Is United States Monetary Policy Devaluing the Dollar?

 

Is United States Monetary Policy Devaluing the Dollar?

Carlos M. Pelaez

The US trade deficit deteriorated from $313 billion in the first eight months of 2009 to $425 billion in the first eight months of 2010, which is still significantly lower than $581 billion in the same period in 2008. The trade deficit in Aug rose to $46.3 billion from $42.6 billion in Jul (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf). Sharp deteriorations of the trade deficit have been affecting the headline numbers of GDP. Is US monetary policy devaluing the dollar deliberately, as an effect of “reflating” the economy, in response to China’s insistence on an undervalued renminbi or all of the above? Is Joan Robinson’s plea for global coordination and cooperation instead of devaluation wars just another footnote in the history of economic thought? Is the US opening or closing to world affairs? The objective of this post is to explore the effects of the zero fed funds rate and quantitative easing on the dollar and risk assets. The Fed policy dual mandate is analyzed in (I), quantitative easing in (II), the world devaluation war in (III), economic indicators in (IV), interest rates in (V) and the conclusion in (VI). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/).

I Fed Policy Dual Mandate. Section 2a, Monetary Policy Objectives of the Federal Reserve Act mandates that “the Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” (http://www.federalreserve.gov/aboutthefed/section2a.htm). Chairman Bernanke argues that the two objectives of maximum employment and stable prices cannot be considered separately (http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm). Analysis of two extremes of policy focus illustrates potential conflicts. First, the benefits of central bank policies maximizing short-run employment could be outweighed by higher inflation in the future, causing disruption of economic activity that would create higher losses of employment. Second, policies attempting solely to constrain short-run inflation could induce more frequent and deeper contractions of economic activity without controlling inflation in the long run. The Fed has a dual mandate of full employment and price stability while some other central banks may have only a price stability mandate. Chairman Bernanke finds useful the consideration of the interactions of the dual mandate by the Federal Open Market Committee (FOMC) by (1) the “longer-run sustainable rate of unemployment; and (2) the “mandate-consistent inflation rate” (Ibid). The longer-run sustainable rate of unemployment is that unemployment rate that is feasible in the economy with stable prices, that is, without creating downward or upward pressure on prices. The process of innovation and growth in a modern economy requires dynamic reallocation of resources among occupations and regions such that some jobs are created while others are destroyed with resulting rate of unemployment that is always above zero. The mandate-consistent inflation rate promoting the dual mandate is not exactly zero such that moderate inflation in the long run is, according to Chairman Bernanke, “most consistent with the dual mandate” (Ibid). The FOMC may require some nominal interest rate that could be lowered to stimulate economic activity during recessions or periods of growth that is insufficient for full employment. Moderate inflation could maintain the nominal interest rate at a level affording such policy alternative.

II Quantitative Easing. The dual mandate of the Fed finds major hurdles in practice because of the interactions or conflicts of policies that seek to maintain full employment while maintaining the mandate-consistent inflation rate. There are limitations in existing knowledge of the theories explaining the overall economy and the impact of monetary policy on employment and the price level. The limitations extend to the calculation of the doses of monetary impulses and the determination of optimum timing. Simulation models of policy suffer from the Lucas Critique by which actual effects in practice may be reversed by changes in behavior of economic agents in a newer structural reality than that used to simulate the effects of policy. An example is the legislative process of approving tax credits for purposes of stimulating the economy in recession. Businesses would postpone investment while the proposal advances in the political process, such that the consideration of the tax credit deepens the recession that it intends to ameliorate (see the 1976 contribution by Robert E. Lucas and the essay by Varadarajan Chari in JEP 1998 (12, 1) cited in Pelaez and Pelaez, Regulation of Banks and Finance, 112-4). There are also problems of time consistency. Economic agents may change their behavior because of expectations of future economic policy such as when the resolve of the central bank in controlling inflation is perceived as being relaxed in the future resulting in a rise in current inflationary expectations. For example, there would not be construction of any type in an area prone to destruction by floods and natural disasters if the government made a believable commitment not to build expensive dams and levees, fully abstaining from rescuing victims of future floods but people would build if they believe the government would attempt to prevent the floods with dams and levees and rescue the victims (Finn Kydland and Edward Prescott, JPE 1977 (85, 3, June), 477, cited in Pelaez and Pelaez, Regulation of Banks and Finance, 114-6). Effective policy also requires knowledge about the state of the current economy and forecasts about future economic conditions but economists provide forecasts that are second only to those of astrologers.

Before the credit/dollar crisis, the consensus of central banking consisted of seven components analyzed by Charles Bean and the staff of the Bank of England (http://www.kansascityfed.org/publicat/sympos/2010/bean-paper.pdf, 2-3): (1) fiscal policy was considered as inadequate for managing aggregate demand because of the superiority of monetary policy, hurdles in reversing fiscal expansion because of political conflicts and Ricardian Equivalence (see Robert J. Barro, On the determination of the public debt, JPE 87 (Oct 1979) and Barro, Are government bonds net wealth? JPE 82 (6, 1974)); (2) monetary policy was more effective in the assignment of managing aggregate demand using the short-term interest rate as an instrument; (3) transmission of monetary policy was processed through long-term interest rates, asset prices and future inflation expectations; communication and transparency are essential in maintaining credibility (http://www.federalreserve.gov/newsevents/speech/bernanke20071114a.htm); (4) an independent central bank without political influence was ideal for conducting monetary policy; (5) ultimate monetary targets, such as the stability of the price level, were preferable, but “constrained discretion” was required because of rigid wages and prices in the short-term and the need of avoiding sharp fluctuations; (6) efficiency in distributing and pricing risk characterized asset markets with desirable effects of financial innovations; policy could contain adverse effects from excessive increases in asset prices; and (7) systemic risks would not occur in advanced economies such that attaining price stability ensured financial stability.

Central bank policy between the 1960s and the 1990s focused on controlling inflation that, according to Chairman Bernanke, was accomplished “through the application of improved policy frameworks, involving both greater transparency and increased independence from short-term political influences, as well as through continued focus and persistence” (http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm). The new challenge has been the decline of inflation to very low levels, flirting with deflation. The short-term nominal interest rate also falls close to the zero percent bound such that other “nonstandard” policies must be used for implementing central bank mandates because nominal interest rates cannot fall below zero. Members of the FOMC currently find conflicts with their dual mandate of high and persistent levels of unemployment and the change in the index of core personal consumption expenditures (PCE) from 2.5 percent in the beginning of the recession to around 1.1 percent in the first eight months of 2010 (Ibid). The FOMC finds inflation of 2 percent or somewhat lower as consistent with their mandate. Chairman Bernanke argues that “given the Committee’s objectives, there would appear—all else being equal—to be a case for further action” (Ibid). Many financial market participants are expecting another round of quantitative easing or purchases of long-term assets such as Treasuries.

On Oct 13, the Fed balance sheet had credit of $2.3 trillion; the total Fed-owned portfolio of long term securities was $1.98 trillion composed of $754 billion of Treasury notes and bonds, $152 billion of federal agency debt securities and $1078 billion of mortgage-backed securities; and reserve balances at the Federal Reserve Banks were $997 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). A measure of aggregate economic activity in the US, GDP, is about $14.8 trillion in 2010. The Fed balance sheet is about 15.5 percent of GDP and another trillion would bring it to 22.3 percent of GDP. The purchase by the Fed of $1.7 trillion in assets between Dec 2008 and Mar 2010 represented 22 percent of the outstanding $7.7 trillion of agency debt, mortgage-backed and Treasury securities. In a different measurement, the Fed purchased $850 billion of 10-year equivalents in the three asset classes that represented more than 20 percent of $3.7 trillion outstanding (http://www.newyorkfed.org/research/staff_reports/sr441.pdf). The purchase of another trillion could bring the Fed purchases to more than 30 percent of 10-year equivalents in various asset classes. There may not be a painless exit from the bloated Fed balance sheet. Chairman Bernanke finds that “one disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public” (http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm). Another concern is that “substantial further expansion of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodation policies at the appropriate time” (Ibid). There could be a disorderly increase in long-term interest rates if the public anticipated large scale sales of the Fed’s portfolio even if strategies for interest rate increases that the Fed has been devising and testing were effective.

III The World Devaluation War. An essay by Chairman Bernanke in 1999 on Japanese monetary policy received attention in the press this week, stating that (http://www.iie.com/publications/chapters_preview/319/7iie289X.pdf, 165):

“Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and experiment—in short, to do whatever it took to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done”

Quantitative easing has never been proposed by Chairman Bernanke or other economists as certain science without adverse effects. What has not been mentioned in the press is another suggestion to the Bank of Japan (BOJ) by Chairman Bernanke in the same essay that is very relevant to current events and the contentious issue of ongoing devaluation wars (Ibid, 161):

“Because the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its mandated objective. The economic validity of the beggar-thy-neighbor thesis is doubtful, as depreciation creates trade—by raising home country income—as well as diverting it. Perhaps not all those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. A yen trading at 100 to the dollar is in no one’s interest”

Chairman Bernanke is referring to the argument by Joan Robinson based on the experience of the Great Depression that: “in times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others (Joan Robinson, Beggar-my-neighbour remedies for unemployment, Essays in the Theory of Employment, Oxford, Basil Blackwell, 1947, 156). Devaluation is one of the tools used in these policies (Ibid, 157). Banking crises dominated the experience of the United States, but countries that recovered were those devaluing early such that competitive devaluations rescued many countries from a recession as strong as that in the US (see references to Ehsan Choudhri, Levis Kochin and Barry Eichengreen in Pelaez and Pelaez, Regulation of Banks and Finance, 205-9; for the case of Brazil that devalued early recovering with an increasing trade balance see Carlos Manuel Pelaez, The State, the Great Depression and the Industrialization of Brazil, PhD diss. Columbia University, 1968, and História da Industrialização Brasileira, Rio, 1972, both available at http://www.columbia.edu/cu/lweb/ cited in Pelaez and Pelaez, Regulation of Banks and Finance, 208-9; Brazil devalued and abandoned the gold standard during the historical period as shown by Pelaez, The theory and reality of imperialism, EHR 1976 (29, 2, May)). Beggar-my-neighbor policies did work for individual countries but the criticism of Joan Robinson was that it was not optimal for the world as a whole. Because of this experience most countries of the world tried to create cooperation through international financial institutions, the International Monetary Fund (IMF) and the World Bank. The global devaluation war is also forcing many countries into painful macroeconomic adjustment and central bank intervention with repeated calls by the IMF for coordination and cooperation in sharing the adjustment to world imbalances. The managing director of the IMF, Dominique Strauss-Khan, warns about obstacles to the operation of the international monetary system: “tensions and risks have been building up in its operations, which manifest themselves in large official reserve accumulation, persistent global imbalances, and capital flow and exchange rate volatility” (http://www.imf.org/external/np/pp/eng/2010/100110c.pdf ).

The critical issue now could be: is US monetary policy devaluing the dollar? In an article for the Financial Times on the “Bernanke put,” Michael Mackenzie and David Oakley perceptively capture the investors’ mantra of not going opposite the Fed with its trillion-dollar liquidity injections, observing that the dollar is collapsing while everything else, such as the Thai baht, UK gilt, gold, crude prices and whatever, is rising (http://www.ft.com/cms/s/0/c0c362a6-d304-11df-9ae9-00144feabdc0.html). There may be a fundamental problem with zero interest rates and quantitative easing that is hinted by Fed Board Governor Yellen: “if compensation incentives in the financial sector are misaligned, low interest rates might heighten the ability and desire of financial market participants to reach for yield and take on risk” (http://www.federalreserve.gov/newsevents/speech/yellen20101011a.htm). The incentive for hunting yield, take risk, reduce liquidity and abandon prudence in credit evaluation does not require misalignment of compensation of finance professionals. Money managers have the responsibility of rewarding investors’ funds with returns above the zero bound, a responsibility that is magnified when a trillion dollars drops from a helicopter in your yard. The trillion dollars is at zero interest cost and you can keep the spread relative to risk assets. If prices of risk assets decline, or equivalently yields increase, “forward guidance” suggests another helicopter drop of one trillion dollars for you to buy to prevent risk asset prices to fall or equivalently interest rates to increase.

A critical fact that needs explaining is that: “in 1984, 3.5 trillion dollars of nominal GDP supported 3.5 trillion dollars of private credit outstanding. By 2007, 14 trillion dollars of nominal GDP supported—until it din’t—25 trillion dollars of private, non financial credit outstanding. Throughout the great credit boom, household net worth rose to record levels, hitting 64 trillion dollars in 2007 (up from a mere 12 trillion back in 1984)” (http://www.bos.frb.org/RevisitingMP/papers/Clarida.pdf).

The intentions of policy have differed with their actual consequences propelling “the great credit boom.” The intention of the Fed in lowering rates to zero or near zero percent is to stimulate investment, consumption, production and employment. The stimulus of monetary policy consists of providing nearly unlimited amounts of credit at close to zero interest rates for short-dated funds and at long-term rates below what they would have been without quantitative easing in an effort of flattening the yield curve. According to Chairman Bernanke:

“That theory [of the balance-sheet channel] builds from the premise that changes in interest rates engineered by the central bank affect the value of assets and the cash flows of potential borrowers and their creditworthiness” (http://www.federalreserve.gov/newsevents/speech/bernanke20070615a.htm)

Lowering interest rates would increase the net worth and liquidity of borrowers, reducing the effective cost of credit “by more than the change in risk-free rates and thus would intensify the effect of the policy action,” analyzing the effects of monetary policy easing instead of tightening as exemplified by Bernanke (Ibid). 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” (Milton Friedman, A Theory of the Consumption Function, Princeton University Press, 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). There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, expected rate of return on physical investment, taxes, government policy and inflation” (Jonathan Ingersoll, Theory of Financial Decision Making, Rowman, 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). The simplified relation of income and wealth can be restated as: W = Y/r, such that as r goes to zero, W grows without bound. The lowering of 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, the so-called “shadow banking system” (http://www.ny.frb.org/research/staff_reports/sr458.pdf) 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 but 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 close to zero interest rates, from adjustable rate mortgages (ARMS) to asset-backed commercial paper.

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. The Fed 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 structured investment vehicles (SIV) created off-balance sheet to issue short-term commercial paper to purchase risky 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 Fed 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. 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 Fed put option on wealth, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the Fed put on wealth 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 consequences of the global hunt for yields created by monetary and housing policy are shown in Table 1. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, a more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, an increase in the Shanghai Composite index of 444.2 percent in 2005-7, a rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and an increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates fostered significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 on Jun 12, 2007, collapsing to 2.247 on Dec 31, 2008, and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. The combination of short-term zero interest rates, quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.

Table 1, Volatility of Assets

DJIA	10/08/02- 10/01/07	10/01/07- 3/4/09	3/4/09- 4/16/10
∆%	87.8	-51.2	60.3
NYSE Financial	1/15/04-6/13/07	6/13/07-3/4/09	3/4/09- 4/16/07
∆%	42.3	-75.9	121.1
Shanghai Composite	6/10/05- 10/15/07	10/15/07- 10/30/08	10/30/08-7/30/09
∆%	444.2	-70.8	85.3
STOXX Europe 50	3/10/03- 7/25/07	7/25/07-3/9/09	3/9/09-4/21/10
∆%	93.5	-57.9	64.3
UBS Com.	1/23/02- 7/1/08	7/1/08- 2/23/09	2/23/09- 1/6/10
∆%	165.5	-56.4	41.4
10-Year Treasury	6/16/03	6/12/07	12/31/08	4/5/10
%	3.112	5.297	2.247	3.986
USD/EUR	7/14/08	6/03/10	8/13/10
Rate	1.59	1.216	1.323
New House	1963	1977	2005	2009
Sales 1000s	560	819	1283	375
New House	2000	2007	2009	2010
Median Price $1000	169	247	217	203

Sources: http://online.wsj.com/mdc/page/marketsdata.html

http://www.census.gov/const/www/newressalesindex_excel.html

 

The investor’s mantra of not going against the Fed is vividly shown in Table 2. Risk assets of various types, such as stocks, commodities and long-dated Treasuries are rising in expectations of quantitative easing and partly also because of the election of Nov 2. World stock exchanges have erased the losses experienced during the sovereign risk doubts in Apr and as the last column in the table shows have soared by double digit percentages from their lows around early Jul.

 

Table 2, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 10/15	∆% Week 10/15	∆% T to 10/15
DJIA	4/26 2010	7/2 2010	-13.6	-1.3	0.5	14.2
S&P 500	4/23 2010	7/2 2010	-16.0	-3.4	0.9	15.0
NYSE Finance	4/15 2010	7/2 2010	-20.3	-11.1	-1.1	11.6
Dow Global	4/15 2010	7/2 2010	-18.4	-2.8	1.5	19.1
Asia Pacific	4/15 2010	7/2 2010	-12.5	2.5	0.6	17.1
China SC	4/15 2010	7/2 2010	-24.7	-6.1	8.5	22.6
STOXX 50	4/15 2010	7/2 2010	-15.3	-6.1	1.3	10.9
Dollar	11/15 2010	6/25 2010	22.3	8.2	-0.3	-14.8
DJ UBS Comm.	1/6 2010	7/2 2010	-14.5	0.4	0.9	17.5
10-Year T	4/5 2010	4/6/10	3.986	2.567

T: trough

Source: http://online.wsj.com/mdc/page/marketsdata.html

 

Since quantitative easing insinuations began in Aug, the dollar has depreciated and nearly every other risky asset has sharply gained. Japan has lost by anticipating its quantitative easing program relative to that of the US that may not be implemented until after the election by soundly preserving the independent nature of the Fed. Table 3 shows the ongoing world competitive devaluation or more commonly called global devaluation war that was not difficult to predict because of heavy employment losses in advanced countries (see Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars). The euro and the yen have appreciated sharply relative to the dollar as a result of the threat of another trillion dollars of bank reserves with opportunity cost near zero percent. The widely anticipated second round of quantitative easing has exaggerated the movement of financial variables, throwing the Fed in a corner of no alternative other than another “shock and awe” large scale purchase of assets.

 

Table 3, Exchange Rates

	Peak	Trough	∆% P/T	Oct 15 2010	∆% T Oct 15	∆% P Oct 15
USD EUR	7/15/ 2008	6/8/10		10/15 2010
Rate	1.59	1.192		1.3977
∆%			-33.4		14.7	-13.8
JPY USD	8/18 2008	9/15 2010		10/15 2010
Rate	110.19	83.07		81.45
∆%			24.6		1.9	26.1
CHF USD	11/21 2008	12/8 2009		10/15 2010
Rate	1.225	1.025		0.9588
∆%			16.3		6.5	25.4
USD GBP	7/15 2008	1/2 2009		10/15 2010
Rate	2.006	1.388		1.5992
∆%			-44.5		13.2	25.4
USD AUD	7/15 2008	10/27 2008		10/15 2010
Rate	0.979	0.601		0.9905
∆%			-62.9		39.3	1.2
ZAR USD	10/22 2008	8/5 2010		10/15 2010
Rate	11.578	7.238		6.827
∆%			37.5		5.7	4.1
SGD USD	3/3 2009	8/9 2010		10/15 2010
Rate	1.553	1.348		1.295
∆%			13.2		16.2	16.6
HKD USD	8/15 2008	12/14 2009		10/15 2010
Rate	7.813	7.752		7.757
∆%			-0.8		0.1	0.7
BRL USD	12/5 2008	4/30 2010		10/15 2010
Rate	2.43	1.737		1.666
∆%			28.5		4.1	31.4
CZK USD	2/13 2009	8/6 2010		10/15 2010
Rate	22.19	18.693		17.509
∆%			17.1		6.3	21.1
SEK USD	3/4 2009	8/9 2010		10/1 2010
Rate	9.313	7.108		6.619
∆%			23.7		6.9	28.9

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough

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

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

 

IV Economic Indicators. The US economy continues to expand moderately relative to recovery of contractions in the 1980s and 1970s, with growing trade deficit, 26.8 million persons in job stress who are unemployed or underemployed and the second highest deficit as percentage of GDP since World War II. US exports not seasonally adjusted (NSA) increased by 22.3 percent in Jan-Aug of 2010 relative to Jan Aug 2009 while imports increased by 26.6 percent (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf). Manufacturing distributive sales and shipments in Aug, seasonally adjusted (SA) increased by 0.1 percent relative to Jul and by 8.2 percent relative to a year earlier. Manufacturers’ and trade inventories SA grew by 0.6 percent in Aug relative to Jul and by 4.7 percent relative to a year earlier (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf). Retail and food services sales SA increased by 0.6 percent in Sep relative to Aug and by 7.3 percent relative to a year earlier (http://www.census.gov/retail/marts/www/marts_current.pdf). The Empire State Manufacturing Index of the Federal Reserve Bank of New York shows improving conditions in Oct with an increase in the general business conditions index by 12 points to reach 15.7 percent. The new orders index rose from 4.33 to 12.90 and shipments from -0.27 to 19.39 (http://www.newyorkfed.org/survey/empire/october2010.pdf). The SA producer price index rose by 0.4 percent in Sep relative to Aug and the NSA index rose 4.0 percent in the 12 months ended in Sep 2010 (http://www.bls.gov/news.release/pdf/ppi.pdf). The SA consumer price index rose by 0.1 percent in Sep relative to Aug and the NSA index by 1.1 percent in the 12 months ending in Sep 2010 (http://www.bls.gov/news.release/pdf/cpi.pdf). SA initial claims of unemployment insurance increased to 462,000 in the week ending Oct 9 or by 13,000 from the earlier week (http://www.dol.gov/opa/media/press/eta/ui/current.htm). The US government deficit reached $1.294 trillion in 2010 for the fiscal year ending Sep 30, about 8.9 percent of GDP, being the second largest as percentage of GDP since World War II, exceeded only by the deficit in 2009. The deficit originates in a decline of revenue by 14 percent from levels in 2008 while in the same period outlays rose by 16 percent (http://professional.wsj.com/article/SB10001424052748704779704575553850474117846.html?mod=wsjproe_hps_LEFTWhatsNews).

V Interest Rates. The 10-year Treasury yield rose to 2.57 percent relative to 2.38 percent a week earlier but declined from 2.76 percent a month before. The 10-year German government bond traded at 2.39 percent for a negative spread of 18 basis points relative to the comparable Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1287274368705). The Treasury with coupon of 2.63 percent, maturing on 08/20 traded on Oct 15 at 100.42 or yield of 2.58 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-151010). If the yield were to back up to 3.986 percent traded on Apr 6, the price for settlement on Oct 18 would be 89.0489 for a principal loss of 11.3 percent. Quantitative easing may create a duration trap with heavy losses even with the expectation of unwinding the Fed portfolio of long-term securities.

VI Conclusion. The combination of near zero bound interest rates and earlier and renewed quantitative easing insinuations by regional Federal Reserve Banks presidents (http://www.bos.frb.org/news/speeches/rosengren/2010/101610/101610.pdf

http://professional.wsj.com/article/SB10001424052748704706904575556283044368588.html?mod=wsjproe_hps_LEFTWhatsNews http://noir.bloomberg.com/apps/news?pid=20601087&sid=aEfo.ZH1ylBU&pos=3) are causing a new mantra of investors to short the dollar and buy every risky asset. Deliberately or as collateral damage, quantitative easing with zero interest rates is devaluing the dollar against almost every currency in the world and inflating nearly every risky asset. The preemptive strike by the Bank of Japan by anticipating its own quantitative easing because of the inability of the Fed to act before the Nov 2 election succumbed to the much higher dimensions of the Fed’s balance sheet. Currency wars turned into quantitative easing wars. There is “overwhelming support” in the Governing Council of the European Central Bank to continue the program of bond purchases (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aBF1CokgQqes&pos=1). The Bank of England may increase its bond plan (http://noir.bloomberg.com/apps/news?pid=20601087&sid=azL9eF.5_2hw&pos=4). Aggressive central banking with unconventional measures does have consequences in the form of distorting financial decisions and overall systems. Concentration in the Fed’s portfolio of more than 30 percent of 10-year equivalents of various long-term asset classes creates an increasing lack of credibility of an exit strategy and doubts if the risks outweigh benefits. If there is a stock market rally after the election of Nov 2 with a change in policy that pauses legislative restructuring and regulation, investor funds may flow away from fixed-income portfolios into equities, causing major losses because of the high duration or interest sensitivity of prices at currently low yields. In addition, international cooperation is eroded during times when it is most needed. Monetary policy is at a critical crossroad and the FOMC should ponder the adverse consequences of further quantitative easing in evaluating and implementing their important dual mandate. Moderate economic recovery plagued by profound legislative and regulatory restructurings of business models may be not be the time for experiments that can revert the direction of the economy. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )