CMP Associates Regulation Blog

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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. (8) Inflation jumped to annual equivalent 7.4 percent in Aug-Sep 2012. Inflationary expectations can be triggered in one of these episodes of rapidly inflation because of commodity carry trades induced by unconventional monetary policy of zero interest rates in perpetuity or QE∞. Alternating episodes of increase and decrease of inflation introduce uncertainty in household planning that frustrates consumption and home buying. Announcement of purchases of impaired sovereign bonds by the European Central Bank relaxed risk aversion that induced carry trades into commodity exposures, increasing prices of food, raw materials and energy. 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 3.9 percent in Apr-Jun 2012 but resuscitating at 4.1 percent in Jul-Sep 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 but resuscitating at 6.8 percent in Aug-Sep 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 4.1 percent annual equivalent in Jul-Sep 2012 and was higher in annual equivalent producer price inflation in the UK in Jul-Sep 2012 at 4.5 percent for output prices and 7.8 percent for input prices (see Table ESI-1).

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

Index 2011-2012	AE ∆%
US Consumer Price Index
AE ∆% Aug-Sep 2012	7.4
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 ∆% Jul-Sep	4.1
AE ∆% Apr-Jun 2012	-3.9
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 ∆% Aug-Sep 2012	6.8
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-Sep 2012	2.4 NSA 2.8 SA
AE ∆% May-Jun 2012	-1.8 NSA 1.2 SA
AE ∆% Feb-Apr 2012	4.9 NSA 2.4 SA
AE ∆% Dec 2011-Jan 2012	1.8 NSA 1.8 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 ∆% Aug-Sep	2.4
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 ∆% Jul-Sep	2.0
AE ∆% May-Jun 2012	1.2
AE ∆% Feb-Apr 2012	5.8
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-Sep 2012	4.1
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://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

http://www.federalreserve.gov/releases/g17/current/

ESII Stagnating United States Manufacturing. Industrial production decreased 1.4 percent in Aug 2012 and increased 0.4 percent in Sep, as shown in Table ESII-1, with all data seasonally adjusted. In the six months ending in Sep, industrial production accumulated increase of 0.6 percent at the annual equivalent rate of 1.2 percent, which is substantially lower than 2.8 percent growth in 12 months. Business equipment fell 0.9 percent in Aug 2012 but increased 0.8 percent in Sep, growing 10.9 percent in the 12 months ending in Sep and at the annual equivalent rate of 7.4 percent in the six months ending in Sep, which is substantially lower than 10.9 percent in 12 months. Capacity utilization of total industry is analyzed by the Fed in its report (http://www.federalreserve.gov/releases/g17/current/): “Capacity utilization for total industry moved up 0.3 percentage point to 78.3 percent, a rate 2.0 percentage points below its long-run (1972-2011) average.” United States industry is decelerating.

Table ESII-1, US, Industrial Production and Capacity Utilization, SA, ∆%, %

2012	Sep	Aug	Jul	Jun	May	Apr	Sep 12/ Sep 11
Total	0.4	-1.4	0.7	0.0	0.1	0.8	2.8
Market Groups
Final Products	0.3	-1.3	0.6	0.3	0.5	0.8	2.9
Consumer Goods	0.0	-1.5	0.8	-0.3	0.7	0.7	0.1
Business Equipment	0.8	-0.9	0.1	1.9	0.3	1.4	10.9
Non Industrial Supplies	0.7	-0.9	0.0	-0.2	-0.3	0.9	1.9
Construction	1.3	0.1	-0.4	-0.7	-1.6	0.8	4.7
Materials	0.4	-1.6	0.9	-0.1	-0.2	0.9	3.0
Industry Groups
Manufacturing	0.2	-0.9	0.3	0.4	-0.6	0.7	3.2
Mining	0.9	-1.6	1.0	0.3	-0.2	0.6	3.8
Utilities	1.5	-4.3	2.8	-2.7	5.4	2.3	-1.4
Capacity	78.3	78.0	79.2	78.8	78.9	79.0	1.4

Sources: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/g17/current/

Manufacturing increased 0.2 percent in Sep seasonally adjusted, increasing 3.2 percent not seasonally adjusted in 12 months, and increased 0.1 percent in the six months ending in Sep or at the annual equivalent rate of 0.2 percent. A longer perspective of manufacturing in the US is provided by Table ESII-2. There has been evident deceleration of manufacturing growth in the US from 2010 and the first three months of 2011 as shown by 12 months rates of growth. Growth rates appeared to be increasing again closer to 5 percent but deteriorated. The rates of decline of manufacturing in 2009 are quite high with a drop of 18.4 percent in the 12 months ending in Apr 2009. Manufacturing recovered from this decline and led the recovery from the recession. Rates of growth appeared to be returning to the levels at 3 percent or higher in the annual rates before the recession but the pace of manufacturing fell in the past six months.

Table ESII-2, US, Monthly and 12-Month Rates of Growth of Manufacturing ∆%

	Month SA ∆%	12-Month NSA ∆%
Sep 2012	0.2	3.2
Aug	-0.9	3.7
Jul	0.3	4.3
Jun	0.4	5.2
May	-0.6	5.1
Apr	0.7	5.7
Mar	-0.7	4.3
Feb	0.9	5.9
Jan	1.1	4.9
Dec 2011	1.5	4.4
Nov	0.0	4.0
Oct	0.5	4.3
Sep	0.4	4.0
Aug	0.2	3.4
Jul	0.8	3.2
Jun	0.1	3.1
May	0.2	2.9
Apr	-0.6	4.1
Mar	0.7	6.0
Feb	0.3	6.3
Jan	0.4	6.3
Dec 2010	1.0	6.6
Nov	0.2	5.5
Oct	0.1	6.6
Sep	0.2	6.7
Aug	0.0	7.1
Jul	0.8	7.3
Jun	0.0	9.0
May	1.4	8.3
Apr	1.0	6.5
Mar	1.1	4.2
Feb	0.2	0.6
Jan	0.9	0.5
Dec 2009	0.1	-3.7
Nov	0.9	-6.6
Oct	-0.1	-9.4
Sep	0.7	-10.7
Aug	1.0	-13.7
Jul	1.2	-15.3
Jun	-0.3	-17.8
May	-1.2	-17.8
Apr	-0.8	-18.4
Mar	-2.1	-17.5
Feb	0.0	-16.3
Jan	-2.9	-16.6
Dec 2008	-3.3	-14.1
Nov	-2.3	-11.4
Oct	-0.7	-9.1
Sep	-3.4	-8.8
Aug	-1.4	-5.3
Jul	-1.1	-3.8
Jun	-0.6	-3.2
May	-0.6	-2.5
Apr	-1.1	-1.3
Mar	-0.4	-0.7
Feb	-0.4	0.8
Jan	-0.4	2.1
Dec 2007	0.3	1.9
Nov	0.4	3.2
Oct	-0.5	2.7
Sep	0.5	2.9
Aug	-0.5	2.6
Jul	0.2	3.4
Jun	0.3	2.9
May	-0.2	3.1
Apr	0.8	3.6
Mar	0.6	2.5
Feb	0.6	1.7
Jan	-0.5	1.4
Dec 2006		2.8
Dec 2005		3.4
Dec 2004		4.0
Dec 2003		1.8
Dec 2002		2.3
Dec 2001		-5.5
Dec 2000		0.4
Dec 1999		5.4
Average ∆% Dec 1986-Dec 2011		2.3
Average ∆% Dec 1986-Dec 1999		4.3
Average ∆% Dec 1999-Dec 2006		1.3
Average ∆% Dec 1999-Dec 2011		0.2

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/g17/current/

United States manufacturing output from 1919 to 2012 on a monthly basis is provided by Chart ESII-1 of the Board of Governors of the Federal Reserve System. The second industrial revolution of Jensen (1993) is quite evident in the acceleration of the rate of growth of output given by the sharper slope in the 1980s and 1990s. Growth was robust after the shallow recession of 2001 but dropped sharply during the global recession after IVQ2007. Manufacturing output recovered sharply but has not reached earlier levels and is stagnating at the margin.

Chart ESII-1, US, Manufacturing Output, 1919-2012

Source: Board of Governors of the Federal Reserve System

Manufacturing jobs fell by 16,000 in Sep 2012 relative to Aug 2012, seasonally adjusted, and fell 40,000 in Sep 2012 relative to Aug 2012, not seasonally adjusted, as shown in Table I-10 in the text at http://cmpassocregulationblog.blogspot.com/2012/10/twenty-nine-million-unemployed-or.html, because of the weaker economy and international trade. In the six months ending in Sep 2012, United States national industrial production accumulated growth of 0.6 percent at the annual equivalent rate of 1.2 percent, which is substantially lower than 2.8 percent growth in 12 months. Capacity utilization for total industry in the United States is 2.0 percentage points lower than the long-run average from 1972 to 2011. Manufacturing increased 0.1 percent in the six months ending in Sep or at the annual equivalent rate of 0.2 percent. Table ESII-3 provides national income by industry without capital consumption adjustment (WCCA). “Private industries” or economic activities have share of 86.5 percent in US national income in IQ2012 and 86.3 percent in IIQ2012. Most of US national income is in the form of services. In Sep 2012, there were 133.797 million nonfarm jobs NSA in the US, according to estimates of the establishment survey of the Bureau of Labor Statistics (BLS) (http://www.bls.gov/news.release/empsit.nr0.htm Table B-1). Total private jobs of 111.989 million NSA in Sep 2012 accounted for 83.7 percent of total nonfarm jobs of 133.797 million, of which 12.028 million, or 10.7 percent of total private jobs and 9.0 percent of total nonfarm jobs, were in manufacturing. Private service-producing jobs were 93.334 million NSA in Sep 2012, or 69.8 percent of total nonfarm jobs and 83.3 percent of total private-sector jobs. Manufacturing has share of 11.0 percent in US national income in IIQ2012, as shown in Table ESII-3. Most income in the US originates in services. Subsidies and similar measures designed to increase artificially and temporarily manufacturing jobs will not increase economic growth and employment and may actually reduce growth by diverting resources away from currently employment-creating activities because of the drain of taxation.

Table ESII-3, US, National Income without Capital Consumption Adjustment by Industry, Seasonally Adjusted Annual Rates, Billions of Dollars, % of Total

	SAAR IQ2012	% Total	SAAR IIQ2012	% Total
National Income WCCA	13,788.3	100.0	13,867.8	100.0
Domestic Industries	13,573.4	98.4	13,620.5	98.2
Private Industries	11,922.7	86.5	11,967.5	86.3
Agriculture	134.0	1.0	132.8	0.9
Mining	211.0	1.5	208.7	1.5
Utilities	211.9	1.5	214.7	1.6
Construction	585.6	4.3	585.8	4.2
Manufacturing	1521.9	11.0	1530.4	11.0
Durable Goods	865.2	6.3	877.3	6.3
Nondurable Goods	656.6	4.8	653.1	4.7
Wholesale Trade	831.6	6.0	852.8	6.2
Retail Trade	947.5	6.9	947.2	6.8
Transportation & WH	416.5	3.0	417.7	3.0
Information	486.7	3.5	497.0	3.6
Finance, insurance, RE	2301.3	16.7	2271.1	16.4
Professional, BS	1955.0	14.2	1983.5	14.3
Education, Health Care	1380.8	10.0	1832.7	13.2
Arts, Entertainment	541.1	3.9	542.7	3.9
Other Services	397.9	2.9	400.3	2.9
Government	1650.7	12.0	1653.0	11.9
Rest of the World	214.9	1.6	247.3	1.8

Notes: SSAR: Seasonally-Adjusted Annual Rate; WCCA: Without Capital Consumption Adjustment by Industry; WH: Warehousing; RE, includes rental and leasing: Real Estate; Art, Entertainment includes recreation, accommodation and food services; BS: business services

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart ESII-2 of the Board of Governors of the Federal Reserve provides output of motor vehicles and parts in the United States from 1972 to 2012. Output has stagnated since the late 1990s.

Chart ESII-2, US, Motor Vehicles and Parts Output, 1972-2012

http://www.federalreserve.gov/releases/g17/current/

Motor vehicle sales and production in the US have been in long-term structural change. Table ESII-4 provides the data on new motor vehicle sales and domestic car production in the US from 1990 to 2010. New motor vehicle sales grew from 14,137 thousand in 1990 to the peak of 17,806 thousand in 2000 or 29.5 percent. In that same period, domestic car production fell from 6,231 thousand in 1990 to 5,542 thousand in 2000 or -11.1 percent. New motor vehicle sales fell from 17,445 thousand in 2005 to 11,772 in 2010 or 32.5 percent while domestic car production fell from 4,321 thousand in 2005 to 2,840 thousand in 2010 or 34.3 percent. In Jan-Sep 2012, light vehicle sales accumulated to 10,899,949, which is higher by 14.5 percent relative to 9,518,172 a year earlier (http://motorintelligence.com/m_frameset.html). The seasonally-adjusted annual rate of light vehicle sales in the US reached 14.94 million in Sep 2012, higher than 14.52 million in Aug 2012 and higher than 13.14 million in Sep 2011 (http://motorintelligence.com/m_frameset.html).

Table ESII-4, US, New Motor Vehicle Sales and Car Production, Thousand Units

	New Motor Vehicle Sales	New Car Sales and Leases	New Truck Sales and Leases	Domestic Car Production
1990	14,137	9,300	4,837	6,231
1991	12,725	8,589	4,136	5,454
1992	13,093	8,215	4,878	5,979
1993	14,172	8,518	5,654	5,979
1994	15,397	8,990	6,407	6,614
1995	15,106	8,536	6,470	6,340
1996	15,449	8,527	6,922	6,081
1997	15,490	8,273	7,218	5,934
1998	15,958	8,142	7,816	5,554
1999	17,401	8,697	8,704	5,638
2000	17,806	8,852	8,954	5,542
2001	17,468	8,422	9,046	4,878
2002	17,144	8,109	9,036	5,019
2003	16,968	7,611	9,357	4,510
2004	17,298	7,545	9,753	4,230
2005	17,445	7,720	9,725	4,321
2006	17,049	7,821	9,228	4,367
2007	16,460	7,618	8,683	3,924
2008	13,494	6,814	6.680	3,777
2009	10,601	5,456	5,154	2,247
2010	11,772	5,729	6,044	2,840

Source: US Census Bureau http://www.census.gov/compendia/statab/cats/wholesale_retail_trade/motor_vehicle_sales.html

Chart ESII-3 of the Board of Governors of the Federal Reserve System provides output of computers and electronic products in the United States from 1972 to 2012. Output accelerated sharply in the 1990s and 2000s and has surpassed the level before the global recession beginning in IVQ2007.

Chart ESII-3, US, Output of Computers and Electronic Products, 1972-2012

http://www.federalreserve.gov/releases/g17/current/

Chart ESII-4 of the Board of Governors of the Federal Reserve System. Output accelerated in the 1980s and 1990s with slower growth in the 2000s perhaps because processes matured. Growth was robust after the major drop during the global recession but appears to vacillate in the final segment.

Chart ESII-4, US, Output of Durable Manufacturing, 1972-2012

http://www.federalreserve.gov/releases/g17/current/

Chart ESII-5 of the Board of Governors of the Federal Reserve System provides output of aerospace and miscellaneous transportation equipment from 1972 to 2012. There is long-term upward trend with oscillations around the trend and cycles of large amplitude.

Chart ESII-5, US, Output of Aerospace and Miscellaneous Transportation Equipment, 1972-2012

http://www.federalreserve.gov/releases/g17/current/

ESIV 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/2012/02/pdf/text.pdf), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/gfsr/2012/02/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/pubs/ft/fm/2012/02/pdf/fm1202.pdf). 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 third quarter of 2012 of 2.2 percent is equivalent to 9.1 percent per year and GDP increased 7.4 percent relative to the third quarter of 2011.

2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 28.7 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically-low hiring and declining real wages.

3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.

4. World Inflation Waves. Inflation continues in repetitive waves globally (see Section I).

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 ESIV-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 10/19/12,” which has been recently stalling or reversing amidst bouts of 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). Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. 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, 2012. The week of Aug 24, 2012 had alternating shocks of risk aversion and risk appetite from the uncertainties of success of the Greek adjustment program, the coming decision of the Federal Constitutional Court of Germany on the European Stability Mechanism, disagreements between the Deutsche Bundesbank and the European Central Bank on purchase of sovereign bonds of highly indebted euro area member countries and the exchange of letters between Darrell E. Issa (2012Aug1), Chairman of the House Committee on Oversight and Government Reform, and Chairman Bernanke (2012Aug22) on monetary policy. Bernanke (2012JHAug31) and Draghi (2012Aug29) generated risk enthusiasm in the week of Aug 31, 2012. Risk appetite returned in the week of Sep 7, 2012, with the announcement of the bond-buying program of OMT (Outright Monetary Transactions) on Sep 6, 2012, by the European Central Bank (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). Valuations of risk financial assets increased sharply after the statement of the FOMC on Sep 13, 2012 with open-ended quantitative easing and self-imposed single-mandate of jobs that would maintain easing monetary policy well after the economy returns to full potential. Risk aversion returned in the week of Sep 21, 2012 on doubts about the success of quantitative easing and weakness in flash purchasing managers’ indices. Risk aversion returned in the week of Sep 28, 2012, because of uncertainty on the consequences of a bailout of Spain and weakness of central banks in controlling financial turbulence but was followed by risk appetite in the week of Oct 5, aversion in the week of Oct 12 and mixed views in the week of Oct 19. The highest valuations in column “∆% Trough to 10/19/12” are by US equities indexes: DJIA 37.8 percent and S&P 500 40.2 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 13,703.53 on Oct 5, 2012, 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 10/19/12” had double digit gains relative to the trough around Jul 2, 2010 but now some valuations of equity indexes show varying increases: China’s Shanghai Composite is 10.7 percent below the trough; Japan’s Nikkei Average is 2.0 percent above the trough; DJ Asia Pacific TSM is 10.0 percent above the trough; Dow Global is 15.0 percent above the trough; STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 12.0 percent above the trough; and NYSE Financial is 15.2 percent above the trough. DJ UBS Commodities is 18.1 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 30.2 percent above the trough. Japan’s Nikkei Average is 2.0 percent above the trough on Aug 31, 2010 and 21.0 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 9002.68 on Fri Oct 19, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 12.2 percent lower than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 9.3 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 10/19/12” in Table ESIV-1 shows that there were increases of valuations of risk financial assets in the week of Oct 19, 2012 such as 2.1 percent for Dow Global, 1.9 percent for NYSE Financial, 1.8 percent for STOXX 50, 2.0 percent for DAX, 2.1 percent for DJ Asia Pacific TSM. Nikkei Average increased 5.5 percent in the week. DJ UBS Commodities decreased 0.4 percent. China’s Shanghai Composite increased 1.1 percent in the week of Oct 19, 2012. The DJIA increased 0.1 percent and S&P 500 increased 0.3 percent. The USD depreciated 0.5 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 ESIV-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 10/19/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Oct 19, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 10/19/12” but also relative to the peak in column “∆% Peak to 10/19/12.” There are now only three equity indexes above the peak in Table ESIV-1: DJIA 19.1 percent, S&P 500 17.7 percent and DAX 16.6 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 8.3 percent, Nikkei Average by 21.0 percent, Shanghai Composite by 32.8 percent, DJ Asia Pacific by 3.7 percent, STOXX 50 by 5.1 percent and Dow Global by 6.1 percent. DJ UBS Commodities Index is now 0.9 percent above the peak. The US dollar strengthened 13.9 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. Kate Linebaugh, writing on “Falling revenue dings stocks,” on Oct 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444592704578066933466076070.html?mod=WSJPRO_hpp_LEFTTopStories), identifies a key financial vulnerability: falling revenues across markets for United States reporting companies. Global economic slowdown is reducing corporate sales and squeezing corporate strategies. Linebaugh quotes data from Thomson Reuters that 100 companies of the S&P 500 index have reported declining revenue only 1 percent higher in Jun-Sep 2012 relative to Jun-Sep 2011 but about 60 percent of the companies are reporting lower sales than expected by analysts with expectation that revenue for the S&P 500 will be lower in Jun-Sep 2012 for the entities represented in the index. Results of US companies are likely repeated worldwide. 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 ESIV-1, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 10/19/ /12	∆% Week 10/19/12	∆% Trough to 10/19/ 12
DJIA	4/26/ 10	7/2/10	-13.6	19.1	0.1	37.8
S&P 500	4/23/ 10	7/20/ 10	-16.0	17.7	0.3	40.2
NYSE Finance	4/15/ 10	7/2/10	-20.3	-8.3	1.9	15.2
Dow Global	4/15/ 10	7/2/10	-18.4	-6.1	2.1	15.0
Asia Pacific	4/15/ 10	7/2/10	-12.5	-3.7	2.1	10.0
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-21.0	5.5	2.0
China Shang.	4/15/ 10	7/02 /10	-24.7	-32.8	1.1	-10.7
STOXX 50	4/15/10	7/2/10	-15.3	-5.1	1.8	12.0
DAX	4/26/ 10	5/25/ 10	-10.5	16.6	2.0	30.2
Dollar Euro	11/25 2009	6/7 2010	21.2	13.9	-0.5	-9.3
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	0.9	-0.4	18.1
10-Year T Note	4/5/ 10	4/6/10	3.986	1.766

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. IA Appendix: Transmission of Unconventional Monetary Policy provides more technical analysis. Section II United States Inflation analyzes inflation in the United States in two subsections: IIA Long-term US Inflation and IIB Current US Inflation.

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).

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 7.5 percent in Apr-Jun 2012. (8) New positions in commodity futures even with continuing risk aversion caused annual equivalent inflation of 3.0 percent in Jun-Jul 2012. (9) Relaxed risk aversion because of announcement of sovereign bond-buying by the European Central Bank caused relaxed risk aversion inducing carry trades that resulted in annual equivalent producer price inflation in the US of 18.2 percent in Aug-Sep 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 and Aug-Sep 2012. An episode of exploding commodity prices could ignite inflationary expectations that would result in an inflation phenomenon of costly resolution. 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 2011, 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. There is currently sharp worldwide jump in producer prices as a result of the combination of zero interest rates forever or QE∞ with temporarily relaxed 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. The economy is constrained in a suboptimal allocation of resources that perpetuated along a continuum of short-term periods results in long-term or dynamic inefficiency in the form of a trajectory of economic activity that is lower than what would be attained with rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html).

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

INDEX 2011-2012	AE ∆%
US Producer Price Index
AE ∆% Aug-Sep 2012	18.2
AE ∆% Jun-Jul 2012	3.0
AE ∆% Apr-May 2012	-7.5
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 ∆% Aug-Sep 2012	3.0
AE ∆% May-Jul 2012	-5.8
AE ∆% Feb-Apr 2012	2.4
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
China Producer Price Index
AE ∆% May-Sep 2012	-5.8
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
Euro Zone Industrial Producer Prices
AE ∆% Jul-Aug 2012	7.4
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
Germany Producer Price Index
AE ∆% Aug-Sep 2012	4.9 NSA 5.5 SA
AE ∆% May-Jul 2012	-2.8 NSA –0.8 SA
AE ∆% Feb-Apr 2012	4.9 NSA 1.2 SA
AE ∆% Dec 2011-Jan 2012	1.2 NSA –0.6 SA
AE ∆% Oct-Nov 2011	1.8 NSA 3.7 SA
AE ∆% Jul-Sep 2011	2.8 NSA 3.7 SA
AE ∆% May-Jun 2011	0.6 NSA 3.7 SA
AE ∆% Jan-Apr 2011	10.4 NSA 6.2 SA
France Producer Price Index for the French Market
AE ∆% Jul-Aug 2012	10.0
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	11.7
Italy Producer Price Index
AE ∆% Jul –Aug 2012	6.2
AE ∆% May-Jun 2012	-2.4
AE ∆% Mar-Apr 2012	4.3
AE ∆% Jan-Feb 2012	7.4
AE ∆% Nov 2011-Jan 2012	4.3
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 ∆% Jul-Sep	4.5
AE ∆% May-Jun 2012	-5.3
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-Sep 2012	7.8
AE ∆% Apr-Jun 2012	-21.9
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://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

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. (8) Inflation jumped to annual equivalent 7.4 percent in Aug-Sep 2012. Inflationary expectations can be triggered in one of these episodes of rapidly inflation because of commodity carry trades induced by unconventional monetary policy of zero interest rates in perpetuity or QE∞. Alternating episodes of increase and decrease of inflation introduce uncertainty in household planning that frustrates consumption and home buying. Announcement of purchases of impaired sovereign bonds by the European Central Bank relaxed risk aversion that induced carry trades into commodity exposures, increasing prices of food, raw materials and energy. 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 3.9 percent in Apr-Jun 2012 but resuscitating at 4.1 percent in Jul-Sep 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 but resuscitating at 6.8 percent in Aug-Sep 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 4.1 percent annual equivalent in Jul-Sep 2012 and was higher in annual equivalent producer price inflation in the UK in Jul-Sep 2012 at 4.5 percent for output prices and 7.8 percent for input prices (see Table I-1).

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

Index 2011-2012	AE ∆%
US Consumer Price Index
AE ∆% Aug-Sep 2012	7.4
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 ∆% Jul-Sep	4.1
AE ∆% Apr-Jun 2012	-3.9
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 ∆% Aug-Sep 2012	6.8
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-Sep 2012	2.4 NSA 2.8 SA
AE ∆% May-Jun 2012	-1.8 NSA 1.2 SA
AE ∆% Feb-Apr 2012	4.9 NSA 2.4 SA
AE ∆% Dec 2011-Jan 2012	1.8 NSA 1.8 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 ∆% Aug-Sep	2.4
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 ∆% Jul-Sep	2.0
AE ∆% May-Jun 2012	1.2
AE ∆% Feb-Apr 2012	5.8
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-Sep 2012	4.1
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://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

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

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: IA1 Theory; IA2 Policy; IA3 Evidence; and IA4 Unwinding Strategy.

IA1 Theory. The transmission mechanism of quantitative easing can be analyzed in three different forms. (1) Portfolio choice theory. General equilibrium value theory was proposed by Hicks (1935) in analyzing the balance sheets of individuals and institutions with assets in the capital segment consisting of money, debts, stocks and productive equipment. Net worth or wealth would be comparable to income in value theory. Expected yield and risk would be the constraint comparable to income in value theory. Markowitz (1952) considers a portfolio of individual securities with mean μ_p and variance σ_p. The Markowitz (1952, 82) rule states that “investors would (or should” want to choose a portfolio of combinations of (μ_p, σ_p) that are efficient, which are those with minimum variance or risk for given expected return μ_p or more and maximum expected μ_p for given variance or risk or less. The more complete model of Tobin (1958) consists of portfolio choice of monetary assets by maximizing a utility function subject to a budget constraint. Tobin (1961, 28) proposes general equilibrium analysis of the capital account to derive choices of capital assets in balance sheets of economic units with the determination of yields in markets for capital assets with the constraint of net worth. A general equilibrium model of choice of portfolios was developed simultaneously by various authors (Hicks 1962; Treynor 1962; Sharpe 1964; Lintner 1965; Mossin 1966). If shocks such as by quantitative easing displace investors from the efficient frontier, there would be reallocations of portfolios among assets until another efficient point is reached. Investors would bid up the prices or lower the returns (interest plus capital gains) of long-term assets targeted by quantitative easing, causing the desired effect of lowering long-term costs of investment and consumption.

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

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

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

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

IA2 Policy. A simplified analysis could consider the portfolio balance equations A_ij = f(r, x) where A_ij is the demand for i = 1,2,∙∙∙n assets from j = 1,2, ∙∙∙m sectors, r the 1xn vector of rates of return, r_i, of n assets and x a vector of other relevant variables. Tobin (1969) and Brunner and Meltzer (1973) assume imperfect substitution among capital assets such that the own first derivatives of A_ij are positive, demand for an asset increases if its rate of return (interest plus capital gains) is higher; and cross first derivatives are negative, demand for an asset decreases if the rate of return of alternative assets increases. Theoretical purity would require the estimation of the complete model with all rates of return. In practice, it may be impossible to observe all rates of return such as in the critique of Roll (1976). Policy proposals by the Fed have been focused on the likely impact of withdrawals of stocks of securities in specific segments, that is, of effects of one or several specific rates of return among the n possible rates. There have been at least seven approaches on the role of monetary policy in purchasing long-term securities that have increased the classes of rates of return targeted by the Fed:

(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.”

IA3 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.

IA4 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/2012/10/twenty-nine-million-unemployed-or.html) and depressed hiring (http://cmpassocregulationblog.blogspot.com/2012/10/recovery-without-hiring-imf-view-united.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 4.7 percent in the recession from IVQ2007 (Dec) to IIQ2009 (June) (http://www.nber.org/cycles.html) followed with unusually low economic growth for an expansion phase after recession (http://cmpassocregulationblog.blogspot.com/2012/09/historically-sharper-recoveries-from.html). BEA data show the US economy in standstill with annual growth of 2.4 percent in 2010 percent decelerating to 1.8 percent annual growth in 2011 (http://www.bea.gov/iTable/index_nipa.cfm) and cumulative 0.82 percent in the first half of 2012 {(1.02)^1/4(1.013)^1/4 = 0.82%}, which is equivalent to 1.65 percent per year {([(1.02)^1/4(1.013)^1/4 ]² – 1)100 = 1.65%}. The expansion of IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent (http://cmpassocregulationblog.blogspot.com/2012/09/historically-sharper-recoveries-from.html ). Between 2000 and 2011, real GDP grew at the average rate of 1.6 percent per year, nominal GDP at 3.9 percent and the implicit deflator at 2.3 percent. 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 2.9 percent per year on average from 2000 to 2012 and at 1.8 percent excluding food and energy. Producer price inflation of finished energy goods increased at average 6.0 percent between 2000 and 2012. There is also inflation in international trade. Import prices increased at 2.8 percent per year between 2000 and 2012. The commodity price shock is revealed by inflation of import prices of petroleum increasing at 11.9 percent per year between 2000 and 2011 and at 10.9 percent between 2000 and 2012. The average percentage rates of increase of import prices excluding fuels are much lower at 2.1 percent for 2002 to 2011 and 1.9 percent for 2002 to 2012. Export prices rose at the average rate of 2.8 percent between 2000 and 2011 and at 2.5 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 7.3 percent from 2000 to 2011 and at 7.3 percent from 2000 to 2012. US nonagricultural export prices rose at 2.3 percent per year from 2000 to 2011 and at 2.0 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.

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: 2.9%
PPI ex Food and Energy	2000-2011: 1.7% 2000-2012: 1.8%
PPI Finished Energy Goods	2000-2011: 6.3% 2000-2012: 6.0%
Import Prices	2000-2011: 3.1% 2000-2012: 2.8%
Import Prices of Petroleum and Petroleum Products	2000-2011: 11.9% 2000-2012: 10.9%
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: 2.8% 2000-2012: 2.5%
Agricultural Export Prices	2000-2011: 7.3% 2000-2012: 7.3%
Nonagricultural Export Prices	2000-2011: 2.3% 2000-2012: 2.0%

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

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

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 (http://cmpassocregulationblog.blogspot.com/2012/09/historically-sharper-recoveries-from.html).

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

Source: US Bureau of Economic Analysis

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

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

Source: US Bureau of Economic Analysis

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

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

Source: US Bureau of Economic Analysis

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

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

Source: US Bureau of Economic Analysis

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

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

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

The producer price index of the US from 1947 to 2012 in Chart II-6 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

Chart II-6, US, Producer Price Index, Finished Goods, NSA, 1947-2012

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

Chart II-7 provides 12-month percentage changes of the producer price index from 1948 to 2012. The distinguishing event in Chart II-7 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2012.

Chart II-7, US, Producer Price Index, Finished Goods, 12-Month Percentage Change, NSA, 1948-2012

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

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.

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/

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

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

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

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.

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

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

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.

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/

Chart II-12 provides the consumer price index NSA from 1913 to 2012. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

Chart II-12, US, Consumer Price Index, NSA, 1913-2012

Source: US Bureau of Labor Statistics

Chart II-13 provides 12-month percentage changes of the consumer price index from 1914 to 2012. The only episode of deflation after 1950 is in 2009, which is explained by the reversal of speculative commodity futures carry trades that were induced by interest rates driven to zero in a shock of monetary policy in 2008. The only persistent case of deflation is from 1930 to 1933, which has little if any relevance to the contemporary United States economy. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.

Chart II-13, US, Consumer Price Index, All Items, 12- Month Percentage Change 1914-2012

Source: US Bureau of Labor Statistics

Table II-2 provides annual percentage changes of United States consumer price inflation from 1914 to 2011. There have been only cases of annual declines of the CPI after World War II: -1.2 percent in 1949, -0.4 percent in 1955 and -0.4 percent in 2009. The decline of 0.4 percent in 2009 followed increase of 3.8 percent in 2008 and is explained by the reversal of speculative carry trades that were created in 2008 as monetary policy rates were driven to zero. The reversal occurred after misleading statement on toxic assets in banks in the proposal for TARP (Cochrane and Zingales 2009). The only persistent deflationary period since 1914 was during the Great Depression in the years from 1930 to 1933. Fear of deflation on the basis of that experience does not justify unconventional monetary policy of zero interest rates that has failed to stop deflation in Japan. Financial repression causes far more adverse effects on allocation of resources by distorting the calculus of risk/returns than alleged employment-creating effects or there would not be current recovery without jobs and hiring after zero interest rates since Dec 2008 and intended now forever in a self-imposed employment mandate of monetary policy.

Table II-2, US, Annual CPI Inflation ∆% 1940-2011

Year	Annual
1914	1.0
1915	1.0
1916	7.9
1917	17.4
1918	18.0
1919	14.6
1920	15.6
1921	-10.5
1922	-6.1
1923	1.8
1924	0.0
1925	2.3
1926	1.1
1927	-1.7
1928	-1.7
1929	0.0
1930	-2.3
1931	-9.0
1932	-9.9
1933	-5.1
1934	3.1
1935	2.2
1936	1.5
1937	3.6
1938	-2.1
1939	-1.4
1940	0.7
1941	5.0
1942	10.9
1943	6.1
1944	1.7
1945	2.3
1946	8.3
1947	14.4
1948	8.1
1949	-1.2
1950	1.3
1951	7.9
1952	1.9
1953	0.8
1954	0.7
1955	-0.4
1956	1.5
1957	3.3
1958	2.8
1959	0.7
1960	1.7
1961	1.0
1962	1.0
1963	1.3
1964	1.3
1965	1.6
1966	2.9
1967	3.1
1968	4.2
1969	5.5
1970	5.7
1971	4.4
1972	3.2
1973	6.2
1974	11.0
1975	9.1
1976	5.8
1977	6.5
1978	7.6
1979	11.3
1980	13.5
1981	10.3
1982	6.2
1983	3.2
1984	4.3
1985	3.6
1986	1.9
1987	3.6
1988	4.1
1989	4.8
1990	5.4
1991	4.2
1992	3.0
1993	3.0
1994	2.6
1995	2.8
1996	3.0
1997	2.3
1998	1.6
1999	2.2
2000	3.4
2001	2.8
2002	1.6
2003	2.3
2004	2.7
2005	3.4
2006	3.2
2007	2.8
2008	3.8
2009	-0.4
2010	1.6
2011	3.2

Source: US Bureau of Labor Statistics

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

Chart II-14, US, Consumer Price Index Excluding Food and Energy, NSA, 1957

Source: US Bureau of Labor Statistics

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

Chart II-15, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1958-2012

Source: US Bureau of Labor Statistics

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

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

Source: US Bureau of Labor Statistics

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

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

Source: US Bureau of Labor Statistics

IIB Current US Inflation. Consumer price inflation has fluctuated in recent months. Table II-3 provides 12-month consumer price inflation in Sep and annual equivalent percentage changes for the months of Jul to Sep 2012 of the CPI and major segments. The final column provides inflation from Aug 2012 to Sep 2012. CPI inflation in the 12 months ending in Sep reached 2.0 percent, the annual equivalent rate Jul to Sep was 4.9 percent and the monthly inflation rate of 0.6 percent annualizes at 7.4 percent in the new sharp inflation wave. 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 caused lower inflation worldwide that is followed by a jump in Aug-Sep 2012 because of the relaxed risk aversion resulting from the bond-buying program of the European Central Bank. With zero interest rates, commodity prices would increase again in an environment of risk appetite. Excluding food and energy, CPI inflation was 2.0 percent in the 12 months ending in Sep 2012 and 1.2 percent in annual equivalent in Jul-Sep 2012. There is no deflation in the US economy that could justify further quantitative easing, which is now open-ended or forever with zero interest rates and bond-buying by the central bank, or QE∞, even if the economy grows back to potential. Financial repression of zero interest rates is now intended as a permanent distortion of resource allocation by clouding risk/return decisions, preventing the economy from expanding along its optimal growth path. Consumer food prices in the US have risen 1.6 percent in 12 months ending in Sep 2012 and at 1.6 percent in annual equivalent in Jul-Sep 2012. Monetary policies stimulating carry trades of commodities futures 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/2012/10/recovery-without-hiring-imf-view-united.html and earlier http://cmpassocregulationblog.blogspot.com/2012/08/recovery-without-hiring-ten-million.html) and without jobs (http://cmpassocregulationblog.blogspot.com/2012/10/twenty-nine-million-unemployed-or.html ). Energy consumer prices increased 2.3 percent in 12 months, increased 46.5 percent in annual equivalent in Jul-Sep and increased 4.5 percent in Sep or at 69.6 percent in annual equivalent 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 Jul-Sep 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-3, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%

	∆% 12 Months Aug 2012/Sep 2011 NSA	∆% Annual Equivalent Jul to Sep 2012 SA	∆% Sep 2012/Aug 2012 SA
CPI All Items	2.0	4.9	0.6
CPI ex Food and Energy	2.0	1.2	0.1
Food	1.6	1.6	0.1
Food at Home	0.8	0.4	0.0
Food Away from Home	2.8	2.8	0.2
Energy	2.3	46.5	4.5
Gasoline	6.8	87.3	7.0
Fuel Oil	4.0	37.8	4.1
New Vehicles	1.0	0.0	-0.1
Used Cars and Trucks	-1.6	-10.7	-1.4
Medical Care Commodities	3.3	2.8	-0.1
Apparel	2.7	0.0	0.3
Services Less Energy Services	2.5	2.0	0.3
Shelter	2.2	2.0	0.2
Transportation Services	1.5	1.2	0.5
Medical Care Services	4.4	3.7	0.4

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

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-4 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-4, 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.

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

Source: US Bureau of Labor Statistics

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

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

Source: US Bureau of Labor Statistics

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/2012/09/recovery-without-hiring-world-inflation.html) that are illustrated in Table II-5. 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 decrease 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 2.8 percent in Feb-Apr and 2.0 percent for the core CPI. The seventh wave in May-Jul occurred 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 eighth wave is with annual equivalent inflation of 7.4 percent in Aug-Sep 2012. 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-5, 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
Sep 2012	0.6	2.0	0.1	2.0
Aug	0.6	1.7	0.1	1.9
AE ∆% Aug-Sep	7.4		1.2
Jul	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).

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

Source: US Bureau of Labor Statistics

Chart II-21 provides 12-month percentage changes of the consumer price index from 2001 to 2012. There was no deflation or threat of deflation from 2008 into 2009. Commodity prices collapsed during the panic of toxic assets in banks. When stress tests 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.

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

Source: US Bureau of Labor Statistics

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

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

Source: US Bureau of Labor Statistics

Chart II-23 provides 12-month percentage change of the consumer price index excluding food and energy. Past-year rates of inflation fell toward 1 percent from 2001 into 2003 as a result of the recession and the decline of commodity prices beginning before the recession with declines of real oil prices. Near zero interest rates with fed funds at 1 percent between Jun 2003 and Jun 2004 stimulated carry trades of all types, including in buying homes with subprime mortgages in expectation that low interest rates forever would increase home prices permanently, creating the equity that would permit the conversion of subprime mortgages into creditworthy mortgages (Gorton 2009EFM; see http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Inflation rose and then collapsed during the unwinding of carry trades and the housing debacle of the global recession. Carry 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.

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

Source: US Bureau of Labor Statistics

Headline and core producer price indexes are in Table II-6. The headline PPI SA increased 1.1 percent in Sep 2012 and 2.1 percent NSA in the 12 months ending in Sep 2012. The core PPI SA increased 0.0 percent in Sep 2012 and rose 2.3 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 7.5 percent in Apr-May 2012 while core PPI inflation was at annual equivalent 1.2 percent. In the eighth wave, annual equivalent inflation returned at 3.0 percent in Jun-Jul and 4.3 percent for the core index. In the ninth wave, relaxed risk aversion because of the announcement of the impaired bond buying program of the European Central Bank induced carry trades that drove annual equivalent inflation of producer prices of the United States at 18.2 percent in Aug-Sep 2012 and 1.2 percent in 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-6, 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
Sep 2012	1.1	2.1	0.0	2.3
Aug	1.7	2.0	0.2	2.5
AE ∆% Aug	18.2		1.2
Jul	0.3	0.5	0.4	2.5
Jun	0.2	0.7	0.3	2.6
AE ∆% Jun-Jul	3.0		4.3
May	-1.0	0.6	0.1	2.7
Apr	-0.3	1.8	0.1	2.7
AE ∆% Apr-May	-7.5		1.2
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/

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.

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

Source: US Bureau of Labor Statistics

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.

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

Source: US Bureau of Labor Statistics

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.

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

Source: US Bureau of Labor Statistics

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

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

Source: US Bureau of Labor Statistics

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.

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

Source: US Bureau of Labor Statistics

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.

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

Source: US Bureau of Labor Statistics