be reflected in persistent bumps. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.5 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). The comparison of the global recession after 2007 with the Great Depression is entirely misleading.

clip_image006

Chart II-1, US, Nominal GDP 1980-2011

Source: US Bureau of Economic Analysis

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

Chart II-2 provides US real GDP from 1980 to 2011. Persistent deflation threatening real economic activity would also be reflected in the series of long-term growth of GDP. There is no such behavior in Chart II-2 except for periodic recessions in the US economy that have occurred throughout history.

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Chart II-2, US, Real GDP 1980-2011

Source: US Bureau of Economic Analysis

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

Deflation would also be in evidence in long-term series of prices in the form of bumps. The GDP implicit deflator series in Chart II-3 from 1980 to 2012 shows sharp dynamic behavior over time. The US economy is not plagued by deflation but by long-run inflation.

clip_image010

Chart II-3, US, GDP Implicit Price Deflator 1980-2012

Source: US Bureau of Economic Analysis

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

Chart II-4 provides percent change from preceding quarter in prices of GDP at seasonally-adjusted annual rates (SAAR) from 1980 to 2011. There is one case of negative change in IIQ2009. There has not been actual deflation or risk of deflation in the US that would justify unconventional monetary policy.

clip_image012

Chart II-4, Percent Change from Preceding Period in Prices for GDP Seasonally Adjusted at Annual Rates 1980-2012

Source: US Bureau of Economic Analysis

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

Chart II-5 provides percent change from preceding year in prices of GDP from 1980 to 2011. There was not one single year of deflation or risk of deflation in the past three decades.

clip_image014

Chart II-5, Percent Change from Preceding Year in Prices for Gross Domestic Product 1980-2011

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

The producer price index of the US from 1960 to 2012 in Chart II-6 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

clip_image016

Chart II-6, US, Producer Price Index, Finished Goods, NSA, 1960-2012

Source: US Bureau of Labor Statistics

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

Chart II-7 provides 12-month percentage changes of the producer price index from 1960 to 2012. The distinguishing event in Chart II-7 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2012.

clip_image018

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

Source: US Bureau of Labor Statistics

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

The producer price index excluding food and energy from 1973 to 2012, the first historical date of availability in the dataset of the Bureau of Labor Statistics (BLS), shows similarly dynamic behavior as the overall index, as shown in Chart II-8. There is no evidence of persistent deflation in the US PPI.

clip_image020

Chart II-8, US Producer Price Index, Finished Goods Excluding Food and Energy, NSA, 1973-2012

Source: US Bureau of Labor Statistics

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

Chart II-9 provides 12-month percentage rates of change of the finished goods index excluding food and energy. The dominating characteristic is the Great Inflation of the 1970s. The double hump illustrates how inflation may appear to be subdued and then returns with strength.

clip_image022

Chart II-9, US Producer Price Index, Finished Goods Excluding Food and Energy, 12-Month Percentage Change, NSA, 1974-2012

Source: US Bureau of Labor Statistics

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

The producer price index of energy goods from 1974 to 2012 is provided in Chart II-10. The first jump occurred during the Great Inflation of the 1970s analyzed in various comments of this blog (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html) and in Appendix I. There is relative stability of producer prices after 1986 with another jump and decline in the late 1990s into the early 2000s. The episode of commodity price increases during a global recession in 2008 could only have occurred with interest rates dropping toward zero, which stimulated the carry trade from zero interest rates to leveraged positions in commodity futures. Commodity futures exposures were dropped in the flight to government securities after Sep 2008. Commodity future exposures were created again when risk aversion diminished around Mar 2011 after the finding that US bank balance sheets did not have the toxic assets that were mentioned in proposing TARP in Congress (see Cochrane and Zingales 2009). Fluctuations in commodity prices and other risk financial assets originate in carry trade when risk aversion ameliorates.

clip_image024

Chart II-10, US, Producer Price Index, Finished Energy Goods, NSA, 1974-2012

Source: US Bureau of Labor Statistics

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

Chart II-11 shows 12-month percentage changes of the producer price index of finished energy goods from 1975 to 2012. This index is only available after 1974 and captures only one of the humps of energy prices during the Great Inflation. Fluctuations in energy prices have occurred throughout history in the US but without provoking deflation. Two cases are the decline of oil prices in 2001 to 2002 that has been analyzed by Barsky and Kilian (2004) and the collapse of oil prices from over $140/barrel with shock of risk aversion to the carry trade in Sep 2008.

clip_image026

Chart II-11, US, Producer Price Index, Finished Energy Goods, 12-Month Percentage Change, NSA, 1974-2012

Source: US Bureau of Labor Statistics

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

Chart II-12 provides the consumer price index NSA from 1960 to 2012. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

clip_image028

Chart II-12, US, Consumer Price Index, NSA, 1960-2012

Source: US Bureau of Labor Statistics

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

Chart II-13 provides 12-month percentage changes of the consumer price index from 1960 to 2012. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.

clip_image030

Chart II-13, US, Consumer Price Index, All Items, 12- Month Percentage Change 1960-2012

Source: US Bureau of Labor Statistics

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

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

clip_image032

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

Source: US Bureau of Labor Statistics

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

Chart II-15 provides 12-month percentage changes of the consumer price index excluding food and energy from 1960 to 2012. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.

clip_image034

Chart II-15, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1960-2012

Source: US Bureau of Labor Statistics

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

The consumer price index of housing is provided in Chart II-16. There was also acceleration during the Great Inflation of the 1970s. The index flattens after the global recession in IVQ2007 to IIQ2009. Housing prices collapsed under the weight of construction of several times more housing than needed. Surplus housing originated in subsidies and artificially low interest rates in the shock of unconventional monetary policy in 2003 to 2004 in fear of deflation.

clip_image036

Chart II-16, US, Consumer Price Index Housing, NSA, 1967-2012

Source: US Bureau of Labor Statistics

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

Chart II-17 provides 12-month percentage changes of the housing CPI. The Great Inflation also had extremely high rates of housing inflation. Housing is considered as potential hedge of inflation.

clip_image038

Chart II-17, US, Consumer Price Index, Housing, 12- Month Percentage Change, NSA, 1968-2012

Source: US Bureau of Labor Statistics

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

IIB Current US Inflation. Consumer price inflation has fluctuated in recent months. Table II-2 provides 12-month consumer price inflation in Jul and annual equivalent percentage changes for the months of May to Jul 2012 of the CPI and major segments. The final column provides inflation from Jun 2012 to Jul 2012. CPI inflation in the 12 months ending in Jul reached 1.4 percent, the annual equivalent rate May to Jul was minus 1.2 percent and the monthly inflation rate of 0.0 percent also annualizes at zero. These inflation rates fluctuate in accordance with inducement of risk appetite or frustration by risk aversion of carry trades from zero interest rates to commodity futures. At the margin, the decline in commodity prices in sharp current risk aversion in financial markets is causing lower inflation worldwide. With zero interest rates, commodity prices would increase again in an environment of risk appetite. Excluding food and energy, CPI inflation was 2.1 percent in the 12 months ending in Jul 2012 and 2.0 percent in annual equivalent in May-Jul 2012. There is no deflation in the US economy that could justify further quantitative easing. Consumer food prices in the US have risen 2.3 percent in 12 months ending in Jul 2012 and at 1.2 percent in annual equivalent in May-Jul 2012. Monetary policies stimulating carry trades of commodities that increase prices of food constitute a highly regressive tax on lower income families for whom food is a major portion of the consumption basket especially with wage increases below inflation in a recovery without hiring (http://cmpassocregulationblog.blogspot.com/2012/08/recovery-without-hiring-ten-million.html) and without jobs (http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html). Energy consumer prices decreased 5.0 percent in 12 months, fell 21.7 percent in annual equivalent in May-Jul and declined 0.3 percent in Jul as carry trades from zero interest rates to commodity futures were unwound and repositioned during alternating risk aversion and risk appetite originating in the European debt crisis and increasingly in growth and politics in China. For lower income families, food and energy are a major part of the family budget. Inflation is not low or threatening deflation in annual equivalent in May-Jul in any of the categories in Table II-2 but simply reflecting waves of inflation originating in carry trades. An upward trend is determined by carry trades from zero interest rates to commodity futures positions with episodes of risk aversion causing fluctuations.

Table II-2, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%

 

∆% 12 Months Jul 2012/Jul
2011 NSA

∆% Annual Equivalent May to Jul 2012 SA

∆% Jul 2012/Jun 2012 SA

CPI All Items

1.4

-1.2

0.0

CPI ex Food and Energy

2.1

2.0

0.1

Food

2.3

1.2

0.1

Food at Home

1.9

0.0

0.0

Food Away from Home

2.9

2.4

0.2

Energy

-5.0

-21.7

-0.3

Gasoline

-5.5

-29.6

0.3

Fuel Oil

-5.6

-37.1

-0.5

New Vehicles

0.8

1.2

-0.1

Used Cars and Trucks

1.1

2.0

-0.5

Medical Care Commodities

3.4

2.4

0.5

Apparel

3.0

4.5

0.2

Services Less Energy Services

2.5

2.0

0.1

Shelter

2.1

1.6

0.1

Transportation Services

1.6

-0.4

-0.2

Medical Care Services

4.4

6.2

0.3

Source: US Bureau of Labor Statistics http://www.bls.gov/news.release/pdf/cpi.pdf

The weights of the CPI, US city average for all urban consumers representing about 87 percent of the US population (http://www.bls.gov/cpi/cpiovrvw.htm#item1), are shown in Table II-3 with the BLS update of Mar 7, 2012 (http://www.bls.gov/cpi/cpiri2011.pdf). Housing has a weight of 41.020 percent. The combined weight of housing and transportation is 57.895 percent or more than one half of consumer expenditures of all urban consumers. The combined weight of housing, transportation and food and beverages is 73.151 percent of the US CPI.

Table II-3, US, Relative Importance, 2009-2010 Weights, of Components in the Consumer Price Index, US City Average, Dec 2011

All Items

100.000

Food and Beverages

15.256

  Food

   14.308

  Food at home

     8.638

  Food away from home

     5.669

Housing

41.020

  Shelter

    31.539

  Rent of primary residence

      6.485

  Owners’ equivalent rent

    23.957

Apparel

  3.562

Transportation

16.875

  Private Transportation

    15.694

  New vehicles

      3.195

  Used cars and trucks

      1.913

  Motor fuel

      5.463

    Gasoline

      5.273

Medical Care

7.061

  Medical care commodities

      1.716

  Medical care services

      5.345

Recreation

6.044

Education and Communication

6.797

Other Goods and Services

3.385

Note: reissued Mar 7, 2012. Refers to all urban consumers, covering approximately 87 percent of the US population (see http://www.bls.gov/cpi/cpiovrvw.htm#item1). Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/cpiri2011.pdf http://www.bls.gov/cpi/cpiriar.htm

Chart II-18 provides the US consumer price index for housing from 2001 to 2012. Housing prices rose sharply during the decade until the bump of the global recession and increased again in 2011 with some stabilization currently. The CPI excluding housing would likely show much higher inflation. Income remaining after paying for indispensable shelter has been compressed by the commodity carry trades resulting from unconventional monetary policy.

clip_image040

Chart II-18, US, Consumer Price Index, Housing, NSA, 2001-2012

Source: US Bureau of Labor Statistics

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

Chart II-19 provides 12-month percentage changes of the housing CPI. Percentage changes collapsed during the global recession but have been rising into positive territory in 2011 and 2012 but with the rate declining recently.

clip_image042

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

Source: US Bureau of Labor Statistics

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

There have been waves of consumer price inflation in the US in 2011 and into 2012 (Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html) that are illustrated in Table II-4. The first wave occurred in Jan-Apr 2011 and was caused by the carry trade of commodity prices induced by unconventional monetary policy of zero interest rates. Cheap money at zero opportunity cost in environment of risk appetite was channeled into financial risk assets, causing increases in commodity prices. The annual equivalent rate of increase of the all-items CPI in Jan-Apr 2011 was 4.9 percent and the CPI excluding food and energy increased at annual equivalent rate of 2.4 percent. The second wave occurred during the collapse of the carry trade from zero interest rates to exposures in commodity futures as a result of risk aversion in financial markets created by the sovereign debt crisis in Europe. The annual equivalent rate of increase of the all-items CPI dropped to 2.8 percent in May-Jul 2011 while the annual equivalent rate of the CPI excluding food and energy increased at 3.0 percent. In the third wave in Jul-Sep 2011, annual equivalent CPI inflation rose to 3.7 percent while the core CPI increased at 2.0 percent. The fourth wave occurred in the form of increase of the CPI all-items annual equivalent rate to 0.6 percent in Oct-Nov 2011 with the annual equivalent rate of the CPI excluding food and energy remaining at 2.4 percent. The fifth wave occurred in Dec 2011 to Jan 2012 with annual equivalent headline inflation of 1.2 percent and core inflation of 1.8 percent. In the sixth wave, headline CPI inflation increased at annual equivalent 4.3 percent in Feb-Mar 2012 and core CPI inflation at 1.8 percent but including Apr, the annual equivalent inflation of the headline CPI was 4.3 percent in Feb-Apr and 2.0 percent for the core CPI. The seventh wave is beginning with annual equivalent inflation of minus 1.2 percent for the headline CPI in May-Jul 2012 and 2.0 percent for the core CPI. The conclusion is that inflation accelerates and decelerates in unpredictable fashion that turns symmetric inflation targets in a source of destabilizing shocks to the financial system and eventually the overall economy. Unconventional monetary policy of zero interest rates and withdrawal of bonds to lower long-term interest rates distorts risk/return decisions required for efficient allocation of resources and attaining optimal growth paths and prosperity.

Table II-4, US, Headline and Core CPI Inflation Monthly SA and 12 Months NSA ∆%

 

All Items 

SA Month

All Items NSA 12 month

Core SA
Month

Core NSA
12 months

Jul 2012

0.0

1.4

0.1

2.1

Jun

0.0

1.7

0.2

2.2

May

-0.3

1.7

0.2

2.3

AE ∆% May-Jul

-1.2

 

2.0

 

Apr

0.0

2.3

0.2

2.3

Mar

0.3

2.7

0.2

2.3

Feb

0.4

2.9

0.1

2.2

AE ∆% Feb-Apr

2.8

 

2.0

 

Jan

0.2

2.9

0.2

2.3

Dec 2011

0.0

3.0

0.1

2.2

AE ∆% Dec-Jan

1.2

 

1.8

 

Nov

0.1

3.4

0.2

2.2

Oct

0.0

3.5

0.2

2.1

AE ∆% Oct-Nov

0.6

 

2.4

 

Sep

0.3

3.9

0.1

2.0

Aug

0.3

3.8

0.2

2.0

Jul

0.3

3.6

0.2

1.8

AE ∆% Jul-Sep

3.7

 

2.0

 

Jun

0.1

3.6

0.2

1.6

May

0.3

3.6

0.3

1.5

AE ∆%  May-Jul

2.8

 

3.0

 

Apr

0.4

3.2

0.2

1.3

Mar

0.5

2.7

0.2

1.2

Feb

0.4

2.1

0.2

1.1

Jan

0.3

1.6

0.2

1.0

AE ∆%  Jan-Apr

4.9

 

2.4

 

Dec 2010

0.4

1.5

0.1

0.8

Nov

0.2

1.1

0.1

0.8

Oct

0.3

1.2

0.0

0.6

Sep

0.1

1.1

0.0

0.8

Aug

0.2

1.1

0.1

0.9

Jul

0.2

1.2

0.1

0.9

Jun

0.0

1.1

0.1

0.9

May

-0.1

2.0

0.1

0.9

Apr

0.0

2.2

0.0

0.9

Mar

0.0

2.3

0.1

1.1

Feb

0.0

2.1

0.1

1.3

Jan

0.1

2.6

-0.1

1.6

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

Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm

The behavior of the US consumer price index NSA from 2001 to 2011 is provided in Chart II-20. Inflation in the US is very dynamic without deflation risks that would justify symmetric inflation targets. The hump in 2008 originated in the carry trade from interest rates dropping to zero into commodity futures. There is no other explanation for the increase of the Cushing OK Crude Oil Future Contract 1 from $55.64/barrel on Jan 9, 2007 to $145.29/barrel on July 3, 2008 during deep global recession, collapsing under a panic of flight into government obligations and the US dollar to $37.51/barrel on Feb 13, 2009 and then rising by carry trades to $113.93/barrel on Apr 29, 2012, collapsing again and then recovering again to $105.23/barrel, all during mediocre economic recovery with peaks and troughs influenced by bouts of risk appetite and risk aversion (data from the US Energy Information Administration EIA, http://www.eia.gov/). The unwinding of the carry trade with the TARP announcement of toxic assets in banks channeled cheap money into government obligations (see Cochrane and Zingales 2009).

clip_image044

Chart II-20, US, Consumer Price Index, NSA, 2001-2012

Source: US Bureau of Labor Statistics

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

Chart II-21 provides 12-month percentage changes of the consumer price index from 2001 to 2012. There was no deflation or threat of deflation from 2008 into 2009. Commodity prices collapsed during the panic of toxic assets in banks. When stress tests in 2009 revealed US bank balance sheets in much stronger position, cheap money at zero opportunity cost exited government obligations and flowed into carry trades of risk financial assets. Increases in commodity prices drove again the all items CPI with interruptions during risk aversion originating in multiple fears but especially from the sovereign debt crisis of Europe.

clip_image046

Chart II-21, US, Consumer Price Index, 12-Month Percentage Change, NSA, 2001-2012

Source: US Bureau of Labor Statistics

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

The trend of increase of the consumer price index excluding food and industry in Chart II-22 does not reveal any threat of deflation that would justify symmetric inflation targets. There are mild oscillations in a neat upward trend.

clip_image048

Chart II-22, US, Consumer Price Index Excluding Food and Energy, NSA, 2001-2012

Source: US Bureau of Labor Statistics

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

Chart II-23 provides 12-month percentage change of the consumer price index excluding food and energy. Past-year rates of inflation fell toward 1 percent from 2001 into 2003 as a result of the recession and the decline of commodity prices beginning before the recession with declines of real oil prices. Near zero interest rates with fed funds at 1 percent between Jun 2003 and Jun 2004 stimulated carry trades of all types, including in buying homes with subprime mortgages in expectation that low interest rates forever would increase home prices permanently, creating the equity that would permit the conversion of subprime mortgages into creditworthy mortgages (Gorton 2009EFM; see http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Inflation rose and then collapsed during the unwinding of carry trades and the housing debacle of the global recession. Carry trades into 2011 and 2012 gave a new impulse to CPI inflation, all items and core. Symmetric inflation targets destabilize the economy by encouraging hunts for yields that inflate and deflate financial assets, obscuring risk/return decisions on production, investment, consumption and hiring.

clip_image050

Chart II-23, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2001-2012

Source: US Bureau of Labor Statistics

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

Headline and core producer price indexes are in Table II-5. The headline PPI SA increased 0.3 percent in Jul 2012 and 0.5 percent NSA in the 12 months ending in Jul 2012. The core PPI SA increased 0.4 percent in Jun 2012 and rose 2.5 percent in 12 months. Analysis of annual equivalent rates of change shows inflation waves similar to those worldwide. In the first wave, the absence of risk aversion from the sovereign risk crisis in Europe motivated the carry trade from zero interest rates into commodity futures that caused the average equivalent rate of 9.7 percent in the headline PPI in Jan-Apr 2011 and 4.0 percent in the core PPI. In the second wave, commodity futures prices collapsed in May 2011 with the return of risk aversion originating in the sovereign risk crisis of Europe. The annual equivalent rate of headline PPI inflation collapsed to 1.2 percent in May-Jun 2011 but the core annual equivalent inflation rate was much higher at 3.0 percent. In the third wave, headline PPI inflation resuscitated with annual equivalent at 6.6 percent in Jul-Sep 2011 and core PPI inflation at 4.1 percent. Core PPI inflation was persistent throughout 2011, jumping from annual equivalent at 1.8 percent in the first four months of 2010 to 3.0 percent in 12 months ending in Dec 2011. Unconventional monetary policy is based on the proposition that core rates reflect more fundamental inflation and are thus better predictors of the future. In practice, the relation of core and headline inflation is as difficult to predict as future inflation (see IIID Supply Shocks in http://cmpassocregulationblog.blogspot.com/2011_05_01_archive.html). In the fourth wave, risk aversion originating in the lack of resolution of the European debt crisis caused unwinding of carry trades with annual equivalent headline PPI inflation of minus 1.2 percent in Oct-Nov 2011 and 0.6 percent in the core annual equivalent. In the fifth wave from Dec 2011 to Jan 2012, annual equivalent inflation was 1.2 percent for the headline index but 4.9 percent for the core index excluding food and energy. In the sixth wave, annual equivalent inflation in Feb-Mar 2012 was 1.2 percent for the headline PPI and 1.8 percent for the core. In the seventh wave, renewed risk aversion caused reversal of carry trade commodity exposures with annual equivalent headline inflation of minus 7.0 percent in Apr-May 2012 while core PPI inflation was at annual equivalent 1.8 percent. An eighth wave could be beginning in Jun-Jul 2012 with annual equivalent inflation of 2.4 percent for the headline index and 3.7 percent for the core index. It is almost impossible to forecast PPI inflation and its relation to CPI inflation. “Inflation surprise” by monetary policy could be proposed to climb along a downward sloping Phillips curve, resulting in higher inflation but lower unemployment (see Kydland and Prescott 1977, Barro and Gordon 1983 and past comments of this blog http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). The architects of monetary policy would require superior inflation forecasting ability compared to forecasting naivety by everybody else. In practice, we are all naïve in forecasting inflation and other economic variables and events.

Table II-5, US, Headline and Core PPI Inflation Monthly SA and 12-Month NSA ∆%

 

Finished
Goods SA
Month

Finished
Goods NSA 12 months

Finished Core SA
Month

Finished Core NSA
12 months

Jul 2012

0.3

0.5

0.4

2.5

Jun

0.1

0.7

0.2

2.6

AE ∆% Jun-Jul

2.4

 

3.7

 

May

-1.0

0.7

0.2

2.7

Apr

-0.2

1.9

0.1

2.7

AE ∆% Apr-May

-7.0

 

1.8

 

Mar

-0.2

2.8

0.2

2.9

Feb

0.4

3.4

0.1

3.1

AE ∆% Feb-Mar

1.2

 

1.8

 

Jan

0.3

4.1

0.6

3.1

Dec 2011

-0.1

4.7

0.2

3.0

AE ∆% Dec-Jan

1.2

 

4.9

 

Nov

0.1

5.6

0.1

3.0

Oct

-0.3

5.8

0.0

2.9

AE ∆% Oct-Nov

-1.2

 

0.6

 

Sep

0.9

7.0

0.3

2.8

Aug

0.2

6.6

0.2

2.7

Jul

0.5

7.1

0.5

2.7

AE ∆% Jul-Sep

6.6

 

4.1

 

Jun

0.1

6.9

0.3

2.3

May

0.1

7.1

0.2

2.1

AE ∆%  May-Jun

1.2

 

3.0

 

Apr

0.7

6.6

0.3

2.3

Mar

0.5

5.6

0.3

2.0

Feb

1.1

5.4

0.2

1.8

Jan

0.8

3.6

0.5

1.6

AE ∆%  Jan-Apr

9.7

 

4.0

 

Dec 2010

0.9

3.8

0.2

1.4

Nov

0.4

3.4

-0.1

1.2

Oct

0.8

4.3

-0.2

1.6

Sep

0.4

3.9

0.2

1.6

Aug

0.7

3.3

0.2

1.3

Jul

0.2

4.1

0.2

1.5

Jun

-0.2

2.7

0.1

1.1

May

-0.2

5.1

0.3

1.3

Apr

-0.1

5.4

0.1

0.9

Mar

0.5

5.9

0.2

0.9

Feb

-0.6

4.2

0.0

1.0

Jan

1.0

4.5

0.3

1.0

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

Source: US Bureau of Labor Statistics http://www.bls.gov/ppi/data.htm

The US producer price index NSA from 2000 to 2012 is shown in Chart II-24. There are two episodes of decline of the PPI during recessions in 2001 and in 2008. Barsky and Kilian (2004) consider the 2001 episode as one in which real oil prices were declining when recession began. Recession and the fall of commodity prices instead of generalized deflation explain the behavior of US inflation in 2008.

clip_image052

Chart II-24, US, Producer Price Index, NSA, 2000-2012

Source: US Bureau of Labor Statistics

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

Twelve-month percentage changes of the PPI NSA from 2000 to 2012 are shown in Chart II-25. It may be possible to forecast trends a few months in the future under adaptive expectations but turning points are almost impossible to anticipate especially when related to fluctuations of commodity prices in response to risk aversion. In a sense, monetary policy has been tied to behavior of the PPI in the negative 12-month rates in 2001 to 2003 and then again in 2009 to 2010. Monetary policy following deflation fears caused by commodity price fluctuations would introduce significant volatility and risks in financial markets and eventually in consumption and investment.

clip_image054

Chart II-25, US, Producer Price Index, 12-Month Percentage Change NSA, 2000-2012

Source: US Bureau of Labor Statistics

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

The US PPI excluding food and energy from 2000 to 2012 is shown in Chart II-26. There is here again a smooth trend of inflation instead of prolonged deflation as in Japan.

clip_image056

Chart II-26, US, Producer Price Index Excluding Food and Energy, NSA, 2000-2012

Source: US Bureau of Labor Statistics

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

Twelve-month percentage changes of the producer price index excluding food and energy are shown in Chart II-27. Fluctuations replicate those in the headline PPI. There is an evident trend of increase of 12 months rates of core PPI inflation in 2011 but lower rates in the beginning of 2012.

clip_image058

Chart II-27, US, Producer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2000-2012

Source: US Bureau of Labor Statistics

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

The US producer price index of energy goods from 2000 to 2012 is in Chart II-28. There is a clear upward trend with fluctuations that would not occur under persistent deflation.

clip_image060

Chart II-28, US, Producer Price Index Finished Energy Goods, NSA, 2000-2012

Source: US Bureau of Labor Statistics

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

Chart II-29 provides 12-month percentage changes of the producer price index of energy goods from 2000 to 2012. The episode of declining prices of energy goods in 2001 to 2002 is related to the analysis of decline of real oil prices by Barsky and Kilian (2004). Interest rates dropping to zero during the global recession explain the rise of the PPI of energy goods toward 30 percent. Bouts of risk aversion with policy interest rates held close to zero explain the fluctuations in the 12-month rates of the PPI of energy goods in the expansion phase of the economy. Symmetric inflation targets induce significant instability in inflation and interest rates with adverse effects on financial markets and the overall economy.

clip_image062

Chart II-29, US, Producer Price Index Energy Goods, 12-Month Percentage Change, NSA, 2000-2012

Source: US Bureau of Labor Statistics

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

Table II-6 provides 12-month percentage changes of the CPI all items, CPI core and CPI housing from 2001 to 2012. There is no evidence in these data supporting symmetric inflation targets that would only induce greater instability in inflation, interest rates and financial markets. Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). The impact on the overall economy and the financial system of errors of policy are magnified by large-scale policy doses of trillions of dollars of quantitative easing and zero interest rates. The US economy has been experiencing financial repression as a result of negative real rates of interest during nearly a decade and programmed in monetary policy statements until 2014 or, for practical purposes, forever. The essential calculus of risk/return in capital budgeting and financial allocations has been distorted. If economic perspectives are doomed until 2014 such as to warrant zero interest rates, rational investors and consumers will not invest and consume until just before interest rates are likely to increase. Monetary policy statements on intentions of zero interest rates for another two years discourage investment and consumption or aggregate demand that can increase economic growth and generate more hiring and opportunities to increase wages and salaries.

Table II-6, CPI All Items, CPI Core and CPI Housing, 12-Month Percentage Change, NSA 2001-2012

Jul

CPI All Items

CPI Core ex Food and Energy

CPI Housing

2012

1.4

2.1

1.4

2011

3.6

1.8

1.5

2010

1.2

0.9

-0.5

2009

-2.1

1.5

-0.7

2008

5.6

2.5

3.9

2007

2.4

2.2

3.2

2006

4.1

2.7

4.1

2005

3.2

2.1

3.0

2004

3.0

1.8

2.7

2003

2.1

1.5

2.6

2002

1.5

2.2

2.0

2001

2.7

2.7

4.1

Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm

III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) slowing growth in China with political development and slowing growth in 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 Aug 10 and daily values throughout the week ending on Aug 17 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 Aug 10 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Aug 10, 2012”, first row “USD/EUR 1.2290 0.8%,” provides the information that the US dollar (USD) appreciated 0.8 percent to USD 1.2290/EUR in the week ending on Fri Aug 10 relative to the exchange rate on Fri Aug 3. 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) and another agreement on Jun 29, 2012 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131388.pdf).

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.2290/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Aug 10, depreciating to USD 1.2335/EUR on Mon Aug 13, or by 0.4 percent. The dollar depreciated because more dollars, $1.2335, were required on Mon Aug 13 to buy one euro than $1.2290 on Aug 10. Table III-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate 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 1.2335/EUR on Aug 13; 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 Aug 10, to the last business day of the current week, in this case Fri Aug 17, such as depreciation by 0.4 percent to USD 1.2335/EUR by Aug 17; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 0.4 percent from the rate of USD 1.2290/EUR on Fri Aug 10 to the rate of USD 1.2335/EUR on Fri Aug 17 {[(1.2335/1.2290) – 1]100 = 0.4%} and appreciated (denoted by positive sign) by 0.2 percent from the rate of USD 1.2358 on Thu Aug 16 to USD 1.2335/EUR on Fri Aug 17 {[(1.2335/1.2358) -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 Aug 13 to Aug 12, 2012

Fri Aug 10, 2012

M 13

Tue 14

W 15

Thu 16

Fr 17

USD/EUR

1.2290

0.8%

1.2335

-0.4%

-0.4%

1.2319

-0.2%

0.1%

1.2284

0.0%

0.3%

1.2358

-0.6%

-0.6%

1.2335

-0.4%

0.2%

JPY/  USD

78.27

0.3%

78.33

-0.1%

-0.1%

78.74

-0.6%

-0.5%

79.01

-0.9%

-0.3%

79.34

-1.4%

-0.4%

79.57

-1.7%

-0.3%

CHF/  USD

0.9771

-0.7%

0.9739

0.3%

0.3%

0.9751

0.2%

-0.1%

0.9778

-0.1%

-0.3%

0.9720

0.5%

0.6%

0.9738

0.3%

-0.2%

CHF/ EUR

1.2008

0.1%

1.2011

0.0%

0.0%

1.2012

0.0%

0.0%

1.2010

0.0%

0.0%

1.2012

0.0%

0.0%

1.2012

0.0%

0.0%

USD/  AUD

1.0577

0.9454

0.1%

1.0521

0.9505

-0.5%

-0.5%

1.0487

0.9536

-0.9%

-0.3%

1.0495

0.9528

-0.8%

0.1%

1.0516

0.9509

-0.6%

0.2%

1.0419

0.9598

-1.5%

-0.9%

10 Year  T Note

1.658

1.66

1.74

1.82

1.83

1.814

2 Year     T Note

0.267

0.26

0.28

0.29

0.29

0.288

German Bond

2Y -0.07 10Y 1.38

2Y -0.05 10Y 1.40

2Y -0.04% 10Y 1.47

2Y -0.02 10Y 1.56

2Y -0.04 10Y 1.53

2Y -0.04 10Y 1.50

DJIA

13207.95

0.9%

13169.43

-0.3%

-0.3%

13172.14

-0.3%

0.0%

13164.78

-0.3%

-0.1%

13250.11

0.3%

0.6%

13275.20

0.5%

0.2%

DJ Global

1880.18

2.0%

1877.01

-0.2%

-0.2%

1877.36

-0.2%

0.0%

1872.78

-0.4%

-0.2%

1889.61

0.5%

0.9%

1893.85

0.7%

0.2%

DJ Asia Pacific

1225.22

2.9%

1222.14

-0.3%

-0.3%

1224.61

0.0%

0.2%

1219.97

-0.4%

-0.4%

1226.00

0.1%

0.5%

1229.43

0.3%

0.3%

Nikkei

8891.44

3.9%

8885.15

-0.1%

-0.1%

8929.88

0.4%

0.5%

8925.04

0.4%

-0.1%

9092.76

2.3%

1.9%

9162.50

3.0%

0.8%

Shanghai

2168.81

1.7%

2136.08

-1.5%

-1.5%

2142.52

-1.2%

0.3%

2118.94

-2.3%

-1.1%

2112.20

-2.6%

-0.3%

2114.89

-2.5%

0.1%

DAX

6944.56

1.1%

6909.68

-0.5%

-0.5%

6974.39

0.4%

0.9%

6946.80

0.0%

-0.4%

6996.29

0.7%

0.7%

7040.88

1.4%

0.6%

DJ UBS

Comm.

143.20

0.2%

141.65

-1.1%

-1.1%

141.84

-0.9%

0.1%

142.27

-0.6%

0.3%

142.72

-0.3%

0.3%

143.11

-0.1%

0.3%

WTI $ B

92.87

1.6%

92.67

-0.2%

-0.2%

93.43

0.6%

0.8%

94.29

1.5%

0.9%

95.24

2.6%

1.0%

96.01

3.4%

0.8%

Brent    $/B

112.95

3.7%

113.60

0.6%

0.6%

114.01

0.9%

0.4%

116.25

2.9%

2.0%

115.27

2.1%

-0.8%

113.76

0.7%

-1.3%

Gold  $/OZ

1622.8

0.8%

1612.7

-0.6%

-0.6%

1602.4

-1.3%

-0.6%

1606.2

-1.0%

0.2%

1617.3

-0.3%

0.7%

1619.4

-0.2%

0.1%

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

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

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

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

There were €1,508,626 million total loans in the balance sheets of supervised institutions in Spain in 2006 of which $10,859 million, or 0.7 percent of total loans, classified as from “doubtful debtors,” according to data from the Bank of Spain (http://www.bde.es/webbde/es/estadis/infoest/a0403e.pdf). Total loans on an annual basis peaked in 2008 at €1,869,882 million of which €63,057 million, or 3.4 percent, from doubtful debtors. Total loans in Dec 2011 reached €1,782,554 million of which €139,760 million, or 7.8 percent, from doubtful debtors. In Jun 2012, total loans reached €1,743,979 million of which €164,361 million, or 9.4 percent, from doubtful debtors. Credit risk in balance sheets of Spanish banks continues to deteriorate. Loans have declined 6.7 percent from the peak in 2008 to Jun 2012 while doubtful loans have increased 160.7 percent.

International financial risk continues to be dominated by whether the European Central Bank (ECB) can rescue sovereign debts of highly-indebted euro zone member countries. The first approach of the ECB was by the program of long-term refinancing operations (LRTO) that swelled its balance sheet risk assets consisting of loans to member banks and purchases of sovereign bonds of member countries from €1.0 trillion in the balance sheet of Dec 31, 2010 to €1.8 trillion in the latest consolidated financial statement on Aug 3, 2012 (http://www.ecb.int/press/pr/wfs/2012/html/fs120807.en.html). The capital of the ECB is €85.7 billion or 4.7 percent of risk assets mostly in banks and sovereigns with high probability of default. It is not possible to measure accurately by how much the ECB would have to increase its holdings of debt of sovereigns with high risk of default that would “resolve” or at least push forward the sovereign debt crisis of the euro zone. There is a sort of chicken game to the edge of the abysm similar in US debt and deficit negotiations (http://cmpassocregulationblog.blogspot.com/2011/07/growth-recession-debt-financial-risk.html) between financial markets and the ECB that created the impasse during the past few weeks.

There were no changes of interest rate policy at the meeting of the European Central Bank (ECB) on Aug 2, 2012 (http://www.ecb.int/press/pr/date/2012/html/pr120802.en.html):

“2 August 2012 - Monetary policy decisions

At today’s meeting the Governing Council of the ECB decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.75%, 1.50% and 0.00% respectively.

The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 2.30 p.m. CET today.”

At the press conference following the announcement, Mario Draghi, President of the ECB, answered the question of whether there would be a program of buying sovereign bonds of euro zone members by the EFSF/ESM (European Financial Stability Fund/European Stability Mechanism) jointly with a program by the ECB (http://www.ecb.int/press/pressconf/2012/html/is120802.en.html):

“Draghi: Let me reread the related passage of my Introductory Statement, because that basically answers your question. It says: “The adherence of governments to their commitments”, namely fiscal reforms, structural reforms and so on, “and the fulfilment by the EFSF/ESM of their role are necessary conditions” for some actions on the ECB’s side. So, the first thing is that governments have to go to the EFSF, because, as I said several times, the ECB cannot replace governments, or cannot replace the action that other institutions have to take on the fiscal side. “The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy” – which means that to go to the EFSF is a necessary condition, but not a sufficient one, because the monetary policy is independent – “may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed.” That gives you the answer to the question. I should add that “over the coming weeks, we will design the appropriate modalities for such policy measures”. So, many of the details will be worked out by the relevant committees within the ECB.”

Further doubts were raised on the “reservations” by the Bundesbank (Central Bank of Germany) concerning sovereign bond purchases by the ECB as revealed by Mario Draghi in an answer to a question at the press conference (http://www.ecb.int/press/pressconf/2012/html/is120802.en.html):

Draghi: And fourth, the endorsement to do whatever it takes – again, to use the same words – whatever it takes to preserve the euro as a stable currency has been unanimous. But, it’s clear and it’s known that Mr Weidmann and the Bundesbank – although we are here in a personal capacity and we should never forget that – have their reservations about programmes that envisage buying bonds, so the idea is now we have given guidance, the Monetary Policy Committee, the Risk Management Committee and the Market Operations Committee will work on this guidance and then we’ll take a final decision where the votes will be counted. But so far that’s the situation; I think that’s a fair representation of our discussion today.”

Participants in financial markets began to believe in further purchases of sovereign bonds of euro zone members by the ECB.

Returning risk appetite on European assets was largely caused by expectations of a different turn in the bailout of highly indebted countries. The enthusiasm of markets was caused by the following remarks of Mario Draghi (2012Jul26), President of the European Central Bank (ECB), at the Global Investment Conference in London (http://www.ecb.int/press/key/date/2012/html/sp120726.en.html):

“But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

These remarks encouraged market participants that the ECB would resume its program of purchasing sovereign bonds of highly indebted members of the euro zone. Valuations of risk financial assets climbed sharply while yields of sovereign bonds of highly indebted members of the euro zone fell substantially. Charles Forelle and Tom Fairless, writing on “Europe’s leaders move to show resolve,” on Jul 27, 2012, published in the WSJ (http://professional.wsj.com/article/SB10000872396390443931404577552920809640442.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyze remarks by various European leaders on the intention to support Spain and Italy with strong measures that also contributed to the jump in valuations of risk financial assets. Brian Blackstone, writing on “ECB to discuss rescue plan with Bundesbank,” on Jul 27, 2012, published in the WSJ (http://professional.wsj.com/article/SB10000872396390444840104577553234196518556.html), inform of a future meeting between the chief executives of the ECB and the Bundesbank to discuss the rescue program. Earlier in the week, Jon Hilsenrath, writing on “Fed moves closer to action,” on Jul 24, 2012, published in the WSJ (http://professional.wsj.com/article/SB10000872396390444025204577547173267325402.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzed economic and financial data and statements by officials that raise the possibility of further easing policies by the Federal Open Market Committee (FOMC). Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. Table III-7 in IIIE Appendix Euro Zone Survival Risk below provides the combined GDP in 2012 of the highly indebted euro zone members estimated in the latest World Economic Outlook of the IMF at $4167 billion or 33.1 percent of total euro zone GDP of $12,586 billion. Using the WEO of the IMF, Table III-8 in IIIE Appendix Euro Zone Survival Risk below provides debt of the highly indebted euro zone members at $3927.8 billion in 2012 that increases to $5809.9 billion when adding Germany’s debt, corresponding to 167.0 percent of Germany’s GDP. There are additional sources of debt in bailing out banks. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html).

The selloff in world financial market on Fri Jul 20 was largely caused by doubts on the success of Spain resolution of its banks. Ilan Brat, David Román and Charles Forelle, writing on “Spanish worries feed global fears,” on Jul 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444464304577538613391486808.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyze the selloff in financial markets by the warning by the Spanish government of prolonged weak economic conditions with decline of GDP of 0.5 percent in 2013 while the government of the province of Valencia will require €18 billion from the central government. Other provincial governments are in need of cash. Spain intends to lower its deficit from 8.9 percent of GDP in 2011 to 2.8 percent by 2014. The yield of the ten-year government bond of Spain rose sharply to 7.224 percent on Fri Jul 20 while the yield of the ten-year government bond of Italy increased to 6.158 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The FTSE MIB index of Italian equities dropped 4.38 percent on Fri Jul 20 while the IBEX 35 index of Spanish equities fell 5.82 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Charles Forelle and David Enrich, writing on “Euro-zone banks cut back lending,” on Jul 13, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303919504577524482252510066.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyze the new mechanics of interbank lending in the euro zone. In the older regime, the deficits of households, corporations and governments of highly-indebted members of the euro zone were financed by banks in their jurisdictions that received interbank loans from banks in the less indebted or financially-stronger countries. The increase of perceptions of default risk in counterparties in transactions among financial institutions constituted an important disruption of the international financial system during the financial crisis (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 217-24, 60, Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 155-7). Counterparty risk perceptions rose significantly in sale and repurchase agreements (SRP) in which the financing counterparty doubted the credit quality of the collateral and of the financed counterparty to repurchase the security. Another form of counterparty risk was the sharp increase in the LIBOR-OIS in which lending banks doubted the balance sheet of borrowing counterparty banks in uncollateralized interbank loans. The sovereign debt crisis in the euro zone caused sharp increases in the perception of counterparty risk evaluation by lending banks in financially-stronger jurisdictions of balance sheets and repayment capacity of borrowing banks in highly-indebted countries. Forelle and Enrich, “Euro zone banks cut back lending,” use central bank information showing that long-term financing by the European Central Bank (ECB) is filling the financing gap of banks in highly indebted countries with significant part of ECB lending simply returning as deposits in countries in stronger jurisdictions and also as deposits at the ECB. As a result, risk spreads of interest rates in highly indebted countries have increased relative to interest rates in stronger countries, which is a movement in opposite direction of what would be desired to resolve the euro zone financial crisis. Crisis resolution has moved to preventing banking instability that could accentuate the financial crisis and fiscal standing of highly-indebted countries.

Current financial risk is dominated by interest rate decisions of major central banks and the new program of rescue of banks and countries in the sovereign risk event in the euro zone. At the meeting of its Governing Council on Jul 5, 2010, the European Central Bank took the following policy measures (http://www.ecb.int/press/pr/date/2012/html/pr120705.en.html):

“5 July 2012 - Monetary policy decisions

At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:

1. The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.75%, starting from the operation to be settled on 11 July 2012.

2. The interest rate on the marginal lending facility will be decreased by 25 basis points to 1.50%, with effect from 11 July 2012.

3. The interest rate on the deposit facility will be decreased by 25 basis points to 0.00%, with effect from 11 July 2012.

The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 2.30 p.m. CET today.”

The President of the ECB Mario Draghi summarized the reasons for the policy measures as follows (http://www.ecb.int/press/pressconf/2012/html/is120705.en.html):

“Based on our regular economic and monetary analyses, we decided to cut the key ECB interest rates by 25 basis points. Inflationary pressure over the policy-relevant horizon has been dampened further as some of the previously identified downside risks to the euro area growth outlook have materialised. Consistent with this picture, the underlying pace of monetary expansion remains subdued. Inflation expectations for the euro area economy continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. At the same time, economic growth in the euro area continues to remain weak, with heightened uncertainty weighing on confidence and sentiment.”

The Bank of England decided on Jul 5, 2012 to increase its policy of quantitative easing (http://www.bankofengland.co.uk/publications/Pages/news/2012/066.aspx ):

“The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%.  The Committee also voted to increase the size of its asset purchase programme, financed by the issuance of central bank reserves, by £50 billion to a total of £375 billion.

UK output has barely grown for a year and a half and is estimated to have fallen in both of the past two quarters.  The pace of expansion in most of the United Kingdom’s main export markets also appears to have slowed.  Business indicators point to a continuation of that weakness in the near term, both at home and abroad.  In spite of the progress made at the latest European Council, concerns remain about the indebtedness and competitiveness of several euro-area economies, and that is weighing on confidence here.  The correspondingly weaker outlook for UK output growth means that the margin of economic slack is likely to be greater and more persistent.”

The People’s Bank of China (PBC) also cut interest rates simultaneously with the other major central banks (http://www.pbc.gov.cn/publish/english/955/2012/20120608171005950734495/20120608171005950734495_.html):

“The PBC has decided to cut RMB benchmark deposit and loan interest rates for financial institutions as of June 8, 2012. The one-year RMB benchmark deposit and loan interest rates will be lowered both by 0.25 percentage points. Adjustments are made correspondingly to benchmark interest rates on deposits and loans of other maturities and to deposit and loan interest rates on personal housing provident fund.”

Monetary authorities worldwide are assessing higher risks to the economy.

The key decisions of the summit of European Leaders with regards to resolving the sovereign debt issues are (http://www.european-council.europa.eu/home-page/highlights/summit-impact-on-the-eurozone?lang=en):

“Euro area summit statement

Eurozone heads of state or government decided:

  • to establish a single banking supervisory mechanism run the by the ECB, and, once this mechanism has been created,
  • to provide the European Stability Mechanism (ESM) with the possibility to inject funds into banks directly.

Spain's bank recapitalisation will begin under current rules, i.e. with assistance provided by the European Financial Stability Facility (EFSF) until the ESM becomes available. The funds will then be transferred to the ESM without gaining seniority status.

It was also agreed that EFSF/ESM funds can be used flexibly to buy bonds for member states that comply with common rules, recommendations and timetables.

The Eurogroup has been asked to implement these decisions by 9 July 2012.”

Valuations of risk financial assets increased sharply after the announcement of these decisions. The details will be crafted at a meeting on finance ministries of the European Union on Jul 9, 2012.

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” 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” 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.”

Yields on sovereign debt backed up again with the yield of the ten-year government bond of Spain rising sharply to 7.224 percent on Fri Jul 20 while the yield of the ten-year government bond of Italy increased to 6.158 percent but eased again on Fri Jul 27 on the expectations of massive government support with the yield of the ten-year government bond of Spain falling to 6.731 percent and the yield of the ten-year government bond of Italy dropping to 5.956 percent. The ten-year government bond of Spain was quoted at yield of 6.827 percent on Fri Aug 3 and the ten-year government bond of Italy was quoted at 6.064 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The ten-year government bond of Spain was quoted at 6.868 percent on Aug 10, declining to 6.447 percent on Aug 17, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10 to 5.709 percent on Aug 17. Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes 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 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. Under increasing risk appetite, the yield of the ten-year Treasury rose to 1.544 on Jul 27, 2012 and 1.569 percent on Aug 3, 2012, while the yield of the ten-year Government bond of Germany rose to 1.40 percent on Jul 27 and 1.42 percent on Aug 3. Yields have been on an increasing trend with the US ten-year note at 1.814 percent on Aug 17 and the German ten-year bond at 1.50 percent. The US dollar strengthened significantly from USD 1.450/EUR on Aug 26, 2011, to USD 1.2158 on Jul 20, 2012, or by 16.2 percent, but depreciated to USD 1.2320/EUR on Jul 27, 2012 and 1.2387 on Aug 3, 2012 in expectation of massive support of highly indebted euro zone members. Doubts returned at the end of the week of Aug 10, 2012 with appreciation to USD 1.2290/EUR and decline of the yields of the two-year government bond of Germany to -0.07 percent and of the ten-year to 1.38 percent. On Aug 17, the US dollar depreciated by 0.4 percent to USD 1.2335/EUR and the ten-year bond of Germany yielded -0.04 percent. 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 around consumer price inflation of 1.4 percent in the 12 months ending in Jul (see subsection II United States Inflation and earlier at http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.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. 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

8/17/12

0.2888

1.814

-0.04

1.50

1.2335

8/10/12

0.267

1.658

-0.07

1.38

1.2290

8/3/12

0.242

1.569

-0.02

1.42

1.2387

7/27/12

0.244

1.544

-0.03

1.40

1.2320

7/20/12

0.207

1.459

-0.07

1.17

1.2158

7/13/12

0.24

1.49

-0.04

1.26

1.2248

7/6/12

0.272

1.548

-0.01

1.33

1.2288

6/29/12

0.305

1.648

0.12

1.58

1.2661

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.bundesbank.de/Navigation/EN/Statistics/Time_series_databases/Macro_economic_time_series/macro_economic_time_series_node.html?anker=GELDZINS

http://www.ecb.int/stats/money/long/html/index.en.html

Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year and two-year Treasury constant maturity yields. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe.

clip_image002[1]

Chart III-1A, US, Ten-Year and Two-Year Treasury Constant Maturity Yields Jan 2, 2001-Aug 16, 2012

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h15/update/

Equity indexes in Table III-1 were mostly higher in the week ending on Aug 17, 2012, because of enthusiasm on resolution of fiscal and banking issues in Spain and Italy. DJIA increased 0.2 percent on Aug 17 and 0.5 percent in the week. Germany’s Dax increased 0.6 percent on Fri Aug 17, gaining 1.4 percent in the week. Dow Global gained 0.2 percent on Aug 17 and increased 0.7 percent in the week. Japan’s Nikkei Average increased 0.8 percent on Fri Aug 17 and increased 3.0 percent in the week. Dow Asia Pacific TSM increased 0.3 percent on Aug 17 and increased 0.3 percent in the week while Shanghai Composite fell 2.5 percent in the week, increasing 0.1 percent on Fri Aug 17.

Commodities were mixed in the week of Aug 17, 2012. The DJ UBS Commodities Index increased 0.3 percent on Fri Aug 17 but fell 0.1 percent in the week, as shown in Table III-1. WTI increased 0.8 percent on Fri Aug 17 and increased 3.4 percent in the week while Brent fell 1.3 percent on Fri Aug 17 but gained 0.7 percent in the week. Gold decreased 0.2 percent in the week of Aug 17.

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” increased from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,210,735 million on Aug 10, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,813,463 million in the statement of Aug 3.

Table III-1B, Consolidated Financial Statement of the Eurosystem, Million EUR

 

Dec 31, 2010

Dec 28, 2011

Aug 10, 2012

1 Gold and other Receivables

367,402

419,822

433,778

2 Claims on Non Euro Area Residents Denominated in Foreign Currency

223,995

236,826

260,384

3 Claims on Euro Area Residents Denominated in Foreign Currency

26,941

95,355

55,550

4 Claims on Non-Euro Area Residents Denominated in Euro

22,592

25,982

16,771

5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro

546,747

879,130

1,210,735

6 Other Claims on Euro Area Credit Institutions Denominated in Euro

45,654

94,989

214,052

7 Securities of Euro Area Residents Denominated in Euro

457,427

610,629

602,728

8 General Government Debt Denominated in Euro

34,954

33,928

30,041

9 Other Assets

278,719

336,574

262,782

TOTAL ASSETS

2,004, 432

2,733,235

3,086,822

Memo Items

     

Sum of 5 and  7

1,004,174

1,489,759

1,813,463

Capital and Reserves

78,143

85,748

85,749

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/fs120814.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” increased from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,210,735 million on Aug 10, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,813,463 million in the statement of Aug 3.

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

Aug 10, 2012

1 Gold and other Receivables

367,402

419,822

433,778

2 Claims on Non Euro Area Residents Denominated in Foreign Currency

223,995

236,826

260,384

3 Claims on Euro Area Residents Denominated in Foreign Currency

26,941

95,355

55,550

4 Claims on Non-Euro Area Residents Denominated in Euro

22,592

25,982

16,771

5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro

546,747

879,130

1,210,735

6 Other Claims on Euro Area Credit Institutions Denominated in Euro

45,654

94,989

214,052

7 Securities of Euro Area Residents Denominated in Euro

457,427

610,629

602,728

8 General Government Debt Denominated in Euro

34,954

33,928

30,041

9 Other Assets

278,719

336,574

262,782

TOTAL ASSETS

2,004, 432

2,733,235

3,086,822

Memo Items

     

Sum of 5 and  7

1,004,174

1,489,759

1,813,463

Capital and Reserves

78,143

85,748

85,749

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/fs120814.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 9.9 percent in Jun 2012 relative to Jun 2011 while those to EMU are falling at 1.2 percent.

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

Jun 2012

Exports
% Share

∆% Jan-Jun 2012/ Jan-Jun 2011

Imports
% Share

Imports
∆% Jan-Jun 2012/ Jan-Jun 2011

EU

56.0

0.0

53.3

-7.5

EMU 17

42.7

-1.2

43.2

-7.1

France

11.6

-0.3

8.3

-5.3

Germany

13.1

1.3

15.6

-10.0

Spain

5.3

-8.5

4.5

-8.1

UK

4.7

10.6

2.7

-14.8

Non EU

44.0

9.9

46.7

-3.8

Europe non EU

13.3

11.3

11.1

-5.6

USA

6.1

18.2

3.3

3.4

China

2.7

-11.6

7.3

-17.1

OPEC

4.7

24.1

8.6

25.3

Total

100.0

4.2

100.0

-5.8

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/68816

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €410 million with the 17 countries of the euro zone (EMU 17) in Jun and deficit of €1619 million in Jan-Jun. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €4964 million in Jan-Jun with Europe non European Union and of €6610 million with the US. There is significant rigidity in the trade deficits in Jan-Jun of €8304 million with China and €11,076 million with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.

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

Regions and Countries

Trade Balance Jun 2012 Millions of Euro

Trade Balance Cumulative Jan-Jun 2012 Millions of Euro

EU

997

5,130

EMU 17

-410

-1,619

France

1,136

5,902

Germany

-536

-3,168

Spain

46

951

UK

990

4,576

Non EU

1,520

-5,215

Europe non EU

1,402

4,964

USA

1,337

6,610

China

-1,515

-8,304

OPEC

-1,301

-11,076

Total

2,517

-85

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/68816

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Jun 2012 relative to Jan-Jun 2011. Growth rates of imports are negative with the exception of energy. The higher rate of growth of exports of 4.2 percent in Jan-Jun 2012/Jan-Jun 2011 relative to imports of minus 5.8 percent may reflect weak demand in Italy with GDP declining during four consecutive quarters from IIIQ2011 through IIQ2012.

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

 

Exports
Share %

Exports
∆% Jan-Jun 2012/ Jan-Jun 2011

Imports
Share %

Imports
∆% Jan-Jun 2012/ Jan-Jun 2011

Consumer
Goods

28.9

5.5

25.0

-3.0

Durable

5.9

2.0

3.0

-7.9

Non
Durable

23.0

6.4

22.0

-2.3

Capital Goods

32.2

2.6

20.8

-12.1

Inter-
mediate Goods

34.3

2.7

34.5

-12.4

Energy

4.7

18.8

19.7

10.5

Total ex Energy

95.3

3.5

80.3

-9.5

Total

100.0

4.2

100.0

-5.8

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/68816

Table III-6 provides Italy’s trade balance by product categories in Jun 2012 and cumulative Jan-Jun 2012. Italy’s trade balance excluding energy generated surplus of €7122 million in Jun 2012 and €32,595 million in Jan-Jun 2012 but the energy trade balance created deficit of €4605 million in Jun 2012 and €32,680 million in Jan-Jun 2012. The overall surplus in Jun 2012 was €2517 million but there was an overall deficit of €85 million in Jan-Jun 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

 

Jun 2012

Cumulative Jan-Jun 2012

Consumer Goods

1,674

7,016

  Durable

1,092

5,600

  Nondurable

583

1,416

Capital Goods

4,747

23,497

Intermediate Goods

700

2,081

Energy

-4,605

-32,680

Total ex Energy

7,122

32,595

Total

2,517

-85

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/68816

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
USD Billions

Primary Net Lending Borrowing
% GDP 2012

General Government Net Debt
% GDP 2012

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 VE-9 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 Jun 2012. German exports to other European Union (EU) members are 56.7 percent of total exports in Jun 2012 and 58.0 percent in Jan-Jun 2012. Exports to the euro area are 41.8 percent in May and 38.7 percent in Jan-May. Exports to third countries are 37.5 percent of the total in Jun and 38.5 percent in Jan-Jun. There is similar distribution for imports. Exports to non-euro countries are growing at 4.8 percent in Jun 2012 and 4.2 percent in Jan-Jun 2012 while exports to the euro area are falling 3.0 percent in Jun and increasing 0.6 percent in Jan-Jun 2012. Price competitiveness through devaluation could improve export performance and growth. 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 ∆%

 

Jun 2012 
€ Billions

Jun 12-Month
∆%

Jan–Jun 2012 € Billions

Jan-Jun 2012/
Jan-Jun 2011 ∆%

Total
Exports

94.6

7.4

550.4

4.8

A. EU
Members

53.6

% 56.7

-0.5

319.0

% 58.0

0.6

Euro Area

35.5

% 37.5

-3.0

212.0

% 38.5

-1.1

Non-euro Area

18.0

% 19.0

4.8

107.1

% 19.5

4.2

B. Third Countries

41.1

% 43.5

19.8

231.4

% 42.0

11.1

Total Imports

76.7

1.5

457.1

2.4

C. EU Members

49.3

% 64.3

-1.4

290.7

% 63.6

2.0

Euro Area

34.9

% 45.5

-2.8

204.8

% 44.8

1.5

Non-euro Area

14.4

% 18.8

2.2

85.9

% 18.8

3.3

D. Third Countries

27.5

% 35.9

7.2

166.4

% 36.4

3.0

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

Source:

Statistiche Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/08/PE12_269_51.html;jsessionid=5AB45783D1BE8502BB1AF4397C769BCD.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)stdτ (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, which are equal to TtGt 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.

clip_image063

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 (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.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
Account BOP

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 Manuel 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.

clip_image064

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

2.2

1.4

0.5

8.3

Japan

3.5

-0.2

-2.1

4.3

China

8.9

1.8

-2.9

 

UK

-0.8

2.6*
RPI 3.2

1.7* output
1.3**
input
-2.4*

8.1

Euro Zone

-0.4

2.4

1.8

11.2

Germany

1.0

1.9

1.6

5.4

France

0.3

2.2

1.3

10.1

Nether-lands

-0.5

2.6

1.8

5.1

Finland

0.6

3.1

1.4

7.5

Belgium

-0.4

2.0

2.6

7.2

Portugal

-3.3

2.8

2.7

15.4

Ireland

NA

2.0

2.4

14.8

Italy

-2.5

3.6

2.2

10.8

Greece

-6.2

0.9

3.1

NA

Spain

-1.0

2.2

2.5

24.8

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

*Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/july-2012/index.html **Core

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-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 2.2 percent in IIQ2012 relative to IIQ2011 (Table 8, p 27 in http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp2q12_adv.pdf) See I Mediocre and Decelerating United States Economic Growth http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/mediocre-economic-growth-united-states.html). Japan’s GDP fell 0.7 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 7.4 percent in IIIQ2011, increasing at the SAAR of 0.3 percent in IVQ 2011, 5.5 percent in IQ2012 and 1.4 percent in IIQ2012 (see Section VB and earlier at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html); the UK grew at minus 0.7 percent in IIQ2012 relative to IQ2012 and GDP fell 0.8 percent in IIQ2012 relative to IIQ2011 (see Section VH http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery_29.html); and the Euro Zone grew at minus 0.2 percent in IIQ2012, 0.0 percent in IQ2012 relative to IVQ2011 and fell 0.4 percent in IIQ2012 relative to IIQ2011 (see Section VD). 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: 8.3 percent in the US but 17.9 percent for unemployment/underemployment or job stress of 28.6 million (see Table I-4 http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real.html http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight.html http://cmpassocregulationblog.blogspot.com/2012/04/thirty-million-unemployed-or.html), 4.3 percent for Japan (see Section VB http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or_3778.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/mediocre-economic-growth-united-states_03.html), 8.0 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/2012/07/world-inflation-waves-financial_22.html and 11.2 percent in the Euro Zone (section VD http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or_3778.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.4 percent in the US, -0.2 percent for Japan, 1.8 percent for China, 2.4 percent for the Euro Zone and 2.6 percent for the UK. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section III and earlier ); (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 IIB http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html), weak hiring with the loss of 10 million full-time jobs (see Section I http://cmpassocregulationblog.blogspot.com/2012/08/recovery-without-hiring-ten-million.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-hiring-ten-million.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 http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real.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 Aug 1, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20120801a.htm):

“Release Date: August 1, 2012

For immediate release

Information received since the Federal Open Market Committee met in June suggests that economic activity decelerated somewhat over the first half of this year. Growth in employment has been slow in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending has been rising at a somewhat slower pace than earlier in the year. Despite some further signs of improvement, the housing sector remains depressed. Inflation has declined since earlier this year, 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 as announced in June, and it 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 will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed 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. The FOMC is extending this program until the end of 2012.

3. Continuing Maturity Extension Program. This program is discussed in Section II Twist Again Extension (http://cmpassocregulationblog.blogspot.com/2012/06/recovery-without-hiring-continuance-of_24.html). 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 as announced in June, and it 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.

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 will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

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 IIQ2012 is analyzed in I Mediocre and Decelerating United States Economic Growth (http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery.html) and the PCE inflation data from the report on personal income and outlays (http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real_09.html). The Bureau of Economic Analysis (BEA) provides the first estimate of IIQ2012 GDP with the second estimate to be released on Aug 29 (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 Jun see http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm and http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html). The next report on “Personal Income and Outlays” for Jul will be released at 8:30 AM on Aug 30, 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 Jul report is analyzed at http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html). The report for Aug will be released on Sep 7, 2012 (http://www.bls.gov/cps/home.htm). “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
Tendency

       

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 
Apr PR

2.2 to 2.8
2.7 to 3.1

7.5 to 8.0
7.3 to 7.7

1.5 to 2.0
1.6 to 2.0

1.6 to 2.0 1.7 to 2.0

2014 
Apr PR

3.0 to 3.5
3.1 to 3.6

7.0 to 7.7
6.7 to 7.4

1.5 to 2.0
1.7 to 2.0

1.6 to 2.0
1.8 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
Apr PR

1.6 to 2.5
2.1 to 3.0

7.8 to 8.4
7.8 to 8.2

1.2 to 2.0
1.8 to 2.3

1.7 to 2.0
1.7 to 2.0

2013
Apr PR

2.2 to 3.5
2.4 to 3.8

7.0 to 8.1
7.0 to 8.1

1.5 to 2.1
1.5 to 2.1

1.4 to 2.1
1.6 to 2.1

2014
Apr PR

2.8 to 4.0
2.9 to 4.3

6.3 to 7.7
6.3 to 7.7

1.5 to 2.2
1.5 to 2.2

1.5 to 2.2
1.7 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

There are two categories of responses in the Empire State Manufacturing Survey of the Federal Reserve Bank of New York (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html): current conditions and expectations for the next six months. There are responses in the survey for two types of prices: prices received or inputs of production and prices paid or sales prices of products. Table IV-5 provides indexes for the two categories and within them for the two types of prices from Jan 2011 to Aug 2012. Current prices paid were rising at an accelerating rate from 35.79 in Jan 2011 to 69.89 in May 2011 but the rate of increase dropped significantly to 25.88 in Feb 2012, increasing sharply to 50.62 in Mar in the commodity price shock but falling to 45.78 in Apr, 37.35 in May, 19.59 in Jun and 7.41 in Jul as risk aversion caused decline of commodity prices. At the margin, the index of prices paid rose to 16.47 in Aug in yet net another bout of carry trade. The index of current prices received also fell sharply from 27.96 in May 2011 to 4.49 in Oct 2011, meaning that prices were increasing at a very low rate and then rose to 13.58 in Mar 2012, increasing to 19.28 in Apr but declining to 12.05 in May, 1.03 in Jun, 3.70 in Jul and 2.35 in Aug, which is also relatively low, near the border of contraction at 0.0. In the expectations for the next six months, the index of prices paid also declined from 68.82 in May 2011 to 56.98 in Dec 2011, rising to 66.67 in Mar 2012 but declining to 50.60 in Apr 2012, increasing to 57.83 in May and falling to 34.02 in Jun, 35.80 in Jul and 31.76 in Aug. Expected prices received also rose in the first five months of 2011, declining from 35.48 in May 2011 to 15.22 in Aug 2011 but then rising to 32.10 in Mar 2012 and declining to 22.89 in Apr and May 2012, 17.53 in Jun, 16.05 in Jul and 14.12 in Aug. Unconventional monetary policy of zero interest rates and quantitative easing has increased the volatility of inflation via carry trades, creating uncertainty in financial and economic decisions.

Table IV-5, US, FRBNY Empire State Manufacturing Survey, Diffusion Indexes, Prices Paid and Prices Received, SA

 

Current Prices Paid

Current Prices Received

Six Months Prices Paid

Six Months Prices Received

Aug 2012

16.47

2.35

31.76

14.12

Jul

7.41

3.70

35.80

16.05

Jun

19.59

1.03

34.02

17.53

May

37.35

12.05

57.83

22.89

Apr

45.78

19.28

50.60

22.89

Mar

50.62

13.58

66.67

32.10

Feb

25.88

15.29

62.35

34.12

Jan

26.37

23.08

53.85

30.77

Dec 20111

24.42

3.49

56.98

36.05

Nov

18.29

6.10

36.59

25.61

Oct

24.47

4.49

40.45

17.98

Sep

32.61

8.70

53.26

22.83

Aug

28.26

2.17

42.39

15.22

Jul

43.33

5.56

51.11

30.00

Jun

56.12

11.22

55.10

19.39

May

69.89

27.96

68.82

35.48

Apr

57.69

26.92

56.41

38.46

Mar

53.25

20.78

71.43

36.36

Feb

45.78

16.87

55.42

27.71

Jan

35.79

15.79

60.00

42.11

Source: http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html

Price indexes of the Federal Reserve Bank of Philadelphia Outlook Survey are provided in Table IV-6. As inflation waves throughout the world (analyzed in Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.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 2011 with even decline of prices received in Aug 2011 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 Aug 2012, the index of current prices received was 2.8 percent, indicating very moderate expansion 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, increasing to 11.2 in Aug in a new round of marginal pressure of input inflation. The index of future prices paid increased from 35.2 percent in Apr 2012 to 37.8 in May but fell to 33.1 in Aug but higher than 22.8 in Jul, 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, 13.5 in Jun and 14.6 in Jul, indicating softness in expected future prices received or sales prices, but rebounded to 20.3 in Aug in yet another round of influence of carry trades.

Table IV-6, 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

Aug 2012

11.2

2.8

33.1

20.3

Jul

3.7

1.6

22.8

14.6

Jun

-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 VI-1of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia provides the diffusion index of current prices paid or prices of inputs from Aug 2011 to Aug 2012. Inflation of inputs moderated significantly during the shock of risk aversion in 2012, even falling briefly into contraction territory below zero and expanding now at very moderate but marginally increasing pace.

clip_image066

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, moving back into very moderate expansion. Carry trades from zero interest rates cause instability in net margins of business because of more dynamic effects on input prices than in prices of product sales.

clip_image068

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 harmonized index of consumer prices of the euro area in Table IV-7 has similar inflation waves as in most countries (see Section I). In the first wave, consumer prices in the euro area increased at the annual equivalent rate of 5.2 percent in Jan-Apr 2011. In the second wave, risk aversion caused unwinding of commodity carry trades with inflation decreasing at the annual equivalent rate of minus 2.4 percent in May-Jul 2011. In the third wave, improved risk appetite resulted in annual equivalent inflation in Aug-Dec at 4.3 percent. In the fourth wave, return of risk aversion caused decline of consumer prices at the annual equivalent rate of minus 3.0 percent in Dec 2011 to Jan 2012. In the fifth wave, improved attitudes toward risk aversion resulted in higher consumer price inflation at the high annual equivalent rate of 9.6 percent in Feb-Apr 2012. A sixth wave is shown by risk aversion forcing decline of annual equivalent inflation to minus 2.8 percent in May-Jul 2012. Inflation volatility around the world is confusing the information required in investment and consumption decisions.

Table IV-7, Euro Area Harmonized Index of Consumer Prices Month and 12 Months ∆%

 

Month ∆%

12 Months ∆%

Jul 2012

-0.5

2.4

Jun

-0.1

2.4

May

-0.1

2.4

AE ∆% May-Jul

-2.8

 

Apr

0.5

2.6

Mar

1.3

2.7

Feb

0.5

2.7

AE ∆%  Feb-Apr

9.6

 

Jan

-0.8

2.7

Dec 2011

0.3

2.7

AE ∆%  Dec-Jan

-3.0

 

Nov

0.1

3.0

Oct

0.4

3.0

Sep

0.7

3.0

Aug

0.2

2.6

AE ∆%  Aug-Dec

4.3

 

Jul

-0.6

2.6

Jun

0.0

2.7

May

0.0

2.7

AE ∆%  May-Jul

-2.4

 

Apr

0.6

2.8

Mar

1.4

2.7

Feb

0.4

2.4

Jan

-0.7

2.3

AE ∆% Jan-Apr

5.2

 

Dec 2010

0.6

2.2

AE: annual equivalent

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

Table IV-8 provides inflation, unemployment and real GDP growth in the euro area yearly from 1999 to 2011 together with growth forecasts of EUROSTAT for 2012 and 2013. Inflation in the euro zone remained subdued around 2 percent in the first five years of the euro zone from 1999 to 2004, as shown in Table IV-13. Inflation climbed above 2.0 percent after 2005, peaking at 3.3 percent in 2008 with the surge in commodity prices but falling to 0.3 percent in 2009 with the collapse of commodity prices. Inflation climbed back to 1.6 percent in 2010 and 2.7 percent in 2011. Under the regime of zero interest rates inflation returns worldwide during relaxation of risk aversion.

Table IV-8, Euro Area, Yearly Percentage Change of Harmonized Index of Consumer Prices, ∆%

Year

HICP ∆%

Unemployment
%

GDP ∆%

1999

1.2

9.6

2.9

2000

2.2

8.7

3.8

2001

2.4

8.1

2.0

2002

2.3

8.5

0.9

2003

2.1

9.0

0.7

2004

2.2

9.3

2.2

2005

2.2

9.2

1.7

2006

2.2

8.5

3.3

2007

2.1

7.6

3.0

2008

3.3

7.6

0.4

2009

0.3

9.6

-4.4

2010

1.6

10.1

2.0

2011

2.7

10.1

1.5

2012*

   

-0.3

2013*

   

1.0

*EUROSTAT forecast Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

EUROSTAT provides the decomposition in percentage point contributions of the rate of inflation of 2.4 percent in the 12 months ending in Jul 2012 relative to Jul 2011 shown in Table IV-9. Energy-rich components dominate the 12-month rate of inflation with percentage point contributions: 0.13 by fuel for transport, 0.10 by gas and 0.10 by electricity. Table IV-9 only lists highest magnitudes of positive and negative contributions.

Table IV-9, Euro Area, Harmonized Index of Consumer Prices Sub-Indices with Most Important Impact %

Jul 2012/ Jul 2011   ∆% 2.4

Weight 2012 %

Rate ∆%

Impact
Percentage
Points PP

Positive Contribution

     

Fuel for Transport

48.5

5.0

0.13

Electricity

26.4

6.1

0.10

Gas

18.3

7.9

0.10

Tobacco

23.4

6.1

0.09

Heating Oil

8.9

6.7

0.04

Jewelry & Watches

5.9

10.4

0.04

Negative Contribution

     

IT Equipment

5.1

-5.9

-0.04

Rents

60.5

1.6

-0.05

Financial Services

6.8

-5.1

-0.05

Audio-visual Equipment

5.0

-7.9

-0.05

Cars

36.2

1.0

-0.06

Telecom

29.8

-3.3

-0.18

PP: percentage points

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16082012-AP/EN/2-16082012-AP-EN.PDF

EUROSTAT provides the decomposition in percentage point contributions of the rate of inflation of minus 0.5 percent in Jul 2012 relative to Jun 2012 shown in Table IV-10. The decline of the HIPC by 0.5 percent was largely dominated by the decline of prices of garments by 0.74 percentage points and footwear by 0.16 percentage points.

Table IV-10, Euro Area, Harmonized Index of Consumer Prices Sub-Indices with Most Important Impact %

Jul 2012/Jun 2012  ∆ % -0.5

Weight 2012 %

Rate ∆%

Impact Percentage Points

Positive Contribution

     

Package Holidays

14.2

13.5

0.18

Accommodation Services

16.5

6.6

0.12

Air Transport

6.3

11.3

0.08

Rents

60.5

0.6

0.07

Fuel for Transport

48.5

0.5

0.05

Restaurants and Cafés

68.8

0.1

0.05

Negative Contribution

     

Household Textiles

5.0

-3.5

-0.01

Other Personal Effects

4.3

-4.3

-0.02

Vegetables

14.0

-2.4

-0.03

Fruit

11.8

-4.5

-0.05

Footwear

13.6

-11.9

-0.16

Garments

50.7

-14.5

-0.74

Source: EUROSTAT

http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16082012-AP/EN/2-16082012-AP-EN.PDF

The producer price index of Germany fell 0.1 percent in Jul 2012, calendar and seasonally adjusted (CSA) and was flat not seasonally adjusted (NS) relative to Jun 2012 and increased 0.9 percent in the 12 months ending in Jul, as shown in Table IV-6. The producer price index of Germany has similar waves of inflation as in many other countries (Section I and earlier http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html). In the first wave from Jan to Apr 2011, the annual equivalent rate of producer price inflation was 10.4 percent NSA and 6.5 percent CSA, 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 NSA because of the collapse of the carry trade in fear of risks of European sovereign debt but 3.0 percent CSA. In the third wave from Jul to Sep 2011, annual-equivalent producer price inflation in Germany was 2.8 percent NSA and 4.8 percent CSA 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 2.8 percent NSA and 4.5 percent CSA 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 NSA and minus 0.0 percent CSA. In the sixth wave, annual equivalent inflation increased to 6.2 percent in Feb-Mar 2012 NSA and 4.9 percent in Feb-Apr and 0.8 percent CSA. In the seventh wave, annual equivalent inflation was minus 2.8 percent in May-Jul 2012 NSA and minus 1.2 percent SA. 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-11, Germany, Index of Producer Prices for Industrial Products ∆%

 

12 Months ∆% NSA

Month ∆%

Calendar and SA

Month ∆%  NSA

Jul 2012

0.9

-0.1

0.0

Jun

1.6

-0.2

-0.4

May

2.1

0.0

-0.3

AE ∆% May-Jul

 

-1.2

-2.8

Apr

2.4

-0.2

0.2

Mar

3.3

0.3

0.6

Feb

3.2

0.1

0.4

AE ∆% Feb-Apr

 

0.8

4.9

Jan

3.4

0.2

0.6

Dec 2011

4.0

-0.2

-0.4

AE ∆% Dec-Jan

 

0.0

1.2

Nov

5.2

0.3

0.1

Oct

5.3

0.3

0.2

AE ∆% Oct-Nov

 

3.7

1.8

Sep

5.5

0.4

0.3

Aug

5.5

0.2

-0.3

Jul

5.8

0.6

0.7

AE ∆% Jul-Sep

 

4.9

2.8

Jun

5.6

0.2

0.1

May

6.1

0.3

0.0

AE ∆% May-Jun

 

3.0

0.6

Apr

6.4

0.6

1.0

Mar

6.2

0.3

0.4

Feb

6.4

0.5

0.7

Jan

5.7

0.7

1.2

AE ∆% Jan-Apr

 

6.5

10.4

Dec 2010

5.3

0.8

0.7

Nov

4.4

0.4

0.2

Oct

4.3

0.5

0.4

Sep

3.9

0.5

0.3

Aug

3.2

0.2

0.0

Jul

3.7

0.6

0.5

Jun

1.7

0.5

0.6

May

0.9

0.3

0.3

Apr

0.6

0.5

0.8

Mar

-1.5

0.6

0.7

Feb

-2.9

0.0

0.0

Jan

-3.4

0.4

0.8

Dec 2009

-5.2

0.2

-0.1

Dec 2008

4.0

-0.2

-0.8

Dec 2007

1.9

0.4

-0.1

Dec 2006

4.2

0.2

0.1

Dec 2005

4.8

0.2

0.3

Dec 2004

2.9

0.2

0.1

Dec 2003

1.8

 

0.0

Dec 2002

0.5

 

0.1

Dec 2001

0.1

 

-0.2

Source: Statistiche Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/08/PE12_281_61241.html;jsessionid=FB34F751FCDF6302CC8113B617BC9B5B.cae4 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 and 0.4 percent in Jun 2012 with flat prices in Jul 2012 with the pace at annual equivalent rate of minus 4.1 percent in May-Jun 2012 and flat prices in Jul 2012.

clip_image070

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 US Bureau of Labor Statistics provides the US producer price index of finished goods from 2004 to 2012. Chart IV-4 of the US mirrors behavior in Chart IV-3 of Germany. Carry trades from zero interest rates to exposures in commodity futures and risk financial assets have synchronized worldwide inflation during periods of risk appetite and disinflation during periods of risk aversion.

clip_image072

Chart IV-4, US, Producer Price Index, Finished Goods, NSA, 2004-2012

Source: US Bureau of Labor Statstics

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

Chart IV-4 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the unadjusted producer price index, trend and trend ends. 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-Jun 2012 with flat prices in Jul 2012.

clip_image074

Chart IV-5, 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

Table IV-12 provides monthly and 12 months consumer price inflation in France. There are the same five waves as in inflation worldwide (Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html). In the first wave, annual equivalent inflation in Jan-Apr 2011 was 4.3 percent driven by the carry trade from zero interest rates to commodity futures positions in an environment of risk appetite. In the second wave, risk aversion caused the reversal of carry trades into commodity futures, resulting in the fall of the annual equivalent inflation rate to minus 0.8 percent in May-Jul 2011. In the third wave, annual equivalent inflation rose to 2.7 percent in Aug-Nov with alternations of risk aversion and risk appetite. In the fourth wave, risk aversion originating in the European debt crisis caused annual equivalent inflation of 0.0 percent from Dec 2011 to Jan 2012. In the fifth wave, annual equivalent inflation increased to 5.3 percent in Feb-Apr 2012. A sixth wave appears is developing at the margin with annual equivalent inflation of minus 2.0 percent in May-Jul 2012 during another bout of risk aversion causing reversal of carry trades from zero interest rates to commodity price futures exposures.

Table IV-12, France, Consumer Price Index, Month and 12-Month ∆%

 

Month ∆%

12-Month ∆%

Jul 2012

-0.4

1.9

Jun

0.0

1.9

May

-0.1

2.0

AE ∆% May-Jul

-2.0

 

Apr

0.1

2.1

Mar

0.8

2.3

Feb

0.4

2.3

AE ∆% Feb-Apr

5.3

 

Jan

-0.4

2.3

Dec 2011

0.4

2.5

AE ∆% Dec-Jan

0.0

 

Nov

0.3

2.5

Oct

0.2

2.3

Sep

-0.1

2.2

Aug

0.5

2.2

AE ∆% Aug-Nov

2.7

 

Jul

-0.4

1.9

Jun

0.1

2.1

May

0.1

2.0

AE ∆% May-Jul

-0.8

 

Apr

0.3

2.1

Mar

0.8

2.0

Feb

0.5

1.7

Jan

-0.2

1.8

AE ∆% Jan-Apr

4.3

 

Dec 2010

0.5

1.8

Annual

   

2011

 

2.1

2010

 

1.5

2009

 

0.1

2008

 

2.8

2007

 

1.5

2006

 

1.6

2005

 

1.8

2004

 

2.1

2003

 

2.1

2002

 

1.9

2001

 

1.7

2000

 

1.7

1999

 

0.5

1998

 

0.7

1997

 

1.2

1996

 

2.0

1995

 

1.8

1994

 

1.6

1993

 

2.1

1992

 

2.4

1991

 

3.2

AE: Annual Equivalent

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120814

Table IV-12 provides in the lower panel the estimates of inflation by the Institut National de la Statistique et des Études Économiques (INSEE) for the years from 1991 to 2011. Inflation has been relatively moderate in France. The rise of inflation to 2.8 percent in 2008 was caused by the commodity price shock as investment funds shifted from other risk financial assets into carry trades driven by interest rates falling toward zero. INSEE estimates 2011 inflation at 2.1 percent.

Chart IV-6 of the Institut National de la Statistique et des Études Économiques (INSEE) of France shows headline and core consumer price inflation of France. Inflation rose during the commodity price shock of unconventional monetary policy. Risk aversion in late 2008 and beginning of 2009 caused collapse of valuation of commodity futures with resulting decline in inflation. Unconventional monetary policy with alternations of risk aversion resulted in higher inflation in France that stabilized in recent months until the increase of 0.2 percent in Oct 2011, 0.3 percent in Nov and 0.4 percent in Dec that were followed by decline of 0.4 percent in Jan 2012 and increases of 0.4 percent in Feb and 0.8 percent in Mar followed by 0.1 percent in Apr minus 0.1 percent in May and no change in Jun 2012 with marginal decline of 0.4 percent in Jul. Both the headline and core indexes are showing negative slopes in the new environment of risk aversion that causes reversals of carry trades into commodity futures prices.

clip_image076

Chart IV-6, France, Consumer Price Index (IPC) and Core Consumer Price Index (ISJ) 12 Months Rates of Change

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120814

Consumer price inflation in the UK is shown in Table IV-13. The CPI index fell 0.1 percent in May. The same inflation waves (Section I and earlier http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.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-Nov 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 3.0 percent in May-Jun 2012. In what could be the beginning of an eighth wave, annual equivalent inflation in Jul 2012 was 1.2 percent.

Table IV-13, UK, Consumer Price Index All Items, Month and 12-Month ∆%

 

Month ∆%

12 Months ∆%

Jul 2012

0.1

2.6

AE ∆% Jul

1.2

 

Jun

-0.4

2.4

May

-0.1

2.8

AE ∆% May-Jun

-3.0

 

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-Nov

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: UK Office for National Statistics

http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/july-2012/stb---consumer-price-indices---july-2012.html

Inflation has been unusually high in the UK since 2006, as shown in Table IV-14. 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-14, 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

http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/july-2012/stb---consumer-price-indices---july-2012.html

Table IV-15 provides the analysis of inflation in Jul 2012 by the UK Office for National Statistics. The drivers of monthly inflation of 0.1 percent are increase of the price of transport of 1.0 percent with contribution of 0.17 percentage points and increase of housing and household services of 0.4 percent with contribution of 0.06 percentage points. Contributions of percentage points to the 12-month rate of consumer price inflation of 2.4 percent are provided by the final two columns in Table IV-14. Housing and household services rose 6.1 percent in 12 months. Transportation rose 1.3 percent in 12 months, contributing 0.16 percentage points

Table IV-15, UK, Consumer Price Index Month ∆% and Percentage Point Contribution by Components

Jul 2012

Month ∆%

0.1 Percentage Point Contribution

12 Months ∆%

0.2 Percentage Point Contribution

CPI All Items

0.1

 

2.6

 

Food & Non-Alcoholic Beverages

0.2

0.02

2.1

-0.02

Alcohol & Tobacco

0.8

0.03

5.0

0.01

Clothing & Footwear

-2.6

-0.17

0.1

0.05

Housing & Household Services

0.4

0.06

6.1

0.01

Furniture & Household Goods

-1.1

-0.07

3.5

0.00

Health

0.0

0.00

3.0

-0.02

Transport

1.0

0.17

1.3

0.08

Communication

0.4

0.01

4.4

-0.01

Recreation & Culture

0.2

0.02

0.4

0.02

Education

0.0

0.00

5.1

0.00

Restaurants & Hotels

0.2

0.02

3.2

0.01

Miscellaneous Goods & Services

0.1

0.01

1.7

-0.02

Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/july-2012/stb---consumer-price-indices---july-2012.html

© Carlos M. Pelaez, 2010, 2011, 2012

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