Recovery without Hiring, Ten Million Fewer Full-time Jobs, Record High Youth and Middle-Aged Unemployment, Financial Turbulence and World Economic Slowdown with Global Recession Risk: Part II

 

Recovery without Hiring, Ten Million Fewer Full-time Jobs, Record High Youth and Middle-Aged Unemployment, Financial Turbulence and World Economic Slowdown with Global Recession Risk

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011, 2012

Executive Summary

I Recovery without Hiring

IA Hiring Collapse

IB Labor Underutilization

IC Ten Million Fewer Full-time Jobs

ID Youth and Middle-Aged Unemployment

II United States International Trade

IIA United States International Trade Balance

IIB United States Import and Export Prices

III World Financial Turbulence

IIIA Financial Risks

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendix I The Great Inflation

 

IIIB Appendix on Safe Haven Currencies. Safe-haven currencies, such as the Swiss franc (CHF) and the Japanese yen (JPY) have been under threat of appreciation but also remained relatively unchanged. A characteristic of the global recession would be struggle for maintaining competitiveness by policies of regulation, trade and devaluation (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation War (2008c)). Appreciation of the exchange rate causes two major effects on Japan.

1. Trade. Consider an example with actual data (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-72). The yen traded at JPY 117.69/USD on Apr 2, 2007 and at JPY 102.77/USD on Apr 2, 2008, or appreciation of 12.7 percent. This meant that an export of JPY 10,000 to the US sold at USD 84.97 on Apr 2, 2007 [(JPY 10,000)/(USD 117.69/USD)], rising to USD 97.30 on Apr 2, 2008 [(JPY 10,000)/(JPY 102.77)]. If the goods sold by Japan were invoiced worldwide in dollars, Japanese’s companies would suffer a reduction in profit margins of 12.7 percent required to maintain the same dollar price. An export at cost of JPY 10,000 would only bring JPY 8,732 when converted at JPY 102.77 to maintain the price of USD 84.97 (USD 84.97 x JPY 102.77/USD). If profit margins were already tight, Japan would be uncompetitive and lose revenue and market share. The pain of Japan from dollar devaluation is illustrated by Table 58 in the Nov 6 comment of this blog (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html): The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 75.812/USD on Oct 28, 2011, for cumulative appreciation of 31.2 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Oct 28, 2011 (JPY 75.812) was 8.7 percent. The pain of Japan from dollar devaluation continues as illustrated by Table VI-6 in Section VII Valuation of Risk Financial Assets: The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 78.08/USD on Dec 23, 2011, for cumulative appreciation of 29.1 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Dec 23, 2011 (JPY 78.08) was 6.0 percent.

2. Foreign Earnings and Investment. Consider the case of a Japanese company receiving earnings from investment overseas. Accounting the earnings and investment in the books in Japan would also result in a loss of 12.7 percent. Accounting would show fewer yen for investment and earnings overseas.

There is a point of explosion of patience with dollar devaluation and domestic currency appreciation. Andrew Monahan, writing on “Japan intervenes on yen to cap sharp rise,” on Oct 31, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204528204577009152325076454.html?mod=WSJPRO_hpp_MIDDLETopStories), analyzes the intervention of the Bank of Japan, at request of the Ministry of Finance, on Oct 31, 2011. Traders consulted by Monahan estimate that the Bank of Japan sold JPY 7 trillion, about $92.31 billion, against the dollar, exceeding the JPY 4.5 trillion on Aug 4, 2011. The intervention caused an increase of the yen rate to JPY 79.55/USD relative to earlier trading at a low of JPY 75.31/USD. The JPY appreciated to JPY76.88/USD by Fri Nov 18 for cumulative appreciation of 3.4 percent from JPY 79.55 just after the intervention. The JPY appreciated another 0.3 percent in the week of Nov 18 but depreciated 1.1 percent in the week of Nov 25. There was mild depreciation of 0.3 percent in the week of Dec 2 that was followed by appreciation of 0.4 percent in the week of Dec 9. The JPY was virtually unchanged in the week of Dec 16 with depreciation of 0.1 percent but depreciated by 0.5 percent in the week of Dec 23, appreciating by 1.5 percent in the week of Dec 30. Historically, interventions in yen currency markets have been unsuccessful (Pelaez and Pelaez, The Global Recession Risk (2007), 107-109). Interventions are even more difficult currently with daily trading of some $4 trillion in world currency markets. Risk aversion with zero interest rates in the US diverts hot capital movements toward safe-haven currencies such as Japan, causing appreciation of the yen. Mitsuru Obe, writing on Nov 25, on “Japanese government bonds tumble,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204452104577060231493070676.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the increase in yields of the Japanese government bond with 10 year maturity to a high for one month of 1.025 percent at the close of market on Nov 25. Thin markets in after-hours trading may have played an important role in this increase in yield but there may have been an effect of a dreaded reduction in positions of bonds by banks under pressure of reducing assets. The report on Japan sustainability by the IMF (2011JSRNov23, 2), analyzes how rising yields could threaten Japan:

· “As evident from recent developments, market sentiment toward sovereigns with unsustainably large fiscal imbalances can shift abruptly, with adverse effects on debt dynamics. Should JGB yields increase, they could initiate an adverse feedback loop from rising yields to deteriorating confidence, diminishing policy space, and a contracting real economy.

· Higher yields could result in a withdrawal of liquidity from global capital markets, disrupt external positions and, through contagion, put upward pressure on sovereign bond yields elsewhere.”

Exchange rate controls by the Swiss National Bank (SNB) fixing the rate at a minimum of CHF 1.20/EUR (http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf) has prevented flight of capital into the Swiss franc. The Swiss franc remained unchanged relative to the USD in the week of Dec 23 and appreciated 0.2 percent in the week of Dec 30 relative to the USD and 0.5 percent relative to the euro, as shown in Table II-1. Risk aversion is evident in the depreciation of the Australian dollar by cumulative 2.5 percent in the week of Fr Dec 16 after no change in the week of Dec 9. In the week of Dec 23, the Australian dollar appreciated 1.9 percent, appreciating another 0.5 percent in the week of Dec 30 as shown in Table II-1. Risk appetite would be revealed by carry trades from zero interest rates in the US and Japan into high yielding currencies such as in Australia with appreciation of the Australian dollar (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4, Pelaez and Pelaez, Government Intervention in Globalization (2008c), 70-4).

IIIC Appendix on Fiscal Compact. There are three types of actions in Europe to steer the euro zone away from the threats of fiscal and banking crises: (1) fiscal compact; (2) enhancement of stabilization tools and resources; and (3) bank capital requirements. The first two consist of agreements by the Euro Area Heads of State and government while the third one consists of measurements and recommendations by the European Banking Authority.

1. Fiscal Compact. The “fiscal compact” consists of (1) conciliation of fiscal policies and budgets within a “fiscal rule”; and (2) establishment of mechanisms of governance, monitoring and enforcement of the fiscal rule.

i. Fiscal Rule. The essence of the fiscal rule is that “general government budgets shall be balanced or in surplus” by compliance of members countries that “the annual structural deficit does not exceed 0.5% of nominal GDP” (European Council 2011Dec9, 3). Individual member states will create “an automatic correction mechanism that shall be triggered in the event of deviation” (European Council 2011Dec9, 3). Member states will define their automatic correction mechanisms following principles proposed by the European Commission. Those member states falling into an “excessive deficit procedure” will provide a detailed plan of structural reforms to correct excessive deficits. The European Council and European Commission will monitor yearly budget plans for consistency with adjustment of excessive deficits. Member states will report in anticipation their debt issuance plans. Deficits in excess of 3 percent of GDP and/or debt in excess of 60 percent of GDP will trigger automatic consequences.

ii. Policy Coordination and Governance. The euro area is committed to following common economic policy. In accordance, “a procedure will be established to ensure that all major economic policy reforms planned by euro area member states will be discussed and coordinated at the level of the euro area, with a view to benchmarking best practices” (European Council 2011Dec9, 5). Governance of the euro area will be strengthened with regular euro summits at least twice yearly.

2. Stabilization Tools and Resources. There are several enhancements to the bailouts of member states.

i. Facilities. The European Financial Stability Facility (EFSF) will use leverage and the European Central Bank as agent of its market operations. The European Stability Mechanism (ESM) or permanent bailout facility will be operational as soon as 90 percent of the capital commitments are ratified by member states. The ESM is planned to begin in Jul 2012.

ii. Financial Resources. The overall ceiling of the EFSF/ESM of €500 billion (USD 670 billion) will be reassessed in Mar 2012. Measures will be taken to maintain “the combined effective lending capacity of EUR 500 billion” (European Council 2011Dec9, 6). Member states will “consider, and confirm within 10 days, the provision of additional resources for the IMF of up to EUR 200 billion (USD 270 billion), in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. We are looking forward to parallel contributions from the international community” (European Council 2011Dec9, 6). Matthew Dalton and Matina Stevis, writing on Dec 20, 2011, on “Euro Zone Agrees to New IMF Loans,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204791104577107974167166272.html?mod=WSJPRO_hps_MIDDLESecondNews), inform that at a meeting on Dec 20, finance ministers of the euro-zone developed plans to contribute €150 billion in bilateral loans to the IMF as provided in the agreement of Dec 9. Bailouts “will strictly adhere to the well established IMF principles and practices.” There is a specific statement on private sector involvement and its relation to recent experience: “We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardized and identical Collective Action clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds” (European Council 2011Dec9, 6). Will there be again “unique and exceptional” conditions? The ESM is authorized to take emergency decisions with “a qualified majority of 85% in case the Commission and the ECB conclude that an urgent decision related to financial assistance is needed when the financial and economic sustainability of the euro area is threatened” (European Council 2011Dec9, 6).

3. Bank Capital. The European Banking Authority (EBA) finds that European banks have a capital shortfall of €114.7 billion (http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf). To avoid credit difficulties, the EBA recommends “that the credit institutions build a temporary capital buffer to reach a 9% Core Tier 1 ratio by 30 June 2012” (http://stress-test.eba.europa.eu/capitalexercise/EBA%20BS%202011%20173%20Recommendation%20FINAL.pdf 6). Patrick Jenkins, Martin Stabe and Stanley Pignal, writing on Dec 9, 2011, on “EU banks slash sovereign holdings,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/a6d2fd4e-228f-11e1-acdc-00144feabdc0.html#axzz1gAlaswcW), analyze the balance sheets of European banks released by the European Banking Authority. They conclude that European banks have reduced their holdings of riskier sovereign debt of countries in Europe by €65 billion from the end of 2010 to Sep 2011. Bankers informed that the European Central Bank and hedge funds acquired those exposures that represent 13 percent of their holdings of debt to Greece, Ireland, Italy, Portugal and Spain, which are down to €513 billion by the end of IIIQ2011.

The members of the European Monetary Union (EMU), or euro area, established the European Financial Stability Facility (EFSF), on May 9, 2010, to (http://www.efsf.europa.eu/about/index.htm):

• “Provide loans to countries in financial difficulties
• Intervene in the debt primary and secondary markets. Intervention in the secondary market will be only on the basis of an ECB analysis recognising the existence of exceptional financial market circumstances and risks to financial stability
• Act on the basis of a precautionary programme
• Finance recapitalisations of financial institutions through loans to governments”

The EFSF will be replaced by the permanent European Stability Mechanism (ESM) in 2013. On Mar 30, 2012, members of the euro area reached an agreement providing for sufficient funding required in rescue programs of members countries facing funding and fiscal difficulties and the transition from the EFSF to the ESM. The agreement of Mar 30, 2012 of the euro area members provides for the following (http://www.consilium.europa.eu/media/1513204/eurogroup_statement_30_march_12.pdf):

· Acceleration of ESM paid-in capital. The acceleration of paid-in capital for the ESM provides for two tranches paid in 2012, in July and Oct; another two tranches in 2013; and a final tranche in the first half of 2014. There could be acceleration of paid-in capital is required to maintain a 15 percent relation of paid-in capital and the outstanding issue of the ESM

· ESM Operation and EFSF transition. ESM will assume all new rescue programs beginning in Jul 2012. EFSF will administer programs begun before initiation of ESM activities. There will be a transition period for the EFSF until mid 2013 in which it can engage in new programs if required to maintain the full lending limit of €500 billion.

· Increase of ESM/EFSF lending limit. The combined ceiling of the ESM and EFSF will be increased to €700 billion to facilitate operation of the transition of the EFSF to the ESM. The ESM lending ceiling will be €500 billion by mid 2013. The combined lending ceiling of the ESM and EFSF will continue to €700 billion

· Prior lending. The bilateral Greek loan facility of €53 billion and €49 billion of the EFSF have been paid-out in supporting programs of countries: “all together the euro area is mobilizing an overall firewall of approximately EUR 800 billion, more than USD 1 trillion” (http://www.consilium.europa.eu/media/1513204/eurogroup_statement_30_march_12.pdf)

· Bilateral IMF contributions. Members of the euro area have made commitments of bilateral contributions to the IMF of €150 billion

A key development in the bailout of Greece is the approval by the Executive Board of the International Monetary Fund (IMF) on Mar 15, 2012, of a new four-year financing in the value of €28 billion to be disbursed in equal quarterly disbursements (http://www.imf.org/external/np/tr/2012/tr031512.htm). The sovereign debt crisis of Europe has moderated significantly with the elimination of immediate default of Greece. New economic and financial risk factors have developed, which are covered in VI Valuation of Risk Financial Assets and V World Economic Slowdown.

IIID Appendix on European Central Bank Large Scale Lender of Last Resort. European Central Bank. The European Central Bank (ECB) has been pressured to assist in the bailouts by acquiring sovereign debts. The ECB has been providing liquidity lines to banks under pressure and has acquired sovereign debts but not in the scale desired by authorities. In an important statement to the European Parliament, the President of the ECB Mario Draghi (2011Dec1) opened the possibility of further ECB actions but after a decisive “fiscal compact:”

“What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.

Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.

We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.

Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.

A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations.”

An important statement of Draghi (2011Dec15) focuses on the role of central banking: “You all know that the statutes of the ECB inherited this important principle and that central bank independence and the credible pursuit of price stability go hand in hand.”

Draghi (2011Dec19) explains measures to ensure “access to funding markets” by euro zone banks:

§ “We have decided on three-year refinancing operations to support the supply of credit to the euro area economy. These measures address the risk that persistent financial markets tensions could affect the capacity of euro area banks to obtain refinancing over longer horizons.

§ Earlier, in October, the Governing Council had already decided to have two more refinancing operations with a maturity of around one year.

§ Also, it was announced then that in all refinancing operations until at least the first half of 2012 all liquidity demand by banks would be fully allotted at fixed rate.

§ Funding via the covered bonds market was also facilitated by the ECB deciding in October to introduce a new Covered Bond Purchase Programme of €40 billion.

§ Funding in US dollar is facilitated by lowering the pricing on the temporary US dollar liquidity swap arrangements.”

Lionel Barber and Ralph Atkins interviewed Mario Draghi on Dec 14 with the transcript published in the Financial Times on Dec 18 (http://www.ft.com/intl/cms/s/0/25d553ec-2972-11e1-a066-00144feabdc0.html#axzz1gzoHXOj6) as “FT interview transcript: Mario Draghi.” A critical question in the interview is if the new measures are a European version of quantitative easing. Draghi analyzes the difference between the measures of the European Central Bank (ECB) and quantitative easing such as in Japan, US and UK:

1. The measures are termed “non-standard” instead of “unconventional.” While quantitative easing attempts to lower the yield of targeted maturities, the three-year facility operates through the “bank channel.” Quantitative easing would not be feasible because the ECB is statutorily prohibited of funding central governments. The ECB would comply with its mandate of medium-term price stability.

2. There is a critical difference in the two programs. Quantitative easing has been used as a form of financial repression known as “directed lending.” For example, the purchase of mortgage-backed securities more recently or the suspension of the auctions of 30-year bonds in response to the contraction early in the 2000s has the clear objective of directing spending to housing. The ECB gives the banks entire discretion on how to use the funding within their risk/return decisions, which could include purchase of government bonds.

The question on the similarity of the ECB three-year lending facility and quantitative easing is quite valid. Tracy Alloway, writing on Oct 10, 2011, on “Investors worry over cheap ECB money side effects,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d2f87d16-f339-11e0-8383-00144feab49a.html#axzz1hAqMH1vn), analyzes the use of earlier long-term refinancing operations (LTRO) of the ECB. LTROs by the ECB in Jun, Sep and Dec 2009 lent €614 billion at 1 percent. Alloway quotes estimates of Deutsche Bank that banks used €442billion to acquire assets with higher yields. Carry trades developed from LTRO funds at 1 percent into liquid investments at a higher yield to earn highly profitable spreads. Alloway quotes estimates of Morgan Stanley that European debt of GIIPS (Greece, Ireland, Italy, Portugal and Spain) in European bank balance sheets is €700 billion. Tracy Alloway, writing on Dec 21, 2011, on “Demand for ECB loans rises to €489bn,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d6ddd0ae-2bbd-11e1-98bc-00144feabdc0.html#axzz1hAqMH1vn), informs that European banks borrowed the largest value of €489 billion in all LTROs of the ECB. Tom Fairless and David Cottle, writing on Dec 21, 2011, on “ECB sees record refinancing demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204464404577111983838592746.html?mod=WSJPRO_hpp_LEFTTopStories), inform that the first of three operations of the ECB lent €489.19 billion, or $639.96 billion, to 523 banks. Three such LTROs could add to $1.9 trillion, which is not far from the value of quantitative easing in the US of $2.5 trillion. Fairless and Cottle find that there could be renewed hopes that banks could use the LTROs to support euro zone bond markets. It is possible that there could be official moral suasion by governments on banks to increase their holdings of government bonds or at least not to sell existing holdings. Banks are not free to choose assets in evaluation of risk and returns. Floods of cheap money at 1 percent per year induce carry trades to high-risk assets and not necessarily financing of growth with borrowing and lending decisions constrained by shocks of confidence.

The LTROs of the ECB are not very different from the liquidity facilities of the Fed during the financial crisis. Kohn (2009Sep10) finds that the trillions of dollars in facilities provided by the Fed (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-64, Regulation of Banks and Finance (2009b), 224-7) could fall under normal principles of “lender of last resort” of central banks:

“The liquidity measures we took during the financial crisis, although unprecedented in their details, were generally consistent with Bagehot's principles and aimed at short-circuiting these feedback loops. The Federal Reserve lends only against collateral that meets specific quality requirements, and it applies haircuts where appropriate. Beyond the collateral, in many cases we also have recourse to the borrowing institution for repayment. In the case of the TALF, we are backstopped by the Treasury. In addition, the terms and conditions of most of our facilities are designed to be unattractive under normal market conditions, thus preserving borrowers' incentives to obtain funds in the market when markets are operating normally. Apart from a very small number of exceptions involving systemically important institutions, such features have limited the extent to which the Federal Reserve has taken on credit risk, and the overall credit risk involved in our lending during the crisis has been small.

In Ricardo's view, if the collateral had really been good, private institutions would have lent against it. However, as has been recognized since Bagehot, private lenders, acting to protect themselves, typically severely curtail lending during a financial crisis, irrespective of the quality of the available collateral. The central bank--because it is not liquidity constrained and has the infrastructure in place to make loans against a variety of collateral--is well positioned to make those loans in the interest of financial stability, and can make them without taking on significant credit risk, as long as its lending is secured by sound collateral. A key function of the central bank is to lend in such circumstances to contain the crisis and mitigate its effects on the economy.”

The Bagehot (1873) principle is that central banks should provide a safety net, lending to temporarily illiquid but solvent banks and not to insolvent banks (see Cline 2001, 2002; Pelaez and Pelaez, International Financial Architecture (2005), 175-8). Kohn (2009Apr18) characterizes “quantitative easing” as “large scale purchases of assets:”

“Another aspect of our efforts to affect financial conditions has been the extension of our open market operations to large-scale purchases of agency mortgage-backed securities (MBS), agency debt, and longer-term Treasury debt. We initially announced our intention to undertake large-scale asset purchases last November, when the federal funds rate began to approach its zero lower bound and we needed to begin applying stimulus through other channels as the economic contraction deepened. These purchases are intended to reduce intermediate- and longer-term interest rates on mortgages and other credit to households and businesses; those rates influence decisions about investments in long-lived assets like houses, consumer durable goods, and business capital. In ordinary circumstances, the typically quite modest volume of central bank purchases and sales of such assets has only small and temporary effects on their yields. However, the extremely large volume of purchases now underway does appear to have substantially lowered yields. The decline in yields reflects "preferred habitat" behavior, meaning that there is not perfect arbitrage between the yields on longer-term assets and current and expected short-term interest rates. These preferences are likely to be especially strong in current circumstances, so that long-term asset prices rise and yields fall as the Federal Reserve acquires a significant portion of the outstanding stock of securities held by the public.”

Non-standard ECB policy and unconventional Fed policy have a common link in the scale of implementation or policy doses. Direct lending by the central bank to banks is the function “large scale lender of last resort.” If there is moral suasion by governments to coerce banks into increasing their holdings of government bonds, the correct term would be financial repression.

An important additional measure discussed by Draghi (2011Nov19) is relaxation on the collateral pledged by banks in LTROs:

“Some banks’ access to refinancing operations may be restricted by lack of eligible collateral. To overcome this, a temporary expansion of the list of collateral has been decided. Furthermore, the ECB intends to enhance the use of bank loans as collateral in Eurosystem operations. These measures should support bank lending, by increasing the amount of assets on euro area banks’ balance sheets that can be used to obtain central bank refinancing.”

There are collateral concerns about European banks. David Enrich and Sara Schaefer Muñoz, writing on Dec 28, on “European bank worry: collateral,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203899504577126430202451796.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the strain on bank funding from a squeeze in the availability of high-quality collateral as guarantee in funding. High-quality collateral includes government bonds and investment-grade non-government debt. There could be difficulties in funding for a bank without sufficient available high-quality collateral to offer in guarantee of loans. It is difficult to assess from bank balance sheets the availability of sufficient collateral to support bank funding requirements. There has been erosion in the quality of collateral as a result of the debt crisis and further erosion could occur. Perceptions of counterparty risk among financial institutions worsened the credit/dollar crisis of 2007 to 2009. The banking theory of Diamond and Rajan (2000, 2001a, 2001b) and the model of Diamond Dybvig (1983, 1986) provide the analysis of bank functions that explains the credit crisis of 2007 to 2008 (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 155-7, 48-52, Regulation of Banks and Finance (2009b), 52-66, 217-24). In fact, Rajan (2005, 339-41) anticipated the role of low interest rates in causing a hunt for yields in multiple financial markets from hedge funds to emerging markets and that low interest rates foster illiquidity. Rajan (2005, 341) argued:

“The point, therefore, is that common factors such as low interest rates—potentially caused by accommodative monetary policy—can engender excessive tolerance for risk on both sides of financial transactions.”

A critical function of banks consists of providing transformation services that convert illiquid risky loans and investment that the bank monitors into immediate liquidity such as unmonitored demand deposits. Credit in financial markets consists of the transformation of asset-backed securities (SRP) constructed with monitoring by financial institutions into unmonitored immediate liquidity by sale and repurchase agreements (SRP). In the financial crisis financial institutions distrusted the quality of their own balance sheets and those of their counterparties in SRPs. The financing counterparty distrusted that the financed counterparty would not repurchase the assets pledged in the SRP that could collapse in value below the financing provided. A critical problem was the unwillingness of banks to lend to each other in unsecured short-term loans. Emse Bartha, writing on Dec 28, on “Deposits at ECB hit high,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204720204577125913779446088.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that banks deposited €453.034 billion, or $589.72 billion, at the ECB on Dec 28, which is a record high in two consecutive days. The deposit facility is typically used by banks when they do prefer not to extend unsecured loans to other banks. In addition, banks borrowed €6.225 billion from the overnight facility on Dec 28, when in normal times only a few hundred million euro are borrowed. The collateral issues and the possible increase in counterparty risk occurred a week after large-scale lender of last resort by the ECB in the value of €489 billion in the prior week. The ECB may need to extend its lender of last resort operations.

The financial reform of the United States around the proposal of a national bank by Alexander Hamilton (1780) to develop the money economy with specialization away from the barter economy is credited with creating the financial system that brought prosperity over a long period (see Pelaez 2008). Continuing growth and prosperity together with sound financial management earned the US dollar the role as reserve currency and the AAA rating of its Treasury securities. McKinnon (2011Dec18) analyzes the resolution of the European debt crisis by comparison with the reform of Alexander Hamilton. Northern states of the US had financed the revolutionary war with the issue of paper notes that were at risk of default by 1890. Alexander Hamilton proposed the purchase of the states’ paper notes by the Federal government without haircuts. McKinnon (2011Dec18) describes the conflicts before passing the assumption bill in 1790 for federal absorption of the debts of states. Other elements in the Hamilton reform consisted of creation of a market for US Treasury bonds by their use as paid-in capital in the First Bank of the United States. McKinnon (2011Dec18) finds growth of intermediation in the US by the branching of the First Bank of the United States throughout several states, accepting deposits to provide commercial short-term credit. The reform consolidated the union of states, fiscal credibility for the union and financial intermediation required for growth. The reform also introduced low tariffs and an excise tax on whisky to service the interest on the federal debt. Trade relations among members of the euro zone are highly important to economic activity. There are two lessons drawn by McKinnon (2011Dec18) from the experience of Hamilton for the euro zone currently. (1) The reform of Hamilton included new taxes for the assumption of debts of states with concrete provisions for their credibility. (2) Commercial lending was consolidated with a trusted bank both for accepting private deposits and for commercial lending, creating the structure of financial intermediation required for growth.

IIIE Appendix Euro Zone Survival Risk. Markets have been dominated by rating actions of Standard & Poor’s Ratings Services (S&PRS) (2012Jan13) on 16 members of the European Monetary Union (EMU) or eurozone. The actions by S&PRS (2012Jan13) are of several types:

1. Downgrades by two notches of long-term credit ratings of Cyprus (from BBB/Watch/NegA-3+ to BB+/Neg/B), Italy (from A/Watch Neg/A-1 to BBB+/Neg/A-2), Portugal (from BBB-/Watch Neg/A-3 to BB/Neg/B) and Spain (from AA-/Watch Neg/A-1+ to A/Neg/A-1).

2. Downgrades by one notch of long-term credit ratings of Austria (from AAA/Watch Neg/A-1+ to AA+/Neg/A-1+), France (from AAA/Watch Neg/A-1+ to AA+/Neg A-1+), Malta (from A/Watch, Neg/A-1 to A-/Neg/A-2), Slovakia (from A+/Watch Neg/A-1 to A/Stable/A-1) and Slovenia (AA-/Watch Neg/A-1+ to A+/Neg/A-1).

3. Affirmation of long-term ratings of Belgium (AA/Neg/A-1+), Estonia (AA-/Neg/A-1+), Finland (AAA/Neg/A-1+), Germany (AAA/Stable/A-1+), Ireland (BBB+/Neg/A-2), Luxembourg (AAA/Neg/A-1+) and the Netherlands (AAA/Neg/A-1+) with removal from CreditWatch.

4. Negative outlook on the long-term credit ratings of Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain, meaning that S&PRS (2012Jan13) finds that the ratings of these sovereigns have a chance of at least 1-to-3 of downgrades in 2012 or 2013.

S&PRS (2012Jan13) finds that measures by European policymakers may not be sufficient to contain sovereign risks in the eurozone. The sources of stress according to S&PRS (2012Jan13) are:

1. Worsening credit environment

2. Increases in risk premiums for many eurozone borrowers

3. Simultaneous attempts at reducing debts by both eurozone governments and households

4. More limited perspectives of economic growth

5. Deepening and protracted division among Europe’s policymakers in agreeing to approaches to resolve the European debt crisis

There is now only one major country in the eurozone with AAA rating of its long-term debt by S&PRS (2012Jan13): Germany. IIIE Appendix Euro Zone Survival Risk analyzes the hurdle of financial bailouts of euro area members by the strength of the credit of Germany alone. The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is abouy $3531.6 billion. There is some simple “unpleasant bond arithmetic.” Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is about $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. Debt as percent of Germany’s GDP would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Charles Forelle, writing on Jan 14, 2012, on “Downgrade hurts euro rescue fund,” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204409004577159210191567778.html), analyzes the impact of the downgrades on the European Financial Stability Facility (EFSF). The EFSF is a special purpose vehicle that has not capital but can raise funds to be used in bailouts by issuing AAA-rated debt. S&P may cut the rating of the EFSF to the new lowest rating of the six countries with AAA rating, which are now down to four with the downgrades of France and Austria. The other rating agencies Moody’s and Fitch have not taken similar action. On Jan, S&PRS (2012Jan16) did cut the long-term credit rating of the EFSF to AA+ and affirmed the short-term credit rating at A-+. The decision is derived from the reduction in credit rating of the countries guaranteeing the EFSF. In the view of S&PRS (2012Jan16), there are not sufficient credit enhancements after the reduction in the creditworthiness of the countries guaranteeing the EFSF. The decision could be reversed if credit enhancements were provided.

The flow of cash from safe havens to risk financial assets is processed by carry trades from zero interest rates that are frustrated by episodes of risk aversion or encouraged with return of risk appetite. European sovereign risk crises are closely linked to the exposures of regional banks to government debt. An important form of financial repression consists of changing the proportions of debt held by financial institutions toward higher shares in government debt. The financial history of Latin America, for example, is rich in such policies. Bailouts in the euro zone have sanctioned “bailing in” the private sector, which means that creditors such as banks will participate by “voluntary” reduction of the principal in government debt (see Pelaez and Pelaez, International Financial Architecture (2005), 163-202). David Enrich, Sara Schaeffer Muñoz and Patricia Knowsmann, writing on “European nations pressure own banks for loans,” on Nov 29, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204753404577066431341281676.html?mod=WSJPRO_hpp_MIDDLETopStories), provide important data and analysis on the role of banks in the European sovereign risk crisis. They assemble data from various sources showing that domestic banks hold 16.2 percent of Italy’s total government securities outstanding of €1,617.4 billion, 22.9 percent of Portugal’s total government securities of €103.9 billion and 12.3 percent of Spain’s total government securities of €535.3 billion. Capital requirements force banks to hold government securities to reduce overall risk exposure in balance sheets. Enrich, Schaeffer Muñoz and Knowsmann find information that governments are setting pressures on banks to acquire more government debt or at least to stop selling their holdings of government debt.

Bond auctions are also critical in episodes of risk aversion. David Oakley, writing on Jan 3, 2012, on “Sovereign issues draw euro to crunch point,” published by the Financial Times (http://www.ft.com/intl/cms/s/0/63b9d7ca-2bfa-11e1-98bc-00144feabdc0.html#axzz1iLNRyEbs), estimates total euro area sovereign issues in 2012 at €794 billion, much higher than the long-term average of €670 billion. Oakley finds that the sovereign issues are: Italy €220 billion, France €197 billion, Germany €178 billion and Spain €81 billion. Bond auctions will test the resilience of the euro. Victor Mallet and Robin Wigglesworth, writing on Jan 12, 2012, on “Spain and Italy raise €22bn in debt sales,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/e22c4e28-3d05-11e1-ae07-00144feabdc0.html#axzz1j4euflAi), analyze debt auctions during the week. Spain placed €10 billion of new bonds with maturities in 2015 and 2016, which was twice the maximum planned for the auction. Italy placed €8.5 billion of one-year bills at average yield of 2.735 percent, which was less than one-half of the yield of 5.95 percent a month before. Italy also placed €3.5 billion of 136-day bills at 1.64 percent. There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20.

A combination of strong economic data in China analyzed in subsection VC and the realization of the widely expected downgrade could explain the strength of the European sovereign debt market. Emese Bartha, Art Patnaude and Nick Cawley, writing on January 17, 2012, on “European T-bills see solid demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204555904577166363369792848.html?mod=WSJPRO_hpp_LEFTTopStories), analyze successful auctions treasury bills by Spain and Greece. A day after the downgrade, the EFSF found strong demand on Jan 17 for its six-month debt auction at the yield of 0.2664 percent, which is about the same as sovereign bills of France with the same maturity.

There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20. Paul Dobson, Emma Charlton and Lucy Meakin, writing on Jan 20, 2012, on “Bonds show return of crisis once ECB loans expire,” published in Bloomberg (http://www.bloomberg.com/news/2012-01-20/bonds-show-return-of-crisis-once-ecb-loans-expire-euro-credit.html), analyze sovereign debt and analysis of market participants. Large-scale lending of last resort by the European Central Bank, considered in VD Appendix on European Central Bank Large Scale Lender of Last Resort, provided ample liquidity in the euro zone for banks to borrow at 1 percent and lend at higher rates, including to government. Dobson, Charlton and Meakin trace the faster decline of yields of short-term sovereign debt relative to decline of yields of long-term sovereign debt. The significant fall of the spread of short relative to long yields could signal concern about the resolution of the sovereign debt while expanding lender of last resort operations have moderated relative short-term sovereign yields. Normal conditions would be attained if there is definitive resolution of long-term sovereign debt that would require fiscal consolidation in an environment of economic growth.

Charles Forelle and Stephen Fidler, writing on Dec 10, 2011, on “Questions place EU pact,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203413304577087562993283958.html?mod=WSJPRO_hpp_LEFTTopStories#project%3DEUSUMMIT121011%26articleTabs%3Darticle), provide data, information and analysis of the agreement of Dec 9. There are multiple issues centering on whether investors will be reassured that the measures have reduced the risks of European sovereign obligations. While the European Central Bank has welcomed the measures, it is not yet clear of its future role in preventing erosion of sovereign debt values.

Another complicating factor is whether there will be further actions on sovereign debt ratings. On Dec 5, 2011, four days before the conclusion of the meeting of European leaders, Standard & Poor’s (2011Dec5) placed the sovereign ratings of 15 members of the euro zone on “CreditWatch with negative implications.” S&P finds five conditions that trigger the action: (1) worsening credit conditions in the euro area; (2) differences among member states on how to manage the debt crisis in the short run and on measures to move toward enhanced fiscal convergence; (3) household and government debt at high levels throughout large parts of the euro area; (4) increasing risk spreads on euro area sovereigns, including those with AAA ratings; and (5) increasing risks of recession in the euro zone. S&P also placed the European Financial Stability Facility (EFSF) in CreditWatch with negative implications (http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245325307963). On Dec 9, 2011, Moody’s Investors Service downgraded the ratings of the three largest French banks (http://www.moodys.com/research/Moodys-downgrades-BNP-Paribass-long-term-ratings-to-Aa3-concluding--PR_232989 http://www.moodys.com/research/Moodys-downgrades-Credit-Agricole-SAs-long-term-ratings-to-Aa3--PR_233004 http://www.moodys.com/research/Moodys-downgrades-Socit-Gnrales-long-term-ratings-to-A1--PR_232986 ).

Improving equity markets and strength of the euro appear related to developments in sovereign debt negotiations and markets. Alkman Granitsas and Costas Paris, writing on Jan 29, 2012, on “Greek debt deal, new loan agreement to finish next week,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204573704577189021923288392.html?mod=WSJPRO_hpp_LEFTTopStories), inform that Greece and its private creditors were near finishing a deal of writing off €100 billion, about $132 billion, of Greece’s debt depending on the conversations between Greece, the euro area and the IMF on the new bailout. An agreement had been reached in Oct 2011 for a new package of fresh money in the amount of €130 billion to fill needs through 2015 but was contingent on haircuts reducing Greece’s debt from 160 percent of GDP to 120 percent of GDP. The new bailout would be required to prevent default by Greece of €14.4 billion maturing on Mar 20, 2012. There has been increasing improvement of sovereign bond yields. Italy’s ten-year bond yield fell from over 6.30 percent on Jan 20, 2012 to slightly above 5.90 percent on Jan 27. Spain’s ten-year bond yield fell from slightly above 5.50 percent on Jan 20 to just below 5 percent on Jan 27.

An important difference, according to Beim (2011Oct9), between large-scale buying of bonds by the central bank between the Federal Reserve of the US and the European Central Bank (ECB) is that the Fed and most banks do not buy local and state government obligations with lower creditworthiness. The European Monetary Union (EMU) that created the euro and the ECB did not include common fiscal policy and affairs. Thus, EMU cannot issue its own treasury obligations. The line “Reserve bank credit” in the Fed balance sheet for Jan 25, 2012, is $2902 billion of which $2570 billion consisting of $1565 billion US Treasury notes and bonds, $68 billion inflation-indexed bonds and notes, $101 billion Federal agency debt securities and $836 billion mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The Fed has been careful in avoiding credit risk in its portfolio of securities. The 11 exceptional liquidity facilities of several trillion dollars created during the financial crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62) have not resulted in any losses. The Fed has used unconventional monetary policy without credit risk as in classical central banking.

Beim (2011Oct9, 6) argues:

“In short, the ECB system holds more than €1 trillion of debt of the banks and governments of the 17 member states. The state-by-state composition of this debt is not disclosed, but the events of the past year suggest that a disproportionate fraction of these assets are likely obligations of stressed countries. If a significant fraction of the €1 trillion were to be restructured at 40-60% discounts, the ECB would have a massive problem: who would bail out the ECB?

This is surely why the ECB has been so shrill in its antagonism to the slightest mention of default and restructuring. They need to maintain the illusion of risk-free sovereign debt because confidence in the euro itself is built upon it.”

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,209,403 million on Aug 3, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,811,911 million in the statement of Aug 3.

This sum is roughly what concerns Beim (2012Oct9) because of the probable exposure relative to capital to institutions and sovereigns with higher default risk. To be sure, there is no precise knowledge of the composition of the ECB portfolio of loans and securities with weights and analysis of the risks of components. Javier E. David, writing on Jan 16, 2012, on “The risks in ECB’s crisis moves,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204542404577158753459542024.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that the estimated debt of weakest euro zone sovereigns held by the ECB is €211 billion, with Greek debt in highest immediate default risk being only 17 percent of the total. Another unknown is whether there is high risk collateral in the €489 billion three-year loans to credit institutions at 1 percent interest rates. The potential risk is the need for recapitalization of the ECB that could find similar political hurdles as the bailout fund EFSF. There is a recurring issue of whether the ECB should accept a haircut on its portfolio of Greek bonds of €40 billion acquired at discounts from face value. An article on “Haircut for the ECB? Not so fast,” published by the Wall Street Journal on Jan 28, 2012 (http://blogs.wsj.com/davos/2012/01/28/haircut-for-the-ecb-not-so-fast/), informs of the remarks by Mark Carney, Governor of the Bank of Canada and President of the Financial Stability Board (FSB) (http://www.financialstabilityboard.org/about/overview.htm), expressing what appears to be correct doctrine that there could conceivably be haircuts for official debt but that such a decision should be taken by governments and not by central banks.

Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR

	Dec 31, 2010	Dec 28, 2011	Aug 3, 2012
1 Gold and other Receivables	367,402	419,822	433,778
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	260,768
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	56,405
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	15,779
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,209,403
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	215,403
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	602,508
8 General Government Debt Denominated in Euro	34,954	33,928	30,041
9 Other Assets	278,719	336,574	261,130
TOTAL ASSETS	2,004, 432	2,733,235	3,085,214
Memo Items
Sum of 5 and  7	1,004,174	1,489,759	1,811,911
Capital and Reserves	78,143	85,748	85,749

Source: European Central Bank

http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html

http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html

http://www.ecb.int/press/pr/wfs/2012/html/fs120807.en.html

Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surplus that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU) are only 42.7 percent of the total. Exports to the non-European Union area are growing at 9.9 percent in Jun 2012 relative to Jun 2011 while those to EMU are falling at 1.2 percent.

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

Jun 2012	Exports % Share	∆% Jan-Jun 2012/ Jan-Jun 2011	Imports % Share	Imports ∆% Jan-Jun 2012/ Jan-Jun 2011
EU	56.0	0.0	53.3	-7.5
EMU 17	42.7	-1.2	43.2	-7.1
France	11.6	-0.3	8.3	-5.3
Germany	13.1	1.3	15.6	-10.0
Spain	5.3	-8.5	4.5	-8.1
UK	4.7	10.6	2.7	-14.8
Non EU	44.0	9.9	46.7	-3.8
Europe non EU	13.3	11.3	11.1	-5.6
USA	6.1	18.2	3.3	3.4
China	2.7	-11.6	7.3	-17.1
OPEC	4.7	24.1	8.6	25.3
Total	100.0	4.2	100.0	-5.8

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

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

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

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

Regions and Countries	Trade Balance Jun 2012 Millions of Euro	Trade Balance Cumulative Jan-Jun 2012 Millions of Euro
EU	997	5,130
EMU 17	-410	-1,619
France	1,136	5,902
Germany	-536	-3,168
Spain	46	951
UK	990	4,576
Non EU	1,520	-5,215
Europe non EU	1,402	4,964
USA	1,337	6,610
China	-1,515	-8,304
OPEC	-1,301	-11,076
Total	2,517	-85

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

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

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

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

	Exports Share %	Exports ∆% Jan-Jun 2012/ Jan-Jun 2011	Imports Share %	Imports ∆% Jan-Jun 2012/ Jan-Jun 2011
Consumer Goods	28.9	5.5	25.0	-3.0
Durable	5.9	2.0	3.0	-7.9
Non Durable	23.0	6.4	22.0	-2.3
Capital Goods	32.2	2.6	20.8	-12.1
Inter- mediate Goods	34.3	2.7	34.5	-12.4
Energy	4.7	18.8	19.7	10.5
Total ex Energy	95.3	3.5	80.3	-9.5
Total	100.0	4.2	100.0	-5.8

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

Table III-6 provides Italy’s trade balance by product categories in Jun 2012 and cumulative Jan-Jun 2012. Italy’s trade balance excluding energy generated surplus of €7122 million in Jun 2012 and €32,595 million in Jan-Jun 2012 but the energy trade balance created deficit of €4605 million in Jun 2012 and €32,680 million in Jan-Jun 2012. The overall surplus in Jun 2012 was €2517 million but there was an overall deficit of €85 million in Jan-Jun 2012. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.

Table III-6, Italy, Trade Balance by Product Categories, € Millions

	Jun 2012	Cumulative Jan-Jun 2012
Consumer Goods	1,674	7,016
Durable	1,092	5,600
Nondurable	583	1,416
Capital Goods	4,747	23,497
Intermediate Goods	700	2,081
Energy	-4,605	-32,680
Total ex Energy	7,122	32,595
Total	2,517	-85

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

Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.

The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the following Subsection IIID Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30 the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent. There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt of 120 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).

Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.

Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:

“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”

If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.

The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2010.

Table III-7, World and Selected Regional and Country GDP and Fiscal Situation

	GDP 2012 USD Billions	Primary Net Lending Borrowing % GDP 2012	General Government Net Debt % GDP 2012
World	69,660
Euro Zone	12,586	-0.5	70.3
Portugal	221	0.1	110.9
Ireland	210	-4.4	102.9
Greece	271	-1.0	153.2
Spain	1,398	-3.6	67.0
Major Advanced Economies G7	34,106	-4.8	88.3
United States	15,610	-6.1	83.7
UK	2,453	-5.3	84.2
Germany	3,479	1.0	54.1
France	2,712.0	-2.2	83.2
Japan	5,981	-8.9	135.2
Canada	1,805	-3.1	35.4
Italy	2,067	2.9	102.3
China	7992	-1.3*	22.0**

*Net Lending/borrowing**Gross Debt

Source: http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weoselgr.aspx

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2012 is $4138.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3927.8 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8066.3 billion, which would be equivalent to 130.3 percent of their combined GDP in 2012. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 231.9 percent if including debt of France and 167.0 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.

Table III-8, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	8,847.9
B Germany	1,882.1		$8066.3 as % of $3479 =231.9% $5809.9 as % of $3479 =167.0%
C France	2,256.4
B+C	4,138.5	GDP $6,191.0 Total Debt $8066.3 Debt/GDP: 130.3%
D Italy	2,114.5
E Spain	936.7
F Portugal	245.3
G Greece	415.2
H Ireland	216.1
Subtotal D+E+F+G+H	3,927.8

Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx

There is extremely important information in Table VE-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Jun 2012. German exports to other European Union (EU) members are 56.7 percent of total exports in Jun 2012 and 58.0 percent in Jan-Jun 2012. Exports to the euro area are 41.8 percent in May and 38.7 percent in Jan-May. Exports to third countries are 37.5 percent of the total in Jun and 38.5 percent in Jan-Jun. There is similar distribution for imports. Exports to non-euro countries are growing at 4.8 percent in Jun 2012 and 4.2 percent in Jan-Jun 2012 while exports to the euro area are falling 3.0 percent in Jun and increasing 0.6 percent in Jan-Jun 2012. Price competitiveness through devaluation could improve export performance and growth. Economic performance in Germany is closely related to its high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone. Germany could benefit from depreciation of the euro because of its high share in exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.

Table III-9, Germany, Structure of Exports and Imports by Region, € Billions and ∆%

	Jun 2012  € Billions	Jun 12-Month ∆%	Jan–Jun 2012 € Billions	Jan-Jun 2012/ Jan-Jun 2011 ∆%
Total Exports	94.6	7.4	550.4	4.8
A. EU Members	53.6 % 56.7	-0.5	319.0 % 58.0	0.6
Euro Area	35.5 % 37.5	-3.0	212.0 % 38.5	-1.1
Non-euro Area	18.0 % 19.0	4.8	107.1 % 19.5	4.2
B. Third Countries	41.1 % 43.5	19.8	231.4 % 42.0	11.1
Total Imports	76.7	1.5	457.1	2.4
C. EU Members	49.3 % 64.3	-1.4	290.7 % 63.6	2.0
Euro Area	34.9 % 45.5	-2.8	204.8 % 44.8	1.5
Non-euro Area	14.4 % 18.8	2.2	85.9 % 18.8	3.3
D. Third Countries	27.5 % 35.9	7.2	166.4 % 36.4	3.0

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

Source:

Statistiche Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/08/PE12_269_51.html;jsessionid=5AB45783D1BE8502BB1AF4397C769BCD.cae1

IIIF Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unpleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.

First, Unpleasant Monetarist Arithmetic. Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:

D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (1)

Equation (1) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,

{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:

N(t+1) = (1+n)N(t), n>-1 (2)

The per capita form of the budget constraint is obtained by dividing (1) by N(t) and rearranging:

B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (3)

On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.

Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:

(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.

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis. This section is divided into two subsections. Subsection IIIGA Monetary Policy with Deficit Financing of Economic Growth analyzes proposals to promote economic growth with government deficits financed by monetary policy. Subsection IIIGB Adjustment during the Debt Crisis of the 1980s provides the routes of adjustment of Brazil during the debt crisis after 1983.

IIIGA Monetary Policy with Deficit Financing of Economic Growth. The advice of Bernanke (2000, 159-161, 165) to the Bank of Japan (BOJ) to reignite growth and employment in the economy consisted of zero interest rates and commitment to a high inflation target as proposed by Krugman (1999):

“I agree that this approach would be helpful, in that it would give private decision makers more information about the objectives of monetary policy. In particular, a target in the 3-4 percent range for inflation to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime but also that it intends to make up some of the ‘price-level gap’ created by 8 years of zero or negative inflation. In stating an inflation target of, say, 3-4 percent, the BOJ would be giving the direction in which it will attempt to move the economy. The important question, of course, is whether a determined Bank of Japan would be able to depreciate the yen. I am not aware of any previous historical episode, including the period of very low interest rates in the 1930s, in which a central bank has been unable to devaluate its currency. There is strong presumption that vigorous intervention by the BOJ, together with appropriate announcements to influence market expectations, could drive down the value of the yen significantly. Further, there seems little reason not to try this strategy. The ‘worst’ that could happen would be that the BOJ would greatly increase its holdings of reserve assets. Perhaps not all of those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. Franklin D. Roosevelt was elected president of the United States in 1932 with the mandate to get the country out of the Depression. In the end, his most effective actions were the same ones that Japan needs to take—namely, rehabilitation of the banking system and devaluation of the currency.”

Bernanke (2002) also finds devaluation to be a powerful policy instrument to move the economy away from deflation and weak economic and financial conditions:

“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.¹⁷ The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

Krugman (2012Apr24) finds that this advice of then Professor Bernanke (2000) is relevant to current monetary policy in the US. The relevance would be in a target of inflation in the US of 4 percent, which was the rate prevailing in the late years of the Reagan Administration. The liquidity trap is defined by Krugman (1998, 141) “as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.” The adversity of the liquidity trap in terms of weakness in output and employment can be viewed as an economy experiencing deflation that cannot be contained by increases in the monetary base, or currency held by the public plus reserves held by banks at the central bank. The argument of monetary neutrality is that an increase in money throughout all future periods will increase prices by the same proportion. According to Krugman (1998, 142), the liquidity trap occurs because the public does not expect that the central bank will continue the monetary expansion once inflation returns to a certain level. Expectations are critical in explaining the liquidity trap and have been shaped by the continued fight against inflation by central banks during several decades with the possible exception of Japan beginning with the lost decade when deflation became the relevant policy concern. In this framework, monetary policy is ineffectual if perceived by the public as temporary. Credible monetary policy is perceived by the public as permanent deliberate increase in prices or output: “if the central bank can credibly promise to be irresponsible—that is, convince the market that it will in fact allow prices to rise sufficiently—it can bootstrap the economy out of the trap” (Krugman 1998, 161).

Fed Chairman Bernanke (2012Apr25, 7-8) argues that there is no conflict between his advice to the Bank of Japan as Princeton Professor Bernanke (2000) and current monetary policy by the Federal Open Market Committee (FOMC):

“So there’s this view circulating [Princeton Professor Paul Krugman at http://www.nytimes.com/2012/04/29/magazine/chairman-bernanke-should-listen-to-professor-bernanke.html?pagewanted=all] that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies. That is absolutely incorrect. Our—my views and our policies today are completely consistent with the views that I held at that time. I made two points at that time to the Bank of Japan. The first was that I believe that a determined central bank could and should work to eliminate deflation—that is, falling prices. The second point that I made was that when short-term interest rates hit zero, the tools of a central bank are no longer—are not exhausted, there are still other things that the central bank can do to create additional accommodation. Now, looking at the current situation in United States, we are not in deflation. When deflation became a significant risk in late 2010, or at least a modest risk in late 2010, we used additional balance sheet tools to help return inflation close to the 2 percent target. Likewise, we have been aggressive and creative in using non-federal-funds-rate-centered tools to achieve additional accommodation for the U.S. economy. So the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation, and, clearly, when you’re in deflation and in recession, then both sides of your mandates, so to speak, are demanding additional accommodation. In this case, it’s—we are not in deflation, we have an inflation rate that’s close to our objective. Now, why don’t we do more? Well, first I would again reiterate that we are doing a great deal; policy is extraordinarily accommodative. We—and I won’t go through the list again, but you know all the things that we have done to try to provide support to the economy. I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction—a slightly increased pace of reduction in the unemployment rate? The view of the Committee is that that would be very reckless. We have—we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been be able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.”

Chairman Bernanke (2012Apr 25, 10-11) explains current FOMC policy:

“So it’s not a ceiling, it’s a symmetric objective, and we attempt to bring inflation close to 2 percent. And in particular, if inflation were to jump for whatever reason—and we don’t have, obviously don’t have perfect control of inflation—we’ll try to return inflation to 2 percent at a pace which takes into account the situation with respect to unemployment. The risk of higher inflation—you say 2½ percent; well, 2½ percent expected change might involve a distribution of outcomes, some of which might be much higher than 2½ percent. And the concern we have is that if inflation were to run well above 2 percent for a protracted period, that the credibility and the well-anchored inflation expectations, which are such a valuable asset of the Federal Reserve, might become eroded, in which case we would in fact have less rather than more flexibility to use accommodative monetary policy to achieve our employment goals. I would cite to you, just as an example, if you look at Vice Chair Yellen’s paper, which she gave—or speech, which she gave a couple of weeks ago, where she described a number of ways of looking at the late 2014 guidance. She showed there some so-called optimal policy rules that come from trying to get the best possible outcomes from our quantitative econometric models, and what you see, if you look at that, is that the best possible outcomes, assuming perfect certainty, assuming perfect foresight—very unrealistic assumptions—still involve inflation staying quite close to 2 percent. So there is no presumption even in our econometric models that you need inflation well above target in order to make progress on unemployment.”

In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in the US. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:

“In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”

In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.

Proposals for higher inflation target of 4 percent for FOMC monetary policy are based on the view that interest rates are too high in real terms because the nominal rate is already at zero and cannot be lowered further. Rajan (2012May8) argues that higher inflation targets by the FOMC need not increase aggregate demand as proposed in those policies because of various factors:

· Pension Crisis. Baby boomers close to retirement calculate that their savings are not enough at current interest rates and may simply save more. Many potential retirees are delaying retirement in order to save what is required to provide for comfortable retirement.

· Regional Income and Debt Disparities. Unemployment, indebtedness and income growth differ by regions in the US. It is not feasible to relocate demand around the country such that decreases in real interest rates may not have aggregate demand effects.

· Inflation Expectations. Rajan (2012May) argues that there is not much knowledge about how people form expectations. Increasing the FOMC target to 4 percent could erode control of monetary policy by the central bank. More technical analysis of this issue, which could be merely repetition of inflation surprise in the US Great Inflation of the 1970s, is presented in Appendix IIA.

· Frictions. Keynesian economics is based on rigidities of wages and benefits in economic activities but there may be even more important current inflexibilities such as moving when it is not possible to sell and buy a house.

Thomas J. Sargent and William L. Silber, writing on “The challenges of the Fed’s bid for transparency,” on Mar 20, published in the Financial Times (http://www.ft.com/intl/cms/s/0/778eb1ce-7288-11e1-9c23-00144feab49a.html#axzz1pexRlsiQ), analyze the costs and benefits of transparency by the Fed. In the analysis of Sargent and Silber (2012Mar20), benefits of transparency by the Fed will exceed costs if the Fed is successful in conveying to the public what policies would be implemented and how forcibly in the presence of unforeseen economic events. History has been unkind to policy commitments. The risk in this case is if the Fed would postpone adjustment because of political pressures as has occurred in the past or because of errors of evaluation and forecasting of economic and financial conditions. Both political pressures and errors abounded in the unhappy stagflation of the 1970s also known as the US Great Inflation (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB). The challenge of the Fed, in the view of Sargent and Silber 2012Mar20), is to convey to the public the need to deviate from the commitment to interest rates of zero to ¼ percent because conditions have changed instead of unwarranted inaction or policy changes. Errors have abounded such as a critical cause of the global recession pointed by Sargent and Silber (2012Mar20): “While no president is known to have explicitly pressurized Mr. Bernanke’s predecessor, Alan Greenspan, he found it easy to maintain low interest rates for too long, fuelling the credit boom and housing bubble that led to the financial crisis in 2008.” Sargent and Silber (2012Mar20) also find need of commitment of fiscal authorities to consolidation needed to attain sustainable path of debt. Further analysis is provided in Appendix IIA Inflation Surprise and Appendix IIB Unpleasant Monetarist Arithmetic at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html.

According to an influential school of thought, the interrelation of growth and inflation in Latin America is complex, preventing analysis of whether inflation promotes or restricts economic growth (Seers 1962, 191). In this view, there are multiple structural factors of inflation. Successful economic policy requires a development program that ameliorates structural weaknesses. Policy measures in developed countries are not transferable to developing economies.

In extensive research and analysis, Kahil (1973) finds no evidence of the role of structural factors in Brazilian inflation from 1947 to 1963. In fact, Kahil (1973, 329) concludes:

“The immediate causes of the persistent and often violent rise in prices, with which Brazil was plagued from the last month of 1948 to the early months of 1964, are pretty obvious: large and generally growing public deficits, together with too rapid an expansion of bank credit in the first years and, later, exaggerated and more and more frequent increases in the legal minimum wages.”

Kahil (1973, 334) analyzes the impact of inflation on the economy and society of Brazil:

“The real incomes of the various social classes alternately suffered increasingly frequent and sharp fluctuations: no sooner had a group succeeded in its struggle to restore its real income to some previous peak than it witnessed its erosion with accelerated speed; and it soon became apparent to all that the success of any important group in raising its real income, through government actions or by other means, was achieved only by reducing theirs. Social harmony, the general climate of euphoria, and also enthusiasm for government policies, which had tended to prevail until the last months of 1958, gave way in the following years of galloping inflation to intense political and social conflict and to profound disillusionment with public policies. By 1963 when inflation reached its runaway stage, the economy had ceased to grow, industry and transport were convulsed by innumerable strikes, and peasants were invading land in the countryside; and the situation further worsened in the first months of 1964.”

Professor Nathiel H. Leff (1975) at Columbia University identified another important contribution of Kahil (1975, Chapter IV“The supply of capital,” 127-185) of key current relevance to current proposals to promote economic growth and employment by raising inflation targets:

“Contrary to the assertions of some earlier writers on this topic, Kahil concludes that inflation did not lead to accelerated capital formation in Brazil.”

In econometric analysis of Brazil’s inflation from 1947 to 1980, Barbosa (1987) concludes:

“The most important result, based on the empirical evidence presented here, is that in the long run inflation is a monetary phenomenon. It follows that the most challenging task for Brazilian society in the near future is to shape a monetary-fiscal constitution that precludes financing much of the budget deficits through the inflation tax.”

Experience with continuing fiscal deficits and money creation tend to show accelerating inflation. Table III-10 provides average yearly rates of growth of two definitions of the money stock, M1, and M2 that adds also interest-paying deposits. The data were part of a research project on the monetary history of Brazil using the NBER framework of Friedman and Schwartz (1963, 1970) and Cagan (1965) as well as the institutional framework of Rondo E. Cameron (1967, 1972) who inspired the research (Pelaez 1974, 1975, 1976a,b, 1977, 1979, Pelaez and Suzigan 1978, 1981). The data were also used to test the correct specification of money and income following Sims (1972; see also Williams et al. 1976) as well as another test of orthogonality of money demand and supply using covariance analysis. The average yearly rates of inflation are high for almost any period in 1861-1970, even when prices were declining at 1 percent in 19^th century England, and accelerated to 27.1 percent in 1945-1970. There may be concern in an uncontrolled deficit monetized by sharp increases in base money. The Fed may have desired to control inflation at 2 percent after lowering the fed funds rate to 1 percent in 2003 but inflation rose to 4.1 percent in 2007. There is not “one hundred percent” confidence in controlling inflation because of the lags in effects of monetary policy impulses and the equally important lags in realization of the need for action and taking of action and also the inability to forecast any economic variable. Romer and Romer (2004) find that a one percentage point tightening of monetary policy is associated with a 4.3 percent decline in industrial production. There is no change in inflation in the first 22 months after monetary policy tightening when it begins to decline steadily, with decrease by 6 percent after 48 months (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 102). Even if there were one hundred percent confidence in reducing inflation by monetary policy, it could take a prolonged period with adverse effects on economic activity. Certainty does not occur in economic policy, which is characterized by costs that cannot be anticipated.

Table III-10, Brazil, Yearly Growth Rates of M1, M2, Nominal Income (Y), Real Income (y), Real Income per Capita (y/n) and Prices (P)

	M1	M2	Y	y	y/N	P
1861-1970	9.3	6.2	10.2	4.6	2.4	5.8
1861-1900	5.4	5.9	5.9	4.4	2.6	1.6
1861-1913	4.7	4.7	5.3	4.4	2.4	0.1
1861-1929	5.5	5.6	6.4	4.3	2.3	2.1
1900-1970	13.9	13.9	15.2	4.9	2.6	10.3
1900-1929	8.9	8.9	10.8	4.2	2.1	6.6
1900-1945	8.6	9.1	9.2	4.3	2.2	4.9
1920-1970	17.8	17.3	19.4	5.3	2.8	14.1
1920-1945	8.3	8.7	7.5	4.3	2.2	3.2
1920-1929	5.4	6.9	11.1	5.3	3.3	5.8
1929-1939	8.9	8.1	11.7	6.3	4.1	5.4
1945-1970	30.3	29.2	33.2	6.1	3.1	27.1

Note: growth rates are obtained by regressions of the natural logarithms on time. M1 and M2 definitions of the money stock; Y nominal GDP; y real GDP; y/N real GDP per capita; P prices.

Source: See Pelaez and Suzigan (1978), 143; M1 and M2 from Pelaez and Suzigan (1981); money income and real income from Contador and Haddad (1975) and Haddad (1974); prices by the exchange rate adjusted by British wholesale prices until 1906 and then from Villela and Suzigan (1973); national accounts after 1947 from Fundação Getúlio Vargas.

Chart III-1 shows in semi-logarithmic scale from 1861 to 1970 in descending order two definitions of income velocity, money income, M1, M2, an indicator of prices and real income.

Chart III-1, Brazil, Money, Income and Prices 1861-1970.

Source: © Carlos Manuel Pelaez and Wilson Suzigan. 1981. História Monetária do Brasil Segunda Edição. Coleção Temas Brasileiros. Brasília: Universidade de Brasília, 21.

Table III-11 provides yearly percentage changes of GDP, GDP per capita, base money, prices and the current account in millions of dollars during the acceleration of inflation after 1947. There was an explosion of base money or the issue of money and three waves of inflation identified by Kahil (1973). Inflation accelerated together with issue of money and political instability from 1960 to 1964. There must be a role for expectations in inflation but there is not much sound knowledge and measurement as Rajan (2012May8) argues. There have been inflation waves documented in periodic comments in this blog (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html) . The risk is ignition of adverse expectations at the crest of one of worldwide inflation waves. Lack of credibility of the commitment by the FOMC to contain inflation could ignite such perverse expectations. Deficit financing of economic growth can lead to inflation and financial instability.

Table III-11, Brazil, GDP, GDP per Capita, Base Money, Prices and Current Account of the Balance of Payments, ∆% and USD Millions, 1947-1971

	GDP ∆%	GDP per Capita ∆%	Base Money ∆%	Prices ∆%	Current Account BOP USD Millions
1947	2.4	0.1	-1.4	14.0	162
1948	7.4	4.9	4.6	7.6	-24
1949	6.6	4.2	14.5	4.0	-74
1950	6.5	4.0	23.0	10.0	52
1951	5.9	2.9	15.3	21.9	-291
1952	8.7	5.6	17.7	10.2	-615
1953	2.5	-0.5	15.5	12.1	16
1954	10.1	6.9	23.4	31.0	-203
1955	6.9	3.8	18.0	14.0	17
1956	3.2	0.2	16.9	21.6	194
1957	8.1	4.9	30.5	13.9	-180
1958	7.7	4.6	26.1	10.4	-253
1959	5.6	2.5	32.3	37.7	-154
1960	9.7	6.5	42.4	27.6	-410
1961	10.3	7.1	54.4	36.1	115
1962	5.3	2.2	66.4	54.1	-346
1963	1.6	-1.4	78.4	75.2	-244
1964	2.9	-0.1	82.5	89.7	40
1965	2.7	-0.6	67.6	62.0	331
1966	4.4	1.5	25.8	37.9	153
1967	4.9	2.0	33.9	28.7	-245
1968	11.2	8.1	31.4	25.2	32
1969	9.9	6.9	22.4	18.2	549
1970	8.9	5.8	20.2	20.7	545
1971	13.3	10.2	29.8	22.0	530

Sources: Fundação Getúlio Vargas, Banco Central do Brasil and Pelaez and Suzigan (1981). Carlos Manuel Pelaez, História Econômica do Brasil: Um Elo entre a Teoria e a Realidade Econômica. São Paulo: Editora Atlas, 1979, 94.

IIIGB Adjustment during the Debt Crisis of the 1980s. Economic and financial risks in the euro area are increasingly being dominated by analytical and political disagreement on conflicts of fiscal adjustment, financial stability, economic growth and employment. Political development is beginning to push for alternative paths of policy. Blanchard (2012WEOApr) and Draghi (2012May3) provide analysis of appropriate directions of policy.

Blanchard (2012WEOApr) finds that interest rates close to zero in advanced economies have not induced higher economic growth because of two main factors—fiscal consolidation and deleveraging—that restrict economic growth in the short-term. First, Blanchard (2012WEOApr, XIII) finds that assuming a multiplier of unity of the fiscal deficit on GDP, decrease of the cyclically-adjusted deficit of advanced economies by 1 percent would reduce economic growth by one percentage point. Second, deleveraging by banks, occurring mainly in Europe, tightens credit supply with similar reduction of euro area economic growth by one percentage point in 2012. The baseline of the World Economic Outlook (WEO) of the IMF (2012WEOApr) for Apr 2012 incorporates both effects, which results in weak economic growth, in particular in Europe, and prolonged unemployment. An important analysis by Blanchard (2012WEOApr, XIII) is that “financial uncertainty, together with sharp shifts in risk appetite, has led to volatile capital flows.” Blanchard (2012WEOApr) still finds that the greatest vulnerability is another profound crisis in Europe (ECB). Crisis prevention should buttress the resilience of affected countries during those shifts in risk appetite. The role of the enhanced firewall of the IMF, European Union (EU) and European Central Bank is gaining time during which countries could engage in fiscal consolidation and structural reforms that would diminish the shifts in risk appetite, preventing devastating effects of financial crises. Volatility in capital flows is equivalent to volatility of valuations of risk financial assets. The challenge to the policy mix consists in balancing the adverse short-term effects of fiscal consolidation and deleveraging with the beneficial long-term effects of eliminating the vulnerability to shocks of risk aversion. Blanchard (2012WEOApr) finds that policy should seek short-term credibility while implementing measures that restrict the path of expenditures together with simultaneous development of institutions and rules that constrain deficits and spending in the future. There is similar policy challenge in deleveraging banks, which is required for sound lending institutions, but without causing an adverse credit crunch. Advanced economies face a tough policy challenge of increasing demand and potential growth.

The President of the European Central Bank (ECB) Mario Draghi (2012May3) also outlines the appropriate policy mix for successful adjustment:

“It is of utmost importance to ensure fiscal sustainability and sustainable growth in the euro area. Most euro area countries made good progress in terms of fiscal consolidation in 2011. While the necessary comprehensive fiscal adjustment is weighing on near-term economic growth, its successful implementation will contribute to the sustainability of public finances and thereby to the lowering of sovereign risk premia. In an environment of enhanced confidence in fiscal balances, private sector activity should also be fostered, supporting private investment and medium-term growth.

At the same time, together with fiscal consolidation, growth and growth potential in the euro area need to be enhanced by decisive structural reforms. In this context, facilitating entrepreneurial activities, the start-up of new firms and job creation is crucial. Policies aimed at enhancing competition in product markets and increasing the wage and employment adjustment capacity of firms will foster innovation, promote job creation and boost longer-term growth prospects. Reforms in these areas are particularly important for countries which have suffered significant losses in cost competitiveness and need to stimulate productivity and improve trade performance.

In this context, let me make a few remarks on the adjustment process within the euro area. As we know from the experience of other large currency areas, regional divergences in economic developments are a normal feature. However, considerable imbalances have accumulated in the last decade in several euro area countries and they are now in the process of being corrected.

As concerns the monetary policy stance of the ECB, it has to be focused on the euro area. Our primary objective remains to maintain price stability over the medium term. This is the best contribution of monetary policy to fostering growth and job creation in the euro area.

Addressing divergences among individual euro area countries is the task of national governments. They must undertake determined policy actions to address major imbalances and vulnerabilities in the fiscal, financial and structural domains. We note that progress is being made in many countries, but several governments need to be more ambitious. Ensuring sound fiscal balances, financial stability and competitiveness in all euro area countries is in our common interest.”

Economic policy during the debt crisis of 1983 may be useful in analyzing the options of the euro area. Brazil successfully combined fiscal consolidation, structural reforms to eliminate subsidies and devaluation to parity. Brazil’s terms of trade, or export prices relative to import prices, deteriorated by 47 percent from 1977 to 1983 (Pelaez 1986, 46). Table III-12 provides selected economic indicators of the economy of Brazil from 1970 to 1985. In 1983, Brazil’s inflation was 164.9 percent, GDP fell 3.2 percent, idle capacity in manufacturing reached 24.0 percent and Brazil had an unsustainable foreign debt. US money center banks would have had negative capital if loans to emerging countries could have been marked according to loss given default and probability of default (for credit risk models see Pelaez and Pelaez (2005), International Financial Architecture, 134-54). Brazil’s current account of the balance of payments shrank from $16,310 million in 1982 to $6,837 million in 1983 because of the abrupt cessation of foreign capital inflows with resulting contraction of Brazil’s GDP by 3.2 percent. An important part of adjustment consisted of agile coordination of domestic production to cushion the impact of drastic reduction in imports. In 1984, Brazil had a surplus of $45 million in current account, the economy grew at 4.5 percent and inflation was stabilized at 232.9 percent.

Table III-12, Brazil, Selected Economic Indicators 1970-1985

	Inflation ∆%	GDP Growth ∆%	Idle Capacity in MFG %	BOP Current Account USD MM
1985	223.4	7.4	19.8	-630
1984	232.9	4.5	22.6	45
1983	164.9	-3.2	24.0	-6,837
1982	94.0	0.9	15.2	-16,310
1981	113.0	-1.6	12.3	-11,374
1980	109.2	7.2	3.5	-12,886
1979	55.4	6.4	4.1	-10,742
1978	38.9	5.0	3.3	-6,990
1977	40.6	5.7	3.2	-4,037
1976	40.4	9.7	0.0	-6,013
1975	27.8	5.4	3.0	-6,711
1974	29.1	9.7	0.1	-7,122
1973	15.4	13.6	0.3	-1,688
1972	17.7	11.1	6.5	-1,489
1971	21.5	12.0	9.8	-1,307
1970	19.3	8.8	12.2	-562

Source: Carlos Manuel Pelaez, O Cruzado e o Austral: Análise das Reformas Monetárias do Brasil e da Argentina. São Paulo, Editora Atlas, 1986, 86.

Chart III-2 provides the tortuous Phillips Circuit of Brazil from 1963 to 1987. There were no reliable consumer price index and unemployment data in Brazil for that period. Chart III-2 used the more reliable indicator of inflation, the wholesale price index, and idle capacity of manufacturing as a proxy of unemployment in large urban centers.

Chart III-2, Brazil, Phillips Circuit 1963-1987

Source:

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

A key to success in stabilizing an economy with significant risk aversion is finding parity of internal and external interest rates. Brazil implemented fiscal consolidation and reforms that are advisable in explosive foreign debt environments. In addition, Brazil had the capacity to find parity in external and internal interest rates to prevent capital flight and disruption of balance sheets (for analysis of balance sheets, interest rates, indexing, devaluation, financial instruments and asset/liability management in that period see Pelaez and Pelaez (2007), The Global Recession Risk: Dollar Devaluation and the World Economy, 178-87). Table III-13 provides monthly percentage changes of inflation, devaluation and indexing and the monthly percent overnight interest rate. Parity was attained by means of a simple inequality:

Cost of Domestic Loan ≥ Cost of Foreign Loan

This ordering was attained in practice by setting the domestic interest rate of the overnight interest rate plus spread higher than indexing of government securities with lower spread than loans in turn higher than devaluation plus spread of foreign loans. Interest parity required equality of inflation, devaluation and indexing. Brazil devalued the cruzeiro by 30 percent in 1983 because the depreciation of the German mark DM relative to the USD had eroded the competitiveness of Brazil’s products in Germany and in competition with German goods worldwide. The database of the Board of Governors of the Federal Reserve System quotes DM 1.7829/USD on Mar 3 1980 and DM 2.4425/USD on Mar 15, 1983 (http://www.federalreserve.gov/releases/h10/hist/dat89_ge.htm) for devaluation of 37.0 percent. Parity of costs and rates of domestic and foreign loans and assets required ensuring that there would not be appreciation of the exchange rate, inducing capital flight in expectation of future devaluation that would have reversed stabilization. One of the main problems of adjustment of members of the euro area with high debts is that they cannot adjust the exchange rate because of the common euro currency. This is not an argument in favor of breaking the euro area because there would be also major problems of adjustment such as exiting the euro in favor of a new Drachma in the case of Greece. Another hurdle of adjustment in the euro area is that Brazil could have moved swiftly to adjust its economy in 1983 but the euro area has major sovereignty and distribution of taxation hurdles in moving rapidly.

Table III-13, Brazil, Inflation, Devaluation, Overnight Interest Rate and Indexing, Percent per Month, 1984

1984	Inflation IGP ∆%	Devaluation ∆%	Overnight Interest Rate %	Indexing ∆%
Jan	9.8	9.8	10.0	9.8
Feb	12.3	12.3	12.2	12.3
Mar	10.0	10.1	11.3	10.0
Apr	8.9	8.8	10.1	8.9
May	8.9	8.9	9.8	8.9
Jun	9.2	9.2	10.2	9.2
Jul	10.3	10.2	11.9	10.3
Aug	10.6	10.6	11.0	10.6
Sep	10.5	10.5	11.9	10.5
Oct	12.6	12.6	12.9	12.6
Nov	9.9	9.9	10.9	9.9
Dec	10.5	10.5	11.5	10.5

Source: Carlos Manuel Pelaez, O Cruzado e o Austral: Análise das Reformas Monetárias do Brasil e da Argentina. São Paulo, Editora Atlas, 1986, 86.

IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table IV-1, updated with every blog comment, provides the latest annual data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of sovereign risk issues (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table IV-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section  as soon as available, following Table IV-1. Data for other countries in Table IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.

Table IV-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	2.2	1.7	0.7	8.3
Japan	2.8	-0.2	-2.1	4.3
China	8.9	1.8	-2.9
UK	-0.8	2.4* RPI 2.8	1.7* output 1.3** input -2.4*	8.1
Euro Zone	-0.1	2.4	1.8	11.2
Germany	1.2	2.0	1.6	5.4
France	0.3	2.3	1.3	10.1
Nether-lands	-1.3	2.5	1.8	5.1
Finland	1.7	2.9	1.4	7.5
Belgium	0.5	2.2	2.6	7.2
Portugal	-2.2	2.7	2.7	15.4
Ireland	NA	1.9	2.4	14.8
Italy	-1.3	3.6	2.2	10.8
Greece	-6.2	1.0	3.1	NA
Spain	-0.4	1.8	2.5	24.8

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

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

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2012/index.html Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html

Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 2.2 percent in IIQ2012 relative to IIQ2011 (Table 8, p 27 in http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp2q12_adv.pdf) See I Mediocre and Decelerating United States Economic Growth http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/mediocre-economic-growth-united-states.html). Japan’s GDP fell 0.6 percent in IVQ2011 relative to IVQ2010 and contracted 1.8 percent in IIQ2011 relative to IIQ2010 because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 but grew at the seasonally-adjusted annual rate (SAAR) of 7.8 percent in IIIQ2011, increasing at the SAAR of 0.1 percent in IVQ 2011 and 4.7 percent in IQ2012 (see Section VB at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html); the UK grew at minus 0.7 percent in IIQ2012 relative to IQ2012 and GDP fell 0.8 percent in IIQ2012 relative to IIQ2011 (see Section VH http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery_29.html); and the Euro Zone grew at 0.0 percent in IQ2012 relative to IVQ2011 and fell 0.1 percent in IQ2012 relative to IQ2011 (see Section VD http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities_10.html and http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-06062012-AP/EN/2-06062012-AP-EN.PDF). These are stagnating or “growth recession” rates, which are positive or about nil growth rates instead of contractions but insufficient to recover employment. The rates of unemployment are quite high: 8.3 percent in the US but 17.9 percent for unemployment/underemployment or job stress of 28.6 million (see Table I-4 http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real.html http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight.html http://cmpassocregulationblog.blogspot.com/2012/04/thirty-million-unemployed-or.html), 4.3 percent for Japan (see Section VB http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or_3778.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/mediocre-economic-growth-united-states_03.html), 8.1 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in Subsection VH http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial_22.html ) and 11.1 percent in the Euro Zone (section VD http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real_6867.html ). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.7 percent in the US, -0.2 percent for Japan, 1.8 percent for China, 2.4 percent for the Euro Zone and 2.4 percent for the UK (see Section IV http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html). Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section III and earlier ); (2) the tradeoff of growth and inflation in China now with change in growth strategy to domestic consumption instead of investment and political developments in a decennial transition; (3) slow growth by repression of savings with de facto interest rate controls (see IIB http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html), weak hiring with the loss of 10 million full-time jobs (see Section I and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-hiring-ten-million.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (see Section I http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see IV Budget/Debt Quagmire in http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) geopolitical events in the Middle East.

In the effort to increase transparency, the Federal Open Market Committee (FOMC) provides both economic projections of its participants and views on future paths of the policy rate that in the US is the federal funds rate or interest on interbank lending of reserves deposited at Federal Reserve Banks. These projections and views are discussed initially followed with appropriate analysis.

The statement of the FOMC at the conclusion of its meeting on Aug 1, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20120801a.htm):

“Release Date: August 1, 2012

For immediate release

Information received since the Federal Open Market Committee met in June suggests that economic activity decelerated somewhat over the first half of this year. Growth in employment has been slow in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending has been rising at a somewhat slower pace than earlier in the year. Despite some further signs of improvement, the housing sector remains depressed. Inflation has declined since earlier this year, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

There are several important issues in this statement.

1. Mandate. The FOMC pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

“Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”

2. Extending Average Maturity of Holdings of Securities. The statement of Apr 25, 2012, invokes the mandate that inflation is subdued but employment below maximum such that further accommodation is required. Accommodation consists of low interest rates. The new “Operation Twist” (http://cmpassocregulationblog.blogspot.com/2011_09_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html) or restructuring the portfolio of securities of the Fed by selling short-dated securities and buying long-term securities has the objective of reducing long-term interest rates. The FOMC is extending this program until the end of 2012.

3. Continuing Maturity Extension Program. This program is discussed in Section II Twist Again Extension (http://cmpassocregulationblog.blogspot.com/2012/06/recovery-without-hiring-continuance-of_24.html). The statement affirms: “The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

4. Target of Fed Funds Rate. The FOMC continues to maintain the target of fed funds rate at 0 to ¼ percent.

5. Advance Guidance. The FOMC increases transparency by advising on the expectation of the future path of fed funds rate. This guidance is the view that conditions such as “low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

6. Monitoring and Policy Focus. The FOMC reconsiders its policy continuously in accordance with available information: “The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

Table IV-2 provides economic projections of governors of the Board of Governors of the Federal Reserve and regional presidents of Federal Reserve Banks released at the meeting of Jun 20, 2012. The Fed releases the data with careful explanations (http://www.federalreserve.gov/newsevents/press/monetary/20120620b.htm). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IIQ2012 is analyzed in I Mediocre and Decelerating United States Economic Growth and the PCE inflation data from the report on personal income and outlays (http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real.html). The Bureau of Economic Analysis (BEA) provides the first estimate of IIQ2012 GDP with the second estimate to be released on Aug 29 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed in this blog as soon as available (for the latest report for Jun see http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm and http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html). The next report on “Personal Income and Outlays” for Jul will be released at 8:30 AM on Aug 30, 2012. PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog (the Jul report is analyzed at http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html). The report for Aug will be released on Sep 7, 2012 (http://www.bls.gov/cps/home.htm). “Longer term projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf).

It is instructive to focus on 2012, as 2013, 2014 and longer term are too far away, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Jun 20, 2012, and the second row “PR” the projection of the Apr 25, 2012 meeting. There are three major changes in the view.

1. Growth “∆% GDP.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun 2011 to 2.5 to 2.9 percent in Nov 2011 and 2.2 to 2.7 percent at the Jan 25 meeting but increased it to 2.4 to 2.9 percent at the Apr 25, 2012 meeting, reducing it to 1.9 to 2.4 percent at the Jun 20, 2012 meeting.

2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun 2011 to 8.5 to 8.7 percent in Nov 2011 but has reduced it to 8.2 to 8.5 percent at the Jan 25 meeting and further down to 7.8 to 8.0 percent at the Apr 25, 2012 meeting but increased it to 8.0 to 8.2 percent at the Jun 20, 2012 meeting.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun 2011 to virtually the same of 1.4 to 2.0 percent in Nov 2011 but has reduced it to 1.4 to 1.8 percent at the Jan 25 meeting but increased it to 1.9 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.2 to 1.7 percent at the Jun 20, 2012 meeting.

4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun 2011 of 1.4 to 2.0 percent and the Nov 2011 projection of 1.5 to 2.0 percent, which has been reduced slightly to 1.5 to 1.8 percent at the Jan 25 meeting but increased to 1.8 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.7 to 2.0 percent at the Jun 20, 2012 meeting.

Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, June 2012 and April 2012

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2012  Apr PR	1.9 to 2.4 2.4 to 2.9	8.0 to 8.2 7.8 to 8.0	1.2 to 1.7 1.9 to 2.0	1.7 to 2.0 1.8 to 2.0
2013  Apr PR	2.2 to 2.8 2.7 to 3.1	7.5 to 8.0 7.3 to 7.7	1.5 to 2.0 1.6 to 2.0	1.6 to 2.0 1.7 to 2.0
2014  Apr PR	3.0 to 3.5 3.1 to 3.6	7.0 to 7.7 6.7 to 7.4	1.5 to 2.0 1.7 to 2.0	1.6 to 2.0 1.8 to 2.0
Longer Run Apr PR	2.3 to 2.5 2.3 to 2.6	5.2 to 6.0 5.2 to 6.0	2.0 2.0
Range
2012 Apr PR	1.6 to 2.5 2.1 to 3.0	7.8 to 8.4 7.8 to 8.2	1.2 to 2.0 1.8 to 2.3	1.7 to 2.0 1.7 to 2.0
2013 Apr PR	2.2 to 3.5 2.4 to 3.8	7.0 to 8.1 7.0 to 8.1	1.5 to 2.1 1.5 to 2.1	1.4 to 2.1 1.6 to 2.1
2014 Apr PR	2.8 to 4.0 2.9 to 4.3	6.3 to 7.7 6.3 to 7.7	1.5 to 2.2 1.5 to 2.2	1.5 to 2.2 1.7 to 2.2
Longer Run Apr PR	2.2 to 3.0 2.2 to 3.0	4.9 to 6.3 4.9 to 6.0	2.0 2.0

Notes: UEM: unemployment; PR: Projection

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf

Another important decision at the FOMC meeting on Jan 25, 2012, is formal specification of the goal of inflation of 2 percent per year but without specific goal for unemployment (http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm):

“Following careful deliberations at its recent meetings, the Federal Open Market Committee (FOMC) has reached broad agreement on the following principles regarding its longer-run goals and monetary policy strategy. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.

The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.

Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier.

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary.  However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. ”

The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.

The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table IV-3 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 2012, 2013, 2014 and the in the longer term. Table IV-3 is inferred from a chart provided by the FOMC with the number of participants expecting the target of fed funds rate (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf). There are 16 participants expecting the rate to remain at 0 to ¼ percent in 2012 and only three to be higher. Not much change is expected in 2013 either with 13 participants anticipating the rate at the current target of 0 to ¼ percent and only six expecting higher rates. The rate would still remain at 0 to ¼ percent in 2014 for six participants with five expecting the rate to be in the range of 0.5 to 1 percent and five participants expecting rates from 1 to 2.0 percent but only three with rates exceeding 2.0 percent. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014.

Table IV-3, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012

	0 to 0.25	0.5 to 1.0	1.0 to 1.5	1.0 to 2.0	2.0 to 3.0	3.0 to 4.5
2012	16	3
2013	13	2	3	1
2014	6	5		5	3
Longer Run						19

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf

Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2012 to 2015. It is evident from Table IV-4 that the prevailing view in the FOMC is for interest rates to continue at low levels in future years. This view is consistent with the economic projections of low economic growth, relatively high unemployment and subdued inflation provided in Table IV-2.

Table IV-4, US, Views of Appropriate Year of Increasing Target Federal Funds Rate of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012

Appropriate Year of Increasing Target Fed Funds Rate	Number of Participants
2012	3
2013	3
2014	7
2015	6

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120620.pdf

Inflation in advanced economies has been fluctuating in waves at the production level alternation of surges and moderation of commodity price shocks. Table IV-6 provides month and 12-month percentage rates of inflation of Japan’s corporate goods price index (CGPI). Inflation measured by the CGPI fell 0.4 percent in Jul and fell 2.1 percent in 12 months. Measured by 12-month rates, CGPI inflation increased from minus 0.2 percent in Jul 2010 to a high of 2.2 percent in Jul 2011 and to minus 2.1 percent in Jul 2012. Calendar-year inflation for 2011 is 1.5 percent, which is the highest after declines in 2009 and 2010 but lower than 4.6 percent in the commodity shock driven by zero interest rates during the global recession in 2008. Inflation of the corporate goods prices follows waves similar to those in other indices around the world (Section I http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html ). In the first wave, annual equivalent inflation reached 5.9 percent in Jan-Apr, driven by commodity price shocks of the carry trade from zero interest rates to commodity futures. In the second wave, carry trades were unwound because of risk aversion caused by the European debt crisis, resulting in average annual equivalent inflation of minus 1.2 percent in May-Jun. In the third wave, renewed risk aversion caused annual equivalent decline of the CGPI of minus 2.2 percent in Jul-Nov. In the fourth wave, continuing risk aversion resulted in annual equivalent inflation of minus 0.6 percent in Dec 2011 to Jan 2012. In the fifth wave, renewed risk appetite resulted in annual equivalent inflation of 3.3 percent in Feb-Apr 2012. Finally, in the sixth wave, annual equivalent inflation dropped to minus 6.2 percent in May-Jul 2012. Unconventional monetary policies of zero interest rates and quantitative easing have created a difficult environment for economic and financial decisions with significant inflation volatility.

Table IV-5, Japan, Corporate Goods Price Index (CGPI) ∆%

	Month	Year
Jul 2012	-0.4	-2.1
Jun	-0.7	-1.4
May	-0.5	-0.7
AE ∆% May-Jul	-6.2
Apr	0.1	-0.4
Mar	0.5	0.3
Feb 2012	0.2	0.4
AE ∆% Feb-Apr	3.3
Jan	-0.1	0.3
Dec 2011	0.0	0.8
AE ∆% Dec-Jan	-0.6
Nov	-0.1	1.3
Oct	-0.8	1.3
Sep	-0.2	2.0
Aug	-0.1	2.2
Jul	0.3	2.2
AE ∆% Jul-Nov	-2.2
Jun	0.0	1.9
May	-0.2	1.6
AE ∆% May-Jun	-1.2
Apr	0.8	1.8
Mar	0.6	1.3
Feb	0.1	0.7
Jan	0.4	0.6
AE ∆% Jan-Apr	5.9
Dec 2010	0.5	1.2
Nov	-0.1	0.9
Oct	-0.1	0.9
Sep	0.0	-0.1
Aug	-0.1	0.0
Jul	0.0	-0.2
Calendar Year
2011		1.5
2010		-0.1
2009		-5.3
2008		4.6

AE: annual equivalent

Source: Bank of Japan

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$graphwnd_en

Chart IV-1 of the Bank of Japan provides year-on-year percentage changes of the domestic and services Corporate Goods Price Index (CGPI) of Japan. Percentage changes of inflation of services are not as sharp as those of goods. Japan had the same sharp waves of inflation during the 1970s as in the US (see Table IV-7 at http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real_09.html). Inflation also collapsed in the beginning of the 1980s as a result of tight monetary policy in the US with focus on inflation instead of on the gap of actual relative to potential output. The areas in shade correspond to the dates of cyclical recessions. The salient event is the sharp rise of inflation of the domestic goods CGPI in 2008 during the global recession that was purely the result of carry trades from fed funds rates collapsing to zero to long positions in commodity futures in an environment of relaxed financial risk appetite. The panic of toxic assets in banks to be withdrawn by the Troubled Asset Relief Program (TARP) (Cochrane and Zingales 2009) drove unusual risk aversion with unwinding of carry trades of exposures in commodities and other risk financial assets. Carry trades returned once TARP was clarified as providing capital to financial institutions and stress tests verified the soundness of US banks. The return of carry trades explains the rise of CGPI inflation after mid 2009. Inflation of the CGPI fluctuated with zero interest rates in alternating episodes of risk aversion and risk appetite.

Chart IV-1, Japan, Domestic Corporate Goods Price and Services Index, Year-on-Year Percentage Change, 1980-2012

Notes: Blue: Domestic Corporate Goods Price Index All Commodities; Red: Corporate Price Services Index

Source: Bank of Japan

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$graphwnd_en

There is similar behavior of year-on-year percentage changes of the US producer price index from 1980 to 2012 in Chart IV-2 of the US Bureau of Labor Statistics as in Chart IV-13 with the domestic goods CGPI. The US producer price index increased together with the CGPI driven by the period of one percent fed funds rates from 2003 to 2004 inducing carry trades into commodity futures and other risk financial assets and the slow adjustment in increments of 25 basis points at every FOMC meeting from Jun 2004 to Jun 2006. There is also the same increase in inflation in 2008 during the global recession followed by collapse because of unwinding positions during risk aversion and new rise of inflation during risk appetite.

Chart IV-2, US, Producer Price Index Finished Goods, Year-on-Year Percentage Change, 1980-2012

Source: US Bureau of Labor Statistics

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

Finer detail is provided by Chart IV-3 of the domestic CGPI from 2008 to 2012. The CGPI rose almost vertically in 2008 as the collapse of fed funds rates toward zero drove exposures in commodities and other risk financial assets because of risk appetite originating in the belief that the financial crisis was restricted to structured financial products and not to contracts negotiated in commodities and other exchanges. The panic with toxic assets in banks to be removed by TARP (Cochrane and Zingales 2009) caused unwinding carry trades in flight to US government obligations that drove down commodity prices and price indexes worldwide. Apparent resolution of the European debt crisis of 2010 drove risk appetite in 2011 with new carry trades from zero fed funds rates into commodity futures and other risk financial assets. Domestic CGPI inflation returned in waves with upward slopes during risk appetite and downward slopes during risk aversion.

Chart IV-3, Japan, Domestic Corporate Goods Price Index, Monthly, 2008-2012

Source: Bank of Japan

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$graphwnd_en

There is similar behavior of the US producer price index from 2008 to 2012 in Chart IV-16 as in the domestic CGPI in Chart IV-4. A major difference is the strong long-term trend in the US producer price index with oscillations originating mostly in bouts of risk aversion such as the downward slope in the final segment in Chart IV-4. Carry trades from zero interest rates to commodity futures and other risk financial assets drive the upward trend of the US producer price index while oscillations originate in alternating episodes of risk aversion and risk appetite.

Chart IV-4, US, Producer Price Index Finished Goods, Monthly, 2008-2012

Source: US Bureau of Labor Statistics

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

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 in Chart IV-5 trends down with oscillations after a brief rise in the final part of the recession in 2009.

Chart IV-5, Japan, Export Corporate Goods Price Index, Monthly, 2008-2012

Source: Bank of Japan

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$graphwnd_en

Japan imports primary commodities and raw materials. As a result, the import corporate goods price index in Chart IV-6 shows an upward trend after the rise during the global recession in 2008 driven by carry trades from fed funds rates collapsing to zero into commodity futures and decline 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.

Chart IV-6, Japan, Import Corporate Goods Price Index, Monthly, 2008-2012

Source: Bank of Japan

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$graphwnd_en

Chart IV-7 provides the monthly corporate goods price index (CGPI) of Japan from 1970 to 2012. Japan also experienced sharp increase in inflation during the 1970s as in the episode of the Great Inflation in the US. Monetary policy focused on accommodating higher inflation, with emphasis solely on the mandate of promoting employment, has been blamed as deliberate or because of model error or imperfect measurement for creating the Great Inflation (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation). A remarkable similarity with US experience is the sharp rise of the CGPI of Japan in 2008 driven by carry trades from interest rapidly falling to zero to exposures in commodity futures during a global recession. Japan had the same sharp waves of consumer price inflation during the 1970s as in the US (see Table IV-7 at http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real_09.html).

Chart IV-7, Japan, Domestic Corporate Goods Price Index, Monthly, 1970-2012

Source: Bank of Japan

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$graphwnd_en

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

Chart IV-8, US, Producer Price Index Finished Goods, Monthly, 1970-2012

Further insight into inflation of the corporate goods price index (CGPI) of Japan is provided in Table IV-6. Petroleum and coal with weight of 5.7 percent declined 5.6 percent in Jul and fell 8.5 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 3.8 percent, fell 0.1 percent in Jul and increased 0.7 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.

Table IV-6, Japan, Corporate Goods Prices and Selected Components, % Weights, Month and 12 Months ∆%

Jul 2012	Weight	Month ∆%	12 Month ∆%
Total	1000.0	-0.4	-2.1
Food, Beverages, Tobacco, Feedstuffs	137.5	0.1	-0.3
Petroleum & Coal	57.4	-5.6	-8.5
Production Machinery	30.8	-0.1	0.7
Electronic Components	31.0	-0.3	-4.4
Electric Power, Gas & Water	52.7	5.3	10.0
Iron & Steel	52.6	-0.4	-8.5
Chemicals	92.1	-1.7	-3.7
Transport Equipment	136.4	-0.1	-1.2

Source: Bank of Japan http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1207.pdf

Percentage point contributions to change of the corporate goods price index (CGPI) in Jun 2012 are provided in Table IV-7 divided into domestic, export and import segments. In the domestic CGPI petroleum and coal deducted 0.36 percentage points because of unwinding carry trades of energy commodity exposures and chemical and related products deducted 0.16 percentage points. The exports CGPI declined 0.5 percent on the basis of the contract currency with deductions of 0.31 percentage points by chemical and related products that are rich in raw materials, 0.14 percentage points by metals and related products and 0.17 percentage points by electric and electronic products. The imports CGPI decreased 2.3 percent on the contract currency basis. Petroleum, coal & natural gas deducted 2.33 percentage points because of the unwinding of carry trade into energy commodity exposures and metals & related products deducted 0.12 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.

Table IV-7, Japan, Percentage Point Contributions to Change of Corporate Goods Price Index

Groups Jun 2012	Contribution to Change Percentage Points
A. Domestic Corporate Goods Price Index	Monthly Change:  -0.4%
Petroleum & Coal Products	-0.36
Chemicals & Related Products	-0.16
Agriculture, Forestry & Fishery Products	-0.04
Iron & Steel	-0.02
Electric Power, Gas & Water	0.31
General Purpose Machinery	0.02
B. Export Price Index	Monthly Change:  -0.5% contract currency
Chemicals & Related Products	-0.31
Metals & Related Products	-0.14
Electric & Electronic Products	-0.14
C. Import Price Index	Monthly Change: -2.3 % contract currency basis
Petroleum, Coal & Natural Gas	-2.33
Metals & Related Products	-0.12
Chemicals & Related Products	-0.06
Foodstuffs % Feedstuffs	0.12

Source: Bank of Japan  http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1207.pdf

China is experiencing similar inflation behavior as the advanced economies in the form of declining commodity prices, as shown in Table IV-8. Inflation of the price indexes for industry in Jul 2012 is minus 0.8 percent; 12-month inflation is minus 2.9 percent in Jul; and inflation in Jan-Jul 2012 relative to Jan-Jul 2011 is minus 1.0 percent. Inflation of segments in Jul 2012 in China is provided in Table IV-8 in column “Month Jun ∆%.” There were decreases of prices of mining & quarrying of 3.7 percent in Jul and 6.2 percent in 12 months. Prices of consumer goods were flat in Jul and increased 0.4 percent in 12 months. Prices of inputs in the purchaser price index fell 0.8 percent in Jul and declined 3.4 percent in 12 months. Fuel and power decreased 2.2 percent in Jul and1.7 percent in 12 months. An important category of inputs for exports is textile raw materials, decreasing 0.3 percent in Jul and 1.8 percent in 12 months.

Table IV-8, China, Price Indexes for Industry ∆%

	Month     Jul ∆%	12-Month Jul ∆%	Jan-Jul 2012/Jan-Jul 2011 ∆%
I Producer Price Indexes	-0.8	-2.9	-1.0
Means of Production	-1.0	-3.9	-1.6
Mining & Quarrying	-3.7	-6.2	0.8
Raw Materials	-1.5	-4.5	-0.7
Processing	-0.5	-3.4	-2.3
Consumer Goods	0.0	0.4	1.2
Food	0.0	0.8	2.1
Clothing	0.0	1.9	2.4
Daily Use Articles	-0.1	0.6	1.1
Durable Consumer Goods	0.0	-1.2	-0.9
II Purchaser Price Indexes	-0.8	-3.4	-0.8
Fuel and Power	-2.2	-1.7	3.0
Ferrous Metals	-1.0	-7.7	-4.8
Nonferrous Metals	-0.4	-9.1	-5.5
Raw Chemical Materials	-1.1	-6.0	-2.9
Wood & Pulp	-0.2	-0.1	0.9
Building Materials	-0.4	-1.7	0.8
Other Industrial Raw Materials	-0.2	-1.6	-0.5
Agricultural	0.0	-2.3	0.6
Textile Raw Materials	-0.3	-1.8	-0.3

Source: National Bureau of Statistics of China

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

China’s producer price inflation follows waves similar to those around the world (http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html), as shown in Table IV-9. In the first wave, annual equivalent inflation was 6.4 percent in Jan-Jun, driven by carry trades from zero interest rates to commodity futures. In the second wave, risk aversion unwound carry trades, resulting in annual equivalent inflation of minus 3.1 percent in Jul-Nov. In the third wave, renewed risk aversion resulted in annual equivalent inflation of minus 2.4 percent in Dec-Jan. In the fourth wave, new carry trades resulted in annual equivalent inflation of 2.4 percent in Feb-Apr 2012. A fifth wave is beginning with annual equivalent minus 7.3 percent in May-Jul 2012.

Table IV-9, China, Month and 12-Month Rate of Change of Producer Price Index, ∆%

	12-Month ∆%	Month ∆%
Jul 2012	-2.9	-0.8
Jun	-2.1	-0.7
May	-1.4	-0.4
AE ∆% May-Jul		-7.3
Apr	-0.7	0.2
Mar	-0.3	0.3
Feb	0.0	0.1
AE ∆% Feb-Apr		2.4
Jan	0.7	-0.1
Dec 2011	1.7	-0.3
AE ∆% Dec-Jan		-2.4
Nov	2.7	-0.7
Oct	5.0	-0.7
Sep	6.5	0.0
Aug	7.3	0.1
Jul	7.5	0.0
AE ∆% Jul-Nov		-3.1
Jun	7.1	0.0
May	6.8	0.3
Apr	6.8	0.5
Mar	7.3	0.6
Feb	7.2	0.8
Jan	6.6	0.9
AE ∆% Jan-Jun		6.4
Dec 2010	5.9	0.7

AE: Annual Equivalent

Source: National Bureau of Statistics of China

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

Chart IV-9 of the National Bureau of Statistics of China provides monthly and 12-month rates of inflation of the price indexes for the industrial sector. Negative monthly rates in Oct, Nov, Dec 2011, Jan, Mar, Apr, May, Jun and Jul 2012 pulled down the 12-month rates to 5.0 percent in Oct 2011, 2.7 percent in Nov, 1.7 percent in Dec, 0.7 percent in Jan 2012, 0.0 percent in Feb, minus 0.3 percent in Mar, minus 0.7 percent in Apr, minus 1.4 percent in May, 2.1 in Jun and minus 2.9 percent in Jul.

Chart IV-9, China, Producer Prices for the Industrial Sector Month and 12 months ∆%

Source: National Bureau of Statistics of China

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

Chart IV-20 of the National Bureau of Statistics of China provides monthly and 12-month inflation of the purchaser product indices for the industrial sector. Decreasing monthly inflation with four successive contractions from Oct 2011 to Jan 2012 and May-Jul 2012 pulled down the 12-month rate to minus 3.4 percent in Jul.

Chart IV-20, China, Purchaser Product Indices for Industrial Sector

Source: National Bureau of Statistics of China

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

China is highly conscious of food price inflation because of its high weight in the basket of consumption of the population. Consumer price inflation in China in Jul was 0.1 percent and 1.8 percent in 12 months, as shown in Table IV-10. Food prices fell 0.1 percent in Jul but increased 2.4 percent in 12 months and 6.2 percent in Jan-Jul 2012 relative to Jan-Jul 2011. Another area of concern is housing inflation which was 0.5 in Jul but increased 2.1 percent in 12 months. Prices of services increased 0.6 percent in Jul and gained 2.0 percent in 12 months.

Table IV-10, China, Consumer Price Index

2012	Jul  Month   ∆%	Jul 12- Month  ∆%	Jan-Jul 2012   ∆% Jan-Jul 2011
Consumer Prices	0.1	1.8	3.1
Urban	0.1	1.9	3.1
Rural	0.0	1.5	3.0
Food	-0.1	2.4	6.2
Non-food	0.2	1.5	1.6
Consumer Goods	-0.1	1.7	3.6
Services	0.6	2.0	1.8
Commodity Categories:
Food	-0.1	2.4	6.2
Tobacco, Liquor	0.1	3.1	3.4
Clothing	-0.5	3.3	3.5
Household	0.2	1.9	2.2
Healthcare & Personal Articles	0.1	1.8	2.3
Transportation & Communication	-0.4	-0.9	-0.1
Recreation, Education, Culture & Services	0.8	0.4	0.2
Residence	0.5	2.1	1.9

Source: National Bureau of Statistics of China

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

Month and 12-month rates of change of consumer prices are provided in Table IV-11. There are waves of consumer price inflation in China similar to those around the world (http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html). In the first wave, consumer prices increased at the annual equivalent rate of 8.3 percent in Jan-Mar 2011, driven by commodity price increases resulting from unconventional monetary policy of zero interest rates. In the second wave, risk aversion unwound carry trades with annual equivalent inflation falling to the rate of 2.0 percent in Apr-Jun 2011. In the third wave, inflation returned at 2.9 percent with renewed interest in commodity exposures in Jul-Nov 2011. In the fourth wave, inflation returned at a high 5.8 percent annual equivalent in Dec 2011 to Mar 2012. In the fifth wave, annual equivalent inflation was minus 2.7 percent in Apr to Jul 2012. Inflation volatility originating in unconventional monetary policy clouds investment and consumption decisions by business and households.

Table IV-11, China, Month and 12-Month Rates of Change of Consumer Price Index ∆%

	Month ∆%	12-Month ∆%
Jul 2012	0.1	1.8
Jun	-0.6	2.2
May	-0.3	3.0
Apr	-0.1	3.4
AE ∆% Apr to Jul	-2.7
Mar	0.2	3.6
Feb	-0.1	3.2
Jan	1.5	4.5
Dec 2011	0.3	4.1
AE ∆% Dec to Mar	5.8
Nov	-0.2	4.2
Oct	0.1	5.5
Sep	0.5	6.1
Aug	0.3	6.2
Jul	0.5	6.5
AE ∆% Jul to Nov	2.9
Jun	0.3	6.4
May	0.1	5.5
Apr	0.1	5.3
AE ∆% Apr to Jun	2.0	2.0
Mar	-0.2	5.4
Feb	1.2	4.9
Jan	1.0	4.9
AE ∆% Jan to Mar	8.3
Dec 2010	0.5	4.6

AE: Annual Equivalent

Source: National Bureau of Statistics of China

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

Chart IV-12 of the National Bureau of Statistics of China provides monthly and 12-month rates of consumer price inflation. In contrast with producer prices, consumer prices had not moderated at the monthly marginal rates. Consumer prices fell 0.2 percent in Nov 2011 after increasing only 0.1 percent in Oct but increased 0.3 percent in Dec and a high 1.5 percent in Jan 2012, declining 0.1 percent in Feb, rising 0.2 percent in Mar and declining 0.1 percent in Apr, 0.3 percent in May and 0.6 percent in Jun 2012 but increasing 0.1 percent in Jul 2012. The decline of 0.1 percent in Feb 2012 pulled down the 12-month rate to 3.2 percent, which bounced back to 3.6 percent in Mar with the monthly increase of 0.2 percent and fell to 2.2 percent in Jun with increasing monthly decline from Apr to Jun 2012. Even with increase of 0.1 percent in Jul 2012, consumer price inflation in 12 months fell to 1.8 percent in Jul 2012.

Chart IV-12, China, Consumer Prices ∆% Month and 12 Months Aug 2010 to Aug 2011

Source: National Bureau of Statistics of China

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

The estimate of consumer price inflation in Germany in Table IV-12 is 1.7 percent in 12 months ending in Jul 2012, 0.4 percent NSA in Jul 2012 relative to Jun 2012 and 0.2 percent SA in Jul 2012 relative to Jun 2012. There are waves of consumer price inflation in Germany similar to those worldwide (http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html), as shown in Table IV-12. In the first wave, annual equivalent inflation was 4.9 percent in Feb-Apr 2011 NSA and 2.4 percent SA during risk appetite in carry trades from zero interest rates to commodity futures. In the second wave, annual equivalent consumer price inflation collapsed to 0.6 percent NSA and 2.4 percent SA in May-Jun 2011 because of risk aversion caused by European sovereign debt event. In the third wave, annual equivalent consumer price inflation was 1.2 percent NSA and 2.2 percent SA in Jul-Nov 2011 as a result of relaxed risk aversion. In the fourth wave, annual equivalent inflation was 1.8 percent NSA and 1.2 percent SA in Dec 2011 to Jan 2012. In the fifth wave, annual equivalent inflation rose to 4.9 percent NSA and 2.4 percent SA in Feb-Apr 2012 during another energy-commodity carry trade shock. In the sixth wave, annual equivalent inflation in Jun 2012 is minus 1.8 percent NSA and flat SA. In the beginning of a new seventh wave, annual equivalent inflation NSA is 4.9 percent in Jul 2012 and 2.4 percent SA. Under unconventional monetary policy of zero interest rates and quantitative easing inflation becomes highly volatile during alternative shocks of risk aversion and risk appetite, preventing sound investment and consumption decisions.

Table IV-12, Germany, Consumer Price Index ∆%

	12-Month ∆%	Month ∆%NSA	Month ∆% SA
Jul 2012	1.7	0.4	0.2
AE ∆% Jul		4.9	2.4
Jun	1.7	-0.1	0.0
May	1.9	-0.2	0.0
AE ∆% May-Jun		-1.8	0.0
Apr	2.1	0.2	0.2
Mar	2.1	0.3	0.1
Feb	2.3	0.7	0.3
AE ∆% Feb-Apr		4.9	2.4
Jan	2.1	-0.4	0.1
Dec 2011	2.1	0.7	0.1
AE ∆% Dec-Jan		1.8	1.2
Nov	2.4	0.0	0.1
Oct	2.5	0.0	0.1
Sep	2.6	0.1	0.3
Aug	2.4	0.0	0.2
Jul	2.4	0.4	0.2
AE ∆% Jul-Nov		1.2	2.2
Jun	2.3	0.1	0.2
May	2.3	0.0	0.2
AE ∆% May-Jun		0.6	2.4
Apr	2.4	0.2	0.2
Mar	2.1	0.5	0.2
Feb	2.1	0.5	0.2
Jan	2.0	-0.4	0.2
AE ∆% Feb-Apr		4.9	2.4
Dec 2010	1.7	1.0
Nov	1.5	0.1
Oct	1.3	0.1
Sep	1.3	-0.1
Aug	1.0	0.0
Annual Average ∆%
2011	2.3
2010	1.1
2009	0.4
2008	2.6

AE: Annual Equivalent

Source: Statistiche Bundesamt Deutschland

https://www.destatis.de/EN/PressServices/Press/pr/2012/08/PE12_271_611.html;jsessionid=1C62846AF9007065E675BAA22C4F4734.cae1

https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html

Chart IV-13, of the Statistiche Bundesamt Deutschland, or Federal Statistical Agency of Germany, provides the unadjusted consumer price index of Germany from 2003 to 2012. There is an evident acceleration in the form of sharper slope in the first months of 2011 and then a flattening in subsequent months with renewed strength in Dec, decline in Jan 2012 and another upward spike from Feb to Apr 2012, new drop in May-Jun 2012 and increase in Jul 2012. If risk aversion declines, new carry trades from zero interest rates to commodity futures could again result in higher inflation.

Chart IV-13, Germany, Consumer Price Index, Unadjusted, 2005=100

Source: Statistiche Bundesamt Deutschland

https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html

Chart IV-14, of the Statistiche Bundesamt Deutschland, or Federal Statistical Agency of Germany, provides the unadjusted consumer price index and trend of Germany from 2003 to 2012. Chart IV-23 captures inflation waves with alternation of periods of positive and negative slopes resulting from zero interest rates with shocks of risk appetite and risk aversion. For example, the negative slope of decline of inflation 0.2 percent in May 2012 and 0.1 percent in Jun 2012 follows an upward slope of price increases in Feb-Apr 2012 after decline of inflation by 0.4 percent in Jan 2012. The final segment shows another positive slope caused by inflation of 0.4 percent in Jul 2012. The waves occur around an upward trend of prices, disproving the proposition of fear of deflation.

Chart IV-14, Germany, Consumer Price Index, Unadjusted and Trend, 2005=100

Source: Statistiche Bundesamt Deutschland

https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html

Table IV-13 provides the monthly and 12-month rate of inflation for segments of the consumer price index of Germany in Jul 2012. Inflation excluding energy increased 0.4 percent in Jul 2012 and rose 1.5 percent in 12 months. Excluding household energy inflation was 0.4 percent in Jul and rose 1.5 percent in 12 months. Food prices decreased 0.8 percent in Jul and increased 3.0 percent in 12 months. There were differences in inflation of energy-related prices. Heating oil rose 4.8 percent in 12 months and increased 4.6 percent in Jul. Motor fuels increased 1.3 percent in Jul and increased 2.9 percent in 12 months.

Table IV-13, Germany, Consumer Price Index ∆%

Jul 2012	Weight	12- Month ∆%	Month   ∆%
Total	1,000.00	1.7	0.4
Excluding heating oil and motor fuels	955.42	1.6	0.4
Excluding household energy	940.18	1.5	0.4
Excluding Energy	904.81	1.4	0.4
Total Goods	493.00	2.5	-0.3
Nondurable Consumer Goods	305.11	3.2	0.2
Medium-Term Life Consumer Goods	95.24	1.7	-2.0
Durable Consumer Goods	92.65	0.3	0.0
Services	507.00	0.9	1.1
Energy Components
Motor Fuels	35.37	2.9	1.3
Household Energy	59.82	5.3	1.0
Heating Oil	9.21	5.8	4.6
Food	89.99	3.0	-0.8

Source: Statistiche Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/08/PE12_271_611.html;jsessionid=1C62846AF9007065E675BAA22C4F4734.cae1

The first wave of commodity price increases in the first four months of Jan-Apr 2011 also influenced the surge of consumer price inflation in Italy shown in Table IV-14. Annual equivalent inflation in the first four months of 2011 was 4.9 percent. The crisis of confidence or risk aversion resulted in reversal of carry trades on commodity positions. Consumer price inflation in Italy was subdued in the second wave in Jun and May at 0.1 percent for annual equivalent 1.2 percent. In the third wave in Jul-Sep, annual equivalent inflation increased to 2.4 percent. In the fourth wave, annual equivalent inflation in Oct-Nov jumped again at 3.0 percent. Inflation returned in the fifth wave from Dec 2011 to Jan 2012 at annual equivalent 4.3 percent. In the sixth wave, annual equivalent inflation rose to 5.7 percent in Feb-Apr 2012. In the seventh wave, annual equivalent inflation was 1.2 percent in May-Jul 2012. Economies are shocked worldwide by intermittent waves of inflation originating in combination of zero interest rates and quantitative easing with alternation of risk appetite and risk aversion.

Table IV-14, Italy, Consumer Price Index

	Month	12 Months
Jul 2012	0.1	3.1
June	0.2	3.3
May 2012	0.0	3.2
AE ∆% May-Jul	1.2
Apr	0.5	3.3
Mar	0.5	3.3
Feb	0.4	3.3
AE ∆% Feb-Apr	5.7
Jan	0.3	3.2
Dec 2011	0.4	3.3
AE ∆% Dec-Jan	4.3
Nov	-0.1	3.3
Oct	0.6	3.4
AE ∆% Oct-Nov	3.0
Sep	0.0	3.0
Aug	0.3	2.8
Jul	0.3	2.7
AE ∆% Jul-Sep	2.4
Jun	0.1	2.7
May	0.1	2.6
AE ∆% May-Jun	1.2
Apr	0.5	2.6
Mar	0.4	2.5
Feb	0.3	2.4
Jan	0.4	2.1
AE ∆% Jan-Apr	4.9
Dec 2010	0.4	1.9
Annual
2011		2.8
2010		1.5
2009		0.8
2008		3.3
2007		1.8
2006		2.1

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/68852

Consumer price inflation in Italy by segments in the estimate by ISTAT for Jul 2012 is provided in Table IV-15. Total consumer price inflation in Jul was 0.1 percent and 3.1 percent in 12 months. Inflation of goods was minus 0.4 percent and 3.8 percent in 12 months. Prices of durable goods fell 0.2 percent in Jul and increased only 0.9 percent in 12 months, as typical in most countries. Prices of energy goods fell 0.2 percent in Jul and increased 12.0 percent in 12 months. Food prices fell 0.9 percent in Jul and increased 2.6 percent in 12 months. Prices of services increased 0.7 percent in Jul and rose 2.0 percent in 12 months. Transport prices, also influenced by commodity prices, increased 1.4 percent in Jul and increased 3.6 percent in 12 months. Carry trades from zero interest rates to positions in commodity futures cause increases in commodity prices. Waves of inflation originate in periods when there is no risk aversion and commodity prices decline during periods of risk aversion.

Table IV-15, Italy, Consumer Price Index and Segments, Month and 12-Month ∆%

Jul 2012	Month ∆%	12-Month ∆%
Total	0.1	3.1
I Goods	-0.4	3.8
Food	-0.9	2.6
Energy	-0.2	12.1
Durable	-0.2	0.9
Nondurable	0.1	0.9
II Services	0.7	2.0
Housing	0.2	2.5
Communications	0.5	1.8
Transport	1.4	3.6

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/68852

Chart IV-16 of the Istituto Nazionale di Statistica shows moderation in 12-month percentage changes of the consumer price index of Italy that could continue in the beginning wave of declines of commodity prices if risk aversion persists.

Chart, IV-15, Italy, Consumer Price Index, 12-Month Percentage Changes

Source: Istituto Nazionale di Statistica

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

Inflation in the UK is somewhat higher than in many advanced economies, deserving more detailed analysis. Table IV-16 provides 12-month percentage changes of UK output prices for all manufactured products, excluding food, beverage and petroleum and excluding duty. The 12-month rates rose significantly in 2011 in all three categories, reaching 6.3 percent for all manufactured products in Sep 2011 but declining to 5.7 percent in Oct, 5.4 in Nov and down to 1.7 percent in Jul 2012. Output price inflation is highly sensitive to commodity prices as shown by the increase by 6.7 percent in 2008 when oil prices rose over $140/barrel even in the midst of a global recession driven by the carry trade from zero interest rates to oil futures. The mirage episode of false deflation in 2001 and 2002 is also captured by output prices for the UK, which was originated in decline of commodity prices but was used as an argument for the unconventional monetary policy of zero interest rates and quantitative easing during the past decade.

Table IV-16, UK Output Prices 12 Months ∆% NSA

	All Manufactured Products	Excluding Food, Beverage and Petroleum	All Excluding Duty
Jul 2012	1.7	1.3	1.4
Jun	2.0	1.7	1.7
May	2.8	2.1	2.5
Apr	3.3	2.3	3.1
Mar	3.7	2.5	3.5
Feb	4.1	3.0	4.1
Jan	4.0	2.4	4.0
Dec 2011	4.8	3.0	4.8
Nov	5.4	3.1	5.6
Oct	5.7	3.3	5.9
Sep	6.3	3.7	6.4
Aug	6.0	3.5	6.2
Jul	6.1	3.4	6.2
Jun	5.8	3.2	5.9
May	5.4	3.4	5.5
Apr	5.6	3.6	5.8
Mar	5.6	3.1	5.5
Feb	5.3	3.1	5.2
Jan	5.0	3.3	5.0
Dec 2010	4.2	2.7	4.0
Year ∆%		Ex Food
2011	5.6	3.4	5.7
2010	4.2	3.0	3.9
2009	1.6	2.5	1.0
2008	6.7	3.7	6.7
2007	2.3	1.4	2.1
2006	2.0	1.5	2.0
2005	1.9	1.0	1.9
2004	1.0	-0.3	0.6
2003	0.6	0.1	0.5
2002	-0.1	-0.4	-0.1
2001	-0.3	-0.6	-0.3
2000	1.4	-0.5	0.8
1999	0.6	-1.0	-0.3
1998	0.0	-0.8	-0.9
1997	0.9	0.3	0.1

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2012/index.html

Monthly and annual equivalent rates of change of output prices are shown in Table IV-13. There are waves of inflation similar to those in other countries (http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html). In the first wave, annual equivalent inflation was 12.0 percent in Jan-Apr 2011 with relaxed risk aversion in commodity markets. In the second wave, intermittent risk aversion resulted in annual equivalent inflation of 2.0 percent in May-Oct 2011. In the third wave, alternation of risk aversion resulted in annual equivalent inflation of 1.6 percent in Nov-Jan. In the fourth wave, the energy commodity shock caused by carry trades caused the jump of annual equivalent inflation to 7.9 percent in Feb-Apr 2012. A fifth wave has begun in May-Jul 2012 with decline of output inflation by 3.5 percent annual equivalent in an environment of risk aversion that is causing decline of commodity prices.

Table IV-17, UK Output Prices Month ∆% NSA

	All Manufactured Products	Excluding Food, Beverage and Petroleum	All Excluding Duty
Jul 2012	0.0	0.0	0.0
Jun	-0.6	-0.2	-0.6
May	-0.3	-0.1	-0.4
∆% AE May-Jul	-3.5	-1.2	-3.9
Apr	0.7	0.6	0.5
Mar	0.6	0.1	0.5
Feb	0.6	0.5	0.6
∆% AE Feb-Apr	7.9	4.9	6.6
Jan	0.4	0.3	0.3
Dec 2011	-0.2	-0.1	-0.2
Nov	0.2	-0.1	0.2
∆% AE Nov-Jan	1.6	0.4	1.2
Oct	0.0	-0.1	0.1
Sep	0.3	0.3	0.2
Aug	0.0	0.1	0.1
Jul	0.3	0.4	0.3
Jun	0.2	0.2	0.2
May	0.2	0.2	0.2
∆% AE May-Oct	2.0	2.2	2.2
Apr	1.1	0.8	0.9
Mar	1.1	0.5	1.1
Feb	0.5	0.0	0.5
Jan	1.1	0.8	1.1
Jan-Apr ∆% AE	12.0	6.5	11.4
Dec 2010	0.5	0.0	0.6

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2012/index.html

Input prices in the UK have been more dynamic than output prices until the current event of risk aversion, as shown by Table IV-18, but with sharp oscillations because of the commodity and raw material content. The 12-month rates of increase of input prices, even excluding food, tobacco, beverages and petroleum, are very high, reaching 18.1 percent in Sep 2011 for materials and fuels purchased and 13.3 percent excluding food, beverages and petroleum. Inflation in 12 months of materials and fuels purchased moderated to 5.4 percent in Mar 2012 and 4.1 percent excluding food, tobacco, beverages and petroleum with the rates falling further in Apr to 1.0 percent for materials and fuels purchased and 2.2 percent excluding food, tobacco, beverages and petroleum. Input-price inflation collapsed in the 12 months ending in Jul 2012 to minus 2.4 percent for materials and fuels purchased and minus 1.5 percent excluding food, beverages and tobacco. There is only comparable experience with 22.2 percent inflation of materials and fuels purchased in 2008 and 16.9 percent excluding food, beverages and petroleum followed in 2009 by decline of 3.8 percent by materials and fuels purchased and increase of 1.6 percent for the index excluding items. UK input and output inflation is sensitive to commodity price increases driven by carry trades from zero interest rates. The mirage of false deflation is also observed in input prices in 1997-9 and then again from 2001 to 2003.

Table IV-18, UK Input Prices 12-Month ∆% NSA

	Materials and Fuels Purchased	Excluding Food, Tobacco, Beverages and Petroleum
Jul 2012	-2.4	-1.5
Jun	-3.0	-0.4
May	0.1	1.0
Apr	1.0	2.2
Mar	5.4	4.1
Feb	7.7	5.7
Jan	6.5	5.6
Dec 2011	8.9	7.2
Nov	13.8	10.2
Oct	14.5	11.0
Sep	18.1	13.3
Aug	16.3	13.0
Jul	18.5	13.3
Jun	16.8	12.6
May	16.3	11.4
Apr	17.9	12.2
Mar	14.8	10.3
Feb	14.9	10.7
Jan	14.2	10.5
Dec 2010	13.1	9.0
Year ∆%
2011	15.4	11.4
2010	9.9	5.7
2009	-3.8	1.6
2008	22.2	16.9
2007	2.9	2.3
2006	9.8	7.3
2005	10.9	6.9
2004	3.3	1.6
2003	1.2	-0.6
2002	-4.4	-4.8
2001	-1.2	-1.2
2000	7.4	3.7
1999	-1.3	-3.6
1998	-9.1	-4.6
1997	-8.2	-6.3

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2012/index.html

Table IV-19 provides monthly percentage changes of UK input prices for materials and fuels purchased and excluding food, tobacco, beverages and petroleum. There are strong waves of inflation of input prices in the UK similar to those worldwide (http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial.html). In the first wave, input prices rose at the high annual equivalent rate of 35.6 percent in Jan-Apr 2011, driven by carry trades from unconventional monetary policy into commodity exposures. In the second wave, alternating risk aversion caused annual equivalent inflation of minus 3.1 percent in May-Oct 2011. In the third wave, renewed risk aversion resulted in annual equivalent inflation of minus 1.2 percent in Nov-Dec 2011. In the fourth wave, annual equivalent inflation of input prices in the UK surged at 18.1 percent in Jan-Mar 2012 under relaxed risk aversion. In the fifth wave, annual equivalent inflation was minus 24.4 percent in Apr-Jun 2012 because of collapse of commodity prices during increasing risk aversion. In what could be the beginning of a sixth wave, annual equivalent inflation of materials and fuels purchased jumped to 16.8 percent.

Table IV-19, UK Input Prices Month ∆% 

	Materials and Fuels Purchased NSA	Excluding Food, Tobacco, Beverages and Petroleum SA
Jul 2012	1.3	-0.3
∆% Jul	16.8	-3.5
Jun	-2.9	-0.3
May	-2.5	-0.8
Apr	-1.5	0.1
∆% Apr-Jun	-24.4	-3.9
Mar	1.6	-0.7
Feb	2.5	1.0
Jan	0.1	-0.1
∆% AE Jan-Mar	18.1	0.8
Dec 2011	-0.6	-0.7
Nov	0.4	0.1
∆% AE Nov-Dec	-1.2	-3.6
Oct	-0.8	-0.4
Sep	2.1	0.7
Aug	-1.9	-0.1
Jul	0.6	0.9
Jun	0.1	1.0
May	-1.6	-0.1
∆% AE May-Oct	-3.1	4.1
Apr	2.8	2.0
Mar	3.8	1.0
Feb	1.4	1.0
Jan	2.3	1.5
∆% AE Jan-Apr	35.6	17.8
Dec 2010	3.9	1.9

Source:

http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2012/index.html

The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12-month rates of inflation of manufactured products, shown in Table IV-20. There are high contributions of 0.34 percentage points by food products, 0.81 percentage points by tobacco and alcohol, 0.30 percentage points by computer, electrical and optical and 0.51 percentage points by other manufactured products. There are diversified sources of contributions to 12 months output price inflation such as 0.22 percentage points by clothing, textile and leather and 0.04 percentage points by transport equipment. In general, contributions by products rich in commodities are the drivers of inflation. There were diversified contributions in percentage points to monthly inflation: 0.03 by tobacco and alcohol, 0.01 percentage points by other manufactured products and 0.09 percentage points by apparel. The collapse of petroleum prices by 0.2 percent deducted 0.02 percentage points from monthly inflation of manufactured products and decline of 1.5 percent by chemical and pharmaceutical deducted 0.13 percentage points.

Table IV-20, Contributions to Month and 12-Month Change in Prices of All Manufactured Products, Percentage Points

Jul 2012	12 Months % Points	12 Months ∆%	Month  % Points	Month ∆%
Total %		1.7		0.0
Food Products	0.34	2.1	-0.01	-0.1
Tobacco & Alcohol	0.81	7.6	0.04	0.3
Clothing, Textile & Leather	0.22	2.0	0.09	0.8
Paper and Printing	-0.02	-0.6	-0.01	-0.2
Petroleum	-0.37	-3.1	-0.02	-0.2
Chemical & Pharmaceutical	-0.17	-1.9	-0.13	-1.5
Metal, Machinery & Equipment	0.03	0.8	0.00	-0.1
Computer, Electrical & Optical	0.30	3.5	0.02	0.3
Transport Equipment	0.04	0.4	-0.01	-0.1
Other Manufactured Products	0.51	3.0	0.01	0.1

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2012/index.html

The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12-month rates of inflation of input prices, shown in Table IV-21. Crude oil is the large contributor with deduction of 2.63 percentage points from the 12-month rate but contribution of 1.35 percentage points to the monthly rate in Jul. Inflation also transfers to the domestic economy through the prices of imported inputs: imported metals deducted 0.418 percentage points to the 12-month rate and deducted 22 percentage points to the Jul rate. Domestic food added 1.22 percentage points to the 12-month rate and added 0.46 percentage points to the Jul rate. Reversals of commodity exposures in carry trades during risk aversion are a major source of financial instability.

Table IV-21, UK, Contributions to Month and 12-Month Change in Prices of Inputs, Percentage Points

Jun 2012	12 Months % Points	12 Months ∆%	Month % Points	Month ∆%
Total		-2.4		1.3
Fuel	0.56	6.3	0.00	0.0
Crude Oil	-2.63	-9.5	1.35	5.3
Domestic Food Materials	1.22	12.7	0.46	4.1
Imported Food Materials	0.15	2.9	0.01	0.3
Other Domestic Produced Materials	0.01	0.4	-0.02	-0.4
Imported Metals	-1.11	-13.2	-0.13	-1.6
Imported Chemicals	-0.18	-1.6	-0.22	-1.9
Imported Parts and Equipment	-0.43	-2.9	-0.05	-0.4
Other Imported Materials	-0.01	-0.1	-0.10	-1.0

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2012/index.html

V World Economic Slowdown. Table V-1 is constructed with the database of the IMF (http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx) to show GDP in dollars in 2010 and the growth rate of real GDP of the world and selected regional countries from 2011 to 2014. The IMF revised some of the projections in its World Economic Outlook Update released on Jul 16, 2012 (http://www.imf.org/external/pubs/ft/weo/2012/update/02/index.htm). Table V-1 incorporates these revisions with lines “Rev” where appropriate. The data illustrate the concept often repeated of “two-speed recovery” of the world economy from the recession of 2007 to 2009. The IMF has lowered its forecast of the world economy to 3.5 percent in 2012 but accelerating to 3.9 percent in 2013 instead of 4.1 percent in the earlier projection, 4.4 percent in 2014 and 4.5 percent in 2015. Slow-speed recovery occurs in the “major advanced economies” of the G7 that account for $33,670 billion of world output of $69,660 billion, or 48.3 percent, but are projected to grow at much lower rates than world output, 2.0 percent on average from 2012 to 2015 in contrast with 4.1 percent for the world as a whole, incorporating the revisions. While the world would grow 17.3 percent in the four years from 2012 to 2015, the G7 as a whole would grow 8.4 percent. The difference in dollars of 2011 is rather high: growing by 17.3 percent would add $12.1 trillion of output to the world economy, or roughly two times the output of the economy of Japan of $5,869 but growing by 8.4 percent would add $5.9 trillion of output to the world, or about the output of Japan in 2011. The “two speed” concept is in reference to the growth of the 150 countries labeled as emerging and developing economies (EMDE) with joint output in 2011 of $25,237 billion, or 36.2 percent of world output. The EMDEs would grow cumulatively 26.3 percent or at the average yearly rate of 6.0 percent, contributing $6.6 trillion from 2012 to 2015 or the equivalent of somewhat less than the GDP of $7,298 billion of China in 2011. The final four countries in Table 1 often referred as BRIC (Brazil, Russia, India, China), are large, rapidly growing emerging economies. Their combined output adds to $13,317 billion, or 19.1 percent of world output, which is equivalent to 39.6 percent of the combined output of the major advanced economies of the G7.

Table V-1, IMF World Economic Outlook Database Projections of Real GDP Growth

	GDP USD 2011	Real GDP ∆% 2012	Real GDP ∆% 2013	Real GDP ∆% 2014	Real GDP ∆% 2015
World Rev	69,660	3.5	4.1 3.9	4.4	4.5
G7 Rev	33,670	1.5 1.4	1.9 1.9	2.3	2.5
Canada	1,737	2.1	2.2	2.4	2.4
France Rev	2,776	0.5 0.3	1.1 0.8	1.9	1.9
DE Rev	3,577	0.6 1.0	1.5 1.4	1.3	1.3
Italy	2,199	-1.9	-0.3	0.5	1.0
Japan Rev	5,869	2.0 2.4	1.7 1.5	1.5	1.3
UK	2,418	0.8	2.0	2.5	2.6
US Rev	15,094	2.1 0.2	2.4 1.4	2.9	3.3
Euro Area Rev	13,115	-0.3	0.9 0.7	1.4	1.6
DE Rev	3,577	0.6 1.0	1.5 1.4	1.3	1.3
France Rev	2,776	0.5 0.3	1.1 0.8	1.9	1.9
Italy	2,199	-1.9	-0.3	0.5	1.0
POT	239	-3.3	0.3	2.1	1.9
Ireland	218	0.5	2.1	2.5	2.8
Greece	303	-4.7	0.0	2.5	3.1
Spain Rev	1,494	-1.8 -1.5	0.1 -0.6	1.6	1.6
EMDE Rev	25,237	5.7 5.6	6.0 5.9	6.2	6.3
Brazil Rev	2,493	3.0 2.5	4.2 4.6	4.0	4.1
Russia	1,850	4.0	3.9	3.9	3.9
India Rev	1,676	6.9 6.1	7.3 6.5	7.5	7.7
China Rev	7,298	8.2 8.0	8.8 8.5	8.7	8.7

Notes: Rev: Revision of July 19, 2012; DE: Germany; EMDE: Emerging and Developing Economies (150 countries); POT: Portugal

Source: IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx

http://www.imf.org/external/pubs/ft/weo/2012/update/02/index.htm

Table V-2 is constructed with the WEO database to provide rates of unemployment from 2011 to 2015 for major countries and regions. In fact, unemployment rates for 2011 in Table ESV-2 are high for all countries: unusually high for countries with high rates most of the time and unusually high for countries with low rates most of the time. The rates of unemployment are particularly high for the countries with sovereign debt difficulties in Europe: 12.7 percent for Portugal (POT), 14.4 percent for Ireland, 17.3 percent for Greece, 21.6 percent for Spain and 8.4 percent for Italy, which is lower but still high. The G7 rate of unemployment is 7.7 percent. Unemployment rates are not likely to decrease substantially if slow growth persists in advanced economies.

Table V-2, IMF World Economic Outlook Database Projections of Unemployment Rate as Percent of Labor Force

	% Labor Force 2011	% Labor Force 2012	% Labor Force 2013	% Labor Force 2014	% Labor Force 2015
World	NA	NA	NA	NA	NA
G7	7.7	7.4	7.3	7.0	6.7
Canada	7.5	7.4	7.3	7.1	6.9
France	9.7	9.9	10.1	9.8	9.4
DE	6.0	5.6	5.5	5.3	5.3
Italy	8.4	9.5	9.7	9.8	9.5
Japan	4.5	4.5	4.4	4.3	4.2
UK	8.0	8.3	8.2	7.8	7.4
US	8.9	8.2	7.9	7.5	6.9
Euro Area	10.1	10.9	10.8	10.5	10.1
DE	6.0	5.6	5.5	5.3	5.3
France	9.7	9.9	10.1	9.8	9.4
Italy	8.4	9.5	9.7	9.8	9.5
POT	12.7	14.3	13.9	13.2	12.4
Ireland	14.4	14.5	13.8	12.9	12.0
Greece	17.3	19.4	19.4	18.2	16.8
Spain	21.6	24.2	23.9	22.8	21.9
EMDE	NA	NA	NA	NA	NA
Brazil	6.0	6.0	6.5	7.0	7.0
Russia	7.5	6.5	6.0	6.0	6.0
India	NA	NA	NA	NA	NA
China	4.1	4.0	4.0	4.0	4.0

Notes: DE: Germany; EMDE: Emerging and Developing Economies (150 countries)

Source: IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weoselgr.aspx

Table V-3 provides the latest available estimates of GDP for the regions and countries followed in this blog. Growth is weak throughout most of the world. Japan’s GDP increased 1.2 percent in IQ2012 and 2.8 percent relative to a year earlier but part of the jump could be the low level a year earlier because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan is experiencing difficulties with the overvalued yen because of worldwide capital flight originating in zero interest rates with risk aversion in an environment of softer growth of world trade. China grew at 1.8 percent in IIQ2012, which annualizes to 7.4 percent. Xinhuanet informs that Premier Wen Jiabao considers the need for macroeconomic stimulus, arguing that “we should continue to implement proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). Premier Wen elaborates that “the country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). China’s GDP grew 7.6 percent in IIQ2012 relative to IQ2011. Growth rates of GDP of China in a quarter relative to the same quarter a year earlier have been declining from 2011 to 2012. GDP was flat in the euro area in IQ2012 and fell 0.1 percent relative to a year earlier. Germany’s GDP increased 0.5 percent in IQ2012 and 1.7 percent relative to a year earlier. US GDP increased 0.4 percent in IIQ2012 and 2.2 percent relative to a year earlier (Section I Mediocre and Decelerating United States Economic Growth http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery.html) but with substantial underemployment and underemployment (Section I http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real.html) and weak hiring (Section I and earlier http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-hiring-ten-million.html). UK GDP fell 0.7 percent in IIQ2012 and fell 0.8 percent relative to IIQ2011. Italy has experienced decline of GDP in four consecutive quarters from IIIQ2011 to IIQ2012. Italy’s GDP fell 0.7 percent in IIQ2012 and declined 2.5 percent relative to IIQ2011.

Table V-3, Percentage Changes of GDP Quarter on Prior Quarter and on Same Quarter Year Earlier, ∆%

	IQ2012/IVQ2011	IQ2012/IQ2011
United States	QOQ: 0.5        SAAR: 2.0	2.4
Japan	1.2	2.8
China	1.8	8.1
Euro Area	0.0	-0.1
Germany	0.5	1.7
France	0.0	0.3
Italy	-0.8	-1.4
United Kingdom	-0.3	-0.2
	IIQ2012/IQ2012	IIQ2012/IIQ2011
United States	QOQ: 0.4         SAAR: 1.5	2.2
China	1.8	7.6
Italy	-0.7	-2.5
United Kingdom	-0.7	-0.8

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

Source: Country Statistical Agencies

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

The JP Morgan Global All-Industry Output Index of the JP Morgan Manufacturing and Services PMI^™, produced by JP Morgan and Markit in association with ISM and IFPSM, with high association with world GDP, increased from 50.3 in Jun to 51.7 in Jul, indicating expansion at a moderate rate, which is one of the lowest in the current expansion (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9928). This index has remained above the contraction territory of 50.0 during 35 months. Both global manufacturing and services have slowed down considerably with services increasing marginally because of activity in the US while manufacturing deepened its decline. The JP Morgan Global Manufacturing PMI^™, produced by JP Morgan and Markit in association with ISM and IFPSM, fell to 48.4 in Jul from 49.1 in Jun, for the lowest reading in three years in two consecutive months below 50.0 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9899). David Hensley, Director of Global Economics Coordination at JPMorgan, finds that inventory adjustment is the driver of deeper contraction in the beginning of IIIQ2012 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9899). The HSBC Brazil Composite Output Index, compiled by Markit, fell from moderate expansion at 51.5 in Jun to moderate contraction at 48.9 in Jul, in the weakest reading in ten months (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9912). Andre Loes, Chief Economist, Brazil, at HSBC, finds that the decline of the HSBC Brazil Services Business Activity Index from 53.0 in Jun to 48.9 in Jul withdraws important support present in the first half of 2012 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9912). The HSBC Brazil Purchasing Managers’ Index^TM (PMI^™) increased slightly to 48.7 in Jul from 48.5 in Jun, indicating modest deterioration of business conditions in Brazilian manufacturing (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9876). Andre Loes, Chief Economist, Brazil at HSBC, finds that moderate improvement in the index suggests that drivers of the drop of activity are moderating (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9876).

VA United States. The purchasing managers’ index (PMI) of the Institute for Supply Management (ISM) Report on Business^® increased 0.1 percentage points from 49.7 in Jun to 49.8 in Jun, for a second monthly contraction, which are the first since Jul 2009 (http://www.ism.ws/ISMReport/MfgROB.cfm?navItemNumber=12942). The index of new orders increased 0.2 percentage points from 47.8 in Jun to 48.0 in Jul, for a second consectuvie contraction interrupting growth in 37 months since Apr 2009. The Non-Manufacturing ISM Report on Business^® PMI increased 0.5 percentage points from 52.1 in Jun to 52.6 in Jul while the index of new orders increased 1.0 percentage points from 53.3 in Jun to 54.3 in Jul (http://www.ism.ws/ISMReport/NonMfgROB.cfm?navItemNumber=12943). Table USA provides the country economic indicators for the US.

Table USA, US Economic Indicators

Consumer Price Index	Jun 12 months NSA ∆%: 1.7; ex food and energy ∆%: 2.2 Jun month ∆%: 0.0; ex food and energy ∆%: 0.2 Blog 7/22/12
Producer Price Index	Jun 12-month NSA ∆%: 0.7; ex food and energy ∆% 2.6 Jun month SA ∆% = 0.1; ex food and energy ∆%: 0.2 Blog 7/15/12 7/22/12
PCE Inflation	Jun 12-month NSA ∆%: headline 1.5; ex food and energy ∆% 1.8 Blog 8/5/12
Employment Situation	Household Survey: Jul Unemployment Rate SA 8.3% Blog calculation People in Job Stress Jul: 28.7 million NSA Establishment Survey: Jul Nonfarm Jobs +163,000; Private +172,000 jobs created  Jun 12-month Average Hourly Earnings Inflation Adjusted ∆%: 0.3% Blog 8/5/12
Nonfarm Hiring	Nonfarm Hiring fell from 69.4 million in 2004 to 50.1 million in 2011 or by 19.3 million Private-Sector Hiring Jun 5057 4.796 million lower by 1.082 million than 6.139 million in Jun 2006 Blog 8/12//12
GDP Growth	BEA Revised National Income Accounts IQ2012/IQ2011 ∆%: 2.4 IIQ2012/IIQ2011 2.2 J]IQ2011 SAAR 2.0 IIQ2012 SAAR 1.5 Blog 7/29/12
Personal Income and Consumption	Jun month ∆% SA Real Disposable Personal Income (RDPI) SA ∆% 0.3 Real Personal Consumption Expenditures (RPCE): -0.1 12-month Jun NSA ∆%: RDPI: 1.7; RPCE ∆%: 2.0 Blog 8/5/2012
Quarterly Services Report	IQ12/IQ11 SA ∆%: Information 3.8 Professional 10.3 Administrative 4.9 Hospitals 5.2 Blog 6/10/12
Employment Cost Index	IIQ2012 SA ∆%: 0.5 Jun 12 months ∆%: 1.7 Blog 8/5/12
Industrial Production	Jun month SA ∆%: 0.4 Jun 12 months SA ∆%: 4.7 Manufacturing Jun SA ∆% 0.7 Jun 12 months SA ∆% 5.6, NSA 5.5 Capacity Utilization: 78.9 Blog 7/22/12
Productivity and Costs	Nonfarm Business Productivity IIQ2012∆% SAAE 1.6; IIQ2012/IIQ2011 ∆% 1.1; Unit Labor Costs SAAE IIQ2012 ∆% 1.7; IIQ2012/IIQ2011 ∆%: 0.8 Blog 8/12/2012
New York Fed Manufacturing Index	General Business Conditions From Jun 2.29 to Jul 7.39 New Orders: From Jun 2.18 to Jul -2.69 Blog 7/22/12
Philadelphia Fed Business Outlook Index	General Index from Jun minus 16.6 to Jul minus 12.9 New Orders from Jun minus 18.8 to Jul minus 6.9 Blog 7/22/12
Manufacturing Shipments and Orders	Jun New Orders SA ∆%: -0.5; ex transport ∆%: -1.8 Jan-Jun New Orders NSA ∆%: 5.2; ex transport ∆% 4.3 Blog 8/5/12
Durable Goods	Jun New Orders SA ∆%: 1.6; ex transport ∆%: 1.1 Jan-Jun 12/Jan-Jun 11 NSA New Orders ∆%: 7.9; ex transport ∆% : 6.6 Blog 7/29/12
Sales of New Motor Vehicles	Jul 2012 8,425,842; Jun 2011 7,392,167. Jul SAAR 14.09 million, Jun SAAR 14.38 million, Jun 2011 SAAR 12.40 million Blog 8/5/12
Sales of Merchant Wholesalers	Jan-Jun 2012/Jan-Jun 2011 NSA ∆%: Total 7.0; Durable Goods: 9.2; Nondurable Goods 5.3 Blog 8/12/12
Sales and Inventories of Manufacturers, Retailers and Merchant Wholesalers	May 12/May 11 NSA ∆%: Sales Total Business 7.2; Manufacturers 6.2 Retailers 6.9; Merchant Wholesalers 8.7 Blog 7/22/12
Sales for Retail and Food Services	Jan-Jun 2012/Jan-Jun 2011 ∆%: Retail and Food Services 6.4; Retail ∆% 6.1 Blog 7/22/12
Value of Construction Put in Place	Jun SAAR month SA ∆%: 0.4 Jun 12-month NSA: 6.5 Blog 8/5/12
Case-Shiller Home Prices	May 2012/Apr 2011 ∆% NSA: 10 Cities minus 2.3; 20 Cities: minus 0.7 ∆% May SA: 10 Cities 0.9 ; 20 Cities: 0.9 Blog 8/5/12
FHFA House Price Index Purchases Only	May SA ∆% 0.8; 12 month ∆%: 3.8 Blog 7/29/12
New House Sales	Jun 2012 month SAAR ∆%: -8.4 Jan-Jun 2012/Jan-Jun 2011 NSA ∆%: 20.3 Blog 7/29/12
Housing Starts and Permits	Jun Starts month SA ∆%: 6.9 ; Permits ∆%: -3.7 Jan-Jun 2012/Jan-Jun 2011 NSA ∆% Starts 26.5; Permits  ∆% 29.1 Blog 7/22/12
Trade Balance	Balance Jun SA -$42294 million versus May -$48044 million Exports Jun SA ∆%: 0.9 Imports Jun SA ∆%: -1.5 Goods Exports Jan-Jun 2012/2011 NSA ∆%: 7.1 Goods Imports Jan-Jun 2011/2011 NSA ∆%: 6.0 Blog 8/12/12
Export and Import Prices	Jul 12-month NSA ∆%: Imports -4.1; Exports -1.0 Blog 8/12/12
Consumer Credit	Jun ∆% annual rate: 3.0 Blog 8/12/12
Net Foreign Purchases of Long-term Treasury Securities	May Net Foreign Purchases of Long-term Treasury Securities: $55.0 billion Major Holders of Treasury Securities: China $1169 billion; Japan $1105 billion; Total Foreign US Treasury Holdings Apr $5264 billion Blog 7/22/12
Treasury Budget	Fiscal Year Oct-Jul 2012/2011 ∆%: Receipts 6.1; Outlays -0.4; Individual Income Taxes 4.2 Deficit Fiscal Year 2011 $1,300 billion Deficit Fiscal Year 2012 Oct-Jul $973,172 million CBO Forecast 2012FY Deficit $1.171 trillion Blog 8/12/2012
Flow of Funds	IQ2012 ∆ since 2007 Assets -$4113B Real estate -$4916B Financial $367.3MM Net Worth -$3300B Blog 6/17/12
Current Account Balance of Payments	IQ2012 -$137B %GDP 3.6 Blog 06/17/12

Links to blog comments in Table USA:

8/5/12 http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html

7/29/12 http://cmpassocregulationblog.blogspot.com/2012/07/decelerating-united-states-recovery_29.html

7/22/12 http://cmpassocregulationblog.blogspot.com/2012/07/world-inflation-waves-financial_22.html

7/15/12 http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-hiring-ten-million_15.html

6/17/12 http://cmpassocregulationblog.blogspot.com/search?updated-min=2012-01-01T00:00:00-08:00&updated-max=2013-01-01T00:00:00-08:00&max-results=48

6/10/12 http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities_10.html

The Bureau of Labor Statistics (BLS) of the Department of Labor provides the quarterly report on productivity and costs. The operational definition of productivity used by the BLS is (http://www.bls.gov/news.release/pdf/prod2.pdf 1): “Labor productivity, or output per hour, is calculated by dividing an index of real output by an index of hours worked of all persons, including employees, proprietors, and unpaid family workers.” The BLS has revised the estimates for productivity and unit costs. Table VA-1 provides revised data for nonfarm business sector productivity and unit labor costs for the final quarter of 2011 and the first two quarters of 2012 in seasonally adjusted annual equivalent (SAAE) rate and the percentage change from the same quarter a year earlier. Reflecting increases in output of 2.0 percent and of 0.4 percent in hours worked, nonfarm business sector labor productivity increased at a SAAE rate of 1.6 percent in IIQ2012, as shown in column 2 “IIQ2012 SAEE.” The increase of labor productivity from IIQ2011 to IIQ2012 was 1.1 percent, reflecting increases in output of 2.9 percent and of hours worked of 1.9 percent, as shown in column 3 “IIQ2012 YoY.” Hours worked decreased from 3.2 percent in IQ2011 in SAAE to 0.4 percent in IIQ2012 but output fell from 2.7 percent in IQ2011 to 2.0 percent in IIQ2012 because of the weakening economy. The BLS defines unit labor costs as (http://www.bls.gov/news.release/pdf/prod2.pdf 2): “BLS defines unit labor costs as the ratio of hourly compensation to labor productivity; increases in hourly compensation tend to increase unit labor costs and increases in output per hour tend to reduce them.” Unit labor costs increased at the SAAE rate of 1.7 percent in IIQ2012 and rose 0.8 percent in IIQ2012 relative to IIQ2011. Hourly compensation in IIQ2012 increased at the SAAE rate of 3.3 percent, which deflating by the estimated consumer price increase SAAE rate in IIQ2012 results in increase of real hourly compensation by 2.6 percent. Real hourly compensation was flat in IIQ2012 relative to IIQ2011.

Table VA-1, US, Nonfarm Business Sector Productivity and Costs %

	IIQ 2012 SAAE	IIQ 2012 YoY	IQ 2012 SAAE	IQ 2012 YoY	IVQ 2011 SAAE	IVQ 2011 YoY
Productivity	1.6	1.1	-0.5	1.0	2.8	0.6
Output	2.0	2.9	2.7	3.2	5.3	2.5
Hours	0.4	1.8	3.2	2.2	2.4	1.9
Hourly Comp.	3.3	1.9	5.1	1.0	-0.7	2.0
Real Hourly Comp.	2.6	0.0	2.6	-1.7	-1.9	-1.3
Unit Labor Costs	1.7	0.8	5.6	0.0	-3.3	1.4
Unit Nonlabor Payments	1.4	3.1	-3.1	5.0	5.0	2.6
Implicit Price Deflator	1.6	1.8	1.9	2.1	0.1	1.9

Notes: SAAE: seasonally adjusted annual equivalent; Comp.: compensation; YoY: Quarter on Same Quarter Year Earlier

Source: US Bureau of Labor Statistics http://www.bls.gov/lpc/home.htm

In 2011, productivity increased 0.7 percent in the annual average, as shown in Table VA-2. Increases in productivity were revised to 3.1 percent in the 2010 annual average and 2.9 percent in the 2009 annual average. The contraction period and the recovery period have been characterized by savings of labor inputs. Real hourly compensation fell 0.5 percent in 2011, interrupting increases of 1.8 percent in 2009 and 0.4 percent in 2010. Unit labor costs fell 1.5 percent in 2009 and 1.0 percent in 2010 but increased 2.0 percent in 2011.

Table VA-2, US, Revised Nonfarm Business Sector Productivity and Costs Annual Average, ∆% Annual Average 

	2011 ∆%	2010 ∆%	2009 ∆%	2008  ∆%	2007 ∆%
Productivity	0.7	3.1	2.9	0.6	1.5
Real Hourly Compensation	-0.5	0.4	1.8	-0.4	1.1
Unit Labor Costs	2.0	-1.0	-1.5	2.8	2.4

Source: http://www.bls.gov/lpc/home.htm

Productivity jumped in the recovery after the recession from Mar IQ2001 to Nov IVQ2001 (http://www.nber.org/cycles.html). Table VA-3 provides quarter on quarter and annual percentage changes in nonfarm business output per hour, or productivity, from 1999 to 2012. The annual average jumped from 2.9 percent in 2001 to 4.6 percent in 2002. Nonfarm business productivity increased at the SAAE rate of 8.8 percent in the first quarter after the recession in IQ2002. Productivity increases decline later in the expansion period. Productivity increases were mediocre during the recession from Dec IVQ2007 to Jun IIQ2009 (http://www.nber.org/cycles.html) and increased during the first phase of expansion from IIQ2009 to IQ2010, trended lower and collapsed in 2011 and 2012.

Table VA-3, US, Nonfarm Business Output per Hour, Percent Change from Prior Quarter at Annual Rate, 1999-2012

Year	Qtr1	Qtr2	Qtr3	Qtr4	Annual
1999	3.9	0.3	3.3	7.1	3.3
2000	-1.5	9.4	0.1	4.0	3.4
2001	-1.3	7.4	2.5	5.8	2.9
2002	8.8	0.5	3.8	-0.2	4.6
2003	3.7	5.5	9.5	1.5	3.7
2004	0.6	3.3	0.7	0.5	2.6
2005	4.2	-0.8	3.1	-0.2	1.6
2006	2.5	0.4	-2.2	2.7	0.9
2007	-0.2	3.4	4.8	1.9	1.5
2008	-2.6	2.4	-0.8	-3.4	0.6
2009	5.5	6.8	5.2	5.0	2.9
2010	2.7	-0.5	3.3	1.9	3.1
2011	-2.0	1.2	0.6	2.8	0.7
2012	-0.5	1.6

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Chart VA-1 of the Bureau of Labor Statistics (BLS) provides SAAE rates of nonfarm business productivity from 1999 to 2012. There is a clear pattern in both episodes of economic cycles in 2001 and 2007 of rapid expansion of productivity in the transition from contraction to expansion followed by more subdued productivity expansion. Part of the explanation is the reduction in labor utilization resulting from adjustment of business to the sudden shock of collapse of revenue. Productivity rose briefly in the expansion after 2009 but then collapsed and moved to negative change.

Chart VA-1, US, Nonfarm Business Output per Hour, Percent Change from Prior Quarter at Annual Rate, 1999-2012

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Percentage changes from prior quarter at SAAE rates and annual average percentage changes of nonfarm business unit labor costs are provided in Table VA-4. Unit labor costs fell during the contractions with continuing negative percentage changes in the early phases of the recovery. Weak labor markets partly explain the decline in unit labor costs. As the economy moves toward full employment, labor markets tighten with increase in unit labor costs. The expansion beginning in IIIQ2009 has been characterized by high unemployment and underemployment. Table VA-4 shows continuing subdued increases in unit labor costs in 2011 but with increase of 5.6 percent in IQ2012 and 1.7 percent in IIQ2012.

Table VA-4, US, Nonfarm Business Unit Labor Costs, Percent Change from Prior Quarter at Annual Rate 1999-2012

Year	Qtr1	Qtr2	Qtr3	Qtr4	Annual
1999	3.0	0.5	0.1	1.6	0.9
2000	17.4	-7.4	8.6	-1.6	3.9
2001	10.9	-5.8	-1.1	-1.7	1.5
2002	-4.1	3.4	-1.6	2.2	-1.3
2003	2.8	1.4	-3.5	1.8	1.0
2004	-2.5	2.4	5.8	2.7	0.7
2005	-1.0	3.5	2.6	2.6	2.3
2006	2.9	1.3	3.6	6.8	2.8
2007	4.0	-1.8	-1.9	4.3	2.4
2008	8.7	-3.4	4.3	5.7	2.8
2009	-8.2	-0.2	-3.1	-3.9	-1.5
2010	-1.3	3.3	-1.4	-1.4	-1.0
2011	11.3	-1.3	-0.6	-3.3	2.0
2012	5.6	1.7

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Chart VA-2 provides percentage changes quarter on quarter at SAAE rates of nonfarm business unit labor costs. With the exception of 3.3 percent in IIQ2010, a jump of 11.3 percent in IQ2011, 5.6 percent in IQ2012 and 1.7 percent in IIQ2012, changes in nonfarm business unit labor costs have been negative.

Chart VA-2, US, Nonfarm Business Unit Labor Costs, Percent Change from Prior Quarter at Annual Rate 1999-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Table VA-5 provides percentage change from prior quarter at annual rates for nonfarm business real hourly worker compensation. The expansion after the contraction of 2001 was followed by strong recovery of real hourly compensation. Real hourly compensation increased at the rate of 4.4 percent in IQ2011 but fell at annual rates of 4.4 percent in IIQ2011, 3.1 percent in IIIQ2011 and 1.9 percent in IVQ2011 but increased at 2.6 percent in IQ2012 and also in IIQ2012. In 2011, real hourly compensation fell 0.5 percent.

Table VA-5, Nonfarm Business Real Hourly Compensation, Percent Change from Prior Quarter at Annual Rate 1999-2012

Year	Qtr1	Qtr2	Qtr3	Qtr4	Annual
1999	5.4	-2.0	0.2	5.6	2.2
2000	11.4	-1.8	4.7	-0.4	4.0
2001	5.4	-1.5	0.2	4.5	1.6
2002	2.8	0.6	0.0	-0.6	1.5
2003	2.4	7.7	2.5	1.8	2.4
2004	-5.2	2.6	3.7	-1.1	0.6
2005	1.3	-0.1	-0.3	-1.3	0.6
2006	3.1	-1.8	-2.6	11.6	0.5
2007	-0.2	-3.0	0.3	1.3	1.1
2008	1.4	-6.1	-2.8	12.2	-0.4
2009	-0.7	4.7	-1.6	-2.1	1.8
2010	0.5	3.1	0.4	-2.4	0.4
2011	4.4	-4.4	-3.1	-1.9	-0.5
2012	2.6	2.6

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Chart VA-3 provides percentage change from prior quarter at annual rate of nonfarm business real hourly compensation from 1999 to 2012. There are significant fluctuations in quarterly percentage changes oscillating between positive and negative. There is no clear pattern in the two contractions in the 2000s.

Chart VA-3, US, Nonfarm Business Real Hourly Compensation, Percent Change from Prior Quarter at Annual Rate 2001-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Chart VA-4 provides percentage change from prior quarter at annual rate for nonfarm business output per hour from 1947 to 2012. The average would be represented by a horizontal line above zero. There is an increase in the rate of improvement of productivity in the 1990s that was not continued into the 2000s.

Chart VA-4, US, Nonfarm Business Output per Hour, Percent Change from Prior Quarter at Annual Rate 1947-2012

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Chart VA-5 provides percentage changes from prior quarter at annual rate for US nonfarm business unit labor costs from 1947 to 2012. The most remarkable period is the 1970s in which stagflation occurred in fluctuating but high positive percentage changes of unit labor costs. There was significant moderation of increases in unit labor costs in the 1980s. Fluctuation has characterized the 2000s.

Chart VA-5, US, Nonfarm Business Unit Labor Costs, Percent Change from Prior Quarter at Annual Rate 1947-2012

Source: US bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Chart VA-6 provides percentage changes from the prior quarter at annual rate of nonfarm business real hourly compensation from 1947 to 2012. Negative changes have occurred more frequently and pronounced in the 2000s than during the Great Inflation of the 1970s.

Chart VA-6, US, Nonfarm Business Real Hourly Compensation, Percent Change from Prior Quarter at Annual Rate 1947-2012

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Sales and inventories of merchant wholesalers except manufacturers’ sales branches and offices are shown in Table VA-6 for Jun 2012 and percentage changes from the prior month and for Jan-Jun 2012 relative to Jan-Jun 2011. These data are volatile aggregating diverse categories of durable and nondurable goods without adjustment for price changes. Total sales for the US rose 7.0 percent in Jan-Jun 2012 relative to Jan-Jun 2011 and fell 1.4 percent in Jun 2012 relative to May 2012. The value of total sales is quite high at $2448.3 billion, exceeding four trillion dollars in a year. Value in the breakdown is useful in identifying relative importance of individual categories. Sales of durable goods in Jan-Jun 2012 reached $1092.9 billion, over two trillion for a year, decreasing 0.7 percent in Jun relative to May and increasing 9.2 percent in Jan-Jun 2012 relative to Jan-Jun 2011. Sales of automotive products reached $195.9 billion in Jan-Jun 2012, increasing 1.2 percent in the month and increasing 26.7 percent relative to a year earlier. There is strong performance of 15.6 percent in machinery and 1.8 percent in electrical products. Sales of nondurable goods rose 5.3 percent over a year earlier but fell 1.9 percent in Jun 2012 relative to May 2012. The influence of commodity prices moderated as shown by decrease of 8.1 percent in farm products and increase of only 7.8 percent in petroleum products with decrease of 5.3 percent in Jun. The final three columns in Table VA-6 provide the value of inventories and percentage changes from the prior month and relative to the same month a year earlier. US total inventories of wholesalers decreased 0.2 percent in Jun and increased 5.5 percent relative to a year earlier. Inventories of durable goods of $285.2 billion are 59.7 percent of total inventories of $477.6 billion and rose 9.1 percent relative to a year earlier. Automotive inventories jumped 13.8 percent relative to a year earlier. Machinery inventories of $78.4 billion rose 17.5 percent relative to a year earlier. Inventories of nondurable goods of $190.4 billion are 39.9 percent of the total and increased 0.4 percent relative to a year earlier. Inventories of farm products increased 7.2 percent in Jun relative to May and declined 9.0 percent relative to a year earlier. Inventories of petroleum products decreased 8.7 percent in Jun and fell 11.7 percent relative to a year earlier.

Table VA-6, US, Sales and Inventories of Merchant Wholesalers except Manufacturers’ Sales Branches and Offices, Month ∆%

2012	Sales $ Billions Jan-Jun 2012 NSA	Sales Jun ∆% SA	Sales∆% Jan-Jun 2012 from Jan-Jun 2011  NSA	INV $ Billions Jun 2012 NSA	INV  Jun ∆% SA	INV  ∆% Jun 2012 from Jun 2011 NSA
US Total	2448.3	-1.4	7.0	477.6	-0.2	5.5
Durable	1092.9	-0.7	9.2	285.2	0.2	9.1
Automotive	195.9	1.2	26.7	45.4	-0.7	13.8
Prof. Equip.	187.7	0.1	3.4	32.1	-0.2	2.6
Computer Equipment	95.1	-0.8	0.8	12.2	0.6	0.1
Electrical	182.7	-0.8	1.8	40.9	0.1	4.0
Machinery	192.4	-2.8	15.6	78.4	1.1	17.5
Not Durable	1355.4	-1.9	5.3	190.4	-0.8	0.4
Drugs	213.5	-0.7	3.0	34.3	-0.4	5.8
Apparel	68.5	4.3	5.5	22.0	-1.6	0.9
Groceries	288.2	1.1	8.7	34.7	0.4	7.8
Farm Products	107.1	-2.8	-8.1	16.5	7.2	-9.0
Petroleum	391.7	-5.3	7.8	24.8	-8.7	-11.7

Note: INV: inventories

Source: US Census Bureau http://www.census.gov/wholesale/index.html

Chart VA-7 of the US Census Bureau provides wholesale trade sales without adjustment for seasonality or price changes from Jan 1992 to Jun 2012. The jagged curve of wholesale trade sales without adjustment shows strong seasonal variations. There is a strong long-term trend interrupted by sharp drop during the global recession. Growth resumed along a stronger upward trend and the level in Jun 2012 surpasses the peak before the global recession.

Chart VA-7, US, Wholesale Trade Sales, Monthly, NSA, Jan 1992-Jun 2012, Millions of Dollars

Source: US Census Bureau http://www.census.gov/wholesale/index.html

Table VA-8 of the US Census Bureau provides US wholesale trade sales with seasonal adjustment from Jan 1992 to Jun 2012. The elimination of seasonality permits enhanced comparison of adjacent sales. The final segment identifies another drop.

Chart VA-8, US, Wholesale Trade Sales, Monthly, SA, Jan 1992-Jun 2012, Millions of Dollars

Source: US Census Bureau http://www.census.gov/wholesale/index.html

Chart VA-9 of the US Census Bureau provides monthly percentage changes of US wholesale trade not seasonally adjusted from Jan 1992 to Jun 2012. The scatter diagram provides wide monthly percentage changes in wholesale trade sales.

Chart VA-9, US, Wholesale Trade Sales, Monthly Percentage Change, NSA, Jan 1992-Jun 2012, %

Source: US Census Bureau http://www.census.gov/wholesale/index.html

Inventory/sales ratios of merchant wholesalers except manufacturers’ sales branches and offices are shown in Table VA-7. The total for the US has remained almost without change at 1.20 in Jun 2012, 1.18 in May 2012 and 1.17 in Jun 2011. Inventory/sales ratios are higher in durable goods industries but still remain relatively stable with 1.55 to 1.55 in May-Jun 2012 and 1.52 in Jun 2011. Computer equipment operates with low inventory/sales ratios of 0.73 to 0.74 in May-Jun 2012 relative to 0.75 in Jun 2011 because of the capacity to fill orders on demand. As expected because of perishable nature, nondurable inventory/sales ratios are quite low with 0.89 in Jun 2012 and 0.88 in May 2012, which is almost equal to 0.89 in 0.90 in Jun 2011. There are exceptions such as 1.76 in Jun 2012 in apparel that is lower than 1.87 in May 2012 and higher than 1.94 in May 2011 perhaps because of stronger spring and summer sales.

Table VA-7, Inventory/Sales Ratios of Merchant Wholesalers except Manufacturers’ Sales Branches and Offices, % SA

	Jun 2012	May 2012	Jun 2011
US Total	1.20	1.18	1.17
Durable	1.57	1.55	1.52
Automotive	1.38	1.41	1.55
Prof. Equip.	1.00	1.00	1.01
Comp. Equip.	0.74	0.73	0.75
Electrical	1.34	1.33	1.25
Machinery	2.43	2.34	2.23
Not Durable	0.89	0.88	0.90
Drugs	0.98	0.97	0.91
Apparel	1.76	1.87	1.94
Groceries	0.73	0.74	0.71
Farm Products	1.22	1.11	1.18
Petroleum	0.40	0.41	0.45

Source: US Census Bureau

http://www.census.gov/wholesale/index.html

Chart VA-10 provides the chart of the US Census Bureau with inventories/sales ratios of merchant wholesalers from 2002 to 2012 seasonally adjusted. Inventory/sales ratios rise during contractions as merchants are caught with increasing inventories because of weak sales and fall during expansions as merchants attempt to fill sales with existing stocks.

Chart VA-10, US, Monthly Inventories/Sales Ratios of Merchant Wholesalers, SA, 2002-2011

Source: US Census Bureau

http://www2.census.gov/wholesale/img/mwtsbrf.jpg

The report of consumer credit outstanding of the Board of Governors of the Federal Reserve System is provided in Table VA-8. The data are in seasonally-adjusted annual rates both percentage changes and billions of dollars. The estimate of consumer credit “covers most short- and intermediate-term credit extended to individuals, excluding loans secured by real estate (http://www.federalreserve.gov/releases/g19/current/default.htm). Consumer credit is divided into two categories. (1) Revolving consumer credit (REV in Table VA-3) consists mainly of unsecured credit cards. (2) Non-revolving consumer credit (NREV in Table VA-3) “includes automobile loans and all other loans not included in revolving credit, such as loans for mobile homes, education, boats, trailers or vacations” (http://www.federalreserve.gov/releases/g19/current/default.htm). In Jun 2012, revolving credit was $865 billion, or 33.6 percent of total consumer credit of $2577 billion, and non-revolving credit was $1713 billion, or 66.5 percent of total consumer credit outstanding. Consumer credit grew at relatively high rates before the recession beginning in IVQ2007 and extending to IIQ2009 as dated by the National Bureau of Economic Research or NBER (http://www.nber.org/cycles/cyclesmain.html). Percentage changes of consumer credit outstanding fell already in 2009. Rates were still negative in 2010 with decline of 1.3 percent in annual data and sharp decline of 7.4 percent in revolving credit. There was a sharp jump in consumer credit outstanding in May 2012: 7.8 percent total, 10.5 percent revolving and 6.5 percent non-revolving. Consumer credit increased 3.0 percent in Jun 2012 with decrease of revolving credit at 5.1 percent and growth of non-revolving credit at 7.2 percent.

Table VA-8, US, Consumer Credit Outstanding, SA, Annual Rate and Billions of Dollars

	Total ∆%	REV ∆%	NRV ∆%	Total $B	REV $B	NREV $B
2012
Jun	3.0	-5.1	7.2	2577	865	1713
May	7.8	10.5	6.5	2571	868	1703
Apr	4.0	-6.8	9.6	2554	861	1693
IIQ	5.0	-0.5	7.8	2577	865	1713
IQ	5.9	0.4	8.9	2546	866	1680
2011
IVQ	6.7	3.2	8.6	2508	865	1644
IIIQ	2.3	-0.4	3.7	2467	858	1609
IIQ	3.3	0.9	4.7	2453	859	1594
IQ	3.5	-0.1	5.5	2433	857	1576
2011	4.0	0.9	5.7	2508	865	1644
2010	-1.3	-7.4	2.5	2412	857	1554
2009	-4.5	-8.8	-1.8	2439	922	1517
2008	0.8	0.2	1.2	2549	1010	1538
2007	5.9	8.5	4.3	2529	1008	1520

Note: REV: Revolving; NREV: Non-revolving; ∆%: simple annual rate from unrounded data; Total may not add exactly because of rounding

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/g19/current/default.htm

Chart VA-11 of the Board of Governors of the Federal Reserve System provides percentage changes of total consumer credit outstanding in the US since 1972. The shaded bars are the cyclical contraction dates of the National Bureau of Economic Research (http://www.nber.org/cycles/cyclesmain.html). Consumer credit is cyclical, declining during contractions as shown by negative percentage changes during economic contractions. There is clear upward trend in 2012 but with significant fluctuations.

Chart VA-11, US, Percent Change of Total Consumer Credit, Seasonally Adjusted at an Annual Rate, Feb 1972-Jun 2012

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g19/current/default.htm

The US Treasury budget for fiscal year 2012 in the first nine months of Oct-Dec 2011 and Jan-Jul 2012 is shown in Table VA-9. Receipts increased 6.1 percent in the first ten months of fiscal year 2012 relative to the same ten months in fiscal year 2011 or Oct-Dec 2010 and Jan-Jul 2011. Individual income taxes have grown 4.2 percent relative to the same period a year earlier. Outlays decreased 0.4 percent relative to a year earlier. The final two rows of Table VA-9 provide the projection of the Congressional Budget Office (CBO) of the deficit for fiscal year 2012 at $1.2 trillion not very different from that in fiscal year 2011 of $1.3 trillion. The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5.2 trillion in four years, which is the worst fiscal performance since World War II.

Table VA-9, US, Treasury Budget in Fiscal Year to Date Million Dollars

Fiscal Year 2012	Oct 2011 to Jul 2012	Oct 2010 to Jul 2011	∆%
Receipts	2,008,667	1,893,096	6.1
Outlays	2,982,507	2,992,998	-0.4
Deficit	-973,840	-1,099,902	NA
Individual Income Taxes	928,172	890,652	4.2
Social Insurance	477,346	475,194	0.5
	Receipts	Outlays	Deficit (-), Surplus (+)
$ Billions
CBO Forecast Fiscal Year 2012	2,456	3,627	-1,171
Fiscal Year 2011	2,303	3,603	-1,300
Fiscal Year 2010	2,162	3,456	-1,294
Fiscal Year 2009	2,105	3,518	-1,413
Fiscal Year 2008	2,524	2,983	-459

Source: http://www.fms.treas.gov/mts/index.html

© Carlos M. Pelaez, 2010, 2011, 2012