Financial Uncertainty, Mediocre Cyclical United States Economic Growth with GDP Two Trillion Dollars below Trend, Stagnating Real Disposable Income, Financial Repression, United States Commercial Banks, United States Housing, World Cyclical Slow Growth and Global Recession Risk
Carlos M. Pelaez
© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014
Executive Summary
I Mediocre Cyclical United States Economic Growth with GDP Two Trillion Dollars Below Trend
IA Mediocre Cyclical United States Economic Growth
IA1 Contracting Real Private Fixed Investment
IA2 Swelling Undistributed Corporate Profits
IB Stagnating Real Disposable Income and Consumption Expenditures
IB1 Stagnating Real Disposable Income and Consumption Expenditures
IB2 Financial Repression
IIA United States Commercial Banks Assets and Liabilities
IIA1 Transmission of Monetary Policy
IIB1 Functions of Banks
IIC United States Commercial Banks Assets and Liabilities
IID Theory and Reality of Economic History, Cyclical Slow Growth Not Secular Stagnation and Monetary Policy Based on Fear of Deflation
IIB United States Housing Collapse
III World Financial Turbulence
IIIA Financial Risks
IIIE Appendix Euro Zone Survival Risk
IIIF Appendix on Sovereign Bond Valuation
IV Global Inflation
V World Economic Slowdown
VA United States
VB Japan
VC China
VD Euro Area
VE Germany
VF France
VG Italy
VH United Kingdom
VI Valuation of Risk Financial Assets
VII Economic Indicators
VIII Interest Rates
IX Conclusion
References
Appendixes
Appendix I The Great Inflation
IIIB Appendix on Safe Haven Currencies
IIIC Appendix on Fiscal Compact
IIID Appendix on European Central Bank Large Scale Lender of Last Resort
IIIG Appendix on Deficit Financing of Growth and the Debt Crisis
IIIGA Monetary Policy with Deficit Financing of Economic Growth
IIIGB Adjustment during the Debt Crisis of the 1980s
III World Financial Turbulence. Financial markets are being shocked by multiple factors including:
(1) World economic slowdown
(2) Slowing growth in China with political development and slowing growth in Japan and world trade
(3) Slow growth propelled by savings/investment reduction in the US with high unemployment/underemployment, falling wages, hiring collapse, contraction of real private fixed investment, decline of wealth of households over the business cycle by 1.9 percent adjusted for inflation while growing 635.2 percent adjusted for inflation from IVQ1945 to IVQ2012 and unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes
(4) Outcome of the sovereign debt crisis in Europe.
This section provides current data and analysis. Subsection IIIA Financial Risks provides analysis of the evolution of valuations of risk financial assets during the week. There are various appendixes for convenience of reference of material related to the debt crisis of the euro area. Some of this material is updated in Subsection IIIA when new data are available and then maintained in the appendixes for future reference until updated again in Subsection IIIA. Subsection IIIB Appendix on Safe Haven Currencies discusses arguments and measures of currency intervention and is available in the Appendixes section at the end of the blog comment. Subsection IIIC Appendix on Fiscal Compact provides analysis of the restructuring of the fiscal affairs of the European Union in the agreement of European leaders reached on Dec 9, 2011 and is available in the Appendixes section at the end of the blog comment. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank and is available in the Appendixes section at the end of the blog comment. Appendix IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union and is available following Subsection IIIA. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis and is available following Subsection IIIA. Subsection IIIG Appendix on Deficit Financing of Growth and the Debt Crisis provides analysis of proposals to finance growth with budget deficits together with experience of the economic history of Brazil and is available in the Appendixes section at the end of the blog comment.
IIIA Financial Risks. Financial turbulence, attaining unusual magnitude in recent months, characterized the expansion from the global recession since IIIQ2009. Table III-1, updated with every comment in this blog, provides beginning values on Fri Mar 21 and daily values throughout the week ending on Mar 21, 2014 of various financial assets. Section VI Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Mar 21 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Mar 21, 2014”, first row “USD/EUR 1.3793 0.9% -0.1 %,” provides the information that the US dollar (USD) appreciated 0.9 percent to USD 1.3793/EUR in the week ending on Fri Mar 21 relative to the exchange rate on Fri Mar 14 and depreciated 0.1 percent relative to Thu Mar 20. The first five asset rows provide five key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy but expanding into possibly France and Germany, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing waves of inflation. An important current shock is that resulting from the agreement by European leaders at their meeting on Dec 9 (European Council 2911Dec9), which is analyzed in IIIC Appendix on Fiscal Compact. European leaders reached a new agreement on Jan 30 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/127631.pdf) and another agreement on Jun 29, 2012 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131388.pdf). The most important source of financial turbulence is shifting toward increasing interest rates. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3793/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Mar 21, depreciating to USD 1.3839/EUR on Mon Mar 24, 2014, or by 0.3 percent. The dollar depreciated because more dollars, $1.3839, were required on Mon Mar 24 to buy one euro than $1.3793 on Fri Mar 21. Table III-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate such as in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3793/EUR on Mar 21. The second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Mar 21, to the last business day of the current week, in this case Fri Mar 28, such as appreciation of 0.3 percent to USD 1.3752/EUR by Mar 28. The third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (denoted by positive sign) by 0.3 percent from the rate of USD 1.3793/EUR on Fri Mar 21 to the rate of USD 1.3752EUR on Fri Mar 28 {[(1.3752/1.3793) – 1]100 = -0.3%}. The dollar depreciated (denoted by negative sign) by 0.1 percent from the rate of USD 1.3741 on Thu Mar 27 to USD 1.3752/EUR on Fri Mar 28 {[(1.3752/1.3741) -1]100 = 0.1%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk assets to the safety of dollar-denominated assets during risk aversion and return to higher yielding risk assets during risk appetite.
Table III-I, Weekly Financial Risk Assets Mar 24 to Mar 28, 2014
| Fri Mar 21, 2014 | Mon 24 | Tue 25 | Wed 26 | Thu 27 | Fri 28 |
| USD/ EUR 1.3793 0.9% -0.1% | 1.3839 -0.3% -0.3% | 1.3826 -0.2% 0.1% | 1.3783 0.1% 0.3% | 1.3741 0.4% 0.3% | 1.3752 0.3% -0.1% |
| JPY/ USD 102.27 -0.9% 0.1% | 102.25 0.0% 0.0% | 102.26 0.0% 0.0% | 102.05 0.2% 0.2% | 102.18 0.1% -0.1% | 102.83 -0.5% -0.6% |
| CHF/ USD 0.8828 -1.2% 0.1% | 0.8808 0.2% 0.2% | 0.8827 0.0% -0.2% | 0.8850 -0.2% -0.3% | 0.8866 -0.4% -0.2% | 0.8868 -0.5% 0.0% |
| CHF/ EUR 1.2176 -0.3% 0.0% | 1.2189 -0.1% -0.1% | 1.2205 -0.2% -0.1% | 1.2199 -0.2% 0.0% | 1.2183 -0.1% 0.1% | 1.2195 -0.2% -0.1% |
| USD/ AUD 0.9084 1.1008 0.6% 0.5% | 0.9132 1.0951 0.5% 0.5% | 0.9166 1.0910 0.9% 0.4% | 0.9226 1.0839 1.5% 0.7% | 0.9261 1.0798 1.9% 0.4% | 0.9249 1.0812 1.8% -0.1% |
| 10Y Note 2.743 | 2.730 | 2.749 | 2.690 | 2.687 | 2.721 |
| 2Y Note 0.431 | 0.439 | 0.427 | 0.436 | 0.444 | 0.448 |
| German Bond 2Y 0.20 10Y 1.63 | 2Y 0.18 10Y 1.58 | 2Y 0.17 10Y 1.57 | 2Y 0.16 10Y 1.57 | 2Y 0.13 10Y 1.53 | 2Y 0.14 10Y 1.55 |
| DJIA 16302.77 1.5% -0.2% | 16276.69 -0.2% -0.2% | 16367.88 0.4% 0.6% | 16268.99 -0.2% -0.6% | 16264.23 -0.2% 0.0% | 16323.06 0.1% 0.4% |
| Dow Global 2450.37 0.9% -0.1% | 2443.48 -0.3% -0.3% | 2458.83 0.3% 0.6% | 2464.32 0.6% 0.2% | 2470.54 0.8% 0.3% | 2484.84 1.4% 0.6% |
| DJ Asia Pacific 1375.02 -1.1% 0.5% | 1389.26 1.0% 1.0% | 1388.11 0.9% -0.1% | 1399.98 1.8% 0.9% | 1404.18 2.1% 0.3% | 1410.26 2.6% 0.5% |
| Nikkei 14224.23 -0.7% 0.0% | 14475.30 1.8% 1.8% | 14423.19 1.4% -0.4% | 14477.16 1.8% 0.4% | 14622.89 2.8% 1.0% | 14696.03 3.3% 0.5% |
| Shanghai 2047.62 2.2% 2.7% | 2066.28 0.9% 0.9% | 2067.31 1.0% 0.0% | 2063.67 0.8% -0.2% | 2046.59 -0.1% -0.8% | 2041.71 -0.3% -0.2% |
| DAX 9342.94 3.2% 0.5% | 9188.77 -1.7% -1.7% | 9338.40 0.0% 1.6% | 9448.58 1.1% 1.2% | 9451.21 1.2% 0.0% | 9587.19 2.6% 1.4% |
| DJ UBS Comm. 132.94 -1.5% -0.2% | 133.08 0.1% 0.1% | 133.66 0.5% 0.4% | 133.44 0.4% -0.2% | 134.60 1.2% 0.9% | 134.75 1.4% 0.2% |
| WTI $/B 99.46 0.6% 0.0% | 99.60 0.1% 0.1% | 99.19 -0.3% -0.4% | 100.26 0.8% 1.1% | 101.28 1.8% 1.0% | 101.67 2.2% 0.4% |
| Brent $/B 106.92 -1.5% 0.4% | 106.81 -0.1% -0.1% | 106.99 0.1% 0.2% | 107.03 0.1% 0.0% | 107.83 0.9% 0.7% | 108.07 1.1% 0.2% |
| Gold $/OZ 1336.0 -3.1% 0.4% | 1311.2 -1.9% -1.9% | 1311.4 -1.8% 0.0% | 1303.4 -2.4% -0.6% | 1294.7 -3.1% -0.7% | 1293.8 -3.2% -0.1% |
Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss
Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce
Sources: http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
There is initial discussion of current and recent risk-determining events followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate.
1 First, risk determining events. Jon Hilsenrath, writing on “New view into Fed’s response to crisis,” on Feb 21, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303775504579396803024281322?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes 1865 pages of transcripts of eight formal and six emergency policy meetings at the Fed in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm). If there were an infallible science of central banking, models and forecasts would provide accurate information to policymakers on the future course of the economy in advance. Such forewarning is essential to central bank science because of the long lag between the actual impulse of monetary policy and the actual full effects on income and prices many months and even years ahead (Romer and Romer 2004, Friedman 1961, 1953, Culbertson 1960, 1961, Batini and Nelson 2002). The transcripts of the Fed meetings in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm) analyzed by Jon Hilsenrath demonstrate that Fed policymakers frequently did not understand the current state of the US economy in 2008 and much less the direction of income and prices. The conclusion of Friedman (1953) is that monetary impulses increase financial and economic instability because of lags in anticipating needs of policy, taking policy decisions and effects of decisions. This is a fortiori true when untested unconventional monetary policy in gargantuan doses shocks the economy and financial markets.
In testimony on the Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, US House of Representatives, on Feb 11, 2014, Chair Janet Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm):
“Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. That said, purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. In December of last year and again this January, the Committee said that its current expectation--based on its assessment of a broad range of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments--is that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the 2 percent goal. I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level (emphasis added).”
Prior risk determining events are in an appendix below following Table III-1A. Current focus is on “tapering” quantitative easing by the Federal Open Market Committee (FOMC). At the meeting on Mar 19, 2014, the FOMC decided additional tapering monthly bond purchases. Earlier programs are continued with an additional lower open-ended $55 billion of bond purchases per month, increasing the stock of $3,956,850 million securities held outright and bank reserves deposited at the Fed of $2,613,997 million (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1) (http://www.federalreserve.gov/newsevents/press/monetary/20140319a.htm):
“The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in April, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month rather than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $30 billion per month rather than $35 billion per month. 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 and of rolling over maturing Treasury securities at auction. The Committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate”
At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states needs and intentions of policy:
“We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve's goal of 2 percent and is expected to continue to do so for some time.
For these reasons, the Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.”
There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. Market are overreacting to the so-called “tapering” of outright purchases of $85 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight. What really matters in the statement of the Federal Open Market Committee (FOMC) on Mar 19, 2014, is interest rates of fed funds at 0 to ¼ percent for the foreseeable future, even with paring of purchases of longer term bonds for the portfolio of the Fed (http://www.federalreserve.gov/newsevents/press/monetary/20140319a.htm):
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.” (emphasis added).
How long is “considerable time”? At the press conference following the meeting on Mar 19, 2014, Chair Yellen answered a question of Jon Hilsenrath of the Wall Street Journal explaining “In particular, the Committee has endorsed the view that it anticipates that will be a considerable period after the asset purchase program ends before it will be appropriate to begin to raise rates. And of course on our present path, well, that's not utterly preset. We would be looking at next, next fall. So, I think that's important guidance” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140319.pdf). Many focused on “next fall,” ignoring that the path of increasing rates is not “utterly preset.”
Another critical concern in the statement of the FOMC on Sep 18, 2013, is on the effects of tapering expectations on interest rates (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm):
“Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth” (emphasis added).
Will the FOMC increase purchases of mortgage-backed securities if mortgage rates increase?
In his classic restatement of the Keynesian demand function in terms of “liquidity preference as behavior toward risk,” James Tobin (http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1981/tobin-bio.html) identifies the risks of low interest rates in terms of portfolio allocation (Tobin 1958, 86):
“The assumption that investors expect on balance no change in the rate of interest has been adopted for the theoretical reasons explained in section 2.6 rather than for reasons of realism. Clearly investors do form expectations of changes in interest rates and differ from each other in their expectations. For the purposes of dynamic theory and of analysis of specific market situations, the theories of sections 2 and 3 are complementary rather than competitive. The formal apparatus of section 3 will serve just as well for a non-zero expected capital gain or loss as for a zero expected value of g. Stickiness of interest rate expectations would mean that the expected value of g is a function of the rate of interest r, going down when r goes down and rising when r goes up. In addition to the rotation of the opportunity locus due to a change in r itself, there would be a further rotation in the same direction due to the accompanying change in the expected capital gain or loss. At low interest rates expectation of capital loss may push the opportunity locus into the negative quadrant, so that the optimal position is clearly no consols, all cash. At the other extreme, expectation of capital gain at high interest rates would increase sharply the slope of the opportunity locus and the frequency of no cash, all consols positions, like that of Figure 3.3. The stickier the investor's expectations, the more sensitive his demand for cash will be to changes in the rate of interest (emphasis added).”
Tobin (1969) provides more elegant, complete analysis of portfolio allocation in a general equilibrium model. The major point is equally clear in a portfolio consisting of only cash balances and a perpetuity or consol. Let g be the capital gain, r the rate of interest on the consol and re the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+re). Thus, g = [(r/re) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dre>0, such that there is expectation of capital losses on the consol, dg<0. Investors move into positions combining only cash and no consols. Valuations of risk financial assets would collapse in reversal of long positions in carry trades with short exposures in a flight to cash. There is no exit from a central bank created liquidity trap without risks of financial crash and another global recession. The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent statement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:
W = Y/r (10
Equation (1) shows that as r goes to zero, r→0, W grows without bound, W→∞. Unconventional monetary policy lowers interest rates to increase the present value of cash flows derived from projects of firms, creating the impression of long-term increase in net worth. An attempt to reverse unconventional monetary policy necessarily causes increases in interest rates, creating the opposite perception of declining net worth. As r→∞, W = Y/r →0. There is no exit from unconventional monetary policy without increasing interest rates with resulting pain of financial crisis and adverse effects on production, investment and employment.
In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:
“Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve's portfolio of longer-term Treasury securities and agency mortgage-backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries. We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized. We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.
The Committee's decisions regarding the asset purchase program (and the overall stance of monetary policy) depend on our assessment of the economic outlook and of the cumulative progress toward our objectives. Of course, economic forecasts must be revised when new information arrives and are thus necessarily provisional.”
Friedman (1953) argues there are three lags in effects of monetary policy: (1) between the need for action and recognition of the need; (2) the recognition of the need and taking of actions; and (3) taking of action and actual effects. Friedman (1953) finds that the combination of these lags with insufficient knowledge of the current and future behavior of the economy causes discretionary economic policy to increase instability of the economy or standard deviations of real income σy and prices σp. Policy attempts to circumvent the lags by policy impulses based on forecasts. We are all naïve about forecasting. Data are available with lags and revised to maintain high standards of estimation. Policy simulation models estimate economic relations with structures prevailing before simulations of policy impulses such that parameters change as discovered by Lucas (1977). Economic agents adjust their behavior in ways that cause opposite results from those intended by optimal control policy as discovered by Kydland and Prescott (1977). Advance guidance attempts to circumvent expectations by economic agents that could reverse policy impulses but is of dubious effectiveness. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities).
The President of the European Central Bank (ECB) Mario Draghi reaffirmed the policy stance at the press conference following the meeting on Feb 6, 2014 (http://www.ecb.europa.eu/press/pressconf/2014/html/is140206.en.html): “As I have said several times we are willing to act and we stand ready to act. We confirmed our forward guidance, so interest rates will stay at the present or lower levels for an extended period of time.”
The President of the European Central Bank (ECB) Mario Draghi explained the indefinite period of low policy rates during the press conference following the meeting on Jul 4, 2013 (http://www.ecb.int/press/pressconf/2013/html/is130704.en.html):
“Yes, that is why I said you haven’t listened carefully. The Governing Council has taken the unprecedented step of giving forward guidance in a rather more specific way than it ever has done in the past. In my statement, I said “The Governing Council expects the key…” – i.e. all interest rates – “…ECB interest rates to remain at present or lower levels for an extended period of time.” It is the first time that the Governing Council has said something like this. And, by the way, what Mark Carney [Governor of the Bank of England] said in London is just a coincidence.”
The European Central Bank (ECB) lowered the policy rates on Nov 7, 2013 (http://www.ecb.europa.eu/press/pr/date/2013/html/pr131107.en.html):
“PRESS RELEASE
7 November 2013 - Monetary policy decisions
At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:
- The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.25%, starting from the operation to be settled on 13 November 2013.
- The interest rate on the marginal lending facility will be decreased by 25 basis points to 0.75%, with effect from 13 November 2013.
- The interest rate on the deposit facility will remain unchanged at 0.00%.
The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 2.30 p.m. CET today.”
Mario Draghi, President of the ECB, explained as follows (http://www.ecb.europa.eu/press/pressconf/2013/html/is131107.en.html):
“Based on our regular economic and monetary analyses, we decided to lower the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.25% and the rate on the marginal lending facility by 25 basis points to 0.75%. The rate on the deposit facility will remain unchanged at 0.00%. These decisions are in line with our forward guidance of July 2013, given the latest indications of further diminishing underlying price pressures in the euro area over the medium term, starting from currently low annual inflation rates of below 1%. In keeping with this picture, monetary and, in particular, credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggests that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. Accordingly, our monetary policy stance will remain accommodative for as long as necessary. It will thereby also continue to assist the gradual economic recovery as reflected in confidence indicators up to October.”
The ECB decision together with the employment situation report on Fri Nov 8, 2013, influenced revaluation of the dollar. Market expectations were of relatively easier monetary policy in the euro area.
The statement of the meeting of the Monetary Policy Committee of the Bank of England on Jul 4, 2013, may be leading toward the same forward guidance (http://www.bankofengland.co.uk/publications/Pages/news/2013/007.aspx):
“At its meeting today, the Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report. The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”
A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2013/01/peaking-valuation-of-risk-financial.html). Matt Jarzemsky, writing on “Dow industrials set record,” on Mar 5, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324156204578275560657416332.html), analyzes that the DJIA broke the closing high of 14,164.53 set on Oct 9, 2007, and subsequently also broke the intraday high of 14,198.10 reached on Oct 11, 2007. The DJIA closed at 16,323.06 on Fri Mar 28, 2014, which is higher by 15.2 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 15.0 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs.
The key policy is maintaining fed funds rate between 0 and ¼ percent. An increase in fed funds rates could cause flight out of risk financial markets worldwide. There is no exit from this policy without major financial market repercussions. There are high costs and risks of this policy because indefinite financial repression induces carry trades with high leverage, risks and illiquidity.
In remarkable anticipation in 2005, Professor Raghuram G. Rajan (2005) warned of low liquidity and high risks of central bank policy rates approaching the zero bound (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 218-9). Professor Rajan excelled in a distinguished career as an academic economist in finance and was chief economist of the International Monetary Fund (IMF). Shefali Anand and Jon Hilsenrath, writing on Oct 13, 2013, on “India’s central banker lobbies Fed,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304330904579133530766149484?KEYWORDS=Rajan), interviewed Raghuram G Rajan, who is the current Governor of the Reserve Bank of India, which is India’s central bank (http://www.rbi.org.in/scripts/AboutusDisplay.aspx). In this interview, Rajan argues that central banks should avoid unintended consequences on emerging market economies of inflows and outflows of capital triggered by monetary policy. Professor Rajan, in an interview with Kartik Goyal of Bloomberg (http://www.bloomberg.com/news/2014-01-30/rajan-warns-of-global-policy-breakdown-as-emerging-markets-slide.html), warns of breakdown of global policy coordination. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows.
Professor Ronald I. McKinnon (2013Oct27), writing on “Tapering without tears—how to end QE3,” on Oct 27, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304799404579153693500945608?KEYWORDS=Ronald+I+McKinnon), finds that the major central banks of the world have fallen into a “near-zero-interest-rate trap.” World economic conditions are weak such that exit from the zero interest rate trap could have adverse effects on production, investment and employment. The maintenance of interest rates near zero creates long-term near stagnation. The proposal of Professor McKinnon is credible, coordinated increase of policy interest rates toward 2 percent. Professor John B. Taylor at Stanford University, writing on “Economic failures cause political polarization,” on Oct 28, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303442004579121010753999086?KEYWORDS=John+B+Taylor), analyzes that excessive risks induced by near zero interest rates in 2003-2004 caused the financial crash. Monetary policy continued in similar paths during and after the global recession with resulting political polarization worldwide.
Second, Risk-Measuring Yields and Exchange Rate. The ten-year government bond of Spain was quoted at 6.868 percent on Aug 10, 2012, declining to 6.447 percent on Aug 17 and 6.403 percent on Aug 24, 2012, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10, 2012 to 5.709 percent on Aug 17 and 5.618 percent on Aug 24, 2012. The yield of the ten-year sovereign bond of Spain traded at 3.235 percent on Mar 28, 2014, and that of the ten-year sovereign bond of Italy at 3.307 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. In the week of Mar 28, 2014, the yield of the two-year Treasury increased to 0.448 percent and that of the ten-year Treasury decreased to 2.721 percent while the yield of the two-year bond of Germany decreased to 0.14 percent and the ten-year yield decreased to 1.55 percent; and the dollar appreciated to USD 1.3752/EUR. The zero interest rates for the monetary policy rate of the US, or fed funds rate, induce carry trades that ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield of 2.721 percent is higher than consumer price inflation of 1.1 percent in the 12 months ending in Feb 2014 (http://cmpassocregulationblog.blogspot.com/2014/03/interest-rate-risks-world-inflation.html and earlier http://cmpassocregulationblog.blogspot.com/2014/02/squeeze-of-economic-activity-by-carry.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.122 percent (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3002) is well below the 12-month consumer price inflation of 1.1 percent. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.
Table III-1A, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate
| US 2Y | US 10Y | DE 2Y | DE 10Y | USD/ EUR | |
| 03/28/14 | 0.448 | 2.721 | 0.14 | 1.55 | 1.3752 |
| 03/21/14 | 0.431 | 2.743 | 0.20 | 1.63 | 1.3793 |
| 03/14/14 | 0.340 | 2.654 | 0.15 | 1.54 | 1.3912 |
| 03/07/14 | 0.367 | 2.792 | 0.17 | 1.65 | 1.3877 |
| 02/28/14 | 0.323 | 2.655 | 0.13 | 1.62 | 1.3801 |
| 02/21/14 | 0.316 | 2.730 | 0.12 | 1.66 | 1.3739 |
| 02/14/14 | 0.313 | 2.743 | 0.11 | 1.68 | 1.3693 |
| 02/07/14 | 0.305 | 2.681 | 0.09 | 1.66 | 1.3635 |
| 1/31/14 | 0.330 | 2.645 | 0.07 | 1.66 | 1.3488 |
| 1/24/14 | 0.342 | 2.720 | 0.12 | 1.66 | 1.3677 |
| 1/17/14 | 0.373 | 2.818 | 0.17 | 1.75 | 1.3541 |
| 1/10/14 | 0.372 | 2.858 | 0.18 | 1.84 | 1.3670 |
| 1/3/14 | 0.398 | 2.999 | 0.20 | 1.94 | 1.3588 |
| 12/27/13 | 0.393 | 3.004 | 0.24 | 1.95 | 1.3746 |
| 12/20/13 | 0.377 | 2.891 | 0.22 | 1.87 | 1.3673 |
| 12/13/13 | 0.328 | 2.865 | 0.24 | 1.83 | 1.3742 |
| 12/6/13 | 0.304 | 2.858 | 0.21 | 1.84 | 1.3705 |
| 11/29/13 | 0.283 | 2.743 | 0.11 | 1.69 | 1.3592 |
| 11/22/13 | 0.280 | 2.746 | 0.13 | 1.74 | 1.3557 |
| 11/15/13 | 0.292 | 2.704 | 0.10 | 1.70 | 1.3497 |
| 11/8/13 | 0.316 | 2.750 | 0.10 | 1.76 | 1.3369 |
| 11/1/13 | 0.311 | 2.622 | 0.11 | 1.69 | 1.3488 |
| 10/25/13 | 0.305 | 2.507 | 0.18 | 1.75 | 1.3804 |
| 10/18/13 | 0.321 | 2.588 | 0.17 | 1.83 | 1.3686 |
| 10/11/13 | 0.344 | 2.688 | 0.18 | 1.86 | 1.3543 |
| 10/4/13 | 0.335 | 2.645 | 0.17 | 1.84 | 1.3557 |
| 9/27/13 | 0.335 | 2.626 | 0.16 | 1.78 | 1.3523 |
| 9/20/13 | 0.333 | 2.734 | 0.21 | 1.94 | 1.3526 |
| 9/13/13 | 0.433 | 2.890 | 0.22 | 1.97 | 1.3297 |
| 9/6/13 | 0.461 | 2.941 | 0.26 | 1.95 | 1.3179 |
| 8/23/13 | 0.401 | 2.784 | 0.23 | 1.85 | 1.3221 |
| 8/23/13 | 0.374 | 2.818 | 0.28 | 1.93 | 1.3380 |
| 8/16/13 | 0.341 | 2.829 | 0.22 | 1.88 | 1.3328 |
| 8/9/13 | 0.30 | 2.579 | 0.16 | 1.68 | 1.3342 |
| 8/2/13 | 0.299 | 2.597 | 0.15 | 1.65 | 1.3281 |
| 7/26/13 | 0.315 | 2.565 | 0.15 | 1.66 | 1.3279 |
| 7/19/13 | 0.300 | 2.480 | 0.08 | 1.52 | 1.3141 |
| 7/12/13 | 0.345 | 2.585 | 0.10 | 1.56 | 1.3068 |
| 7/5/13 | 0.397 | 2.734 | 0.11 | 1.72 | 1.2832 |
| 6/28/13 | 0.357 | 2.486 | 0.19 | 1.73 | 1.3010 |
| 6/21/13 | 0.366 | 2.542 | 0.26 | 1.72 | 1.3122 |
| 6/14/13 | 0.276 | 2.125 | 0.12 | 1.51 | 1.3345 |
| 6/7/13 | 0.304 | 2.174 | 0.18 | 1.54 | 1.3219 |
| 5/31/13 | 0.299 | 2.132 | 0.06 | 1.50 | 1.2996 |
| 5/24/13 | 0.249 | 2.009 | 0.00 | 1.43 | 1.2932 |
| 5/17/13 | 0.248 | 1.952 | -0.03 | 1.32 | 1.2837 |
| 5/10/13 | 0.239 | 1.896 | 0.05 | 1.38 | 1.2992 |
| 5/3/13 | 0.22 | 1.742 | 0.00 | 1.24 | 1.3115 |
| 4/26/13 | 0.209 | 1.663 | 0.00 | 1.21 | 1.3028 |
| 4/19/13 | 0.232 | 1.702 | 0.02 | 1.25 | 1.3052 |
| 4/12/13 | 0.228 | 1.719 | 0.02 | 1.26 | 1.3111 |
| 4/5/13 | 0.228 | 1.706 | 0.01 | 1.21 | 1.2995 |
| 3/29/13 | 0.244 | 1.847 | -0.02 | 1.29 | 1.2818 |
| 3/22/13 | 0.242 | 1.931 | 0.03 | 1.38 | 1.2988 |
| 3/15/13 | 0.246 | 1.992 | 0.05 | 1.46 | 1.3076 |
| 3/8/13 | 0.256 | 2.056 | 0.09 | 1.53 | 1.3003 |
| 3/1/13 | 0.236 | 1.842 | 0.03 | 1.41 | 1.3020 |
| 2/22/13 | 0.252 | 1.967 | 0.13 | 1.57 | 1.3190 |
| 2/15/13 | 0.268 | 2.007 | 0.19 | 1.65 | 1.3362 |
| 2/8/13 | 0.252 | 1.949 | 0.18 | 1.61 | 1.3365 |
| 2/1/13 | 0.26 | 2.024 | 0.25 | 1.67 | 1.3642 |
| 1/25/13 | 0.278 | 1.947 | 0.26 | 1.64 | 1.3459 |
| 1/18/13 | 0.252 | 1.84 | 0.18 | 1.56 | 1.3321 |
| 1/11/13 | 0.247 | 1.862 | 0.13 | 1.58 | 1.3343 |
| 1/4/13 | 0.262 | 1.898 | 0.08 | 1.54 | 1.3069 |
| 12/28/12 | 0.252 | 1.699 | -0.01 | 1.31 | 1.3218 |
| 12/21/12 | 0.272 | 1.77 | -0.01 | 1.38 | 1.3189 |
| 12/14/12 | 0.232 | 1.704 | -0.04 | 1.35 | 1.3162 |
| 12/7/12 | 0.256 | 1.625 | -0.08 | 1.30 | 1.2926 |
| 11/30/12 | 0.248 | 1.612 | 0.01 | 1.39 | 1.2987 |
| 11/23/12 | 0.273 | 1.691 | 0.00 | 1.44 | 1.2975 |
| 11/16/12 | 0.24 | 1.584 | -0.03 | 1.33 | 1.2743 |
| 11/9/12 | 0.256 | 1.614 | -0.03 | 1.35 | 1.2711 |
| 11/2/12 | 0.274 | 1.715 | 0.01 | 1.45 | 1.2838 |
| 10/26/12 | 0.299 | 1.748 | 0.05 | 1.54 | 1.2942 |
| 10/19/12 | 0.296 | 1.766 | 0.11 | 1.59 | 1.3023 |
| 10/12/12 | 0.264 | 1.663 | 0.04 | 1.45 | 1.2953 |
| 10/5/12 | 0.26 | 1.737 | 0.06 | 1.52 | 1.3036 |
| 9/28/12 | 0.236 | 1.631 | 0.02 | 1.44 | 1.2859 |
| 9/21/12 | 0.26 | 1.753 | 0.04 | 1.60 | 1.2981 |
| 9/14/12 | 0.252 | 1.863 | 0.10 | 1.71 | 1.3130 |
| 9/7/12 | 0.252 | 1.668 | 0.03 | 1.52 | 1.2816 |
| 8/31/12 | 0.225 | 1.543 | -0.03 | 1.33 | 1.2575 |
| 8/24/12 | 0.266 | 1.684 | -0.01 | 1.35 | 1.2512 |
| 8/17/12 | 0.288 | 1.814 | -0.04 | 1.50 | 1.2335 |
| 8/10/12 | 0.267 | 1.658 | -0.07 | 1.38 | 1.2290 |
| 8/3/12 | 0.242 | 1.569 | -0.02 | 1.42 | 1.2387 |
| 7/27/12 | 0.244 | 1.544 | -0.03 | 1.40 | 1.2320 |
| 7/20/12 | 0.207 | 1.459 | -0.07 | 1.17 | 1.2158 |
| 7/13/12 | 0.24 | 1.49 | -0.04 | 1.26 | 1.2248 |
| 7/6/12 | 0.272 | 1.548 | -0.01 | 1.33 | 1.2288 |
| 6/29/12 | 0.305 | 1.648 | 0.12 | 1.58 | 1.2661 |
| 6/22/12 | 0.309 | 1.676 | 0.14 | 1.58 | 1.2570 |
| 6/15/12 | 0.272 | 1.584 | 0.07 | 1.44 | 1.2640 |
| 6/8/12 | 0.268 | 1.635 | 0.04 | 1.33 | 1.2517 |
| 6/1/12 | 0.248 | 1.454 | 0.01 | 1.17 | 1.2435 |
| 5/25/12 | 0.291 | 1.738 | 0.05 | 1.37 | 1.2518 |
| 5/18/12 | 0.292 | 1.714 | 0.05 | 1.43 | 1.2780 |
| 5/11/12 | 0.248 | 1.845 | 0.09 | 1.52 | 1.2917 |
| 5/4/12 | 0.256 | 1.876 | 0.08 | 1.58 | 1.3084 |
| 4/6/12 | 0.31 | 2.058 | 0.14 | 1.74 | 1.3096 |
| 3/30/12 | 0.335 | 2.214 | 0.21 | 1.79 | 1.3340 |
| 3/2/12 | 0.29 | 1.977 | 0.16 | 1.80 | 1.3190 |
| 2/24/12 | 0.307 | 1.977 | 0.24 | 1.88 | 1.3449 |
| 1/6/12 | 0.256 | 1.957 | 0.17 | 1.85 | 1.2720 |
| 12/30/11 | 0.239 | 1.871 | 0.14 | 1.83 | 1.2944 |
| 8/26/11 | 0.20 | 2.202 | 0.65 | 2.16 | 1.450 |
| 8/19/11 | 0.192 | 2.066 | 0.65 | 2.11 | 1.4390 |
| 6/7/10 | 0.74 | 3.17 | 0.49 | 2.56 | 1.192 |
| 3/5/09 | 0.89 | 2.83 | 1.19 | 3.01 | 1.254 |
| 12/17/08 | 0.73 | 2.20 | 1.94 | 3.00 | 1.442 |
| 10/27/08 | 1.57 | 3.79 | 2.61 | 3.76 | 1.246 |
| 7/14/08 | 2.47 | 3.88 | 4.38 | 4.40 | 1.5914 |
| 6/26/03 | 1.41 | 3.55 | NA | 3.62 | 1.1423 |
Note: DE: Germany
Source: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
http://www.bloomberg.com/markets/
http://www.federalreserve.gov/releases/h15/
Appendix: Prior Risk Determining Events. Current risk analysis concentrates on deciphering what the Federal Open Market Committee (FOMC) may decide on quantitative easing. The week of May 24 was dominated by the testimony of Chairman Bernanke to the Joint Economic Committee of the US Congress on May 22, 2013 (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm), followed by questions and answers and the release on May 22, 2013 of the minutes of the meeting of the Federal Open Market Committee (FOMC) from Apr 30 to May 1, 2013 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm). Monetary policy emphasizes communication of policy intentions to avoid that expectations reverse outcomes in reality (Kydland and Prescott 1977). Jon Hilsenrath, writing on “In bid for clarity, Fed delivers opacity,” on May 23, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath), analyzes discrepancies in communication by the Fed. The annotated chart of values of the Dow Jones Industrial Average (DJIA) during trading on May 23, 2013 provided by Hinselrath, links the prepared testimony of Chairman Bernanke at 10:AM, following questions and answers and the release of the minutes of the FOMC at 2PM. Financial markets strengthened between 10 and 10:30AM on May 23, 2013, perhaps because of the statement by Chairman Bernanke in prepared testimony (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm):
“A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further. Such outcomes tend to be associated with extended periods of lower, not higher, interest rates, as well as poor returns on other assets. Moreover, renewed economic weakness would pose its own risks to financial stability.”
In that testimony, Chairman Bernanke (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm) also analyzes current weakness of labor markets:
“Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers' skills and--particularly relevant during this commencement season--by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.”
Hilsenrath (op. cit. http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath) analyzes the subsequent decline of the market from 10:30AM to 10:40AM as Chairman Bernanke responded questions with the statement that withdrawal of stimulus would be determined by data but that it could begin in one of the “next few meetings.” The DJIA recovered part of the losses between 10:40AM and 2PM. The minutes of the FOMC released at 2PM on May 23, 2013, contained a phrase that troubled market participants (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm): “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.” The DJIA closed at 15,387.58 on May 21, 2013 and fell to 15,307.17 at the close on May 22, 2013, with the loss of 0.5 percent occurring after release of the minutes of the FOMC at 2PM when the DJIA stood at around 15,400. The concern about exist of the Fed from stimulus affected markets worldwide as shown in declines of equity indexes in Table III-1 with delays because of differences in trading hours. This behavior shows the trap of unconventional monetary policy with no exit from zero interest rates without risking financial crash and likely adverse repercussions on economic activity.
Financial markets worldwide were affected by the reduction of policy rates of the European Central Bank (ECB) on May 2, 2013. (http://www.ecb.int/press/pr/date/2013/html/pr130502.en.html):
“2 May 2013 - Monetary policy decisions
At today’s meeting, which was held in Bratislava, the Governing Council of the ECB took the following monetary policy decisions:
- The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.50%, starting from the operation to be settled on 8 May 2013.
- The interest rate on the marginal lending facility will be decreased by 50 basis points to 1.00%, with effect from 8 May 2013.
- The interest rate on the deposit facility will remain unchanged at 0.00%.”
Financial markets in Japan and worldwide were shocked by new bold measures of “quantitative and qualitative monetary easing” by the Bank of Japan (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The objective of policy is to “achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The main elements of the new policy are as follows:
- Monetary Base Control. Most central banks in the world pursue interest rates instead of monetary aggregates, injecting bank reserves to lower interest rates to desired levels. The Bank of Japan (BOJ) has shifted back to monetary aggregates, conducting money market operations with the objective of increasing base money, or monetary liabilities of the government, at the annual rate of 60 to 70 trillion yen. The BOJ estimates base money outstanding at “138 trillion yen at end-2012) and plans to increase it to “200 trillion yen at end-2012 and 270 trillion yen at end 2014” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
- Maturity Extension of Purchases of Japanese Government Bonds. Purchases of bonds will be extended even up to bonds with maturity of 40 years with the guideline of extending the average maturity of BOJ bond purchases from three to seven years. The BOJ estimates the current average maturity of Japanese government bonds (JGB) at around seven years. The BOJ plans to purchase about 7.5 trillion yen per month (http://www.boj.or.jp/en/announcements/release_2013/rel130404d.pdf). Takashi Nakamichi, Tatsuo Ito and Phred Dvorak, wiring on “Bank of Japan mounts bid for revival,” on Apr 4, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323646604578401633067110420.html ), find that the limit of maturities of three years on purchases of JGBs was designed to avoid views that the BOJ would finance uncontrolled government deficits.
- Seigniorage. The BOJ is pursuing coordination with the government that will take measures to establish “sustainable fiscal structure with a view to ensuring the credibility of fiscal management” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
- Diversification of Asset Purchases. The BOJ will engage in transactions of exchange traded funds (ETF) and real estate investment trusts (REITS) and not solely on purchases of JGBs. Purchases of ETFs will be at an annual rate of increase of one trillion yen and purchases of REITS at 30 billion yen.
The European sovereign debt crisis continues to shake financial markets and the world economy. Debt resolution within the international financial architecture requires that a country be capable of borrowing on its own from the private sector. Mechanisms of debt resolution have included participation of the private sector (PSI), or “bail in,” that has been voluntary, almost coercive, agreed and outright coercive (Pelaez and Pelaez, International Financial Architecture: G7, IMF, BIS, Creditors and Debtors (2005), Chapter 4, 187-202). Private sector involvement requires losses by the private sector in bailouts of highly indebted countries. The essence of successful private sector involvement is to recover private-sector credit of the highly indebted country. Mary Watkins, writing on “Bank bailouts reshuffle risk hierarchy,” published on Mar 19, 2013, in the Financial Times (http://www.ft.com/intl/cms/s/0/7666546a-9095-11e2-a456-00144feabdc0.html#axzz2OSpbvCn8) analyzes the impact of the bailout or resolution of Cyprus banks on the hierarchy of risks of bank liabilities. Cyprus banks depend mostly on deposits with less reliance on debt, raising concerns in creditors of fixed-income debt and equity holders in banks in the euro area. Uncertainty remains as to the dimensions and structure of losses in private sector involvement or “bail in” in other rescue programs in the euro area. Alkman Granitsas, writing on “Central bank details losses at Bank of Cyprus,” on Mar 30, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324000704578392502889560768.html), analyzes the impact of the agreement with the €10 billion agreement with IMF and the European Union on the banks of Cyprus. The recapitalization plan provides for immediate conversion of 37.5 percent of all deposits in excess of €100,000 to shares of special class of the bank. An additional 22.5 percent will be frozen without interest until the plan is completed. The overwhelming risk factor is the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). Another rising risk is division within the Federal Open Market Committee (FOMC) on risks and benefits of current policies as expressed in the minutes of the meeting held on Jan 29-30, 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130130.pdf 13):
“However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy.
Jon Hilsenrath, writing on “Fed maps exit from stimulus,” on May 11, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324744104578475273101471896.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the development of strategy for unwinding quantitative easing and how it can create uncertainty in financial markets. Jon Hilsenrath and Victoria McGrane, writing on “Fed slip over how long to keep cash spigot open,” published on Feb 20, 2013 in the Wall street Journal (http://professional.wsj.com/article/SB10001424127887323511804578298121033876536.html), analyze the minutes of the Fed, comments by members of the FOMC and data showing increase in holdings of riskier debt by investors, record issuance of junk bonds, mortgage securities and corporate loans.
Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.
An important risk event is the reduction of growth prospects in the euro zone discussed by European Central Bank President Mario Draghi in “Introductory statement to the press conference,” on Dec 6, 2012 (http://www.ecb.int/press/pressconf/2012/html/is121206.en.html):
“This assessment is reflected in the December 2012 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP growth in a range between -0.6% and -0.4% for 2012, between -0.9% and 0.3% for 2013 and between 0.2% and 2.2% for 2014. Compared with the September 2012 ECB staff macroeconomic projections, the ranges for 2012 and 2013 have been revised downwards.
The Governing Council continues to see downside risks to the economic outlook for the euro area. These are mainly related to uncertainties about the resolution of sovereign debt and governance issues in the euro area, geopolitical issues and fiscal policy decisions in the United States possibly dampening sentiment for longer than currently assumed and delaying further the recovery of private investment, employment and consumption.”
Reuters, writing on “Bundesbank cuts German growth forecast,” on Dec 7, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/8e845114-4045-11e2-8f90-00144feabdc0.html#axzz2EMQxzs3u), informs that the central bank of Germany, Deutsche Bundesbank reduced its forecast of growth for the economy of Germany to 0.7 percent in 2012 from an earlier forecast of 1.0 percent in Jun and to 0.4 percent in 2012 from an earlier forecast of 1.6 percent while the forecast for 2014 is at 1.9 percent.
The major risk event during earlier weeks was sharp decline of sovereign yields with the yield on the ten-year bond of Spain falling to 5.309 percent and that of the ten-year bond of Italy falling to 4.473 percent on Fri Nov 30, 2012 and 5.366 percent for the ten-year of Spain and 4.527 percent for the ten-year of Italy on Fri Nov 14, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Vanessa Mock and Frances Robinson, writing on “EU approves Spanish bank’s restructuring plans,” on Nov 28, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578146520774638316.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the European Union regulators approved restructuring of four Spanish banks (Bankia, NCG Banco, Catalunya Banc and Banco de Valencia), which helped to calm sovereign debt markets. Harriet Torry and James Angelo, writing on “Germany approves Greek aid,” on Nov 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578150532603095790.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the German parliament approved the plan to provide Greece a tranche of €44 billion in promised financial support, which is subject to sustainability analysis of the bond repurchase program later in Dec 2012. A hurdle for sustainability of repurchasing debt is that Greece’s sovereign bonds have appreciated significantly from around 24 percent for the bond maturing in 21 years and 20 percent for the bond maturing in 31 years in Aug 2012 to around 17 percent for the 21-year maturity and 15 percent for the 31-year maturing in Nov 2012. Declining years are equivalent to increasing prices, making the repurchase more expensive. Debt repurchase is intended to reduce bonds in circulation, turning Greek debt more manageable. Ben McLannahan, writing on “Japan unveils $11bn stimulus package,” on Nov 30, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/adc0569a-3aa5-11e2-baac-00144feabdc0.html#axzz2DibFFquN), informs that the cabinet in Japan approved another stimulus program of $11 billion, which is twice larger than another stimulus plan in late Oct and close to elections in Dec. Henry Sender, writing on “Tokyo faces weak yen and high bond yields,” published on Nov 29, 2012 in the Financial Times (http://www.ft.com/intl/cms/s/0/9a7178d0-393d-11e2-afa8-00144feabdc0.html#axzz2DibFFquN), analyzes concerns of regulators on duration of bond holdings in an environment of likelihood of increasing yields and yen depreciation.
First, Risk-Determining Events. The European Council statement on Nov 23, 2012 asked the President of the European Commission “to continue the work and pursue consultations in the coming weeks to find a consensus among the 27 over the Union’s Multiannual Financial Framework for the period 2014-2020” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf) Discussions will continue in the effort to reach agreement on a budget: “A European budget is important for the cohesion of the Union and for jobs and growth in all our countries” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf). There is disagreement between the group of countries requiring financial assistance and those providing bailout funds. Gabrielle Steinhauser and Costas Paris, writing on “Greek bond rally puts buyback in doubt,” on Nov 23, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324352004578136362599130992.html?mg=reno64-wsj) find a new hurdle in rising prices of Greek sovereign debt that may make more difficult buybacks of debt held by investors. European finance ministers continue their efforts to reach an agreement for Greece that meets with approval of the European Central Bank and the IMF. The European Council (2012Oct19 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/133004.pdf ) reached conclusions on strengthening the euro area and providing unified financial supervision:
“The European Council called for work to proceed on the proposals on the Single Supervisory Mechanism as a matter of priority with the objective of agreeing on the legislative framework by 1st January 2013 and agreed on a number of orientations to that end. It also took note of issues relating to the integrated budgetary and economic policy frameworks and democratic legitimacy and accountability which should be further explored. It agreed that the process towards deeper economic and monetary union should build on the EU's institutional and legal framework and be characterised by openness and transparency towards non-euro area Member States and respect for the integrity of the Single Market. It looked forward to a specific and time-bound roadmap to be presented at its December 2012 meeting, so that it can move ahead on all essential building blocks on which a genuine EMU should be based.”
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. The Bank of Spain released new data on doubtful debtors in Spain’s credit institutions (http://www.bde.es/bde/en/secciones/prensa/Agenda/Datos_de_credit_a6cd708c59cf931.html). In 2006, the value of doubtful credits reached €10,859 million or 0.7 percent of total credit of €1,508,626 million. In Aug 2012, doubtful credit reached €178,579 million or 10.5 percent of total credit of €1,698,714 million.
There are three critical factors influencing world financial markets. (1) Spain could request formal bailout from the European Stability Mechanism (ESM) that may also affect Italy’s international borrowing. David Roman and Jonathan House, writing on “Spain risks backlash with budget plan,” on Sep 27, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443916104578021692765950384.html?mod=WSJ_hp_LEFTWhatsNewsCollection) analyze Spain’s proposal of reducing government expenditures by €13 billion, or around $16.7 billion, increasing taxes in 2013, establishing limits on early retirement and cutting the deficit by €65 billion through 2014. Banco de España, Bank of Spain, contracted consulting company Oliver Wyman to conduct rigorous stress tests of the resilience of its banking system. (Stress tests and their use are analyzed by Pelaez and Pelaez Globalization and the State Vol. I (2008b), 95-100, International Financial Architecture (2005) 112-6, 123-4, 130-3).) The results are available from Banco de España (http://www.bde.es/bde/en/secciones/prensa/infointeres/reestructuracion/ http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). The assumptions of the adverse scenario used by Oliver Wyman are quite tough for the three-year period from 2012 to 2014: “6.5 percent cumulative decline of GDP, unemployment rising to 27.2 percent and further declines of 25 percent of house prices and 60 percent of land prices (http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). Fourteen banks were stress tested with capital needs estimates of seven banks totaling €59.3 billion. The three largest banks of Spain, Banco Santander (http://www.santander.com/csgs/Satellite/CFWCSancomQP01/es_ES/Corporativo.html), BBVA (http://www.bbva.com/TLBB/tlbb/jsp/ing/home/index.jsp) and Caixabank (http://www.caixabank.com/index_en.html), with 43 percent of exposure under analysis, have excess capital of €37 billion in the adverse scenario in contradiction with theories that large, international banks are necessarily riskier. Jonathan House, writing on “Spain expects wider deficit on bank aid,” on Sep 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444138104578028484168511130.html?mod=WSJPRO_hpp_LEFTTopStories), analyzes the 2013 budget plan of Spain that will increase the deficit of 7.4 percent of GDP in 2012, which is above the target of 6.3 percent under commitment with the European Union. The ratio of debt to GDP will increase to 85.3 percent in 2012 and 90.5 percent in 2013 while the 27 members of the European Union have an average debt/GDP ratio of 83 percent at the end of IIQ2012. (2) Symmetric inflation targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even after the economy grows again at or close to potential output. Monetary easing by unconventional measures is now apparently open ended in perpetuity as provided in the statement of the meeting of the Federal Open Market Committee (FOMC) on Sep 13, 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm):
“To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”
In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is the concern of the production and employment costs of controlling future inflation.
(2) The European Central Bank (ECB) approved a new program of bond purchases under the name “Outright Monetary Transactions” (OMT). The ECB will purchase sovereign bonds of euro zone member countries that have a program of conditionality under the European Financial Stability Facility (EFSF) that is converting into the European Stability Mechanism (ESM). These programs provide enhancing the solvency of member countries in a transition period of structural reforms and fiscal adjustment. The purchase of bonds by the ECB would maintain debt costs of sovereigns at sufficiently low levels to permit adjustment under the EFSF/ESM programs. Purchases of bonds are not limited quantitatively with discretion by the ECB as to how much is necessary to support countries with adjustment programs. Another feature of the OMT of the ECB is sterilization of bond purchases: funds injected to pay for the bonds would be withdrawn or sterilized by ECB transactions. The statement by the European Central Bank on the program of OTM is as follows (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html):
“6 September 2012 - Technical features of Outright Monetary Transactions
As announced on 2 August 2012, the Governing Council of the European Central Bank (ECB) has today taken decisions on a number of technical features regarding the Eurosystem’s outright transactions in secondary sovereign bond markets that aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy. These will be known as Outright Monetary Transactions (OMTs) and will be conducted within the following framework:
Conditionality
A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.
The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.
Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.
Coverage
Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above. They may also be considered for Member States currently under a macroeconomic adjustment programme when they will be regaining bond market access.
Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.
No ex ante quantitative limits are set on the size of Outright Monetary Transactions.
Creditor treatment
The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.
Sterilisation
The liquidity created through Outright Monetary Transactions will be fully sterilised.
Transparency
Aggregate Outright Monetary Transaction holdings and their market values will be published on a weekly basis. Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.
Securities Markets Programme
Following today’s decision on Outright Monetary Transactions, the Securities Markets Programme (SMP) is herewith terminated. The liquidity injected through the SMP will continue to be absorbed as in the past, and the existing securities in the SMP portfolio will be held to maturity.”
Jon Hilsenrath, writing on “Fed sets stage for stimulus,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443864204577623220212805132.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the essay presented by Chairman Bernanke at the Jackson Hole meeting of central bankers, as defending past stimulus with unconventional measures of monetary policy that could be used to reduce extremely high unemployment. Chairman Bernanke (2012JHAug31, 18-9) does support further unconventional monetary policy impulses if required by economic conditions (http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm):
“Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
Professor John H Cochrane (2012Aug31), at the University of Chicago Booth School of Business, writing on “The Federal Reserve: from central bank to central planner,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444812704577609384030304936.html?mod=WSJ_hps_sections_opinion), analyzes that the departure of central banks from open market operations into purchase of assets with risks to taxpayers and direct allocation of credit subject to political influence has caused them to abandon their political independence and accountability. Cochrane (2012Aug31) finds a return to the proposition of Milton Friedman in the 1960s that central banks can cause inflation and macroeconomic instability.
Mario Draghi (2012Aug29), President of the European Central Bank, also reiterated the need of exceptional and unconventional central bank policies (http://www.ecb.int/press/key/date/2012/html/sp120829.en.html):
“Yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole.
The ECB is not a political institution. But it is committed to its responsibilities as an institution of the European Union. As such, we never lose sight of our mission to guarantee a strong and stable currency. The banknotes that we issue bear the European flag and are a powerful symbol of European identity.”
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. 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. Table III-7 in IIIE Appendix Euro Zone Survival Risk below provides the combined GDP in 2012 of the highly indebted euro zone members estimated in the latest World Economic Outlook of the IMF at $4167 billion or 33.1 percent of total euro zone GDP of $12,586 billion. Using the WEO of the IMF, Table III-8 in IIIE Appendix Euro Zone Survival Risk below provides debt of the highly indebted euro zone members at $3927.8 billion in 2012 that increases to $5809.9 billion when adding Germany’s debt, corresponding to 167.0 percent of Germany’s GDP. There are additional sources of debt in bailing out banks. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html).
Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields together with the overnight fed funds rate, and the yield of the corporate bond with Moody’s rating of Baa. The riskier yield of the Baa corporate bond exceeds the relatively riskless yields of the Treasury securities. The beginning yields in Chart III-1A for Jan 2, 1962, are 2.75 percent for the fed fund rates and 4.06 percent for the ten-year Treasury constant maturity. On July 31, 2001, the yields in Chart III-1A are 3.67 percent for one month, 3.79 percent for two years, 5.07 percent for ten years, 3.82 percent for the fed funds rate and 7.85 percent for the Baa corporate bond. On July 30, 2007, yields inverted with the one-month at 4.95 percent, the two-year at 4.59 percent and the ten-year at 5.82 percent with the yield of the Baa corporate bond at 6.70 percent. Another interesting point is for Oct 31, 2008, with the yield of the Baa jumping to 9.54 percent and the Treasury yields declining: one month 0.12 percent, two years 1.56 percent and ten years 4.01 percent during a flight to the dollar and government securities analyzed by Cochrane and Zingales (2009). Another spike in the series is for Apr 4, 2006 with the yield of the corporate Baa bond at 8.63 and the Treasury yields of 0.12 percent for one month, 0.94 for two years and 2.95 percent for ten years. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield 1.64 percent and the ten-year yield 3.41. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe. The final point of Chart III1-A is for Mar 27, 2014, with the one-month yield at 0.02 percent, the two-year at 0.45 percent, the ten-year at 2.69 percent, the fed funds rate at 0.08 percent and the corporate Baa bond at 4.95 percent. There is an evident increase in the yields of the 10-year Treasury constant maturity and the Moody’s Baa corporate bond with reduction in wide swings of portfolio reallocations.
Chart III-1A, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields, Overnight Fed Funds Rate and Yield of Moody’s Baa Corporate Bond, Jan 2, 1962-Mar 27, 2014
Note: US Recessions in shaded areas
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h15
Alexandra Scaggs, writing on “Tepid profits, roaring stocks,” on May 16, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323398204578487460105747412.html), analyzes stabilization of earnings growth: 70 percent of 458 reporting companies in the S&P 500 stock index reported earnings above forecasts but sales fell 0.2 percent relative to forecasts of increase of 0.5 percent. Paul Vigna, writing on “Earnings are a margin story but for how long,” on May 17, 2013, published in the Wall Street Journal (http://blogs.wsj.com/moneybeat/2013/05/17/earnings-are-a-margin-story-but-for-how-long/), analyzes that corporate profits increase with stagnating sales while companies manage costs tightly. More than 90 percent of S&P components reported moderate increase of earnings of 3.7 percent in IQ2013 relative to IQ2012 with decline of sales of 0.2 percent. Earnings and sales have been in declining trend. In IVQ2009, growth of earnings reached 104 percent and sales jumped 13 percent. Net margins reached 8.92 percent in IQ2013, which is almost the same at 8.95 percent in IIIQ2006. Operating margins are 9.58 percent. There is concern by market participants that reversion of margins to the mean could exert pressure on earnings unless there is more accelerated growth of sales. Vigna (op. cit.) finds sales growth limited by weak economic growth. 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. Future company cash flows derive from investment projects. In IQ1980, gross private domestic investment in the US was $951.6 billion of 2009 dollars, growing to $1,174.4 billion in IIQ1987 or 23.4 percent. Real gross private domestic investment in the US increased 1.5 percent from $2,605.2 billion of 2009 dollars in IVQ2007 to $2,643.3 billion in IVQ2013. As shown in Table IAI-2, real private fixed investment fell 2.9 percent from $2,586.3 billion of 2009 dollars in IVQ2007 to $2,511.2 billion in IVQ2013. Growth of real private investment in Table IA1-2 is mediocre for all but four quarters from IIQ2011 to IQ2012 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html). The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Corporate profits with IVA and CCA fell $26.6 billion in IQ2013 after increasing $34.9 billion in IVQ2012 and $13.9 billion in IIIQ2012. Corporate profits with IVA and CCA rebounded with $66.8 billion in IIQ2013 and $39.2 billion in IIIQ2013. Corporate profits with IVA and CCA increased $47.1 billion in IVQ2013. Profits after tax with IVA and CCA fell $1.7 billion in IQ2013 after increasing $40.8 billion in IVQ2012 and $4.5 billion in IIIQ2012. In IIQ2013, profits after tax with IVA and CCA increased $56.9 billion and $39.5 billion in IIIQ2013. In IVQ2013, profits after tax with IVA and CCA increased $33.8 billion. Anticipation of higher taxes in the “fiscal cliff” episode caused increase of $120.9 billion in net dividends in IVQ2012 followed with adjustment in the form of decrease of net dividends by $103.8 billion in IQ2013, rebounding with $273.5 billion in IIQ2013. Net dividends fell at $179.0 billion in IIIQ2013 and increased at $90.5 billion in IVQ2013. There is similar decrease of $80.1 billion in undistributed profits with IVA and CCA in IVQ2012 followed by increase of $102.1 billion in IQ2013 and decline of $216.6 billion in IIQ2013. Undistributed profits with IVA and CCA rose at $218.6 billion in IIIQ2013 and fell at $56.7 billion in IVQ2013. Undistributed profits of US corporations swelled 375.4 percent from $107.7 billion IQ2007 to $512.0 billion in IVQ2013 and changed signs from minus $55.9 billion in billion in IVQ2007 (Section IA2). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $26.6 billion relative to IVQ2012, from $2047.2 billion to $2020.6 billion at the quarterly rate of minus 1.3 percent. In IIQ2013, corporate profits with IVA and CCA increased $66.8 billion from $2020.6 billion in IQ2013 to $2087.4 billion at the quarterly rate of 3.3 percent. Corporate profits with IVA and CCA increased $39.2 billion from $2087.4 billion in IIQ2013 to $2126.6 billion in IIIQ2013 at the annual rate of 1.9 percent. Corporate profits with IVA and CCA increased at $47.1 billion in IVQ2013 from $2126.6 billion in IIIQ2013 to $2173.7 billion in IVQ2013 (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp4q13_3rd.pdf). Uncertainty originating in fiscal, regulatory and monetary policy causes wide swings in expectations and decisions by the private sector with adverse effects on investment, real economic activity and employment. The investment decision of US business is fractured. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:
Where Rτ is expected revenue in the time horizon from τ =1 to T; Cτ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that interest rates increase without bound, then V → 0, or
declines.
There is mostly stronger performance in equity indexes with several indexes in Table III-1 increasing in the week ending on Mar 28, 2014, after wide swings caused by reallocations of investment portfolios worldwide. Stagnating revenues, corporate cash hoarding and declining investment are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. DJIA increased 0.4 percent on Mar 28, increasing 0.1 percent in the week. Germany’s Dax increased 1.4 percent on Fri Mar 28 and increased 2.6 percent in the week. Dow Global increased 0.6 percent on Mar 28 and increased 1.4 percent in the week. Japan’s Nikkei Average increased 0.5 percent on Mar 28 and increased 3.3 percent in the week as the yen continues oscillating but relatively weaker and the stock market gains in expectations of success of fiscal stimulus by a new administration and monetary stimulus by a new board of the Bank of Japan. Dow Asia Pacific TSM increased 0.5 percent on Mar 28 and increased 2.6 percent in the week. Shanghai Composite that decreased 0.2 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2041.71 on Mar 28 for decrease of 0.2 percent and decrease of 0.3 percent in the week of Mar 28. There is deceleration with oscillations of the world economy that could affect corporate revenue and equity valuations, causing fluctuations in equity markets with increases during favorable risk appetite.
Commodities were mixed in the week of Mar 21, 2014. The DJ UBS Commodities Index increased 0.2 percent on Fri Mar 28 and increased 1.4 percent in the week, as shown in Table III-1. WTI increased 2.2 percent in the week of Mar 28 while Brent increased 1.1 percent in the week. Gold decreased 0.1 percent on Fri Mar 28 and decreased 3.2 percent in the week.
Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €644,074 million on Mar 21, 2014, with some repayment of loans already occurring. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has reached €1,232,539 million in the statement of Mar 21, 2014, with marginal reduction. There is high credit risk in these transactions with capital of only €92,454 million as analyzed by Cochrane (2012Aug31).
Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | Mar 21, 2014 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 303,134 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 244,650 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 23,893 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 19,200 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 644,074 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 77,848 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 588,465 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 28,237 |
| 9 Other Assets | 278,719 | 336,574 | 236,578 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 2,166,080 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 1,232,539 |
| Capital and Reserves | 78,143 | 81,481 | 92,454 |
Source: European Central Bank
http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html
http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html
http://www.ecb.europa.eu/press/pr/wfs/2014/html/fs140325.en.html
IIIE Appendix Euro Zone Survival Risk. Resolution of the European sovereign debt crisis with survival of the euro area would require success in the restructuring of Italy. Growth of the Italian economy would assure that success. A critical problem is that the common euro currency prevents Italy from devaluing the exchange to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surpluses that ensure creditworthiness.
Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. Growth of the Italian economy would ensure that success. A critical problem is that the common euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surpluses that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU), or euro area, are only 39.8 percent of the total in Jan 2014. Exports to the non-European Union area with share of 46.3 percent in Italy’s total exports are growing at minus 2.7 percent in Jan 2014 relative to Jan 2013 while those to EMU are growing at 1.7 percent.
Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%
| Dec 2013 | Exports | ∆% Jan 2014/ Jan 2013 | Imports | ∆% Jan 2014/ Jan 2013 |
| EU | 53.7 | 2.6 | 55.3 | -1.6 |
| EMU 18 | 39.8 | 1.7 | 44.3 | -2.4 |
| France | 10.8 | -1.8 | 8.4 | -2.8 |
| Germany | 12.4 | 3.2 | 14.7 | -0.4 |
| Spain | 4.4 | 0.0 | 4.5 | 0.0 |
| UK | 5.0 | 2.4 | 2.7 | -1.5 |
| Non EU | 46.3 | -2.7 | 44.7 | -11.9 |
| Europe non EU | 13.0 | -11.5 | 12.1 | -14.9 |
| USA | 6.9 | 7.1 | 3.2 | -1.4 |
| China | 2.5 | 11.4 | 6.4 | 0.2 |
| OPEC | 6.0 | -15.5 | 8.1 | -42.0 |
| Total | 100.0 | 0.2 | 100.0 | -6.6 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/115726
Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade surplus of €168 million with the 17 countries of the euro zone (EMU 17) in Jan 2014 and cumulative surplus of €168 million in Jan 2014. Depreciation to parity could permit greater competitiveness in improving the trade deficit of €897 million in Jan 2014 with Europe non-European Union, the trade surplus of €899 million with the US and trade deficit with non-European Union of €897 million in Jan 2014. There is significant rigidity in the trade deficits in Jan 2014 of €1557 million with China and €388 million with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.
Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro
| Regions and Countries | Trade Balance Jan 2014 Millions of Euro | Trade Balance Cumulative Jan 2014 Millions of Euro |
| EU | 1,262 | 1,262 |
| EMU 18 | 168 | 168 |
| France | 1,000 | 1,000 |
| Germany | -125 | -125 |
| Spain | 155 | 155 |
| UK | 754 | 754 |
| Non EU | -897 | -897 |
| Europe non EU | -43 | -43 |
| USA | 899 | 899 |
| China | -1,557 | -1,557 |
| OPEC | -388 | -388 |
| Total | 365 | 365 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/115726
Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan 2014 relative to Jan 2013. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 18.8 percent. Exports of durable goods grew minus 1.9 percent and exports of capital goods increased 2.3 percent. The higher rate of growth of exports of 0.2 percent in Jan 2014/Jan 2013 relative to imports of minus 6.6 percent may reflect weak demand in Italy with GDP declining during nine consecutive quarters from IIIQ2011 through IIIQ2013 together with softening commodity prices. GDP increased marginally 0.1 percent in IVQ2013.
Table III-5, Italy, Exports and Imports % Share of Products in Total and ∆%
| Exports | Exports | Imports | Imports | |
| Consumer | 31.0 | 1.8 | 27.3 | 0.1 |
| Durable | 6.0 | -1.2 | 2.9 | 4.7 |
| Non-Durable | 25.1 | 2.4 | 24.4 | -0.4 |
| Capital Goods | 32.3 | 2.3 | 20.3 | -6.6 |
| Inter- | 32.3 | -2.5 | 32.5 | -3.9 |
| Energy | 4.4 | -3.6 | 19.9 | -18.8 |
| Total ex Energy | 95.6 | 0.4 | 80.1 | -3.2 |
| Total | 100.0 | 0.2 | 100.0 | -6.6 |
Note: % Share for 2012 total trade.
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/115726
Table III-6 provides Italy’s trade balance by product categories in Jan 2014 and cumulative Jan 2014. Italy’s trade balance excluding energy, generated surplus of €4664 million in Jan 2014 and €4664 million cumulative in Jan 2014 but the energy trade balance created deficit of €4299 million in Jan 2014 and cumulative €4299 million in Jan 2014. The overall surplus in Jan 2014 was €365 million with cumulative surplus of €365 million in Jan 2014. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.
Table III-6, Italy, Trade Balance by Product Categories, € Millions
| Jan 2014 | Cumulative Jan 2014 | |
| Consumer Goods | 1,143 | 1,143 |
| Durable | 744 | 744 |
| Nondurable | 398 | 398 |
| Capital Goods | 3,518 | 3,518 |
| Intermediate Goods | 4 | 4 |
| Energy | -4,299 | -4,299 |
| Total ex Energy | 4,664 | 4,664 |
| Total | 365 | 365 |
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/115726
Brazil faced in the debt crisis of 1982 a more complex policy mix. Between 1977 and 1983, Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.
The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the Subsection IIIF Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30, 2011, the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent. There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt exceeding 100 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).
Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.
Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:
“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”
If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.
The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2013.
Table III-7, World and Selected Regional and Country GDP and Fiscal Situation
| GDP 2013 | Primary Net Lending Borrowing | General Government Net Debt | |
| World | 73,454 | ||
| Euro Zone | 12,685 | -0.4 | 74.9 |
| Portugal | 219 | 0.1 | 119.3 |
| Ireland | 221 | -3.3 | 105.5 |
| Greece | 243 | -- | 172.6 |
| Spain | 1,356 | -3.7 | 80.7 |
| Major Advanced Economies G7 | 34,068 | -3.8 | 91.5 |
| United States | 16,724 | -3.6 | 87.4 |
| UK | 2,490 | -4.7 | 84.8 |
| Germany | 3,593 | 1.7 | 56.3 |
| France | 2,739 | -2.0 | 87.2 |
| Japan | 5,007 | -8.8 | 139.9 |
| Canada | 1,825 | -2.8 | 36.5 |
| Italy | 2,068 | 2.0 | 110.5 |
| China | 8,939 | -2.5* | 22.9** |
*Net Lending/borrowing**Gross Debt
Source: IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx
The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2013” to the column “GDP USD Billions.” The total debt of France and Germany in 2013 is $4411.3 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $4293.3 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8704.6 billion, which would be equivalent to 137.5 percent of their combined GDP in 2013. Under this arrangement, the entire debt of selected members of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 242.3 percent if including debt of France and 175.8 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing
Table III-8, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %
| Net Debt USD Billions | Debt as % of Germany Plus France GDP | Debt as % of Germany GDP | |
| A Euro Area | 9,501.1 | ||
| B Germany | 2,022.9 | $8704.6 as % of $3593 =242.3% $6316.2 as % of $3593 =175.8% | |
| C France | 2,388.4 | ||
| B+C | 4,411.3 | GDP $6,332.0 Total Debt $8704.6 Debt/GDP: 137.5% | |
| D Italy | 2,285.1 | ||
| E Spain | 1,094.3 | ||
| F Portugal | 261.3 | ||
| G Greece | 419.4 | ||
| H Ireland | 233.2 | ||
| Subtotal D+E+F+G+H | 4,293.3 |
Source: calculation with IMF data IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx
There is extremely important information in Table VE-11 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Jan 2014. German exports to other European Union (EU) members are 60.1 percent of total exports in Jan 2014 and 60.1 percent in cumulative Jan 2014. Exports to the euro area are 38.7 percent of the total in Jan and 38.7 percent cumulative in Jan. Exports to third countries are 39.9 percent of the total in Jan and 38.7 percent cumulative in Jan. There is similar distribution for imports. Exports to non-euro countries are increasing 9.1 percent in the 12 months ending in Jan 2014, increasing 9.1 percent cumulative in Jan 2014 while exports to the euro area are increasing 3.2 percent in the 12 months ending in Jan 2014 and increasing 3.2 percent cumulative in Jan 2014. Exports to third countries, accounting for 39.9 percent of the total in Jan 2014, are decreasing 0.4 percent in the 12 months ending in Jan 2014 and decreasing 0.4 percent cumulative in Jan 2014, accounting for 39.9 percent of the cumulative total in Jan 2014. Price competitiveness through devaluation could improve export performance and growth. Economic performance in Germany is closely related to Germany’s high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone. Germany could benefit from depreciation of the euro because of high share in its exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.
Table III-9, Germany, Structure of Exports and Imports by Region, € Billions and ∆%
| Jan 2014 | Jan 12-Month | Cumulative Jan 2014 € Billions | Cumulative Jan 2014/ | |
| Total | 90.7 | 2.9 | 90.7 | 2.9 |
| A. EU | 54.5 % 60.1 | 5.3 | 54.5 % 60.1 | 5.3 |
| Euro Area | 35.1 % 38.7 | 3.2 | 35.1 % 38.7 | 3.2 |
| Non-euro Area | 19.4 % 21.4 | 9.1 | 19.4 % 21.4 | 9.1 |
| B. Third Countries | 36.2 % 39.9 | -0.4 | 36.2 % 39.9 | -0.4 |
| Total Imports | 75.7 | 1.5 | 75.7 | 1.5 |
| C. EU Members | 48.3 % 63.8 | 3.6 | 48.3 % 63.8 | 3.6 |
| Euro Area | 33.5 % 44.3 | 4.0 | 33.5 % 44.3 | 4.0 |
| Non-euro Area | 14.7 % 19.4 | 2.6 | 14.7 % 19.4 | 2.6 |
| D. Third Countries | 27.4 % 36.2 | -1.9 | 27.4 % 36.2 | -1.9 |
Notes: Total Exports = A+B; Total Imports = C+D
Source: Statistisches Bundesamt Deutschland
https://www.destatis.de/EN/PressServices/Press/pr/2014/03/PE14_088_51.html
IIIF Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unpleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.
First, Unpleasant Monetarist Arithmetic. Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:
D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (1)
Equation (1) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,
{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:
N(t+1) = (1+n)N(t), n>-1 (2)
The per capita form of the budget constraint is obtained by dividing (1) by N(t) and rearranging:
B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (3)
On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.
Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+τ or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (5)
Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):
“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”
An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.
There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:
(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress
(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality
(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.
IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table IV-1, updated with every blog comment, provides the latest annual data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of sovereign risk issues (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table IV-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table IV-1. Data for other countries in Table IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.
Table IV-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 2.6 | 1.1 | 1.3 FD 0.9 | 6.7 |
| Japan | 2.6 | 1.5 | 1.8 | 3.6 |
| China | 7.7 | 2.0 | -2.0 | |
| UK | 2.7 | 1.7* CPIH 1.6 | 0.5 output | 7.2 |
| Euro Zone | 0.5 | 0.7 | -1.4 | 12.0 |
| Germany | 1.4 | 1.0 | -1.0 | 5.0 |
| France | 0.8 | 1.1 | -1.3 | 10.9 |
| Nether-lands | 0.7 | 0.4 | -2.0 | 7.1 |
| Finland | -0.5 | 1.6 | -0.2 | 8.3 |
| Belgium | 1.0 | 1.0 | -3.9 | 8.5 |
| Portugal | 1.6 | -0.1 | -1.5 | 15.3 |
| Ireland | 1.7 | 0.1 | 2.1 | 11.9 |
| Italy | -0.8 | 0.4 | -1.7 | 12.9 |
| Greece | -2.6 | -0.9 | -0.4 | 28.0 |
| Spain | -0.2 | 0.1 | -1.8 | 25.8 |
Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier
*Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2014/index.html **Core
PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/february-2014/index.html
Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/; country statistical sources http://www.census.gov/aboutus/stat_int.html
Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 2.6 percent in IVQ2013 relative to IVQ2012 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html, Table 8 in http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp4q13_3rd.pdf). Japan’s GDP grew 0.2 percent in IVQ2013 relative to IIIQ2013 and 2.6 percent relative to a year earlier. Japan’s GDP grew at the seasonally adjusted annual rate (SAAR) of 0.7 percent in IVQ2013 (http://cmpassocregulationblog.blogspot.com/2014/03/global-financial-risks-recovery-without.html and earlier http://cmpassocregulationblog.blogspot.com/2014/02/squeeze-of-economic-activity-by-carry.html). The UK grew at 0.7 percent in IVQ2013 relative to IIIQ2013 and GDP increased 2.7 percent in IVQ2013 relative to IVQ2012 (http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html and earlier http://cmpassocregulationblog.blogspot.com/2014/02/mediocre-cyclical-united-states.html). The Euro Zone grew at 0.3 percent in IVQ2013 and 0.5 percent in IVQ2013 relative to IVQ2012 (Section VD http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html and earlier http://cmpassocregulationblog.blogspot.com/2014/01/twenty-nine-million-unemployed-or.html). These are stagnating or “growth recession” rates, which are positive or about nil growth rates with some contractions that are insufficient to recover employment. The rates of unemployment are quite high: 6.7 percent in the US but 17.8 percent for unemployment/underemployment or job stress of 29.1 million (http://cmpassocregulationblog.blogspot.com/2014/03/rules-discretionary-authorities-and.html
and earlier http://cmpassocregulationblog.blogspot.com/2014/02/financial-instability-rules.html), 3.6 percent for Japan (Section VB and earlier http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html and earlier at http://cmpassocregulationblog.blogspot.com/2014/02/mediocre-cyclical-united-states.html), 7.2 percent for the UK with high rates of unemployment for young people (http://cmpassocregulationblog.blogspot.com/2014/03/interest-rate-risks-world-inflation.html and earlier http://cmpassocregulationblog.blogspot.com/2014/02/squeeze-of-economic-activity-by-carry.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.1 percent in the US, 1.4 percent for Japan, 2.0 percent for China, 0.7 percent for the Euro Zone and 1.7 percent for the UK. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. Six key interrelated vulnerabilities in the world economy have been causing global financial turbulence. (1) Sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section III and earlier http://cmpassocregulationblog.blogspot.com/2014/03/interest-rate-risks-world-inflation.html). (2) The tradeoff of growth and inflation in China now with change in growth strategy to domestic consumption instead of investment, high debt and political developments in a decennial transition. (3) Slow growth by repression of savings with de facto interest rate controls (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html)weak hiring with the loss of 10 million full-time jobs (http://cmpassocregulationblog.blogspot.com/2014/03/global-financial-risks-recovery-without.html and earlier http://cmpassocregulationblog.blogspot.com/2014/02/theory-and-reality-of-cyclical-slow.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (http://cmpassocregulationblog.blogspot.com/2014/03/rules-discretionary-authorities-and.html and earlier http://cmpassocregulationblog.blogspot.com/2014/02/financial-instability-rules.html). (4) The timing, dose, impact and instruments of normalizing monetary and fiscal policies (http://cmpassocregulationblog.blogspot.com/2014/02/theory-and-reality-of-cyclical-slow.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/duration-dumping-and-peaking-valuations.html http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html http://cmpassocregulationblog.blogspot.com/2012/08/expanding-bank-cash-and-deposits-with.html http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies. (5) The Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 had repercussions throughout the world economy. Japan has share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) geopolitical events in the Middle East.
In the effort to increase transparency, the Federal Open Market Committee (FOMC) provides both economic projections of its participants and views on future paths of the policy rate that in the US is the federal funds rate or interest on interbank lending of reserves deposited at Federal Reserve Banks. These policies and views are discussed initially followed with appropriate analysis.
Charles Evans, President of the Federal Reserve Bank of Chicago, proposed an “economic state-contingent policy” or “7/3” approach (Evans 2012 Aug 27):
“I think the best way to provide forward guidance is by tying our policy actions to explicit measures of economic performance. There are many ways of doing this, including setting a target for the level of nominal GDP. But recognizing the difficult nature of that policy approach, I have a more modest proposal: I think the Fed should make it clear that the federal funds rate will not be increased until the unemployment rate falls below 7 percent. Knowing that rates would stay low until significant progress is made in reducing unemployment would reassure markets and the public that the Fed would not prematurely reduce its accommodation.
Based on the work I have seen, I do not expect that such policy would lead to a major problem with inflation. But I recognize that there is a chance that the models and other analysis supporting this approach could be wrong. Accordingly, I believe that the commitment to low rates should be dropped if the outlook for inflation over the medium term rises above 3 percent.
The economic conditionality in this 7/3 threshold policy would clarify our forward policy intentions greatly and provide a more meaningful guide on how long the federal funds rate will remain low. In addition, I would indicate that clear and steady progress toward stronger growth is essential.”
Evans (2012Nov27) modified the “7/3” approach to a “6.5/2.5” approach:
“I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Price Index) inflation over the next two to three years, would be appropriate.”
The Federal Open Market Committee (FOMC) decided at its meeting on Dec 12, 2012 to implement the “6.5/2.5” approach (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm):
“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
Another rising risk is division within the Federal Open Market Committee (FOMC) on risks and benefits of current policies as expressed in the minutes of the meeting held on Jan 29-30, 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130130.pdf 13):
“However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy.”
Jon Hilsenrath, writing on “Fed maps exit from stimulus,” on May 11, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324744104578475273101471896.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the development of strategy for unwinding quantitative easing and how it can create uncertainty in financial markets. Jon Hilsenrath and Victoria McGrane, writing on “Fed slip over how long to keep cash spigot open,” published on Feb 20, 2013 in the Wall street Journal (http://professional.wsj.com/article/SB10001424127887323511804578298121033876536.html), analyze the minutes of the Fed, comments by members of the FOMC and data showing increase in holdings of riskier debt by investors, record issuance of junk bonds, mortgage securities and corporate loans. Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.
Unconventional monetary policy will remain in perpetuity, or QE→∞, changing to a “growth mandate.” There are two reasons explaining unconventional monetary policy of QE→∞: insufficiency of job creation to reduce unemployment/underemployment at current rates of job creation; and growth of GDP at around 2.3 percent, which is well below 3.0 percent estimated by Lucas (2011May) from 1870 to 2010. Unconventional monetary policy interprets the dual mandate of low inflation and maximum employment as mainly a “growth mandate” of forcing economic growth in the US at a rate that generates full employment. A hurdle to this “growth mandate” is that US economic growth has been at only 2.4 percent on average in the cyclical expansion in the 18 quarters from IVQ2009 to IVQ2013. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) and the second estimate of GDP for IVQ2013 (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp4q13_2nd.pdf). The average of 7.7 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 2.7 percent obtained by diving GDP of $14,738.0 billion in IIQ2010 by GDP of $14,356.9 billion in IIQ2009 {[$14,738.0/$14,356.9 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.2 percent from IQ1983 to IVQ1986, 5.0 percent from IQ1983 to IQ1987, 5.0 percent from IQ1983 to IIQ1987 and at 7.8 percent from IQ1983 to IVQ1983 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html). The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth under trend in the entire cycle from IVQ2007 to IV2013 would have accumulated to 20.3 percent. GDP in IVQ2013 would be $18,040.3 billion if the US had grown at trend, which is higher by $2,098.0 billion than actual $15,942.3 billion. There are about two trillion dollars of GDP less than under trend, explaining the 29.1 million unemployed or underemployed equivalent to actual unemployment of 17.8 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/03/rules-discretionary-authorities-and.html). US GDP grew from $14,996.1 billion in IVQ2007 in constant dollars to $15,942.3 billion in IVQ2013 or 6.3 percent at the average annual equivalent rate of 1.0 percent. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation.
First, total nonfarm payroll employment seasonally adjusted (SA) increased 175,000 in Feb 2014 and private payroll employment rose 162,000. The average number of nonfarm jobs created from Feb 2012 to Feb 2013 was 177,250, using seasonally adjusted data, while the average number of nonfarm jobs created from Feb 2013 to Feb 2014 was 179,833, or increase by 1.5 percent. The average number of private jobs created in the US from Feb 2012 to Feb 2013 was 182,000, using seasonally adjusted data, while the average from Feb 2013 to Feb 2014 was 182,500, or increase by 0.3 percent. This blog calculates the effective labor force of the US at 162.076 million in Feb 2013 and 163.570 million in Feb 2014 (Table I-4), for growth of 1.494 million at average 124,500 per month. The difference between the average increase of 182,500 new private nonfarm jobs per month in the US from Feb 2013 to Feb 2014 and the 124,500 average monthly increase in the labor force from Feb 2013 to Feb 2014 is 58,000 monthly new jobs net of absorption of new entrants in the labor force. There are 29.136 million in job stress in the US currently. Creation of 58,000 new jobs per month net of absorption of new entrants in the labor force would require 502 months to provide jobs for the unemployed and underemployed (29.136 million divided by 58,000) or 42 years (502 divided by 12). The civilian labor force of the US in Feb 2014 not seasonally adjusted stood at 155.027 million with 10.893 million unemployed or effectively 19.436 million unemployed in this blog’s calculation by inferring those who are not searching because they believe there is no job for them for effective labor force of 163.570 million. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 1.4 years (1 million divided by product of 58,000 by 12, which is 696,000). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.751 million (0.05 times labor force of 155.027 million) for new net job creation of 3.142 million (10.893 million unemployed minus 7.751 million unemployed at rate of 5 percent) that at the current rate would take 4.5 years (3.142 million divided by 0.696000). Under the calculation in this blog, there are 19.436 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 163.570 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 11.257 million jobs net of labor force growth that at the current rate would take 16.2 years (19.436 million minus 0.05(163.570 million) = 11.257 million divided by 0.696000, using LF PART 66.2% and Total UEM in Table I-4). These calculations assume that there are no more recessions, defying United States economic history with periodic contractions of economic activity when unemployment increases sharply. The number employed in Feb 2014 was 144.134 million (NSA) or 3.181 million fewer people with jobs relative to the peak of 147.315 million in Jul 2007 while the civilian noninstitutional population increased from 231.958 million in Jul 2007 to 247.085 million in Feb 2014 or by 15.127 million. The number employed fell 2.2 percent from Jul 2007 to Feb 2014 while population increased 6.5 percent. There is actually not sufficient job creation in merely absorbing new entrants in the labor force because of those dropping from job searches, worsening the stock of unemployed or underemployed in involuntary part-time jobs.
There is current interest in past theories of “secular stagnation.” Alvin H. Hansen (1939, 4, 7; see Hansen 1938, 1941; for an early critique see Simons 1942) argues:
“Not until the problem of full employment of our productive resources from the long-run, secular standpoint was upon us, were we compelled to give serious consideration to those factors and forces in our economy which tend to make business recoveries weak and anaemic (sic) and which tend to prolong and deepen the course of depressions. This is the essence of secular stagnation-sick recoveries which die in their infancy and depressions which feed on them-selves and leave a hard and seemingly immovable core of unemployment. Now the rate of population growth must necessarily play an important role in determining the character of the output; in other words, the com-position of the flow of final goods. Thus a rapidly growing population will demand a much larger per capita volume of new residential building construction than will a stationary population. A stationary population with its larger proportion of old people may perhaps demand more personal services; and the composition of consumer demand will have an important influence on the quantity of capital required. The demand for housing calls for large capital outlays, while the demand for personal services can be met without making large investment expenditures. It is therefore not unlikely that a shift from a rapidly growing population to a stationary or declining one may so alter the composition of the final flow of consumption goods that the ratio of capital to output as a whole will tend to decline.”
The argument that anemic population growth causes “secular stagnation” in the US (Hansen 1938, 1939, 1941) is as misplaced currently as in the late 1930s (for early dissent see Simons 1942). There is currently population growth in the ages of 16 to 24 years but not enough job creation and discouragement of job searches for all ages (http://cmpassocregulationblog.blogspot.com/2014/03/global-financial-risks-recovery-without.html and earlier http://cmpassocregulationblog.blogspot.com/2014/02/theory-and-reality-of-cyclical-slow.html).
Second, the US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth under trend in the entire cycle from IVQ2007 to IV2013 would have accumulated to 20.3 percent. GDP in IVQ2013 would be $18,040.3 billion if the US had grown at trend, which is higher by $2,098.0 billion than actual $15,942.3 billion. There are about two trillion dollars of GDP less than under trend, explaining the 29.1 million unemployed or underemployed equivalent to actual unemployment of 17.8 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/03/rules-discretionary-authorities-and.html). US GDP grew from $14,996.1 billion in IVQ2007 in constant dollars to $15,942.3 billion in IVQ2013 or 6.3 percent at the average annual equivalent rate of 1.0 percent. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. The economy of the US can be summarized in growth of economic activity or GDP as decelerating from mediocre growth of 2.5 percent on an annual basis in 2010 to 1.8 percent in 2011, 2.8 percent in 2012 and 1.9 percent in 2013. The following calculations show that actual growth is around 2.2 to 2.5 percent per year. The rate of growth of 1.0 percent in the entire cycle from 2007 to 2013 is well below 3 percent per year in trend from 1870 to 2010, which the economy of the US always attained for entire cycles in expansions after events such as wars and recessions (Lucas 2011May). Revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) provide important information on long-term growth and cyclical behavior. Table Summary provides relevant data.
- Long-term. US GDP grew at the average yearly rate of 3.3 percent from 1929 to 2013 and at 3.2 percent from 1947 to 2013. There were periodic contractions or recessions in this period but the economy grew at faster rates in the subsequent expansions, maintaining long-term economic growth at trend.
- Whole Cycles. Long-term growth was around 3.0 percent per year during entire cycles including contractions and expansions. The average growth rate of GDP was 3.2 percent per year in the entire cycle from 1980 to 1989 but only 1.0 percent in the entire cycle from 2007 to 2013.
- Cycles. The combined contraction of GDP in the two almost consecutive recessions in the early 1980s is 4.7 percent. The contraction of US GDP from IVQ2007 to IIQ2009 during the global recession was 4.3 percent. The critical difference in the expansion is growth at average 7.8 percent in annual equivalent in the first four quarters of recovery from IQ1983 to IVQ1983. The average rate of growth of GDP in four cyclical expansions in the postwar period is 7.7 percent. In contrast, the rate of growth in the first four quarters from IIIQ2009 to IIQ2010 was only 2.7 percent. Average annual equivalent growth in the expansion from IQ1983 to IVQ1985 was 5.9 percent and 5.0 percent from IQ1983 to IIQ1987. In contrast, average annual equivalent growth in the expansion from IIIQ2009 to IVQ2013 was only 2.4 percent. The US appears to have lost its dynamism of income growth and employment creation.
Table Summary, Long-term and Cyclical Growth of GDP, Real Disposable Income and Real Disposable Income per Capita
| GDP | ||
| Long-Term | ||
| 1929-2013 | 3.3 | |
| 1947-2013 | 3.2 | |
| Whole Cycles | ||
| 1980-1989 | 3.2 | |
| 2006-2013 | 1.1 | |
| 2007-2013 | 1.0 | |
| Cyclical Contractions ∆% | ||
| IQ1980 to IIIQ1980, IIIQ1981 to IVQ1982 | -4.7 | |
| IVQ2007 to IIQ2009 | -4.3 | |
| Cyclical Expansions Average Annual Equivalent ∆% | ||
| IQ1983 to IVQ1985 IQ1983-IQ1986 IQ1983-IIIQ1986 IQ1983-IVQ1986 IQ1983-IQ1987 IQ1983-IIQ1987 | 5.9 5.7 5.4 5.2 5.0 5.0 | |
| First Four Quarters IQ1983 to IVQ1983 | 7.8 | |
| IIIQ2009 to IVQ2013 | 2.4 | |
| First Four Quarters IIIQ2009 to IIQ2010 | 2.7 | |
| Real Disposable Income | Real Disposable Income per Capita | |
| Long-Term | ||
| 1929-2013 | 3.2 | 2.0 |
| 1947-1999 | 3.7 | 2.3 |
| Whole Cycles | ||
| 1980-1989 | 3.5 | 2.6 |
| 2006-2013 | 1.3 | 0.5 |
Source: Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm
The revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) also provide critical information in assessing the current rhythm of US economic growth. The economy appears to be moving at a pace from 2.3 to 2.6 percent per year. Table Summary GDP provides the data.
1. Average Annual Growth in the Past Eight Quarters. GDP growth in the four quarters of 2012 and the four quarters of 2013 accumulated to 4.6 percent. This growth is equivalent to 2.2 percent per year, obtained by dividing GDP in IVQ2013 of $15,942.3 billion by GDP in IVQ2011 of $15,242.1 billion and compounding by 4/8: {[($15,942.3/$15,242.1)4/8 -1]100 = 2.3 percent.
2. Average Annual Growth in the Four Quarters of 2013. GDP growth in the four quarters of 2013 accumulated to 2.6 percent that is equivalent to 2.6 percent in a year. This is obtained by dividing GDP in IVQ2013 of $15,942.3 billion by GDP in IVQ2012 of $15,539.6 billion and compounding by 4/4: {[($15,942.3/$15,539.6)4/4 -1]100 = 2.6%}. The US economy grew 2.6 percent in IVQ2013 relative to the same quarter a year earlier in IVQ2012. Another important revelation of the revisions and enhancements is that GDP was flat in IVQ2012, which is just at the borderline of contraction. The rate of growth of GDP in the third estimate of IIIQ2013 is 4.1 percent in seasonally adjusted annual rate (SAAR). Inventory accumulation contributed 1.67 percentage points to this rate of growth. The actual rate without this impulse of unsold inventories would have been 2.43 percent, or 0.6 percent in IIIQ2013, such that annual equivalent growth in 2013 is closer to 2.1 percent {[(1.003)(1.006)(1.006)(1.007)4/4-1]100 = 2.2%}, compounding the quarterly rates and converting into annual equivalent.
Table Summary GDP, US, Real GDP and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions Chained 2005 Dollars and ∆%
| Real GDP, Billions Chained 2009 Dollars | ∆% Relative to IVQ2007 | ∆% Relative to Prior Quarter | ∆% | |
| IVQ2007 | 14,996.1 | NA | NA | 1.9 |
| IVQ2011 | 15,242.1 | 1.6 | 1.2 | 2.0 |
| IQ2012 | 15,381.6 | 2.6 | 0.9 | 3.3 |
| IIQ2012 | 15,427.7 | 2.9 | 0.3 | 2.8 |
| IIIQ2012 | 15,534.0 | 3.6 | 0.7 | 3.1 |
| IVQ2012 | 15,539.6 | 3.6 | 0.0 | 2.0 |
| IQ2013 | 15,583.9 | 3.9 | 0.3 | 1.3 |
| IIQ2013 | 15,679.7 | 4.6 | 0.6 | 1.6 |
| IIIQ2013 | 15,839.3 | 5.6 | 1.0 | 2.0 |
| IVQ2013 | 15,942.3 | 6.3 | 0.7 | 2.6 |
| Cumulative ∆% IQ2012 to IVQ2013 | 4.6 | 4.6 | ||
| Annual Equivalent ∆% | 2.3 | 2.3 |
Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm
In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is concern of the production and employment costs of controlling future inflation. Even if there is no inflation, QE→∞ cannot be abandoned because of the fear of rising interest rates. The economy would operate in an inferior allocation of resources and suboptimal growth path, or interior point of the production possibilities frontier where the optimum of productive efficiency and wellbeing is attained, because of the distortion of risk/return decisions caused by perpetual financial repression. Not even a second-best allocation is feasible with the shocks to efficiency of financial repression in perpetuity.
The statement of the FOMC at the conclusion of its meeting on Dec 12, 2012, revealed policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm) practically unchanged in the statement at its meeting on Mar 19, 2014 with symbolic reduction of purchases of securities for the Fed’s balance sheet (http://www.federalreserve.gov/newsevents/press/monetary/20140319a.htm):
“Release Date: March 19, 2014
For immediate release
Information received since the Federal Open Market Committee met in January indicates that growth in economic activity slowed during the winter months, in part reflecting adverse weather conditions. Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated. Household spending and business fixed investment continued to advance, while the recovery in the housing sector remained slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in April, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month rather than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $30 billion per month rather than $35 billion per month. 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 and of rolling over maturing Treasury securities at auction. The Committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
With the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward guidance. The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Richard W. Fisher; Sandra Pianalto; Charles I. Plosser; Jerome H. Powell; Jeremy C. Stein; and Daniel K. Tarullo.
Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the Committee's commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity.”
There are several important issues in this statement.
- Mandate. The FOMC pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):
“Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”
- Open-ended Quantitative Easing or QE∞ with Symbolic Tapering. Earlier programs are continued with an additional lower open-ended $55 billion of bond purchases per month, increasing the stock of $3,830,311 million securities held outright and bank reserves deposited at the Fed of $2,525,773 million (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1): “The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in April, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month rather than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $30 billion per month rather than $35 billion per month. 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 and of rolling over maturing Treasury securities at auction. The Committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.”
- New Advance Guidance.” Policy will be accommodative even after the economy recovers satisfactorily: “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored (emphasis added).”
- Policy Commitment with Unemployment Rate. “With the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward guidance. The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements.
Current focus is on tapering quantitative easing by the Federal Open Market Committee (FOMC). There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. Market are overreacting to the so-called “paring” of outright purchases to $55 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight as evident in the FOMC statement for Mar 19, 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20140319a.htm):
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.” (emphasis added).
How long is “considerable time”? At the press conference following the meeting on Mar 19, 2014, Chair Yellen answered a question of Jon Hilsenrath of the Wall Street Journal explaining “In particular, the Committee has endorsed the view that it anticipates that will be a considerable period after the asset purchase program ends before it will be appropriate to begin to raise rates. And of course on our present path, well, that's not utterly preset. We would be looking at next, next fall. So, I think that's important guidance” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140319.pdf). Many focused on “next fall,” ignoring that the path of increasing rates is not “utterly preset.”
There is a critical phrase in the statement of Sep 19, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm): “but mortgage rates have risen further.” Did the increase of mortgage rates influence the decision of the FOMC not to taper? Is FOMC “communication” and “guidance” successful? Will the FOMC increase purchases of mortgage-backed securities if mortgage rates increase?
In testimony on the Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, US House of Representatives, on Feb 11, 2014, Chair Janet Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm):
“Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. That said, purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. In December of last year and again this January, the Committee said that its current expectation--based on its assessment of a broad range of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments--is that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the 2 percent goal. I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level (emphasis added).”
At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states needs and intentions of policy:
“We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve's goal of 2 percent and is expected to continue to do so for some time.
For these reasons, the Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.”
In his classic restatement of the Keynesian demand function in terms of “liquidity preference as behavior toward risk,” James Tobin (http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1981/tobin-bio.html) identifies the risks of low interest rates in terms of portfolio allocation (Tobin 1958, 86):
“The assumption that investors expect on balance no change in the rate of interest has been adopted for the theoretical reasons explained in section 2.6 rather than for reasons of realism. Clearly investors do form expectations of changes in interest rates and differfrom each other in their expectations. For the purposes of dynamic theory and of analysis of specific market situations, the theories of sections 2 and 3 are complementary rather than competitive. The formal apparatus of section 3 will serve just as well for a non-zero expected capital gain or loss as for a zero expected value of g. Stickiness of interest rate expectations would mean that the expected value of g is a function of the rate of interest r, going down when r goes down and rising when r goes up. In addition to the rotation of the opportunity locus due to a change in r itself, there would be a further rotation in the same direction due to the accompanying change in the expected capital gain or loss. At low interest rates expectation of capital loss may push the opportunity locus into the negative quadrant, so that the optimal position is clearly no consols, all cash. At the other extreme, expectation of capital gain at high interest rates would increase sharply the slope of the opportunity locus and the frequency of no cash, all consols positions, like that of Figure 3.3. The stickier the investor's expectations, the more sensitive his demand for cash will be to changes in the rate of interest (emphasis added).”
Tobin (1969) provides more elegant, complete analysis of portfolio allocation in a general equilibrium model. The major point is equally clear in a portfolio consisting of only cash balances and a perpetuity or consol. Let g be the capital gain, r the rate of interest on the consol and re the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+re). Thus, g = [(r/re) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dre>0, such that there is expectation of capital losses on the consol, dg<0. Investors move into positions combining only cash and no consols. Valuations of risk financial assets would collapse in reversal of long positions in carry trades with short exposures in a flight to cash. There is no exit from a central bank created liquidity trap without risks of financial crash and another global recession. The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent statement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:
W = Y/r (10
Equation (1) shows that as r goes to zero, r→0, W grows without bound, W→∞. Unconventional monetary policy lowers interest rates to increase the present value of cash flows derived from projects of firms, creating the impression of long-term increase in net worth. An attempt to reverse unconventional monetary policy necessarily causes increases in interest rates, creating the opposite perception of declining net worth. As r→∞, W = Y/r →0. There is no exit from unconventional monetary policy without increasing interest rates with resulting pain of financial crisis and adverse effects on production, investment and employment.
In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:
“Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve's portfolio of longer-term Treasury securities and agency mortgage-backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries. We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized. We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.
The Committee's decisions regarding the asset purchase program (and the overall stance of monetary policy) depend on our assessment of the economic outlook and of the cumulative progress toward our objectives. Of course, economic forecasts must be revised when new information arrives and are thus necessarily provisional.”
Friedman (1953) argues there are three lags in effects of monetary policy: (1) between the need for action and recognition of the need; (2) the recognition of the need and taking of actions; and (3) taking of action and actual effects. Friedman (1953) finds that the combination of these lags with insufficient knowledge of the current and future behavior of the economy causes discretionary economic policy to increase instability of the economy or standard deviations of real income σy and prices σp. Policy attempts to circumvent the lags by policy impulses based on forecasts. We are all naïve about forecasting. Data are available with lags and revised to maintain high standards of estimation. Policy simulation models estimate economic relations with structures prevailing before simulations of policy impulses such that parameters change as discovered by Lucas (1977). Economic agents adjust their behavior in ways that cause opposite results from those intended by optimal control policy as discovered by Kydland and Prescott (1977). Advance guidance attempts to circumvent expectations by economic agents that could reverse policy impulses but is of dubious effectiveness. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities).
The key policy is maintaining fed funds rate between 0 and ¼ percent. An increase in fed funds rates could cause flight out of risk financial markets worldwide. There is no exit from this policy without major financial market repercussions. Indefinite financial repression induces carry trades with high leverage, risks and illiquidity.
Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). Symmetric targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even with the economy growing at or close to potential output that is actually a target of growth forecast. The impact on the overall economy and the financial system of errors of policy are magnified by large-scale policy doses of trillions of dollars of quantitative easing and zero interest rates. The US economy has been experiencing financial repression as a result of negative real rates of interest during nearly a decade and programmed in monetary policy statements until 2015 or, for practical purposes, forever. The essential calculus of risk/return in capital budgeting and financial allocations has been distorted. If economic perspectives are doomed until 2015 such as to warrant zero interest rates and open-ended bond-buying by “printing” digital bank reserves (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html; see Shultz et al 2012), rational investors and consumers will not invest and consume until just before interest rates are likely to increase. Monetary policy statements on intentions of zero interest rates for another three years or now virtually forever discourage investment and consumption or aggregate demand that can increase economic growth and generate more hiring and opportunities to increase wages and salaries. The doom scenario used to justify monetary policy accentuates adverse expectations on discounted future cash flows of potential economic projects that can revive the economy and create jobs. If it were possible to project the future with the central tendency of the monetary policy scenario and monetary policy tools do exist to reverse this adversity, why the tools have not worked before and even prevented the financial crisis? If there is such thing as “monetary policy science”, why it has such poor record and current inability to reverse production and employment adversity? There is no excuse of arguing that additional fiscal measures are needed because they were deployed simultaneously with similar ineffectiveness. Jon Hilsenrath, writing on “New view into Fed’s response to crisis,” on Feb 21, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303775504579396803024281322?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes 1865 pages of transcripts of eight formal and six emergency policy meetings at the Fed in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm). If there were an infallible science of central banking, models and forecasts would provide accurate information to policymakers on the future course of the economy in advance. Such forewarning is essential to central bank science because of the long lag between the actual impulse of monetary policy and the actual full effects on income and prices many months and even years ahead (Romer and Romer 2004, Friedman 1961, 1953, Culbertson 1960, 1961, Batini and Nelson 2002). The transcripts of the Fed meetings in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm) analyzed by Jon Hilsenrath demonstrate that Fed policymakers frequently did not understand the current state of the US economy in 2008 and much less the direction of income and prices. The conclusion of Friedman (1953) is that monetary impulses increase financial and economic instability because of lags in anticipating needs of policy, taking policy decisions and effects of decisions. This is a fortiori true when untested unconventional monetary policy in gargantuan doses shocks the economy and financial markets.
In remarkable anticipation in 2005, Professor Raghuram G. Rajan (2005) warned of low liquidity and high risks of central bank policy rates approaching the zero bound (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 218-9). Professor Rajan excelled in a distinguished career as an academic economist in finance and was chief economist of the International Monetary Fund (IMF). Shefali Anand and Jon Hilsenrath, writing on Oct 13, 2013, on “India’s central banker lobbies Fed,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304330904579133530766149484?KEYWORDS=Rajan), interviewed Raghuram G Rajan, who is the current Governor of the Reserve Bank of India, which is India’s central bank (http://www.rbi.org.in/scripts/AboutusDisplay.aspx). In this interview, Rajan argues that central banks should avoid unintended consequences on emerging market economies of inflows and outflows of capital triggered by monetary policy. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows. Professor Rajan, in an interview with Kartik Goyal of Bloomberg (http://www.bloomberg.com/news/2014-01-30/rajan-warns-of-global-policy-breakdown-as-emerging-markets-slide.html), warns of breakdown of global policy coordination.
Professor Ronald I. McKinnon (2013Oct27), writing on “Tapering without tears—how to end QE3,” on Oct 27, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304799404579153693500945608?KEYWORDS=Ronald+I+McKinnon), finds that the major central banks of the world have fallen into a “near-zero-interest-rate trap.” World economic conditions are weak such that exit from the zero interest rate trap could have adverse effects on production, investment and employment. The maintenance of interest rates near zero creates long-term near stagnation. The proposal of Professor McKinnon is credible, coordinated increase of policy interest rates toward 2 percent. Professor John B. Taylor at Stanford University, writing on “Economic failures cause political polarization,” on Oct 28, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303442004579121010753999086?KEYWORDS=John+B+Taylor), analyzes that excessive risks induced by near zero interest rates in 2003-2004 caused the financial crash. Monetary policy continued in similar paths during and after the global recession with resulting political polarization worldwide.
Table IV-2 provides economic projections of governors of the Board of Governors of the Federal Reserve and regional presidents of Federal Reserve Banks released at the meeting of Dec 18, 2013. The Fed releases the data with careful explanations (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20131218.pdf). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IVQ2013 is analyzed in Section I (and earlier http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html) and the PCE inflation data from the report on personal income and outlays in Section IV (Section I). The Bureau of Economic Analysis provides the estimate of IVQ2013 GDP (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed in Section IV (and earlier http://cmpassocregulationblog.blogspot.com/2014/03/rules-discretionary-authorities-and.html). The report on “Personal Income and Outlays” on Mar 28, 2014 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/03/rules-discretionary-authorities-and.html). PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog. The report for Jul 2013 was released on Aug 2 and analyzed in this blog and the report for Aug 2013 was released on Sep 6, 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html
and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html). The report for Feb 2014 was released on Mar 7, 2014 (http://cmpassocregulationblog.blogspot.com/2014/03/rules-discretionary-authorities-and.html). “The longer-run projections are the rates of growth, unemployment, and inflation to which a policymaker expects the economy to converge over time—maybe in five or six years—in the absence of further shocks and under appropriate monetary policy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20131218.pdf).
It is instructive to focus on 2013, 2014 and 2015 because 2016 and longer term are too far away, and there is not much information even on what will happen in 2013-2015 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Mar 19, 2014 and the second row “PR” the projection of the Dec 18, 2013 meeting. There are three changes in the view.
1. Growth “∆% GDP.” The FOMC has changed the forecast of GDP growth in 2014. The FOMC decreased GDP growth in 2014 from 2.8 to 3.2 percent at the meeting in Dec 2013 to 2.8 to 3.0 percent at the meeting in Mar 2014.
2. Rate of Unemployment “UNEM%.” The FOMC reduced the forecast of the rate of unemployment for 2014 from 6.3 to 6.6 percent at the meeting on Dec 18, 2013 to 6.1 to 6.3 percent at the meeting on Mar 19, 2014. The projection for 2015 decreased to the range of 5.6 to 5.9 in Mar 2014 from 5.8 to 6.1 in Dec 2013. Projections of the rate of unemployment are moving closer to the desire 6.5 percent or lower with 5.2 to 5.6 percent in 2016 after the meeting on Mar 19, 2013.
3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation for 2014 from 1.4 to 1.6 percent at the meeting on Dec 18, 2013 to 1.5 to 1.6 percent at the meeting on Mar 19, 2014. There are no projections exceeding 2.0 percent in the central tendency but some in the range reach 2.4 percent in 2015. The longer run projection is at 2.0 percent.
4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2014, not changing from 1.3 to 1.8 percent at the meeting on Dec 18, 2013 to 1.3 to 1.8 percent at the meeting Mar 19, 2014. In 2015, there is minor change in the projection from 1.5 to 2.3 percent at the meeting on Dec 18, 2013 to 1.5 to 2.4 percent on Mar 19, 2014. The rate of change of the core PCE is below 2.0 percent in the central tendency with 2.4 percent at the top of the range in 2015.
Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, Dec 18, 2013 and Mar 19, 2014
| ∆% GDP | UNEM % | ∆% PCE Inflation | ∆% Core PCE Inflation | |
| Central | ||||
| 2014 | 2.8 to 3.0 | 6.1 to 6.3 | 1.5 to 1.6 | 1.4 to 1.6 |
| 2015 Dec PR | 3.0 to 3.2 3.0 to 3.4 | 5.6 to 5.9 5.8 to 6.1 | 1.5 to 2.0 1.5 to 2.0 | 1.7 to 2.0 1.6 to 2.0 |
| 2016 Dec PR | 2.5 to 3.0 2.5 to 3.2 | 5.2 to 5.6 5.3 to 5.8 | 1.7 to 2.0 1.7 to 2.0 | 1.8 to 2.0 1.8 to 2.0 |
| Longer Run Dec PR | 2.2 to 2.3 2.2 to 2.4 | 5.2 to 5.6 5.2 to 5.8 | 2.0 2.0 | |
| Range | ||||
| 2014 | 2.1 to 3.0 | 6.0 to 6.5 | 1.3 to 1.8 | 1.3 to 1.8 |
| 2015 Dec PR | 2.2 to 3.5 2.2 to 3.6 | 5.4 to 5.9 5.5 to 6.2 | 1.5 to 2.4 1.4 to 2.3 | 1.5 to 2.4 1.5 to 2.3 |
| 2016 Dec PR | 2.2 to 3.4 2.1 to 3.5 | 5.1 to 5.8 5.0 to 6.0 | 1.6 to 2.0 1.6 to 2.2 | 1.6 to 2.0 1.6 to 2.2 |
| Longer Run Dec PR | 1.8 to 2.4 1.8 to 2.5 | 5.2 to 6.0 5.2 to 6.0 | 2.0 2.0 |
Notes: UEM: unemployment; PR: Projection
Source: Board of Governors of the Federal Reserve System, FOMC
http://www.federalreserve.gov/newsevents/press/monetary/20140319b.htm
http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140319.pdf
Another important decision at the FOMC meeting on Jan 25, 2012, is formal specification of the goal of inflation of 2 percent per year but without specific goal for unemployment (http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm):
“Following careful deliberations at its recent meetings, the Federal Open Market Committee (FOMC) has reached broad agreement on the following principles regarding its longer-run goals and monetary policy strategy. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.
The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decision making by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.
Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.
The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier.
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. ”
The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html See Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 99-116). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.
The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table IV-3 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 2014, 2015, 2016 and the in the longer term. Table IV-3 is inferred from a chart provided by the FOMC with the number of participants expecting the target of fed funds rate (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130320.pdf). The rate would still remain at 0 to ¼ percent in 2014 for 15 participants with one expecting the rate to be in the range of 0.5 to 1.0. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels. For 2015, 2 participants expect 0 to 0.25 percent, 4 participants expect the rate to remain between 0.5 and 1.0 percent, 7 to be between 1.0 and 1.5 percent, one between 1 and 2 percent and 3 between 2 and 3 percent. For 2016, one participant expects the rate between 0.5 and 1 percent, 6 between 1 and 2 percent, 9 between 2 and 3 percent and 4 between 3 and 4.5 percent. In the long term, all 16 participants expect the fed funds rate in the range of 3.0 to 4.5 percent.
Table IV-3, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board
Members and Federal Reserve Bank Presidents Participating in FOMC, Mar 19, 2014
| 0 to 0.25 | 0.5 to 1.0 | 1.0 to 1.5 | 1.0 to 2.0 | 2.0 to 3.0 | 3.0 to 4.5 | |
| 2014 | 15 | 1 | ||||
| 2015 | 2 | 4 | 7 | 1 | 3 | |
| 2016 | 1 | 6 | 9 | 4 | ||
| Longer Run | 16 |
Source: Board of Governors of the Federal Reserve System, FOMC
http://www.federalreserve.gov/newsevents/press/monetary/20140319b.htm
http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140319.pdf
Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2014 to 2016. It is evident from Table IV-4 that the prevailing view of the FOMC is for interest rates to continue at low levels until 2015. This view is consistent with the economic projections of low economic growth, relatively high unemployment and subdued inflation provided in Table IV-2. The FOMC states that rates will continue to be low even after return of the economy to potential growth.
Table IV-4, US, Views of Appropriate Year of Increasing Target Federal Funds Rate of Federal
Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, Mar 19, 2014
| Appropriate Year of Increasing Target Fed Funds Rate | Number of Participants |
| 2014 | 1 |
| 2015 | 13 |
| 2016 | 2 |
Source: Board of Governors of the Federal Reserve System, FOMC
http://www.federalreserve.gov/newsevents/press/monetary/20140319b.htm
http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140319.pdf
The revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) also provide critical information in assessing indexes of prices of personal consumption. There are waves of inflation similar to those worldwide (http://cmpassocregulationblog.blogspot.com/2014/03/interest-rate-risks-world-inflation.html) in inflation of personal consumption expenditures (PCE) in Table IV-5. These waves are in part determined by commodity price shocks originating in the carry trade from zero interest rates to positions in risk financial assets, in particular in commodity futures, which increase the prices of food and energy when there is relaxed risk aversion. Return of risk aversion causes collapse in prices. Resulting fluctuations of prices confuse risk/return decisions, inducing financial instability with adverse financial and economic consequences. The first wave is in Jan-Apr 2011 when headline PCE inflation increased at the average annual equivalent rate of 3.7 percent and PCE inflation excluding food and energy (PCEX) at 1.5 percent. The drivers of inflation were increases in food prices (PCEF) at the annual equivalent rate of 7.8 percent and of energy prices (PCEE) at 26.4 percent. This behavior will prevail under zero interest rates and relaxed risk aversion because of carry trades from zero interest rates to leveraged positions in commodity futures. The second wave occurred in May-Jun 2011 when risk aversion from the European sovereign risk crisis interrupted the carry trade. PCE prices increased 2.4 percent in annual equivalent and 2.4 percent excluding food and energy. The third wave is captured by the annual equivalent rates in Jul-Sep 2011 of headline PCE inflation of 2.4 percent with subdued PCE inflation excluding food and energy of 2.0 percent while PCE food rose at 6.2 percent and PCE energy increased at 6.2 percent. In the fourth wave in Oct-Dec 2011, increased risk aversion explains the fall of the annual equivalent rate of inflation to 0.8 percent for headline PCE inflation and 2.0 percent for PCEX excluding food and energy. PCEF of prices of food rose at the annual equivalent rate of 1.2 percent in Oct-Dec 2011 while PCEE of prices of energy fell at the annual equivalent rate of 10.7 percent. In the fifth wave in Jan-Mar 2012, headline PCE in annual equivalent was 2.4 percent and 2.4 percent excluding food and energy (PCEX). Energy prices of personal consumption (PCEE) increased at the annual equivalent rate of 15.8 percent because of the jump of 2.3 percent in Feb 2012 followed by 1.3 percent in Mar 2012. In the sixth wave, renewed risk aversion caused reversal of carry trades with headline PCE inflation at the annual equivalent rate of 0.0 percent in Apr-May 2012 while PCE inflation excluding food and energy increased at the annual equivalent rate of 1.2 percent. In the seventh wave, further shocks of risk aversion resulted in headline PCE annual equivalent inflation at 1.2 percent in Jun-Jul 2012 with core PCE excluding food and energy at 1.8 percent. In the eighth wave, temporarily relaxed risk aversion with zero interest rates resulted in central PCE inflation at 3.7 percent annual equivalent in Aug-Sep 2012 with PCEX excluding food and energy at 0.6 percent while PCEE energy jumped at 67.6 percent annual equivalent. The program of outright monetary transactions (OTM) of the European Central Bank induced relaxed risk aversion (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). In the ninth wave, prices collapsed with reversal of carry trade positions in a new episode of risk aversion with central PCE at annual equivalent 0.6 percent in Oct 2012 to Jan 2013 and PCEX at 1.8 percent while energy prices fell at minus 16.9 percent. In the tenth wave, central PCE increased at annual equivalent 4.9 percent in Feb 2013, PCEX at 1.2 percent and PCEE at 92.3 percent. In the eleventh wave, renewed risk aversion resulted in decline in annual equivalent of general PCE prices at 2.4 percent in Mar-Apr 2013 while PCEX increased at 0.6 percent and energy prices fell at 34.8 percent. In the twelfth wave, central PCE increased at 1.7 percent annual equivalent in May-Nov 2013 with PCEX increasing at 1.4 percent, food PCEF increasing at 0.5 percent and energy PCEE increasing at 5.3 percent with the jump of 3.4 percent in Jun 2013. In the thirteenth wave, central PCE increased at annual equivalent 1.6 percent in Dec 2013-Feb 2014 and PCEX at 1.2 percent. PCEE increased at 6.5 percent annual equivalent. Commodity prices have moderated with reallocation of financial investments to carry trades in equities.
Table IV-5, US, Percentage Change from Prior Month of Prices of Personal Consumption
Expenditures, Seasonally Adjusted Monthly ∆%
| PCE | PCEG | PCEG | PCES | PCEX | PCEF | PCEE | |
| 2014 | |||||||
| Feb | 0.1 | -0.1 | -0.2 | 0.2 | 0.1 | 0.3 | -0.4 |
| Jan | 0.1 | 0.0 | -0.1 | 0.2 | 0.1 | 0.0 | 0.4 |
| 2013 | |||||||
| Dec | 0.2 | 0.1 | -0.4 | 0.2 | 0.1 | 0.1 | 1.6 |
| ∆% AE Dec-Feb | 1.6 | 0.0 | -2.8 | 2.4 | 1.2 | 1.6 | 6.5 |
| Nov | 0.1 | -0.2 | -0.3 | 0.2 | 0.1 | 0.0 | -0.5 |
| Oct | 0.1 | -0.2 | -0.1 | 0.2 | 0.1 | 0.0 | -1.0 |
| Sep | 0.1 | 0.0 | 0.0 | 0.2 | 0.1 | -0.1 | 0.8 |
| Aug | 0.1 | 0.0 | -0.3 | 0.1 | 0.1 | 0.2 | -0.2 |
| Jul | 0.1 | 0.1 | -0.3 | 0.1 | 0.1 | 0.1 | 0.3 |
| Jun | 0.4 | 0.7 | 0.0 | 0.2 | 0.2 | 0.3 | 3.4 |
| May | 0.1 | -0.1 | -0.1 | 0.2 | 0.1 | -0.2 | 0.3 |
| ∆% AE May-Nov | 1.7 | 0.5 | -1.9 | 2.1 | 1.4 | 0.5 | 5.3 |
| Apr | -0.3 | -0.9 | -0.3 | 0.0 | 0.0 | 0.1 | -4.4 |
| Mar | -0.1 | -0.6 | -0.2 | 0.1 | 0.1 | 0.1 | -2.6 |
| ∆% AE Mar-Apr | -2.4 | -8.6 | -3.0 | 0.6 | 0.6 | 1.2 | -34.8 |
| Feb | 0.4 | 0.8 | -0.1 | 0.2 | 0.1 | 0.2 | 5.6 |
| ∆% AE Feb | 4.9 | 10.0 | -1.2 | 2.4 | 1.2 | 2.4 | 92.3 |
| Jan | 0.1 | -0.2 | 0.1 | 0.2 | 0.2 | 0.0 | -1.8 |
| 2012 | |||||||
| Dec | 0.0 | -0.3 | -0.2 | 0.2 | 0.1 | 0.2 | -0.9 |
| Nov | -0.1 | -0.7 | -0.1 | 0.2 | 0.1 | 0.2 | -3.5 |
| Oct | 0.2 | 0.1 | -0.2 | 0.2 | 0.2 | 0.3 | 0.1 |
| ∆% AE Oct-Jan | 0.6 | -3.3 | -1.2 | 2.4 | 1.8 | 2.1 | -16.9 |
| Sep | 0.3 | 0.6 | -0.2 | 0.1 | 0.1 | -0.1 | 4.1 |
| Aug | 0.3 | 0.7 | -0.2 | 0.1 | 0.0 | 0.1 | 4.7 |
| ∆% AE Aug-Sep | 3.7 | 8.1 | -2.4 | 1.2 | 0.6 | 0.0 | 67.6 |
| Jul | 0.0 | -0.2 | -0.3 | 0.1 | 0.1 | 0.0 | -1.2 |
| Jun | 0.2 | 0.0 | -0.1 | 0.3 | 0.2 | 0.2 | -0.7 |
| ∆% AE Jun-Jul | 1.2 | -1.2 | -2.4 | 2.4 | 1.8 | 1.2 | -10.8 |
| May | 0.0 | -0.5 | 0.0 | 0.2 | 0.1 | 0.0 | -2.9 |
| Apr | 0.0 | -0.3 | -0.1 | 0.2 | 0.1 | 0.0 | -1.9 |
| ∆% AE Apr- May | 0.0 | -4.7 | -0.6 | 2.4 | 1.2 | 0.0 | -25.3 |
| Mar | 0.2 | 0.3 | -0.2 | 0.2 | 0.2 | 0.2 | 1.3 |
| Feb | 0.2 | 0.4 | 0.0 | 0.2 | 0.1 | 0.0 | 2.3 |
| Jan | 0.2 | 0.2 | 0.1 | 0.2 | 0.3 | 0.2 | 0.1 |
| ∆% AE Jan- Mar | 2.4 | 3.7 | -0.4 | 2.4 | 2.4 | 1.6 | 15.8 |
| 2011 | |||||||
| Dec | 0.1 | -0.1 | -0.2 | 0.2 | 0.1 | 0.2 | -1.2 |
| Nov | 0.1 | 0.1 | -0.2 | 0.2 | 0.2 | -0.1 | 0.0 |
| Oct | 0.0 | -0.2 | 0.0 | 0.1 | 0.1 | 0.2 | -1.6 |
| ∆% AE Oct- Dec | 0.8 | -1.2 | -1.6 | 2.0 | 2.0 | 1.2 | -10.7 |
| Sep | 0.2 | 0.2 | -0.4 | 0.2 | 0.1 | 0.5 | 1.3 |
| Aug | 0.2 | 0.3 | -0.2 | 0.2 | 0.2 | 0.6 | 0.1 |
| Jul | 0.2 | 0.2 | -0.1 | 0.2 | 0.2 | 0.4 | 0.1 |
| ∆% AE Jul-Sep | 2.4 | 2.8 | -2.8 | 2.4 | 2.0 | 6.2 | 6.2 |
| Jun | 0.1 | 0.1 | 0.2 | 0.1 | 0.2 | 0.2 | -0.7 |
| May | 0.3 | 0.5 | 0.1 | 0.2 | 0.2 | 0.5 | 1.4 |
| ∆% AE May-Jun | 2.4 | 3.7 | 1.8 | 1.8 | 2.4 | 4.3 | 4.2 |
| Apr | 0.3 | 0.5 | 0.3 | 0.2 | 0.2 | 0.4 | 1.8 |
| Mar | 0.4 | 0.8 | -0.1 | 0.2 | 0.1 | 0.8 | 3.6 |
| Feb | 0.3 | 0.5 | 0.1 | 0.2 | 0.1 | 0.7 | 1.7 |
| Jan | 0.2 | 0.4 | 0.0 | 0.1 | 0.1 | 0.6 | 0.8 |
| ∆% AE Jan-Apr | 3.7 | 6.8 | 0.9 | 2.1 | 1.5 | 7.8 | 26.4 |
| 2010 | |||||||
| Dec | 0.2 | 0.6 | -0.3 | 0.1 | 0.0 | 0.1 | 4.1 |
| Nov | 0.2 | 0.2 | -0.2 | 0.1 | 0.1 | 0.2 | 1.1 |
| Oct | 0.2 | 0.4 | -0.2 | 0.1 | 0.1 | 0.1 | 3.1 |
| Sep | 0.1 | 0.2 | -0.1 | 0.1 | 0.0 | 0.2 | 0.6 |
| Aug | 0.1 | 0.3 | 0.1 | 0.1 | 0.1 | 0.1 | 1.0 |
| Jul | 0.1 | 0.1 | -0.3 | 0.1 | 0.1 | 0.1 | 1.2 |
| Jun | 0.1 | -0.1 | -0.4 | 0.1 | 0.1 | -0.1 | -0.5 |
| May | 0.0 | -0.2 | -0.2 | 0.2 | 0.1 | 0.1 | -1.2 |
| Apr | 0.0 | -0.3 | -0.2 | 0.1 | 0.0 | 0.1 | -0.8 |
| Mar | 0.1 | -0.1 | 0.0 | 0.2 | 0.1 | 0.2 | -0.5 |
| Feb | 0.0 | -0.2 | -0.3 | 0.1 | 0.1 | 0.1 | -1.2 |
| Jan | 0.2 | 0.3 | -0.1 | 0.1 | 0.1 | 0.1 | 1.7 |
Notes: percentage changes in price index relative to the same month a year earlier of PCE: personal consumption expenditures; PCEG: PCE goods; PCEG-D: PCE durable goods; PCES: PCE services; PCEX: PCE excluding food and energy; PCEF: PCE food; PCEE: PCE energy goods and services. AE: annual equivalent.
Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm
The charts of PCE inflation are also instructive. Chart IV-1 provides the monthly change of headline PCE price index. There is significant volatility in the monthly changes but excluding outliers fluctuations have been in a tight range between 1999 and 2014 around 0.2 percent per month.
Chart IV-1, US, Percentage Change of PCE Price Index from Prior Month, 1999-2014
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
There is much less volatility in the PCE index excluding food and energy shown in Chart IV-2 with monthly percentage changes from 1999 to 2014. With the exception of 2001, there are no negative changes and again changes around 0.2 percent when excluding outliers.
Chart IV-2, US, Percentage Change of PCE Price Index Excluding Food and Energy from Prior Month, 1999-2014
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Fluctuations in the PCE index of food are much wider as shown in Chart IV-3 by monthly percentage changes from 1999 to 2014. There are also multiple negative changes and positive changes even exceeding 1.0 percent in three months.
Chart IV-3, US, Percentage Change of PCE Price Index Food from Prior Month, 1999-2014
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
The band of fluctuation of the PCE price index of energy in Chart IV-4 is much wider. An interesting feature is the abundance of negative changes and large percentages.
Chart IV-4, US, Percentage Change of PCE Price Index Energy from Prior Month, 1999-2014
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Table IV-6 provides 12-month rates of PCE inflation from Jan 2012 to Feb 2014, annual inflation rates from 2000 to 2013 and average yearly rates of PCE inflation for various periods since 1929. Headline 12-month PCE inflation decreased from 2.5 percent in in the 12 months ending in Jan 2012 to 0.9 percent in the 12 months ending in Feb 2014. PCE inflation excluding food and energy (PCEX), used as indicator in monetary policy, decreased from 2.0 percent in the 12 months ending in Jan 2012 to 1.1 percent in the 12 months ending in Feb 2014, which is still below or at the tolerable maximum of 2.0-2.5 percent in monetary policy. The unintended effect of shocks of commodity prices from zero interest rates captured by PCE food prices (PCEF) and energy (PCEE) in the absence of risk aversion should be weighed in design and implementation of monetary policy. Annual PCE inflation in the second part of Table IV-6 shows significant fluctuations. Headline PCE inflation rose during the period of 1 percent interest rates from Jun 2003 to Jun 2005, reaching 2.9 percent in 2005. PCEE rose at very high two-digit rates after 2003. Headline PCE inflation increased 3.1 percent in 2008 while PCEE energy increased 14.3 percent in carry trades from zero interest rates to commodity derivatives during deep global recession. Flight away from risk financial assets to US government obligations fueled by proposals of TARP in Congress (Cochrane and Zingales 2009) caused decline of PCEE of 19.0 percent in 2009 and minus 0.1 percent in headline PCE. There is no deflation in the US economy. Headline PCEE inflation increased at the average rate of 2.0 percent from 1929 to 2013, as shown in Table IV-6 using the revisions by the BEA. PCE inflation was 6.1 percent on average during the Great Inflation episode from 1965 to 1981 (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). PCE inflation was 3.2 percent on average from 1947 to 2013 and 3.2 percent on average for PCEX. The long-term charts of PCEE and PCEX show almost identical behavior.
Table IV-6, US, Percentage Change in 12 Months of Prices of Personal Consumption Expenditures ∆%
| PCE | PCEG | PCEG | PCES | PCEX | PCEF | PCEE | |
| 2014 | |||||||
| Feb | 0.9 | -1.1 | -2.3 | 1.9 | 1.1 | 0.7 | -2.3 |
| Jan | 1.2 | -0.2 | -2.2 | 1.9 | 1.1 | 0.6 | 3.5 |
| 2013 | |||||||
| Dec | 1.2 | -0.4 | -2.0 | 1.9 | 1.2 | 0.6 | 1.2 |
| Nov | 1.0 | -0.7 | -1.9 | 1.9 | 1.2 | 0.7 | -1.3 |
| Oct | 0.8 | -1.3 | -1.8 | 1.9 | 1.1 | 1.0 | -4.3 |
| Sep | 0.9 | -1.0 | -1.8 | 1.9 | 1.2 | 1.2 | -3.3 |
| Aug | 1.1 | -0.4 | -2.0 | 1.9 | 1.2 | 1.2 | -0.1 |
| Jul | 1.3 | 0.3 | -1.8 | 1.9 | 1.1 | 1.2 | 4.8 |
| Jun | 1.3 | 0.0 | -1.8 | 1.9 | 1.2 | 1.0 | 3.2 |
| May | 1.0 | -0.7 | -1.9 | 1.9 | 1.2 | 1.0 | -0.9 |
| Apr | 0.9 | -1.1 | -1.8 | 1.9 | 1.2 | 1.2 | -4.1 |
| Mar | 1.2 | -0.5 | -1.7 | 2.1 | 1.4 | 1.1 | -1.6 |
| Feb | 1.5 | 0.4 | -1.7 | 2.1 | 1.5 | 1.2 | 2.4 |
| Jan | 1.4 | 0.0 | -1.6 | 2.1 | 1.5 | 1.1 | -0.8 |
| 2012 | |||||||
| Dec | 1.5 | 0.4 | -1.6 | 2.1 | 1.6 | 1.3 | 1.1 |
| Nov | 1.6 | 0.5 | -1.5 | 2.1 | 1.7 | 1.3 | 0.8 |
| Oct | 1.8 | 1.3 | -1.6 | 2.1 | 1.8 | 1.0 | 4.4 |
| Sep | 1.7 | 1.0 | -1.5 | 2.0 | 1.7 | 0.9 | 2.7 |
| Aug | 1.6 | 0.6 | -1.7 | 2.1 | 1.7 | 1.5 | -0.2 |
| Jul | 1.5 | 0.2 | -1.6 | 2.2 | 1.9 | 2.0 | -4.6 |
| Jun | 1.6 | 0.5 | -1.4 | 2.2 | 1.9 | 2.4 | -3.3 |
| May | 1.6 | 0.7 | -1.1 | 2.1 | 1.9 | 2.4 | -3.3 |
| Apr | 2.0 | 1.6 | -1.2 | 2.1 | 1.9 | 2.9 | 1.5 |
| Mar | 2.3 | 2.5 | -0.6 | 2.0 | 2.0 | 3.3 | 4.9 |
| Feb | 2.4 | 2.9 | -0.6 | 2.2 | 2.0 | 3.9 | 7.3 |
| Jan | 2.5 | 3.0 | -0.4 | 2.2 | 2.0 | 4.7 | 6.8 |
| Annual ∆% | |||||||
| 2013 | 1.1 | -0.4 | -1.8 | 1.9 | 1.2 | 1.1 | -0.5 |
| 2012 | 1.8 | 1.3 | -1.2 | 2.2 | 1.8 | 2.3 | 1.4 |
| 2011 | 2.4 | 3.6 | -1.0 | 1.8 | 1.4 | 4.0 | 15.8 |
| 2010 | 1.7 | 1.6 | -1.4 | 1.7 | 1.3 | 0.3 | 10.1 |
| 2009 | -0.1 | -2.3 | -1.7 | 1.1 | 1.2 | 1.2 | -19.0 |
| 2008 | 3.1 | 3.0 | -1.9 | 3.1 | 2.1 | 6.1 | 14.3 |
| 2007 | 2.5 | 1.1 | -2.0 | 3.2 | 2.2 | 3.9 | 6.0 |
| 2006 | 2.7 | 1.4 | -1.6 | 3.4 | 2.2 | 1.7 | 11.3 |
| 2005 | 2.9 | 2.0 | -1.0 | 3.3 | 2.2 | 1.7 | 17.3 |
| 2004 | 2.4 | 1.4 | -1.9 | 3.0 | 1.9 | 3.1 | 11.3 |
| 2003 | 2.0 | -0.1 | -3.6 | 3.1 | 1.5 | 1.9 | 12.6 |
| 2002 | 1.3 | -0.9 | -2.5 | 2.6 | 1.7 | 1.5 | -5.8 |
| 2001 | 1.9 | -0.1 | -2.0 | 3.1 | 1.8 | 2.9 | 2.5 |
| 2000 | 2.5 | 2.0 | -1.8 | 2.8 | 1.7 | 2.3 | 18.3 |
| Average ∆% | |||||||
| 2000-2013 | 2.0 | 0.9 | -21.3* | 2.6 | 1.7 | 2.4 | 5.5 |
| 1929-2013 | 2.9 | 2.3 | 1.4 | 3.2 | 2.8 | 2.9 | 3.3 |
| 1947-2013 | 3.2 | 2.3 | 1.1 | 3.9 | 3.2 | 3.0 | 4.2 |
| 1965-1981 | 6.1 | 5.6 | 4.3 | 6.5 | 5.7 | 6.3 | 9.3 |
*Percentage change from 2000 to 2012.
Notes: percentage changes in price index relative to the same month a year earlier of PCE: personal consumption expenditures; PCEG: PCE goods; PCEG-D: PCE durable goods; PCES: PCE services; PCEX: PCE excluding food and energy; PCEF: PCE food; PCEE: PCE energy goods and services
Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm
The headline PCE index is shown in Chart IV-5 from 1999 to 2013. There is an evident upward trend with the carry-trade bump in 2008-2009 during the global recession.
Chart IV-5, US, Price Index of Personal Consumption Expenditures 1999-2014
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
The consumer price index in Chart IV-6 mirrors the behavior of the PCE price index in Chart IV-6. There is the same upward trend with the carry-trade bump in 2008 during the global recession.
Chart IV-6, US, Consumer Price Index, NSA, 1999-2014
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart IV-7 provides the PCE price index excluding food and energy. There is milder upward trend with fewer oscillations.
Chart IV-7, US, Price Index of Personal Consumption Expenditures Excluding Food and Energy 1999-2014
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
The core consumer price index, excluding food and energy, is shown in Chart IV-8. There is also an upward trend but with fluctuations.
Chart IV-8, US, Consumer Price Index Excluding Food and Energy, NSA, 1999-2014
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
The PCE price index of food is shown in Chart IV-9. There is a more pronounced upward trend and sharper fluctuations.
Chart IV-9, US, Price Index of Personal Consumption Expenditures Food 1999-2014
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
There is similar behavior in the consumer price index of food in Chart IV-10. There is an upward trend from 1999 to 2011 with a major bump in 2009 when commodity futures positions were unwound. Zero interest rates with bouts of risk aversion dominate the trend into 2011. Risk aversion softens the trend toward the end of 2011 and in 2012-2013.
Chart IV-10, US, Consumer Price Index, Food, NSA, 1999-2014
Source: US Bureau of Labor Statistics
http://www.bea.gov/iTable/index_nipa.cfm
The most pronounced trend of PCE price indexes is that of energy in Chart IV-11. It is impossible to explain the hump in 2008 in the middle of the global recession without the carry trade from zero interest rates to leveraged positions in commodity futures. Risk aversion after Sep 2008 caused flight to the safe haven of government obligations. The return of risk appetite with zero interest rates caused a first wave of carry trades with another upward trend interrupted by the first European sovereign risk crisis in Apr-Jul 2010. Zero interest rates with risk appetite caused another sharp upward trend of commodity prices interrupted by risk aversion from the second sovereign crisis. In the absence of risk aversion, carry trades from zero interest rates to positions in risk financial assets will continue to cause distortions such as commodity price trends and fluctuations.
Chart IV-11, US, Price Index of Personal Consumption Expenditures Energy Goods and Services 1999-2014
Source: US Bureau of Economic Analysis
http://www.bea.gov/iTable/index_nipa.cfm
Chart IV-12 provides the consumer price index of energy commodities. Unconventional monetary policy of zero or near zero interest rates causes upward trends in commodity prices reflected in (1) increase from 2003 to 2007; (2) sharp increase during the global contraction in 2008; (3) collapse from 2008 into 2009 as positions in commodity futures were unwound in a flight to government obligations; (4) new upward trend after 2010; and (5) episodes of decline during risk aversion shocks such as the more recent segment during the worsening European debt crisis in Nov and Dec of 2011 and with new strength of commodity prices in the beginning of 2012 followed by softness in another episode of risk aversion and increases during risk appetite.
Chart IV-12, US, Consumer Price Index, Energy, NSA, 1999-2014
Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm
Chart IV-13 of the US Energy Information Administration provides prices of the crude oil futures contract. Unconventional monetary policy of very low interest rates and quantitative easing with suspension of the 30-year bond to lower mortgage rates caused a sharp upward trend of oil prices. There is no explanation for the jump of oil prices to $149/barrel in 2008 during a sharp global recession other than carry trades from zero interest rates to commodity futures. The peak in Chart IV-13 is $145.18 on Jul 14, 2008, in the midst of deep global recession, falling to $33.87/barrel on Dec 19, 2008 (data from the US Energy Information Administration (http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D). Prices collapsed in the flight to government obligations caused by proposals for withdrawing “toxic assets” in the Troubled Asset Relief Program (TARP) as analyzed by Cochrane and Zingales (2009). Risk appetite with zero interest rates after stress tests of US banks resulted in another upward trend of commodity prices after 2009 with fluctuations during periods of risk aversion. All price indexes are affected by unconventional monetary policy.
Chart IV-13, US, Crude Oil Futures Contract
Source: US Energy Information Administration
http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D
Table IV-14 provides the annual PCE price index from the revised and enhanced dataset of the Bureau of Economic Analysis (BEA). The annual PCEE index increased at the average rate of 2.9 percent from 1929 to 2013. There is no support for fear of deflation.
Chart IV-14, US, Price Index of Personal Consumption Expenditures, Annual, 1929-2013
Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm
Chart IV-15 of the Bureau of Labor Statistics (BLS) provides the consumer price index from 1915 to 2013. There is long-term inflation and no evidence in support of fear of deflation.
Chart IV-15, US, Consumer Price Index, Annual, 1915-2014
Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm
Chart IV-16 provides the BEA annual index of PCE prices excluding food and energy. The average rate of increase from 1929 to 2013 is 2.8 percent.
Chart IV-16, US, Price Index of Personal Consumption Expenditures Excluding Food and Energy, Annual, 1929-2013
Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm
Chart IV-17 of the Bureau of Labor Statistics (BLS) provides the annual consumer price index excluding food and energy from 1957 to 2013. There is long-term, fluctuating inflation.
Chart IV-17, US, Consumer Price Index Excluding Food and Energy, Annual, 1957-2013
Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm
Chart IV-18 provides annual percentage changes of the index of prices of personal consumption expenditures. With the exception of the Great Depression of the 1930s, the index was negative only after World War II high inflation and the speculative carry trades on commodities induced by zero interest rates in 2008. Deflation fear does not have support in reality.
Chart IV-18, US, Price Index of Personal Consumption Expenditures, Annual Percentage Changes 1930-2013
Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm
Chart IV-19 provides annual percentage changes of the US consumer price index since 1914. Besides the Great Depression, the index of consumer prices all items fell only after World War II, the Korean War and the episode of speculative carry trades induced by zero interest rates during the global recession in 2008.
Chart IV-19, US, Consumer Price Index, Annual Percentage Changes, 1915-2013
Source: US bureau of Labor Statistics http://www.bls.gov/cpi/data.htm
Chart IV-20 provides annual percentage changes of the price index of personal consumption expenditures excluding food and energy since 1930. Besides the episode of the Great Depression, there are no negative changes with the lowest reading after fast inflation during World War II.
Chart IV-20, US, Price Index of Personal Consumption Expenditures Excluding Food and Energy, Annual Percentage Changes, 1930-2013
Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm
Chart IV 21 provides annual percentage changes of the US consumer price index all items excluding food and energy since its first availability in 1958. There is not one single year of negative inflation. Fear of deflation is void of reality.
Chart IV-21, US, Consumer Price Index Excluding Food and Energy, Annual Percentage Changes, 1958-2013
Source: US bureau of Labor Statistics http://www.bls.gov/cpi/data.htm
Unconventional monetary policy of zero interest rates and quantitative easing has been used in Japan and now also in the US. Table IV-7 provides the consumer price index of Japan, with inflation of 1.5 percent in 12 months ending in Feb 2014 and change of 0.0 percent NSA (not-seasonally-adjusted) in Feb 2014. Inflation of consumer prices in the first three months of 2012 annualizes at 0.0 percent NSA. Inflation in Mar-Dec 2013 not seasonally adjusted annualizes at 1.9 percent. There are negative percentage changes in most of the 12-month rates in 2011 with the exception of Jul and Aug both with 0.2 percent and stability in Sep. All 12-month rates of inflation in the first five months of 2013 are negative. Inflation in the 12 months ending in Jun 2013 was 0.2 percent and 0.7 percent in the 12 months ending in Jul 2013. Inflation increased to 0.9 percent in the 12 months ending in Aug 2013 and 1.1 percent in the 12 months ending in Sep 2013. Inflation was 1.1 percent in the 12 months ending in Oct 2013 and 1.5 percent in the 12 months ending in Nov 2013. Inflation was 1.6 percent in the 12 months ending in Dec 2013 and 1.4 percent in the 12 months ending in Jan 2014. Inflation was 1.5 percent in the 12 months ending in Feb 2014.There are ten years of deflation, three of zero inflation and only six of inflation in the annual rate of inflation from 1995 to 2013. This experience is entirely different from that of the US that shows long-term inflation. There is only one annual negative change of the CPI all items of the US in Table IV-5, minus 0.4 percent in 2009 but following 3.8 percent in 2008 because of carry trades from policy rates moving to zero in 2008 during a global contraction that were reversed because of risk aversion in late 2008 and early 2009, causing decreasing commodity prices. Both the US and Japan experienced high rates of inflation during the US Great Inflation of the 1970s (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). It is difficult to justify unconventional monetary policy because of risks of deflation similar to that experienced in Japan. Fear of deflation as had occurred during the Great Depression and in Japan was used as an argument for the first round of unconventional monetary policy with 1 percent interest rates from Jun 2003 to Jun 2004. The 1 percent interest rate combined with quantitative easing in the form of withdrawal of supply of 30-year securities by suspension of the auction of 30-year Treasury bonds with the intention of reducing mortgage rates. For fear of deflation, see Pelaez and Pelaez, International Financial Architecture (2005), 18-28, and Pelaez and Pelaez, The Global Recession Risk (2007), 83-95. The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html
Table IV-7, Japan, Consumer Price Index, All Items ∆%
| ∆% Month NSA | ∆% 12-Month NSA | |
| Feb 2014 | 0.0 | 1.5 |
| Jan | -0.2 | 1.4 |
| Dec 2013 | 0.1 | 1.6 |
| Nov | 0.0 | 1.5 |
| Oct | 0.1 | 1.1 |
| Sep | 0.3 | 1.1 |
| Aug | 0.3 | 0.9 |
| Jul | 0.2 | 0.7 |
| Jun | 0.0 | 0.2 |
| May | 0.1 | -0.3 |
| Apr | 0.3 | -0.7 |
| Mar | 0.2 | -0.9 |
| Feb | -0.2 | -0.7 |
| Jan | 0.0 | -0.3 |
| Dec 2012 | 0.0 | -0.1 |
| Nov | -0.4 | -0.2 |
| Oct | 0.0 | -0.4 |
| Sep | 0.1 | -0.3 |
| Aug | 0.1 | -0.4 |
| Jul | -0.3 | -0.4 |
| Jun | -0.5 | -0.2 |
| May | -0.3 | 0.2 |
| Apr | 0.1 | 0.4 |
| Mar | 0.5 | 0.5 |
| Feb | 0.2 | 0.3 |
| Jan | 0.2 | 0.1 |
| Dec 2011 | 0.0 | -0.2 |
| Nov | -0.6 | -0.5 |
| Oct | 0.1 | -0.2 |
| Sep | 0.0 | 0.0 |
| Aug | 0.1 | 0.2 |
| Jul | 0.0 | 0.2 |
| Jun | -0.2 | -0.4 |
| May | 0.0 | -0.4 |
| Apr | 0.1 | -0.5 |
| Mar | 0.3 | -0.5 |
| Feb | 0.0 | -0.5 |
| Jan | -0.1 | -0.6 |
| Dec 2010 | –0.3 | 0.0 |
| CPI All Items USA | CPI All Items Japan | |
| Annual | ||
| 2013 | 1.5 | 0.4 |
| 2012 | 2.1 | 0.0 |
| 2011 | 3.2 | -0.3 |
| 2010 | 1.6 | -0.7 |
| 2009 | -0.4 | -1.4 |
| 2008 | 3.8 | 1.4 |
| 2007 | 2.8 | 0.0 |
| 2006 | 3.2 | 0.3 |
| 2005 | 3.4 | -0.3 |
| 2004 | 2.7 | 0.0 |
| 2003 | 2.3 | -0.3 |
| 2002 | 1.6 | -0.9 |
| 2001 | 2.8 | -0.7 |
| 2000 | 3.4 | -0.7 |
| 1999 | 2.2 | -0.3 |
| 1998 | 1.6 | 0.6 |
| 1997 | 2.3 | 1.8 |
| 1996 | 3.0 | 0.1 |
| 1995 | 2.8 | -0.1 |
| 1994 | 2.6 | 0.7 |
| 1993 | 3.0 | 1.3 |
| 1992 | 3.0 | 1.6 |
| 1991 | 4.2 | 3.3 |
| 1990 | 5.4 | 3.1 |
| 1989 | 4.8 | 2.3 |
| 1988 | 4.1 | 0.7 |
| 1987 | 3.6 | 0.1 |
| 1986 | 1.9 | 0.6 |
| 1985 | 3.6 | 2.0 |
| 1984 | 4.3 | 2.3 |
| 1983 | 3.2 | 1.9 |
| 1982 | 6.2 | 2.8 |
| 1981 | 10.3 | 4.9 |
| 1980 | 13.5 | 7.7 |
| 1979 | 11.3 | 3.7 |
| 1978 | 7.6 | 4.2 |
| 1977 | 6.5 | 8.1 |
| 1976 | 5.8 | 9.4 |
| 1975 | 9.1 | 11.7 |
| 1974 | 11.0 | 23.2 |
| 1973 | 6.2 | 11.7 |
| 1972 | 3.2 | 4.9 |
| 1971 | 4.4 | 6.3 |
Source: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications
http://www.stat.go.jp/english/data/cpi/index.htm
Chart IV-22 of Japan’s Statistics Bureau at the Ministry of Internal Affairs and Communications provides the major consumer price indexes of Japan on an annual basis. There is inflexion of the trend of decline of the index of all items and the index of all items excluding fresh food in 20012 and 2013.
Chart IV-22, Japan, Consumer Price Index All Items, Consumer Price Index All Items Less Fresh Food and Consumer Price Index All Items Less Food, Alcoholic Beverages and Energy, Annual, 2001-2013
Sources: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications
http://www.stat.go.jp/english/data/cpi/index.htm
Chart IV-23 of Japan’s Statistics Bureau at the Ministry of Internal Affairs and Communications provides annual percentage changes of the consumer price index all items, excluding fresh food and excluding food, alcoholic beverages and energy. The indexes of all items and excluding fresh food increased in 2013.
Chart IV-23, Japan, Japan, Consumer Price Index, Percentage Changes Relative to Prior Year, 2001-2013
Sources: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications
http://www.stat.go.jp/english/data/cpi/index.htm
Internal Affairs and Communications provides the consumer price index for all items and regions of Japan monthly from 1971 to 2013 with 2010=100, shown in Chart IV-24. There was inflation in Japan during the 1970s and 1980s similar to other countries and regions. The index shows stability after the 1990s with sporadic cases of deflation. Slower growth with sporadic inflation has been characterized as a “lost decade” in Japan (see Pelaez and Pelaez, The Global Recession Risk (2007), 82-115).
Chart IV-24, Japan, Consumer Price Index All Items, All Japan, Index 2010=100, Monthly, 1970-2013
Source: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications
http://www.stat.go.jp/english/data/cpi/index.htm
Chart IV-25 provides the US consumer price index NSA from 1914 to 2014. 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 IV-25, US, Consumer Price Index, All Items, NSA, 1915-2014
Source: US Bureau of Labor Statistics
Chart IV-26 of the Statistics Bureau of the Ministry of Internal Affairs and Communications of Japan provides 12-month percentage changes of the consumer price index for all items and regions of Japan monthly from 1971 to 2013. Japan experienced the same inflation waves of the United States during the Great Inflation of the 1970s followed by similar low inflation after the inflation-control increase of interest rates in the early 1980s. Numerous cases of negative inflation or deflation are observed after the 1990s.
Chart IV-26, Japan, CPI All Items, All Japan, 12-Month ∆%, 1971-2013
Sources: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications
http://www.stat.go.jp/english/data/cpi/index.htm
Chart IV-27 provides 12-month percentage changes of the US consumer price index from 1914 to 2013. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Table IV-7 provides similar inflation waves in the economy of Japan with 11.7 percent in 1973, 23.1 percent in 1974 and 11.7 percent in 1975. The Great Inflation of the 1970s is 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 The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). Inflation rates then stabilized in the US in a range with only two episodes above 5 percent. There are isolated cases of deflation concentrated over extended periods only during the 1930s. There is no case in United States economic history for unconventional monetary policy because of fear of deflation. There are cases of long-term deflation without lost decades or depressions.
Delfim Netto (1958) partly reprinted in Pelaez (1973) conducted two classical nonparametric tests (Mann 1945, Wallis and Moore 1941; see Kendall and Stuart 1968) with coffee-price data in the period of free markets from 1857 to 1906 with the following conclusions (Pelaez, 1976a, 280):
“First, the null hypothesis of no trend was accepted with high confidence; secondly, the null hypothesis of no oscillation was rejected also with high confidence. Consequently, in the nineteenth century international prices of coffee fluctuated but without long-run trend. This statistical fact refutes the extreme argument of structural weakness of the coffee trade.”
The conventional theory that the terms of trade of Brazil deteriorated over the long term is without reality (Pelaez 1976a, 280-281):
“Moreover, physical exports of coffee by Brazil increased at the high average rate of 3.5 per cent per year. Brazil's exchange receipts from coffee-exporting in sterling increased at the average rate of 3.5 per cent per year and receipts in domestic currency at 4.5 per cent per year. Great Britain supplied nearly all the imports of the coffee economy. In the period of the free coffee market, British export prices declined at the rate of 0.5 per cent per year. Thus, the income terms of trade of the coffee economy improved at the relatively satisfactory average rate of 4.0 per cent per year. This is only a lower bound of the rate of improvement of the terms of trade. While the quality of coffee remained relatively constant, the quality of manufactured products improved significantly during the fifty-year period considered. The trade data and the non-parametric tests refute conclusively the long-run hypothesis. The valid historical fact is that the tropical export economy of Brazil experienced an opportunity of absorbing rapidly increasing quantities of manufactures from the "workshop" countries. Therefore, the coffee trade constituted a golden opportunity for modernization in nineteenth-century Brazil.”
Imlah (1958) provides decline of British export prices at 0.5 percent in the nineteenth century and there were no lost decades, depressions or unconventional monetary policies in the highly dynamic economy of England that provided the world’s growth impulse. The experience of the United Kingdom with deflation and economic growth is relevant and rich. Yearly percentage changes of the composite index of prices of the United Kingdom of O’Donoghue and Goulding (2004) provide strong evidence. There are 73 declines of inflation in the 145 years from 1751 to 1896. Prices declined in 50.3 percent of 145 years. Some price declines were quite sharp and many occurred over several years. O’Donoghue and Goulding (2004) also provide inflation data for the UK from 1929 to 1934. Deflation was much sharper in continuous years in earlier periods than during the Great Depression. The United Kingdom could not have led the world in modern economic growth if there were meaningful causality from deflation to depression.
Chart IV-27, US, Consumer Price Index, All Items, NSA, 12-Month Percentage Change 1915-2014
Source: US Bureau of Labor Statistics
Chart IV-28 provides the US consumer price index excluding food and energy from 1957 (when it first becomes available) to 2014. There is long-term inflation in the US without episodes of deflation that would justify symmetric inflation targets to increase inflation from low levels.
Chart IV-28, US, Consumer Price Index Excluding Food and Energy, NSA, 1957-2014
Source: US Bureau of Labor Statistics
Chart IV-29 provides 12-month percentage changes of the consumer price index excluding food and energy from 1958 (when it first becomes available) to 2014. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.
Chart IV-29, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1958-2014
Source: US Bureau of Labor Statistics
More detail on the consumer price index of Japan in Dec is in Table IV-8. Items rich in commodities, such as 5.8 percent in fuel, light and water charges in 12 months with increase of 0.2 percent in the month, have driven inflation in the 12 months ending in Feb 2014. Fiscal and monetary policies promoting devaluation of the yen are causing inflation in Japan. There is similar behavior in the preliminary estimate for Mar for the Ku Area of Tokyo with increase of 0.9 percent of fuel, light and water charges and increase of 6.1 percent in 12 months. There is 12-month increase of 1.3 percent of CPI transport and communications. The CPI excluding fresh food, which is the inflation indicator of the Bank of Japan, increased 1.3 percent in the 12 months ending in Feb 2014. There is mild inflation in the CPI excluding food, alcoholic beverages and energy with 0.8 percent in the 12 months ending in Feb 2014 and increase of 0.1 percent in Feb 2014. The CPI excluding imputed rent changed 0.0 percent in Feb 2014 and increased 1.9 percent in 12 months. The all-items CPI estimate for Feb 2014 of the Ku-Area of Tokyo shows change of increase of 0.4 percent in Feb 2014 and increase of 1.3 percent in 12 months.
Table IV-8, Japan, Consumer Price Index, ∆%
| 2014 | Feb 2014/Jan 2014 ∆% | Year ∆% |
| CPI All Items | 0.0 | 1.5 |
| CPI Excluding Fresh Food | 0.1 | 1.3 |
| CPI Excluding Food, Alcoholic Beverages and Energy | 0.1 | 0.8 |
| CPI Goods | 0.0 | 2.6 |
| CPI Services | 0.0 | 0.6 |
| CPI Excluding Imputed Rent | 0.0 | 1.9 |
| CPI Fuel, Light, Water Charges | 0.2 | 5.8 |
| CPI Transport & Communications | -0.1 | 1.3 |
| CPI Ku-Area Tokyo All Items | 0.4 | 1.3 |
| Fuel, Light, Water Charges Ku Area Tokyo | 0.9 | 6.1 |
Note: Ku-area Tokyo CPI data preliminary for Mar 2014
Sources: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications
http://www.stat.go.jp/english/data/cpi/index.htm
Inflation in the UK is somewhat higher than in many advanced economies, deserving more detailed analysis. Table IV-9 provides 12-month percentage changes of UK output prices for all manufactured products, excluding food, beverage and petroleum and excluding duty. The UK Office for National Statistics introduced rebasing for 2010=100 of the producer price index with important revisions (http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/producer-price-index-rebasing--2010-100-/index.html). The 12-month rates rose significantly in 2011 in all three categories, reaching 5.3 percent for all manufactured products in Sep 2011 but declining to 4.9 percent in Oct 2011, 4.6 percent in Nov 2011 and down to 1.3 percent in Jul 2012. Inflation of all manufactured products increased marginally to 1.7 percent in Aug 2012, 1.8 percent in Sep, 1.9 percent in Oct, 1.7 percent in Feb 2013, 1.5 percent in Mar 2013 and 1.0 percent in Apr 2013. Output prices increased 1.2 percent in the 12 months ending in May 2013, 1.7 percent in Jun 2013 and 1.8 percent in Jul 2013. Output price inflation was 1.5 percent in the 12 months ending in Aug 2013 and 1.2 percent in the 12 months ending in Sep 2013. Output price inflation was 0.8 percent in the 12 months ending in Oct 2013 and 0.8 percent in the 12 months ending in Nov 2013. Prices of output increased 1.0 percent in the 12 months ending in Dec 2013 and 0.9 percent in the 12 months ending in Jan 2014. Output prices increased 0.5 percent in the 12 months ending in Feb 2014. Output price inflation is highly sensitive to commodity prices as shown by the increase by 6.7 percent in 2008 when oil prices rose over $140/barrel even in the midst of a global recession driven by the carry trade from zero interest rates to oil futures. The mirage episode of false deflation in 2001 and 2002 is also captured by output prices for the UK, which originated in decline of commodity prices (see Barsky and Killian 2004) but was used as an argument for unconventional monetary policy of zero interest rates and quantitative easing during the past decade. Arguments for symmetric up and down inflation targets are based on fear of deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, Pelaez and Pelaez, The Global Recession Risk (2007), 83-95).
Table IV-9, UK Output Prices 12 Months ∆% NSA
| All Manufactured Products | Excluding Food, Beverage, Tobacco and | All Excluding Duty | |
| Feb 2014 | 0.5 | 1.1 | 0.6 |
| Jan | 0.9 | 1.2 | 1.0 |
| Dec 2013 | 1.0 | 1.0 | 1.1 |
| Nov | 0.8 | 0.7 | 1.0 |
| Oct | 0.8 | 0.8 | 1.1 |
| Sep | 1.2 | 0.8 | 1.4 |
| Aug | 1.5 | 0.9 | 1.7 |
| Jul | 1.8 | 0.9 | 2.0 |
| Jun | 1.7 | 0.9 | 2.0 |
| May | 1.2 | 0.8 | 1.5 |
| Apr | 1.0 | 0.8 | 1.4 |
| Mar | 1.5 | 0.9 | 1.5 |
| Feb | 1.7 | 0.7 | 1.7 |
| Jan | 1.6 | 0.8 | 1.6 |
| Dec 2012 | 1.4 | 0.4 | 1.4 |
| Nov | 1.5 | 0.7 | 1.6 |
| Oct | 1.9 | 0.6 | 1.7 |
| Sep | 1.8 | 0.5 | 1.5 |
| Aug | 1.7 | 0.5 | 1.5 |
| Jul | 1.3 | 0.8 | 1.1 |
| Jun | 1.4 | 1.0 | 1.2 |
| May | 2.0 | 1.3 | 1.9 |
| Apr | 2.3 | 1.4 | 2.1 |
| Mar | 2.9 | 2.0 | 2.9 |
| Feb | 3.4 | 2.3 | 3.3 |
| Jan | 3.5 | 2.2 | 3.4 |
| Dec 2011 | 4.0 | 2.6 | 3.9 |
| Nov | 4.6 | 2.6 | 4.4 |
| Oct | 4.9 | 2.9 | 4.7 |
| Sep | 5.3 | 3.1 | 5.2 |
| Aug | 5.2 | 3.2 | 5.0 |
| Jul | 5.2 | 2.8 | 5.0 |
| Jun | 5.0 | 2.8 | 4.9 |
| May | 4.8 | 3.0 | 4.6 |
| Apr | 4.9 | 3.0 | 4.8 |
| Mar | 4.7 | 2.5 | 4.4 |
| Feb | 4.4 | 2.5 | 4.2 |
| Jan | 4.0 | 2.4 | 3.7 |
| Dec 2010 | 3.4 | 2.0 | 2.9 |
| Year ∆% | |||
| 2013 | 1.3 | 0.9 | 1.5 |
| 2012 | 2.1 | 1.1 | 1.9 |
| 2011 | 4.8 | 2.8 | 4.6 |
| 2010 | 2.7 | 1.5 | 2.1 |
| 2009 | 0.5 | 1.4 | -0.1 |
| 2008 | 6.7 | 3.6 | 6.8 |
| 2007 | 2.3 | 1.4 | 2.0 |
| 2006 | 2.1 | 1.5 | 2.0 |
| 2005 | 1.9 | 0.9 | 1.8 |
| 2004 | 1.1 | -0.1 | 0.7 |
| 2003 | 0.6 | 0.0 | 0.6 |
| 2002 | -0.1 | -0.3 | -0.1 |
| 2001 | -0.2 | -0.7 | -0.3 |
| 2000 | 1.4 | -0.4 | 0.8 |
| 1999 | 0.5 | -1.1 | -0.2 |
| 1998 | 0.1 | -0.9 | -1.0 |
| 1997 | 1.0 | 0.3 | 0.2 |
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/february-2014/index.html
Monthly and annual equivalent rates of change of output prices are shown in Table IV-10. There are waves of inflation similar to those in other countries (http://cmpassocregulationblog.blogspot.com/2014/03/interest-rate-risks-world-inflation.html). In the first wave, annual equivalent inflation was 10.0 percent in Jan-Apr 2011 with relaxed risk aversion in commodity markets. In the second wave, intermittent risk aversion resulted in annual equivalent inflation of 1.6 percent in May-Oct 2011. In the third wave, alternation of risk aversion resulted in annual equivalent inflation of 1.2 percent in Nov 2011 to Jan 2012. In the fourth wave, the energy commodity shock processed through carry trades caused the jump of annual equivalent inflation to 5.3 percent in Feb-Apr 2012. A fifth wave occurred in May-Jun 2012 with decline of output inflation at 3.5 percent annual equivalent in an environment of risk aversion that caused decline of commodity prices. A sixth wave under commodity shocks induced by carry trades from zero interest rates resulted in annual equivalent inflation of 3.7 percent in Jul-Sep 2012 and 3.0 percent in Jul-Oct 2012. In the seventh wave, annual equivalent inflation in Nov-Dec 2012 fell to minus 2.4 percent. In the eighth wave, annual equivalent inflation returned at 4.9 percent in Jan-Mar 2013. In the ninth wave, risk aversion returned with annual equivalent inflation of minus 0.6 percent in Apr-May 2013. In the tenth wave, annual equivalent inflation was 2.0 percent in Jun-Aug 2013. In the eleventh wave, annual equivalent inflation was -1.5 percent in Sep-Dec 2013. In the twelfth wave, annual equivalent inflation returned at 1.8 percent in Jan-Feb 2014.
Table IV-10, UK Output Prices Month ∆% NSA
| All Manufactured Products | Excluding Food, Beverage and | All Excluding Duty | |
| Feb 2014 | 0.0 | 0.1 | 0.1 |
| Jan | 0.3 | 0.5 | 0.3 |
| ∆% AE Jan-Feb | 1.8 | 3.7 | 2.4 |
| Dec 2013 | 0.0 | 0.1 | -0.1 |
| Nov | -0.2 | -0.1 | -0.1 |
| Oct | -0.3 | 0.0 | -0.2 |
| Sep | 0.0 | 0.0 | 0.0 |
| ∆% AE Sep-Dec | -1.5 | 0.0 | -1.2 |
| Aug | 0.1 | 0.0 | 0.1 |
| Jul | 0.3 | 0.1 | 0.2 |
| Jun | 0.1 | 0.0 | 0.1 |
| ∆% AE Jun-Aug | 2.0 | 0.4 | 1.6 |
| May | 0.0 | 0.0 | 0.0 |
| Apr | -0.1 | 0.1 | 0.0 |
| ∆% AE Apr-May | -0.6 | 0.6 | 0.0 |
| Mar | 0.3 | 0.3 | 0.3 |
| Feb | 0.5 | 0.2 | 0.5 |
| Jan | 0.4 | 0.3 | 0.4 |
| ∆% AE Jan-Mar | 4.9 | 3.2 | 4.9 |
| Dec 2012 | -0.2 | -0.2 | -0.2 |
| Nov | -0.2 | 0.0 | 0.0 |
| ∆% AE Nov-Dec | -2.4 | -1.2 | -1.2 |
| Oct | 0.1 | 0.0 | 0.1 |
| Sep | 0.3 | 0.1 | 0.3 |
| Aug | 0.4 | 0.0 | 0.4 |
| Jul | 0.2 | 0.1 | 0.2 |
| ∆% AE Jul-Oct | 3.0 | 0.6 | 3.0 |
| Jun | -0.4 | -0.1 | -0.4 |
| May | -0.2 | 0.0 | -0.1 |
| ∆% AE May-Jun | -3.5 | -0.6 | -3.0 |
| Apr | 0.4 | 0.2 | 0.1 |
| Mar | 0.5 | 0.1 | 0.5 |
| Feb | 0.4 | 0.3 | 0.4 |
| ∆% AE Feb-Apr | 5.3 | 2.4 | 4.1 |
| Jan | 0.2 | -0.1 | 0.2 |
| Dec 2011 | -0.1 | 0.1 | 0.0 |
| Nov | 0.2 | -0.1 | 0.1 |
| ∆% AE Nov-Jan | 1.2 | 0.4 | 1.2 |
| Oct | 0.0 | -0.1 | -0.1 |
| Sep | 0.2 | 0.1 | 0.3 |
| Aug | 0.0 | 0.3 | 0.0 |
| Jul | 0.3 | 0.3 | 0.3 |
| Jun | 0.2 | 0.2 | 0.3 |
| May | 0.1 | 0.1 | 0.1 |
| ∆% AE May-Oct | 1.6 | 1.8 | 1.8 |
| Apr | 1.0 | 0.8 | 0.9 |
| Mar | 1.0 | 0.4 | 0.9 |
| Feb | 0.5 | 0.2 | 0.5 |
| Jan | 0.7 | 0.3 | 0.7 |
| Jan-Apr | 10.0 | 5.2 | 9.4 |
| Dec 2010 | 0.5 | 0.1 | 0.4 |
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/february-2014/index.html
Input prices in the UK have been more dynamic than output prices until the current event of risk aversion, as shown by Table IV-11, but with sharp oscillations because of the commodity and raw material content. The UK Office for National Statistics introduced rebasing for 2010=100 of the producer price index with important revisions (http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/producer-price-index-rebasing--2010-100-/index.html). The 12-month rates of increase of input prices, even excluding food, tobacco, beverages and petroleum, are very high, reaching 16.9 percent in Sep 2011 for materials and fuels purchased and 10.6 percent excluding food, beverages and petroleum. Inflation in 12 months of materials and fuels purchased moderated to 5.7 percent in Mar 2012 and 3.2 percent excluding food, tobacco, beverages and petroleum with the rates falling further in Apr 2012 to 1.5 percent for materials and fuels purchased and 1.1 percent excluding food, tobacco, beverages and petroleum. Input-price inflation collapsed in the 12 months ending in Jul 2012 to minus 2.5 percent for materials and fuels purchased and minus 2.5 percent excluding food, beverages and tobacco. Inflation returned at 0.7 percent in the 12 months ending in Aug 2012 but minus 2.6 percent excluding food, tobacco, beverages and petroleum. Inflation of input prices in Sep 2012 was minus 1.2 percent and minus 3.1 percent excluding food, beverages and petroleum. In Nov 2012, inflation of input prices of all manufacturing and materials purchased was minus 0.2 percent in 12 months and minus 1.6 percent in 12 months excluding food, tobacco, beverages and petroleum. Inflation of materials and fuels purchased in 12 months was 0.4 percent in Dec 2012 and minus 1.2 percent excluding tobacco, beverages and petroleum. Inflation of inputs returned with 1.6 percent in the 12 months ending in Jan 2013 and minus 0.2 percent excluding various items, increasing to 2.0 percent in Feb 2013 and 1.0 percent excluding various items. In Mar 2013, inflation of all manufacturing materials and fuels increased 0.9 percent in 12 months and 1.6 percent excluding various items. Prices of all manufacturing materials and fuels increased 0.3 percent in the 12 months ending in Apr 2013 and increased 0.9 percent excluding food and other items. Prices of all manufacturing increased 1.4 percent in the 12 months ending in May 2013 and 0.4 percent excluding various items. In Jul 2013, prices of manufactured products increased 4.7 percent in 12 months and 2.1 percent excluding food, tobacco, beverages and petroleum. In Aug 2013, prices of manufactured products increased 1.8 percent in 12 months and 1.4 percent excluding items. Inflation of input prices in the 12 months ending in Sep 2013 was 1.0 percent and 0.4 percent excluding items. Inflation collapsed in Oct 2013, with 0.0 percent for all manufacturing materials and fuels and minus 0.2 percent excluding various items. In Nov 2013, inflation of all manufacturing materials and fuels purchased fell 0.9 percent in 12 months and excluding items 1.0 percent. In Dec 2013, input prices for all manufacturing fell 0.9 percent in 12 months and fell 1.4 percent with exclusions. Inflation of all manufacturing fell 2.9 percent in the 12 months ending in Jan 2014 and 2.8 percent with exclusions. Inflation of input prices fell 5.7 percent in the 12 months ending in Feb 2014 and 5.3 percent with exclusions. There is comparable experience with 22.1 percent inflation of materials and fuels purchased in 2008 and 16.9 percent excluding food, beverages and petroleum followed in 2009 by decline of 5.7 percent for materials and fuels purchased and decrease of 1.3 percent for the index excluding items. UK input and output inflation is sensitive to commodity price increases driven by carry trades from zero interest rates. The mirage of false deflation is also observed in input prices in 1997-9 and then again from 2001 to 2003.
Table IV-11, UK, Input Prices 12-Month ∆% NSA
| All Manufacturing Materials and Fuels Purchased | Excluding Food, Tobacco, Beverages and Petroleum | |
| Feb 2014 | -5.7 | -5.3 |
| Jan | -2.9 | -2.8 |
| Dec 2013 | -0.9 | -1.4 |
| Nov | -0.9 | -1.0 |
| Oct | 0.0 | -0.2 |
| Sep | 1.0 | 0.4 |
| Aug | 1.8 | 1.4 |
| Jul | 4.7 | 2.1 |
| Jun | 3.0 | 0.0 |
| May | 1.4 | 0.4 |
| Apr | 0.3 | 0.9 |
| Mar | 0.9 | 1.6 |
| Feb | 2.0 | 1.0 |
| Jan | 1.6 | -0.2 |
| Dec 2012 | 0.4 | -1.2 |
| Nov | -0.2 | -1.6 |
| Oct | -0.2 | -2.1 |
| Sep | -1.2 | -3.1 |
| Aug | 0.7 | -2.6 |
| Jul | -2.5 | -2.5 |
| Jun | -1.7 | -1.0 |
| May | 0.3 | -0.5 |
| Apr | 1.5 | 1.1 |
| Mar | 5.7 | 3.2 |
| Feb | 7.5 | 4.4 |
| Jan | 6.4 | 3.9 |
| Dec 2011 | 8.6 | 5.0 |
| Nov | 12.8 | 7.6 |
| Oct | 13.4 | 8.1 |
| Sep | 16.9 | 10.6 |
| Aug | 15.6 | 10.9 |
| Jul | 17.6 | 10.7 |
| Jun | 16.4 | 10.3 |
| May | 15.3 | 9.3 |
| Apr | 16.9 | 10.2 |
| Mar | 13.5 | 7.8 |
| Feb | 13.9 | 9.2 |
| Jan | 13.2 | 9.6 |
| Dec 2010 | 12.1 | 8.9 |
| Year ∆% | ||
| 2013 | 1.2 | 0.4 |
| 2012 | 1.3 | -0.2 |
| 2011 | 14.5 | 9.1 |
| 2010 | 8.0 | 4.7 |
| 2009 | -5.7 | -1.3 |
| 2008 | 22.1 | 16.9 |
| 2007 | 2.9 | 2.5 |
| 2006 | 9.8 | 7.2 |
| 2005 | 10.9 | 6.9 |
| 2004 | 3.4 | 1.7 |
| 2003 | 1.1 | -0.7 |
| 2002 | -4.5 | -4.9 |
| 2001 | -1.1 | -1.2 |
| 2000 | 7.3 | 3.8 |
| 1999 | -1.3 | -3.6 |
| 1998 | -8.9 | -4.6 |
| 1997 | -8.3 | -6.4 |
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/february-2014/index.html
Table IV-12 provides monthly percentage changes of UK input prices for materials and fuels purchased and excluding food, tobacco, beverages and petroleum. There are strong waves of inflation of input prices in the UK similar to those worldwide (http://cmpassocregulationblog.blogspot.com/2014/03/interest-rate-risks-world-inflation.html). In the first wave, input prices rose at the high annual equivalent rate of 30.6 percent in Jan-Apr 2011, driven by carry trades from unconventional monetary policy into commodity exposures. Inflation of input prices was at 31.8 percent annual equivalent in Oct-Dec 2010. In the second wave, alternating risk aversion caused annual equivalent inflation of minus 1.3 percent in May-Oct 2011. In the third wave, renewed risk aversion resulted in annual equivalent inflation of 0.0 percent in Nov-Dec 2011. In the fourth wave, annual equivalent inflation of input prices in the UK surged at 14.9 percent in Jan-Mar 2012 under relaxed risk aversion. In the fifth wave, annual equivalent inflation was minus 16.1 percent in Apr-Jul 2012 because of collapse of commodity prices during increasing risk aversion. In the sixth wave, annual equivalent inflation of materials and fuels purchased jumped to 23.9 percent in Aug 2012. In the seventh wave, annual equivalent inflation moderated to 3.0 percent in Sep-Dec 2012. In the eighth wave, annual equivalent inflation in Jan-Feb 2013 jumped to 24.6 percent. In the eighth wave, annual equivalent inflation of materials and fuels purchased was minus 9.5 percent in Mar-Jun 2013. In the ninth wave, annual equivalent inflation returned at 18.2 percent in annual equivalent in Jul 2013. In the tenth wave, annual equivalent inflation was minus 8.4 percent in Aug-Nov 2013. In the eleventh wave, annual equivalent inflation of manufacturing materials and fuels was 3.7 percent in Dec 2013. In the twelfth wave, annual equivalent inflation was minus 7.5 percent in Jan-Feb 2014.
Table IV-12, UK Input Prices Month ∆%
| All Manufacturing Materials and Fuels Purchased NSA | Excluding Food, Tobacco, Beverages and Petroleum SA | |
| Feb 2014 | -0.4 | -1.1 |
| Jan | -0.9 | -0.7 |
| ∆% Jan-Feb | -7.5 | -10.3 |
| Dec 2013 | 0.3 | -0.4 |
| ∆% Dec | 3.7 | -4.7 |
| Nov | -0.6 | -0.5 |
| Oct | -0.4 | -0.3 |
| Sep | -0.9 | -0.8 |
| Aug | -1.0 | -0.5 |
| ∆% Aug-Nov | -8.4 | -6.1 |
| Jul | 1.4 | 1.1 |
| ∆% Jul | 18.2 | 14.0 |
| Jun | -0.3 | -0.3 |
| May | -1.3 | -0.9 |
| Apr | -1.9 | -0.9 |
| Mar | 0.2 | 0.1 |
| ∆% Mar-Jun | -9.5 | -5.8 |
| Feb | 2.5 | 1.5 |
| Jan | 1.2 | 0.6 |
| ∆% Jan-Feb | 24.6 | 13.3 |
| Dec 2012 | 0.3 | 0.0 |
| Nov | 0.3 | 0.3 |
| Oct | 0.5 | 0.4 |
| Sep | -0.1 | 0.2 |
| ∆% Sep-Dec | 3.0 | 2.7 |
| Aug | 1.8 | 0.0 |
| ∆% Aug | 23.9 | 0.0 |
| Jul | -0.3 | -0.7 |
| Jun | -1.8 | 0.2 |
| May | -2.4 | -0.6 |
| Apr | -1.3 | -0.1 |
| ∆% Apr-Jul | -16.1 | -3.5 |
| Mar | 1.3 | -0.5 |
| Feb | 2.2 | 0.4 |
| Jan | 0.0 | -0.4 |
| ∆% AE Jan-Mar | 14.9 | -2.0 |
| Dec 2011 | -0.3 | -0.7 |
| Nov | 0.3 | -0.1 |
| ∆% AE Nov-Dec | 0.0 | -4.7 |
| Oct | -0.5 | -0.6 |
| Sep | 1.8 | 0.5 |
| Aug | -1.5 | 0.3 |
| Jul | 0.5 | 0.7 |
| Jun | 0.2 | 0.8 |
| May | -1.1 | 0.6 |
| ∆% AE May-Oct | -1.3 | 4.7 |
| Apr | 2.8 | 2.1 |
| Mar | 3.0 | 0.6 |
| Feb | 1.1 | 0.1 |
| Jan | 2.1 | 0.7 |
| ∆% AE Jan-Apr | 30.6 | 11.0 |
| Dec 2010 | 3.5 | 1.7 |
| Nov | 0.9 | 0.4 |
| Oct | 2.5 | 1.7 |
| ∆% AE Oct-Dec | 31.8 | 16.3 |
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/february-2014/index.html
The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12-month rates of inflation of manufactured products, shown in Table IV-13. There are high contributions to 12-month percentage changes of 0.29 percentage points by food products, 0.20 percentage points by tobacco and alcohol, 0.23 percentage points by computer, electrical and optical and 0.25 percentage points by other manufactured products. There are diversified sources of contributions to 12 months output price inflation such as 0.29 percentage points by clothing, textile and leather and 0.06 percentage points by transport equipment. Petroleum deducted 0.80 percentage points. In general, contributions by products rich in commodities are the drivers of price changes. There were diversified contributions in percentage points to monthly inflation: 0.03 percentage points deducted by petroleum and 0.01 percentage points deducted by chemicals and pharmaceuticals.
Table IV-13, UK, Contributions to Month and 12-Month Change in Prices of All Manufactured Products, Percentage Points, NSA
| Feb 2014 | 12 Months | 12 Months ∆% | Month % Points | Month ∆% |
| Total % | 0.5 | 0.0 | ||
| Food Products | 0.29 | 1.6 | -0.01 | -0.1 |
| Tobacco & Alcohol | 0.20 | 1.9 | 0.02 | 0.3 |
| Clothing, Textile & Leather | 0.29 | 2.3 | 0.01 | 0.2 |
| Paper and Printing | 0.06 | 1.2 | 0.01 | 0.1 |
| Petroleum | -0.80 | -7.3 | -0.03 | -0.4 |
| Chemicals & Pharmaceutical | -0.17 | -1.9 | -0.01 | -0.1 |
| Metal, Machinery & Equipment | 0.06 | 0.8 | 0.00 | 0.1 |
| Computer, Electrical & Optical | 0.23 | 1.6 | -0.01 | -0.1 |
| Transport Equipment | 0.06 | 0.4 | 0.02 | 0.1 |
| Other Manufactured Products | 0.25 | 1.4 | 0.05 | 0.3 |
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/february-2014/index.html
The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12-month rates of inflation of input prices in Feb 2014, shown in Table IV-14. Crude oil is a large factor with deduction of 2.66 percentage points to the 12-month rate and deduction of 0.01 percentage points to the monthly rate in Feb 2014. Price changes also transfer to the domestic economy through the prices of imported inputs: imported metals deducted 1.11 percentage points from the 12-month rate and added 0.00 percentage points to the Feb rate. Domestic food materials deducted 0.61 percentage points from the 12-month rate and contributed 0.03 percentage points to the Feb rate. Exposures and reversals of commodity exposures in carry trades during risk aversion are a major source of price and financial instability.
Table IV-14, UK, Contributions to Month and 12-Month Change in Prices of Inputs, Percentage Points NSA
| Feb 2014 | 12 Months | 12 Months ∆% | Month % Points | Month ∆% |
| Total | -5.7 | -0.4 | ||
| Fuel | 0.21 | 2.0 | -0.27 | -3.0 |
| Crude Oil | -2.66 | -11.1 | -0.01 | -0.1 |
| Domestic Food Materials | -0.61 | -4.6 | 0.03 | 0.2 |
| Imported Food Materials | 0.19 | 3.0 | -0.10 | -1.9 |
| Other Domestic Produced Materials | 0.13 | 5.2 | 0.02 | 1.1 |
| Imported Metals | -1.11 | -15.4 | 0.00 | 0.0 |
| Imported Chemicals | -0.46 | -3.6 | 0.01 | 0.1 |
| Imported Parts and Equipment | -1.02 | -6.6 | -0.05 | -0.4 |
| Other Imported Materials | -0.36 | -4.7 | -0.04 | -0.5 |
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/february-2014/index.html
Consumer price inflation in the UK is shown in Table IV-18. The CPI index increased 0.5 percent in Feb 2014 and increased 1.7 percent in 12 months. The same inflation waves (http://cmpassocregulationblog.blogspot.com/2014/03/interest-rate-risks-world-inflation.html) are present in UK CPI inflation. In the first wave in Jan-Apr 2011, annual equivalent inflation was at a high 6.5 percent. In the second wave in May-Jul 2011, annual equivalent inflation fell to only 0.4 percent. In the third wave in Aug-Nov 2011, annual equivalent inflation returned at 4.6 percent. In the fourth wave in Dec 2011 to Jan 2012, annual equivalent inflation was minus 0.6 percent because of decline of 0.5 percent in Jan 2012. In the fifth wave, annual equivalent inflation increased to 6.2 percent in Feb-Apr 2012. In the seventh wave, annual equivalent inflation was minus 3.0 percent in May-Jun 2012. In the eighth wave, annual equivalent inflation in Jul-Dec 2012 was 4.5 percent and 6.2 percent in Oct 2012 with the rate in Oct caused mostly by increases in university tuition payments. In the ninth wave, annual equivalent inflation was minus 5.8 percent in Jan 2013. In the tenth wave, annual equivalent inflation jumped to 4.3 percent in Feb-May 2013. In the eleventh wave, annual equivalent inflation was minus 1.2 percent in Jun-Jul 2013. In the twelfth wave, annual equivalent inflation was 3.4 percent in Aug-Dec 2013. In the thirteenth wave, annual equivalent inflation was minus 7.0 percent in Jan 2014. In the fourteenth wave, annual equivalent inflation returned at 6.2 percent in Feb 2014.
Table IV-15, UK, Consumer Price Index All Items, Month and 12-Month ∆%
| Month ∆% | 12 Months ∆% | |
| Feb 2014 | 0.5 | 1.7 |
| AE ∆% Feb | 6.2 | |
| Jan | -0.6 | 1.9 |
| AE ∆% Jan | -7.0 | |
| Dec 2013 | 0.4 | 2.0 |
| Nov | 0.1 | 2.1 |
| Oct | 0.1 | 2.2 |
| Sep | 0.4 | 2.7 |
| Aug | 0.4 | 2.7 |
| AE ∆% Aug-Dec | 3.4 | |
| Jul | 0.0 | 2.8 |
| Jun | -0.2 | 2.9 |
| AE ∆% Jun-Jul | -1.2 | |
| May | 0.2 | 2.7 |
| Apr | 0.2 | 2.4 |
| Mar | 0.3 | 2.8 |
| Feb | 0.7 | 2.8 |
| AE ∆% Feb-May | 4.3 | |
| Jan 2013 | -0.5 | 2.7 |
| AE ∆% Jan | -5.8 | |
| Dec 2012 | 0.5 | 2.7 |
| Nov | 0.2 | 2.7 |
| Oct | 0.5 | 2.7 |
| Sep | 0.4 | 2.2 |
| Aug | 0.5 | 2.5 |
| Jul | 0.1 | 2.6 |
| AE ∆% Jul-Dec | 4.5 | |
| Jun | -0.4 | 2.4 |
| May | -0.1 | 2.8 |
| AE ∆% May-Jun | -3.0 | |
| Apr | 0.6 | 3.0 |
| Mar | 0.3 | 3.5 |
| Feb | 0.6 | 3.4 |
| AE ∆% Feb-Apr | 6.2 | |
| Jan | -0.5 | 3.6 |
| Dec 2011 | 0.4 | 4.2 |
| AE ∆% Dec-Jan | -0.6 | |
| Nov | 0.2 | 4.8 |
| Oct | 0.1 | 5.0 |
| Sep | 0.6 | 5.2 |
| Aug | 0.6 | 4.5 |
| AE ∆% Aug-Nov | 4.6 | |
| Jul | 0.0 | 4.4 |
| Jun | -0.1 | 4.2 |
| May | 0.2 | 4.5 |
| May-Jul | 0.4 | |
| Apr | 1.0 | 4.5 |
| Mar | 0.3 | 4.0 |
| Feb | 0.7 | 4.4 |
| Jan | 0.1 | 4.0 |
| AE ∆% Jan-Apr | 6.5 | |
| Dec 2010 | 1.0 | 3.7 |
| Nov | 0.4 | 3.3 |
| Oct | 0.3 | 3.2 |
| Sep | 0.0 | 3.1 |
| Aug | 0.5 | 3.1 |
| Jul | -0.2 | 3.1 |
| Jun | 0.1 | 3.2 |
| May | 0.2 | 3.4 |
| Apr | 0.6 | 3.7 |
| Mar | 0.6 | 3.4 |
| Feb | 0.4 | 3.0 |
| Jan | -0.2 | 3.5 |
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2014/index.html
Inflation has been unusually high in the UK since 2006, as shown in Table IV-16. There were no rates of inflation close to 2.0 percent in the period from 1997 to 2004. Inflation has exceeded 2 percent since 2005, reaching 3.6 percent in 2008, 3.3 percent in 2010, 4.5 percent in 2011 and 2.8 percent in 2012. Annual inflation in 2013 was 2.6 percent.
Table IV-16, UK, Consumer Price Index, Annual ∆%
| Annual | |
| Change ∆% | |
| 2005=100 | |
| 1998 | 1.6 |
| 1999 | 1.3 |
| 2000 | 0.8 |
| 2001 | 1.2 |
| 2002 | 1.3 |
| 2003 | 1.4 |
| 2004 | 1.3 |
| 2005 | 2.1 |
| 2006 | 2.3 |
| 2007 | 2.3 |
| 2008 | 3.6 |
| 2009 | 2.2 |
| 2010 | 3.3 |
| 2011 | 4.5 |
| 2012 | 2.8 |
| 2013 | 2.6 |
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2014/index.html
Table IV-17 provides the analysis of inflation in Feb 2013 by the UK Office for National Statistics. In the rate of 0.5 percent for Feb 2014, clothing and footwear added 0.06 percentage points, furniture and household goods added 0.15 percentage points and transport added 0.04 percentage points. Contributions of percentage points to the 12-month rate of consumer price inflation of 1.7 percent are in the second column in Table IV-20. Food and nonalcoholic beverages added 0.19 percentage points, alcohol and tobacco added 0.19 percentage points, housing and household services added 0.44 percentage points and transport deducted 0.06 percentage points. Housing and household services added 0.44 percentage points.
Table IV-17, UK, Consumer Price Index Month and Twelve-month Percentage Point Contributions to Change by Components
| Feb 2014 | Percentage Point Contribution 12 M Feb | Percentage Point Contribution Feb |
| CPI All Items ∆% | 1.7 | 0.5 |
| Food & Non-Alcoholic Beverages | 0.19 | 0.06 |
| Alcohol & Tobacco | 0.19 | -0.04 |
| Clothing & Footwear | 0.05 | 0.08 |
| Housing & Household Services | 0.44 | 0.01 |
| Furniture & Household Goods | 0.10 | 0.15 |
| Health | 0.08 | 0.01 |
| Transport | -0.06 | 0.04 |
| Communication | 0.06 | 0.01 |
| Recreation & Culture | 0.11 | 0.12 |
| Education | 0.21 | 0.00 |
| Restaurants & Hotels | 0.27 | 0.05 |
| Miscellaneous Goods & Services | 0.08 | 0.02 |
| Rounding Effects | -0.02 | -0.01 |
Note: there are rounding effects in contributions
Source: UK Office for National Statistics
http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2014/index.html
© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014.
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