CMP Associates Regulation Blog: Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities, United States Industrial Production, United States Commercial Banks Assets and Liabilities, Collapse of United States Dynamism of Income Growth and Employment Creation, World Cyclical Slow Growth and Global Recession Risk: Part I

Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities, United States Industrial Production, United States Commercial Banks Assets and Liabilities, Collapse of United States Dynamism of Income Growth and Employment Creation, World Cyclical Slow Growth and Global Recession Risk

Carlos M. Pelaez

I United States Commercial Banks Assets and Liabilities

II United States Industrial Production

IIA Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities

II IB Collapse of United States Dynamism of Income Growth and Employment Creation

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

Executive Summary

Contents of Executive Summary

ESI Financial “Irrational Exuberance,” Increasing Interest Rate and Exchange Rate Risk, Duration Dumping, Competitive Devaluations, Steepening Yield Curve and Global Financial and Economic Risk

ESII Valuations of Risk Financial Assets

ESIII Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities

ESIV United States Industrial Production

ESV United States Commercial Banks Assets and Liabilities

ESVI Collapse of United States Dynamism of Income Growth and Employment Creation

ESVII Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates

ESI “Financial “Irrational Exuberance,” Increasing Interest Rate and Exchange Rate Risk, Duration Dumping, Competitive Devaluations, Steepening Yield Curve and Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task for both theory and measurement. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task for both theory and measurement. The IMF provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/ns/cs.aspx?id=29), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/gfsr/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/ns/cs.aspx?id=262). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider a summary of global economic and financial risks, which are analyzed in detail in the comments of this blog in Section VI Valuation of Risk Financial Assets, Table VI-4.

Economic risks include the following:

China’s Economic Growth. The National People’s Congress of China in Mar 2016 is reducing the GDP growth target to the range of 6.5 percent to 7.0 percent in guiding stable market expectations (http://news.xinhuanet.com/english/photo/2016-03/05/c_135157171.htm). President Xi Jinping announced on Nov 3, 2015 that “For China to double 2010 GDP and the per capita income of both urban and rural residents by 2010, annual growth for the 2016-2020 period must be at least 6.5 percent,” as quoted by Xinhuanet (http://news.xinhuanet.com/english/2015-11/03/c_134780377.htm). China lowered the growth target to approximately 7.0 percent in 2015, as analyzed by Xiang Bo, writing on “China lowers 2015 economic growth target to around 7 percent,” published on Xinhuanet on Mar 5, 2015 (http://news.xinhuanet.com/english/2015-03/05/c_134039341.htm). China had lowered its growth target to 7.5 percent per year. Lu Hui, writing on “China lowers GDP target to achieve quality economic growth, on Mar 12, 2012, published in Beijing by Xinhuanet (http://news.xinhuanet.com/english/china/2012-03/12/c_131461668.htm), informs that Premier Jiabao wrote in a government work report that the GDP growth target will be lowered to 7.5 percent to enhance the quality and level of development of China over the long term. The Third Plenary Session of the 18^th Central Committee of the Communist Party of China adopted unanimously on Nov 15, 2013, a new round of reforms with 300 measures (Xinhuanet, “China details reform decision-making process,” Nov 19, 2013 http://news.xinhuanet.com/english/china/2013-11/19/c_125722517.htm). Growth rates of GDP of China in a quarter relative to the same quarter a year earlier have been declining from 2011 to 2016. China’s GDP grew 1.8 percent in IQ2012, annualizing to 7.4 percent, and 8.1 percent relative to a year earlier. The GDP of China grew at 2.2 percent in IIQ2012, which annualizes to 9.1 percent, and 7.6 percent relative to a year earlier. China grew at 1.8 percent in IIIQ2012, which annualizes at 7.4 percent, and 7.5 percent relative to a year earlier. In IVQ2012, China grew at 1.9 percent, which annualizes at 7.8 percent, and 8.1 percent in IVQ2012 relative to IVQ2011. In IQ2013, China grew at 1.9 percent, which annualizes at 7.8 percent, and 7.9 percent relative to a year earlier. In IIQ2013, China grew at 1.7 percent, which annualizes at 7.0 percent, and 7.6 percent relative to a year earlier. China grew at 2.1 percent in IIIQ2013, which annualizes at 8.7 percent, and increased 7.9 percent relative to a year earlier. China grew at 1.6 percent in IVQ2013, which annualized to 7.0 percent, and 7.7 percent relative to a year earlier. China’s GDP grew 1.7 percent in IQ2014, which annualizes to 7.0 percent, and 7.4 percent relative to a year earlier. China’s GDP grew 1.8 percent in IIQ2014, which annualizes at 7.4 percent, and 7.5 percent relative to a year earlier. China’s GDP grew 1.9 percent in IIIQ2014, which is equivalent to 7.8 percent in a year, and 7.1 percent relative to a year earlier. The GDP of China grew 1.7 percent in IVQ2014, which annualizes at 7.0 percent, and 7.2 percent relative to a year earlier. The GDP of China grew at 1.6 percent in IQ2015, which annualizes at 6.6 percent, and 7.0 percent relative to a year earlier. The GDP of China grew 1.8 percent in IIQ2015, which annualizes at 7.4 percent, and increased 7.0 percent relative to a year earlier. In IIIQ2015, China’s GDP grew at 1.8 percent, which annualizes at 7.4 percent, and increased 6.9 percent relative to a year earlier. The GDP of China grew at 1.5 percent in IVQ2015, which annualizes at 6.1 percent, and increased 6.8 percent relative to a year earlier. The GDP of China grew 1.2 percent in IQ2016, which annualizes at 4.9 percent, and increased 6.7 percent relative to a year earlier. In IIQ2016, the GDP of China increased 1.8 percent, which annualizes to 7.4 percent, and increased 6.7 percent relative to a year earlier. There is decennial change in leadership in China (http://www.xinhuanet.com/english/special/18cpcnc/index.htm). (Section VC and earlier http://cmpassocregulationblog.blogspot.com/2016/04/imf-view-of-world-economy-and-finance.html and earlier http://cmpassocregulationblog.blogspot.com/2016/01/uncertainty-of-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2015/07/valuation-of-risk-financial-assets.html and earlier (http://cmpassocregulationblog.blogspot.com/2016/04/imf-view-of-world-economy-and-finance.html and earlier (http://cmpassocregulationblog.blogspot.com/2015/04/imf-view-of-economy-and-finance-united.html and earlier http://cmpassocregulationblog.blogspot.com/2015/01/competitive-currency-conflicts-world.html and earlier http://cmpassocregulationblog.blogspot.com/2014/10/financial-oscillations-world-inflation.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html and earlier http://cmpassocregulationblog.blogspot.com/2014/04/imf-view-world-inflation-waves-squeeze.html and earlier http://cmpassocregulationblog.blogspot.com/2014/01/capital-flows-exchange-rates-and.html). There is also ongoing political development in China during a decennial political reorganization with new leadership (http://www.xinhuanet.com/english/special/18cpcnc/index.htm). Xinhuanet informs that Premier Wen Jiabao considers the need for macroeconomic stimulus, arguing that “we should continue to implement proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). Premier Wen elaborates that “the country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). Bob Davis, writing on “At China’s NPC, Proposed Changes,” on Mar 5, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304732804579420743344553328?KEYWORDS=%22china%22&mg=reno64-wsj), analyzes the wide ranging policy changes in the annual work report by Prime Minister Li Keqiang to China’s NPC (National People’s Congress of the People’s Republic of China http://www.npc.gov.cn/englishnpc/news/). There are about sixty different fiscal and regulatory measures.
United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 24.0 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically low hiring and declining/stagnating real wages. Actual GDP is about two trillion dollars lower than trend GDP.
Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
World Inflation Waves. Inflation continues in repetitive waves globally (http://cmpassocregulationblog.blogspot.com/2016/07/oscillating-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/06/fomc-projections-world-inflation-waves.html). There is growing concern on capital outflows and currency depreciation of emerging markets.

A list of financial uncertainties includes:

Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk. There are complex economic, financial and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times).
Competitive Devaluations. Exchange rate struggles continue as zero interest rates and negative interest rates in advanced economies induce devaluation of their currencies with alternating episodes of revaluation.
Valuation and Volatility of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with oscillating volumes. The President of the European Central Bank (ECB), Mario Draghi, warned on Jun 3, 2015 that (http://www.ecb.europa.eu/press/pressconf/2015/html/is150603.en.html):

“But certainly one lesson is that we should get used to periods of higher volatility. At very low levels of interest rates, asset prices tend to show higher volatility…the Governing Council was unanimous in its assessment that we should look through these developments and maintain a steady monetary policy stance.”

Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20)
Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion mixed with reallocations of portfolios of risk financial assets

There are collateral effects of unconventional monetary policy. Chart VIII-1 of the Board of Governors of the Federal Reserve System provides the rate on the overnight fed funds rate and the yields of the 10-year constant maturity Treasury and the Baa seasoned corporate bond. Table VIII-3 provides the data for selected points in Chart VIII-1. There are two important economic and financial events, illustrating the ease of inducing carry trade with extremely low interest rates and the resulting financial crash and recession of abandoning extremely low interest rates.

The Federal Open Market Committee (FOMC) lowered the target of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85). Central bank commitment to maintain the fed funds rate at 1.00 percent induced adjustable-rate mortgages (ARMS) linked to the fed funds rate. Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment. The exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at interest rates close to zero, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV). The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper with the objective of purchasing default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever-increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity by the penalty in the form of low interest rates and unsound credit decisions. The put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The FOMC implemented increments of 25 basis points of the fed funds target from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006, as shown in Chart VIII-1. The gradual exit from the first round of unconventional monetary policy from 1.00 percent in Jun 2004 (http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) to 5.25 percent in Jun 2006 (http://www.federalreserve.gov/newsevents/press/monetary/20060629a.htm) caused the financial crisis and global recession.
On Dec 16, 2008, the policy determining committee of the Fed decided (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm): “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.” Policymakers emphasize frequently that there are tools to exit unconventional monetary policy at the right time. 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 that: “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.” Perception of withdrawal of $2671 billion, or $2.7 trillion, of bank reserves (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1), would cause Himalayan increase in interest rates that would provoke another recession. There is no painless gradual or sudden exit from zero interest rates because reversal of exposures created on the commitment of zero interest rates forever.

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 r^e the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+r^e). Thus, g = [(r/r^e) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dr^e>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 (Friedman 1957). 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 (1)

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.

Dan Strumpf and Pedro Nicolaci da Costa, writing on “Fed’s Yellen: Stock Valuations ‘Generally are Quite High,’” on May 6, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/feds-yellen-cites-progress-on-bank-regulation-1430918155?tesla=y ), quote Chair Yellen at open conversation with Christine Lagarde, Managing Director of the IMF, finding “equity-market valuations” as “quite high” with “potential dangers” in bond valuations. The DJIA fell 0.5 percent on May 6, 2015, after the comments and then increased 0.5 percent on May 7, 2015 and 1.5 percent on May 8, 2015.

Fri May 1

Mon 4

Tue 5

Wed 6

Thu 7

Fri 8

DJIA

18024.06

-0.3%

1.0%

18070.40

0.3%

17928.20

-0.5%

-0.8%

17841.98

-1.0%

-0.5%

17924.06

-0.6%

0.5%

18191.11

0.9%

1.5%

There are two approaches in theory considered by Bordo (2012Nov20) and Bordo and Lane (2013). The first approach is in the classical works of Milton Friedman and Anna Jacobson Schwartz (1963a, 1987) and Karl Brunner and Allan H. Meltzer (1973). There is a similar approach in Tobin (1969). Friedman and Schwartz (1963a, 66) trace the effects of expansionary monetary policy into increasing initially financial asset prices: “It seems plausible that both nonbank and bank holders of redundant balances will turn first to securities comparable to those they have sold, say, fixed-interest coupon, low-risk obligations. But as they seek to purchase these they will tend to bid up the prices of those issues. Hence they, and also other holders not involved in the initial central bank open-market transactions, will look farther afield: the banks, to their loans; the nonbank holders, to other categories of securities-higher risk fixed-coupon obligations, equities, real property, and so forth.”

The second approach is by the Austrian School arguing that increases in asset prices can become bubbles if monetary policy allows their financing with bank credit. Professor Michael D. Bordo provides clear thought and empirical evidence on the role of “expansionary monetary policy” in inflating asset prices (Bordo2012Nov20, Bordo and Lane 2013). Bordo and Lane (2013) provide revealing narrative of historical episodes of expansionary monetary policy. Bordo and Lane (2013) conclude that policies of depressing interest rates below the target rate or growth of money above the target influences higher asset prices, using a panel of 18 OECD countries from 1920 to 2011. Bordo (2012Nov20) concludes: “that expansionary money is a significant trigger” and “central banks should follow stable monetary policies…based on well understood and credible monetary rules.” Taylor (2007, 2009) explains the housing boom and financial crisis in terms of expansionary monetary policy. Professor Martin Feldstein (2016), at Harvard University, writing on “A Federal Reserve oblivious to its effects on financial markets,” on Jan 13, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/a-federal-reserve-oblivious-to-its-effect-on-financial-markets-1452729166), analyzes how unconventional monetary policy drove values of risk financial assets to high levels. Quantitative easing and zero interest rates distorted calculation of risks with resulting vulnerabilities in financial markets.

Another hurdle of exit from zero interest rates is “competitive easing” that Professor Raghuram Rajan, governor of the Reserve Bank of India, characterizes as disguised “competitive devaluation” (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). The fed has been considering increasing interest rates. The European Central Bank (ECB) announced, on Mar 5, 2015, the beginning on Mar 9, 2015 of its quantitative easing program denominated as Public Sector Purchase Program (PSPP), consisting of “combined monthly purchases of EUR 60 bn [billion] in public and private sector securities” (http://www.ecb.europa.eu/mopo/liq/html/pspp.en.html). Expectation of increasing interest rates in the US together with euro rates close to zero or negative cause revaluation of the dollar (or devaluation of the euro and of most currencies worldwide). US corporations suffer currency translation losses of their foreign transactions and investments (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318) while the US becomes less competitive in world trade (Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), Government Intervention in Globalization (2008c)). The DJIA fell 1.5 percent on Mar 6, 2015 and the dollar revalued 2.2 percent from Mar 5 to Mar 6, 2015. The euro has devalued 44.8 percent relative to the dollar from the high on Jul 15, 2008 to Jul 22, 2016.

Fri 27 Feb

Mon 3/2

Tue 3/3

Wed 3/4

Thu 3/5

Fri 3/6

USD/ EUR

1.1197

1.6%

0.0%

1.1185

0.1%

1.1176

0.2%

0.1%

1.1081

1.0%

0.9%

1.1030

1.5%

0.5%

1.0843

3.2%

1.7%

Chair Yellen explained the removal of the word “patience” from the advanced guidance at the press conference following the FOMC meeting on Mar 18, 2015 (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150318.pdf):

“In other words, just because we removed the word “patient” from the statement doesn’t mean we are going to be impatient. Moreover, even after the initial increase in the target funds rate, our policy is likely to remain highly accommodative to support continued progress toward our objectives of maximum employment and 2 percent inflation.”

Exchange rate volatility is increasing in response of “impatience” in financial markets with monetary policy guidance and measures:

Fri Mar 6

Mon 9

Tue 10

Wed 11

Thu 12

Fri 13

USD/ EUR

1.0843

3.2%

1.7%

1.0853

-0.1%

1.0700

1.3%

1.4%

1.0548

2.7%

1.4%

1.0637

1.9%

-0.8%

1.0497

3.2%

1.3%

Fri Mar 13

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.0497

3.2%

1.3%

1.0570

-0.7%

1.0598

-1.0%

-0.3%

1.0864

-3.5%

-2.5%

1.0661

-1.6%

1.9%

1.0821

-3.1%

-1.5%

Fri Apr 24

Mon 27

Tue 28

Wed 29

Thu 30

May Fri 1

USD/ EUR

1.0874

-0.6%

-0.4%

1.0891

-0.2%

1.0983

-1.0%

-0.8%

1.1130

-2.4%

-1.3%

1.1223

-3.2%

-0.8%

1.1199

-3.0%

0.2%

In a speech at Brown University on May 22, 2015, Chair Yellen stated (http://www.federalreserve.gov/newsevents/speech/yellen20150522a.htm):

“For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term. After we begin raising the federal funds rate, I anticipate that the pace of normalization is likely to be gradual. The various headwinds that are still restraining the economy, as I said, will likely take some time to fully abate, and the pace of that improvement is highly uncertain.”

The US dollar appreciated 3.8 percent relative to the euro in the week of May 22, 2015:

Fri May 15

Mon 18

Tue 19

Wed 20

Thu 21

Fri 22

USD/ EUR

1.1449

-2.2%

-0.3%

1.1317

1.2%

1.1150

2.6%

1.5%

1.1096

3.1%

0.5%

1.1113

2.9%

-0.2%

1.1015

3.8%

0.9%

The Managing Director of the International Monetary Fund (IMF), Christine Lagarde, warned on Jun 4, 2015, that: (http://blog-imfdirect.imf.org/2015/06/04/u-s-economy-returning-to-growth-but-pockets-of-vulnerability/):

“The Fed’s first rate increase in almost 9 years is being carefully prepared and telegraphed. Nevertheless, regardless of the timing, higher US policy rates could still result in significant market volatility with financial stability consequences that go well beyond US borders. I weighing these risks, we think there is a case for waiting to raise rates until there are more tangible signs of wage or price inflation than are currently evident. Even after the first rate increase, a gradual rise in the federal fund rates will likely be appropriate.”

The President of the European Central Bank (ECB), Mario Draghi, warned on Jun 3, 2015 that (http://www.ecb.europa.eu/press/pressconf/2015/html/is150603.en.html):

The Chair of the Board of Governors of the Federal Reserve System, Janet L. Yellen, stated on Jul 10, 2015 that (http://www.federalreserve.gov/newsevents/speech/yellen20150710a.htm):

“Based on my outlook, I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy. But I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step. I currently anticipate that the appropriate pace of normalization will be gradual, and that monetary policy will need to be highly supportive of economic activity for quite some time. The projections of most of my FOMC colleagues indicate that they have similar expectations for the likely path of the federal funds rate. But, again, both the course of the economy and inflation are uncertain. If progress toward our employment and inflation goals is more rapid than expected, it may be appropriate to remove monetary policy accommodation more quickly. However, if progress toward our goals is slower than anticipated, then the Committee may move more slowly in normalizing policy.”

There is essentially the same view in the Testimony of Chair Yellen in delivering the Semiannual Monetary Policy Report to the Congress on Jul 15, 2015 (http://www.federalreserve.gov/newsevents/testimony/yellen20150715a.htm).

At the press conference after the meeting of the FOMC on Sep 17, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150917.pdf 4):

“The outlook abroad appears to have become more uncertain of late, and heightened concerns about growth in China and other emerging market economies have led to notable volatility in financial markets. Developments since our July meeting, including the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads, have tightened overall financial conditions to some extent. These developments may restrain U.S. economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Given the significant economic and financial interconnections between the United States and the rest of the world, the situation abroad bears close watching.”

Some equity markets fell on Fri Sep 18, 2015:

Fri Sep 11

Mon 14

Tue 15

Wed 16

Thu 17

Fri 18

DJIA

16433.09

2.1%

0.6%

16370.96

-0.4%

16599.85

1.0%

1.4%

16739.95

1.9%

0.8%

16674.74

1.5%

-0.4%

16384.58

-0.3%

-1.7%

Nikkei 225

18264.22

2.7%

-0.2%

17965.70

-1.6%

18026.48

-1.3%

0.3%

18171.60

-0.5%

0.8%

18432.27

0.9%

1.4%

18070.21

-1.1%

-2.0%

DAX

10123.56

0.9%

-0.9%

10131.74

0.1%

10188.13

0.6%

10227.21

1.0%

0.4%

10229.58

1.0%

0.0%

9916.16

-2.0%

-3.1%

Frank H. Knight (1963, 233), in Risk, uncertainty and profit, distinguishes between measurable risk and unmeasurable uncertainty. Chair Yellen, in a lecture on “Inflation dynamics and monetary policy,” on Sep 24, 2015 (http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm), states that (emphasis added):

· “The economic outlook, of course, is highly uncertain”

· “Considerable uncertainties also surround the outlook for economic activity”

· “Given the highly uncertain nature of the outlook…”

Is there a “science” or even “art” of central banking under this extreme uncertainty in which policy does not generate higher volatility of money, income, prices and values of financial assets?

Lingling Wei, writing on Oct 23, 2015, on China’s central bank moves to spur economic growth,” published in the Wall Street Journal (http://www.wsj.com/articles/chinas-central-bank-cuts-rates-1445601495), analyzes the reduction by the People’s Bank of China (http://www.pbc.gov.cn/ http://www.pbc.gov.cn/english/130437/index.html) of borrowing and lending rates of banks by 50 basis points and reserve requirements of banks by 50 basis points. Paul Vigna, writing on Oct 23, 2015, on “Stocks rally out of correction territory on latest central bank boost,” published in the Wall Street Journal (http://blogs.wsj.com/moneybeat/2015/10/23/stocks-rally-out-of-correction-territory-on-latest-central-bank-boost/), analyzes the rally in financial markets following the statement on Oct 22, 2015, by the President of the European Central Bank (ECB) Mario Draghi of consideration of new quantitative measures in Dec 2015 (https://www.youtube.com/watch?v=0814riKW25k&rel=0) and the reduction of bank lending/deposit rates and reserve requirements of banks by the People’s Bank of China on Oct 23, 2015. The dollar revalued 2.8 percent from Oct 21 to Oct 23, 2015, following the intended easing of the European Central Bank. The DJIA rose 2.8 percent from Oct 21 to Oct 23 and the DAX index of German equities rose 5.4 percent from Oct 21 to Oct 23, 2015.

Fri Oct 16

Mon 19

Tue 20

Wed 21

Thu 22

Fri 23

USD/ EUR

1.1350

0.1%

0.3%

1.1327

0.2%

1.1348

0.0%

-0.2%

1.1340

0.1%

1.1110

2.1%

2.0%

1.1018

2.9%

0.8%

DJIA

17215.97

0.8%

0.4%

17230.54

0.1%

17217.11

0.0%

-0.1%

17168.61

-0.3%

17489.16

1.6%

1.9%

17646.70

2.5%

0.9%

Dow Global

2421.58

0.3%

0.6%

2414.33

-0.3%

2411.03

-0.4%

-0.1%

2411.27

-0.4%

0.0%

2434.79

0.5%

1.0%

2458.13

1.5%

1.0%

DJ Asia Pacific

1402.31

1.1%

0.3%

1398.80

-0.3%

1395.06

-0.5%

-0.3%

1402.68

0.0%

0.5%

1396.03

-0.4%

-0.5%

1415.50

0.9%

1.4%

Nikkei 225

18291.80

-0.8%

1.1%

18131.23

-0.9%

18207.15

-0.5%

0.4%

18554.28

1.4%

1.9%

18435.87

0.8%

-0.6%

18825.30

2.9%

2.1%

Shanghai

3391.35

6.5%

1.6%

3386.70

-0.1%

3425.33

1.0%

1.1%

3320.68

-2.1%

-3.1%

3368.74

-0.7%

1.4%

3412.43

0.6%

1.3%

DAX

10104.43

0.1%

0.4%

10164.31

0.6%

10147.68

0.4%

-0.2%

10238.10

1.3%

0.9%

10491.97

3.8%

2.5%

10794.54

6.8%

2.9%

Ben Leubsdorf, writing on “Fed’s Yellen: December is “Live Possibility” for First Rate Increase,” on Nov 4, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/feds-yellen-december-is-live-possibility-for-first-rate-increase-1446654282) quotes Chair Yellen that a rate increase in “December would be a live possibility.” The remark of Chair Yellen was during a hearing on supervision and regulation before the Committee on Financial Services, US House of Representatives (http://www.federalreserve.gov/newsevents/testimony/yellen20151104a.htm) and a day before the release of the employment situation report for Oct 2015 (Section I). The dollar revalued 2.4 percent during the week. The euro has devalued 44.8 percent relative to the dollar from the high on Jul 15, 2008 to Jul 22, 2016.

Fri Oct 30

Mon 2

Tue 3

Wed 4

Thu 5

Fri 6

USD/ EUR

1.1007

0.1%

-0.3%

1.1016

-0.1%

1.0965

0.4%

0.5%

1.0867

1.3%

0.9%

1.0884

1.1%

-0.2%

1.0742

2.4%

1.3%

The release on Nov 18, 2015 of the minutes of the FOMC (Federal Open Market Committee) meeting held on Oct 28, 2015 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20151028.htm) states:

“Most participants anticipated that, based on their assessment of the current economic situation and their outlook for economic activity, the labor market, and inflation, these conditions [for interest rate increase] could well be met by the time of the next meeting. Nonetheless, they emphasized that the actual decision would depend on the implications for the medium-term economic outlook of the data received over the upcoming intermeeting period… It was noted that beginning the normalization process relatively soon would make it more likely that the policy trajectory after liftoff could be shallow.”

Markets could have interpreted a symbolic increase in the fed funds rate at the meeting of the FOMC on Dec 15-16, 2015 (http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm) followed by “shallow” increases, explaining the sharp increase in stock market values and appreciation of the dollar after the release of the minutes on Nov 18, 2015:

Fri Nov 13

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.0774

-0.3%

0.4%

1.0686

0.8%

1.0644

1.2%

0.4%

1.0660

1.1%

-0.2%

1.0735

0.4%

-0.7%

1.0647

1.2%

0.8%

DJIA

17245.24

-3.7%

-1.2%

17483.01

1.4%

17489.50

1.4%

0.0%

17737.16

2.9%

1.4%

17732.75

2.8%

0.0%

17823.81

3.4%

0.5%

DAX

10708.40

-2.5%

-0.7%

10713.23

0.0%

10971.04

2.5%

2.4%

10959.95

2.3%

-0.1%

11085.44

3.5%

1.1%

11119.83

3.8%

0.3%

In testimony before The Joint Economic Committee of Congress on Dec 3, 2015 (http://www.federalreserve.gov/newsevents/testimony/yellen20151203a.htm), Chair Yellen reiterated that the FOMC (Federal Open Market Committee) “anticipates that even after employment and inflation are near mandate-consistent levels, economic condition may, for some time, warrant keeping the target federal funds rate below the Committee views as normal in the longer run.” Todd Buell and Katy Burne, writing on “Draghi says ECB could step up stimulus efforts if necessary,” on Dec 4, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/draghi-says-ecb-could-step-up-stimulus-efforts-if-necessary-1449252934), analyze that the President of the European Central Bank (ECB), Mario Draghi, reassured financial markets that the ECB will increase stimulus if required to raise inflation the euro area to targets. The USD depreciated 3.1 percent on Thu Dec 3, 2015 after weaker than expected measures by the European Central Bank. DJIA fell 1.4 percent on Dec 3 and increased 2.1 percent on Dec 4. DAX fell 3.6 percent on Dec 3.

Fri Nov 27

Mon 30

Tue 1

Wed 2

Thu 3

Fri 4

USD/ EUR

1.0594

0.5%

0.2%

1.0565

0.3%

1.0634

-0.4%

-0.7%

1.0616

-0.2%

0.2%

1.0941

-3.3%

-3.1%

1.0885

-2.7%

0.5%

DJIA

17798.49

-0.1%

17719.92

-0.4%

17888.35

0.5%

1.0%

17729.68

-0.4%

-0.9%

17477.67

-1.8%

-1.4%

17847.63

0.3%

2.1%

DAX

11293.76

1.6%

-0.2%

11382.23

0.8%

11261.24

-0.3%

-1.1%

11190.02

-0.9%

-0.6%

10789.24

-4.5%

-3.6%

10752.10

-4.8%

-0.3%

At the press conference following the meeting of the FOMC on Dec 16, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20151216.pdf page 8):

“And we recognize that monetary policy operates with lags. We would like to be able to move in a prudent, and as we've emphasized, gradual manner. It's been a long time since the Federal Reserve has raised interest rates, and I think it's prudent to be able to watch what the impact is on financial conditions and spending in the economy and moving in a timely fashion enables us to do this.”

The implication of this statement is that the state of the art is not accurate in analyzing the effects of monetary policy on financial markets and economic activity. The US dollar appreciated and equities fluctuated:

Fri Dec 11

Mon 14

Tue 15

Wed 16

Thu 17

Fri 18

USD/ EUR

1.0991

-1.0%

-0.4%

1.0993

0.0%

1.0932

0.5%

0.6%

1.0913

0.7%

0.2%

1.0827

1.5%

0.8%

1.0868

1.1%

-0.4%

DJIA

17265.21

-3.3%

-1.8%

17368.50

0.6%

17524.91

1.5%

0.9%

17749.09

2.8%

1.3%

17495.84

1.3%

-1.4%

17128.55

-0.8%

-2.1%

DAX

10340.06

-3.8%

-2.4%

10139.34

-1.9%

10450.38

-1.1%

3.1%

10469.26

1.2%

0.2%

10738.12

3.8%

2.6%

10608.19

2.6%

-1.2%

On January 29, 2016, the Policy Board of the Bank of Japan introduced a new policy to attain the “price stability target of 2 percent at the earliest possible time” (https://www.boj.or.jp/en/announcements/release_2016/k160129a.pdf). The new framework consists of three dimensions: quantity, quality and interest rate. The interest rate dimension consists of rates paid to current accounts that financial institutions hold at the Bank of Japan of three tiers zero, positive and minus 0.1 percent. The quantitative dimension consists of increasing the monetary base at the annual rate of 80 trillion yen. The qualitative dimension consists of purchases by the Bank of Japan of Japanese government bonds (JGBs), exchange traded funds (ETFs) and Japan real estate investment trusts (J-REITS). The yen devalued sharply relative to the dollar and world equity markets soared after the new policy announced on Jan 29, 2016:

Fri 22

Mon 25

Tue 26

Wed 27

Thu 28

Fri 29

JPY/ USD

118.77

-1.5%

-0.9%

118.30

0.4%

118.42

0.3%

-0.1%

118.68

0.1%

-0.2%

118.82

0.0%

-0.1%

121.13

-2.0%

-1.9%

DJIA

16093.51

0.7%

1.3%

15885.22

-1.3%

16167.23

0.5%

1.8%

15944.46

-0.9%

-1.4%

16069.64

-0.1%

0.8%

16466.30

2.3%

2.5%

Nikkei

16958.53

-1.1%

5.9%

17110.91

0.9%

16708.90

-1.5%

-2.3%

17163.92

1.2%

2.7%

17041.45

0.5%

-0.7%

17518.30

3.3%

2.8%

Shanghai

2916.56

0.5%

1.3

2938.51

0.8%

2749.79

-5.7%

-6.4%

2735.56

-6.2%

-0.5%

2655.66

-8.9%

-2.9%

2737.60

-6.1%

3.1%

DAX

9764.88

2.3%

2.0%

9736.15

-0.3%

9822.75

0.6%

0.9%

9880.82

1.2%

0.6%

9639.59

-1.3%

-2.4%

9798.11

0.3%

1.6%

In testimony on the Semiannual Monetary Policy Report to the Congress on Feb 10-11, 2016, Chair Yellen (http://www.federalreserve.gov/newsevents/testimony/yellen20160210a.htm) states: “U.S. real gross domestic product is estimated to have increased about 1-3/4 percent in 2015. Over the course of the year, subdued foreign growth and the appreciation of the dollar restrained net exports. In the fourth quarter of last year, growth in the gross domestic product is reported to have slowed more sharply, to an annual rate of just 3/4 percent; again, growth was held back by weak net exports as well as by a negative contribution from inventory investment.”

Jon Hilsenrath, writing on “Yellen Says Fed Should Be Prepared to Use Negative Rates if Needed,” on Feb 11, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/yellen-reiterates-concerns-about-risks-to-economy-in-senate-testimony-1455203865), analyzes the statement of Chair Yellen in Congress that the FOMC (Federal Open Market Committee) is considering negative interest rates on bank reserves. The Wall Street Journal provides yields of two and ten-year sovereign bonds with negative interest rates on shorter maturities where central banks pay negative interest rates on excess bank reserves:

Sovereign Yields 2/12/16	Japan	Germany	USA
2 Year	-0.168	-0.498	0.694
10 Year	0.076	0.262	1.744

On Mar 10, 2016, the European Central Bank (ECB) announced (1) reduction of the refinancing rate by 5 basis points to 0.00 percent; decrease the marginal lending rate to 0.25 percent; reduction of the deposit facility rate to 0,40 percent; increase of the monthly purchase of assets to €80 billion; include nonbank corporate bonds in assets eligible for purchases; and new long-term refinancing operations (https://www.ecb.europa.eu/press/pr/date/2016/html/pr160310.en.html). The President of the ECB, Mario Draghi, stated in the press conference (https://www.ecb.europa.eu/press/pressconf/2016/html/is160310.en.html): “How low can we go? Let me say that rates will stay low, very low, for a long period of time, and well past the horizon of our purchases…We don’t anticipate that it will be necessary to reduce rates further. Of course, new facts can change the situation and the outlook.”

The dollar devalued relative to the euro and open stock markets traded lower after the announcement on Mar 10, 2016, but stocks rebounded on Mar 11:

Fri 4

Mon 7

Tue 8

Wed 9

Thu10

Fri 11

USD/ EUR

1.1006

-0.7%

-0.4%

1.1012

-0.1%

1.1013

-0.1%

0.0%

1.0999

0.1%

1.1182

-1.6%

-1.7%

1.1151

-1.3%

0.3%

DJIA

17006.77

2.2%

0.4%

17073.95

0.4%

16964.10

-0.3%

-0.6%

17000.36

0.0%

0.2%

16995.13

-0.1%

0.0%

17213.31

1.2%

1.3%

DAX

9824.17

3.3%

0.7%

9778.93

-0.5%

0.5%

9692.82

-1.3%

-0.9%

9723.09

-1.0%

0.3%

9498.15

-3.3%

-2.3%

9831.13

0.1%

3.5%

In a speech at the World Affairs Council of Philadelphia, on Jun 6, 2016 (http://www.federalreserve.gov/newsevents/speech/yellen20160606a.htm), Chair Yellen finds that “there is considerable uncertainty about the economic outlook.” There are fifteen references to this uncertainty in the text of 18 pages double-spaced. In the Semiannual Monetary Policy Report to the Congress on Jun 21, 2016, Chair Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20160621a.htm), “Of course, considerable uncertainty about the economic outlook remains.” Frank H. Knight (1963, 233), in Risk, uncertainty and profit, distinguishes between measurable risk and unmeasurable uncertainty. Is there a “science” or even “art” of central banking under this extreme uncertainty in which policy does not generate higher volatility of money, income, prices and values of financial assets?

Chart VIII-1, Fed Funds Rate and Yields of Ten-year Treasury Constant Maturity and Baa Seasoned Corporate Bond, Jan 2, 2001 to Jul 21, 2016

Source: Board of Governors of the Federal Reserve System

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

Table VIII-3, Selected Data Points in Chart VIII-1, % per Year

	Fed Funds Overnight Rate	10-Year Treasury Constant Maturity	Seasoned Baa Corporate Bond
1/2/2001	6.67	4.92	7.91
10/1/2002	1.85	3.72	7.46
7/3/2003	0.96	3.67	6.39
6/22/2004	1.00	4.72	6.77
6/28/2006	5.06	5.25	6.94
9/17/2008	2.80	3.41	7.25
10/26/2008	0.09	2.16	8.00
10/31/2008	0.22	4.01	9.54
4/6/2009	0.14	2.95	8.63
4/5/2010	0.20	4.01	6.44
2/4/2011	0.17	3.68	6.25
7/25/2012	0.15	1.43	4.73
5/1/13	0.14	1.66	4.48
9/5/13	0.089	2.98	5.53
11/21/2013	0.09	2.79	5.44
11/26/13	0.09	2.74	5.34 (11/26/13)
12/5/13	0.09	2.88	5.47
12/11/13	0.09	2.89	5.42
12/18/13	0.09	2.94	5.36
12/26/13	0.08	3.00	5.37
1/1/2014	0.08	3.00	5.34
1/8/2014	0.07	2.97	5.28
1/15/2014	0.07	2.86	5.18
1/22/2014	0.07	2.79	5.11
1/30/2014	0.07	2.72	5.08
2/6/2014	0.07	2.73	5.13
2/13/2014	0.06	2.73	5.12
2/20/14	0.07	2.76	5.15
2/27/14	0.07	2.65	5.01
3/6/14	0.08	2.74	5.11
3/13/14	0.08	2.66	5.05
3/20/14	0.08	2.79	5.13
3/27/14	0.08	2.69	4.95
4/3/14	0.08	2.80	5.04
4/10/14	0.08	2.65	4.89
4/17/14	0.09	2.73	4.89
4/24/14	0.10	2.70	4.84
5/1/14	0.09	2.63	4.77
5/8/14	0.08	2.61	4.79
5/15/14	0.09	2.50	4.72
5/22/14	0.09	2.56	4.81
5/29/14	0.09	2.45	4.69
6/05/14	0.09	2.59	4.83
6/12/14	0.09	2.58	4.79
6/19/14	0.10	2.64	4.83
6/26/14	0.10	2.53	4.71
7/2/14	0.10	2.64	4.84
7/10/14	0.09	2.55	4.75
7/17/14	0.09	2.47	4.69
7/24/14	0.09	2.52	4.72
7/31/14	0.08	2.58	4.75
8/7/14	0.09	2.43	4.71
8/14/14	0.09	2.40	4.69
8/21/14	0.09	2.41	4.69
8/28/14	0.09	2.34	4.57
9/04/14	0.09	2.45	4.70
9/11/14	0.09	2.54	4.79
9/18/14	0.09	2.63	4.91
9/25/14	0.09	2.52	4.79
10/02/14	0.09	2.44	4.76
10/09/14	0.08	2.34	4.68
10/16/14	0.09	2.17	4.64
10/23/14	0.09	2.29	4.71
11/13/14	0.09	2.35	4.82
11/20/14	0.10	2.34	4.86
11/26/14	0.10	2.24	4.73
12/04/14	0.12	2.25	4.78
12/11/14	0.12	2.19	4.72
12/18/14	0.13	2.22	4.78
12/23/14	0.13	2.26	4.79
12/30/14	0.06	2.20	4.69
1/8/15	0.12	2.03	4.57
1/15/15	0.12	1.77	4.42
1/22/15	0.12	1.90	4.49
1/29/15	0.11	1.77	4.35
2/05/15	0.12	1.83	4.43
2/12/15	0.12	1.99	4.53
2/19/15	0.12	2.11	4.64
2/26/15	0.11	2.03	4.47
3/5/215	0.11	2.11	4.58
3/12/15	0.11	2.10	4.56
3/19/15	0.12	1.98	4.48
3/26/15	0.11	2.01	4.56
4/03/15	0.12	1.92	4.47
4/9/15	0.12	1.97	4.50
4/16/15	0.13	1.90	4.45
4/23/15	0.13	1.96	4.50
5/1/15	0.08	2.05	4.65
5/7/15	0.13	2.18	4.82
5/14/15	0.13	2.23	4.97
5/21/15	0.12	2.19	4.94
5/28/15	0.12	2.13	4.88
6/04/15	0.13	2.31	5.03
6/11/15	0.13	2.39	5.10
6/18/15	0.14	2.35	5.17
6/25/15	0.13	2.40	5.20
7/1/15	0.13	2.43	5.26
7/9/15	0.13	2.32	5.20
7/16/15	0.14	2.36	5.24
7/23/15	0.13	2.28	5.13
7/30/15	0.14	2.28	5.16
8/06/15	0.14	2.23	5.15
8/20/15	0.15	2.09	5.13
8/27/15	0.14	2.18	5.33
9/03/15	0.14	2.18	5.35
9/10/15	0.14	2.23	5.35
9/17/15	0.14	2.21	5.39
9/25/15	0.14	2.13	5.29
10/01/15	0.13	2.05	5.36
10/08/15	0.13	2.12	5.40
10/15/15	0.13	2.04	5.33
10/22/15	0.12	2.04	5.30
10/29/15	0.12	2.19	5.40
11/05/15	0.12	2.26	5.44
11/12/15	0.12	2.32	5.51
11/19/15	0.12	2.24	5.44
11/25/15	0.12	2.23	5.44
12/03/15	0.13	2.33	5.51
12/10/15	0.14	2.24	5.43
12/17/15	0.37	2.24	5.45
12/23/15	0.36	2.27	5.53
12/30/15	0.35	2.31	5.54
1/07/2016	0.36	2.16	5.44
01/14/16	0.36	2.10	5.46
01/20/16	0.37	2.01	5.41
01/29/16	0.38	2.00	5.48
02/04/16	0.38	1.87	5.40
02/11/16	0.38	1.63	5.26
02/18/16	0.38	1.75	5.37
02/25/16	0.37	1.71	5.27
03/03/16	0.37	1.83	5.30
03/10/16	0.36	1.93	5.23
03/17/16	0.37	1.91	5.11
03/24/16	0.37	1.91	4.97
03/31/16	0.25	1.78	4.90
04/07/16	0.37	1.70	4.76
04/14/16	0.37	1.80	4.79
04/21/16	0.37	1.88	4.79
04/28/16	0.37	1.84	4.73
05/05/16	0.37	1.76	4.62
05/12/16	0.37	1.75	4.66
05/19/16	0.37	1.85	4.70
05/26/16	0.37	1.83	4.69
06/02/16	0.37	1.81	4.64
06/09/16	0.37	1.68	4.53
06/16/16	0.38	1.57	4.47
06/23/16	0.39	1.74	4.60
06/30/16	0.36	1.49	4.41
07/07/16	0.40	1.40	4.19
07/14/16	0.40	1.53	4.23
07/21/16	0.40	1.57	4.25

Source: Board of Governors of the Federal Reserve System

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

Chart VIII-2 of the Board of Governors of the Federal Reserve System provides the rate of US dollars (USD) per euro (EUR), USD/EUR. The rate depreciated from USD 1.0965/EUR on Jul 15, 2015 to USD 1.1059/EUR on Jul 15, 2016 or 0.9 percent. The euro has devalued 44.8 percent relative to the dollar from the high on Jul 15, 2008 to Jul 22, 2016. US corporations with foreign transactions and net worth experience losses in their balance sheets in converting revenues from depreciated currencies to the dollar. Corporate profits with IVA and CCA decreased at $123.0 billion in IQ2015 and increased at $70.5 billion in IIQ2015. Corporate profits with IVA and CCA decreased at $33.1 billion in IIIQ2015. Corporate profits with IVA and CCA decreased at 159.6 billion in IVQ2015 and increased at $34.7 billion in IQ2016. Profits after tax with IVA and CCA fell at $128.5 billion in IQ2015. Profits after tax with IVA and CCA increased at $39.2 billion in IIQ2015. Profits after tax with IVA and CCA decreased at $26.2 billion in IIIQ2015. Profits after tax with IVA and CCA fell at $127.3 billion in IVQ2015 and increased at $30.3 billion in IQ2016. There is increase in corporate profits from devaluing the dollar with unconventional monetary policy of zero interest rates and decrease of corporate profits in revaluing the dollar with attempts at “normalization” or increases in interest rates. Conflicts arise while other central banks differ in their adjustment process. The current account deficit seasonally adjusted increases from 2.3 percent of GDP in IVQ2014 to 2.7 percent in IQ2015. The current account deficit increases to 2.7 percent of GDP in IQ2015 and decreases to 2.5 percent of GDP in IIQ2015. The deficit increases to 2.9 percent of GDP in IIIQ2015, easing to 2.8 percent of GDP in IVQ2015. The net international investment position decreases from minus $7.0 trillion in IVQ2014 to minus $6.8 trillion in IQ2015, decreasing at minus $6.7 trillion in IIQ2015. The net international investment position increases to minus 7.3 trillion in IIIQ2015 and increases to minus $7.4 trillion in IVQ2015. The BEA explains as follows (http://www.bea.gov/newsreleases/international/intinv/2016/pdf/intinv415.pdf):

“The U.S. net international investment position at the end of the fourth quarter of 2015 was -$7,356.8 billion (preliminary) as the value of U.S. liabilities exceeded the value of U.S. assets (chart 1, table 1). At the end of the third quarter, the net investment position was -$7,311.6 billion (revised). The U.S. net international investment position was -$7,356.8 billion (preliminary) at the end of 2015 compared with -$7,019.7 billion at the end of 2014. The $337.1 billion decrease in the net position reflected a $1,387.3 billion decrease in the value of U.S. assets that exceeded a $1,050.2 billion decrease in the value of U.S. liabilities. The U.S. net international investment position decreased 4.8 percent from the end of 2014 to the end of 2015, compared with a 31.8 percent decrease from the end of 2013 to the end of 2014.”

The BEA explains further (http://www.bea.gov/newsreleases/international/intinv/2016/pdf/intinv415.pdf): “U.S. assets were $23,208.3 billion at the end of 2015 compared with $24,595.5 billion at the end of 2014. The $1,387.3 billion decrease reflected an $826.9 billion decrease in the value of financial derivatives, mostly in single-currency interest rate contracts, and a $560.4 billion decrease in the value of assets excluding financial derivatives. U.S. assets excluding financial derivatives were $20,810.6 billion at the end of 2015 compared with $21,371.0 billion at the end of 2014. The $560.4 billion decrease was mostly attributable to the depreciation of major foreign currencies against the U.S. dollar that lowered the value of U.S. assets in dollar terms. U.S. liabilities were $30,565.1 billion at the end of 2015 compared with $31,615.2 billion at the end of 2014. The $1,050.2 billion decrease reflected an $810.1 billion decrease in the value of financial derivatives, mostly in single-currency interest rate contracts, and a $240.0 billion decrease in the value of liabilities excluding financial derivatives. U.S. liabilities excluding financial derivatives were $28,224.5 billion at the end of 2015 compared with $28,464.6 billion at the end of 2014. The $240.0 billion decrease was mostly attributable to decreases in U.S. equity and bond prices that lowered the value of portfolio investment liabilities.”

Chart VIII-2, Exchange Rate of US Dollars (USD) per Euro (EUR), Jul 15, 2015 to Jul 15, 2016

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VIII-3 of the Board of Governors of the Federal Reserve System provides the yield of the 10-year Treasury constant maturity note from 1.89 percent on Apr 21, 2016 to 1.57 percent on Jul 21, 2016. There is turbulence in financial markets originating in a combination of intentions of normalizing or increasing US policy fed funds rate, quantitative easing in Europe and Japan and increasing perception of financial/economic risks.

Chart VIII-3, Yield of Ten-year Constant Maturity Treasury, Apr 21, 2016 to Jul 21, 2016

Source: Board of Governors of the Federal Reserve System

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

What is truly important is the fixing of the overnight fed funds at ¼ to ½ percent with gradual consideration of further rate increases (http://www.federalreserve.gov/newsevents/press/monetary/20160615a.htm): “In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to 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 and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data” (emphasis added).

There is concern at the Federal Open Market Committee (FOMC) with the world economy and financial markets (http://www.federalreserve.gov/newsevents/press/monetary/20160127a.htm): “The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook” (emphasis added). This concern should include the effects on dollar revaluation of competitive easing by other central banks such as quantitative and qualitative easing with negative nominal interest rates (https://www.boj.or.jp/en/announcements/release_2016/k160129a.pdf).

Chart S provides the yield of the two-year Treasury constant maturity from Mar 17, 2014, two days before the guidance of Chair Yellen on Mar 19, 2014, to Jun 30, 2016. Chart SA provides the yields of the seven-, ten- and thirty-year Treasury constant maturity in the same dates. Yields increased right after the guidance of Chair Yellen. The two-year yield remain at a higher level than before while the ten-year yield fell and increased again. There could be more immediate impact on two-year yields of an increase in the fed funds rates but the effects would spread throughout the term structure of interest rates (Cox, Ingersoll and Ross 1981, 1985, Ingersoll 1987). Yields converged toward slightly lower earlier levels in the week of Apr 24, 2014 with reallocation of portfolios of risk financial assets away from equities and into bonds and commodities. There is ongoing reshuffling of portfolios to hedge against geopolitical events and world/regional economic performance.

Chart S, US, Yield of Two-Year Treasury Constant Maturity, Mar 17, 2014 to Jul 21, 2016

Source: Board of Governors of the Federal Reserve System

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

Chart SA, US, Yield of Seven-Year, Ten-Year and Thirty-Year Treasury Constant Maturity, Mar 17, 2014 to Jul 21, 2016

Source: Board of Governors of the Federal Reserve System

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

Chair Yellen states (http://www.federalreserve.gov/newsevents/speech/yellen20140331a.htm):

“And based on the evidence available, it is clear to me that the U.S. economy is still considerably short of the two goals assigned to the Federal Reserve by the Congress. The first of those goals is maximum sustainable employment, the highest level of employment that can be sustained while maintaining a stable inflation rate. Most of my colleagues on the Federal Open Market Committee and I estimate that the unemployment rate consistent with maximum sustainable employment is now between 5.2 percent and 5.6 percent, well below the 6.7 percent rate in February.

Let me explain what I mean by that word "slack" and why it is so important.

Slack means that there are significantly more people willing and capable of filling a job than there are jobs for them to fill. During a period of little or no slack, there still may be vacant jobs and people who want to work, but a large share of those willing to work lack the skills or are otherwise not well suited for the jobs that are available. With 6.7 percent unemployment, it might seem that there must be a lot of slack in the U.S. economy, but there are reasons why that may not be true.”

Inflation and unemployment in the period 1966 to 1985 is analyzed by Cochrane (2011Jan, 23) by means of a Phillips circuit joining points of inflation and unemployment. Chart VI-1B for Brazil in Pelaez (1986, 94-5) was reprinted in The Economist in the issue of Jan 17-23, 1987 as updated by the author. Cochrane (2011Jan, 23) argues that the Phillips circuit shows the weakness in Phillips curve correlation. The explanation is by a shift in aggregate supply, rise in inflation expectations or loss of anchoring. The case of Brazil in Chart VI-1B cannot be explained without taking into account the increase in the fed funds rate that reached 22.36 percent on Jul 22, 1981 (http://www.federalreserve.gov/releases/h15/data.htm) in the Volcker Fed that precipitated the stress on a foreign debt bloated by financing balance of payments deficits with bank loans in the 1970s. The loans were used in projects, many of state-owned enterprises with low present value in long gestation. The combination of the insolvency of the country because of debt higher than its ability of repayment and the huge government deficit with declining revenue as the economy contracted caused adverse expectations on inflation and the economy. This interpretation is consistent with the case of the 24 emerging market economies analyzed by Reinhart and Rogoff (2010GTD, 4), concluding that “higher debt levels are associated with significantly higher levels of inflation in emerging markets. Median inflation more than doubles (from less than seven percent to 16 percent) as debt rises from the low (0 to 30 percent) range to above 90 percent. Fiscal dominance is a plausible interpretation of this pattern.”

The reading of the Phillips circuits of the 1970s by Cochrane (2011Jan, 25) is doubtful about the output gap and inflation expectations:

“So, inflation is caused by ‘tightness’ and deflation by ‘slack’ in the economy. This is not just a cause and forecasting variable, it is the cause, because given ‘slack’ we apparently do not have to worry about inflation from other sources, notwithstanding the weak correlation of [Phillips circuits]. These statements [by the Fed] do mention ‘stable inflation expectations. How does the Fed know expectations are ‘stable’ and would not come unglued once people look at deficit numbers? As I read Fed statements, almost all confidence in ‘stable’ or ‘anchored’ expectations comes from the fact that we have experienced a long period of low inflation (adaptive expectations). All these analyses ignore the stagflation experience in the 1970s, in which inflation was high even with ‘slack’ markets and little ‘demand, and ‘expectations’ moved quickly. They ignore the experience of hyperinflations and currency collapses, which happen in economies well below potential.”

Yellen (2014Aug22) states that “Historically, slack has accounted for only a small portion of the fluctuations in inflation. Indeed, unusual aspects of the current recovery may have shifted the lead-lag relationship between a tightening labor market and rising inflation pressures in either direction.”

Chart VI-1B provides the tortuous Phillips Circuit of Brazil from 1963 to 1987. There were no reliable consumer price index and unemployment data in Brazil for that period. Chart VI-1B used the more reliable indicator of inflation, the wholesale price index, and idle capacity of manufacturing as a proxy of unemployment in large urban centers.

ChVI1-B, Brazil, Phillips Circuit, 1963-1987

Source:

©Carlos Manuel Pelaez, O Cruzado e o Austral: Análise das Reformas Monetárias do Brasil e da Argentina. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.

The minutes of the meeting of the Federal Open Market Committee (FOMC) on Sep 16-17, 2014, reveal concern with global economic conditions (http://www.federalreserve.gov/monetarypolicy/fomcminutes20140917.htm):

“Most viewed the risks to the outlook for economic activity and the labor market as broadly balanced. However, a number of participants noted that economic growth over the medium term might be slower than they expected if foreign economic growth came in weaker than anticipated, structural productivity continued to increase only slowly, or the recovery in residential construction continued to lag.”

There is similar concern in the minutes of the meeting of the FOMC on Dec 16-17, 2014 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20141217.htm):

“In their discussion of the foreign economic outlook, participants noted that the implications of the drop in crude oil prices would differ across regions, especially if the price declines affected inflation expectations and financial markets; a few participants said that the effect on overseas employment and output as a whole was likely to be positive. While some participants had lowered their assessments of the prospects for global economic growth, several noted that the likelihood of further responses by policymakers abroad had increased. Several participants indicated that they expected slower economic growth abroad to negatively affect the U.S. economy, principally through lower net exports, but the net effect of lower oil prices on U.S. economic activity was anticipated to be positive.”

It is quite difficult to measure inflationary expectations because they tend to break abruptly from past inflation. There could still be an influence of past and current inflation in the calculation of future inflation by economic agents. Table VIII-1 provides inflation of the CPI. In the three months from Apr 2016 to Jun 2016, CPI inflation for all items seasonally adjusted was 3.2 percent in annual equivalent, obtained by calculating accumulated inflation from Apr 2016 to Jun 2016 and compounding for a full year. In the 12 months ending in Jun 2016, CPI inflation of all items not seasonally adjusted was 1.0 percent. Inflation in Jun 2016 not seasonally adjusted was 0.2 percent relative to May 2016, or 2.4 percent annual equivalent (http://www.bls.gov/cpi/). The second row provides the same measurements for the CPI of all items excluding food and energy: 2.3 percent in 12 months, 2.4 percent in annual equivalent Apr 2016-Jun 2016 and 0.2 percent in Jun 2016 or 2.4 percent in annual equivalent. The Wall Street Journal provides the yield curve of US Treasury securities (http://professional.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3000). The shortest term is 0.267 percent for one month, 0.322 percent for three months, 0.434 percent for six months, 0.545 percent for one year, 0.719 percent for two years, 0.841 percent for three years, 1.123 percent for five years, 1.389 percent for seven years, 1.566 percent for ten years and 2.283 percent for 30 years. The Irving Fisher (1930) definition of real interest rates is approximately the difference between nominal interest rates, which are those estimated by the Wall Street Journal, and the rate of inflation expected in the term of the security, which could behave as in Table VIII-1. Inflation in Jan 2016 is low in 12 months because of the unwinding of carry trades from zero interest rates to commodity futures prices but could ignite again with subdued risk aversion. Real interest rates in the US have been negative during substantial periods in the past decade while monetary policy 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”

Negative real rates of interest distort calculations of risk and returns from capital budgeting by firms, through lending by financial intermediaries to decisions on savings, housing and purchases of households. Inflation on near zero interest rates misallocates resources away from their most productive uses and creates uncertainty of the future path of adjustment to higher interest rates that inhibit sound decisions.

Table I-3, US, Consumer Price Index Percentage Changes 12 months NSA and Annual

	% RI	∆% 12 Months Jun 2016/Jun 2015 NSA	∆% Annual Equivalent Apr 2015 to Jun 2016 SA	∆% Jun 2016/May 2016 SA
CPI All Items	100.000	1.0	3.2	0.2
CPI ex Food and Energy	79.153	2.3	2.4	0.2

Source: US Bureau of Labor Statistics

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

Professionals use a variety of techniques in measuring interest rate risk (Fabozzi, Buestow and Johnson, 2006, Chapter Nine, 183-226):

Full valuation approach in which securities and portfolios are shocked by 50, 100, 200 and 300 basis points to measure their impact on asset values
Stress tests requiring more complex analysis and translation of possible events with high impact even if with low probability of occurrence into effects on actual positions and capital
Value at Risk (VaR) analysis of maximum losses that are likely in a time horizon
Duration and convexity that are short-hand convenient measurement of changes in prices resulting from changes in yield captured by duration and convexity
Yield volatility

Analysis of these methods is in Pelaez and Pelaez (International Financial Architecture (2005), 101-162) and Pelaez and Pelaez, Globalization and the State, Vol. (I) (2008a), 78-100). Frederick R. Macaulay (1938) introduced the concept of duration in contrast with maturity for analyzing bonds. Duration is the sensitivity of bond prices to changes in yields. In economic jargon, duration is the yield elasticity of bond price to changes in yield, or the percentage change in price after a percentage change in yield, typically expressed as the change in price resulting from change of 100 basis points in yield. The mathematical formula is the negative of the yield elasticity of the bond price or –[dB/d(1+y)]((1+y)/B), where d is the derivative operator of calculus, B the bond price, y the yield and the elasticity does not have dimension (Hallerbach 2001). The duration trap of unconventional monetary policy is that duration is higher the lower the coupon and higher the lower the yield, other things being constant. Coupons and yields are historically low because of unconventional monetary policy. Duration dumping during a rate increase may trigger the same crossfire selling of high duration positions that magnified the credit crisis. Traders reduced positions because capital losses in one segment, such as mortgage-backed securities, triggered haircuts and margin increases that reduced capital available for positioning in all segments, causing fire sales in multiple segments (Brunnermeier and Pedersen 2009; see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 217-24). Financial markets are currently experiencing fear of duration and riskier asset classes resulting from the debate within and outside the Fed on tapering quantitative easing. Table VIII-2 provides the yield curve of Treasury securities on Jul 22, 2016, Dec 31, 2013, May 1, 2013, Jul 22, 2015 and Jul 21, 2006. There is oscillating steepening of the yield curve for longer maturities, which are also the ones with highest duration. The 10-year yield increased from 1.45 percent on Jul 26, 2012 to 3.04 percent on Dec 31, 2013 and 1.57 percent on Jul 22, 2016, as measured by the United States Treasury. Assume that a bond with maturity in 10 years were issued on Dec 31, 2013, at par or price of 100 with coupon of 1.45 percent. The price of that bond would be 86.3778 with instantaneous increase of the yield to 3.04 percent for loss of 13.6 percent and far more with leverage. Assume that the yield of a bond with exactly ten years to maturity and coupon of 1.57 percent would jump instantaneously from yield of 1.57 percent on Jul 22, 2016 to 5.05 percent as occurred on Jul 21, 2006 when the economy was closer to full employment. The price of the hypothetical bond issued with coupon of 1.57 percent would drop from 100 to 72.9388 after an instantaneous increase of the yield to 5.05 percent. The price loss would be 27.1 percent. Losses absorb capital available for positioning, triggering crossfire sales in multiple asset classes (Brunnermeier and Pedersen 2009). What is the path of adjustment of zero interest rates on fed funds and artificially low bond yields? There is no painless exit from unconventional monetary policy. Chris Dieterich, writing on “Bond investors turn to cash,” on Jul 25, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323971204578625900935618178.html), uses data of the Investment Company Institute (http://www.ici.org/) in showing withdrawals of $43 billion in taxable mutual funds in Jun, which is the largest in history, with flows into cash investments such as $8.5 billion in the week of Jul 17 into money-market funds.

Table VIII-2, United States, Treasury Yields

	7/22/16	12/31/13	5/01/13	7/22/15	7/21/06
1 M	0.29	0.00	0.03	0.04	4.88
3 M	0.33	0.01	0.06	0.04	5.10
6 M	0.44	0.07	0.08	0.13	5.25
1 Y	0.55	0.25	0.11	0.34	5.19
2 Y	0.71	0.56	0.20	0.75	5.08
3 Y	0.84	0.91	0.30	1.08	5.02
5 Y	1.13	1.43	0.65	1.69	4.99
7 Y	1.40	1.80	1.07	2.07	5.00
10 Y	1.57	3.04	1.66	2.33	5.05
20 Y	1.90	3.72	2.44	2.73	5.21
30 Y	2.29	3.96	2.83	3.04	5.10

M: Months; Y: Years

Source: United States Treasury

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

Interest rate risk is increasing in the US with amplifying fluctuations. Chart VI-13 of the Board of Governors provides the conventional mortgage rate for a fixed-rate 30-year mortgage. The rate stood at 5.87 percent on Jan 8, 2004, increasing to 6.79 percent on Jul 6, 2006. The rate bottomed at 3.35 percent on May 2, 2013. Fear of duration risk in longer maturities such as mortgage-backed securities caused continuing increases in the conventional mortgage rate that rose to 4.51 percent on Jul 11, 2013, 4.58 percent on Aug 22, 2013 and 3.45 percent on Jul 21, 2016, which is the last data point in Chart VI-13. The current decline of yields is encouraging a surge in mortgage applications that could be reversed in a new increase. Shayndi Raice and Nick Timiraos, writing on “Banks cut as mortgage boom ends,” on Jan 9, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303754404579310940019239208), analyze the drop in mortgage applications to a 13-year low, as measured by the Mortgage Bankers Association. Nick Timiraos, writing on “Demand for home loans plunges,” on Apr 24, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304788404579522051733228402?mg=reno64-wsj), analyzes data in Inside Mortgage Finance that mortgage lending of $235 billion in IQ2014 is 58 percent lower than a year earlier and 23 percent below IVQ2013. Mortgage lending collapsed to the lowest level in 14 years. In testimony before the Committee on the Budget of the US Senate on May 8, 2004, Chair Yellen provides analysis of the current economic situation and outlook (http://www.federalreserve.gov/newsevents/testimony/yellen20140507a.htm): “One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.”

Chart VI-13, US, Conventional Mortgage Rate, Jan 8, 2004 to Jul 21, 2016

Source: Board of Governors of the Federal Reserve System

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

There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table VI-7G when monetary policy pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table VI-7G shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.

Table VI-7G, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994

1994	FF	30Y	30P	10Y	10P	MOR	CPI
Jan	3.00	6.29	100	5.75	100	7.06	2.52
Feb	3.25	6.49	97.37	5.97	98.36	7.15	2.51
Mar	3.50	6.91	92.19	6.48	94.69	7.68	2.51
Apr	3.75	7.27	88.10	6.97	91.32	8.32	2.36
May	4.25	7.41	86.59	7.18	88.93	8.60	2.29
Jun	4.25	7.40	86.69	7.10	90.45	8.40	2.49
Jul	4.25	7.58	84.81	7.30	89.14	8.61	2.77
Aug	4.75	7.49	85.74	7.24	89.53	8.51	2.69
Sep	4.75	7.71	83.49	7.46	88.10	8.64	2.96
Oct	4.75	7.94	81.23	7.74	86.33	8.93	2.61
Nov	5.50	8.08	79.90	7.96	84.96	9.17	2.67
Dec	6.00	7.87	81.91	7.81	85.89	9.20	2.67

Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months

Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.t

Chart VI-14 provides the overnight fed funds rate, the yield of the 10-year Treasury constant maturity bond, the yield of the 30-year constant maturity bond and the conventional mortgage rate from Jan 1991 to Dec 1996. In Jan 1991, the fed funds rate was 6.91 percent, the 10-year Treasury yield 8.09 percent, the 30-year Treasury yield 8.27 percent and the conventional mortgage rate 9.64 percent. Before monetary policy tightening in Oct 1993, the rates and yields were 2.99 percent for the fed funds, 5.33 percent for the 10-year Treasury, 5.94 for the 30-year Treasury and 6.83 percent for the conventional mortgage rate. After tightening in Nov 1994, the rates and yields were 5.29 percent for the fed funds rate, 7.96 percent for the 10-year Treasury, 8.08 percent for the 30-year Treasury and 9.17 percent for the conventional mortgage rate.

Chart VI-14, US, Overnight Fed Funds Rate, 10-Year Treasury Constant Maturity, 30-Year Treasury Constant Maturity and Conventional Mortgage Rate, Monthly, Jan 1991 to Dec 1996

Source: Board of Governors of the Federal Reserve System

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

Chart VI-15 of the Bureau of Labor Statistics provides the all items consumer price index from Jan 1991 to Dec 1996. There does not appear acceleration of consumer prices requiring aggressive tightening.

Chart VI-15, US, Consumer Price Index All Items, Jan 1991 to Dec 1996

Source: Bureau of Labor Statistics

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

Chart IV-16 of the Bureau of Labor Statistics provides 12-month percentage changes of the all items consumer price index from Jan 1991 to Dec 1996. Inflation collapsed during the recession from Jul 1990 (III) and Mar 1991 (I) and the end of the Kuwait War on Feb 25, 1991 that stabilized world oil markets. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). Policy tightening had adverse collateral effects in the form of emerging market crises in Mexico and Argentina and fixed income markets worldwide.

Chart VI-16, US, Consumer Price Index All Items, Twelve-Month Percentage Change, Jan 1991 to Dec 1996

Source: Bureau of Labor Statistics

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

Table VI-2 provides the Euro/Dollar (EUR/USD) exchange rate and Chinese Yuan/Dollar (CNY/USD) exchange rate that reveal pursuit of exchange rate policies resulting from monetary policy in the US and capital control/exchange rate policy in China. The ultimate intentions are the same: promoting internal economic activity at the expense of the rest of the world. The easy money policy of the US was deliberately or not but effectively to devalue the dollar from USD 1.1423/EUR on Jun 26, 2003 to USD 1.5914/EUR on Jul 14, 2008, or by 39.3 percent. The flight into dollar assets after the global recession caused revaluation to USD 1.192/EUR on Jun 7, 2010, or by 25.1 percent. After the temporary interruption of the sovereign risk issues in Europe from Apr to Jul, 2010, shown in Table VI-4 below, the dollar has revalued to USD 1.0980 EUR on Jul 22, 2016 or by 7.9 percent {[(1.0980/1.192)-1]100 = -7.9%}. Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment. Risk aversion erodes devaluation of the dollar. China fixed the CNY to the dollar for a long period at a highly undervalued level of around CNY 8.2765/USD subsequently revaluing to CNY 6.8211/USD until Jun 7, 2010, or by 17.6 percent. After fixing again the CNY to the dollar, China revalued to CNY 6.6819/USD on Fri Jul 22, 2016, or by an additional 2.0 percent, for cumulative revaluation of 19.3 percent. The final row of Table VI-2 shows: devaluation of 0.7 percent in the week of Jul 1, 2016; devaluation of 0.5 percent in the week of Jul 8, 2016; devaluation of 0.1 percent in the week of Jul 15, 2016; and revaluation of 0.2 percent in the week of Jul 22. There could be reversal of revaluation to devalue the Yuan.

Table VI-2, Dollar/Euro (USD/EUR) Exchange Rate and Chinese Yuan/Dollar (CNY/USD) Exchange Rate

USD/EUR	12/26/03	7/14/08	6/07/10	07/22/16
Rate	1.1423	1.5914	1.192	1.0980
CNY/USD	01/03 2000	07/21 2005	7/15 2008	07/22/16
Rate	8.2765	8.2765	6.8211	6.6819
Weekly Rates	07/01/2016	07/08/2016	07/15/2016	07/22/16
CNY/USD	6.6564	6.6881	6.6924	6.6819
∆% from Earlier Week*	-0.7	-0.5	-0.1	0.2

*Negative sign is depreciation; positive sign is appreciation

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

Professor Edward P Lazear (2013Jan7), writing on “Chinese ‘currency manipulation’ is not the problem,” on Jan 7, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323320404578213203581231448.html), provides clear thought on the role of the yuan in trade between China and the United States and trade between China and Europe. There is conventional wisdom that Chinese exchange rate policy causes the loss of manufacturing jobs in the United States, which is shown by Lazear (2013Jan7) to be erroneous. The fact is that manipulation of the CNY/USD rate by China has only minor effects on US employment. Lazear (2013Jan7) shows that the movement of monthly exports of China to its major trading partners, United States and Europe, since 1995 cannot be explained by the fixing of the CNY/USD rate by China. The period is quite useful because it includes rapid growth before 2007, contraction until 2009 and weak subsequent expansion. Chart VI-1 of the Board of Governors of the Federal Reserve System provides the CNY/USD exchange rate from Jan 3, 1995 to Jul 15, 2016 together with US recession dates in shaded areas. China fixed the CNY/USD rate for a long period as shown in the horizontal segment from 1995 to 2005. There was systematic revaluation of 17.6 percent from CNY 8.2765 on Jul 21, 2005 to CNY 6.8211 on Jul 15, 2008. China fixed the CNY/USD rate until Jun 7, 2010, to avoid adverse effects on its economy from the global recession, which is shown as a horizontal segment from 2009 until mid 2010. China then continued the policy of appreciation of the CNY relative to the USD with oscillations until the beginning of 2012 when the rate began to move sideways followed by a final upward slope of devaluation that is measured in Table VI-2A but virtually disappeared in the rate of CNY 6.3589/USD on Aug 17, 2012 and was nearly unchanged at CNY 6.3558/USD on Aug 24, 2012. China then appreciated 0.2 percent in the week of Dec 21, 2012, to CNY 6.2352/USD for cumulative 1.9 percent revaluation from Oct 28, 2011 and left the rate virtually unchanged at CNY 6.2316/USD on Jan 11, 2013, appreciating to CNY 6.6865/USD on Jul 15, 2016, which is the last data point in Chart VI-1. Revaluation of the CNY relative to the USD by 19.3 percent by Jul 22, 2016 has not reduced the trade surplus of China but reversal of the policy of revaluation could result in international confrontation. The interruption with upward slope in the final segment on the right of Chart VI-I is measured as virtually stability in Table VI-2A followed with decrease or revaluation and subsequent increase or devaluation. The final segment shows decline or revaluation with another upward move or devaluation. Linglin Wei, writing on “China intervenes to lower yuan,” on Feb 26, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304071004579406810684766716?KEYWORDS=china+yuan&mg=reno64-wsj), finds from informed sources that the central bank of China conducted the ongoing devaluation of the yuan with the objective of driving out arbitrageurs to widen the band of fluctuation. There is concern if the policy of revaluation is changing to devaluation.

Chart VI-1, Chinese Yuan (CNY) per US Dollar (USD), Business Days, Jan 3, 1995-Jul 15, 2016

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-1A provides the daily CNY/USD rate from Jan 5, 1981 to Jul 15, 2016. The exchange rate was CNY 1.5418/USD on Jan 5, 1981. There is sharp cumulative depreciation of 107.8 percent to CNY 3.2031 by Jul 2, 1986, continuing to CNY 5.8145/USD on Dec 29, 1993 for cumulative 277.1 percent since Jan 5, 1981. China then devalued sharply to CNY 8.7117/USD on Jan 7, 1994 for 49.8 percent relative to Dec 29, 1993 and cumulative 465.0 percent relative to Jan 5, 1981. China then fixed the rate at CNY 8.2765/USD until Jul 21, 2005 and revalued as analyzed in Chart VI-1. The final data point in Chart VI-1A is CNY 6.6865/USD on Jul 15, 2016. To be sure, China fixed the exchange rate after substantial prior devaluation. It is unlikely that the devaluation could have been effective after many years of fixing the exchange rate with high inflation and multiple changes in the world economy. The argument of Lazear (2013Jan7) is still valid in view of the lack of association between monthly exports of China to the US and Europe since 1995 and the exchange rate of China.

Chart VI-1A, Chinese Yuan (CNY) per US Dollar (USD), Business Days, Jan 5, 1981-Jul 15, 2016

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-1B provides finer details with the rate of Chinese Yuan (CNY) to the US Dollar (USD) from Oct 28, 2011 to Jul 15, 2016. There have been alternations of revaluation and devaluation. The initial data point is CNY 6.5370 on Oct 28, 2011. There is an episode of devaluation from CNY 6.2790 on Apr 30, 2012 to CNY 6.3879 on Jul 25, 2012, or devaluation of 1.4 percent. Another devaluation is from CNY 6.0402/USD on Jan 21, 2014 to CNY 6.6865/USD on Jul 15, 2016, or devaluation of 10.7 percent. The United States Treasury estimates US government debt held by private investors at $10,970 billion in Mar 2016. China’s holding of US Treasury securities represent 11.3 percent of US government marketable interest-bearing debt held by private investors (http://www.fms.treas.gov/bulletin/index.html). Min Zeng, writing on “China plays a big role as US Treasury yields fall,” on Jul 16, 2004, published in the Wall Street Journal (http://online.wsj.com/articles/china-plays-a-big-role-as-u-s-treasury-yields-fall-1405545034?tesla=y&mg=reno64-wsj), finds that acceleration in purchases of US Treasury securities by China has been an important factor in the decline of Treasury yields in 2014. Japan decreased its holdings from $1214.9 billion in May 2015 to $1133.2 billion in May 2016 or 6.7 percent. The combined holdings of China and Japan in May 2016 add to $2377.2 billion, which is equivalent to 21.7 percent of US government marketable interest-bearing securities held by investors of $10,970 billion in Mar 2016 (http://www.fms.treas.gov/bulletin/index.html). Total foreign holdings of Treasury securities increased from $6134.8 billion in May 2015 to $6208.3 billion in May 2016, or 1.2 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Pelaez and Pelaez, The Global Recession Risk (2007)). A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt. In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

“Imagine that fiscal policy dominates monetary policy. The fiscal authority independently sets its budgets, announcing all current and future deficits and surpluses and thus determining the amount of revenue that must be raised through bond sales and seignorage. Under this second coordination scheme, the monetary authority faces the constraints imposed by the demand for government bonds, for it must try to finance with seignorage any discrepancy between the revenue demanded by the fiscal authority and the amount of bonds that can be sold to the public. Suppose that the demand for government bonds implies an interest rate on bonds greater than the economy’s rate of growth. Then if the fiscal authority runs deficits, the monetary authority is unable to control either the growth rate of the monetary base or inflation forever. If the principal and interest due on these additional bonds are raised by selling still more bonds, so as to continue to hold down the growth of base money, then, because the interest rate on bonds is greater than the economy’s growth rate, the real stock of bonds will growth faster than the size of the economy. This cannot go on forever, since the demand for bonds places an upper limit on the stock of bonds relative to the size of the economy. Once that limit is reached, the principal and interest due on the bonds already sold to fight inflation must be financed, at least in part, by seignorage, requiring the creation of additional base money.”

Chart VI-1B, Chinese Yuan (CNY) per US Dollar (US), Business Days, Oct 28, 2011-Jul 15, 2016

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

There are major ongoing and unresolved realignments of exchange rates in the international financial system as countries and regions seek parities that can optimize their productive structures. Seeking exchange rate parity or exchange rate optimizing internal economic activities is complex in a world of unconventional monetary policy of zero interest rates and even negative nominal interest rates of government obligations such as negative yields for the two-year government bond of Germany. Regulation, trade and devaluation conflicts should have been expected from a global recession (Pelaez and Pelaez (2007), The Global Recession Risk, Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008a)): “There are significant grounds for concern on the basis of this experience. International economic cooperation and the international financial framework can collapse during extreme events. It is unlikely that there will be a repetition of the disaster of the Great Depression. However, a milder contraction can trigger regulatory, trade and exchange wars” (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 181). Chart VI-2 of the Board of Governors of the Federal Reserve System provides the key exchange rate of US dollars (USD) per euro (EUR) from Jan 4, 1999 to Jul 15, 2016. US recession dates are in shaded areas. The rate on Jan 4, 1999 was USD 1.1812/EUR, declining to USD 0.8279/EUR on Oct 25, 2000, or appreciation of the USD by 29.9 percent. The rate depreciated 21.9 percent to USD 1.0098/EUR on Jul 22, 2002. There was sharp devaluation of the USD of 34.9 percent to USD 1.3625/EUR on Dec 27, 2004 largely because of the 1 percent interest rate between Jun 2003 and Jun 2004 together with a form of quantitative easing by suspension of auctions of the 30-year Treasury, which was equivalent to withdrawing supply from markets. Another depreciation of 17.5 percent took the rate to USD 1.6010/EUR on Apr 22, 2008, already inside the shaded area of the global recession. The flight to the USD and obligations of the US Treasury appreciated the dollar by 22.3 percent to USD 1.2446/EUR on Oct 27, 2008. In the return of the carry trade after stress tests showed sound US bank balance sheets, the rate depreciated 21.2 percent to USD 1.5085/EUR on Nov 25, 2009. The sovereign debt crisis of Europe in the spring of 2010 caused sharp appreciation of 20.7 percent to USD 1.1959/EUR on Jun 6, 2010. Renewed risk appetite depreciated the rate 24.4 percent to USD 1.4875/EUR on May 3, 2011. The rate appreciated 7.5 percent to USD 1.1059/EUR on Jul 15, 2016, which is the last point in Chart VI-2. The data in Table VI-6 is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Chart VI-2, US Dollars (USD) per Euro (EUR), Jan 4, 1999 to Jul 15, 2016

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-3 provides three indexes of the US Dollars (USD) from Jan 4, 1995 to Jul 15, 2016.

Chart VI-3A provides the overnight fed funds rate and yields of the three-month constant maturity Treasury bill, the ten-year constant maturity Treasury note and Moody’s Baa bond from Jan 4, 1995 to Jul 7, 2016. Chart VI-3B provides the overnight fed funds rate and yields of the three-month constant maturity Treasury bill, the ten-year constant maturity Treasury note and Moody’s Baa bond from Jan 2, 2001 to Jul 21, 2016. The first phase from 1995 to 2001 shows sharp trend of appreciation of the USD while interest rates remained at relatively high levels. The dollar revalued partly because of the emerging market crises that provoked inflows of financial investment into the US and partly because of a deliberate strong dollar policy. DeLong and Eichengreen (2001, 4-5) argue:

“That context was an economic and political strategy that emphasized private investment as the engine for U.S. economic growth. Both components of this term, "private" and "investment," had implications for the administration’s international economic strategy. From the point of view of investment, it was important that international events not pressure on the Federal Reserve to raise interest rates, since this would have curtailed capital formation and vitiated the effects of the administration’s signature achievement: deficit reduction. A strong dollar -- or rather a dollar that was not expected to weaken -- was a key component of a policy which aimed at keeping the Fed comfortable with low interest rates. In addition, it was important to create a demand for the goods and services generated by this additional productive capacity. To the extent that this demand resided abroad, administration officials saw it as important that the process of increasing international integration, of both trade and finance, move forward for the interest of economic development in emerging markets and therefore in support of U.S. economic growth.”

The process of integration consisted of restructuring “international financial architecture” (Pelaez and Pelaez, International Financial Architecture: G7, IMF, BIS, Debtors and Creditors (2005)). Policy concerns subsequently shifted to the external imbalances, or current account deficits, and internal imbalances, or government deficits (Pelaez and Pelaez, The Global Recession Risk: Dollar Devaluation and the World Economy (2007)). Fed policy consisted of lowering the policy rate or fed funds rate, which is close to the marginal cost of funding of banks, toward zero during the past decade. Near zero interest rates induce carry trades of selling dollar debt (borrowing), shorting the USD and investing in risk financial assets. Without risk aversion, near zero interest rates cause devaluation of the dollar. Chart VI-3 shows the weakening USD between the recession of 2001 and the contraction after IVQ2007. There was a flight to dollar assets and especially obligations of the US government after Sep 2008. Cochrane and Zingales (2009) show that flight was coincident with proposals of TARP (Troubled Asset Relief Program) to withdraw “toxic assets” in US banks (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a) and Regulation of Banks and Finance (2009b)). There are shocks to globalization in the form of regulation, trade and devaluation wars and breakdown of international cooperation (Pelaez and Pelaez, Globalization and the State: Vol. I (2008a), Globalization and the State: Vol. II (2008b) and Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c)). As evident in Chart VI-3A, there is no exit from near zero interest rates without a financial crisis and economic contraction, verified by the increase of interest rates from 1 percent in Jun 2004 to 5.25 percent in Jun 2006. The Federal Open Market Committee (FOMC) lowered the target of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85). The FOMC implemented increments of 25 basis points of the fed funds target from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006, as shown in Chart VI-3A. The gradual exit from the first round of unconventional monetary policy from 1.00 percent in Jun 2004 (http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) to 5.25 percent in Jun 2006 (http://www.federalreserve.gov/newsevents/press/monetary/20060629a.htm) caused the financial crisis and global recession. There are conflicts on exchange rate movements among central banks.

Chart VI-3, US Dollar Currency Indexes, Jan 4, 1995-Jul 15, 2016

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-3A, US, Overnight Fed Funds Rate, Yield of Three-Month Treasury Constant Maturity, Yield of Ten-Year Treasury Constant Maturity and Yield of Moody’s Baa Bond, Jan 4, 1995 to Jul 7, 2016

Source: Board of Governors of the Federal Reserve System

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

Chart VI-3B, US, Overnight Fed Funds Rate, Yield of Three-Month Treasury Constant Maturity, Yield of Ten-Year Treasury Constant Maturity and Yield of Moody’s Baa Bond, Jan 2, 2001 to Jul 21, 2016

Source: Board of Governors of the Federal Reserve System

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

Carry trades induced by zero interest rates increase capital flows into emerging markets that appreciate exchange rates. Portfolio reallocations away from emerging markets depreciate their exchange rates in reversals of capital flows. Chart VI-4A provides the exchange rate of the Mexican peso (MXN) per US dollar from Nov 8, 1993 to Jul 15, 2016. The first data point in Chart VI-4A is MXN 3.1520 on Nov 8, 1993. The rate devalued to 11.9760 on Nov 14, 1995 during emerging market crises in the 1990s and the increase of interest rates in the US in 1994 that stressed world financial markets (Pelaez and Pelaez, International Financial Architecture 2005, The Global Recession Risk 2007, 147-77). The MXN depreciated sharply to MXN 15.4060/USD on Mar 2, 2009, during the global recession. The rate moved to MXN 11.5050/USD on May 2, 2011, during the sovereign debt crisis in the euro area. The rate depreciated to 11.9760 on May 9, 2013. The final data point is MXN 18.5190/USD on Jul 15, 2016.

Chart VI-4A, Mexican Peso (MXN) per US Dollar (USD), Nov 8, 1993 to Jul 15, 2016

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

There are collateral effects worldwide from unconventional monetary policy. 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. Professor Willem Buiter (2014Feb4), a distinguished economist currently Global Chief Economist at Citigroup (http://www.willembuiter.com/resume.pdf), writing on “The Fed’s bad manners risk offending foreigners,” on Feb 4, 2014, published in the Financial Times (http://www.ft.com/intl/cms/s/0/fbb09572-8d8d-11e3-9dbb-00144feab7de.html#axzz2suwrwkFs), concurs with Raghuram Rajan. Buiter (2014Feb4) argues that international policy cooperation in monetary policy is both in the interest of the world and the United States. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows. In a speech at the Brookings Institution on Apr 10, 2014, Raghuram G. Rajan (2014Apr10, 1, 10) argues:

“As the world seems to be struggling back to its feet after the great financial crisis, I want to draw attention to an area we need to be concerned about: the conduct of monetary policy in this integrated world. A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially, as I will argue, and both advanced economies and emerging economies engage in it. Aggregate world demand may be weaker and more distorted than it should be, and financial risks higher. To ensure stable and sustainable growth, the international rules of the game need to be revisited. Both advanced economies and emerging economies need to adapt, else I fear we are about to embark on the next leg of a wearisome cycle. A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have.”

Chart VI-4B provides the rate of the Indian rupee (INR) per US dollar (USD) from Jan 2, 1973 to Jul 15, 2016. The first data point is INR 8.0200 on Jan 2, 1973. The rate depreciated sharply to INR 51.9600 on Mar 3, 2009, during the global recession. The rate appreciated to INR 44.0300/USD on Jul 28, 2011 in the midst of the sovereign debt event in the euro area. The rate overshot to INR 68.8000 on Aug 28, 2013. The final data point is INR 67.0700/USD on Jul 15, 2016.

Chart VI-4B, Indian Rupee (INR) per US Dollar (USD), Jan 2, 1973 to Jul 15, 2016

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-5 provides the exchange rate of JPY (Japan yen) per USD (US dollars). The first data point on the extreme left is JPY 357.7300/USD for Jan 4, 1971. The JPY has appreciated over the long term relative to the USD with fluctuations along an evident long-term appreciation. Before the global recession, the JPY stood at JPY 124.0900/USD on Jun 22, 2007. The use of the JPY as safe haven is evident by sharp appreciation during the global recession to JPY 110.48/USD on Aug 15, 2008, and to JPY 87.8000/USD on Jan 21, 2009. The final data point in Chart VI-5 is JPY 105.6400/USD on Jul 15, 2016 for appreciation of 14.9 percent relative to JPY 124.0900/USD on Jun 22, 2007 before the global recession and expansion characterized by recurring bouts of risk aversion. Takashi Nakamichi and Eleanor Warnock, writing on “Japan lashes out over dollar, euro,” on Dec 29, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323530404578207440474874604.html?mod=WSJ_markets_liveupdate&mg=reno64-wsj), analyze the “war of words” launched by Japan’s new Prime Minister Shinzo Abe and his finance minister Taro Aso, arguing of deliberate devaluations of the USD and EUR relative to the JPY, which are hurting Japan’s economic activity. Gerard Baker and Jacob M. Shlesinger, writing on “Bank of Japan’s Kuroda signals impatience with Abe government,” on May 23, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303480304579579311491068756?KEYWORDS=bank+of+japan+kuroda&mg=reno64-wsj), analyze concerns of the Governor of the Bank of Japan Haruhiko Kuroda that the JPY has strengthened relative to the USD, partly eroding earlier depreciation. The data in Table VI-6 is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Chart VI-5, Japanese Yen JPY per US Dollars USD, Monthly, Jan 4, 1971-Jul 15, 2016

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

The causes of the financial crisis and global recession were 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

Zero interest rates in the United States forever tend to depreciate the dollar against every other currency if there is no risk aversion preventing portfolio rebalancing toward risk financial assets, which include the capital markets and exchange rates of emerging-market economies. The objective of unconventional monetary policy as argued by Yellen 2011AS) is to devalue the dollar to increase net exports that increase US economic growth. Increasing net exports and internal economic activity in the US is equivalent to decreasing net exports and internal economic activity in other countries.

Continental territory, rich endowment of natural resources, investment in human capital, teaching and research universities, motivated labor force and entrepreneurial initiative provide Brazil with comparative advantages in multiple economic opportunities. Exchange rate parity is critical in achieving Brazil’s potential but is difficult in a world of zero interest rates. Chart IV-6 of the Board of Governors of the Federal Reserve System provides the rate of Brazilian real (BRL) per US dollar (USD) from BRL 1.2074/USD on Jan 4, 1999 to BRL 3.2731/USD on Jul 15, 2016. The rate reached BRL 3.9450/USD on Oct 10, 2002 appreciating 60.5 percent to BRL 1.5580/USD on Aug 1, 2008. The rate depreciated 68.1 percent to BRL 2.6187/USD on Dec 5, 2008 during worldwide flight from risk. The rate appreciated again by 41.3 percent to BRL 1.5375/USD on Jul 26, 2011. The final data point in Chart VI-6 is BRL 3.2731/USD on Jul 15, 2016 for depreciation of 112.9 percent. The data in Table VI-6 is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Chart VI-6, Brazilian Real (BRL) per US Dollar (USD) Jan 4, 1999 to Jul 15, 2016

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-7 of the Board of Governors of the Federal Reserve System provides the history of the BRL beginning with the first data point of BRL 0.8440/USD on Jan 2, 1995. The rate jumped to BRL 2.0700/USD on Jan 29, 1999 after changes in exchange rate policy and then to BRL 2.2000/USD on Mar 3, 1999. The rate depreciated 26.7 percent to BRL 2.7880 on Sep 21, 2001 relative to Mar 3, 1999.

Chart VI-7, Brazilian Real (BRL) per US Dollar (USD), Jan 2, 1995 to Jul 15, 2016

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

The major reason and channel of transmission of unconventional monetary policy is through expectations of inflation. Fisher (1930) provided theoretical and historical relation of interest rates and inflation. Let i_n be the nominal interest rate, i_r the real or inflation-adjusted interest rate and π^e the expectation of inflation in the time term of the interest rate, which are all expressed as proportions. The following expression provides the relation of real and nominal interest rates and the expectation of inflation:

(1 + i_r) = (1 + i_n)/(1 + π^e) (1)

That is, the real interest rate equals the nominal interest rate discounted by the expectation of inflation in time term of the interest rate. Fisher (1933) analyzed the devastating effect of deflation on debts. Nominal debt contracts remained at original principal interest but net worth and income of debtors contracted during deflation. Real interest rates increase during declining inflation. For example, if the interest rate is 3 percent and prices decline 0.2 percent, equation (1) calculates the real interest rate as:

(1 +0.03)/(1 – 0.02) = 1.03/(0.998) = 1.032

That is, the real rate of interest is (1.032 – 1)100 or 3.2 percent. If inflation were 2 percent, the real rate of interest would be 0.98 percent, or about 1.0 percent {[(1.03/1.02) -1]100 = 0.98%}.

The yield of the one-year Treasury security was quoted in the Wall Street Journal at 0.114 percent on Fri May 17, 2013 (http://online.wsj.com/mdc/page/marketsdata.html?mod=WSJ_topnav_marketdata_main). The expected rate of inflation π^e in the next twelve months is not observed. Assume that it would be equal to the rate of inflation in the past twelve months estimated by the Bureau of Economic Analysis (BLS) at 1.1 percent (http://www.bls.gov/cpi/). The real rate of interest would be obtained as follows:

(1 + 0.00114)/(1 + 0.011) = (1 + r_r) = 0.9902

That is, i_r is equal to 1 – 0.9902 or minus 0.98 percent. Investing in a one-year Treasury security results in a loss of 0.98 percent relative to inflation. The objective of unconventional monetary policy of zero interest rates is to induce consumption and investment because of the loss to inflation of riskless financial assets. Policy would be truly irresponsible if it intended to increase inflationary expectations or π^e. The result could be the same rate of unemployment with higher inflation (Kydland and Prescott 1977).

Focus is shifting from 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. Markets overreacted to the so-called “paring” of outright purchases to $15 billion of securities per month for the balance sheet of the Fed.

In the Semiannual Monetary Policy Report to Congress on Feb 24, 2015, Chair Yellen analyzes the timing of interest rate increases (http://www.federalreserve.gov/newsevents/testimony/yellen20150224a.htm):

“The FOMC's assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings. If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting. Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the Committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.”

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.”

At the press conference following the meeting on Dec 17, 2014, Chair Yellen answered a question by Jon Hilseranth of the Wall Street Journal explaining “patience” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20141217.pdf):

“So I did say that this statement that the committee can be patient should be interpreted as meaning that it is unlikely to begin the normalization process, for at least the next couple of meetings. Now that doesn't point to any preset or predetermined time at which normalization is -- will begin. There are a range of views on the committee, and it will be dependent on how incoming data bears on the progress, the economy is making. First of all, I want to emphasize that no meeting is completely off the table in the sense that if we do see faster progress toward our objectives than we currently expect, then it is possible that the process of normalization would occur sooner than we now anticipated. And of course the converse is also true. So at this point, we think it unlikely that it will be appropriate, that we will see conditions for at least the next couple of meetings that will make it appropriate for us to decide to begin normalization. A number of committee participants have indicated that in their view, conditions could be appropriate by the middle of next year. But there is no preset time.”

At a speech on Mar 31, 2014, Chair Yellen analyzed labor market conditions as follows (http://www.federalreserve.gov/newsevents/speech/yellen20140331a.htm):

Let me explain what I mean by that word "slack" and why it is so important.

Yellen (2014Aug22) provides comprehensive review of the theory and measurement of labor markets. Monetary policy 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”

Yellen (2014Aug22) finds that the unemployment rate is not sufficient in determining slack:

“One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.”

Yellen (2014Aug22) restates that the FOMC determines monetary policy on newly available information and interpretation of labor markets and inflation and does not follow a preset path:

“But if progress in the labor market continues to be more rapid than anticipated by the Committee or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter. Of course, if economic performance turns out to be disappointing and progress toward our goals proceeds more slowly than we expect, then the future path of interest rates likely would be more accommodative than we currently anticipate. As I have noted many times, monetary policy is not on a preset path. The Committee will be closely monitoring incoming information on the labor market and inflation in determining the appropriate stance of monetary policy.”

There is similar concern in the minutes of the meeting of the FOMC on Dec 16-17, 2014 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20141217.htm):

Chair Yellen analyzes the view of inflation (http://www.federalreserve.gov/newsevents/speech/yellen20140416a.htm):

“Inflation, as measured by the price index for personal consumption expenditures, has slowed from an annual rate of about 2-1/2 percent in early 2012 to less than 1 percent in February of this year. This rate is well below the Committee's 2 percent longer-run objective. Many advanced economies are observing a similar softness in inflation.

To some extent, the low rate of inflation seems due to influences that are likely to be temporary, including a deceleration in consumer energy prices and outright declines in core import prices in recent quarters. Longer-run inflation expectations have remained remarkably steady, however. We anticipate that, as the effects of transitory factors subside and as labor market gains continue, inflation will gradually move back toward 2 percent.”

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?

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.”

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 r^e the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+r^e). Thus, g = [(r/r^e) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dr^e>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

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/2016/07/oscillating-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/06/considerable-uncertainty-about-economic.html). This is merely another case of theory without reality with dubious policy proposals. The current reality is cyclical slow growth.

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 σ_y and prices σ_p. 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 http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html). 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.

A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2016/01/unconventional-monetary-policy-and.html and earlier http://cmpassocregulationblog.blogspot.com/2015/01/peaking-valuations-of-risk-financial.html and earlier http://cmpassocregulationblog.blogspot.com/2014/01/theory-and-reality-of-secular.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 18,570.85 on Fri Jul 22, 2016, which is higher by 31.1 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 30.8 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial assets have been approaching or exceeding historical highs. Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):

So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly” (emphasis added).

In a speech at the IMF on Jul 2, 2014, Chair Yellen analyzed the link between monetary policy and financial risks (http://www.federalreserve.gov/newsevents/speech/yellen20140702a.htm):

“Monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

Yellen (2014Jul14) warned again at the Committee on Banking, Housing and Urban Affairs on Jul 15, 2014:

“The Committee recognizes that low interest rates may provide incentives for some investors to “reach for yield,” and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance. More broadly, the financial sector has continued to become more resilient, as banks have continued to boost their capital and liquidity positions, and growth in wholesale short-term funding in financial markets has been modest” (emphasis added).

Greenspan (1996) made similar warnings:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy” (emphasis added).

Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. What is the success in evaluating deviations of valuations of risk financial assets from “historical norms”? What are the consequences on economic activity and employment of deviations of valuations of risk financial assets from those “historical norms”? What are the policy tools and their effectiveness in returning valuations of risk financial assets to their “historical norms”?

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.

The Communiqué of the Istanbul meeting of G20 Finance Ministers and Central Bank Governors on February 10, 2015, sanctions the need of unconventional monetary policy with warning on collateral effects (http://www.g20.utoronto.ca/2015/150210-finance.html):

“We agree that consistent with central banks' mandates, current economic conditions require accommodative monetary policies in some economies. In this regard, we welcome that central banks take appropriate monetary policy action. The recent policy decision by the ECB aims at fulfilling its price stability mandate, and will further support the recovery in the euro area. We also note that some advanced economies with stronger growth prospects are moving closer to conditions that would allow for policy normalization. In an environment of diverging monetary policy settings and rising financial market volatility, policy settings should be carefully calibrated and clearly communicated to minimize negative spillovers.”

Professor Raguram G Rajan, governor of the Reserve Bank of India, which is India’s central bank, warned about risks in high valuations of asset prices in an interview with Christopher Jeffery of Central Banking Journal on Aug 6, 2014 (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). Professor Rajan demystifies in the interview “competitive easing” by major central banks as equivalent to competitive devaluation. Rajan (2005) anticipated the risks of the world financial crisis. Professor John B. Taylor (2014Jul15, 2014Jun26) building on advanced research (Taylor (1993, 1998LB, 1999, 1998LB, 1999, 2007JH, 2008Nov, 2009, 2012JMCB, 2014Jan3) finds that a monetary policy rule would function best in promoting an environment of low inflation and strong economic growth with stability of financial markets. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html).

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.

The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. There are complex economic, financial and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times). The DJIA has increased 91.7 percent since the trough of the sovereign debt crisis in Europe on Jul 16, 2010 to Jul 22, 2016; S&P 500 has gained 112.7 percent and DAX 79.0 percent. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 7/22/16” had double digit gains relative to the trough around Jul 2, 2010 followed by negative performance but now some valuations of equity indexes show varying behavior. China’s Shanghai Composite is 26.4 percent above the trough. Japan’s Nikkei Average is 88.4 percent above the trough. DJ Asia Pacific TSM is 23.6 percent above the trough. Dow Global is 40.7 percent above the trough. STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 25.5 percent above the trough. NYSE Financial Index is 44.1 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 79.0 percent above the trough. Japan’s Nikkei Average is 88.4 percent above the trough on Aug 31, 2010 and 45.9 percent above the peak on Apr 5, 2010. The Nikkei Average closed at 16,627.25 on Jul 22, 2016 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 62.1 percent higher than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar appreciated 7.9 percent relative to the euro. The dollar devalued before the new bout of sovereign risk issues in Europe. The column “∆% week to 7/22/16” in Table VI-4 shows

decrease of 1.4 percent in the week for China’s Shanghai Composite. The Nikkei increased 0.8 percent. DJ Asia Pacific increased 0.3 percent. NYSE Financial increased 0.7 percent in the week. Dow Global changed 0.0 percent in the week of Jul 22, 2016. The DJIA increased 0.3 percent and S&P 500 increased 0.6 percent. DAX of Germany increased 0.8 percent. STOXX 50 increased 0.5 percent. The USD appreciated 0.5 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table VI-4 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 7/22/16” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Jul 22, 2016. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 7/22/16” but also relative to the peak in column “∆% Peak to 7/22/16.” There are now several equity indexes above the peak in Table VI-4: DJIA 65.7 percent, S&P 500 78.7 percent, DAX 60.3 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 14.8 percent, Dow Global 14.8 percent, and Nikkei Average 45.9 percent. Shanghai Composite is 4.8 percent below the peak; STOXX 50 is 6.3 percent above the peak; and DJ Asia Pacific TSM is 8.2 percent above the peak. The Shanghai Composite increased 52.6 percent from March 12, 2014, to Jul 22, 2016. The US dollar strengthened 27.4 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. Sharp and continuing strengthening of the dollar is affecting balance sheets of US corporations with foreign operations (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318). The Federal Open Market Committee (FOMC) is following “financial and international developments” as part of the process of framing interest rate policy (http://www.federalreserve.gov/newsevents/press/monetary/20150128a.htm). Theo Francis and Kate Linebaugh, writing on “US corporate profits on pace for third straight decline,” on Apr 28, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/u-s-corporate-profits-on-pace-for-third-straight-decline-1461872242), analyze three consecutive quarters of decline of corporate earnings and revenue in companies in S&P 500. They quote Thomson Reuters on expected decline of earnings of 6.1 percent in IQ2016 based on 55 percent of reporting companies. Weakness of economic activity shows in decline of revenues in IQ2016 of 1.4 percent, increasing 1.7 percent excluding energy, and contraction of profits of 0.5 percent. Justin Lahart, writing on “S&P 500 Earnings: far worse than advertised,” on Feb 24, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/s-p-500-earnings-far-worse-than-advertised-1456344483), analyzes S&P 500 earnings in 2015. Under data provided by companies, earnings increased 0.4 percent in 2015 relative to 2014 but under GAAP (Generally Accepted Accounting Principles), earnings fell 12.7 percent, which is the worst decrease since 2008. Theo Francis e Kate Linebaugh, writing on Oct 25, 2015, on “US Companies Warn of Slowing Economy, published in the Wall Street Journal (http://www.wsj.com/articles/u-s-companies-warn-of-slowing-economy-1445818298) analyze the first contraction of earnings and revenue of big US companies. Production, sales and employment are slowing in a large variety of companies with some contracting. Corporate profits also suffer from revaluation of the dollar that constrains translation of foreign profits into dollar balance sheets. Francis and Linebaugh quote Thomson Reuters that analysts expect decline of earnings per share of 2.8 percent in IIIQ2015 relative to IIIQ2014 based on reports by one third of companies in the S&P 500. Sales would decline 4.0% in a third quarter for the first joint decline of earnings per share and revenue in the same quarter since IIIQ2009. Dollar revaluation also constrains corporate results.

Inyoung Hwang, writing on “Fed optimism spurs record bets against stock volatility,” on Aug 21, 2014, published in Bloomberg.com (http://www.bloomberg.com/news/2014-08-21/fed-optimism-spurs-record-bets-against-stock-voalitlity.html), informs that the S&P 500 is trading at 16.6 times estimated earnings, which is higher than the five-year average of 14.3 Tom Lauricella, writing on Mar 31, 2014, on “Stock investors see hints of a stronger quarter,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304157204579473513864900656?mod=WSJ_smq0314_LeadStory&mg=reno64-wsj), finds views of stronger earnings among many money managers with positive factors for equity markets in continuing low interest rates and US economic growth. There is important information in the Quarterly Markets review of the Wall Street Journal (http://online.wsj.com/public/page/quarterly-markets-review-03312014.html) for IQ2014. 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, real gross private domestic investment in the US was $951.6 billion of chained 2009 dollars, growing to $1,266.9 billion in IIIQ1989 or 33.1 percent. Real gross private domestic investment in the US increased 9.0 percent from $2605.2 billion in IVQ2007 to $2,840.2 billion in IQ2016. As shown in Table IAI-2, real private fixed investment increased 6.7 percent from $2,586.3 billion of chained 2009 dollars in IVQ2007 to $2,760.6 billion in IQ2016. Private fixed investment fell relative to IVQ2007 in all quarters preceding IIQ2014 and fell 0.1 percent in IQ2016. Growth of real private investment is mediocre for all but four quarters from IIQ2011 to IQ2012. The investment decision of United States corporations is fractured in the current economic cycle in preference of cash.

There are three aspects. First, there is decrease in corporate profits. Corporate profits with IVA and CCA decreased at $123.0 billion in IQ2015 and increased at $70.5 billion in IIQ2015. Corporate profits with IVA and CCA decreased at $33.1 billion in IIIQ2015. Corporate profits with IVA and CCA decreased at 159.6 billion in IVQ2015 and increased at $34.7 billion in IQ2016. Profits after tax with IVA and CCA fell at $128.5 billion in IQ2015. Profits after tax with IVA and CCA increased at $39.2 billion in IIQ2015. Profits after tax with IVA and CCA decreased at $26.2 billion in IIIQ2015. Profits after tax with IVA and CCA fell at $127.3 billion in IVQ2015 and increased at $30.3 billion in IQ2016. Net dividends increased at $6.3 billion in IQ2015. Net dividends increased at $1.1 billion in IIQ2015 and increased at $26.1 billion in IIIQ2015. Net dividends fell at $15.2 billion in IVQ2015 and increased at $8.2 billion in IQ2016. Undistributed corporate profits fell at $134.7 billion in IQ2015 and increased at $38.0 billion in IIQ2015. Undistributed profits with IVA and CCA decreased at $52.2 billion in IIIQ2015. Undistributed corporate profits with IVA and CCA fell at $112.2 billion in IVQ2015 and increased at $22.1 billion in IQ2016. Undistributed corporate profits swelled 171.0 percent from $107.7 billion in IQ2007 to $291.9 billion in IQ2016 and changed signs from minus $55.9 billion in current dollars in IVQ2007. 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. Second, sharp and continuing strengthening of the dollar is affecting balance sheets of US corporations with foreign operations (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318) and the overall US economy. The bottom part of Table IA1-9 provides the breakdown of corporate profits with IVA and CCA in domestic industries and the rest of the world. Corporate profits with IVA and CCA fell at $159.6 billion in IVQ2015 with decrease of domestic industries at $153.1 billion, mostly because of decrease of nonfinancial business at $129.2 billion, and decrease of profits from operations in the rest of the world at $6.5 billion. Receipts from the rest of the world fell at $22.4 billion. Corporate profits with IVA and CCA increased at $34.7 billion in IQ2016 with increase of domestic industries at $61.6 billion. Profits from operations from the rest of the world fell at $26.9 billion and payments to the rest of the world increased at $35.6 billion. Total corporate profits with IVA and CCA were $1925.0 billion in IQ2016 of which $1576.3 billion from domestic industries, or 81.9 percent of the total, and $348.7 billion, or 18.1 percent, from the rest of the world. Nonfinancial corporate profits of $1214.8 billion account for 63.1 percent of the total. Third, there is reduction in the use of corporate cash for investment. Vipal Monga, David Benoit and Theo Francis, writing on “Companies send more cash back to shareholders,” published on May 26, 2015 in the Wall Street Journal (http://www.wsj.com/articles/companies-send-more-cash-back-to-shareholders-1432693805?tesla=y), use data of a study by Capital IQ conducted for the Wall Street Journal. This study shows that companies in the S&P 500 reduced investment in plant and equipment to median 29 percent of operating cash flow in 2013 from 33 percent in 2003 while increasing dividends and buybacks to median 36 percent in 2013 from 18 percent in 2003.

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 R_τ is expected revenue in the time horizon from τ =1 to T; C_τ 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. Equally, decline in expected revenue from the stock or project, R_τ, causes decline in valuation.

An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.

Table VI-4, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 7/22/ /16	∆% Week 7/22/16	∆% Trough to 7/22/ 16
DJIA	4/26/ 10	7/2/10	-13.6	65.7	0.3	91.7
S&P 500	4/23/ 10	7/20/ 10	-16.0	78.7	0.6	112.7
NYSE Finance	4/15/ 10	7/2/10	-20.3	14.8	0.7	44.1
Dow Global	4/15/ 10	7/2/10	-18.4	14.8	0.0	40.7
Asia Pacific	4/15/ 10	7/2/10	-12.5	8.2	0.3	23.6
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	45.9	0.8	88.4
China Shang.	4/15/ 10	7/02 /10	-24.7	-4.8	-1.4	26.4
STOXX 50	4/15/10	7/2/10	-15.3	6.3	0.5	25.5
DAX	4/26/ 10	5/25/ 10	-10.5	60.3	0.8	79.0
Dollar Euro	11/25 2009	6/7 2010	21.2	27.4	0.5	7.9
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	NA	NA	NA
10-Year T Note	4/5/ 10	4/6/10	3.986	2.784	1.567

T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)

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

ESII Valuations of Risk Financial Assets. The most important source of financial turbulence is shifting toward fluctuating interest rates. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.1037/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jul 15, depreciating to USD 1.1076/EUR on Mon Jul 18, 2016, or by 0.4 percent. The dollar depreciated because more dollars, 1.1076, were required on Mon Jul 18 to buy one euro than $1.1037 on Fri Jul 15. Table III-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate such as in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.1037/EUR on Jul 15. 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 Jul 15, to the last business day of the current week, in this case Jul 22, such as appreciation of 0.5 percent to USD 1.0980/EUR by Jul 22. 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 0.5 percent from the rate of USD 1.1037/EUR on Fri Jul 15 to the rate of USD 1.0980/EUR on Jul 22 {[(1.0980/1.1037) - 1]100 = -0.5%}. The dollar appreciated (denoted by positive sign) by 0.4 percent from the rate of USD 1.1028 on

Thu Jul 21 to USD 1.0980/EUR on Fri Jul 22 {[(1.0980/1.1028) -1]100 = -0.4 %}. Other factors constant, increasing risk aversion causes appreciation of the dollar relative to the euro, with rising uncertainty on European and global 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.

There is mixed performance in equity indexes with several indexes in Table III-1 increasing in the week ending on Jul 22, 2016, after wide swings caused by reallocations of investment portfolios worldwide. Stagnating revenues, corporate cash hoarding, effects of currency oscillations on corporate earnings 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. There are complex economic, financial and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times). DJIA increased 0.3 percent on Jul 22, increasing 0.3 percent in the week. Germany’s DAX decreased 0.1 percent on Jul 22 and increased 0.8 percent in the week. Dow Global changed 0.0 percent on Jul 22 and changed 0.0 percent in the week. Japan’s Nikkei Average decreased 1.1 percent on Jul 22 and increased 0.8 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 decreased 0.5 percent on Jul 22 and increased 0.3 percent in the week. Shanghai Composite that decreased 1.0 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 at 1974.38 on Mar 12, 2014 but closing at 3012.82 on Jul 22, 2016, for decrease of 0.9 percent and decreasing 1.4 percent in the week. The Shanghai Composite increased 52.6 percent from March 12, 2014 to Jul 22, 2016. 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. The global hunt for yield induced by central bank policy rates of near zero percent motivates wide portfolio reshufflings among classes of risk financial assets.

Commodities were mixed in the week of Jul 22, 2016. Table III-1 shows that WTI decreased 3.8 percent in the week of Jul 22 while Brent decreased 4.0 percent in the week with turmoil in oil producing regions but lack of action by OPEC. Gold decreased 0.6 percent on Jul 22 and decreased 0.3 percent in the week.

Table III-I, Weekly Financial Risk Assets Jul 18 to Jul 22, 2016

Fri 15

Mon 18

Tue 19

Wed 20

Thu 21

Fri 22

USD/ EUR

1.1037

0.1%

0.8%

1.1076

-0.4%

1.1022

0.1%

0.5%

1.1016

0.2%

0.1%

1.1028

0.1%

-0.1%

1.0980

0.5%

0.4%

JPY/ USD

104.91

-4.3%

0.4%

106.15

-1.2%

106.12

-1.2%

0.0%

106.89

-1.9%

-0.7%

105.82

-0.9%

1.0%

106.12

-1.2%

-0.3%

CHF/ USD

0.9828

0.1%

-0.2%

0.9825

0.0%

0.9855

-0.3%

0.9874

-0.5%

-0.2%

0.9858

-0.3%

0.2%

0.9871

-0.4%

-0.1%

CHF/ EUR

1.0847

0.2%

0.6%

1.0882

-0.3%

1.0862

-0.1%

0.2%

1.0877

-0.3%

-0.1%

1.0871

-0.2%

0.1%

1.0838

0.1%

0.3%

USD/ AUD

0.7575

1.3201

0.1%

-0.7%

0.7590

1.3175

0.2%

0.7504

1.3326

-0.9%

-1.1%

0.7479

1.3371

-1.3%

-0.3%

0.7494

1.3344

-1.1%

0.2%

0.7464

1.3398

-1.5%

-0.4%

10Y Note

1.595

1.585

1.560

1.581

1.564

1.567

2Y Note

0.706

0.686

0.690

0.718

0.694

0.703

German Bond

2Y -0.65 10Y 0.01

2Y -0.64 10Y -0.01

2Y -0.63 10Y -0.03

2Y -0.63 10Y -0.01

2Y -0.61 10Y -0.01

2Y -0.61 10Y -0.03

DJIA

18516.55

2.0%

0.1%

18533.05

0.1%

18559.01

0.2%

0.1%

18595.03

0.4%

0.2%

18517.23

0.0%

-0.4%

18570.85

0.3%

Dow Global

2395.21

3.3%

-0.1%

2399.14

0.2%

2387.13

-0.3%

-0.5%

2395.65

0.0%

0.4%

2395.21

0.0%

2395.87

0.0%

DJ Asia Pacific

1410.40

3.8%

0.1%

1412.43

0.1%

1412.86

0.2%

0.0%

1413.77

0.2%

0.1%

1421.77

0.8%

0.6%

1414.78

0.3%

-0.5%

Nikkei

16497.85

9.2%

0.7%

16497.85

0.0%

16723.31

1.4%

16681.89

1.1%

-0.2%

16810.22

1.9%

0.8%

16627.25

0.8%

-1.1%

Shanghai

3054.30

2.2%

0.0%

3043.56

-0.4%

3036.60

-0.6%

-0.2%

3027.90

-0.9%

-0.3%

3039.01

-0.5%

0.4%

3012.82

-1.4%

-0.9%

DAX

10066.90

4.5%

0.0%

10063.13

0.0%

9981.24

-0.9%

-0.8%

10142.01

0.7%

1.6%

10156.21

0.9%

0.1%

10147.46

0.8%

-0.1%

DJ UBS Comm.

WTI $/B

45.95

1.2%

0.6%

45.24

-1.5%

44.65

-2.8%

-1.3%

44.94

-2.2%

0.6%

44.75

-2.6%

-0.4%

44.19

-3.8%

-1.3%

Brent $/B

47.61

1.8%

0.5%

46.96

-1.4%

46.66

-2.0%

-0.6%

47.17

-0.9%

1.1%

46.20

-3.0%

-2.1%

45.69

-4.0%

-1.1%

44Gold $/OZ

1326.5

-2.2%

-0.4%

1328.4

0.1%

1331.5

0.4%

0.2%

1318.8

-0.6%

-1.0%

1330.5

0.3%

0.9%

1323.1

-0.3%

-0.6%

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 are complex economic, financial and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times). The British pound (GBP) devalued 5.9 percent from the trough of ₤1.388 on Jan 2, 2009 to ₤1.3106 on Jul 22, 2016 and devalued 53.1 percent from the high of ₤2.006 on Sep 15, 2008.

Table VI-6, Exchange Rates

	Peak	Trough	∆% P/T	Jul 22, 2016	∆% T Jul 22, 2016	∆% P Jul 22, 2016
USD GBP	7/15 2008	1/2/ 2009		7/22/ 2016
Rate	2.006	1.388		1.3106
∆%			-44.5		-5.9	-53.1

Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation

Source:

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

ESIII Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities. Table IIA1-1 of the CBO (2012NovMBR, 2013BEOFeb5, 2013HBDFFeb5, 2013MEFFeb5, 2013Aug12, CBO, Feb 2014, CBO, Apr 2014, CBO, Jan 2015 https://www.cbo.gov/about/products/budget_economic_data#3) shows the significant worsening of United States fiscal affairs from 2007-2008 to 2009-2012 with marginal improvement in 2013-2015 but with much higher debt relative to GDP. The deficit of $1.1 trillion in fiscal year 2012 was the fourth consecutive federal deficit exceeding one trillion dollars. All four deficits are the highest in share of GDP since 1946 (CBO 2012MBR, 2013HBDFeb5, 2013Aug12, 2013AugHBD, CBO, Jan 2015 https://www.cbo.gov/about/products/budget_economic_data#3).

Table IAI-1, US, Budget Fiscal Year Totals, Billions of Dollars and % GDP

	2007	2008	2009	2010	2011
Receipts	2568	2524	2105	2163	2303
Outlays	2729	2983	3518	3457	3603
Deficit	-161	-459	1413	1294	1300
% GDP	-1.1	-3.1	-9.8	-8.7	-8.5

	2012	2013	2014	2015
Receipts	2450	2775	3021	3250
Outlays	3537	3455	3506	3688
Deficit	1087	680	-485	-438
% GDP	-6.8	-4.1	-2.8	-2.5

Source: https://www.cbo.gov/about/products/budget_economic_data#2 CBO (2012NovMBR), CBO (2013BEOFeb5), CBO (2013HBDFeb5), CBO (2013Aug12). CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, Historical Budget Data—April 2014, Washington DC, Congressional Budget Office, Apr 14. CBO, Historical budget data—August 2014 release. Washington, DC, Congressional Budget Office, Aug 27. CBO, Monthly budget review: summary of fiscal year 2014. Washington, DC, Congressional Budget Office, Nov 10, 2014. CBO, Historical Budget Data, January 2015 Baseline from Budget and economic outlook: 2015 to 2025. Washington, DC, CBO, Jan 26. CBO. 2015. An update to the budget and economic outlook: 2015 to 2025. Washington, DC, CBO, Aug 25.

Table IIAI-2 provides additional information required for understanding the deficit/debt situation of the United States. The table is divided into four parts: Treasury budget in the 2016 fiscal year beginning on Oct 1, 2015 and ending on Sep 30, 2016; federal fiscal data for the years from 2009 to 2015; federal fiscal data for the years from 2005 to 2008; and Treasury debt held by the public from 2005 to 2015. Receipts increased 0.9 percent in the cumulative fiscal year 2016 ending in Jun 2016 relative to the cumulative in fiscal year 2015. Individual income taxes increased 0.4 percent relative to the same fiscal period a year earlier. Outlays increased 3.9 percent relative to a year earlier. There are also receipts, outlays, deficit and debt for fiscal years 2013, 2014 and 2015. Total revenues of the US from 2009 to 2012 accumulate to $9021 billion, or $9.0 trillion, while expenditures or outlays accumulate to $14,115 billion, or $14.1 trillion, with the deficit accumulating to $5094 billion, or $5.1 trillion. Revenues decreased 6.5 percent from $9653 billion in the four years from 2005 to 2008 to $9021 billion in the years from 2009 to 2012. Decreasing revenues were caused by the global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and also by growth of only 2.1 percent on average in the cyclical expansion from IIIQ2009 to IQ2016. In contrast, the expansion from IQ1983 to IIIQ1989 was at the average annual growth rate of 4.7 percent and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2016/07/financial-asset-values-rebound-from.html and earlier http://cmpassocregulationblog.blogspot.com/2016/05/appropriate-for-fed-to-increase.html). Because of mediocre GDP growth, there are 23.7 million unemployed or underemployed in the United States for an effective unemployment/underemployment rate of 14.1 percent (http://cmpassocregulationblog.blogspot.com/2016/07/fluctuating-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/06/financial-turbulence-twenty-four.html). Weakness of growth and employment creation is analyzed in II Collapse of United States Dynamism of Income Growth and Employment Creation (Section II and earlier http://cmpassocregulationblog.blogspot.com/2016/05/recovery-without-hiring-ten-million.html). In contrast with the decline of revenue, outlays or expenditures increased 30.2 percent from $10,839 billion, or $10.8 trillion, in the four years from 2005 to 2008, to $14,115 billion, or $14.1 trillion, in the four years from 2009 to 2012. Increase in expenditures by 30.2 percent while revenue declined by 6.5 percent caused the increase in the federal deficit from $1186 billion in 2005-2008 to $5094 billion in 2009-2012. Federal revenue was 14.9 percent of GDP on average in the years from 2009 to 2012, which is well below 17.4 percent of GDP on average from 1966 to 2015. Federal outlays were 23.3 percent of GDP on average from 2009 to 2012, which is well above 20.2 percent of GDP on average from 1966 to 2015. The lower part of Table IIA1-2 shows that debt held by the public swelled from $5803 billion in 2008 to $13,117 billion in 2015, by $7314 billion or 126.0 percent. Debt held by the public as percent of GDP or economic activity jumped from 39.3 percent in 2008 to 73.6 percent in 2016, which is well above the average of 39.0 percent from 1966 to 2015. The United States faces tough adjustment because growth is unlikely to recover, creating limits on what can be obtained by increasing revenues, while continuing stress of social programs restricts what can be obtained by reducing expenditures.

Table IIA1-2, US, Treasury Budget in Fiscal Year to Date Million Dollars

Jun	Fiscal Year 2016	Fiscal Year 2015	∆%
Receipts	2,468,827	2,446,920	0.9
Outlays	2,869,674	2,763,281	3.9
Deficit	-400,847	-316,361
Individual Income Tax	1,171,623	1,167,500	0.4
Corporation Income Tax	223,388	255,453	-12.6
Social Insurance	616,441	588,659	4.7
	Receipts	Outlays	Deficit (-), Surplus (+)
$ Billions
Fiscal Year 2015	3,250	3,688	-438
% GDP	18.2	20.7	2.5
Fiscal Year 2014	3,021	3,506	-485
% GDP	17.6	20.4	2.8
Fiscal Year 2013	2,775	3,455	-680
% GDP	16.8	20.9	-4.1
Fiscal Year 2012	2,450	3,537	-1,087
% GDP	15.3	22.1	-6.8
Fiscal Year 2011	2,303	3,603	-1,300
% GDP	15.0	23.4	-8.5
Fiscal Year 2010	2,163	3,457	-1,294
% GDP	14.6	23.4	-8.7
Fiscal Year 2009	2,105	3,518	-1,413
% GDP	14.6	24.4	-9.8
Total 2009-2012	9,021	14,115	-5,094
Average % GDP 2009-2012	14.9	23.3	-8.5
Fiscal Year 2008	2,524	2,983	-459
% GDP	17.1	20.2	-3.1
Fiscal Year 2007	2,568	2,729	-161
% GDP	17.9	19.1	-1.1
Fiscal Year 2006	2,407	2,655	-248
% GDP	17.6	19.4	-1.8
Fiscal Year 2005	2,154	2,472	-318
% GDP	16.7	19.2	-2.5
Total 2005-2008	9,653	10,839	-1,186
Average % GDP 2005-2008	17.3	19.5	-2.1
Debt Held by the Public	Billions of Dollars	Percent of GDP
2005	4,592	35.6
2006	4,829	35.3
2007	5,035	35.2
2008	5,803	39.3
2009	7,545	52.3
2010	9,019	60.9
2011	10,128	65.9
2012	11,281	70.4
2013	11,983	72.6
2014	12,780	74.4
2015	13,117	73.6

Source: http://www.fiscal.treasury.gov/fsreports/rpt/mthTreasStmt/mthTreasStmt_home.htm

CBO (2012NovMBR). CBO (2011AugBEO); Office of Management and Budget 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5. CBO (2013Aug12). 2013AugHBD. Historical budget data—August 2013. Washington, DC, Congressional Budget Office, Aug. CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, Historical budget data—April 2014 release. Washington, DC, Congressional Budget Office, Apr. Congressional Budget Office, August 2014 baseline: an update to the budget and economic outlook: 2014 to 2024. Washington, DC, CBO, Aug 27, 2014. CBO, Monthly budget review: summary of fiscal year 2014. Washington, DC, Congressional Budget Office, Nov 10, 2014. CBO, The budget and economic outlook: 2015 to 2025. Washington, DC, Congressional Budget Office, Jan 26, 2015. https://www.cbo.gov/about/products/budget_economic_data#3 https://www.cbo.gov/about/products/budget_economic_data#2

Total outlays of the federal government of the United States have grown to extremely high levels. Table IIA1-4 of the CBO (2014Feb, Apr 2014, CBO, Jan 2015 https://www.cbo.gov/about/products/budget_economic_data#3) provides total outlays in 2006 and 2015. Total outlays of $3688.3 billion in 2015, or $3.7 trillion, are higher by $1033.2 billion, or $1.0 trillion, relative to $2655.1 billion in 2006, or $2.7 trillion. Outlays have grown from 19.4 percent of GDP in 2006 to 20.7 percent of GDP in 2015. Outlays as percent of GDP were on average 20.2 percent from 1966 to 2015 and receipts as percent of GDP were on average 17.4 percent of GDP. It has proved extremely difficult to increase receipts above 19 percent of GDP. Mandatory outlays increased from $1411.8 billion in 2006 to $2297.2 billion in 2015, by $885.4 billion. The first to the final row shows that the total of social security, Medicare, Medicaid, Income Security, net interest and defense absorbs 80.6 percent of US total outlays, which is equal to 17.6 percent of GDP. There has been no meaningful constraint of spending, which is quite difficult because of the rigid structure of social programs.

Table IIA1-4, US, Central Government Total Revenue and Outlays, Billions of Dollars and Percent

	2006	% Total	2015	% Total
I TOTAL REVENUE $B	2406.9	100.0	3249.9	100.0
% GDP	17.6		18.2
Individual Income Taxes $B	1043.9		1540.8
% GDP	7.6		8.7
Corporate Income Taxes $B	353.9		343.8
% GDP	2.6		1.9
Social Insurance Taxes	837.8		1065.3
% GDP	6.1		6.0
II TOTAL OUTLAYS	2655.1		3688.3
% GDP	19.4		20.7
Discretionary	1016.6		1167.9
% GDP	7.4		6.6
Defense	520.0		583.3
% GDP	3.8		3.3
Nondefense	496.7		584.7
% GDP	3.6		3.3
Mandatory	1411.8		2297.2
% GDP	10.3		12.9
Social Security	543.9		881.9
% GDP	4.0		5.0
Medicare	376.8		634.1
% GDP	2.8		3.6
Medicaid	180.6		349.8
% GDP	1.3		2.0
Income Security	200.0		300.4
% GDP	1.5		1.7
Offsetting Receipts	-144.3		-257.5
% GDP	-1.1		-1.4
Net Interest	226.6		223.2
% GDP	1.7		1.3
Defense +Social Security +Medicare +Medicaid +Income Security +Net interest	2047.9	77.1*	2972.7	80.6*
% GDP	15.1		17.6

*Percent of Total Outlays

Source: https://www.cbo.gov/about/products/budget_economic_data#3 https://www.cbo.gov/about/products/budget_economic_data#2 CBO (2013Aug12). 2013AugHBD. Historical budget data—August 2013. Washington, DC, Congressional Budget Office, Aug. CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, Historical budget data—April 2014 release. Washington, DC, Congressional Budget Office, Apr. CBO, Historical budget data—August 2014 release. Washington, DC, Congressional Budget Office, Aug 27. CBO, Historical budget data—August 2014 release. Washington, DC, Congressional Budget Office, Aug 27. CBO, The budget and economic outlook: 2015 to 2025. Washington, DC, Congressional Budget Office, Jan 26, 2015.

Table IIA1-9 provides the long-term budget outlook of the CBO for 2016, 2026 and 2046. Revenues increase from 18.2 percent of GDP in 2016 to 19.4 percent in 2046. The growing stock of debt raises net interest spending from 1.4 percent of GDP in 2016 to 3.0 percent in 2026 and 5.8 percent 2046. Total spending increases from 21.1 percent of GDP in 2016 to 23.1 percent in 2026 and 28.2 percent in 2046. Federal debt held by the public rises to 141.1 percent of GDP in 2046. US fiscal

Table IIA1-9, Congressional Budget Office, Long-term Budget Outlook, % of GDP

	2016	2026	2046
Revenues	18.2	18.2	19.4
Total Noninterest Spending	19.7	20.1	22.4
Social Security	4.9	5.9	6.3
Medicare	3.2	3.9	5.7
Medicaid, CHIP and Exchange Subsidies	2.3	2.6	3.1
Other	9.2	7.7	7.3
Net Interest	1.4	3.0	5.8
Total Spending	21.1	23.1	28.2
Revenues Minus Total Noninterest Spending	-1.5	-1.8	-3.0
Revenues Minus Total Spending	-2.9	-4.9	-8.8
Federal Debt Held by the Public	75.4	85.7	141.1

Source: CBO, The 2016 long-term budget outlook. Washington, DC, Jul 12 https://www.cbo.gov/publication/51580

Chart IIA1-3 provides actual federal debt held by the public as percent of GDP from 1790 to 2015 and projected by the CBO from 2016 to 2046. The ratio of debt to GDP climbed from 42.3 percent in 1941 to a peak of 108.7 percent in 1946 because of the Second World War. The ratio of debt to GDP declined to 80.2 percent in 1950 and 66.9 percent in 1951 because of unwinding war effort, economy growing to capacity and less rigid mandatory expenditures. The ratio of debt to GDP of 75.4 percent projected in 2016 is the highest in the United States since 1950. The CBO (2015BEOJun17) projects the ratio of debt of GDP of the United States to reach 141.1 percent in 2046, which will be more than double the average ratio of 39.0 percent in 1966-2015. The misleading debate on the so-called “fiscal cliff” has disguised the unsustainable path of United States fiscal affairs.

Chart IIA1-3, Congressional Budget Office, Federal Debt Held by the Public, Extended Baseline Projection, % of GDP

Source: CBO, The 2016 long-term budget outlook. Washington, DC, Jul 12 https://www.cbo.gov/publication/51580

Chart IIA1-7 of the Congressional Budget Office provides alternative paths of the federal debt as percent of GDP according to assumptions on rates of borrowing for the Federal debt, growth of productivity, participation of the population in the labor force and growth of excess cost for Federal spending on Medicare and Medicaid. The extended baseline is debt to GDP ratio of 141.1 percent in 2046. The upper curve shows that the debt/GDP ratio could rise to 196 percent in 2046 with different assumptions of rates that increase projected deficits or could be as low as 93 percent with rates that lower projected deficits. There are tough policy choices in managing the fiscal affairs of the United States.

Chart IIA1-7, Congressional Budget Office, Paths of Federal Debt under Alternatives

Source: Congressional Budget Office, The 2016 long-term budget outlook. Washington, DC, Jul 12 https://www.cbo.gov/publication/51580

Recovery of growth rates of US economy are critical to resolving is fiscal sustainability. The revealing Chart IA1-8 of the Congressional Budget Office (CBO) provides alternative paths of the debt/GDP ratio according to assumptions on the growth of productivity. The extended baseline projects debt/GDP of 141.1 percent in 2046. With lower rate of growth of productivity, the debt/GDP ratio would increase to 173 percent in 2046. The debt/GDP ratio would be much lower at 112 percent in 2046 with higher rate of productivity growth.

Chart IIA1-8, Congressional Budget Office, Paths of Federal Debt under Alternative Rates of Productivity Growth,

Source: Congressional Budget Office, The 2016 long-term budget outlook. Washington, DC, Jul 12 https://www.cbo.gov/publication/51580

Table IA1-10 of the Congressional Budget Office (CBO) provides the data in Chart IIA1-8. Economy policy must focus intensively on stimulating productivity growth that would recover the high rates of economic growth of the US over the long-term.

Table IIA1-10, Congressional Budget Office, Long-term Budget Outlook, % of GDP, Alternative Paths of Federal Debt According to the Rate of Productivity Growth

Extended Baseline	Given a Lower Rate	Given a Higher Rate
34
31
33
35
36
36
35
35
39
52
61
66
70
73
74
74
75	75	75
76	76	75
75	76	75
76	77	75
77	79	76
78	80	77
80	82	78
81	84	79
82	86	79
84	88	80
86	90	81
88	93	82
90	96	83
92	99	85
94	102	86
97	106	88
99	109	89
102	113	91
105	117	92
107	121	94
110	125	96
113	129	98
116	134	99
119	138	101
122	143	103
125	148	104
129	153	106
132	158	107
135	163	109
138	168	110
141	173	112

Source: Congressional Budget Office, The 2016 long-term budget outlook. Washington, DC, Jul 12 https://www.cbo.gov/publication/51580

In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

The alternative fiscal scenario of the CBO (2012NovCDR, 2013Sep17) resembles an economic world in which eventually the placement of debt reaches a limit of what is proportionately desired of US debt in investment portfolios. This unpleasant environment is occurring in various European countries.

The current real value of government debt plus monetary liabilities depends on the expected discounted values of future primary surpluses or difference between tax revenue and government expenditure excluding interest payments (Cochrane 2011Jan, 27, equation (16)). There is a point when adverse expectations about the capacity of the government to generate primary surpluses to honor its obligations can result in increases in interest rates on government debt.

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:

(M_t + B_t)/P_t = E_t∫(1/R_t_{, t+τ})s_t_+τdτ (4)

Equation (4) expresses the monetary, M_t, and debt, B_t, liabilities of the government, divided by the price level, P_t, in terms of the expected value discounted by the ex-post rate on government debt, R_t_{, t+τ}, of the future primary surpluses s_t_+τ, which are equal to T_t_+τ – G_t_+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 R_t_{, t+τ}. The second equation of Cochrane (2011Jan, 5) is:

M_tV(i_t, ·) = P_tY_t (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.

This analysis suggests that there may be a point of saturation of demand for United States financial liabilities without an increase in interest rates on Treasury securities. A risk premium may develop on US debt. Such premium is not apparent currently because of distressed conditions in the world economy and international financial system. Risk premiums are observed in the spread of bonds of highly indebted countries in Europe relative to bonds of the government of Germany.

The issue of global imbalances centered on the possibility of a disorderly correction (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). Such a correction has not occurred historically but there is no argument proving that it could not occur. The need for a correction would originate in unsustainable large and growing United States current account deficits (CAD) and net international investment position (NIIP) or excess of financial liabilities of the US held by foreigners net relative to financial liabilities of foreigners held by US residents. The IMF estimated that the US could maintain a CAD of two to three percent of GDP without major problems (Rajan 2004). The threat of disorderly correction is summarized by Pelaez and Pelaez, The Global Recession Risk (2007), 15):

“It is possible that foreigners may be unwilling to increase their positions in US financial assets at prevailing interest rates. An exit out of the dollar could cause major devaluation of the dollar. The depreciation of the dollar would cause inflation in the US, leading to increases in American interest rates. There would be an increase in mortgage rates followed by deterioration of real estate values. The IMF has simulated that such an adjustment would cause a decline in the rate of growth of US GDP to 0.5 percent over several years. The decline of demand in the US by four percentage points over several years would result in a world recession because the weakness in Europe and Japan could not compensate for the collapse of American demand. The probability of occurrence of an abrupt adjustment is unknown. However, the adverse effects are quite high, at least hypothetically, to warrant concern.”

The United States could be moving toward a situation typical of heavily indebted countries, requiring fiscal adjustment and increases in productivity to become more competitive internationally. The CAD and NIIP of the United States are not observed in full deterioration because the economy is well below trend. There are two complications in the current environment relative to the concern with disorderly correction in the first half of the past decade. In the release of Jun 14, 2013, the Bureau of Economic Analysis (http://www.bea.gov/newsreleases/international/transactions/2013/pdf/trans113.pdf) informs of revisions of US data on US international transactions since 1999:

“The statistics of the U.S. international transactions accounts released today have been revised for the first quarter of 1999 to the fourth quarter of 2012 to incorporate newly available and revised source data, updated seasonal adjustments, changes in definitions and classifications, and improved estimating methodologies.”

The BEA introduced new concepts and methods (http://www.bea.gov/international/concepts_methods.htm) in comprehensive restructuring on Jun 18, 2014 (http://www.bea.gov/international/modern.htm):

“BEA introduced a new presentation of the International Transactions Accounts on June 18, 2014 and will introduce a new presentation of the International Investment Position on June 30, 2014. These new presentations reflect a comprehensive restructuring of the international accounts that enhances the quality and usefulness of the accounts for customers and bring the accounts into closer alignment with international guidelines.”

Table IIA2-3 provides data on the US fiscal and balance of payments imbalances incorporating all revisions and methods. In 2007, the federal deficit of the US was $161 billion corresponding to 1.1 percent of GDP while the Congressional Budget Office estimates the federal deficit in 2012 at $1087 billion or 6.8 percent of GDP. The estimate of the deficit for 2013 is $680 billion or 4.1 percent of GDP. The combined record federal deficits of the US from 2009 to 2012 are $5094 billion or 31.6 percent of the estimate of GDP for fiscal year 2012 implicit in the CBO (CBO 2013Sep11) estimate of debt/GDP. The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5.094 trillion in four years, using the fiscal year deficit of $1087 billion for fiscal year 2012, which is the worst fiscal performance since World War II. Federal debt in 2007 was $5035 billion, slightly less than the combined deficits from 2009 to 2012 of $5094 billion. Federal debt in 2012 was 70.4 percent of GDP (CBO 2015Jan26) and 72.6 percent of GDP in 2013 (http://www.cbo.gov/). This situation may worsen in the future (CBO 2013Sep17):

“Between 2009 and 2012, the federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing federal debt to soar. Federal debt held by the public is now about 73 percent of the economy’s annual output, or gross domestic product (GDP). That percentage is higher than at any point in U.S. history except a brief period around World War II, and it is twice the percentage at the end of 2007. If current laws generally remained in place, federal debt held by the public would decline slightly relative to GDP over the next several years, CBO projects. After that, however, growing deficits would ultimately push debt back above its current high level. CBO projects that federal debt held by the public would reach 100 percent of GDP in 2038, 25 years from now, even without accounting for the harmful effects that growing debt would have on the economy. Moreover, debt would be on an upward path relative to the size of the economy, a trend that could not be sustained indefinitely.

The gap between federal spending and revenues would widen steadily after 2015 under the assumptions of the extended baseline, CBO projects. By 2038, the deficit would be 6½ percent of GDP, larger than in any year between 1947 and 2008, and federal debt held by the public would reach 100 percent of GDP, more than in any year except 1945 and 1946. With such large deficits, federal debt would be growing faster than GDP, a path that would ultimately be unsustainable.

Incorporating the economic effects of the federal policies that underlie the extended baseline worsens the long-term budget outlook. The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. With those effects included, debt under the extended baseline would rise to 108 percent of GDP in 2038.”

The most recent CBO long-term budget on Jul 12, 2016, projects US federal debt at 141.1 percent of GDP in 2046 (Congressional Budget Office, The 2016 long-term budget outlook. Washington, DC, Jul 12 https://www.cbo.gov/publication/51580).

Table VI-3B, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2007	2008	2009	2010	2011
Goods & Services	-705	-709	-384	-495	-549
Primary Income	101	146	124	178	221
Secondary Income	-114	-128	-124	-125	-133
Current Account	-719	-691	-384	-442	-460
NGDP	14478	14719	14419	14964	15518
Current Account % GDP	-5.0	-4.7	-2.7	-3.0	-3.0
NIIP	-1279	-3995	-2628	-2512	-4455
US Owned Assets Abroad	20705	19423	19426	21767	22209
Foreign Owned Assets in US	21984	23418	22054	24279	26664
NIIP % GDP	-8.8	-27.1	-18.2	-16.8	-28.7
Exports Goods, Services and Income	2569	2751	2286	2631	2988
NIIP % Exports Goods, Services and Income	-50	-145	-115	-95	-149
DIA MV	5858	3707	4945	5486	5215
DIUS MV	4134	3091	3619	4099	4199
Fiscal Balance	-161	-459	-1413	-1294	-1300
Fiscal Balance % GDP	-1.1	-3.1	-9.8	-8.7	-8.5
Federal Debt	5035	5803	7545	9019	10128
Federal Debt % GDP	35.2	39.3	52.3	60.9	65.9
Federal Outlays	2729	2983	3518	3457	3603
∆%	2.8	9.3	17.9	-1.7	4.2
% GDP	19.1	20.2	24.4	23.4	23.4
Federal Revenue	2568	2524	2105	2163	2303
∆%	6.7	-1.7	-16.6	2.7	6.5
% GDP	17.9	17.1	14.6	14.6	15.0

	2012	2013	2014	2015
Goods & Services	-538	-462	-490	-500
Primary Income	216	219	224	182
Secondary Income	-126	-124	-126	-145
Current Account	-447	-366	-392	-463
NGDP	16155	16663	17348	17947
Current Account % GDP	-2.8	-2.2	-2.3	2.6
NIIP	-4518	-5373	-7046	-7281
US Owned Assets Abroad	22562	24145	24718	23341
Foreign Owned Assets in US	27080	29517	31764	30621
NIIP % GDP	-28.0	-32.2	-40.6	-40.6
Exports Goods, Services and Income	3097	3215	3339	3173
NIIP % Exports Goods, Services and Income	-146	-167	-211	-229
DIA MV	5969	7121	7133	6978
DIUS MV	4662	5815	6350	6544
Fiscal Balance	-1087	-680	-485	-438
Fiscal Balance % GDP	-6.8	-4.1	-2.8	-2.5
Federal Debt	11281	11983	12780	13117
Federal Debt % GDP	70.4	72.6	74.4	73.6
Federal Outlays	3537	3455	3506	3688
∆%	-1.8	-2.3	1.5	5.2
% GDP	22.1	20.9	20.4	20.7
Federal Revenue	2450	2775	3022	3250
∆%	6.4	13.3	8.9	7.6
% GDP	15.3	16.8	17.6	18.2

Sources:

Notes: NGDP: nominal GDP or in current dollars; NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value. There are minor discrepancies in the decimal point of percentages of GDP between the balance of payments data and federal debt, outlays, revenue and deficits in which the original number of the CBO source is maintained. See Bureau of Economic Analysis, US International Economic Accounts: Concepts and Methods. 2014. Washington, DC: BEA, Department of Commerce, Jun 2014 http://www.bea.gov/international/concepts_methods.htm These discrepancies do not alter conclusions. Budget http://www.cbo.gov/ https://www.cbo.gov/about/products/budget_economic_data#3 https://www.cbo.gov/about/products/budget_economic_data#2 Balance of Payments and NIIP

ESIV United States Industrial Production. Industrial production increased 0.6 percent in Jun 2016 and decreased 0.3 percent in May 2016 after increasing 0.5 percent in Apr 2016, with all data seasonally adjusted, as shown in Table I-1. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Apr 1, 2016 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

“The Federal Reserve has revised its index of industrial production (IP) and the related measures of capacity and capacity utilization.[1] Total IP is now reported to have increased about 2 1/2 percent per year, on average, from 2011 through 2014 before falling 1 1/2 percent in 2015.[2] Relative to earlier reports, the current rates of change are lower, especially for 2014 and 2015. Total IP is now estimated to have returned to its pre-recession peak in November 2014, six months later than previously estimated. Capacity for total industry is now reported to have increased about 2 percent in 2014 and 2015 after having increased only 1 percent in 2013. Compared with the previously reported estimates, the gain in 2015 is 1/2 percentage point higher, and the gain in 2013 is 1/2 percentage point lower. Industrial capacity is expected to increase 1/2 percent in 2016.”

The report of the Board of Governors of the Federal Reserve System states (http://www.federalreserve.gov/releases/g17/Current/default.htm):

“Industrial production increased 0.6 percent in June after declining 0.3 percent in May. For the second quarter as a whole, industrial production fell at an annual rate of 1.0 percent, its third consecutive quarterly decline. Manufacturing output moved up 0.4 percent in June, a gain largely due to an increase in motor vehicle assemblies. The output of manufactured goods other than motor vehicles and parts was unchanged. The index for utilities rose 2.4 percent as a result of warmer weather than is typical for June boosting demand for air conditioning. The output of mining moved up 0.2 percent for its second consecutive small monthly increase following eight straight months of decline. At 104.1 percent of its 2012 average, total industrial production in June was 0.7 percent lower than its year-earlier level. Capacity utilization for the industrial sector increased 0.5 percentage point in June to 75.4 percent, a rate that is 4.6 percentage points below its long-run (1972–2015) average.” In the six months ending in Jun 2016, United States national industrial production accumulated change of 0.1 percent at the annual equivalent rate of 0.2 percent, which is higher than decline of 0.7 percent in the 12 months ending in Jun 2016. Excluding growth of 0.6 percent in Jun 2016, growth in the remaining five months from Jan to Jun 2016 accumulated to minus 0.5 percent or minus 1.0 percent annual equivalent. Industrial production declined in three of the past six months and increased 0.5 percent in two months and 0.6 percent in another month. Industrial production expanded at annual equivalent 3.2 percent in the most recent quarter from Apr 2016 to Jun 2016 and contracted at 2.8 percent in the prior quarter Jan 2016 to Mar 2016. Business equipment accumulated change of 1.6 percent in the six months from Jan 2016 to Jun 2016, at the annual equivalent rate of 3.2 percent, which is higher than growth of minus 0.6 percent in the 12 months ending in Jun 2016. The Fed analyzes capacity utilization of total industry in its report (http://www.federalreserve.gov/releases/g17/Current/default.htm): “Capacity utilization for the industrial sector increased 0.5 percentage point in June to 75.4 percent, a rate that is 4.6 percentage points below its long-run (1972–2015) average.” United States industry apparently decelerated to a lower growth rate followed by possible acceleration and weakening growth in past months.

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

	Jun 16	May 15	Apr 15	Mar 16	Feb 16	Jan 16	Jun 16/ Jun 15
Total	0.6	-0.3	0.5	-1.0	-0.2	0.5	-0.7
Market Groups
Final Products	0.9	-0.6	1.1	-1.0	0.0	0.8	0.5
Consumer Goods	1.1	-0.8	1.3	-1.2	-0.1	1.2	1.6
Business Equipment	0.7	-0.3	1.1	-0.6	0.5	0.2	-0.6
Non Industrial Supplies	-0.3	-0.2	0.2	-1.1	0.0	0.4	-0.3
Construction	-0.8	-0.5	0.2	-0.8	-0.1	0.0	0.0
Materials	0.6	0.0	-0.1	-0.9	-0.4	0.2	-1.9
Industry Groups
Manufacturing	0.4	-0.3	0.1	-0.4	0.0	0.4	0.4
Mining	0.2	0.3	-2.8	-2.4	-0.5	-1.8	-10.5
Utilities	-2.4	-0.9	6.2	-4.0	-1.1	3.6	0.5
Capacity	75.4	74.9	75.2	74.8	75.6	75.7	0.6

Sources: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Manufacturing decreased 0.4 percent in Jun 2016 after decreasing 0.3 percent in May 2016 and decreasing 0.1 percent in Apr 2016 seasonally adjusted, increasing 0.5 percent not seasonally adjusted in the 12 months ending in Jun 2016, as shown in Table I-2. Manufacturing increased cumulatively 0.2 percent in the six months ending in Jun 2016 or at the annual equivalent rate of 0.4 percent. Excluding the increase of 0.4 percent in Jun 2016, manufacturing changed minus 0.2 percent from Jan 2016 to Jun 2016 or at the annual equivalent rate of minus 0.5 percent. Table I-2 provides a longer perspective of manufacturing in the US. There has been evident deceleration of manufacturing growth in the US from 2010 and the first three months of 2011 with recovery followed by renewed deterioration in more recent months as shown by 12 months rates of growth. Growth rates appeared to be increasing again closer to 5 percent in Apr-Jun 2012 but deteriorated. The rates of decline of manufacturing in 2009 are quite high with a drop of 18.5 percent in the 12 months ending in Apr 2009. Manufacturing recovered from this decline and led the recovery from the recession. Rates of growth appeared to be returning to the levels at 3 percent or higher in the annual rates before the recession but the pace of manufacturing fell steadily with some strength at the margin. There is renewed deterioration. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Apr 1, 2016 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

The bottom part of Table I-2 shows decline of manufacturing by 22.3 from the peak in Jun 2007 to the trough in Apr 2009 and increase of 16.0 percent from the trough in Apr 2009 to Dec 2015. Manufacturing grew 16.0 percent from the trough in Apr 2009 to Jun 2016. Manufacturing in Jun 2016 is lower by 6.1 percent relative to the peak in Jun 2007. The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IQ2016 would have accumulated to 27.6 percent. GDP in IQ2016 would be $19,129.5 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2614.9 billion than actual $16,514.6 billion. There are about two trillion dollars of GDP less than at trend, explaining the 23.7 million unemployed or underemployed equivalent to actual unemployment/underemployment of 14.1 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2016/07/fluctuating-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/06/financial-turbulence-twenty-four.html). US GDP in IQ2016 is 13.7 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,514.6 billion in IQ2016 or 10.2 percent at the average annual equivalent rate of 1.2 percent. Professor John H. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. Cochrane (2016May02) measures GDP growth in the US at average 3.5 percent per year from 1950 to 2000 and only at 1.76 percent per year from 2000 to 2015 with only at 2.0 percent annual equivalent in the current expansion. Cochrane (2016May02) proposes drastic changes in regulation and legal obstacles to private economic activity. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth 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. There is similar behavior in manufacturing. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.2 percent per year from Jun 1919 to Jun 2016. Growth at 3.2 percent per year would raise the NSA index of manufacturing output from 108.2316 in Dec 2007 to 141.4587 in Jun 2016. The actual index NSA in Jun 2016 is 105.6646, which is 25.3 percent below trend. Manufacturing output grew at average 2.1 percent between Dec 1986 and Dec 2015. Using trend growth of 2.1 percent per year, the index would increase to 129.1203 in Jun 2016. The output of manufacturing at 105.6646 in Jun 2016 is 18.2 percent below trend under this alternative calculation.

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

	Month SA ∆%	12-Month NSA ∆%
Jun 2016	0.4	0.5
May	-0.3	-0.2
Apr	0.1	0.7
Mar	-0.4	-0.4
Feb	0.0	0.9
Jan	0.4	0.6
Dec 2015	0.0	-0.4
Nov	-0.3	-0.2
Oct	0.2	0.9
Sep	-0.2	-0.1
Aug	-0.1	0.8
Jul	0.7	0.9
Jun	-0.2	0.3
May	0.0	1.1
Apr	0.2	1.1
Mar	0.2	1.1
Feb	-0.4	1.6
Jan	-0.4	2.9
Dec 2014	-0.2	2.4
Nov	0.9	2.4
Oct	0.0	1.4
Sep	0.1	1.5
Aug	-0.4	1.5
Jul	0.4	2.2
Jun	0.4	1.4
May	0.2	1.2
Apr	0.1	0.8
Mar	0.7	1.3
Feb	1.1	0.0
Jan	-1.1	-0.8
Dec 2013	0.0	-0.1
Nov	-0.1	0.9
Oct	0.1	1.7
Sep	0.1	1.1
Aug	0.9	1.3
Jul	-1.0	0.3
Jun	0.2	0.8
May	0.2	1.0
Apr	-0.3	1.1
Mar	-0.3	0.8
Feb	0.5	0.9
Jan	-0.3	1.1
Dec 2012	0.7	2.0
Nov	0.7	2.0
Oct	-0.3	0.9
Sep	0.0	1.8
Aug	-0.2	2.2
Jul	-0.1	2.5
Jun	0.2	3.3
May	-0.4	3.2
Apr	0.7	3.6
Mar	-0.6	2.5
Feb	0.4	3.9
Jan	1.0	3.2
Dec 2011	0.6	2.7
Nov	-0.4	2.3
Oct	0.6	2.5
Sep	0.3	2.3
Aug	0.3	1.9
Jul	0.6	2.2
Jun	0.1	1.8
May	0.1	1.6
Apr	-0.6	2.9
Mar	0.5	4.5
Feb	0.1	5.1
Jan	0.2	5.2
Dec 2010	0.4	5.8
Nov	0.0	4.9
Oct	0.1	6.1
Sep	0.1	6.4
Aug	0.2	7.0
Jul	0.6	7.5
Jun	0.0	9.2
May	1.5	8.7
Apr	0.9	6.9
Mar	1.2	4.6
Feb	-0.1	1.2
Jan	1.1	1.1
Dec 2009	-0.2	-3.4
Nov	0.9	-6.3
Oct	0.2	-9.3
Sep	0.8	-10.7
Aug	1.1	-13.7
Jul	1.4	-15.4
Jun	-0.4	-18.0
May	-1.1	-17.9
Apr	-0.8	-18.5
Mar	-1.9	-17.4
Feb	-0.2	-16.3
Jan	-3.0	-16.6
Dec 2008	-3.4	-14.1
Nov	-2.3	-11.4
Oct	-0.6	-8.9
Sep	-3.4	-8.7
Aug	-1.2	-5.2
Jul	-1.2	-3.7
Jun	-0.5	-3.3
May	-0.5	-2.6
Apr	-1.1	-1.3
Mar	-0.3	-0.8
Feb	-0.6	0.8
Jan	-0.4	2.1
Dec 2007	0.1	1.8
Nov	0.5	3.3
Oct	-0.4	2.7
Sep	0.4	2.9
Aug	-0.3	2.7
Jul	0.1	3.6
Jun	0.3	3.1
May	-0.1	3.3
Apr	0.7	3.7
Mar	0.8	2.6
Feb	0.4	1.7
Jan	-0.5	1.3
Dec 2006		2.8
Dec 2005		3.5
Dec 2004		4.0
Dec 2003		2.2
Dec 2002		2.3
Dec 2001		-5.3
Dec 2000		0.8
Dec 1999		5.2
Average ∆% Dec 1986-Dec 2015		2.1
Average ∆% Dec 1986-Dec 2014		2.2
Average ∆% Dec 1986-Dec 2013		2.2
Average ∆% Dec 1986-Dec 1999		4.3
Average ∆% Dec 1999-Dec 2006		1.4
Average ∆% Dec 1999-Dec 2015		0.3
∆% Peak 112.5837 in 06/2007 to 101.4354 in 12/2015		-9.9
∆% Peak 112.5837 in 06/2007 to Trough 87.4314 in 4/2009		-22.3
∆% Trough 87.4314 in 04/2009 to 101.4354 in 12/2015		16.0
∆% Trough 87.4314 in 04/2009 to 105.6646 in 6/2016		2.9
∆% Peak 112.5837 on 06/2007 to 105.6646 in 6/2016		-6.1

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

United States manufacturing output from 1919 to 2016 on a monthly basis is in Chart I-4 of the Board of Governors of the Federal Reserve System. The second industrial revolution of Jensen (1993) is quite evident in the acceleration of the rate of growth of output given by the sharper slope in the 1980s and 1990s. Growth was robust after the shallow recession of 2001 but dropped sharply during the global recession after IVQ2007. Manufacturing output recovered sharply but has not reached earlier levels and is losing momentum at the margin. Current output is well below extrapolation of trend. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.2 percent per year from Jun 1919 to Jun 2016. Growth at 3.2 percent per year would raise the NSA index of manufacturing output from 108.2316 in Dec 2007 to 141.4587 in Jun 2016. The actual index NSA in Jun 2016 is 105.6646, which is 25.3 percent below trend. Manufacturing output grew at average 2.1 percent between Dec 1986 and Dec 2015. Using trend growth of 2.1 percent per year, the index would increase to 129.1203 in Jun 2016. The output of manufacturing at 105.6646 in Jun 2016 is 18.2 percent below trend under this alternative calculation.

Chart I-4, US, Manufacturing Output, 1919-2016

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Manufacturing jobs not seasonally adjusted decreased 33,000 from Jun 2015 to Jun 2016 or at the average monthly rate of minus 2750. There are effects of the weaker economy and international trade together with the yearly adjustment of labor statistics. Industrial production increased 0.6 percent in Jun 2016 and decreased 0.3 percent in May 2016 after increasing 0.5 percent in Apr 2016, with all data seasonally adjusted. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Apr 1, 2016 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

Manufacturing fell 22.3 from the peak in Jun 2007 to the trough in Apr 2009 and increased 16.0 percent from the trough in Apr 2009 to Dec 2015. Manufacturing in Jun 2016 is lower by 6.1 percent relative to the peak in Jun 2007. The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IQ2016 would have accumulated to 27.6 percent. GDP in IQ2016 would be $19,129.5 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2614.9 billion than actual $16,514.6 billion. There are about two trillion dollars of GDP less than at trend, explaining the 23.7 million unemployed or underemployed equivalent to actual unemployment/underemployment of 14.1 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2016/07/fluctuating-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/06/financial-turbulence-twenty-four.html). US GDP in IQ2016 is 13.7 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,514.6 billion in IQ2016 or 10.2 percent at the average annual equivalent rate of 1.2 percent. Professor John H. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. Cochrane (2016May02) measures GDP growth in the US at average 3.5 percent per year from 1950 to 2000 and only at 1.76 percent per year from 2000 to 2015 with only at 2.0 percent annual equivalent in the current expansion. Cochrane (2016May02) proposes drastic changes in regulation and legal obstacles to private economic activity. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth 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. There is similar behavior in manufacturing. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.2 percent per year from Jun 1919 to Jun 2016. Growth at 3.2 percent per year would raise the NSA index of manufacturing output from 108.2316 in Dec 2007 to 141.4587 in Jun 2016. The actual index NSA in Jun 2016 is 105.6646, which is 25.3 percent below trend. Manufacturing output grew at average 2.1 percent between Dec 1986 and Dec 2015. Using trend growth of 2.1 percent per year, the index would increase to 129.1203 in Jun 2016. The output of manufacturing at 105.6646 in Jun 2016 is 18.2 percent below trend under this alternative calculation.

Table I-13 provides national income by industry without capital consumption adjustment (WCCA). “Private industries” or economic activities have share of 87.6 percent in IQ2016. Most of US national income is in the form of services. In Jun 2016, there were 145.239 million nonfarm jobs NSA in the US, according to estimates of the establishment survey of the Bureau of Labor Statistics (BLS) (http://www.bls.gov/news.release/empsit.nr0.htm Table B-1). Total private jobs of 123.191 million NSA in Jun 2016 accounted for 84.8 percent of total nonfarm jobs of 145.239 million, of which 12.374 million, or 10.0 percent of total private jobs and 8.5 percent of total nonfarm jobs, were in manufacturing. Private service-providing jobs were 103.275 million NSA in Jun 2016, or 71.1 percent of total nonfarm jobs and 83.8 percent of total private-sector jobs. Manufacturing has share of 10.8 percent in US national income in IQ2016 and durable goods 6.3 percent, as shown in Table I-13. Most income in the US originates in services. Subsidies and similar measures designed to increase manufacturing jobs will not increase economic growth and employment and may actually reduce growth by diverting resources away from currently employment-creating activities because of the drain of taxation.

Table I-13, US, National Income without Capital Consumption Adjustment by Industry, Seasonally Adjusted Annual Rates, Billions of Dollars, % of Total

	SAAR IVQ2015	% Total	SAAR IQ2016	% Total
National Income WCCA	15,949.3	100.0	16,047.3	100.0
Domestic Industries	15,756.7	98.8	15,893.5	99.0
Private Industries	13,940.7	87.4	14,062.9	87.6
Agriculture	156.2	1.0	146.6	0.9
Mining	239.6	1.5	233.4	1.5
Utilities	178.9	1.1	178.8	1.1
Construction	755.0	4.7	767.7	4.8
Manufacturing	1733.7	10.9	1730.7	10.8
Durable Goods	1015.8	6.4	1013.8	6.3
Nondurable Goods	718.0	4.5	716.9	4.5
Wholesale Trade	972.5	6.1	976.7	6.1
Retail Trade	1096.6	6.9	1104.0	6.9
Transportation & WH	527.7	3.3	522.9	3.3
Information	609.7	3.8	617.4	3.8
Finance, Insurance, RE	2779.1	17.4	2843.6	17.7
Professional & Business Services	2159.8	13.5	2170.6	13.5
Education, Health Care	1596.3	10.0	1621.8	10.1
Arts, Entertainment	675.8	4.2	683.8	4.3
Other Services	459.7	2.9	465.0	2.9
Government	1816.0	11.4	1830.6	11.4
Rest of the World	192.7	1.2	153.9	1.0

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

Source: US Bureau of Economic Analysis

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

ESV United States Commercial Banks Assets and Liabilities. Selected assets and liabilities of US commercial banks, not seasonally adjusted, in billions of dollars, from Report H.8 of the Board of Governors of the Federal Reserve System are in Table I-1. Data are not seasonally adjusted to permit comparison between Jun 2015 and Jun 2016. Total assets of US commercial banks grew 4.1 percent from $15,279.6 billion in Jun 2015 to $15,912.0 billion in Jun 2016. The Bureau of Economic Analysis (BEA) estimates US GDP in 2015 at $17,947.0 billion (http://www.bea.gov/iTable/index_nipa.cfm). Thus, total assets of US commercial banks are equivalent to over 80 percent of US GDP. Bank credit grew 7.2 percent from $11,302.9 billion in Jun 2015 to $12,113.7 billion in Jun 2016. Securities in bank credit increased 5.6 percent from $3039 billion in Jun 2015 to $3209 billion in Jun 2016. A large part of securities in banking credit consists of US Treasury and agency securities, increasing 7.5 percent from $2145 billion in Jun 2015 to $2305 billion in Jun 2016. Credit to the government that issues or backs Treasury and agency securities of $2305 billion in Jun 2016 is about 19.0 percent of total bank credit of US commercial banks of $12,113.7 billion. Mortgage-backed securities, providing financing of home loans, increased 8.1 percent, from $1488 billion in Jun 2015 to $1608 billion in Jun 2016. Loans and leases are relatively dynamic, growing 7.8 percent from $8264 billion in Jun 2015 to $8905 billion in Jun 2016. A dynamic class is commercial and industrial loans, growing 9.6 percent from Jun 2015 to Jun 2016 and providing $2066 billion or 23.2 percent of total loans and leases of $8905 billion in Jun 2016. Real estate loans increased 6.9 percent, providing $4002 billion in Jun 2016 or 44.9 percent of total loans and leases. Consumer loans increased 8.5 percent, providing $1316 billion in Jun 2016 or 14.8 percent of total loans. Cash assets are measured to “include vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks” (http://www.federalreserve.gov/releases/h8/current/default.htm). Cash assets in US commercial banks decreased 6.8 percent from $2657 billion in Jun 2015 to $2477 billion in Jun 2016 but a single year of the series masks exploding cash in banks because of unconventional monetary policy, which is discussed below. Bank deposits increased 4.7 percent from $10,706 billion in Jun 2015 to $11,204 billion in Jun 2016. The difference between bank deposits and total loans and leases in banks decreased from $2442 billion in Jun 2015 to $2299 billion in Jun 2016 or by $143 billion. Securities in bank credit increased by $170 billion from $3039 billion in Jun 2015 to $3209 billion in Jun 2016 and Treasury and agency securities increased by $160 billion from $2145 billion in Jun 2015 to $2305 billion in Jun 2016. Loans and leases increased $641 billion from $8264 billion in Jun 2015 to $8905 billion in Jun 2016. Banks expanded both lending and investment in lower risk securities partly because of the weak economy and credit disappointments during the global recession that has resulted in an environment of fewer sound lending opportunities. Investing in securities with high duration, or price elasticity of yields, is riskier because of the increase in yields that can cause loss of principal as investors shift away from bond funds into money market funds invested in short-term assets. Lower interest rates resulting from monetary policy may not necessarily encourage higher borrowing in the current loss of dynamism of the US economy. Real disposable income per capita in IQ2016 is higher by only 8.1 percent than in IVQ2007 (Table IB-2 IX Conclusion and extended analysis in IB Collapse of United States Dynamism of Income Growth and Employment Creation) in contrast with 17.7 percent higher if the economy had performed in long-term growth of per capita income in the United States at 2 percent per year from 1870 to 2010 (Lucas 2011May). In contrast, real disposable income per capita grew cumulatively 25.1 percent in the cycle from IQ1980 to IIIQ1989 that was close to trend growth of 21.9 percent.

Table I-1, US, Assets and Liabilities of Commercial Banks, NSA, Billions of Dollars

	Jun 2015	Jun 2016	∆%
Total Assets	15,279.6	15,912.0	4.1
Bank Credit	11,302.9	12,113.7	7.2
Securities in Bank Credit	3039	3209	5.6
Treasury & Agency Securities	2145	2305	7.5
Mortgage-Backed Securities	1488	1608	8.1
Loans & Leases	8264	8905	7.8
Real Estate Loans	3743	4002	6.9
Commercial Real Estate Loans	1684	1878	11.5
Consumer Loans	1213	1316	8.5
Commercial & Industrial Loans	1885	2066	9.6
Other Loans & Leases	1423	1522	7.0
Cash Assets*	2657	2477	-6.8
Total Liabilities	13,631	14,177	4.0
Deposits	10,706	11,204	4.7
Residual (Assets less Liabilities)	1649	1735	NA

Note: balancing item of residual assets less liabilities not included

*”Includes vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks.”

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Seasonally adjusted annual equivalent rates (SAAR) of change of selected assets and liabilities of US commercial banks from the report H.8 of the Board of Governors of the Federal Reserve System are in Table I-2 annually from 2011 to 2015 and for May 2016 and Jun 2016. The global recession had strong impact on bank assets as shown by declines of total assets of 6.0 percent in 2009 and 2.6 percent in 2010. Loans and leases fell 10.2 percent in 2009 and 5.7 percent in 2010. Commercial and industrial loans fell 18.7 percent in 2009 and 9.2 percent in 2010. Unconventional monetary policy caused an increase of cash assets of banks of 159.2 percent in 2008, 49.5 percent in 2009 and 48.1 percent in 2011 followed by decline by 2.2 percent in 2012. Cash assets of banks increased 54.5 percent in 2013 and 12.2 percent in 2014, decreasing 8.1 percent in 2015. Cash assets of banks increased at the SAAR of 22.5 percent in Aug 2012 but contraction by 49.6 percent in Sep 2012 and 6.3 percent in Oct 2012. Cash assets of banks increased at 56.0 percent in Nov 2012, minus 7.8 percent in Dec 2012, 38.8 percent in Jan 2013, 66.2 percent in Feb 2013, 66.0 percent in Mar 2013 and 14.5 percent in Apr 2013. Cash assets of banks increased at the SAAR of 63.2 percent in May 2013, 42.4 percent in Jun 2013, 28.6 percent in Jul 2013, 71.5 percent in Aug 2013, 57.5 percent in Sep 2013 and 50.2 percent in Oct 2013. Cash assets of banks increased at the rate of 29.0 percent in Nov 2013 and fell at 1.5 percent in Dec 2013. Cash assets of banks increased at 20.1 percent in Jan 2014 and at 20.5 percent in Feb 2014. Cash assets of banks increased at 24.4 percent in Mar 2014 and at 8.1 percent in Apr 2014. Cash assets of banks increased at 3.5 percent in May 2014 and 29.8 percent in Jun 2014. Cash assets of banks increased at 8.4 percent in Jul 2014 and 16.0 percent in Aug 2014. Cash assets of banks increased at 16.8 percent in Sep 2014. Cash assets of banks increased at 2.9 percent in Oct 2014 and fell at 1.0 percent in Nov 2014. Cash assets of banks fell at 32.1 percent in Dec 2014. Cash assets of banks increased at 5.0 percent in Jan 2015, declining at 14.1 percent in Feb 2015 and increasing at 5.3 percent in Mar 2015. Cash assets of banks fell at 1.9 percent in Apr 2015 and at 31.4 percent in May 2015. Cash assets of banks fell at 29.0 percent in Jun 2015 and increased at 8.8 percent in Jul 2015. Cash assets of banks increased at 11.8 percent in Aug 2015 and fell at 29.2 percent in Sep 2015. Cash assets of banks increased at 51.2 percent in Oct 2015 and fell at 33.0 percent in Nov 2015. Cash assets of banks fell at 37.7 percent in Dec 2015 and fell at 14.0 percent in Jan 2016. Cash assets of banks increased at 9.0 percent in Feb 2016 and fell at 4.6 percent in Mar 2016. Cash assets of banks increased at 12.7 percent in Apr 2016 and fell at 4.4 percent in May 2016. Cash assets of banks fell at 18.4 percent in Jun 2016. Acquisitions of securities for the portfolio of the central bank injected reserves in depository institutions that banks held as cash and reserves at the central bank because of the lack of sound lending opportunities and the adverse expectations in the private sector on doing business. The truly dynamic investment of banks has been in securities in bank credit: growing at the SAAR of 15.4 percent in Jul 2012, 2.6 percent in Aug 2012, 5.3 percent in Sep 2012, 4.7 percent in Oct 2012, 1.7 percent in Nov 2012 and 20.5 percent in Dec 2012. There were declines of securities in bank credit at 1.1 percent in Jan 2013, 3.2 percent in Feb 2013 and 2.7 percent in Mar 2013 but growth of 1.5 percent in Apr 2013. Securities in bank credit fell at the SAAR of 2.6 percent in May 2013 and 5.7 percent in Jun 2013. Securities in bank credit fell at the SAAR of 11.9 percent in Jul 2013 and at 8.3 percent in Aug 2013. Securities in bank credit fell at the SAAR of 6.8 percent in Sep 2013 and increased at 3.0 percent in Oct 2013. Securities in bank credit increased at 5.2 percent in Nov 2013 and at 10.5 percent in Dec 2013. Securities in bank credit increased at 4.1 percent in Jan 2014 and at 8.3 percent in Feb 2014. Securities in bank credit increased at 7.8 percent in Mar 2014 and at 4.4 percent in Apr 2014. Securities in bank credit increased at 10.1 percent in May 2014 and at 7.9 percent in Jun 2014. Securities in bank credit increased at 10.1 percent in Jul 2014, at 0.3 percent in Aug 2014 and at 7.6 percent in Sep 2014. Securities in bank credit increased at 2.8 percent in Oct 2014 and at 5.3 percent in Nov 2014. Securities in bank credit jumped at 19.1 percent in Dec 2014. Securities in bank credit increased at 11.2 percent in Jan 2015 and at 7.8 percent in Feb 2015. Securities in bank credit increased at 0.5 percent in Mar 2015 and increased at 7.9 percent in Apr 2015. Securities in bank credit increased at 11.3 percent in May 2015 and at 0.8 percent in Jun 2015. Securities in bank credit fell at 1.9 percent in Jul 2015. Securities in bank credit increased at 5.2 percent in Aug 2015 and fell at 3.5 percent in Sep 2015. Securities in bank credit increased at 5.8 percent in Oct 2015 and increased at 6.5 percent in Nov 2015, increasing at 9.0 percent in Dec 2015. Securities in bank credit increased at 10.7 percent in Jan 2016 and changed at 0.0 percent in Feb 2016. Securities in bank credit increased at 0.8 percent in Mar 2016 and increased at 10.0 percent in Apr 2016. Securities in bank credit increased at 9.0 percent in May 2016 and increased at 7.0 percent in Jun 2016. Fear of loss of principal in securities with high duration or price elasticity of yield is shifting investments away from bonds into cash and other assets with less price risk. Positions marked to market in balance sheets experience sharp declines. Throughout the crisis, banks allocated increasing part of their assets to the safety of Treasury and agency securities, or credit to the US government and government-backed credit: with growth of 13.5 percent in 2009 and 15.4 percent in 2010. Treasury and agency securities in bank credit increased at the rate of 16.3 percent in Jul 2012, declining to the rate of 3.4 percent in Aug 2012, 2.1 percent in Sep 2012 and 0.7 percent in Oct 2012. Treasury and agency securities in bank credit fell at the rate of 0.8 percent in Nov 2012, increasing at 17.2 percent in Dec 2012. Treasury and agency securities in bank credit fell at 5.9 percent in Jan 2013, 3.1 percent in Feb 2013, 7.0 percent in Mar 2013 and 5.4 percent in Apr 2013 and 8.3 percent in May 2013. Treasury and agency securities in US commercial banks fell at the SAAR of 6.8 percent in Jun 2013, 19.7 percent in Jul 2013 and 15.7 percent in Aug 2013. Treasury and agency securities fell at the SAAR of 5.6 percent in Sep 2013 and increased at 1.3 percent in Oct 2013. Treasury and agency securities increased at 5.6 percent in Nov 2013 and at 8.9 percent in Dec 2013. Treasury and agency securities increased at 4.2 percent in Jan 2014 and at 8.1 percent in Feb 2014. Treasury and agency securities increased at 9.3 percent in Mar 2014 and at 7.9 percent in Apr 2014. Treasury and agency securities increased at 17.4 percent in May 2014 and 10.1 percent in Jun 2014. Treasury and agency securities increased at 14.6 percent in Jul 2014, at 6.4 percent in Aug 2014 and at 19.5 percent in Sep 2014. Treasury and agency securities increased at 9.3 percent in Oct 2014 and at 6.5 percent in Nov 2014. Treasury and agency securities jumped at 24.0 percent in Dec 2014, 15.3 percent in Jan 2015 and 9.9 percent in Feb 2015, decreasing at 0.5 percent in Mar 2015. Treasury and agency securities increased at 8.1 percent in Apr 2015, at 18.3 percent in May 2015 and at 1.2 percent in Jun 2015. Treasury and agency securities fell at 0.4 percent in Jul 2015, increasing at 8.2 percent in Aug 2015 and decreasing at 0.2 percent in Sep 2015. Treasury and agency securities increased at 9.7 percent in Oct 2015 and increased at 9.0 percent in Nov 2015, increasing at 12.0 percent in Dec 2015. Treasury and agency securities increased at 12.3 percent in Jan 2016 and fell at 0.9 percent in Feb 2016. Treasury and agency securities fell at 1.4 percent in Mar 2016 and increased at 13.5 percent in Apr 2016. Treasury and agency securities increased at 11.5 percent in May 2016 and increased at 4.8 percent in Jun 2016. Increases in yield result in capital losses that may explain less interest in holding securities with higher duration. Deposits grew at the rate of 10.5 percent in Jul 2012, with the rate declining as for most assets of commercial banks to the rate of 6.2 percent in Aug 2012 but increasing to 7.2 percent in Sep 2012, 8.4 percent in Oct 2012, 5.7 percent in Nov 2012, 18.7 percent in Dec 2012, 2.7 percent in Jan 2013. Deposits grew at the rate of 4.4 percent in Feb 2013, 7.7 percent in Mar 2013, 3.5 percent in Apr 2013 and 2.4 percent in May 2013. Deposits increased at the SAAR of 6.3 percent in Jun 2013, 8.0 percent in Jul 2013 and 3.5 percent in Aug 2013. Deposits grew at the rate of 7.2 percent in Sep 2013 and at 9.0 percent in Oct 2013. Deposits grew at 9.1 percent in Nov 2013 and at 9.1 percent in Dec 2013. Deposits increased at 8.7 percent in Jan 2014 and at 9.6 percent in Feb 2014. Deposits grew at 6.7 percent in Mar 2014 and at 8.4 percent in Apr 2014. Deposits grew at 7.9 percent in May and 3.4 percent in Jun 2014. Deposits increased at 7.2 percent in Jul 2014, at 1.5 percent in Aug 2014 and at 9.9 percent in Sep 2014. Deposits fell at 4.4 percent in Oct 2014 and increased at 9.8 percent in Nov 2014. Deposits increased at 8.2 percent in Dec 2014, 7.0 percent in Jan 2015, 11.3 percent in Feb 2015 and 5.7 percent in Mar 2015. Deposits fell at 1.1 percent in Apr 2015 and increased at 4.8 percent in May 2015 and at 5.6 percent in Jun 2015. Deposits increased at 5.5 percent in Jul 2015, increasing at 7.3 percent in Aug 2015 and increasing at 0.6 percent in Sep 2015. Deposits increased at 6.0 percent in Oct 2015 and increased at 2.4 percent in Nov 2015. Deposits fell at 4.0 percent in Dec 2015 and increased at 5.4 percent in Jan 2016. Deposits increased at 6.2 percent in Feb 2016 and increased at 7.9 percent in Mar 2016. Deposits increased at 5.2 percent in Apr 2016 and increased at 4.3 percent in May 2016, increasing at 7.0 percent in Jun 2016. The credit intermediation function of banks is broken because of adverse expectations on future business and cannot be fixed by monetary and fiscal policy. Incentives to business and consumers are more likely to be effective in this environment in recovering willingness to assume risk on the part of the private sector, which is the driver of growth and job creation.

Table I-2, US, Selected Assets and Liabilities of Commercial Banks, at Break Adjusted, Seasonally Adjusted Annual Rate, ∆%

	2011	2012	2013	2014	2015	May 2016	Jun 2016
Total Assets	5.2	2.6	7.1	7.4	3.4	3.6	4.3
Bank Credit	1.6	4.1	1.3	6.9	7.1	7.3	6.0
Securities in Bank Credit	1.9	7.6	-1.5	7.1	5.8	8.9	7.1
Treasury & Agency Securities	3.2	8.4	-5.1	11.8	8.7	11.5	4.8
Other Securities	-0.9	5.8	6.8	-2.3	-0.8	2.7	12.7
Loans & Leases	1.5	2.9	2.3	6.8	7.6	6.7	5.6
Real Estate Loans	-3.7	-1.1	-1.0	2.5	5.0	8.1	5.9
Commercial Real Estate Loans	-6.3	-1.2	4.5	6.8	9.9	10.1	10.7
Consumer Loans	-1.8	0.6	3.2	5.3	5.7	6.6	8.1
Commercial & Industrial Loans	8.6	11.6	6.9	12.0	10.3	8.8	3.5
Other Loans & Leases	18.6	8.1	6.0	14.6	13.1	0.6	5.5
Cash Assets	48.1	-2.2	54.5	12.2	-8.1	-4.4	-18.4
Total Liabilities	5.5	2.3	8.2	7.6	3.3	4.3	5.7
Deposits	6.7	7.2	6.4	6.4	4.9	4.3	7.0

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart I-8 of the Board of Governors of the Federal Reserve System provides cash assets in commercial banks not seasonally adjusted in billions of dollars from 1973 to 2016. Increases in bank cash reserves processed acquisitions of securities for the portfolio of the central bank. There is no comparable experience in US economic history and such flood of money was never required to return US economic growth to trend of 3 percent per year and 2 percent per year in per capita income after events such as recessions and wars (Lucas 2011May). It is difficult to argue that higher magnitudes of monetary and fiscal policy impulses would have been more successful. Discovery of such painless and fast adjustment by gigantic impulses of monetary policy of zero interest rates and trillions of dollars of bond buying would have occurred earlier with prior cases of successful implementation. Selective incentives to the private sector of a long-term nature could have been more effective.

Chart I-8, US, Cash Assets in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2016, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart I-9 of the Board of Governors of the Federal Reserve System provides total assets of Federal Reserve Banks in millions of dollars on Wednesdays from Dec 18, 2002 to Jul 20, 2016. This is what is referred as the leverage of the central bank balance sheet in monetary policy (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62, Regulation of Banks and Finance (2009b) 224-27). Consecutive rounds of unconventional monetary policy increased total assets by purchase of mortgage-backed securities, agency securities and Treasury securities. Bank reserves in cash and deposited at the central bank swelled as shown in Chart I-8. The central bank created assets in the form of securities financed with creation of liabilities in the form of reserves of depository institutions.

Chart I-9, US, Total Assets of Federal Reserve Banks, Wednesday Level, Millions of Dollars, Dec 18, 2002 to Jul 20, 2016

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1

Chart I-16 is quite revealing in analyzing the state of bank credit in the US economy. The upper curves are (1) deposits and (2) loans and leases in bank credit. Historically since 1973, the level and rate of change of deposits and loans and leases in bank credit were almost identical. The lower two curves are Treasury and agency securities in bank credit and cash assets with treasury and agency securities moving closely with cash assets until the 1990s when Treasury and agency securities exceeded cash assets. There is convergence in the final segment after cash assets exceeded treasury and agency securities. The shaded area of the recession from IV2007 to IIQ2009 shows a break in the level and rate of movement of the series. Deposits continued to expand rapidly through the recession and the following expansion period. Loans and leases fell and barely recovered the level of trend before the recession while deposits moved nearly vertically well above the level before the recession. While Treasury and agency securities in bank credit continued to expand at a higher rate, reaching a level well above that before the recession, cash assets jumped as the counterpart of excess reserves in banks that financed quantitative easing or massive outright purchases of securities for the balance sheet of the Fed. Unconventional monetary policy of zero interest rates and outright purchases of securities caused sharp increases of deposits, cash assets and Treasury and agency securities in bank credit but not in loans and leases. There is much discussion about the almost impossible task of evaluating monetary policy in terms of costs and benefits. Before the financial crisis, Chairman Greenspan (2004) analyzes monetary policy and its limitations (see Pelaez and Pelaez, The Global Recession Risk (2007), 13-4, 212-13) that do not differ from those of private financial institutions:

“The Federal Reserve’s experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term “uncertainty” is meant here to encompass both “Knightian uncertainty,” in which the probability distribution of outcomes is unknown, and “risk,” in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.

As a consequence, the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks. In essence, the risk management approach to monetary policymaking is an application of Bayesian decision making.

This framework also entails devising, in light of those risks, a strategy for policy directed at maximizing the probabilities of achieving over time our goals of price stability and the maximum sustainable economic growth that we associate with it. In designing strategies to meet our policy objectives, we have drawn on the work of analysts, both inside and outside the Fed, who over the past half century have devoted much effort to improving our understanding of the economy and its monetary transmission mechanism. A critical result has been the identification of a relatively small set of key relationships that, taken together, provide a useful approximation of our economy’s dynamics. Such an approximation underlies the statistical models that we at the Federal Reserve employ to assess the likely influence of our policy decisions.

However, despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and, in all likelihood, will always remain so. Every model, no matter how detailed or how well designed, conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis.

Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decision makers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy.”

Risk management tools are as likely to fail in private financial institutions as in central banks because of the difficulty of modeling risk during uncertainty. There is no such thing as riskless financial management. “Whale” trades at official institutions causing wide swings of financial and economic variables do not receive the same attention as those in large private banking institutions such as the teapot storm over JP Morgan Chase.

The post of this blog on Nov 8, 2009 is currently relevant (http://cmpassocregulationblog.blogspot.com/2009/11/how-big-bank-carlos-manuel-pelaezs.html):

Sunday, November 8, 2009

How Big a Bank
Carlos Manuel Peláez's Latest Blog Posts
How Big a Bank
5:56 PM PST, November 8, 2009
Agendas of financial regulation in parliaments, international official institutions and monetary authorities include limits on the size of banks or how big a bank should be. These proposals imply that regulators would decide the total value of assets held by banks. Assets would have to be weighted by risk, which is the best practice applied in the Basel capital accords. Regulators would decide not only the total value of assets but also the structure or percentage share of assets by risk class and credit rating such as how much in consumer credit, real estate lending, securities holding, corporate lending and so on. If the regulators decide on the total value of assets and their risk, they effectively micro manage bank decisions on risk and return. Managers would only implement regulatory criteria with little decision power on how best to reward shareholder capital. Regulators would mandate maximum assets and their risk distribution by leverage, credit and liquidity regulation. There are two concerns on the regulation of how big a bank should be. First, there is the issue of best practice in bank management and its consequences for financing prosperity. Banking is characterized by declining costs because of bulky fixed investments required for initiation of lines of business (Pelaez and Pelaez, Regulation of Banks and Finance, 82-9, Financial Regulation after the Global Recession, 63-9). There has been a new industrial/technological revolution in the past three decades centered on information technology (IT). Banking is highly intensive in the creation, processing, transmission and decision use of information. The first transaction of a $100 million IT facility costs $100 million but the hundred millionth costs only one dollar. Competitive banking requires a large volume of transactions to reach the minimum cost of operations. At the time of the call report for the implementation of Basel II in 2006, 11 banking organizations had total assets of $4.6 trillion, equivalent to 44 percent of total US banking assets of $10.5 trillion, and about $978 billion in foreign assets, equivalent to 96 percent of US foreign banking assets of $1 trillion (Pelaez and Pelaez, Globalization and the State: Vol. II, 147). Concentration likely increased during the credit/dollar crisis and its reversal by regulation could cause another confidence shock. The regulation of how big a bank should be would disrupt investment in the best practice of using technology and delivery of products at lowest cost by US banking organizations. It would also undermine the competitiveness of US banks in international business, violating the essential principle of the Basel capital accords of maintaining fair competitive international banking. Second, the regulation of how big a bank should be is based on an inadequate interpretation of the credit crisis/global recession. The panic of confidence in financial markets is commonly attributed to the failure of Lehman Bros. in September 2008. Cochrane and Zingales have shown that the crisis of confidence originated in the proposal of the Troubled Asset Relief Program (TARP) of $700 billion two weeks after the failure of Lehman Bros. TARP was proposed in negative terms of: withdraw "toxic" assets from bank balance sheets of banks or there would be an economic catastrophe similar to the Great Depression. Counterparty risk perception rose sharply because of fear of banking panics, paralyzing sale and repurchase transactions and causing illiquidity of multiple market segments. The "toxin" was introduced by zero interest rates in 2003-4 that induced high leverage and risk, low liquidity and imprudent credit together with the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie on the good faith and credit of the US. Regulatory micro management of the volume and structure of risk of banks and financial markets will weaken banks, reducing the volume of credit required for steering the world economy from currently low levels of activity. It will also restructure markets with arbitrary concession of monopolistic power to less efficient banks, creating vulnerabilities to new crises. There is need for less intrusive regulation that induces a sustainable path of prosperity, using effectively the staff, expertise and resources of existing regulatory agencies.

Chart I-16, US, Deposits, Loans and Leases in Bank Credit, Cash Assets and Treasury and Agency Securities in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2016, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

ESVI Collapse of United States Dynamism of Income Growth and Employment Creation. The departing theoretical framework of Bordo and Haubrich (2012DR) is the plucking model of Friedman (1964, 1988). Friedman (1988, 1) recalls, “I was led to the model in the course of investigating the direction of influence between money and income. Did the common cyclical fluctuation in money and income reflect primarily the influence of money on income or of income on money?” Friedman (1964, 1988) finds useful for this purpose to analyze the relation between expansions and contractions. Analyzing the business cycle in the United States between 1870 and 1961, Friedman (1964, 15) found that “a large contraction in output tends to be followed on the average by a large business expansion; a mild contraction, by a mild expansion.” The depth of the contraction opens up more room in the movement toward full employment (Friedman 1964, 17):

“Output is viewed as bumping along the ceiling of maximum feasible output except that every now and then it is plucked down by a cyclical contraction. Given institutional rigidities and prices, the contraction takes in considerable measure the form of a decline in output. Since there is no physical limit to the decline short of zero output, the size of the decline in output can vary widely. When subsequent recovery sets in, it tends to return output to the ceiling; it cannot go beyond, so there is an upper limit to output and the amplitude of the expansion tends to be correlated with the amplitude of the contraction.”

Kim and Nelson (1999) test the asymmetric plucking model of Friedman (1964, 1988) relative to a symmetric model using reference cycles of the NBER and find evidence supporting the Friedman model. Bordo and Haubrich (2012DR) analyze 27 cycles beginning in 1872, using various measures of financial crises while considering different regulatory and monetary regimes. The revealing conclusion of Bordo and Haubrich (2012DR, 2) is that:

“Our analysis of the data shows that steep expansions tend to follow deep contractions, though this depends heavily on when the recovery is measured. In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength. For many configurations, the evidence for a robust bounce-back is stronger for cycles with financial crises than those without.”

The average rate of growth of real GDP in expansions after recessions with financial crises was 8 percent but only 6.9 percent on average for recessions without financial crises (Bordo 2012Sep27). Real GDP declined 12 percent in the Panic of 1907 and increased 13 percent in the recovery, consistent with the plucking model of Friedman (Bordo 2012Sep27). Bordo (2012Sep27) finds two probable explanations for the weak recovery during the current economic cycle: (1) collapse of United States housing; and (2) uncertainty originating in fiscal policy, regulation and structural changes. There are serious doubts if monetary policy is adequate to recover the economy under these conditions.

Lucas (2011May) estimates US economic growth in the long-term at 3 percent per year and about 2 percent per year in per capita terms. There are displacements from this trend caused by events such as wars and recessions but the economy grows much faster during the expansion, compensating for the contraction and maintaining trend growth over the entire cycle. Historical US GDP data exhibit remarkable growth: Lucas (2011May) estimates an increase of US real income per person by a factor of 12 in the period from 1870 to 2010. The explanation by Lucas (2011May) of this remarkable growth experience is that government provided stability and education while elements of “free-market capitalism” were an important driver of long-term growth and prosperity. Lucas sharpens this analysis by comparison with the long-term growth experience of G7 countries (US, UK, France, Germany, Canada, Italy and Japan) and Spain from 1870 to 2010. Countries benefitted from “common civilization” and “technology” to “catch up” with the early growth leaders of the US and UK, eventually growing at a faster rate. Significant part of this catch up occurred after World War II. Lucas (2011May) finds that the catch up stalled in the 1970s. The analysis of Lucas (2011May) is that the 20-40 percent gap that developed originated in differences in relative taxation and regulation that discouraged savings and work incentives in comparison with the US. A larger welfare and regulatory state, according to Lucas (2011May), could be the cause of the 20-40 percent gap. Cobet and Wilson (2002) provide estimates of output per hour and unit labor costs in national currency and US dollars for the US, Japan and Germany from 1950 to 2000 (see Pelaez and Pelaez, The Global Recession Risk (2007), 137-44). The average yearly rate of productivity change from 1950 to 2000 was 2.9 percent in the US, 6.3 percent for Japan and 4.7 percent for Germany while unit labor costs in USD increased at 2.6 percent in the US, 4.7 percent in Japan and 4.3 percent in Germany. From 1995 to 2000, output per hour increased at the average yearly rate of 4.6 percent in the US, 3.9 percent in Japan and 2.6 percent in Germany while unit labor costs in USD fell at minus 0.7 percent in the US, 4.3 percent in Japan and 7.5 percent in Germany. There was increase in productivity growth in Japan and France within the G7 in the second half of the 1990s but significantly lower than the acceleration of 1.3 percentage points per year in the US. The key indicator of growth of real income per capita, which is what a person earns after inflation, measures long-term economic growth and prosperity. A refined concept would include real disposable income per capita, which is what a person earns after inflation and taxes.

Table IB-1 provides the data required for broader comparison of long-term and cyclical performance of the United States economy. 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. First, Long-term performance. Using annual data, US GDP grew at the average rate of 3.2 percent per year from 1929 to 2015 and at 3.2 percent per year from 1947 to 2015. Real disposable income grew at the average yearly rate of 3.2 percent from 1929 to 2015 and at 3.7 percent from 1947 to 1999. Real disposable income per capita grew at the average yearly rate of 2.0 percent from 1929 to 2015 and at 2.3 percent from 1947 to 1999. US economic growth was much faster during expansions, compensating contractions in maintaining trend growth for whole cycles. Using annual data, US real disposable income grew at the average yearly rate of 3.5 percent from 1980 to 1989 and real disposable income per capita at 2.6 percent. The US economy has lost its dynamism in the current cycle: real disposable income grew at the yearly average rate of 1.6 percent from 2006 to 2015 and real disposable income per capita at 0.8 percent. Real disposable income grew at the average rate of 1.6 percent from 2007 to 2015 and real disposable income per capita at 0.7 percent. Table IB-1 illustrates the contradiction of long-term growth with the proposition of secular stagnation (Hansen 1938, 1938, 1941 with early critique by Simons (1942). Secular stagnation would occur over long periods. Table IB-1 also provides the corresponding rates of population growth that is only marginally lower at 0.8 to 0.9 percent recently from 1.1 percent over the long-term. GDP growth fell abruptly from 2.6 percent on average from 2000 to 2006 to 1.3 percent from 2006 to 2015 and 1.2 percent from 2007 to 2015 and real disposable income growth fell from 2.9 percent on average from 2000 to 2006 to 1.6 percent from 2006 to 2015. The decline of growth of real per capita disposable income is even sharper from average 2.0 percent from 2000 to 2006 to 0.8 percent from 2006 to 2015 and 0.7 percent from 2007 to 2015 while population growth was 0.8 percent on average. Lazear and Spletzer (2012JHJul122) provide theory and measurements showing that cyclic factors explain currently depressed labor markets. This is also the case of the overall economy. Second, first four quarters of expansion. Growth in the first four quarters of expansion is critical in recovering loss of output and employment occurring during the contraction. In the first four quarters of expansion from IQ1983 to IVQ1983: GDP increased 7.8 percent, real disposable personal income 5.3 percent and real disposable income per capita 4.4 percent. In the first four quarters of expansion from IIIQ2009 to IIQ2010: GDP increased 2.7 percent, real disposable personal income 0.2 percent and real disposable income per capita decreased 0.7 percent. Third, first 27 quarters of expansion. In the expansion from IQ1983 to IIIQ1989: GDP grew 36.0 percent at the annual equivalent rate of 4.7 percent; real disposable income grew 29.6 percent at the annual equivalent rate of 3.9 percent; and real disposable income per capita grew 22.0 percent at the annual equivalent rate of 3.0 percent. In the expansion from IIIQ2009 to IQ2016: GDP grew 15.0 percent at the annual equivalent rate of 2.1 percent; real disposable income grew 13.5 percent at the annual equivalent rate of 1.9 percent; and real disposable personal income per capita grew 7.7 percent at the annual equivalent rate of 1.1 percent. Fourth, entire quarterly cycle. In the entire cycle combining contraction and expansion from IQ1980 to IIIQ1989: GDP grew 35.8 percent at the annual equivalent rate of 3.1 percent; real disposable personal income grew 37.1 percent at the annual equivalent rate of 3.2 percent; and real disposable personal income per capita 25.2 percent at the annual equivalent rate of 2.3 percent. In the entire cycle combining contraction and expansion from IVQ2007 to IQ2016: GDP grew 10.2 percent at the annual equivalent rate of 1.2 percent; real disposable personal income increased 15.4 percent at the annual equivalent rate of 1.7 percent; and real disposable personal income per capita grew 8.1 percent at the annual equivalent rate of 0.9 percent. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction of 4.2 percent from IVQ2007 to IIQ2009 and the financial crisis. The proposition of secular stagnation should explain a long-term process of decay and not the actual abrupt collapse of the economy and labor markets currently.

Table IB-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population Long-term and in 1983-88 and 2007-2015, %

Long-term Average ∆% per Year	GDP	Population
1929-2015	3.2	1.1
1947-2015	3.2	1.2
1947-1999	3.6	1.3
1980-1989	3.5	0.9
2000-2015	1.8	0.9
2000-2006	2.6	0.9
2006-2015	1.3	0.8
2007-2015	1.2	0.8
Long-term Average ∆% per Year	Real Disposable Income	Real Disposable Income per Capita	Population
1929-2015	3.2	2.0	1.1
1947-1999	3.7	2.3	1.3
2000-2015	2.1	1.3	0.9
2000-2006	2.9	2.0	0.9
2006-2015	1.6	0.8	0.8
2007-2015	1.6	0.7	0.8
Whole Cycles Average ∆% per Year
1980-1989	3.5	2.6	0.9
2006-2015	1.6	0.8	0.8
2007-2015	1.6	0.7	0.8
Comparison of Cycles	# Quarters	∆%	∆% Annual Equivalent
GDP
I83 to IV83 I83 to IQ87 I83 to II87 I83 to III87 I83 to IV87 I83 to I88 I83 to II88 I83 to III88 I83 to IV88 I83 to I89 I83 to II89 I83 to III89	4 17 18 19 20 21 22 23 24 25 26 27	7.8 23.1 24.5 25.6 27.7 28.4 30.1 30.9 32.6 34.0 35.0 36.0	7.8 5.0 5.0 4.9 5.0 4.9 4.9 4.8 4.8 4.8 4.7 4.7
RDPI
I83 to IV83 I83 to I87 I83 to III87 I83 to IV87 I83 to I88 I83 to II88 I83 to III88 I83 to IV88 I83 to I89 I83 to II89 I83 to III89	4 17 19 20 21 22 23 24 25 26 27	5.3 19.5 20.5 22.1 23.8 25.1 26.3 27.5 29.1 28.7 29.6	5.3 4.3 4.0 4.1 4.2 4.2 4.1 4.1 4.2 4.0 3.9
RDPI Per Capita
I83 to IV83 I83 to I87 I83 to III87 I83 to IV87 I83 to I88 I83 to II88 I83 to III88 I83 to IV88 I83 to I89 I83 to II89 I83 to III89	4 17 19 20 21 22 23 24 25 26 27	4.4 15.1 15.5 16.7 18.2 19.2 20.0 20.9 22.1 21.5 22.0	4.4 3.4 3.1 3.1 3.2 3.2 3.2 3.2 3.2 3.0 3.0
Whole Cycle IQ1980 to IIIQ1989
GDP	40	35.8	3.1
RDPI	40	37.1	3.2
RDPI per Capita	40	25.2	2.3
Population	40	9.5	0.9
GDP
III09 to II10 III09 to I16	4 27	2.7 15.0	2.7 2.1
RDPI
III09 to II10 III09 to I16	4 27	0.2 13.5	0.2 1.9
RDPI per Capita
III09 to II10 III09 to I16	4 27	-0.7 7.7	-0.7 1.1
Population
III09 to II10 III09 to I16	4 27	0.8 5.3	0.8 0.8
IVQ2007 to IQ201	33
GDP	33	10.2	1.2
RDPI	33	15.4	1.7
RDPI per Capita	33	8.1	0.9
Population	33	6.7	0.8

RDPI: Real Disposable Personal Income

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

ESVII Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates. Long-term economic growth in Japan significantly improved by increasing competitiveness in world markets. Net trade of exports and imports is an important component of the GDP accounts of Japan. Table VB-3 provides quarterly data for net trade, exports and imports of Japan. Net trade had strong positive contributions to GDP growth in Japan in all quarters from IQ2007 to IIQ2009 with exception of IVQ2008 and IQ2009. The US recession is dated by the National Bureau of Economic Research (NBER) as beginning in IVQ2007 (Dec) and ending in IIQ2009 (Jun) (http://www.nber.org/cycles/cyclesmain.html). Net trade contributions helped to cushion the economy of Japan from the global recession. Net trade deducted from GDP growth in seven of the nine quarters from IVQ2010 to IQ2012. The only strong contribution of net trade was 3.9 percent in IIIQ2011. Net trade added 1.9 percentage points to GDP growth in IQ2013 but deducted 0.3 percentage points in IIQ2013, 1.5 percentage points in IIIQ2013 and 1.9 percentage points in IVQ2013. Net trade deducted 0.8 percentage points from GDP growth in IQ2014. Net trade added 3.5 percentage points to GDP growth in IIQ2014 and 0.2 percentage points in IIIQ2014. Net trade added 1.5 percentage points to GDP growth in IVQ2014. Net trade contributed 0.4 percentage points to GDP growth in IQ2015 and deducted 1.4 percentage points in IIQ2015. Net trade added 0.5 percentage points to GDP growth in IIIQ2015. Net trade added 0.3 percentage points to GDP growth in IVQ2015 and added 0.7 percentage points in IQ2016. Private consumption assumed the role of driver of Japan’s economic growth but should moderate as in most mature economies.

Table VB-3, Japan, Contributions to Changes in Real GDP, Seasonally Adjusted Annual Rates (SAAR), %

	Net Trade	Exports	Imports
2016
I	0.7	0.4	0.3
2015
I	0.4	1.6	-1.2
II	-1.4	-3.5	2.1
III	0.5	1.8	-1.4
IV	0.3	-0.6	0.9
2014
I	-0.8	3.8	-4.6
II	3.5	0.0	3.5
III	0.2	1.0	-0.8
IV	1.5	2.4	-0.9
2013
I	1.9	2.2	-0.4
II	-0.3	1.8	-2.1
III	-1.5	-0.3	-1.2
IV	-1.9	0.1	-2.0
2012
I	0.4	1.5	-1.2
II	-1.7	-0.2	-1.5
III	-1.9	-2.3	0.4
IV	-0.5	-2.1	1.6
2011
I	-1.2	-0.6	-0.7
II	-4.5	-4.6	0.1
III	3.9	5.8	-1.9
IV	-2.8	-1.9	-0.9
2010
I	2.3	3.6	-1.3
II	0.1	2.8	-2.6
III	0.5	1.4	-0.9
IV	-0.3	0.1	-0.4
2009
I	-4.4	-16.4	12.0
II	7.5	4.7	2.7
III	2.2	5.2	-3.1
IV	2.8	4.1	-1.4
2008
I	1.1	2.1	-1.0
II	0.6	-1.5	2.1
III	0.0	0.1	-0.2
IV	-11.4	-10.2	-1.2
2007
I	1.1	1.7	-0.5
II	0.8	1.6	-0.8
III	2.0	1.4	0.6
IV	1.4	2.0	-0.7

Source: Japan Economic and Social Research Institute, Cabinet Office

http://www.esri.cao.go.jp/index-e.html

http://www.esri.cao.go.jp/en/sna/sokuhou/sokuhou_top.html

There was milder increase in Japan’s export corporate goods price index during the global recession in 2008 but similar sharp decline during the bank balance sheets effect in late 2008, as shown in Chart IV-5 of the Bank of Japan. Japan exports industrial goods whose prices have been less dynamic than those of commodities and raw materials. As a result, the export CGPI on the yen basis in Chart IV-5 trends down with oscillations after a brief rise in the final part of the recession in 2009. The export corporate goods price index on the yen basis fell from 104.9 in Jun 2009 to 94.0 in Jan 2012 or minus 10.4 percent and increased to 98.6 in Jun 2016 for gain of 4.9 percent relative to Jan 2012 and minus 6.0 percent relative to Jun 2009. The choice of Jun 2009 is designed to capture the reversal of risk aversion beginning in Sep 2008 with the announcement of toxic assets in banks that would be withdrawn with the Troubled Asset Relief Program (TARP) (Cochrane and Zingales 2009). Reversal of risk aversion in the form of flight to the USD and obligations of the US government opened the way to renewed carry trades from zero interest rates to exposures in risk financial assets such as commodities. Japan exports industrial products and imports commodities and raw materials. The recovery from the global recession began in the third quarter of 2009.

Chart IV-5, Japan, Export Corporate Goods Price Index, Monthly, Yen Basis, 2008-2016

Source: Bank of Japan

http://www.stat-search.boj.or.jp/index_en.html

Chart IV-5A provides the export corporate goods price index on the basis of the contract currency. The export corporate goods price index on the basis of the contract currency increased from 97.9 in Jun 2009 to 103.1 in Apr 2012 or 5.3 percent but dropped to 89.6 in Jun 2016 or minus 13.1 percent relative to Apr 2012 and fell 8.5 percent to 89.6 in Jun 2016 relative to Jun 2009.

Chart IV-5A, Japan, Export Corporate Goods Price Index, Monthly, Contract Currency Basis, 2008-2016

Source: Bank of Japan

http://www.stat-search.boj.or.jp/index_en.html

Japan imports primary commodities and raw materials. As a result, the import corporate goods price index on the yen basis in Chart IV-6 shows an upward trend after declining from the increase during the global recession in 2008 driven by carry trades from fed funds rates. The index increases with carry trades from zero interest rates into commodity futures and declines during risk aversion from late 2008 into beginning of 2008 originating in doubts about soundness of US bank balance sheets. More careful measurement should show that the terms of trade of Japan, export prices relative to import prices, declined during the commodity shocks originating in unconventional monetary policy. The decline of the terms of trade restricted potential growth of income in Japan (for the relation of terms of trade and growth see Pelaez 1979, 1976a). The import corporate goods price index on the yen basis increased from 93.5 in Jun 2009 to 113.1 in Apr 2012 or 21.0 percent and to 91.1 in Jun 2016 or decline of 19.5 percent relative to Apr 2012 and decrease of 2.6 percent relative to Jun 2009.

Chart IV-6, Japan, Import Corporate Goods Price Index, Monthly, Yen Basis, 2008-2016

Source: Bank of Japan

http://www.stat-search.boj.or.jp/index_en.html

Chart IV-6A provides the import corporate goods price index on the contract currency basis. The import corporate goods price index on the basis of the contract currency increased from 86.2 in Jun 2009 to 119.5 in Apr 2012 or 38.6 percent and to 80.8 in Jun 2016 or minus 32.4 percent relative to Apr 2012 and decline of 6.3 percent relative to Jun 2009. There is evident deterioration of the terms of trade of Japan: the export corporate goods price index on the basis of the contract currency decreased 8.5 percent from Jun 2009 to Jun 2016 while the import corporate goods price index decreased 6.3 percent. Prices of Japan’s exports of corporate goods, mostly industrial products, increased only 5.3 percent from Jun 2009 to Apr 2012, while imports of corporate goods, mostly commodities and raw materials increased 38.6 percent. Unconventional monetary policy induces carry trades from zero interest rates to exposures in commodities that squeeze economic activity of industrial countries by increases in prices of imported commodities and raw materials during periods without risk aversion. Reversals of carry trades during periods of risk aversion decrease prices of exported commodities and raw materials that squeeze economic activity in economies exporting commodities and raw materials. Devaluation of the dollar by unconventional monetary policy could increase US competitiveness in world markets but economic activity is squeezed by increases in prices of imported commodities and raw materials. Unconventional monetary policy causes instability worldwide instead of the mission of central banks of promoting financial and economic stability.

Chart IV-6A, Japan, Import Corporate Goods Price Index, Monthly, Contract Currency Basis, 2008-2015

Source: Bank of Japan

http://www.stat-search.boj.or.jp/index_en.html

Table IV-6B provides the Bank of Japan’s Corporate Goods Price indexes of exports and imports on the yen and contract bases from Jan 2008 to Jun 2016. There are oscillations of the indexes that are shown vividly in the four charts above. For the entire period from Jan 2008 to Jun 2016, the export index on the contract currency basis decreased 9.7 percent and decreased 14.6 percent on the yen basis. For the entire period from Jan 2008 to Jun 2016, the import price index decreased 19.8 percent on the contract currency basis and decreased 23.4 percent on the yen basis. During significant part of the expansion period, prices of Japan’s exports of corporate goods on the contract currency, mostly industrial products, increased only 5.3 percent from Jun 2009 to Apr 2012, while prices of imports of corporate goods on the contract currency, mostly commodities and raw materials, increased 38.6 percent. The charts show sharp deteriorations in relative prices of exports to prices of imports during multiple periods. Price margins of Japan’s producers are subject to periodic squeezes resulting from carry trades from zero interest rates of monetary policy to exposures in commodities.

Table IV-6B, Japan, Exports and Imports Corporate Goods Price Index, Contract Currency Basis and Yen Basis

	X-CC	X-Y	M-CC	M-Y
2008/01	99.2	115.5	100.7	119.0
2008/02	99.8	116.1	102.4	120.6
2008/03	100.5	112.6	104.5	117.4
2008/04	101.6	115.3	110.1	125.2
2008/05	102.4	117.4	113.4	130.4
2008/06	103.5	120.7	119.5	140.3
2008/07	104.7	122.1	122.6	143.9
2008/08	103.7	122.1	123.1	147.0
2008/09	102.7	118.3	117.1	137.1
2008/10	100.2	109.6	109.1	121.5
2008/11	98.6	104.5	97.8	105.8
2008/12	97.9	100.6	89.3	93.0
2009/01	98.0	99.5	85.6	88.4
2009/02	97.5	100.1	85.7	89.7
2009/03	97.3	104.2	85.2	93.0
2009/04	97.6	105.6	84.4	93.0
2009/05	97.5	103.8	84.0	90.8
2009/06	97.9	104.9	86.2	93.5
2009/07	97.5	103.1	89.2	95.0
2009/08	98.3	104.4	89.6	95.8
2009/09	98.3	102.1	91.0	94.7
2009/10	98.0	101.2	91.0	94.0
2009/11	98.4	100.8	92.8	94.8
2009/12	98.3	100.7	95.4	97.5
2010/01	99.4	102.2	97.0	100.0
2010/02	99.7	101.6	97.6	99.8
2010/03	99.7	101.8	97.0	99.2
2010/04	100.5	104.6	99.9	104.6
2010/05	100.7	102.9	101.7	104.9
2010/06	100.1	101.6	100.0	102.3
2010/07	99.4	99.0	99.9	99.8
2010/08	99.1	97.3	99.5	97.5
2010/09	99.4	97.0	100.0	97.2
2010/10	100.1	96.4	100.5	95.8
2010/11	100.7	97.4	102.6	98.2
2010/12	101.2	98.3	104.4	100.6
2011/01	102.1	98.6	107.2	102.6
2011/02	102.9	99.5	109.0	104.3
2011/03	103.5	99.6	111.8	106.3
2011/04	104.1	101.7	115.9	111.9
2011/05	103.9	99.9	118.8	112.4
2011/06	103.8	99.3	117.5	110.5
2011/07	103.6	98.3	118.3	110.2
2011/08	103.6	96.6	118.6	108.1
2011/09	103.7	96.1	117.0	106.2
2011/10	103.0	95.2	116.6	105.6
2011/11	101.9	94.8	115.4	105.4
2011/12	101.5	94.5	116.1	106.2
2012/01	101.8	94.0	115.0	104.2
2012/02	102.4	95.8	115.8	106.4
2012/03	102.9	99.2	118.3	112.9
2012/04	103.1	98.7	119.5	113.1
2012/05	102.3	96.3	118.1	109.8
2012/06	101.4	95.0	115.2	106.7
2012/07	100.6	94.0	112.0	103.5
2012/08	100.9	94.1	112.4	103.6
2012/09	101.0	94.1	114.7	105.2
2012/10	101.1	94.7	113.8	105.2
2012/11	100.9	95.9	113.2	106.5
2012/12	100.7	98.0	113.4	109.5
2013/01	101.0	102.4	113.8	115.4
2013/02	101.5	105.9	114.8	120.2
2013/03	101.3	106.6	115.1	122.0
2013/04	100.2	107.5	114.1	123.8
2013/05	99.6	109.1	112.6	125.3
2013/06	99.2	106.1	112.0	121.2
2013/07	99.1	107.5	111.6	122.8
2013/08	99.0	106.1	111.8	121.3
2013/09	99.0	107.2	113.0	124.0
2013/10	99.2	106.7	113.1	122.9
2013/11	99.1	108.0	113.1	124.9
2013-12	99.1	110.4	113.8	129.0
2014-01	99.2	110.7	114.4	130.1
2014-02	98.9	109.2	113.8	127.7
2014-03	98.6	109.1	113.4	127.4
2014-04	98.3	109.0	112.7	126.9
2014-05	98.2	108.2	112.4	125.9
2014-06	97.9	108.1	112.5	126.2
2014-07	98.0	107.9	112.5	125.9
2014-08	98.1	108.8	112.3	126.7
2014-09	97.9	111.0	111.5	129.4
2014-10	97.3	110.8	109.6	127.9
2014-11	96.9	115.6	106.9	131.6
2014-12	96.0	116.4	103.3	129.4
2015-01	94.4	113.1	98.3	121.5
2015-02	93.7	112.1	93.1	114.8
2015-03	93.7	112.8	93.8	117.0
2015-04	93.6	112.1	92.2	114.4
2015-05	93.7	113.4	91.5	114.7
2015-06	93.7	115.2	92.8	118.6
2015-07	93.0	113.6	91.8	116.6
2015-08	92.2	112.7	90.2	114.3
2015-09	91.3	109.5	88.0	109.3
2015-10	90.6	108.7	86.9	107.7
2015-11	90.4	109.5	86.2	108.4
2015-12	89.8	108.4	84.5	105.5
2016-01	89.2	105.4	81.5	99.4
2016-02	88.9	103.2	79.0	94.2
2016-03	89.1	102.5	78.9	93.1
2016-04	89.5	101.3	79.3	91.8
2016-05	89.6	100.8	79.4	91.6
2016-06	89.6	98.6	80.8	91.1

Note: X-CC: Exports Contract Currency; X-Y: Exports Yen; M-CC: Imports Contract; M-Y: Imports Yen

Source: Bank of Japan

http://www.boj.or.jp/en/statistics/index.htm/

Chart IV-7, Japan, Domestic Corporate Goods Price Index, Monthly, 1970-2016

Source: Bank of Japan

http://www.stat-search.boj.or.jp/index_en.html

The producer price index of the US from 1970 to 2016 in Chart IV-8 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

Chart IV-8, US, Producer Price Index Finished Goods, Monthly, 1970-2016

Source: US Bureau of Labor Statistics

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

Further insight into inflation of the corporate goods price index (CGPI) of Japan is in Table IV-7. The increase in the tax on value added of consumption caused sharp increases in prices across all segments. Petroleum and coal with weight of 5.7 percent increased 4.9 percent in Jun 2016 and decreased 21.0 percent in 12 months. Japan exports manufactured products and imports raw materials and commodities such that the country’s terms of trade, or export prices relative to import prices, deteriorate during commodity price increases. In contrast, prices of production machinery, with weight of 3.1 percent, decreased 0.1 percent in Jun 2016 and increased 0.4 percent in 12 months. In general, most manufactured products have been experiencing negative or low increases in prices while inflation rates have been high in 12 months for products originating in raw materials and commodities. Ironically, unconventional monetary policy of zero interest rates and quantitative easing that intended to increase aggregate demand and GDP growth deteriorated the terms of trade of advanced economies with adverse effects on real income (for analysis of terms of trade and growth see Pelaez (1979, 1976a). There are now inflation effects of the intentional policy of devaluing the yen and recent collapse of commodity prices.

Table IV-7, Japan, Corporate Goods Prices and Selected Components, % Weights, Month and 12 Months ∆%

May 2016	Weight	Month ∆%	12 Month ∆%
Total	1000.0	-0.1	-4.2
Food, Beverages, Tobacco, Feedstuffs	137.5	0.0	0.0
Petroleum & Coal	57.4	4.9	-21.0
Production Machinery	30.8	0.1	0.4
Electronic Components	31.0	0.0	-2.7
Electric Power, Gas & Water	52.7	-2.1	-14.1
Iron & Steel	56.6	-0.2	-6.6
Chemicals	92.1	-0.5	-8.7
Transport Equipment	136.4	0.0	-0.7

Source: Bank of Japan

http://www.boj.or.jp/en/statistics/index.htm/

Percentage point contributions to change of the corporate goods price index (CGPI) in Jun 2016 are in Table IV-8, divided into domestic, export and import segments. In the domestic CGPI, decreasing 0.1 percent in Jun 2016, the energy shock is evident in the contribution of 0.23 percentage points by petroleum and coal products in renewed carry trades of exposures in commodity futures. The exports CGPI changed 0.0 percent on the basis of the contract currency with contribution of 0.09 percentage points by other primary products and manufactured goods and deduction of 0.04 percentage points by general purpose, production and business oriented machinery. The imports CGPI increased 1.8 percent on the contract currency basis. Petroleum, coal and natural gas products added 1.75 percentage points. Shocks of risk aversion cause unwinding carry trades that result in declining commodity prices with resulting downward pressure on price indexes. The volatility of inflation adversely affects financial and economic decisions worldwide.

Table IV-8, Japan, Percentage Point Contributions to Change of Corporate Goods Price Index

Groups Jun 2016	Contribution to Change Percentage Points
A. Domestic Corporate Goods Price Index	Monthly Change: -0.1%
Electric Power, Gas & Water	-0.13
Scrap & Waste	-0.06
Chemicals & Related Products	-0.05
Nonferrous Metals	-0.04
Petroleum & Coal Products	0.23
B. Export Price Index	Monthly Change: 0.0% contract currency
Other Primary Products & Manufactured Goods	0.09
Transportation Equipment	0.03
Metals & Related Products	0.01
General Purpose, Production & Business Oriented Machinery	-0.04
Electric & Electronic Products	-0.02
C. Import Price Index	Monthly Change: 1.8% contract currency basis
Petroleum, Coal & Natural Gas	1.75
Foodstuffs & Feedstuffs	0.07
Chemicals & Related Products	-0.05
Metals & Related Products	-0.05

Source: Bank of Japan

http://www.boj.or.jp/en/statistics/index.htm/

There are two categories of responses in the Empire State Manufacturing Survey of the Federal Reserve Bank of New York (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html): current conditions and expectations for the next six months. There are responses in the survey for two types of prices: prices received or inputs of production and prices paid or sales prices of products. Table IV-5 provides indexes for the two categories and within them for the two types of prices from Jan 2011 to Jul 2016. The index of current prices paid or costs of inputs moved from 16.13 in Dec 2012 to 18.68 in Jul 2016 while the index of current prices received or sales prices moved from 1.08 in Dec 2012 to 1.10 in Jul 2016. The farther the index is from the area of no change at zero, the faster the rate of change. Prices paid or costs of inputs at 18.68 in Jul 2016 are expanding at faster pace than prices received or of sales of products at 1.10. The index of future prices paid or expectations of costs of inputs in the next six months fell from 51.61 in Dec 2012 to 26.37 in Jul 2016 while the index of future prices received or expectation of sales prices in the next six months decreased from 25.81 in Dec 2012 to 7.69 in Jul 2016. Prices paid or of inputs are expected to increase at a faster pace in the next six months than prices received or prices of sales products. Prices of sales of finished products are less dynamic than prices of costs of inputs during waves of increases. Prices of costs of costs of inputs fall less rapidly than prices of sales of finished products during waves of price decreases. As a result, margins of prices of sales less costs of inputs oscillate with typical deterioration against producers, forcing companies to manage tightly costs and labor inputs. Instability of sales/costs margins discourages investment and hiring.

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

	Current Prices Paid	Current Prices Received	Six Months Prices Paid	Six Months Prices Received
Jan-11	35.79	15.79	60	42.11
Feb-11	45.78	16.87	55.42	27.71
Mar-11	53.25	20.78	71.43	36.36
Apr-11	57.69	26.92	56.41	38.46
May-11	69.89	27.96	68.82	35.48
Jun-11	56.12	11.22	55.1	19.39
Jul-11	43.33	5.56	51.11	30
Aug-11	28.26	2.17	42.39	15.22
Sep-11	32.61	8.7	53.26	22.83
Oct-11	22.47	4.49	40.45	17.98
Nov-11	18.29	6.1	36.59	25.61
Dec-11	24.42	3.49	56.98	36.05
Jan-12	26.37	23.08	53.85	30.77
Feb-12	25.88	15.29	62.35	34.12
Mar-12	50.62	13.58	66.67	32.1
Apr-12	45.78	19.28	50.6	22.89
May-12	37.35	12.05	57.83	22.89
Jun-12	19.59	1.03	34.02	17.53
Jul-12	7.41	3.7	35.8	16.05
Aug-12	16.47	2.35	31.76	14.12
Sep-12	19.15	5.32	40.43	23.4
Oct-12	17.2	4.3	44.09	24.73
Nov-12	14.61	5.62	39.33	15.73
Dec-12	16.13	1.08	51.61	25.81
Jan-13	22.58	10.75	38.71	21.51
Feb-13	26.26	8.08	44.44	13.13
Mar-13	25.81	2.15	50.54	23.66
Apr-13	28.41	5.68	44.32	14.77
May-13	20.45	4.55	29.55	14.77
Jun-13	20.97	11.29	45.16	17.74
Jul-13	17.39	1.09	28.26	11.96
Aug-13	20.48	3.61	40.96	19.28
Sep-13	21.51	8.6	39.78	24.73
Oct-13	21.69	2.41	45.78	25.3
Nov-13	17.11	-3.95	42.11	17.11
Dec-13	15.66	3.61	48.19	27.71
Jan-14	36.59	13.41	45.12	23.17
Feb-14	25	15	40	23.75
Mar-14	21.18	2.35	43.53	25.88
Apr-14	22.45	10.2	33.67	14.29
May-14	19.78	6.59	31.87	14.29
Jun-14	17.2	4.3	36.56	16.13
Jul-14	25	6.82	37.5	18.18
Aug-14	27.27	7.95	42.05	21.59
Sep-14	23.91	17.39	43.48	32.61
Oct-14	11.36	6.82	42.05	26.14
Nov-14	10.64	0	41.49	25.53
Dec-14	10.42	6.25	40.63	32.29
Jan-15	12.63	12.63	33.68	15.79
Feb-15	14.61	3.37	26.97	5.62
Mar-15	12.37	8.25	31.96	12.37
Apr-15	19.15	4.26	38.3	13.83
May-15	9.38	1.04	26.04	7.29
Jun-15	9.62	0.96	24.04	5.77
Jul-15	7.45	5.32	27.66	6.38
Aug-15	7.27	0.91	34.55	10.91
Sep-15	4.12	-5.15	28.87	7.22
Oct-15	0.94	-8.49	27.36	7.55
Nov-15	4.55	-4.55	29.09	11.82
Dec-15	4.04	-4.04	27.27	20.2
Jan-16	16	4	31	12
Feb-16	2.97	-4.95	14.85	3.96
Mar-16	2.97	-5.94	19.8	7.92
Apr-16	19.23	2.88	27.88	5.77
May-16	16.67	-3.13	28.13	6.25
Jun-16	18.37	-1.02	29.59	7.14
Jul-16	18.68	1.10	26.37	7.69

Source: Federal Reserve Bank of New York

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

Price indexes of the Federal Reserve Bank of Philadelphia Outlook Survey are in Table IV-5A. As in inflation waves throughout the world (http://cmpassocregulationblog.blogspot.com/2016/07/oscillating-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/06/fomc-projections-world-inflation-waves.html) indexes of both current and expectations of future prices paid and received were quite high until May 2011. Prices paid, or inputs, were more dynamic, reflecting carry trades from zero interest rates to commodity futures. All indexes softened after May 2011 with even decline of prices received in Aug 2011 during the first round of risk aversion. Current and future price indexes have increased again but not back to the intensity in the beginning of 2011 because of risk aversion frustrating carry trades even induced by zero interest rates. The index of prices paid or prices of inputs moved from 20.6 in Dec 2012 to 9.9 in Jul 2016. The index of current prices received was minus 1.6 in Apr 2013, indicating decrease of prices received. The index of current prices received decreased from 8.5 in Dec 2012 to minus 5.5 in Sep 2015, decreasing to minus 4.5 in Feb 2016. The index of current prices received was 0.3 in Jun 2016. The farther the index is from the area of no change at zero, the faster the rate of change. The index of current prices paid or costs of inputs at 9.9 in Jul 2016 indicates faster expansion than the index of current prices received or sales prices of production in Jul 2016, showing expansion at 0.3. Prices paid indicate faster expansion than prices received during most of the history of the index. The index of future prices paid decreased to 26.4 in Jul 2016 from 42.3 in Dec 2012 while the index of future prices received increased from 22.2 in Dec 2012 to 24.1 in Jul 2016. Expectations are incorporating faster increases in prices of inputs or costs of production, 26.4 in Jul 2016, than of sales prices of produced goods, 24.1 in Jun 2016, forcing companies to manage tightly costs and labor inputs. Volatility of margins of sales/costs discourages investment and hiring.

Table IV-5A, US, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current and Future Prices Paid and Prices Received, SA

	Current Prices Paid	Current Prices Received	Six Months Prices Paid	Six Months Prices Received
Dec-10	42.6	5.1	56.3	24.5
Jan-11	48.2	12.5	58.9	34.4
Feb-11	61.8	13.6	67.9	31.5
Mar-11	59.2	17.8	61.5	33.5
Apr-11	52.8	23.1	56.4	36.3
May-11	51.3	20.8	54.8	28.4
Jun-11	36.3	6.5	40.8	6.7
Jul-11	34.1	5.6	48.2	17.3
Aug-11	23.4	-3	42.8	22.8
Sep-11	30.1	6.3	38.6	20.5
Oct-11	22.6	1.5	41.5	28.1
Nov-11	21.8	4.9	34.5	26.6
Dec-11	24.9	5.3	42.8	21.3
Jan-12	26	9	48	21.3
Feb-12	33.6	10.4	50.5	26.2
Mar-12	17.4	6.9	38.6	24.8
Apr-12	22	10	37.1	25
May-12	10.4	1.6	40.2	8.9
Jun-12	1.7	-5.7	33.1	16.6
Jul-12	8	3.3	27.2	20.8
Aug-12	16.3	7.1	35	23.9
Sep-12	12.8	2.5	38.8	24.7
Oct-12	17	4.3	44.3	15.6
Nov-12	21.9	4.1	45.9	11
Dec-12	20.6	8.5	42.3	22.2
Jan-13	13.2	0.4	35.1	21.1
Feb-13	13	0.4	33.8	22.7
Mar-13	13	1.4	35.1	20.2
Apr-13	11.7	-1.6	31.7	16.6
May-13	13.5	1.4	34.9	18.7
Jun-13	18.2	12	30.3	23.6
Jul-13	18.2	5.2	39.6	25.4
Aug-13	18.1	13	33.8	22.9
Sep-13	21.9	11.5	38.3	27.8
Oct-13	16.8	8.3	41.7	35
Nov-13	22.8	5.7	40.9	36.6
Dec-13	16.9	7.9	40.9	29.2
Jan-14	20.6	8.1	37.6	12.9
Feb-14	16.7	10	27.4	18.8
Mar-14	21	7.8	33.7	20.4
Apr-14	21.2	11.7	39.2	21.3
May-14	28.2	18.9	38.3	28.1
Jun-14	28	10.6	42.8	29.1
Jul-14	28.7	13.3	35.5	22.7
Aug-14	22.1	6.3	43.9	27.7
Sep-14	21.5	7.5	40.4	26.8
Oct-14	22.5	15.9	31.5	22.5
Nov-14	13.6	7.1	32.2	18.8
Dec-14	15.2	9.7	26.6	21.2
Jan-15	12.6	2.5	30.6	19.8
Feb-15	6.6	2.8	33	20.8
Mar-15	1.3	-4.1	30.4	9.8
Apr-15	1.3	-0.7	21.1	14.2
May-15	-12.0	-4.7	23.1	17.7
Jun-15	12	1.4	40.6	11.2
Jul-15	14.8	-0.6	31.9	17.1
Aug-15	3.8	-3.4	33.1	8.5
Sep-15	-3.1	-5.5	26.9	6.4
Oct-15	-3.2	-2.8	18.4	9.7
Nov-15	-7.5	-4.1	22.4	10.8
Dec-15	-8.3	-8.5	26	15
Jan-16	-1.1	-2.8	18.8	10.1
Feb-16	-2.2	-4.5	11.9	2.1
Mar-16	-0.9	3.5	24.7	15.1
Apr-16	13.2	7.4	36.7	22.6
May-16	15.7	14.8	24.8	10.5
Jun-16	23.0	3.9	37.8	16.5
Jul-16	9.9	0.3	26.4	24.1

Source: Federal Reserve Bank of Philadelphia

http://www.philadelphiafed.org/index.cfm

Chart IV-1 of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia Outlook Survey provides the diffusion index of current prices paid or prices of inputs from 2006 to 2016. Recession dates are in shaded areas. In the middle of deep global contraction after IVQ2007, input prices continued to increase in speculative carry trades from central bank policy rates falling toward zero into commodities futures. The index peaked above 70 in the second half of 2008. Inflation of inputs moderated significantly during the shock of risk aversion in late 2008, even falling briefly into contraction territory below zero during several months in 2009 in the flight away from risk financial assets into US government securities (Cochrane and Zingales 2009) that unwound carry trades. Return of risk appetite induced carry trade with significant increase until return of risk aversion in the first round of the European sovereign debt crisis in Apr 2010. Carry trades returned during risk appetite in expectation that the European sovereign debt crisis was resolved. The various inflation waves originating in carry trades induced by zero interest rates with alternating episodes of risk aversion are mirrored in the prices of inputs after 2011, in particular after Aug 2012 with the announcement of the Outright Monetary Transactions Program of the European Central Bank (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). Subsequent risk aversion and flows of capital away from commodities into stocks and high-yield bonds caused sharp decline in the index of prices paid followed by another recent rebound with marginal decline and new increase. The index falls, rebounds and falls again in the final segment but there are no episodes of contraction after 2009 with exception of minus 12.0 in May 2015, minus 3.1 in Sep 2015, minus 3.2 in Oct 2015, minus 7.5 in Nov 2015 and minus 8.3 in Dec 2015. The reading for the index in Jan 2016 is minus 1.1 and minus 2.2 for Feb 2016. The index is minus 0.9 in Mar 2016 and 13.2 in Apr 2016, increasing to 15.7 in May 2016 and 23.0 in Jun 2016. The index reached 9.9 in Jul 2016.

Chart IV-1, Federal Reserve Bank of Philadelphia Business Outlook Survey Current Prices Paid Diffusion Index SA

Source: Federal Reserve Bank of Philadelphia

http://www.philadelphiafed.org/index.cfm

Chart IV-2 of the Federal Reserve Bank of Philadelphia Outlook Survey provides the diffusion index of current prices received from 2006 to 2016. The significant difference between the index of current prices paid in Chart IV-1 and the index of current prices received in Chart IV-2 is that increases in prices paid are significantly sharper than increases in prices received. There were several periods of negative readings of prices received from 2010 to 2016. Prices paid increased at 1.3 in Mar 2015 while prices received contracted at 4.1. There were several contraction of prices paid: 12.0 in May 2015 with milder contraction of 4.7 of prices received; minus 3.1 for prices paid in Sep 2015 with minus 5.5 for prices received; and minus 3.2 for prices paid in Oct 2015 with minus 2.8 for prices received. The index of prices received fell to minus 4.1 in Nov 2015 with minus 7.5 for prices paid and to minus 8.5 in Dec 2015 with minus 8.3 for prices paid. The index of prices received fell to minus 4.5 in Feb 2016 with minus 2.2 for prices paid. The index of prices received increased to 3.5 in Mar 2016 with minus 0.9 for prices paid. Prices paid moved to 9.9 in Jul 2016 while prices received moved to 0.3. Prices received relative to prices paid deteriorate most of the time largely because of the carry trades from zero interest rates to commodity futures. Profit margins of business are compressed intermittently by fluctuations of commodity prices induced by unconventional monetary policy of zero interest rates, frustrating production, investment and hiring decisions of business, which is precisely the opposite outcome pursued by unconventional monetary policy.

Chart IV-2, Federal Reserve Bank of Philadelphia Business Outlook Survey Current Prices Received Diffusion Index SA

Source: Federal Reserve Bank of Philadelphia

http://www.philadelphiafed.org/index.cfm

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