CMP Associates Regulation Blog

Chart II-2 provides US real GDP from 1929 to 2012. The chart also disguises the Great Depression of the 1930s. In the four years of 1929 to 1933, GDP in constant dollars fell 26.6 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7; data from the US Bureau of Economic Analysis at http://www.bea.gov/iTable/index_nipa.cfm). Persistent deflation threatening real economic activity would also be reflected in the series of long-term growth of real GDP. There is no such behavior in Chart II-2 except for periodic recessions in the US economy that have occurred throughout history.

Chart II-2, US, Real GDP 1929-2012

Source: US Bureau of Economic Analysis

Deflation would also be in evidence in long-term series of prices in the form of bumps. The GDP implicit deflator series in Chart II-3 from 1929 to 2012 shows sharp dynamic behavior over time. There is decline of the implicit price deflator of GDP by 25.8 percent from 1929 to 1933 (data from the US Bureau of Economic Analysis at http://www.bea.gov/iTable/index_nipa.cfm). In contrast, the implicit price deflator of GDP of the US increased from 106.227 (2005 =100) in 2007 to 109.529 in 2009 or by 3.1 percent and to 115.381 in 2012 or by 5.3 percent relative to 2009 and 8.6 percent relative to 2007. The implicit price deflator of US GDP increased in every quarter from IVQ2007 to IVQ2012 with only a decline from 109.539 in IQ2009 to 109.325 in IIQ2009 or by 0.2 percent (http://www.bea.gov/iTable/index_nipa.cfm). Wars are characterized by rapidly rising prices followed by declines when peace is restored. The US economy is not plagued by deflation but by long-run inflation.

Chart II-3, US, GDP Implicit Price Deflator 1929-2012

Source: US Bureau of Economic Analysis

Chart II-4 provides percent change from preceding quarter in prices of GDP at seasonally-adjusted annual rates (SAAR) from 1980 to 2012. There is one case of negative change by 0.8 percent in IIQ2009 that was adjustment from 3.1 percent in IIIQ2008 following 2.5 percent in both IQ2008 and IIQ2008 caused by carry trades from policy interest rates being moved to zero into commodity futures reversed by the fear of toxic assets in banks in the proposal of TARP in late 2008 (Cochrane and Zingales 2009). There has not been actual deflation or risk of deflation threatening depression in the US that would justify unconventional monetary policy.

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

Source: US Bureau of Economic Analysis

Chart II-5 provides percent change from preceding year in prices of GDP from 1929 to 2012. There are four consecutive years of declines of prices of GDP during the Great Depression: 3.9 percent in 1930, 9.9 percent in 1931, 11.4 percent in 1932 and 2.6 percent in 1933. There were two consecutive declines of 1.9 percent in 1938 and 1.3 percent in 1939. Prices of GDP were unchanged in 1949 after increasing 11.5 percent in 1946, 11.1 percent in 1947 and 5.7 percent in 1948, which is similar to experience with wars in other countries. There are no other negative changes of annual prices of GDP in 72 years from 1939 to 2012.

Chart II-5, Percent Change from Preceding Year in Prices for Gross Domestic Product 1930-2012

The producer price index of the US from 1947 to 2013 in Chart I-6 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

Chart II-6, US, Producer Price Index, Finished Goods, NSA, 1947-2013

Source: US Bureau of Labor Statistics

Chart II-7 provides 12-month percentage changes of the producer price index from 1948 to 2013. The distinguishing event in Chart I-7 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2013.

Chart II-7, US, Producer Price Index, Finished Goods, 12-Month Percentage Change, NSA, 1948-2013

Source: US Bureau of Labor Statistics

Annual percentage changes of the producer price index from 1948 to 2012 are shown in Table II-1A. The producer price index fell 2.8 percent in 1949 following the adjustment to World War II and fell 0.6 percent in 1952 and 1.0 percent in 1953 around the Korean War. There are two other mild decline of 0.3 percent in 1959 and 0.3 percent in 1963. There are only few subsequent and isolated declines of the producer price index of 1.4 percent in 1986, 0.8 percent in 1998, 1.3 percent in 2002 and 2.6 percent in 2009. The decline of 2009 was caused by unwinding of carry trades in 2008 that had lifted oil prices to $140/barrel during deep global recession because of the panic of probable toxic assets in banks that would be removed with the Troubled Asset Relief Program (TARP) (Cochrane and Zingales 2009). There is no evidence in this history of 65 years of the US producer price index suggesting that there is frequent and persistent deflation shock requiring aggressive unconventional monetary policy. The design of such anti-deflation policy could provoke price and financial instability because of lags in effect of monetary policy, model errors, inaccurate forecasts and misleading analysis of current economic conditions.

Table II-1A, US, Annual PPI Inflation ∆% 1948-2012

Year	Annual
1948	8.0
1949	-2.8
1950	1.8
1951	9.2
1952	-0.6
1953	-1.0
1954	0.3
1955	0.3
1956	2.6
1957	3.8
1958	2.2
1959	-0.3
1960	0.9
1961	0.0
1962	0.3
1963	-0.3
1964	0.3
1965	1.8
1966	3.2
1967	1.1
1968	2.8
1969	3.8
1970	3.4
1971	3.1
1972	3.2
1973	9.1
1974	15.4
1975	10.6
1976	4.5
1977	6.4
1978	7.9
1979	11.2
1980	13.4
1981	9.2
1982	4.1
1983	1.6
1984	2.1
1985	1.0
1986	-1.4
1987	2.1
1988	2.5
1989	5.2
1990	4.9
1991	2.1
1992	1.2
1993	1.2
1994	0.6
1995	1.9
1996	2.7
1997	0.4
1998	-0.8
1999	1.8
2000	3.8
2001	2.0
2002	-1.3
2003	3.2
2004	3.6
2005	4.8
2006	3.0
2007	3.9
2008	6.3
2009	-2.6
2010	4.2
2011	6.0
2012	1.9

http://www.bls.gov/ppi

The producer price index excluding food and energy from 1973 to 2013, the first historical date of availability in the dataset of the Bureau of Labor Statistics (BLS), shows similarly dynamic behavior as the overall index, as shown in Chart II-8. There is no evidence of persistent deflation in the US PPI.

Chart II-8, US Producer Price Index, Finished Goods Excluding Food and Energy, NSA, 1973-2013

Source: US Bureau of Labor Statistics

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

Chart II-9, US Producer Price Index, Finished Goods Excluding Food and Energy, 12-Month Percentage Change, NSA, 1974-2013

Source: US Bureau of Labor Statistics

The producer price index of energy goods from 1974 to 2013 is provided in Chart II-10. The first jump occurred during the Great Inflation of the 1970s analyzed in various comments of this blog (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html) and in Appendix I. There is relative stability of producer prices after 1986 with another jump and decline in the late 1990s into the early 2000s. The episode of commodity price increases during a global recession in 2008 could only have occurred with interest rates dropping toward zero, which stimulated the carry trade from zero interest rates to leveraged positions in commodity futures. Commodity futures exposures were dropped in the flight to government securities after Sep 2008. Commodity future exposures were created again when risk aversion diminished around Mar 2011 after the finding that US bank balance sheets did not have the toxic assets that were mentioned in proposing TARP in Congress (see Cochrane and Zingales 2009). Fluctuations in commodity prices and other risk financial assets originate in carry trade when risk aversion ameliorates.

Chart II-10, US, Producer Price Index, Finished Energy Goods, NSA, 1974-2013

Source: US Bureau of Labor Statistics

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

Chart II-11 shows 12-month percentage changes of the producer price index of finished energy goods from 1975 to 2013. This index is only available after 1974 and captures only one of the humps of energy prices during the Great Inflation. Fluctuations in energy prices have occurred throughout history in the US but without provoking deflation. Two cases are the decline of oil prices in 2001 to 2002 that has been analyzed by Barsky and Kilian (2004) and the collapse of oil prices from over $140/barrel with shock of risk aversion to the carry trade in Sep 2008.

Chart II-11, US, Producer Price Index, Finished Energy Goods, 12-Month Percentage Change, NSA, 1974-2013

Source: US Bureau of Labor Statistics

http://www.bls.gov/ppi

Chart II-12 provides the consumer price index NSA from 1913 to 2013. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

Chart II-12, US, Consumer Price Index, NSA, 1914-2013

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

Chart II-13 provides 12-month percentage changes of the consumer price index from 1914 to 2013. The only episode of deflation after 1950 is in 2009, which is explained by the reversal of speculative commodity futures carry trades that were induced by interest rates driven to zero in a shock of monetary policy in 2008. The only persistent case of deflation is from 1930 to 1933, which has little if any relevance to the contemporary United States economy. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.

Chart II-13, US, Consumer Price Index, All Items, 12- Month Percentage Change 1914-2013

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

Table II-2 provides annual percentage changes of United States consumer price inflation from 1914 to 2013. There have been only cases of annual declines of the CPI after wars: (1) World War I minus 10.5 percent in 1921 and minus 6.1 percent in 1922 following cumulative increases of 83.5 percent in four years from 1917 to 1920 at the average of 16.4 percent per year; (2) World War II: minus 1.2 percent in 1949 following cumulative 33.9 percent in three years from 1946 to 1948 at average 10.2 percent per year (3) minus 0.4 percent in 1955 two years after the end of the Korean War; and (4) minus 0.4 percent in 2009. The decline of 0.4 percent in 2009 followed increase of 3.8 percent in 2008 and is explained by the reversal of speculative carry trades into commodity futures that were created in 2008 as monetary policy rates were driven to zero. The reversal occurred after misleading statement on toxic assets in banks in the proposal for TARP (Cochrane and Zingales 2009). There were declines of 1.7 percent in both 1927 and 1928 during the episode of revival of rules of the gold standard. The only persistent deflationary period since 1914 was during the Great Depression in the years from 1930 to 1933 and again in 1938-1939. Fear of deflation on the basis of that experience does not justify unconventional monetary policy of zero interest rates that has failed to stop deflation in Japan. Financial repression causes far more adverse effects on allocation of resources by distorting the calculus of risk/returns than alleged employment-creating effects or there would not be current recovery without jobs and hiring after zero interest rates since Dec 2008 and intended now forever in a self-imposed forecast growth and employment mandate of monetary policy.

Table II-2, US, Annual CPI Inflation ∆% 1914-2012

Year	Annual
1914	1.0
1915	1.0
1916	7.9
1917	17.4
1918	18.0
1919	14.6
1920	15.6
1921	-10.5
1922	-6.1
1923	1.8
1924	0.0
1925	2.3
1926	1.1
1927	-1.7
1928	-1.7
1929	0.0
1930	-2.3
1931	-9.0
1932	-9.9
1933	-5.1
1934	3.1
1935	2.2
1936	1.5
1937	3.6
1938	-2.1
1939	-1.4
1940	0.7
1941	5.0
1942	10.9
1943	6.1
1944	1.7
1945	2.3
1946	8.3
1947	14.4
1948	8.1
1949	-1.2
1950	1.3
1951	7.9
1952	1.9
1953	0.8
1954	0.7
1955	-0.4
1956	1.5
1957	3.3
1958	2.8
1959	0.7
1960	1.7
1961	1.0
1962	1.0
1963	1.3
1964	1.3
1965	1.6
1966	2.9
1967	3.1
1968	4.2
1969	5.5
1970	5.7
1971	4.4
1972	3.2
1973	6.2
1974	11.0
1975	9.1
1976	5.8
1977	6.5
1978	7.6
1979	11.3
1980	13.5
1981	10.3
1982	6.2
1983	3.2
1984	4.3
1985	3.6
1986	1.9
1987	3.6
1988	4.1
1989	4.8
1990	5.4
1991	4.2
1992	3.0
1993	3.0
1994	2.6
1995	2.8
1996	3.0
1997	2.3
1998	1.6
1999	2.2
2000	3.4
2001	2.8
2002	1.6
2003	2.3
2004	2.7
2005	3.4
2006	3.2
2007	2.8
2008	3.8
2009	-0.4
2010	1.6
2011	3.2
2012	2.1

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

Chart II-14 provides the consumer price index excluding food and energy from 1960 to 2013. There is long-term inflation in the US without episodes of persistent deflation.

Chart II-14, US, Consumer Price Index Excluding Food and Energy, NSA, 1957-2013

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

Chart II-15 provides 12-month percentage changes of the consumer price index excluding food and energy from 1960 to 2013. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.

Chart II-15, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1958-2013

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

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

Chart II-16, US, Consumer Price Index Housing, NSA, 1967-2013

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

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

Chart II-17, US, Consumer Price Index, Housing, 12- Month Percentage Change, NSA, 1968-2013

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

ID Current US Inflation. Consumer price inflation has fluctuated in recent months. Table I-3 provides 12-month consumer price inflation in Feb 2013 and annual equivalent percentage changes for the months of Dec 2012 to Feb 2013 of the CPI and major segments. The final column provides inflation from Jan 2013 to Feb 2013. CPI inflation in the 12 months ending in Feb 2013 reached 2.0 percent, the annual equivalent rate Dec 2012 to Feb 2013 was minus 2.8 percent in the new episode of carry trades from zero interest rates to commodities exposures and the monthly inflation rate of 0.7 percent annualizes at 8.7 percent. These inflation rates fluctuate in accordance with inducement of risk appetite or frustration by risk aversion of carry trades from zero interest rates to commodity futures. At the margin, the decline in commodity prices in sharp recent risk aversion in financial markets caused lower inflation worldwide (with return in some countries in Dec 2012 and Jan-Feb 2013) that followed a jump in Aug-Sep 2012 because of the relaxed risk aversion resulting from the bond-buying program of the European Central Bank or Outright Monetary Transactions (OMT) (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). With zero interest rates, commodity prices would increase again in an environment of risk appetite. Excluding food and energy, CPI inflation was 2.0 percent in the 12 months ending in Feb 2013 and 2.4 percent in annual equivalent in Dec 2012-Feb 2013. There is no deflation in the US economy that could justify further quantitative easing, which is now open-ended or forever with zero interest rates and bond-buying by the central bank, or QE→∞, even if the economy grows back to potential. Financial repression of zero interest rates is now intended as a permanent distortion of resource allocation by clouding risk/return decisions, preventing the economy from expanding along its optimal growth path. Consumer food prices in the US have risen 1.6 percent in 12 months ending in Feb 2013 and at 1.2 percent in annual equivalent in Dec 2012-Feb 2013. Monetary policies stimulating carry trades of commodities futures that increase prices of food constitute a highly regressive tax on lower income families for whom food is a major portion of the consumption basket especially with wage increases below inflation in a recovery without hiring (Section and earlier http://cmpassocregulationblog.blogspot.com/2013/02/recovery-without-hiring-united-states.html) and without jobs (http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.html). Energy consumer prices increased 2.3 percent in 12 months, increased 11.6 percent in annual equivalent in Dec 2012-Feb 2013 and increased 5.4 percent in Feb 2013 or at 11.6 percent in annual equivalent as carry trades from zero interest rates to commodity futures are unwound and repositioned during alternating risk aversion and risk appetite originating in the European debt crisis and increasingly in growth and politics in China. For lower income families, food and energy are a major part of the family budget. Inflation is not persistently low or threatening deflation in annual equivalent in Dec 2012-Feb 2013 in any of the categories in Table II-2 but simply reflecting waves of inflation originating in carry trades. An upward trend is determined by carry trades from zero interest rates to commodity futures positions with episodes of risk aversion causing fluctuations.

Table II-3, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%

	% RI	∆% 12 Months Feb 2013/Feb 2012 NSA	∆% Annual Equivalent Dec 2012 to Feb 2013 SA	∆% Feb 2013/Jan 2013 SA
CPI All Items	100.000	2.0	2.8	0.7
CPI ex Food and Energy	76.093	2.0	2.4	0.2
Food	14.327	1.6	1.2	0.1
Food at Home	8.622	1.2	1.2	0.1
Food Away from Home	5.705	2.3	1.2	0.1
Energy	9.580	2.3	11.6	5.4
Gasoline	5.273	3.3	16.2	9.1
Electricity	2.881	0.8	6.6	0.3
Commodities less Food and Energy	19.530	0.3	0.4	0.0
New Vehicles	3.195	1.1	0.0	-0.3
Used Cars and Trucks	1.839	-0.2	2.8	0.8
Medical Care Commodities	1.716	0.8	-2.4	-0.4
Apparel	3.526	2.4	3.2	-0.1
Services Less Energy Services	56.563	2.6	2.8	0.2
Shelter	31.678	2.3	2.0	0.2
Rent of Primary Residence	6.540	2.7	2.8	0.3
Owner’s Equivalent Rent of Residences	24.016	2.1	2.0	0.2
Transportation Services	5.840	3.1	4.1	0.1
Medical Care Services	5.460	3.9	3.3	0.3

% RI: Percent Relative Importance Oct 2012

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

The weights of the CPI, US city average for all urban consumers representing about 87 percent of the US population (http://www.bls.gov/cpi/cpiovrvw.htm#item1), are shown in Table II-4 with the BLS update of Mar 7, 2012 (http://www.bls.gov/cpi/cpiri2011.pdf). Housing has a weight of 41.020 percent. The combined weight of housing and transportation is 57.895 percent or more than one half of consumer expenditures of all urban consumers. The combined weight of housing, transportation and food and beverages is 73.151 percent of the US CPI. Table II-3 provides relative importance of key items in Feb 2013.

Table II-4, US, Relative Importance, 2009-2010 Weights, of Components in the Consumer Price Index, US City Average, Dec 2011

All Items	100.000
Food and Beverages	15.256
Food	14.308
Food at home	8.638
Food away from home	5.669
Housing	41.020
Shelter	31.539
Rent of primary residence	6.485
Owners’ equivalent rent	23.957
Apparel	3.562
Transportation	16.875
Private Transportation	15.694
New vehicles	3.195
Used cars and trucks	1.913
Motor fuel	5.463
Gasoline	5.273
Medical Care	7.061
Medical care commodities	1.716
Medical care services	5.345
Recreation	6.044
Education and Communication	6.797
Other Goods and Services	3.385

Note: reissued Mar 7, 2012. Refers to all urban consumers, covering approximately 87 percent of the US population (see http://www.bls.gov/cpi/cpiovrvw.htm#item1). Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/cpiri2011.pdf http://www.bls.gov/cpi/cpiriar.htm

Chart II-18 provides the US consumer price index for housing from 2001 to 2013. Housing prices rose sharply during the decade until the bump of the global recession and increased again in 2011-2012 with some stabilization. The CPI excluding housing would likely show much higher inflation. Income remaining after paying for indispensable shelter has been compressed by the commodity carry trades resulting from unconventional monetary policy.

Chart II-18, US, Consumer Price Index, Housing, NSA, 2001-2013

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

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

Chart II-19, US, Consumer Price Index, Housing, 12-Month Percentage Change, NSA, 2001-2013

Source: US Bureau of Labor Statistics

There have been waves of consumer price inflation in the US in 2011 and into 2012 (Section IIA and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/world-inflation-waves-united-states.html) that are illustrated in Table II-5. The first wave occurred in Jan-Apr 2011 and was caused by the carry trade of commodity prices induced by unconventional monetary policy of zero interest rates. Cheap money at zero opportunity cost in environment of risk appetite was channeled into financial risk assets, causing increases in commodity prices. The annual equivalent rate of increase of the all-items CPI in Jan-Apr 2011 was 4.6 percent and the CPI excluding food and energy increased at annual equivalent rate of 2.1 percent. The second wave occurred during the collapse of the carry trade from zero interest rates to exposures in commodity futures as a result of risk aversion in financial markets created by the sovereign debt crisis in Europe. The annual equivalent rate of increase of the all-items CPI dropped to 3.0 percent in May-Jun 2011 while the annual equivalent rate of the CPI excluding food and energy increased at 3.0 percent. In the third wave in Jul-Sep 2011, annual equivalent CPI inflation rose to 3.3 percent while the core CPI increased at 2.0 percent. The fourth wave occurred in the form of decrease of the CPI all-items annual equivalent rate to 0.6 percent in Oct-Nov 2011 with the annual equivalent rate of the CPI excluding food and energy remaining at 2.4 percent. The fifth wave occurred in Dec 2011 to Jan 2012 with annual equivalent headline inflation of 1.2 percent and core inflation of 2.4 percent. In the sixth wave, headline CPI inflation increased at annual equivalent 3.7 percent in Feb-Mar 2012 and core CPI inflation at 1.8 percent but including Apr, the annual equivalent inflation of the headline CPI was 2.4 percent in Feb-Apr and 2.0 percent for the core CPI. The seventh wave in May-Jul occurred with annual equivalent inflation of 0.0 percent for the headline CPI in May-Jul 2012 and 2.0 percent for the core CPI. The eighth wave is with annual equivalent inflation of 6.2 percent in Aug-Sep 2012 but 4.9 percent including Oct. In the ninth wave, annual equivalent inflation in Nov 2012 was minus 2.4 percent under the new shock of risk aversion and 0.0 percent in Dec 2012 with annual equivalent of minus 0.8 percent in Nov 2012-Jan 2013 and 2.0 percent for the core CPI. In the tenth wave, annual equivalent of headline CPI was 8.7 percent in Feb 2013 and 2.4 percent for the core CPI. The conclusion is that inflation accelerates and decelerates in unpredictable fashion that turns symmetric inflation targets in a source of destabilizing shocks to the financial system and eventually the overall economy. Inflation waves are destabilizing because of unpredictable moods of risk aversion and risk appetite. Unconventional monetary policy of zero interest rates and withdrawal of bonds to lower long-term interest rates distorts risk/return decisions required for efficient allocation of resources and attaining optimal growth paths and prosperity.

Table II-5, US, Headline and Core CPI Inflation Monthly SA and 12 Months NSA ∆%

	All Items SA Month	All Items NSA 12 month	Core SA Month	Core NSA 12 months
Feb 2013	0.7	2.0	0.2	2.0
AE ∆% Feb	8.7		2.4
Jan	0.0	1.6	0.3	1.9
Dec 2012	0.0	1.7	0.1	1.9
Nov	-0.2	1.8	0.1	1.9
AE ∆% Nov-Jan	-0.8		2.0
Oct	0.2	2.2	0.2	2.0
Sep	0.5	2.0	0.2	2.0
Aug	0.5	1.7	0.1	1.9
AE ∆% Aug-Oct	4.9		2.0
Jul	0.0	1.4	0.1	2.1
Jun	0.1	1.7	0.2	2.2
May	-0.1	1.7	0.2	2.3
AE ∆% May-Jul	0.0		2.0
Apr	0.0	2.3	0.2	2.3
Mar	0.3	2.7	0.2	2.3
Feb	0.3	2.9	0.1	2.2
AE ∆% Feb-Apr	2.4		2.0
Jan	0.2	2.9	0.2	2.3
Dec 2011	0.0	3.0	0.2	2.2
AE ∆% Dec-Jan	1.2		2.4
Nov	0.1	3.4	0.2	2.2
Oct	0.0	3.5	0.2	2.1
AE ∆% Oct-Nov	0.6		2.4
Sep	0.3	3.9	0.1	2.0
Aug	0.3	3.8	0.2	2.0
Jul	0.2	3.6	0.2	1.8
AE ∆% Jul-Sep	3.3		2.0
Jun	0.1	3.6	0.2	1.6
May	0.4	3.6	0.3	1.5
AE ∆% May-Jun	3.0		3.0
Apr	0.3	3.2	0.2	1.3
Mar	0.5	2.7	0.1	1.2
Feb	0.4	2.1	0.2	1.1
Jan	0.3	1.6	0.2	1.0
AE ∆% Jan-Apr	4.6		2.1
Dec 2010	0.5	1.5	0.1	0.8
Nov	0.2	1.1	0.1	0.8
Oct	0.3	1.2	0.0	0.6
Sep	0.1	1.1	0.1	0.8
Aug	0.2	1.1	0.1	0.9
Jul	0.2	1.2	0.1	0.9
Jun	0.0	1.1	0.1	0.9
May	0.0	2.0	0.1	0.9
Apr	0.0	2.2	0.0	0.9
Mar	0.0	2.3	0.0	1.1
Feb	-0.1	2.1	0.1	1.3
Jan	0.1	2.6	-0.1	1.6

Note: Core: excluding food and energy; AE: annual equivalent

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

The behavior of the US consumer price index NSA from 2001 to 2013 is provided in Chart II-20. Inflation in the US is very dynamic without deflation risks that would justify symmetric inflation targets. The hump in 2008 originated in the carry trade from interest rates dropping to zero into commodity futures. There is no other explanation for the increase of the Cushing OK Crude Oil Future Contract 1 from $55.64/barrel on Jan 9, 2007 to $145.29/barrel on July 3, 2008 during deep global recession, collapsing under a panic of flight into government obligations and the US dollar to $37.51/barrel on Feb 13, 2009 and then rising by carry trades to $113.93/barrel on Apr 29, 2012, collapsing again and then recovering again to $105.23/barrel, all during mediocre economic recovery with peaks and troughs influenced by bouts of risk appetite and risk aversion (data from the US Energy Information Administration EIA, http://www.eia.gov/). The unwinding of the carry trade with the TARP announcement of toxic assets in banks channeled cheap money into government obligations (see Cochrane and Zingales 2009).

Chart II-20, US, Consumer Price Index, NSA, 2001-2013

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

Chart II-21 provides 12-month percentage changes of the consumer price index from 2001 to 2013. There was no deflation or threat of deflation from 2008 into 2009. Commodity prices collapsed during the panic of toxic assets in banks. When stress tests in 2009 revealed US bank balance sheets in much stronger position, cheap money at zero opportunity cost exited government obligations and flowed into carry trades of risk financial assets. Increases in commodity prices drove again the all items CPI with interruptions during risk aversion originating in multiple fears but especially from the sovereign debt crisis of Europe.

Chart II-21, US, Consumer Price Index, 12-Month Percentage Change, NSA, 2001-2013

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

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

Chart II-22, US, Consumer Price Index Excluding Food and Energy, NSA, 2001-2013

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

Chart II-23 provides 12-month percentage change of the consumer price index excluding food and energy. Past-year rates of inflation fell toward 1 percent from 2001 into 2003 as a result of the recession and the decline of commodity prices beginning before the recession with declines of real oil prices. Near zero interest rates with fed funds at 1 percent between Jun 2003 and Jun 2004 stimulated carry trades of all types, including in buying homes with subprime mortgages in expectation that low interest rates forever would increase home prices permanently, creating the equity that would permit the conversion of subprime mortgages into creditworthy mortgages (Gorton 2009EFM; see http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Inflation rose and then collapsed during the unwinding of carry trades and the housing debacle of the global recession. Carry trades into 2011 and 2012 gave a new impulse to CPI inflation, all items and core. Symmetric inflation targets destabilize the economy by encouraging hunts for yields that inflate and deflate financial assets, obscuring risk/return decisions on production, investment, consumption and hiring.

Chart II-23, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2001-2013

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

Headline and core producer price indexes are in Table II-6. The headline PPI SA increased 0.7 percent in Feb 2013 and increased 1.7 percent NSA in the 12 months ending in Feb 2013. The core PPI SA increased 0.2 percent in Feb 2013 and rose 1.7 percent in 12 months. Analysis of annual equivalent rates of change shows inflation waves similar to those worldwide. In the first wave, the absence of risk aversion from the sovereign risk crisis in Europe motivated the carry trade from zero interest rates into commodity futures that caused the average equivalent rate of 10.0 percent in the headline PPI in Jan-Apr 2011 and 4.0 percent in the core PPI. In the second wave, commodity futures prices collapsed in Jun 2011 with the return of risk aversion originating in the sovereign risk crisis of Europe. The annual equivalent rate of headline PPI inflation collapsed to 1.8 percent in May-Jun 2011 but the core annual equivalent inflation rate was much higher at 2.4 percent. In the third wave, headline PPI inflation resuscitated with annual equivalent at 4.9 percent in Jul-Sep 2011 and core PPI inflation at 3.7 percent. Core PPI inflation was persistent throughout 2011, jumping from annual equivalent at 1.5 percent in the first four months of 2010 to 3.0 percent in 12 months ending in Dec 2011. Unconventional monetary policy is based on the proposition that core rates reflect more fundamental inflation and are thus better predictors of the future. In practice, the relation of core and headline inflation is as difficult to predict as future inflation (see IIID Supply Shocks in http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html). In the fourth wave, risk aversion originating in the lack of resolution of the European debt crisis caused unwinding of carry trades with annual equivalent headline PPI inflation of 0.6 percent in Oct-Nov 2011 and 1.8 percent in the core annual equivalent. In the fifth wave from Dec 2011 to Jan 2012, annual equivalent inflation was 0.0 percent for the headline index but 4.3 percent for the core index excluding food and energy. In the sixth wave, annual equivalent inflation in Feb-Mar 2012 was 2.4 percent for the headline PPI and 2.4 percent for the core. In the seventh wave, renewed risk aversion caused reversal of carry trade commodity exposures with annual equivalent headline inflation of minus 4.7 percent in Apr-May 2012 while core PPI inflation was at annual equivalent 1.2 percent. In the eighth wave, annual equivalent inflation returned at 3.0 percent in Jun-Jul 2012 and 4.3 percent for the core index. In the ninth wave, relaxed risk aversion because of the announcement of the impaired bond buying program or Outright Monetary Transactions (OMT) of the European Central Bank (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html) induced carry trades that drove annual equivalent inflation of producer prices of the United States at 12.7 percent in Aug-Sep 2012 and 0.6 percent in the core index. In the tenth wave, renewed risk aversion caused annual equivalent inflation of minus 3.5 percent in Oct-Dec in the headline index and 0.8 percent in the core index. In the eleventh wave, annual equivalent inflation was 5.5 percent in the headline index in Jan-Feb 2013 and 2.4 percent in the core index. It is almost impossible to forecast PPI inflation and its relation to CPI inflation. “Inflation surprise” by monetary policy could be proposed to climb along a downward sloping Phillips curve, resulting in higher inflation but lower unemployment (see Kydland and Prescott 1977, Barro and Gordon 1983 and past comments of this blog http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). The architects of monetary policy would require superior inflation forecasting ability compared to forecasting naivety by everybody else. In practice, we are all naïve in forecasting inflation and other economic variables and events.

Table II-6, US, Headline and Core PPI Inflation Monthly SA and 12-Month NSA ∆%

	Finished Goods SA Month	Finished Goods NSA 12 months	Finished Core SA Month	Finished Core NSA 12 months
Feb 2013	0.7	1.7	0.2	1.7
Jan	0.2	1.4	0.2	1.8
AE ∆% Jan-Feb	5.5		2.4
Dec 2012	-0.3	1.3	0.1	2.0
Nov	-0.4	1.5	0.1	2.2
Oct	-0.2	2.3	0.0	2.2
AE ∆% Oct-Dec	-3.5		0.8
Sep	1.0	2.1	0.1	2.4
Aug	1.0	1.9	0.0	2.6
AE ∆% Aug-Sep	12.7		0.6
Jul	0.4	0.5	0.5	2.6
Jun	0.1	0.7	0.2	2.6
AE ∆% Jun-Jul	3.0		4.3
May	-0.6	0.6	0.1	2.7
Apr	-0.2	1.8	0.1	2.7
AE ∆% Apr-May	-4.7		1.2
Mar	0.1	2.8	0.2	2.9
Feb	0.3	3.4	0.2	3.1
AE ∆% Feb-Mar	2.4		2.4
Jan	0.1	4.1	0.4	3.1
Dec 2011	-0.1	4.7	0.3	3.0
AE ∆% Dec-Jan	0.0		4.3
Nov	0.4	5.6	0.1	3.0
Oct	-0.3	5.8	0.2	2.9
AE ∆% Oct-Nov	0.6		1.8
Sep	0.9	7.0	0.3	2.8
Aug	-0.3	6.6	0.1	2.7
Jul	0.6	7.1	0.5	2.7
AE ∆% Jul-Sep	4.9		3.7
Jun	-0.1	6.9	0.3	2.3
May	0.4	7.1	0.1	2.1
AE ∆% May-Jun	1.8		2.4
Apr	0.7	6.6	0.3	2.3
Mar	0.7	5.6	0.3	2.0
Feb	1.1	5.4	0.3	1.8
Jan	0.7	3.6	0.4	1.6
AE ∆% Jan-Apr	10.0		4.0
Dec 2010	0.9	3.8	0.2	1.4
Nov	0.6	3.4	0.0	1.2
Oct	0.7	4.3	-0.1	1.6
Sep	0.4	3.9	0.2	1.6
Aug	0.4	3.3	0.1	1.3
Jul	0.3	4.1	0.1	1.5
Jun	-0.3	2.7	0.1	1.1
May	0.0	5.1	0.3	1.3
Apr	-0.2	5.4	0.0	0.9
Mar	0.7	5.9	0.2	0.9
Feb	-0.7	4.2	0.0	1.0
Jan	1.0	4.5	0.3	1.0

Note: Core: excluding food and energy; AE: annual equivalent

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

The US producer price index NSA from 2000 to 2013 is shown in Chart II-24. There are two episodes of decline of the PPI during recessions in 2001 and in 2008. Barsky and Kilian (2004) consider the 2001 episode as one in which real oil prices were declining when recession began. Recession and the fall of commodity prices instead of generalized deflation explain the behavior of US inflation in 2008.

Chart II-24, US, Producer Price Index, NSA, 2000-2013

Source: US Bureau of Labor Statistics

Twelve-month percentage changes of the PPI NSA from 2000 to 2013 are shown in Chart II-25. It may be possible to forecast trends a few months in the future under adaptive expectations but turning points are almost impossible to anticipate especially when related to fluctuations of commodity prices in response to risk aversion. In a sense, monetary policy has been tied to behavior of the PPI in the negative 12-month rates in 2001 to 2003 and then again in 2009 to 2010. Monetary policy following deflation fears caused by commodity price fluctuations would introduce significant volatility and risks in financial markets and eventually in consumption and investment.

Chart II-25, US, Producer Price Index, 12-Month Percentage Change NSA, 2000-2013

Source: US Bureau of Labor Statistics

The US PPI excluding food and energy from 2000 to 2013 is shown in Chart II-26. There is here again a smooth trend of inflation instead of prolonged deflation as in Japan.

Chart II-26, US, Producer Price Index Excluding Food and Energy, NSA, 2000-2013

Source: US Bureau of Labor Statistics

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

Chart II-27, US, Producer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2000-2013

Source: US Bureau of Labor Statistics

The US producer price index of energy goods from 2000 to 2013 is in Chart II-28. There is a clear upward trend with fluctuations that would not occur under persistent deflation.

Chart II-28, US, Producer Price Index Finished Energy Goods, NSA, 2000-2013

Source: US Bureau of Labor Statistics

Chart II-29 provides 12-month percentage changes of the producer price index of energy goods from 2000 to 2013. The episode of declining prices of energy goods in 2001 to 2002 is related to the analysis of decline of real oil prices by Barsky and Kilian (2004). Interest rates dropping to zero during the global recession explain the rise of the PPI of energy goods toward 30 percent. Bouts of risk aversion with policy interest rates held close to zero explain the fluctuations in the 12-month rates of the PPI of energy goods in the expansion phase of the economy. Symmetric inflation targets induce significant instability in inflation and interest rates with adverse effects on financial markets and the overall economy.

Chart II-29, US, Producer Price Index Energy Goods, 12-Month Percentage Change, NSA, 2000-2013

Source: US Bureau of Labor Statistics

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

Table II-3 provides 12-month percentage changes of the CPI all items, CPI core and CPI housing from 2001 to 2013. There is no evidence in these data supporting symmetric inflation targets that would only induce greater instability in inflation, interest rates and financial markets. Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). Symmetric targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even with the economy growing at or close to potential output (http://www.federalreserve.gov/newsevents/press/monetary/20130130a.htm):

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

Table II-7, CPI All Items, CPI Core and CPI Housing, 12-Month Percentage Change, NSA 2001-2013

Feb	CPI All Items	CPI Core ex Food and Energy	CPI Housing
2013	2.0	2.0	1.9
2012	2.9	2.2	1.8
2011	2.1	1.1	0.7
2010	2.1	1.3	-0.6
2009	0.2	1.8	1.9
2008	4.0	2.3	2.8
2007	2.4	2.7	3.3
2006	3.6	2.1	4.0
2005	3.0	2.4	3.0
2004	1.7	1.2	2.1
2003	3.0	1.7	2.6
2002	1.1	2.6	2.2
2001	3.5	2.7	4.5

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

IIE Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation. Fear of deflation as had occurred during the Great Depression and in Japan was used as an argument for the first round of unconventional monetary policy with 1 percent interest rates from Jun 2003 to Jun 2004 and quantitative easing in the form of withdrawal of supply of 30-year securities by suspension of the auction of 30-year Treasury bonds with the intention of reducing mortgage rates (for fear of deflation see Pelaez and Pelaez, International Financial Architecture (2005), 18-28, and Pelaez and Pelaez, The Global Recession Risk (2007), 83-95). The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html

If the forecast of the central bank is of recession and low inflation with controlled inflationary expectations, monetary policy should consist of lowering the short-term policy rate of the central bank, which in the US is the fed funds rate. The intended effect is to lower the real rate of interest (Svensson 2003LT, 146-7). The real rate of interest, r, is defined as the nominal rate, i, adjusted by expectations of inflation, π*, with all variables defined as proportions: (1+r) = (1+i)/(1+π*) (Fisher 1930). If i, the fed funds rate, is lowered by the Fed, the numerator of the right-hand side is lower such that if inflationary expectations, π*, remain unchanged, the left-hand (1+r) decreases, that is, the real rate of interest, r, declines. Expectations of lowering short-term real rates of interest by policy of the Federal Open Market Committee (FOMC) fixing a lower fed funds rate would lower long-term real rates of interest, inducing with a lag investment and consumption, or aggregate demand, that can lift the economy out of recession. Inflation also increases with a lag by higher aggregate demand and inflation expectations (Fisher 1933). This reasoning explains why the FOMC lowered the fed funds rate in Dec 2008 to 0 to 0.25 percent and left it unchanged.

The fear of the Fed is expected deflation or negative π*. In that case, (1+ π*) < 1, and (1+r) would increase because the right-hand side of the equation would be divided by a fraction. A simple numerical example explains the effect of deflation on the real rate of interest. Suppose that the nominal rate of interest or fed funds rate, i, is 0.25 percent, or in proportion 0.25/100 = 0.0025, such that (1+i) = 1.0025. Assume now that economic agents believe that inflation will remain at 1 percent for a long period, which means that π* = 1 percent, or in proportion 1/100 =0.01. The real rate of interest, using the equation, is (1+0.0025)/(1+0.01) = (1+r) = 0.99257, such that r = 0.99257 - 1 = -0.00743, which is a proportion equivalent to –(0.00743)100 = -0.743 percent. That is, Fed policy has created a negative real rate of interest of 0.743 percent with the objective of inducing aggregate demand by higher investment and consumption. This is true if expected inflation, π*, remains at 1 percent. Suppose now that expectations of deflation become generalized such that π* becomes -1 percent, that is, the public believes prices will fall at the rate of 1 percent in the foreseeable future. Then the real rate of interest becomes (1+0.0025) divided by (1-0.01) equal to (1.0025)/(0.99) = (1+r) = 1.01263, or r = (1.01263-1) = 0.01263, which results in positive real rate of interest of (0.01263)100 = 1.263 percent.

Irving Fisher also identified the impact of deflation on debts as an important cause of deepening contraction of income and employment during the Great Depression illustrated by an actual example (Fisher 1933, 346):

“By March, 1933, liquidation had reduced the debts about 20 percent, but had increased the dollar about 75 percent, so that the real debt, that is the debt measured in terms of commodities, was increased about 40 percent [100%-20%)X(100%+75%) =140%]. Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized”

The nominal rate of interest must always be nonnegative, that is, i ≥ 0 (Hick 1937, 154-5):

“If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall”

The interpretation by Hicks of the General Theory of Keynes is the special case in which at interest rates close to zero liquidity preference is infinitely or perfectly elastic, that is, the public holds infinitely large cash balances at that near zero interest rate because there is no opportunity cost of foregone interest. Increases in the money supply by the central bank would not decrease interest rates below their near zero level, which is called the liquidity trap. The only alternative public policy would consist of fiscal policy that would act similarly to an increase in investment, increasing employment without raising the interest rate.

An influential view on the policy required to steer the economy away from the liquidity trap is provided by Paul Krugman (1998). Suppose the central bank faces an increase in inflation. An important ingredient of the control of inflation is the central bank communicating to the public that it will maintain a sustained effort by all available policy measures and required doses until inflation is subdued and price stability is attained. If the public believes that the central bank will control inflation only until it declines to a more benign level but not sufficiently low level, current expectations will develop that inflation will be higher once the central bank abandons harsh measures. During deflation and recession the central bank has to convince the public that it will maintain zero interest rates and other required measures until the rate of inflation returns convincingly to a level consistent with expansion of the economy and stable prices. Krugman (1998, 161) summarizes the argument as:

“The ineffectuality of monetary policy in a liquidity trap is really the result of a looking-glass version of the standard credibility problem: monetary policy does not work because the public expects that whatever the central bank may do now, given the chance, it will revert to type and stabilize prices near their current level. 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”

This view is consistent with results of research by Christina Romer that “the rapid rates of growth of real output in the mid- and late 1930s were largely due to conventional aggregate demand stimulus, primarily in the form of monetary expansion. My calculations suggest that in the absence of these stimuli the economy would have remained depressed far longer and far more deeply than it actually did” (Romer 1992, 757-8, cited in Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 210-2). The average growth rate of the money supply in 1933-1937 was 10 percent per year and increased in the early 1940s. Romer calculates that GDP would have been much lower without this monetary expansion. The growth of “the money supply was primarily due to a gold inflow, which was in turn due to the devaluation in 1933 and to capital flight from Europe because of political instability after 1934” (Romer 1992, 759). Gold inflow coincided with the decline in real interest rates in 1933 that remained negative through the latter part of the 1930s, suggesting that they could have caused increases in spending that was sensitive to declines in interest rates. Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (Bernanke 2002):

“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US 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 US 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. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”

Fed policy is seeking what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher 1933, 350).

The President of the Federal Reserve Bank of Chicago argues that (Charles Evans 2010):

“I believe the US economy is best described as being in a bona fide liquidity trap. Highly plausible projections are 1 percent for core Personal Consumption Expenditures (PCE) inflation at the end of 2012 and 8 percent for the unemployment rate. For me, the Fed’s dual mandate misses are too large to shrug off, and there is currently no policy conflict between improving employment and inflation outcomes”

There are two types of monetary policies that could be used in this situation. First, the Fed could announce a price-level target to be attained within a reasonable time frame (Evans 2010):

“For example, if the slope of the price path is 2 percent and inflation has been underunning the path for some time, monetary policy would strive to catch up to the path. Inflation would be higher than 2 percent for a time until the path was reattained”

Optimum monetary policy with interest rates near zero could consist of “bringing the price level back up to a level even higher than would have prevailed had the disturbance never occurred” (Gauti Eggertsson and Michael Woodford 2003, 207). Bernanke (2003JPY) explains as follows:

“Failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods—greater quantities of assets purchased on the open market for example. So even if the central bank is reluctant to provide a time frame for meetings its objective, the structure of the price-level objective provides a means for the bank to commit to increasing its anti-deflationary efforts when its earlier efforts prove unsuccessful. As Eggertsson and Woodford show, the expectations that an increasing price level gap will give rise to intensified effort by the central bank should lead the public to believe that ultimately inflation will replace deflation, a belief that supports the central bank’s own objectives by lowering the current real rate of interest”

Second, the Fed could use its balance sheet to increase purchases of long-term securities together with credible commitment to maintain the policy until the dual mandates of maximum employment and price stability are attained.

In the restatement of the liquidity trap and large-scale policies of monetary/fiscal stimulus, Krugman (1998, 162) finds:

“In the traditional open economy IS-LM model developed by Robert Mundell [1963] and Marcus Fleming [1962], and also in large-scale econometric models, monetary expansion unambiguously leads to currency depreciation. But there are two offsetting effects on the current account balance. On one side, the currency depreciation tends to increase net exports; on the other side, the expansion of the domestic economy tends to increase imports. For what it is worth, policy experiments on such models seem to suggest that these effects very nearly cancel each other out.

Krugman (1998) uses a different dynamic model with expectations that leads to similar conclusions.

The central bank could also be pursuing competitive devaluation of the national currency in the belief that it could increase inflation to a higher level and promote domestic growth and employment at the expense of growth and unemployment in the rest of the world. An essay by Chairman Bernanke in 1999 on Japanese monetary policy received attention in the press, stating that (Bernanke 2000, 165):

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

Quantitative easing has never been proposed by Chairman Bernanke or other economists as certain science without adverse effects. What has not been mentioned in the press is another suggestion to the Bank of Japan (BOJ) by Chairman Bernanke in the same essay that is very relevant to current events and the contentious issue of ongoing devaluation wars (Bernanke 2000, 161):

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

Chairman Bernanke is referring to the argument by Joan Robinson based on the experience of the Great Depression that: “in times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others” (Robinson 1947, 156). Devaluation is one of the tools used in these policies (Robinson 1947, 157). Banking crises dominated the experience of the United States, but countries that recovered were those devaluing early such that competitive devaluations rescued many countries from a recession as strong as that in the US (see references to Ehsan Choudhri, Levis Kochin and Barry Eichengreen in Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 205-9; for the case of Brazil that devalued early in the Great Depression recovering with an increasing trade balance see Pelaez, 1968, 1968b, 1972; Brazil devalued and abandoned the gold standard during crises in the historical period as shown by Pelaez 1976, Pelaez and Suzigan 1981). Beggar-my-neighbor policies did work for individual countries but the criticism of Joan Robinson was that it was not optimal for the world as a whole.

Is depreciation of the dollar the best available tool currently for achieving the dual mandate of higher inflation and lower unemployment? Bernanke (2002) finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):

“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.”

Should the US devalue following Roosevelt? Or has monetary policy intended devaluation? Fed policy is seeking, deliberately or as a side effect, what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher, 1933, 350). The Fed has created not only high volatility of assets but also what many countries are regarding as a competitive devaluation similar to those criticized by Nurkse (1944). Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment.

Friedman (1969) finds that the optimal rule for the quantity of money is deflation at a rate that results in a zero nominal interest rate (see Ireland 2003 and Cole and Kocherlakota 1998). Atkeson and Kehoe (2004) argue that central bankers are not inclined to implement policies that could result in deflation because of the interpretation of the Great Depression as closely related to deflation. They use panel data on inflation and growth of real output for 17 countries over more than 100 years. The time-series data for each individual country are broken into five-year events with deflation measured as average negative inflation and depression as average negative growth rate of real output. Atkeson and Kehoe (2004) find that the Great Depression from 1929 to 1934 is the only case of association between deflation and depression without any evidence whatsoever of such relation in any other period. Their conclusion is (Atkeson and Kehoe 2004, 99): “Our finding thus suggests that policymakers’ fear of anticipated policy-induced deflation that would result from following, say, the Friedman rule is greatly overblown.” Their conclusion on the experience of Japan is (Atkeson and Kehoe 2004, 99):

“Since 1960, Japan’s average growth rates have basically fallen monotonically, and since 1970, its average inflation rates have too. Attributing this 40-year slowdown to monetary forces is a stretch. More reasonable, we think, is that much of the slowdown is the natural pattern for a country that was far behind the world leaders and had begun to catch up.”

In the sample of Atkeson and Kehoe (2004), there are only eight five-year periods besides the Great Depression with both inflation and depression. Deflation and depression is shown in 65 cases with 21 of depression without deflation. There is no depression in 65 of 73 five-year periods and there is no deflation in 29 episodes of depression. There is a remarkable result of no depression in 90 percent of deflation episodes. Excluding the Great Depression, there is virtually no relation of deflation and depression. Atkeson and Kehoe (2004, 102) find that the average growth rate of Japan of 1.41 percent in the 1990s is “dismal” when compared with 3.20 percent in the United States but is not “dismal” when compared with 1.61 percent for Italy and 1.84 percent for France, which are also catch-up countries in modern economic growth (see Atkeson and Kehoe 1998). The conclusion of Atkeson and Kehoe (2004), without use of controls, is that there is no association of deflation and depression in their dataset.

Benhabib and Spiegel (2009) use a dataset similar to that of Atkeson and Kehoe (2004) but allowing for nonlinearity and inflation volatility. They conclude that in cases of low and negative inflation an increase of average inflation of 1 percent is associated with an increase of 0.31 percent of average annual growth. The analysis of Benhabib and Spiegel (2009) leads to the significantly different conclusion that inflation and economic performance are strongly associated for low and negative inflation. There is no claim of causality by Atkeson and Kehoe (2004) and Benhabib and Spiegel (2009).

Delfim Netto (1959) partly reprinted in Pelaez (1973) conducted two classical nonparametric tests (Mann 1945, Wallis and Moore 1941; see Kendall and Stuart 1968) with coffee-price data in the period of free markets from 1857 to 1906 with the following conclusions (Pelaez, 1976a, 280):

“First, the null hypothesis of no trend was accepted with high confidence; secondly, the null hypothesis of no oscillation was rejected also with high confidence. Consequently, in the nineteenth century international prices of coffee fluctuated but without long-run trend. This statistical fact refutes the extreme argument of structural weakness of the coffee trade.”

In his classic work on the theory of international trade, Jacob Viner (1937, 563) analyzed the “index of total gains from trade,” or “amount of gain per unit of trade,” denoted as T:

T= (∆P^e/∆Pⁱ)∆Q

Where ∆P^e is the change in export prices, ∆Pⁱ is the change in import prices and ∆Q is the change in export volume. Dorrance (1948, 52) restates “Viner’s index of total gain from trade” as:

“What should be done is to calculate an index of the value (quantity multiplied by price) of exports and the price of imports for any country whose foreign accounts are to be analysed. Then the export value index should be divided by the import price index. The result would be an index which would reflect, for the country concerned, changes in the volume of imports obtainable from its export income (i.e. changes in its "real" export income, measured in import terms). The present writer would suggest that this index be referred to as the ‘income terms of trade’ index to differentiate it from the other indexes at present used by economists.”

What really matters for an export activity especially during modernization is the purchasing value of goods that it exports in terms of prices of imports. For a primary producing country, the purchasing power of exports in acquiring new technology from the country providing imports is the critical measurement. The barter terms of trade of Brazil improved from 1857 to 1906 because international coffee prices oscillated without trend (Delfim Netto 1959) while import prices from the United Kingdom declined at the rate of 0.5 percent per year (Imlah 1958). The accurate measurement of the opportunity afforded by the coffee exporting economy was incomparably greater when considering the purchasing power in British prices of the value of coffee exports, or Dorrance’s (1948) income terms of trade.

The conventional theory that the terms of trade of Brazil deteriorated over the long term is without reality (Pelaez 1976a, 280-281):

“Moreover, physical exports of coffee by Brazil increased at the high average rate of 3.5 per cent per year. Brazil's exchange receipts from coffee-exporting in sterling increased at the average rate of 3.5 per cent per year and receipts in domestic currency at 4.5 per cent per year. Great Britain supplied nearly all the imports of the coffee economy. In the period of the free coffee market, British export prices declined at the rate of 0.5 per cent per year. Thus, the income terms of trade of the coffee economy improved at the relatively satisfactory average rate of 4.0 per cent per year. This is only a lower bound of the rate of improvement of the terms of trade. While the quality of coffee remained relatively constant, the quality of manufactured products improved significantly during the fifty-year period considered. The trade data and the non-parametric tests refute conclusively the long-run hypothesis. The valid historical fact is that the tropical export economy of Brazil experienced an opportunity of absorbing rapidly increasing quantities of manufactures from the "workshop" countries. Therefore, the coffee trade constituted a golden opportunity for modernization in nineteenth-century Brazil.”

Imlah (1958) provides decline of British export prices at 0.5 percent in the nineteenth century and there were no lost decades, depressions or unconventional monetary policies in the highly dynamic economy of England that drove the world’s growth impulse. Inflation in the United Kingdom between 1857 and 1906 is measured by the composite price index of O’Donoghue and Goulding (2004) at minus 7.0 percent or average rate of decline of 0.2 percent per year.

Simon Kuznets (1971) analyzes modern economic growth in his Lecture in Memory of Alfred Nobel:

“The major breakthroughs in the advance of human knowledge, those that constituted dominant sources of sustained growth over long periods and spread to a substantial part of the world, may be termed epochal innovations. And the changing course of economic history can perhaps be subdivided into economic epochs, each identified by the epochal innovation with the distinctive characteristics of growth that it generated.Without considering the feasibility of identifying and dating such economic epochs, we may proceed on the working assumption that modern economic growth represents such a distinct epoch - growth dating back to the late eighteenth century and limited (except in significant partial effects) to economically developed countries. These countries, so classified because they have managed to take adequate advantage of the potential of modern technology, include most of Europe, the overseas offshoots of Western Europe, and Japan—barely one quarter of world population.”

Cameron (1961) analyzes the mechanism by which the Industrial Revolution in Great Britain spread throughout Europe and Cameron (1967) analyzes the financing by banks of the Industrial Revolution in Great Britain. O’Donoghue and Goulding (2004) provide consumer price inflation in England since 1750 and MacFarlane and Mortimer-Lee (1994) analyze inflation in England over 300 years. Lucas (2004) estimates world population and production since the year 1000 with sustained growth of per capita incomes beginning to accelerate for the first time in English-speaking countries and in particular in the Industrial Revolution in Great Britain. The conventional theory is unequal distribution of the gains from trade and technical progress between the industrialized countries and developing economies (Singer 1950, 478):

“Dismissing, then, changes in productivity as a governing factor in changing terms of trade, the following explanation presents itself: the fruits of technical progress may be distributed either to producers (in the form of rising incomes) or to consumers (in the form of lower prices). In the case of manufactured commodities produced in more developed countries, the former method, i.e., distribution to producers through higher incomes, was much more important relatively to the second method, while the second method prevailed more in the case of food and raw material production in the underdeveloped countries. Generalizing, we may say -that technical progress in manufacturing industries showed in a rise in incomes while technical progress in the production of food and raw materials in underdeveloped countries showed in a fall in prices”

Temin (1997, 79) uses a Ricardian trade model to discriminate between two views on the Industrial Revolution with an older view arguing broad-based increases in productivity and a new view concentration of productivity gains in cotton manufactures and iron:

“Productivity advances in British manufacturing should have lowered their prices relative to imports. They did. Albert Imlah [1958] correctly recognized this ‘severe deterioration’ in the net barter terms of trade as a signal of British success, not distress. It is no surprise that the price of cotton manufactures fell rapidly in response to productivity growth. But even the price of woolen manufactures, which were declining as a share of British exports, fell almost as rapidly as the price of exports as a whole. It follows, therefore, that the traditional ‘old-hat’ view of the Industrial Revolution is more accurate than the new, restricted image. Other British manufactures were not inefficient and stagnant, or at least, they were not all so backward. The spirit that motivated cotton manufactures extended also to activities as varied as hardware and haberdashery, arms, and apparel.”

Phyllis Deane (1968, 96) estimates growth of United Kingdom gross national product (GNP) at around 2 percent per year for several decades in the nineteenth century. The facts that the terms of trade of Great Britain deteriorated during the period of epochal innovation and high rates of economic growth while the income terms of trade of the coffee economy of nineteenth-century Brazil improved at the average yearly rate of 4.0 percent from 1857 to 1906 disprove the hypothesis of weakness of trade as an explanation of relatively lower income and wealth. As Temin (1997) concludes, Britain did pass on lower prices and higher quality the benefits of technical innovation. Explanation of late modernization must focus on laborious historical research on institutions and economic regimes together with economic theory, data gathering and measurement instead of grand generalizations of weakness of trade and alleged neocolonial dependence (Stein and Stein 1970, 134-5):

“Great Britain, technologically and industrially advanced, became as important to the Latin American economy as to the cotton-exporting southern United States. [After Independence in the nineteenth century] Latin America fell back upon traditional export activities, utilizing the cheapest available factor of production, the land, and the dependent labor force.”

The experience of the United Kingdom with deflation and economic growth is relevant and rich. Table IIE-1 uses yearly percentage changes of the composite index of prices of the United Kingdom of O’Donoghue and Goulding (2004). There are 73 declines of inflation in the 145 years from 1751 to 1896. Prices declined in 50.3 percent of 145 years. Some price declines were quite sharp and many occurred over several years. Table IE-1 also provides yearly percentage changes of the UK composite price index of O’Donoghue and Goulding (2004) from 1929 to 1934. Deflation was much sharper in continuous years in earlier periods than during the Great Depression. The United Kingdom could not have led the world in modern economic growth if there were meaningful causality from deflation to depression.

Table IIE-1, United Kingdom, Negative Percentage Changes of Composite Price Index, 1751-1896, 1929-1934, Yearly ∆%

Year	∆%	Year	∆%	Year	∆%	Year	∆%
1751	-2.7	1797	-10.0	1834	-7.8	1877	-0.7
1753	-2.7	1798	-2.2	1841	-2.3	1878	-2.2
1755	-6.0	1802	-23.0	1842	-7.6	1879	-4.4
1758	-0.3	1803	-5.9	1843	-11.3	1881	-1.1
1759	-7.9	1806	-4.4	1844	-0.1	1883	-0.5
1760	-4.5	1807	-1.9	1848	-12.1	1884	-2.7
1761	-4.5	1811	-2.9	1849	-6.3	1885	-3.0
1768	-1.1	1814	-12.7	1850	-6.4	1886	-1.6
1769	-8.2	1815	-10.7	1851	-3.0	1887	-0.5
1770	-0.4	1816	-8.4	1857	-5.6	1893	-0.7
1773	-0.3	1819	-2.5	1858	-8.4	1894	-2.0
1775	-5.6	1820	-9.3	1859	-1.8	1895	-1.0
1776	-2.2	1821	-12.0	1862	-2.6	1896	-0.3
1777	-0.4	1822	-13.5	1863	-3.6	1929	-0.9
1779	-8.5	1826	-5.5	1864	-0.9	1930	-2.8
1780	-3.4	1827	-6.5	1868	-1.7	1931	-4.3
1785	-4.0	1828	-2.9	1869	-5.0	1932	-2.6
1787	-0.6	1830	-6.1	1874	-3.3	1933	-2.1
1789	-1.3	1832	-7.4	1875	-1.9	1934	0.0
1791	-0.1	1833	-6.1	1876	-0.3

Source:

O’Donoghue, Jim and Louise Goulding, 2004. Consumer Price Inflation since 1750. UK Office for National Statistics Economic Trends 604, Mar 2004, 38-46.

Lucas (2011May) estimates US economic growth in the long-term at 3 percent per year and about 2 percent per year in per capita terms. There are displacements from this trend caused by events such as wars and recessions but the economy then returns to trend. Historical US GDP data exhibit remarkable growth: Lucas (2011May) estimates an increase of US real income per person by a factor of 12 in the period from 1870 to 2010. The explanation by Lucas (2011May) of this remarkable growth experience is that government provided stability and education while elements of “free-market capitalism” were an important driver of long-term growth and prosperity. The analysis is sharpened by comparison with the long-term growth experience of G7 countries (US, UK, France, Germany, Canada, Italy and Japan) and Spain from 1870 to 2010. Countries benefitted from “common civilization” and “technology” to “catch up” with the early growth leaders of the US and UK, eventually growing at a faster rate. Significant part of this catch up occurred after World War II. If deflation causes depressions as embedded in the theory of unconventional monetary policy, the United Kingdom would not have been a growth leader in the nineteenth century while staying almost half of the time in deflation.

Nicholas Georgescu-Rogen (1960, 1) reprinted in Pelaez (1973) argues that “the agrarian economy has to this day remained a reality without theory.” The economic history of Latin America shares with the relation of deflation and unconventional monetary policy a more frustrating intellectual misfortune: theory without reality. MacFarlane and Mortimer-Lee (1994, 159) quote in a different context a phrase by Thomas Henry Huxley in the President’s Address to the British Association for the Advancement of Science on Sep 14, 1870 that is appropriate to these issues: “The great tragedy of science—the slaying of a beautiful hypothesis by an ugly fact.”

III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) slowing growth in China with political development and slowing growth in Japan and world trade; (3) slow growth propelled by savings/investment reduction in the US with high unemployment/underemployment, falling wages, hiring collapse, contraction of real private fixed investment, decline of wealth of households over the business cycle by 10.9 percent adjusted for inflation while growing 617.2 percent adjusted for inflation from IVQ1945 to IIIQ2012 and unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes; and (3) the outcome of the sovereign debt crisis in Europe. This section provides current data and analysis. Subsection IIIA Financial Risks provides analysis of the evolution of valuations of risk financial assets during the week. There are various appendixes for convenience of reference of material related to the euro area debt crisis. Some of this material is updated in Subsection IIIA when new data are available and then maintained in the appendixes for future reference until updated again in Subsection IIIA. Subsection IIIB Appendix on Safe Haven Currencies discusses arguments and measures of currency intervention and is available in the Appendixes section at the end of the blog comment. Subsection IIIC Appendix on Fiscal Compact provides analysis of the restructuring of the fiscal affairs of the European Union in the agreement of European leaders reached on Dec 9, 2011 and is available in the Appendixes section at the end of the blog comment. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank and is available in the Appendixes section at the end of the blog comment. Appendix IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union and is available following Subsection IIIA. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis and is available following Subsection IIIA. Subsection IIIG Appendix on Deficit Financing of Growth and the Debt Crisis provides analysis of proposals to finance growth with budget deficits together with experience of the economic history of Brazil and is available in the Appendixes section at the end of the blog comment.

IIIA Financial Risks. The past half year has been characterized by financial turbulence, attaining unusual magnitude in recent months. Table III-1, updated with every comment in this blog, provides beginning values on Fr Mar 8 and daily values throughout the week ending on Mar 15, 2013 of various financial assets. Section VI Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Mar 8 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Mar 8, 2013”, first row “USD/EUR 1.3003 0.1%,” provides the information that the US dollar (USD) appreciated 0.1 percent to USD 1.3003/EUR in the week ending on Fri Mar 8 relative to the exchange rate on Fri Mar 1. The first five asset rows provide five key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy but expanding into possibly France and Germany, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing waves of inflation. The most important current shock is that resulting from the agreement by European leaders at their meeting on Dec 9 (European Council 2911Dec9), which is analyzed in IIIC Appendix on Fiscal Compact. European leaders reached a new agreement on Jan 30 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/127631.pdf) and another agreement on Jun 29, 2012 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131388.pdf).

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3003/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Mar 8, depreciating to USD 1.3046/EUR on Mon Mar 11, 2013, or by 0.3 percent. The dollar depreciated because more dollars, $1.3046, were required on Mon Mar 11 to buy one euro than $1.3003 on Mar 8. Table III-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate such as in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3003/EUR on Mar 8; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Mar 8, to the last business day of the current week, in this case Fri Mar 15, such as depreciation to USD 1.3076/EUR by Mar 15; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 0.6 percent from the rate of USD 1.3003/EUR on Fri Mar 8 to the rate of USD 1.3076/EUR on Fri Mar 15 {[(1.3076/1.3003) – 1]100 = 0.6%} and depreciated (denoted by negative sign) by 0.5 percent from the rate of USD 1.3005 on Thu Mar 14 to USD 1.3076/EUR on Fri Mar 15 {[(1.3076/1.3005) -1]100 = 0.5%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk financial assets to the safety of dollar investments. When risk aversion declines, funds have been moving away from safe assets in dollars to risk financial assets, depreciating the dollar.

Table III-I, Weekly Financial Risk Assets Mar 11 to Mar 15, 2013

Fri Mar 8, 2013

M 11

Tue 12

W 13

Thu 14

Fr 15

USD/EUR

1.3003

0.1%

1.3046

-0.3%

1.3033

-0.2%

0.1%

1.2961

0.3%

0.6%

1.3005

0.0%

-0.3%

1.3076

-0.6%

-0.5%

JPY/ USD

96.03

-2.6%

96.29

-0.3%

96.09

-0.1%

0.2%

96.11

-0.1%

0.0%

96.11

-0.1%

0.0%

95.29

0.8%

0.9%

CHF/ USD

0.9515

-0.9%

0.9472

0.5%

0.9471

0.5%

0.0%

0.9524

-0.1%

-0.6%

0.9472

0.5%

0.9386

1.4%

0.9%

CHF/ EUR

1.2372

-0.7%

1.2358

0.1%

1.2344

0.2%

0.1%

1.2345

0.2%

0.0%

1.2318

0.4%

0.2%

1.2273

0.8%

0.4%

USD/ AUD

1.0233

0.9772

0.3%

1.0281

0.9727

0.5%

1.0323

0.9687

0.9%

0.4%

1.0298

0.9711

0.6%

-0.2%

1.0384

0.9630

1.5%

0.8%

1.0410

0.9606

1.7%

0.2%

10 Year T Note

2.056

2.014

2.02

2.032

1.992

2 Year T Note

0.256

0.25

0.256

0.26

0.246

German Bond

2Y 0.09 10Y 1.53

2Y 0.08 10Y 1.52

2Y 0.07 10Y 1.48

2Y 0.06 10Y 1.48

2Y 0.06 10Y 1.47

2Y 0.05 10Y 1.46

DJIA

14397.07

2.2%

14447.29

0.4%

0.4

14450.06

0.4%

0.0%

14455.28

0.4%

0.0%

14539.14

1.0%

0.6%

14514.11

0.8%

-0.2%

DJ Global

2126.69

2.3%

2137.09

0.5%

2137.21

0.5%

0.0%

2123.23

-0.2%

-0.7%

2139.52

0.6%

0.8%

2143.58

0.8%

0.2%

DJ Asia Pacific

1380.48

0.7%

1390.77

0.7%

1386.20

0.4%

-0.3%

1376.86

-0.3%

-0.7%

1379.24

-0.1%

0.2%

1393.74

1.0%

1.1%

Nikkei

12283.62

5.8%

12349.05

0.5%

12314.81

0.2%

-0.3%

12239.66

-0.4%

-0.6%

12381.19

0.8%

1.2%

12560.95

2.3%

1.5%

Shanghai

2318.61

-1.7%

2310.59

-0.3%

2286.90

-1.4%

-1.0%

2263.97

-2.4%

-1.0%

2270.28

-2.1%

0.3%

2278.40

-1.7%

0.4%

DAX

7986.47

3.6%

7984.29

0.0%

7966.12

-0.3%

-0.2%

7970.91

-0.2%

0.1%

8058.37

0.9%

1.1%

8042.85

0.7%

-0.2%

DJ UBS

Comm.

137.25

1.1%

137.41

0.1

0.1%

137.76

0.4%

0.3%

137.29

0.0%

-0.3%

138.23

0.7%

138.37

0.8%

0.1%

WTI $ B

91.84

1.0%

91.98

0.2%

92.62

0.8%

0.7%

92.41

0.6%

-0.2%

93.23

1.5%

0.9%

93.59

1.9%

0.4%

Brent $/B

110.77

0.1%

110.05

-0.7%

109.65

-1.0%

-0.4%

108.35

-2.2%

-1.2%

109.42

-1.2%

1.0%

110.00

-0.7%

0.5%

Gold $/OZ

1578.3

0.2%

1580.5

0.1%

1591.5

0.8%

0.7%

1586.7

0.5%

-0.3%

1589.1

0.7%

0.2%

1590.9

0.8%

0.1%

Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss

Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce

Sources: http://www.bloomberg.com/markets/

Discussion of current and recent risk-determining events is followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate. The overwhelming risk factor is the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). Another rising risk is division within the Federal Open Market Committee (FOMC) on risks and benefits of current policies as expressed in the minutes of the meeting held on Jan 29-30, 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130130.pdf 13):

“However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy.

A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2013/01/peaking-valuation-of-risk-financial.html). Matt Jarzemsky, writing on Dow industrials set record,” on Mar 5, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324156204578275560657416332.html), analyzes that the DJIA broke the closing high of 14164.53 set on Oct 9, 2007, and subsequently also broke the intraday high of 14198.10 reached on Oct 11, 2007. The DJIA closed at 14514.11 on Fri Mar 15, 2013, which is higher by 2.5 percent than the value of 14,164.52 reached on Oct 9, 2007 and higher by 2.2 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs. Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.

An important risk event is the reduction of growth prospects in the euro zone discussed by European Central Bank President Mario Draghi in “Introductory statement to the press conference,” on Dec 6, 2012 (http://www.ecb.int/press/pressconf/2012/html/is121206.en.html):

“This assessment is reflected in the December 2012 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP growth in a range between -0.6% and -0.4% for 2012, between -0.9% and 0.3% for 2013 and between 0.2% and 2.2% for 2014. Compared with the September 2012 ECB staff macroeconomic projections, the ranges for 2012 and 2013 have been revised downwards.

The Governing Council continues to see downside risks to the economic outlook for the euro area. These are mainly related to uncertainties about the resolution of sovereign debt and governance issues in the euro area, geopolitical issues and fiscal policy decisions in the United States possibly dampening sentiment for longer than currently assumed and delaying further the recovery of private investment, employment and consumption.”

Reuters, writing on “Bundesbank cuts German growth forecast,” on Dec 7, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/8e845114-4045-11e2-8f90-00144feabdc0.html#axzz2EMQxzs3u), informs that the central bank of Germany, Deutsche Bundesbank reduced its forecast of growth for the economy of Germany to 0.7 percent in 2012 from an earlier forecast of 1.0 percent in Jun and to 0.4 percent in 2012 from an earlier forecast of 1.6 percent while the forecast for 2014 is at 1.9 percent.

The major risk event during earlier weeks was sharp decline of sovereign yields with the yield on the ten-year bond of Spain falling to 5.309 percent and that of the ten-year bond of Italy falling to 4.473 percent on Fri Nov 30, 2012 and 5.366 percent for the ten-year of Spain and 4.527 percent for the ten-year of Italy on Fri Nov 14, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Vanessa Mock and Frances Robinson, writing on “EU approves Spanish bank’s restructuring plans,” on Nov 28, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578146520774638316.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the European Union regulators approved restructuring of four Spanish banks (Bankia, NCG Banco, Catalunya Banc and Banco de Valencia), which helped to calm sovereign debt markets. Harriet Torry and James Angelo, writing on “Germany approves Greek aid,” on Nov 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578150532603095790.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the German parliament approved the plan to provide Greece a tranche of €44 billion in promised financial support, which is subject to sustainability analysis of the bond repurchase program later in Dec 2012. A hurdle for sustainability of repurchasing debt is that Greece’s sovereign bonds have appreciated significantly from around 24 percent for the bond maturing in 21 years and 20 percent for the bond maturing in 31 years in Aug 2012 to around 17 percent for the 21-year maturity and 15 percent for the 31-year maturing in Nov 2012. Declining years are equivalent to increasing prices, making the repurchase more expensive. Debt repurchase is intended to reduce bonds in circulation, turning Greek debt more manageable. Ben McLannahan, writing on “Japan unveils $11bn stimulus package,” on Nov 30, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/adc0569a-3aa5-11e2-baac-00144feabdc0.html#axzz2DibFFquN

), informs that the cabinet in Japan approved another stimulus program of $11 billion, which is twice larger than another stimulus plan in late Oct and close to elections in Dec. Henry Sender, writing on “Tokyo faces weak yen and high bond yields,” published on Nov 29, 2012 in the Financial Times (http://www.ft.com/intl/cms/s/0/9a7178d0-393d-11e2-afa8-00144feabdc0.html#axzz2DibFFquN), analyzes concerns of regulators on duration of bond holdings in an environment of likelihood of increasing yields and yen depreciation.

First, Risk-Determining Events. The European Council statement on Nov 23, 2012 asked the President of the European Commission “to continue the work and pursue consultations in the coming weeks to find a consensus among the 27 over the Union’s Multiannual Financial Framework for the period 2014-2020” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf) Discussions will continue in the effort to reach agreement on a budget: “A European budget is important for the cohesion of the Union and for jobs and growth in all our countries” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf). There is disagreement between the group of countries requiring financial assistance and those providing bailout funds. Gabrielle Steinhauser and Costas Paris, writing on “Greek bond rally puts buyback in doubt,” on Nov 23, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324352004578136362599130992.html?mg=reno64-wsj) find a new hurdle in rising prices of Greek sovereign debt that may make more difficult buybacks of debt held by investors. European finance ministers continue their efforts to reach an agreement for Greece that meets with approval of the European Central Bank and the IMF. The European Council (2012Oct19 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/133004.pdf ) reached conclusions on strengthening the euro area and providing unified financial supervision:

“The European Council called for work to proceed on the proposals on the Single Supervisory Mechanism as a matter of priority with the objective of agreeing on the legislative framework by 1st January 2013 and agreed on a number of orientations to that end. It also took note of issues relating to the integrated budgetary and economic policy frameworks and democratic legitimacy and accountability which should be further explored. It agreed that the process towards deeper economic and monetary union should build on the EU's institutional and legal framework and be characterised by openness and transparency towards non-euro area Member States and respect for the integrity of the Single Market. It looked forward to a specific and time-bound roadmap to be presented at its December 2012 meeting, so that it can move ahead on all essential building blocks on which a genuine EMU should be based.”

Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. The Bank of Spain released new data on doubtful debtors in Spain’s credit institutions (http://www.bde.es/bde/en/secciones/prensa/Agenda/Datos_de_credit_a6cd708c59cf931.html). In 2006, the value of doubtful credits reached €10,859 million or 0.7 percent of total credit of €1,508,626 million. In Aug 2012, doubtful credit reached €178,579 million or 10.5 percent of total credit of €1,698,714 million.

There are three critical factors influencing world financial markets. (1) Spain could request formal bailout from the European Stability Mechanism (ESM) that may also affect Italy’s international borrowing. David Roman and Jonathan House, writing on “Spain risks backlash with budget plan,” on Sep 27, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443916104578021692765950384.html?mod=WSJ_hp_LEFTWhatsNewsCollection) analyze Spain’s proposal of reducing government expenditures by €13 billion, or around $16.7 billion, increasing taxes in 2013, establishing limits on early retirement and cutting the deficit by €65 billion through 2014. Banco de España, Bank of Spain, contracted consulting company Oliver Wyman to conduct rigorous stress tests of the resilience of its banking system. (Stress tests and their use are analyzed by Pelaez and Pelaez Globalization and the State Vol. I (2008b), 95-100, International Financial Architecture (2005) 112-6, 123-4, 130-3).) The results are available from Banco de España (http://www.bde.es/bde/en/secciones/prensa/infointeres/reestructuracion/ http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). The assumptions of the adverse scenario used by Oliver Wyman are quite tough for the three-year period from 2012 to 2014: “6.5 percent cumulative decline of GDP, unemployment rising to 27.2 percent and further declines of 25 percent of house prices and 60 percent of land prices (http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). Fourteen banks were stress tested with capital needs estimates of seven banks totaling €59.3 billion. The three largest banks of Spain, Banco Santander (http://www.santander.com/csgs/Satellite/CFWCSancomQP01/es_ES/Corporativo.html), BBVA (http://www.bbva.com/TLBB/tlbb/jsp/ing/home/index.jsp) and Caixabank (http://www.caixabank.com/index_en.html), with 43 percent of exposure under analysis, have excess capital of €37 billion in the adverse scenario in contradiction with theories that large, international banks are necessarily riskier. Jonathan House, writing on “Spain expects wider deficit on bank aid,” on Sep 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444138104578028484168511130.html?mod=WSJPRO_hpp_LEFTTopStories), analyzes the 2013 budget plan of Spain that will increase the deficit of 7.4 percent of GDP in 2012, which is above the target of 6.3 percent under commitment with the European Union. The ratio of debt to GDP will increase to 85.3 percent in 2012 and 90.5 percent in 2013 while the 27 members of the European Union have an average debt/GDP ratio of 83 percent at the end of IIQ2012. (2) Symmetric inflation targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even after the economy grows again at or close to potential output. Monetary easing by unconventional measures is now apparently open ended in perpetuity as provided in the statement of the meeting of the Federal Open Market Committee (FOMC) on Sep 13, 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm):

In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is the concern of the production and employment costs of controlling future inflation.

(2) The European Central Bank (ECB) approved a new program of bond purchases under the name “Outright Monetary Transactions” (OMT). The ECB will purchase sovereign bonds of euro zone member countries that have a program of conditionality under the European Financial Stability Facility (EFSF) that is converting into the European Stability Mechanism (ESM). These programs provide enhancing the solvency of member countries in a transition period of structural reforms and fiscal adjustment. The purchase of bonds by the ECB would maintain debt costs of sovereigns at sufficiently low levels to permit adjustment under the EFSF/ESM programs. Purchases of bonds are not limited quantitatively with discretion by the ECB as to how much is necessary to support countries with adjustment programs. Another feature of the OMT of the ECB is sterilization of bond purchases: funds injected to pay for the bonds would be withdrawn or sterilized by ECB transactions. The statement by the European Central Bank on the program of OTM is as follows (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html):

“6 September 2012 - Technical features of Outright Monetary Transactions

As announced on 2 August 2012, the Governing Council of the European Central Bank (ECB) has today taken decisions on a number of technical features regarding the Eurosystem’s outright transactions in secondary sovereign bond markets that aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy. These will be known as Outright Monetary Transactions (OMTs) and will be conducted within the following framework:

Conditionality

A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.

The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.

Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.

Coverage

Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above. They may also be considered for Member States currently under a macroeconomic adjustment programme when they will be regaining bond market access.

Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.

No ex ante quantitative limits are set on the size of Outright Monetary Transactions.

Creditor treatment

The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

Sterilisation

The liquidity created through Outright Monetary Transactions will be fully sterilised.

Transparency

Aggregate Outright Monetary Transaction holdings and their market values will be published on a weekly basis. Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.

Securities Markets Programme

Following today’s decision on Outright Monetary Transactions, the Securities Markets Programme (SMP) is herewith terminated. The liquidity injected through the SMP will continue to be absorbed as in the past, and the existing securities in the SMP portfolio will be held to maturity.”

Jon Hilsenrath, writing on “Fed sets stage for stimulus,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443864204577623220212805132.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the essay presented by Chairman Bernanke at the Jackson Hole meeting of central bankers, as defending past stimulus with unconventional measures of monetary policy that could be used to reduce extremely high unemployment. Chairman Bernanke (2012JHAug31, 18-9) does support further unconventional monetary policy impulses if required by economic conditions (http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm):

“Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

Professor John H Cochrane (2012Aug31), at the University of Chicago Booth School of Business, writing on “The Federal Reserve: from central bank to central planner,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444812704577609384030304936.html?mod=WSJ_hps_sections_opinion), analyzes that the departure of central banks from open market operations into purchase of assets with risks to taxpayers and direct allocation of credit subject to political influence has caused them to abandon their political independence and accountability. Cochrane (2012Aug31) finds a return to the proposition of Milton Friedman in the 1960s that central banks can cause inflation and macroeconomic instability.

Mario Draghi (2012Aug29), President of the European Central Bank, also reiterated the need of exceptional and unconventional central bank policies (http://www.ecb.int/press/key/date/2012/html/sp120829.en.html):

“Yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole.

The ECB is not a political institution. But it is committed to its responsibilities as an institution of the European Union. As such, we never lose sight of our mission to guarantee a strong and stable currency. The banknotes that we issue bear the European flag and are a powerful symbol of European identity.”

Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. Table III-7 in IIIE Appendix Euro Zone Survival Risk below provides the combined GDP in 2012 of the highly indebted euro zone members estimated in the latest World Economic Outlook of the IMF at $4167 billion or 33.1 percent of total euro zone GDP of $12,586 billion. Using the WEO of the IMF, Table III-8 in IIIE Appendix Euro Zone Survival Risk below provides debt of the highly indebted euro zone members at $3927.8 billion in 2012 that increases to $5809.9 billion when adding Germany’s debt, corresponding to 167.0 percent of Germany’s GDP. There are additional sources of debt in bailing out banks. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html).

Second, Risk-Measuring Yields and Exchange Rate. The ten-year government bond of Spain was quoted at 6.868 percent on Aug 10, 2012, declining to 6.447 percent on Aug 17 and 6.403 percent on Aug 24, 2012, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10, 2012 to 5.709 percent on Aug 17 and 5.618 percent on Aug 24, 2012. The yield of the ten-year sovereign bond of Spain traded at 4.765 percent on Mar 18, 2013 and that of the ten-year sovereign bond of Italy at 4.614 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. In the week of Mar 15, 2013, the yield of the two-year Treasury decreased to 0.246 percent and that of the ten-year Treasury decreased to 1.992 percent while the two-year bond of Germany decreased to 0.05 percent and the ten-year decreased to 1.46 percent; and the dollar depreciated to USD 1.3763/EUR. The zero interest rates for the monetary policy rate of the US, or fed funds rate, carry trades ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield is about equal to consumer price inflation of 2.0 percent in the 12 months ending in Feb 2013 (Section II and earlier http://cmpassocregulationblog.blogspot.com/2013/02/world-inflation-waves-united-states.html) and the expectation of higher inflation if risk aversion diminishes. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.

Table III-1A, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate

	US 2Y	US 10Y	DE 2Y	DE 10Y	USD/ EUR
3/15/13	0.246	1.992	0.05	1.46	1.3076
3/8/13	0.256	2.056	0.09	1.53	1.3003
3/1/13	0.236	1.842	0.03	1.41	1.3020
2/22/13	0.252	1.967	0.13	1.57	1.3190
2/15/13	0.268	2.007	0.19	1.65	1.3362
2/8/13	0.252	1.949	0.18	1.61	1.3365
2/1/13	0.26	2.024	0.25	1.67	1.3642
1/25/13	0.278	1.947	0.26	1.64	1.3459
1/18/13	0.252	1.84	0.18	1.56	1.3321
1/11/13	0.247	1.862	0.13	1.58	1.3343
1/4/13	0.262	1.898	0.08	1.54	1.3069
12/28/12	0.252	1.699	-0.01	1.31	1.3218
12/21/12	0.272	1.77	-0.01	1.38	1.3189
12/14/12	0.232	1.704	-0.04	1.35	1.3162
12/7/12	0.256	1.625	-0.08	1.30	1.2926
11/30/12	0.248	1.612	0.01	1.39	1.2987
11/23/12	0.273	1.691	0.00	1.44	1.2975
11/16/12	0.24	1.584	-0.03	1.33	1.2743
11/9/12	0.256	1.614	-0.03	1.35	1.2711
11/2/12	0.274	1.715	0.01	1.45	1.2838
10/26/12	0.299	1.748	0.05	1.54	1.2942
10/19/12	0.296	1.766	0.11	1.59	1.3023
10/12/12	0.264	1.663	0.04	1.45	1.2953
10/5/12	0.26	1.737	0.06	1.52	1.3036
9/28/12	0.236	1.631	0.02	1.44	1.2859
9/21/12	0.26	1.753	0.04	1.60	1.2981
9/14/12	0.252	1.863	0.10	1.71	1.3130
9/7/12	0.252	1.668	0.03	1.52	1.2816
8/31/12	0.225	1.543	-0.03	1.33	1.2575
8/24/12	0.266	1.684	-0.01	1.35	1.2512
8/17/12	0.288	1.814	-0.04	1.50	1.2335
8/10/12	0.267	1.658	-0.07	1.38	1.2290
8/3/12	0.242	1.569	-0.02	1.42	1.2387
7/27/12	0.244	1.544	-0.03	1.40	1.2320
7/20/12	0.207	1.459	-0.07	1.17	1.2158
7/13/12	0.24	1.49	-0.04	1.26	1.2248
7/6/12	0.272	1.548	-0.01	1.33	1.2288
6/29/12	0.305	1.648	0.12	1.58	1.2661
6/22/12	0.309	1.676	0.14	1.58	1.2570
6/15/12	0.272	1.584	0.07	1.44	1.2640
6/8/12	0.268	1.635	0.04	1.33	1.2517
6/1/12	0.248	1.454	0.01	1.17	1.2435
5/25/12	0.291	1.738	0.05	1.37	1.2518
5/18/12	0.292	1.714	0.05	1.43	1.2780
5/11/12	0.248	1.845	0.09	1.52	1.2917
5/4/12	0.256	1.876	0.08	1.58	1.3084
4/6/12	0.31	2.058	0.14	1.74	1.3096
3/30/12	0.335	2.214	0.21	1.79	1.3340
3/2/12	0.29	1.977	0.16	1.80	1.3190
2/24/12	0.307	1.977	0.24	1.88	1.3449
1/6/12	0.256	1.957	0.17	1.85	1.2720
12/30/11	0.239	1.871	0.14	1.83	1.2944
8/26/11	0.20	2.202	0.65	2.16	1.450
8/19/11	0.192	2.066	0.65	2.11	1.4390
6/7/10	0.74	3.17	0.49	2.56	1.192
3/5/09	0.89	2.83	1.19	3.01	1.254
12/17/08	0.73	2.20	1.94	3.00	1.442
10/27/08	1.57	3.79	2.61	3.76	1.246
7/14/08	2.47	3.88	4.38	4.40	1.5914
6/26/03	1.41	3.55	NA	3.62	1.1423

Note: DE: Germany

Source:

http://www.bloomberg.com/markets/

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

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

http://www.bundesbank.de/Navigation/EN/Statistics/Time_series_databases/Macro_economic_time_series/macro_economic_time_series_node.html?anker=GELDZINS

http://www.ecb.int/stats/money/long/html/index.en.html

Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields together with the overnight fed funds rate and the yield of the corporate bond with Moody’s rating of Baa. The riskier yield of the Baa corporate bond exceeds the relatively riskless yields of the Treasury securities. The beginning yields in Chart III-1A for July 31, 2001, are 3.67 percent for one month, 3.79 percent for two years, 5.07 percent for ten years, 3.82 percent for the fed funds rate and 7.85 percent for the Baa corporate bond. On July 30, 2007, yields inverted with the one month at 4.95 percent, the two-year at 4.59 percent and the ten year at 5.82 percent with the yield of the Baa corporate bond at 6.70 percent. Another interesting point is for Oct 31, 2008, with the yield of the Baa jumping to 9.54 percent and the Treasury yields declining: one month 0.12 percent, two years 1.56 percent and ten years 4.01 percent during a flight to the dollar and government securities analyzed by Cochrane and Zingales (2009). Another spike in the series is for Apr 4, 2006 with the yield of the corporate Baa bond at 8.63 and the Treasury yields of 0.12 percent for one month, 0.94 for two years and 2.95 percent for ten years. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield 1.64 percent and the ten-year yield 3.41. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe. The final point of Chart III1-A is for Mar 14, 2013, with the one-month yield at 0.08 percent, the two-year at 0.27 percent, the ten-year at 2.04 percent, the fed funds rate at 0.15 percent and the corporate Baa bond at 4.92 percent.

Chart III-1A, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields, Overnight Fed Funds Rate and Yield of Moody’s Baa Corporate Bond, Jul 31, 2001-Mar 14, 2013

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Kate Linebaugh, writing on “Falling revenue dings stocks,” on Oct 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444592704578066933466076070.html?mod=WSJPRO_hpp_LEFTTopStories), identifies a key financial vulnerability: falling revenues across markets for United States reporting companies. Global economic slowdown is reducing corporate sales and squeezing corporate strategies. Linebaugh quotes data from Thomson Reuters that 100 companies of the S&P 500 index have reported declining revenue only 1 percent higher in Jun-Sep 2012 relative to Jun-Sep 2011 but about 60 percent of the companies are reporting lower sales than expected by analysts with expectation that revenue for the S&P 500 will be lower in Jun-Sep 2012 for the entities represented in the index. Results of US companies are likely repeated worldwide. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

Where R_τ is expected revenue in the time horizon from τ =1 to T; C_τ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that interest rates increase without bound, then V → 0, or

declines.

There was mostly strong performance in equity indexes with many indexes gaining in Table III-1 in the week ending on Mar 15, 2013. Stagnating revenues are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. DJIA decreased 0.2 percent on Mar 15, increasing 0.8 percent in the week, repeatedly breaking historical highs. Germany’s Dax increased 0.6 percent on Fri Mar 8 and increased 3.6 percent in the week. Dow Global decreased 0.2 percent on Mar 15 and increased 0.7 percent in the week. Japan’s Nikkei Average increased 1.5 percent on Fri Mar 15 and increased 2.3 percent in the week as the yen continues to be oscillating but relatively weaker and the stock market gains in expectations of fiscal stimulus by a new administration and monetary stimulus by a new board of the Bank of Japan. Dow Asia Pacific TSM increased 1.1 percent on Mar 15 and increased 1.0 percent in the week while Shanghai Composite that decreased 0.2 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2278.40 on Fri Mar 15 for gain of 0.4 percent but loss of 1.7 percent in the week of Mar 15. There is evident trend of deceleration of the world economy that could affect corporate revenue and equity valuations, causing oscillation in equity markets with increases during favorable risk appetite.

Commodities were mostly stronger in the week of Mar 8, 2013. The DJ UBS Commodities Index increased 0.1 percent on Fri Mar 15 and increased 0.8 percent in the week, as shown in Table III-1. WTI increased 1.9 percent in the week of Mar 8 while Brent decreased 0.7 percent in the week. Gold increased 0.1 percent on Fri Mar 15 and increased 0.8 percent in the week.

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €931,808 million on Mar 8, 2013 with some repayment of loans already occurring. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,539,735 million in the statement of Mar 8, 2013, with marginal reduction. There is high credit risk in these transactions with capital of only €88,121 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Mar 8, 2013
1 Gold and other Receivables	367,402	419,822	438,691
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	252,554
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	30,027
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	22,297
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	931,808
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	73,427
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	607,927
8 General Government Debt Denominated in Euro	34,954	33,928	29,912
9 Other Assets	278,719	336,574	279,305
TOTAL ASSETS	2,004, 432	2,733,235	2,665,947
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,539,735
Capital and Reserves	78,143	85,748	88,121

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/2013/html/fs130312.en.html

IIIE Appendix Euro Zone survival risk. 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), or euro area, are only 42.6 percent of the total. Exports to the non-European Union area with share of 44.0 percent in Italy’s total exports are growing at 9.2 percent in Jan-Dec 2012 relative to Jan-Dec 2011 while those to EMU are falling at 1.5 percent.

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

Dec 2012	Exports % Share	∆% Jan-Dec 2012/ Jan-Dec 2011	Imports % Share	Imports ∆% Jan-Dec 2012/ Jan-Dec 2011
EU	56.0	-0.7	53.7	-7.2
EMU 17	42.6	-1.5	43.4	-7.1
France	11.6	-1.0	8.4	-6.8
Germany	13.1	-1.1	15.5	-11.5
Spain	5.3	-8.1	4.5	-7.0
UK	4.7	8.0	2.7	-12.8
Non EU	44.0	9.2	46.3	-3.9
Europe non EU	13.3	8.4	10.8	-1.0
USA	6.1	16.8	3.2	-2.8
China	2.7	-9.9	7.4	-16.5
OPEC	4.7	24.6	8.5	19.7
Total	100.0	3.7	100.0	-5.7

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/82327

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €1722 million with the 17 countries of the euro zone (EMU 17) in Dec 2012 and deficit of €3915 million in Jan-Dec 2012. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €11,495 million in Jan-Dec 2012 with Europe non European Union and of €13,990 million with the US and with non European Union of €2066 million in Jan-Dec 2012. There is significant rigidity in the trade deficits in Jan-Dec of €15,692 million with China and €19,003 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 Dec 2012 Millions of Euro	Trade Balance Cumulative Jan-Dec 2012 Millions of Euro
EU	-1,155	8,956
EMU 17	-1,722	-3,915
France	582	11,845
Germany	-1,029	-6,501
Spain	-71	1,443
UK	562	9,404
Non EU	3,317	2,066
Europe non EU	908	11,495
USA	1,275	13,990
China	-687	-15,692
OPEC	-795	-19,003
Total	2,162	11,022

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/82327

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Dec 2012 relative to Jan-Dec 2011. Growth rates in 12 months of imports are negative with the exception of 7.1 percent for energy. The higher rate of growth of exports of 3.7 percent in Jan-Dec 2012/Jan-Dec 2011 relative to imports of minus 5.7 percent may reflect weak demand in Italy with GDP declining during six consecutive quarters from IIIQ2011 through IVQ2012.

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

	Exports Share %	Exports ∆% Jan-Dec 2012/ Jan-Dec 2011	Imports Share %	Imports ∆% Jan-Dec 2012/ Jan-Dec 2011
Consumer Goods	28.9	5.1	25.0	-3.3
Durable	5.9	2.6	3.0	-7.1
Non Durable	23.0	5.8	22.0	-2.7
Capital Goods	32.3	1.5	21.1	-12.9
Inter- mediate Goods	34.2	1.9	34.3	-10.3
Energy	4.7	21.9	19.6	7.1
Total ex Energy	95.3	2.8	80.4	-8.8
Total	100.0	3.7	100.0	-5.7

Note: % Share for Jan-Nov 2012.

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/82327

Table III-6 provides Italy’s trade balance by product categories in Dec 2012 and cumulative Jan-Dec 2012. Italy’s trade balance excluding energy generated surplus of €6814 million in Dec 2012 and €74,016 million in Jan-Dec 2012 but the energy trade balance created deficit of €4653 million in Dec 2012 and €62,994 million in Jan-Dec 2012. The overall surplus in Dec 2012 was €2162 million with surplus of €11,022 million in Jan-Dec 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

	Dec 2012	Cumulative Jan-Dec 2012
Consumer Goods	1,694	17,197
Durable	1,038	11,623
Nondurable	656	5,574
Capital Goods	4,454	49,327
Intermediate Goods	665	7,492
Energy	-4,653	-62,994
Total ex Energy	6,814	74,016
Total	2,162	11,022

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/82327

Brazil faced in the debt crisis of 1982 a more complex policy mix. Between 1977 and 1983, Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.

The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the Subsection IIIF Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30 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/datamapper/index.php?db=WEO) 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	71,277
Euro Zone	12,065	-0.5	73.4
Portugal	211	-0.7	110.9
Ireland	205	-4.4	103.0
Greece	255	-1.7	170.7
Spain	1,340	-4.5	78.6
Major Advanced Economies G7	33,769	-5.1	89.0
United States	15,653	-6.5	83.8
UK	2,434	-5.6	83.7
Germany	3,367	1.4	58.4
France	2,580	-2.2	83.7
Japan	5,984	-9.1	135.4
Canada	1,770	-3.2	35.8
Italy	1,980	2.6	103.1
China	8,250	-1.3*	22.2**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook databank http://www.imf.org/external/datamapper/index.php?db=WEO

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 $4155.8 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 $3975.1 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 $8130.8 billion, which would be equivalent to 136.7 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 241.5 percent if including debt of France and 177.4 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	8,855.7
B Germany	1,996.3		$8130.9 as % of $3367 =241.5% $5971.4 as % of $3367 =177.4%
C France	2,159.5
B+C	4,155.8	GDP $5,947.0 Total Debt $8130.9 Debt/GDP: 136.7%
D Italy	2,041.4
E Spain	1,053.2
F Portugal	234.0
G Greece	435.3
H Ireland	211.2
Subtotal D+E+F+G+H	3,975.1

Source: calculation with IMF data http://www.imf.org/external/datamapper/index.php?db=WEO

There is extremely important information in Table III-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 Jan 2013. German exports to other European Union (EU) members are 58.7 percent of total exports in Jan 2013 and 58.7 percent in cumulative Jan 2013. Exports to the euro area are 38.7 percent in Jan and 38.7 percent cumulative in Jan. Exports to third countries are 41.3 percent of the total in Jan and 41.3 percent cumulative in Jan. There is similar distribution for imports. Exports to non-euro countries are increasing 5.5 percent in Jan 2013 and increasing 5.5 percent cumulative in Jan 2013 while exports to the euro area are increasing 0.4 percent in Jan and increasing 0.4 percent cumulative in Jan 2013. Exports to third countries, accounting for 44.3 percent of the total in Jan 2013, are increasing 4.5 percent in Jan and increasing 4.5 percent cumulative in Jan, accounting for 41.3 percent of the cumulative total in Jan 2013. 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 high share in its exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.

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

	Jan 2013 € Billions	Jan 12-Month ∆%	Cumulative Jan 2012 € Billions	Cumulative Jan 2013/ Jan 2012 ∆%
Total Exports	88.6	3.1	88.6	3.1
A. EU Members	52.0 % 58.7	2.1	52.0 % 58.7	2.1
Euro Area	34.3 % 38.7	0.4	34.3 % 38.7	0.4
Non-euro Area	17.7 % 20.0	5.5	17.7 % 20.0	5.5
B. Third Countries	36.6 % 41.3	4.5	36.6 % 41.3	4.5
Total Imports	74.9	2.9	74.9	2.9
C. EU Members	46.9 % 62.6	4.6	46.9 % 62.6	4.6
Euro Area	32.3 % 43.1	2.8	32.3 % 43.1	2.8
Non-euro Area	14.6 % 19.5	8.7	14.6 % 19.5	8.7
D. Third Countries	28.0 % 37.4	0.2	28.0 % 37.4	0.2

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

Source:

Statistisches Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2013/03/PE13_094_51.html

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

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

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

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

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

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

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

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

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

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

(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.

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	1.6	2.0	1.7	7.7
Japan	0.5	-0.3	-0.1	4.2
China	7.9	3.2	-1.6
UK	0.3	2.7* RPI 3.3	2.0* output 1.4** input 1.8*	7.8
Euro Zone	-0.9	1.8	1.9	11.9
Germany	0.4	1.8	1.7	5.3
France	-0.3	1.2	1.4	10.6
Nether-lands	-0.9	3.2	1.2	6.0
Finland	-1.4	2.5	2.2	7.9
Belgium	-0.4	1.3	5.4	7.4
Portugal	-3.8	0.2	1.9	17.6
Ireland	0.8	1.2	1.0	14.7
Italy	-2.7	2.0	2.0	11.7
Greece	-6.0	0.1	-0.1	NA
Spain	-1.9	2.9	2.6	26.2

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/january-2013/index.html **Core

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/january-2013/index.html

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/; country statistical sources http://www.census.gov/aboutus/stat_int.html

Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.6 percent in IVQ2012 relative to IVQ2011 (Table 8 in http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp4q12_2nd.pdf See I Mediocre and Decelerating United States Economic Growth at http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html). Japan’s GDP grew 0.3 percent in IVQ2011 relative to IVQ2010 and contracted 1.6 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 10.6 percent in IIIQ2011, increasing at the SAAR of 0.4 percent in IVQ 2011, increasing at the SAAR of 6.1 percent in IQ2012 and decreasing at 0.9 percent in IIQ2012 but contracting at the SAAR of 3.7 percent in IIIQ2012 and increasing at the SAAR of 0.2 percent in IVQ2012 (see Section VB http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.htm and earlier at

http://cmpassocregulationblog.blogspot.com/2013/02/recovery-without-hiring-united-states.html); the UK grew at minus 0.3 percent in IVQ2012 relative to IIIQ2012 and GDP increased 0.3 percent in IVQ2012 relative to IVQ2011 (see Section VH at http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/01/united-states-commercial-banks-assets_27.html); and the Euro Zone grew at minus 0.6 percent in IVQ2012 and minus 0.9 percent in IVQ2012 relative to IVQ2011 (see Section VD http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.htm and earlier at

http://cmpassocregulationblog.blogspot.com/2013/02/recovery-without-hiring-united-states.html ). These are stagnating or “growth recession” rates, which are positive or about nil growth rates with some contractions that are insufficient to recover employment. The rates of unemployment are quite high: 7.7 percent in the US but 19.0 percent for unemployment/underemployment or job stress of 30.8 million (see Table I-4 http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.htm and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html), 4.2 percent for Japan (see Section VB at http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html), 7.8 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in Subsection VH at http://cmpassocregulationblog.blogspot.com/2013/02/world-inflation-waves-united-states.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/01/united-states-commercial-banks-assets.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.7 percent in the US, -0.3 percent for Japan, 3.2 percent for China, 1,8 percent for the Euro Zone and 2.7 percent for the UK. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. 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 http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.htm); (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 (http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html), weak hiring with the loss of 10 million full-time jobs (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/02/recovery-without-hiring-united-states.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.htm and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html http://cmpassocregulationblog.blogspot.com/2012/08/expanding-bank-cash-and-deposits-with.html http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 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.

Charles Evans, President of the Federal Reserve Bank of Chicago, proposed an “economic state-contingent policy” or “7/3” approach (Evans 2012 Aug 27):

Evans (2012Nov27) modified the “7/3” approach to a “6.5/2.5” approach:

The Federal Open Market Committee (FOMC) decided at its meeting on Dec 12, 2012 to implement the “6.5/2.5” approach (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm):

Another rising risk is division within the Federal Open Market Committee (FOMC) on risks and benefits of current policies as expressed in the minutes of the meeting held on Jan 29-30, 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130130.pdf 13):

Jon Hilsenrath and Victoria McGrane, writing on “Fed slip over how long to keep cash spigot open,” published on Feb 20, 2013 in the Wall street Journal (http://professional.wsj.com/article/SB10001424127887323511804578298121033876536.html), analyze the minutes of the Fed, comments by members of the FOMC and data showing increase in holdings of riskier debt by investors, record issuance of junk bonds, mortgage securities and corporate loans. Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.

Unconventional monetary policy will remain in perpetuity, or QE→∞, changing to a “growth mandate.” There are two reasons explaining unconventional monetary policy of QE→∞: insufficiency of job creation to reduce unemployment/underemployment at current rates of job creation; and growth of GDP at 1.5 percent, which is well below 3.0 percent estimated by Lucas (2011May) from 1870 to 2010. Unconventional monetary policy interprets the dual mandate of low inflation and maximum employment as mainly a “growth mandate” of forcing economic growth in the US at a rate that generates full employment. A hurdle to this “growth mandate” is that the US economy grew at 6.2 percent on average during cyclical expansions in the postwar period while growth has been at only 2.1 percent on average in the cyclical expansion in the 14 quarters from IIIQ2009 to IVQ2012. Zero interest rates and quantitative easing have not provided the impulse for growth and were not required in past successful cyclical expansions.

Second, calculations show that actual growth is around 1.6 to 2.0 percent per year. This rate is well below 3 percent per year in trend from 1870 to 2010, which has been always recovered after events such as wars and recessions (Lucas 2011May). Growth is not only mediocre but sharply decelerating to a rhythm that is not consistent with reduction of unemployment and underemployment of 30.8 million people corresponding to 19.0 percent of the effective labor force of the United States (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html). In the four quarters of 2011 and the four quarters of 2012, US real GDP grew at the seasonally-adjusted annual equivalent rates of 0.1 percent in the first quarter of 2011 (IQ2011), 2.5 percent in IIQ2011, 1.3 percent in IIIQ2011, 4.1 percent in IVQ2011, 2.0 percent in IQ2012, 1.3 percent in IIQ2012, 3.1 percent in IIIQ2012 and revised 0.1 percent in IVQ2012. GDP growth in IIIQ2012 was revised from 2.7 percent seasonally adjusted annual rate (SAAR) to 3.1 percent but mostly because of contribution of 0.73 percentage points of inventory accumulation and one-time contribution of 0.64 percentage points of expenditures in national defense that without them would have reduced growth from 3.1 percent to 1.73 percent. Equally, GDP growth in IVQ2012 is measured in the advanced estimate as 0.1 percent but mostly because of deduction of divestment of inventories of 1.55 percentage points and deduction of one-time national defense expenditures of 1.28 percentage points. The annual equivalent rate of growth of GDP for the four quarters of 2011 and the four quarters of 2012 is 2.0 percent, obtained as follows. Discounting 0.1 percent to one quarter is 0.025 percent {[(1.001)^1/4 -1]100 = 0.025}; discounting 2.5 percent to one quarter is 0.62 percent {[(1.025)^1/4 – 1]100}; discounting 1.3 percent to one quarter is 0.32 percent {[(1.013)^1/4 – 1]100}; discounting 4.1 percent to one quarter is 1.0 {[(1.04)^1/4 -1]100; discounting 2.0 percent to one quarter is 0.50 percent {[(1.020)^1/4 -1]100); discounting 1.3 percent to one quarter is 0.32 percent {[(1.013)^1/4 -1]100}; discounting 3.1 percent to one quarter is 0.77 {[(1.031)^1/4 -1]100); and discounting 0.1 percent to one quarter is 0.025 percent {[(1.001)^1/4 – 1]100}. Real GDP growth in the four quarters of 2011 and the four quarters of 2012 accumulated to 3.6 percent {[(1.00025 x 1.0062 x 1.0032 x 1.010 x 1.005 x 1.0032 x 1.0077 x 1.00025) - 1]100 = 3.6%}. This is equivalent to growth from IQ2011 to IVQ2012 obtained by dividing the seasonally-adjusted annual rate (SAAR) of IVQ2012 of $13,656.8 billion by the SAAR of IVQ2010 of $13,181.2 (http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1) and expressing as percentage {[($13,658.8/$13,181.2) - 1]100 = 3.6%}. The growth rate in annual equivalent for the four quarters of 2011 and the four quarters of 2012 is 1.8 percent {[(1.00025 x 1.0062 x 1.0032 x 1.010 x 1.005 x 1.0032 x 1.0077 x 1.00025)^4/8 -1]100 = 1.8%], or {[($13,656.8/$13,181.2)]^4/8-1]100 = 1.8%} dividing the SAAR of IVQ2012 by the SAAR of IVQ2010 in Table II-6 below, obtaining the average for eight quarters and the annual average for one year of four quarters. Growth in the four quarters of 2012 accumulates to 1.6 percent {[(1.02)^1/4(1.013)^1/4(1.031)^1/4(1.001)^1/4 -1]100 = 1.6%}. This is equivalent to dividing the SAAR of $13,656.8 billion for IVQ2012 by the SAAR of $13,441.0 billion in IVQ2011 to obtain 1.6 percent {[($13,656.8/$13,441.0) – 1]100 = 1.6%}. The US economy is still close to a standstill especially considering the GDP report in detail. Excluding growth at the SAAR of 2.5 percent in IIQ2011 and 4.1 percent in IVQ2011 while converting growth in IIIQ2012 to 1.73 percent by deducting from 3.1 percent one-time inventory accumulation of 0.73 percentage points and national defense expenditures of 0.64 percentage points and converting growth in IVQ2012 by adding 1.55 percentage points of inventory divestment and 1.28 percentage points of national defense expenditure reductions to obtain 2.84 percent, the US economy grew at 1.5 percent in the remaining six quarters {[(1.00025x1.0032x1.005x1.0032x1.0043x1.0070)^4/6 – 1]100 = 1.5%} with declining growth trend in three consecutive quarters from 4.1 percent in IVQ2011, to 2.0 percent in IQ2012, 1.3 percent in IIQ2012, 3.1 percent in IIIQ2012 that is more like 1.73 percent without inventory accumulation and national defense expenditures and 0.1 percent in IVQ2012 that is more likely 2.84 percent by adding 1.55 percentage points of inventory divestment and 1.28 percentage points of national defense expenditures. Weakness of growth is more clearly shown by adjusting the exceptional one-time contributions to growth from items that are not aggregate demand: 2.53 percentage points contributed by inventory change to growth of 4.1 percent in IVQ2011; 0.64 percentage points contributed by expenditures in national defense together with 0.73 points of inventory accumulation to growth of 3.1 percent in IIIQ2012; and deduction of 1.55 percentage points of inventory divestment and 1.28 percentage points of national defense expenditure reductions. The Bureau of Economic Analysis (BEA) of the US Department of Commerce released on Thus Feb 28, 2012, the second estimate of GDP for IVQ2012 at 0.1 percent seasonally-adjusted annual rate (SAAR) (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp4q12_2nd.pdf). In the four quarters of 2012, the US economy is growing at the annual equivalent rate of 2.0 percent {([(1.02^1/4(1.013)^1/4(1.0173)^1/4(1.0284)^1/4]-1)100 = 2.0%} by excluding inventory accumulation of 0.73 percentage points and exceptional defense expenditures of 0.64 percentage points from growth 3.1 percent at SAAR in IIIQ2012 to obtain adjusted 1.73 percent SSAR and adding 1.28 percentage points of national defense expenditure reductions and 1.55 percentage points of inventory divestment to growth of 0.1 percent SAAR in IVQ2012 to obtain 2.84 percent.

The statement of the FOMC at the conclusion of its meeting on Dec 12, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm) practically unchanged in the statement at the conclusion of its meeting on Jan 30, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130130a.htm):

“Release Date: December 12, 2012

For immediate release

Information received since the Federal Open Market Committee met in October suggests that economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions. Although the unemployment rate has declined somewhat since the summer, it remains elevated. Household spending has continued to advance, and the housing sector has shown further signs of improvement, but growth in business fixed investment has slowed. Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.

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 will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and, in January, will resume rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

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. Open-ended Quantitative Easing or QE_∞. Earlier programs are continued with an additional open-ended $85 billion of bond purchases per month: “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 will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month.”

3. Advance Guidance on “6 ¼ 2 ½ “Rule. Policy will be accommodative even after the economy recovers satisfactorily: “o support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

4. Monitoring and Policy Focus on Jobs. The FOMC reconsiders its policy continuously in accordance with available information: “The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). Symmetric targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even with the economy growing at or close to potential output that is actually a target of growth forecast. The impact on the overall economy and the financial system of errors of policy are magnified by large-scale policy doses of trillions of dollars of quantitative easing and zero interest rates. The US economy has been experiencing financial repression as a result of negative real rates of interest during nearly a decade and programmed in monetary policy statements until 2015 or, for practical purposes, forever. The essential calculus of risk/return in capital budgeting and financial allocations has been distorted. If economic perspectives are doomed until 2015 such as to warrant zero interest rates and open-ended bond-buying by “printing” digital bank reserves (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html; see Shultz et al 2012), rational investors and consumers will not invest and consume until just before interest rates are likely to increase. Monetary policy statements on intentions of zero interest rates for another three years or now virtually forever discourage investment and consumption or aggregate demand that can increase economic growth and generate more hiring and opportunities to increase wages and salaries. The doom scenario used to justify monetary policy accentuates adverse expectations on discounted future cash flows of potential economic projects that can revive the economy and create jobs. If it were possible to project the future with the central tendency of the monetary policy scenario and monetary policy tools do exist to reverse this adversity, why the tools have not worked before and even prevented the financial crisis? If there is such thing as “monetary policy science”, why it has such poor record and current inability to reverse production and employment adversity? There is no excuse of arguing that additional fiscal measures are needed because they were deployed simultaneously with similar ineffectiveness.

Table IV-2 provides economic projections of governors of the Board of Governors of the Federal Reserve and regional presidents of Federal Reserve Banks released at the meeting of Dec 12, 2012. The Fed releases the data with careful explanations (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IVQ2012 is analyzed in Section I (http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html) and the PCE inflation data from the report on personal income and outlays in Section IV (http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html and earlier at (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html). The Bureau of Economic Analysis (BEA) provides the second estimate of IVQ2012 GDP and annual for 2012 with the third estimate be released on Mar 28 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm See Section I http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed in Section IV http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html and the report for Nov 2012 at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states.html. The next report on “Personal Income and Outlays” for Feb will be released at 8:30 AM on Mar 29, 2013 (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm). PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog. The report for Jan 2013 was released on Feb 1, 2013 and analyzed in this blog (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html). The report for Feb 2013 was released on Mar 8, 2013 (http://www.bls.gov/ces/) and analyzed in this blog on Mar 10, 2013 (http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.htm). The report for Mar 2013 will be released on Apr 5, 2013 (http://www.bls.gov/ces/) and analyzed in this blog in the comment on Apr 7. “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/fomcprojtabl20121212.pdf).

It is instructive to focus on 2012 and 2013 as 2014, 2015 and longer term are too far away, and there is not much information even 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 Dec 12, 2012 and the second row “PR” the projection of the Sep 13, 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 and further to 1.7 to 2.0 percent at the Sep 13, 2012 meeting and 1.7 to 1.8 percent at the Dec 12, 2012 meeting. GDP growth in 2013 has been increased to 2.5 to 3.0 percent at the meeting on Sep 13

2012 from 2.2 to 2.8 percent at the meeting on Jun 20, 2012 but reduced to 2.3 to 3.0 percent at the Dec 12, 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 and did not change it at 8.0 to 8.2 at the meeting on Sep 13, 2012, lowering the projection to 7.8 to 7.9 percent at the Dec 12, 2012 meeting. The rate of unemployment for 2013 has been changed to 7.6 to 7.9 percent at the Sep 13 meeting compared with 7.5 to 8.0 percent at the Jun 20 meeting and reduced to 7.4 to 7.7 percent at the Dec 12 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. The interval was increased to 1.7 to 1.8 percent at the Sep 13, 2012 meeting and 1.6 to 1.7 percent at the Dec 12, 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. The projection was virtually unchanged at 1.7 to 1.9 percent at the Sep 13 meeting. For 2013, the projection for core inflation was changed from 1.6 to 2.0 percent at the Jun 20, 2012 meeting to 1.7 to 2.0 percent at the Sep 13, 2012 meeting and lowered to 1.7 to 1.9 percent at the Dec 12, 2012 meeting.

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

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2012 Sep PR	1.7 to 1.8 1.7 to 2.0	7.8 to 7.9 8.0 to 8.2	1.6 to 1.7 1.7. to 1.8	1.6 to 1.7 1.7 to 1.9
2013 Sep PR	2.3 to 3.0 2.5 to 3.0	7.4 to 7.7 7.6 to 7.9	1.3 to 2.0 1.6 to 2.0	1.6 to 1.9 1.7 to 2.0
2014 Sep PR	3.0 to 3.5 3.0 to 3.8	6.8 to 7.3 6.7 to 7.3	1.5 to 2.0 1.6 to 2.0	1.6 to 2.0 1.8 to 2.0
2015 Sep	3.0 to 3.7 3.0 to 3.8	6.0 to 6.6 6.0 to 6.8	1.7 to 2.0 1.8 to 2.0	1.8 to 2.0 1.9 to 2.0
Longer Run Sep PR	2.3 to 2.5 2.3 to 2.5	5.2 to 6.0 5.2 to 6.0	2.0 2.0
Range
2012 Sep PR	1.6 to 2.0 1.6 to 2.0	7.7 to 8.0 8.0 to 8.3	1.6 to 1.8 1.5 to 1.9	1.6 to 1.8 1.6 to 2.0
2013 Sep PR	2.0 to 3.2 2.3 to 3.5	6.9 to 7.8 7.0 to 8.0	1.3 to 2.0 1.5 to 2.1	1.5 to 2.0 1.6 to 2.0
2014 Sep PR	2.8 to 4.0 2.7 to 4.1	6.1 to 7.4 6.3 to 7.5	1.4 to 2.2 1.6 to 2.2	1.5 to 2.0 1.6 to 2.2
2015 Sep PR	2.5 to 4.2 2.5 to 4.2	5.7 to 6.8 5.7 to 6.9	1.5 to 2.2 1.8 to 2.3	1.7 to 2.2 1.8 to 2.3
Longer Run Sep PR	2.2 to 3.0 2.2 to 3.0	5.0 to 6.0 5.0 to 6.3	2.0 2.0

Notes: UEM: unemployment; PR: Projection

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf

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

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

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

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

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

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

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

The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html See Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 99-116). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.

The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table IV-3 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 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/fomcprojtabl20121212.pdf). There are 19 participants expecting the rate to remain at 0 to ¼ percent in 2012 and none to be higher. Not much change is expected in 2013 either with 17 participants anticipating the rate at the current target of 0 to ¼ percent and only two expecting higher rates. The rate would still remain at 0 to ¼ percent in 2014 for 14 participants with three expecting the rate to be in the range of 1.0 to 2.0 percent, one participant expecting rates at 0.5 to 1.0 percent and one participant expecting rates from 2.0 to 3.0. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014. For 2015, nine participants expect rates to be below 1.0 percent while nine expect rates from 1.0 to 4.5 percent. In the long-run, all 19 participants expect rates to be between 3.0 and 4.5 percent.

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

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.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 of 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	1
2013	2
2014	3
2015	13
2016	1

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf

Inflation in advanced economies has been fluctuating in waves at the production level with alternating 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 increased 0.4 percent in Feb 2013 as in many European countries and the US and fell 0.1 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-Aug 2011 and declined to minus 0.1 percent in Feb 2013. Calendar-year inflation for 2012 is minus 0.9 percent and 1.5 percent for 2011, 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 II and earlier http://cmpassocregulationblog.blogspot.com/2013/02/world-inflation-waves-united-states.html). In the first wave, annual equivalent inflation reached 5.9 percent in Jan-Apr 2011, 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 2011. In the third wave, renewed risk aversion caused annual equivalent decline of the CGPI of minus 2.2 percent in Jul-Nov 2011. 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 2.4 percent in Feb-Apr 2012. In the sixth wave, annual equivalent inflation dropped to minus 5.8 percent in May-Jul 2012. In the seventh wave, annual equivalent inflation jumped to 2.4 percent in Aug-Sep 2012. In the eighth wave, annual equivalent inflation was minus 1.8 percent in Oct-Nov 2012 in a new round of risk aversion. In the ninth wave, annual equivalent inflation returned at 3.7 percent in Dec 2012-Feb 2013. 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
Feb 2013	0.4	-0.1
Jan	0.2	-0.3
Dec 2012	0.3	-0.6
AE ∆% Dec-Feb	3.7
Nov	0.0	-0.9
Oct	-0.3	-1.0
AE ∆% Oct-Nov	-1.8
Sep	0.2	-1.5
Aug	0.2	-1.9
AE ∆% Aug-Sep	2.4
Jul	-0.4	-2.2
Jun	-0.7	-1.5
May	-0.4	-0.8
AE ∆% May-Jul	-5.8
Apr	-0.1	-0.6
Mar	0.5	0.3
Feb	0.2	0.4
AE ∆% Feb-Apr	2.4
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
2012		-0.9
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/index_en.html http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1302.pdf

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 from 1970 to 2013. 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). Behavior of the CGPI of Japan in the 1970s mirrors the Great Inflation episode in the United States with waves of inflation rising to two digits. 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 and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.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 mostly 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, 1970-2013

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

Source: Bank of Japan

There is similar behavior of year-on-year percentage changes of the US producer price index from 1970 to 2013 in Chart IV-2 of the US Bureau of Labor Statistics as in Chart IV-1 with the domestic goods CGPI. The behavior of the CGPI of Japan in the 1970s is quite similar to that of the US PPI. 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, 1970-2013

Source: US Bureau of Labor Statistics

Finer detail is provided by Chart IV-3 of the domestic CGPI from 2008 to 2013. 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, 2008-2013

Source: Bank of Japan

There is similar behavior of the US producer price index from 2008 to 2013 in Chart IV-4 as in the domestic CGPI in Chart IV-3. 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 followed by increasing slope during periods of risk appetite. 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, 2008-2013

Source: US Bureau of Labor Statistics

There was milder increase in Japan’s export corporate goods price index during the global recession in 2008 but similar sharp decline during the bank balance sheets effect in late 2008, as shown in Chart IV-5 of the Bank of Japan. Japan exports industrial goods whose prices have been less dynamic than those of commodities and raw materials. As a result, the export CGPI on the yen basis in Chart IV-5 trends down with oscillations after a brief rise in the final part of the recession in 2009. The export corporate goods price index fell from 104.8 in Jun 2009 to 94 in Feb 2012 or minus 10.3 percent and increased to 105.9 in Feb 2013 for a gain of 12.7 percent relative to Feb 2012 and 1.0 percent relative to Jun 2009. The choice of Jun 2009 is designed to capture the reversal of risk aversion beginning in Sep 2008 with the announcement of toxic assets in banks that would be withdrawn with the Troubled Asset Relief Program (TARP) (Cochrane and Zingales 2009). Reversal of risk aversion in the form of flight to the USD and obligations of the US government opened the way to renewed carry trades from zero interest rates to exposures in risk financial assets such as commodities. Japan exports industrial products and imports commodities and raw materials.

Chart IV-5, Japan, Export Corporate Goods Price Index, Monthly, Yen Basis, 2008-2013

Source: Bank of Japan

Chart IV-5A provides the export corporate goods price index on the basis of the contract currency. The export corporate goods price index on the basis of the contract currency increased from 97.9 in Jun 2009 to 102.3 in Feb 2012 or 4.5 percent but dropped to 101.5 in Feb 2013 or minus 0.8 percent relative to Feb 2012 and gained 3.7 percent relative to Jun 2009.

Chart IV-5A, Japan, Export Corporate Goods Price Index, Monthly, Contract Currency Basis, 2008-2013

Source: Bank of Japan

Japan imports primary commodities and raw materials. As a result, the import corporate goods price index on the yen basis in Chart IV-6 shows an upward trend after 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. The import corporate goods price index on the yen basis increased from 93.5 in Jun 2009 to 106.4 in Feb 2012 or 13.8 percent and to 120.4 in Feb 2013 or gain of 13.2 percent relative to Feb 2012 and 28.8 percent relative to Jun 2009. Recent depreciation of the yen relative to the dollar explains the increase in imports in domestic yen prices.

Chart IV-6, Japan, Import Corporate Goods Price Index, Monthly, Yen Basis, 2008-2013

Source: Bank of Japan

Chart IV-6A provides the import corporate goods price index on the contract currency basis. The import corporate goods price index on the basis of the contract currency increased from 86.2 in Jun 2009 to 115.8 in Feb 2012 or 34.3 percent and to 114.9 in Feb 2013 or minus 0.8 percent relative to Feb 2012 and gain of 33.3 percent relative to Jun 2009. There is evident deterioration of the terms of trade of Japan: the export corporate goods price index on the basis of the contract currency increased 3.7 percent from Jun 2009 to Feb 2012 while the import corporate goods price index increased 33.3 percent. Prices of Japan’s exports of corporate goods, mostly industrial products, increased only 3.7 percent from Jun 2009 to Feb 2012, while imports of corporate goods, mostly commodities and raw materials increased 33.3 percent. Unconventional monetary policy induces carry trades from zero interest rates to exposures in commodities that squeeze economic activity of industrial countries by increases in prices of imported commodities and raw materials during periods without risk aversion. Reversals of carry trades during periods of risk aversion decrease prices of exported commodities and raw materials that squeeze economic activity in economies exporting commodities and raw materials. Devaluation of the dollar by unconventional monetary policy could increase US competitiveness in world markets but economic activity is squeezed by increases in prices of imported commodities and raw materials. Unconventional monetary policy causes instability worldwide instead of the mission of central banks of promoting financial and economic stability.

Chart IV-6A, Japan, Import Corporate Goods Price Index, Monthly, Contract Currency Basis, 2008-2013

Source: Bank of Japan

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; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). 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, 1970-2013

Source: Bank of Japan

The producer price index of the US from 1970 to 2012 in Chart IV-8 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

Chart IV-8, US, Producer Price Index Finished Goods, Monthly, 1970-2013

Source: US Bureau of Labor Statistics