CMP Associates Regulation Blog: Recovery without Hiring, Seven Million Fewer Full-time Jobs while Population Increased Thirteen Million, Record Youth and Middle Age Unemployment, Destruction of Household Wealth for Inflation Adjusted Loss, Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Debt, Peaking Valuations of Risk Financial Assets, World Economic Slowdown and Global Recession Risk: Part II

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Recovery without Hiring, Seven Million Fewer Full-time Jobs while Population Increased Thirteen Million, Record Youth and Middle Age Unemployment, Destruction of Household Wealth for Inflation Adjusted Loss, Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Debt, Peaking Valuations of Risk Financial Assets, World Economic Slowdown and Global Recession Risk

Carlos M. Pelaez

Executive Summary

I Recovery without Hiring

IA1 Hiring Collapse

IA2 Labor Underutilization

IA3 Ten Million Fewer Full-time Job

IA4 Youth and Middle-Aged Unemployment

IIA Destruction of Household Wealth for Inflation Adjusted Loss

IIB Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

IIB Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities. The current account of the US balance of payments is provided in Table IIB-1 for IQ2012 and IQ2013. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US decreased from $100.4 billion in IQ2012, or 3.1 percent of GDP, to $83.2 billion in IQ2013, or 2.7 percent of GDP. The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession but is combined now with much higher imbalance in the Treasury budget (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71).

Table IIB-1, US, Balance of Payments, Millions of Dollars NSA

	IQ2012	IQ2013	Difference
Goods Balance	-174,091	-157,503	16,588
X Goods	385,589	385,955	0.1 ∆%
M Goods	-559,679	-543,459	-2.9 ∆%
Services Balance	51,893	56,222	4,329
X Services	157,061	164,383	4.7 ∆%
M Services	-105,169	-108,161	2.8 ∆%
Balance Goods and Services	-122,198	-101,281	20,917
Balance Income	55,315	53,030	-2,285
Unilateral Transfers	-33,546	-34,968	-1,422
Current Account Balance	-100,429	-83,219	17,210
% GDP	IQ2012	IQ2013	IVQ2012
	3.1	2.7	2.6

X: exports; M: imports

Balance on Current Account = Balance on Goods and Services + Balance on Income + Unilateral Transfers

Source: Bureau of Economic Analysis http://www.bea.gov/international/index.htm#bop http://www.bea.gov/iTable/index_nipa.cfm

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

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

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

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

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

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

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

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

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

Table IIB-2 provides data on the US fiscal and balance of payments imbalances. In 2007, the federal deficit of the US was $161 billion corresponding to 1.2 percent of GDP while the Congressional Budget Office (CBO 2012NovCDR) estimates the federal deficit in 2012 at $1089 billion or 7.0 percent of GDP (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). The combined record federal deficits of the US from 2009 to 2012 are $5092 billion or 33 percent of the estimate of GDP of $15,549 billion for fiscal year 2012 by the CBO (http://www.cbo.gov/publication/43905 CBO (2013BEOFeb5)). The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5.090 trillion in four years, using the fiscal year deficit of $1087 billion for fiscal year 2012, which is the worst fiscal performance since World War II. Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5.090 billion. Federal debt in 2011 was 67.8 percent of GDP and is estimated to reach 72.6 percent of GDP in 2012 (CBO2012AugBEO, CBO2012NovCDR, CBO2013BEOFeb5). This situation may worsen in the future (CBO 2012LTBO):

“The budget outlook is much bleaker under the extended alternative fiscal scenario, which maintains what some analysts might consider “current policies,” as opposed to current laws. Federal debt would grow rapidly from its already high level, exceeding 90 percent of GDP in 2022. After that, the growing imbalance between revenues and spending, combined with spiraling interest payments, would swiftly push debt to higher and higher levels. Debt as a share of GDP would exceed its historical peak of 109 percent by 2026, and it would approach 200 percent in 2037.

The changes under this scenario would result in much lower revenues than would occur under the extended baseline scenario because almost all expiring tax provisions are assumed to be extended through 2022 (with the exception of the current reduction in the payroll tax rate for Social Security). After 2022, revenues under this scenario are assumed to remain at their 2022 level of 18.5 percent of GDP, just above the average of the past 40 years.

Outlays would be much higher than under the other scenario. This scenario incorporates assumptions that through 2022, lawmakers will act to prevent Medicare’s payment rates for physicians from declining; that after 2022, lawmakers will not allow various restraints on the growth of Medicare costs and health insurance subsidies to exert their full effect; and that the automatic reductions in spending required by the Budget Control Act of 2011 will not occur (although the original caps on discretionary appropriations in that law are assumed to remain in place). Finally, under this scenario, federal spending as a percentage of GDP for activities other than Social Security, the major health care programs, and interest payments is assumed to return to its average level during the past two decades, rather than fall significantly below that level, as it does under the extended baseline scenario.”

Table IIB-2, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2007	2008	2009	2010	2011	2012
Goods & Services	-699	-702	-384	-499	-557	-535
Income	101	146	124	178	233	224
UT	-115	-125	-122	-128	-134	-130
Current Account	-713	-681	-382	-449	-458	-440
NGDP	14028	14291	13974	14499	15076	15684
Current Account % GDP	-5.1	-4.8	-2.7	-3.1	-3.1	-2.8
NIIP	-1796	-3260	-2321	-2474	-4030	-4416
US Owned Assets Abroad	18400	19464	18512	20298	21132	20760
Foreign Owned Assets in US	20196	22724	20833	22772	25162	25176
NIIP % GDP	-12.8	-22.8	-16.6	-17.1	-26.7	-28.2
Exports Goods Services Income	2487	2654	2185	2523	2874	2987
NIIP % Exports Goods Services Income	-72	-123	-106	-98	-140	-148
DIA MV	5274	3102	4287	4767	4499	5191
DIUS MV	3551	2486	2995	3397	3509	3931
Fiscal Balance	-161	-459	-1413	-1294	-1296	-1087
Fiscal Balance % GDP	-1.2	-3.2	-10.1	-9.0	-8.7	-7.0
Federal Debt	5035	5803	7545	9019	10128	11281
Federal Debt % GDP	36.3	40.5	54.0	62.9	67.8	72.6
Federal Outlays	2729	2983	3518	3456	3598	3537
∆%	2.8	9.3	17.9	-1.8	4.1	-1.7
% GDP	19.7	20.8	25.2	24.1	24.1	22.7
Federal Revenue	2568	2524	2105	2162	2302	2450
∆%	6.7	-1.7	-16.6	2.7	6.5	6.4
% GDP	18.5	17.6	15.1	15.1	15.4	15.8

Sources:

Notes: UT: unilateral transfers; NGDP: nominal GDP or in current dollars; NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value. There are minor discrepancies in the decimal point of percentages of GDP between the balance of payments data and federal debt, outlays, revenue and deficits in which the original number of the CBO source is maintained. These discrepancies do not alter conclusions.

Sources: http://www.cbo.gov/ budget http://www.bea.gov/international/index.htm#bop Balance of Payments and NIIP, Bureau of Economic Analysis (BEA)

Gross Domestic Product, Bureau of Economic Analysis (BEA) http://www.bea.gov/iTable/index_nipa.cfm

Chart IIA-1 of the Board of Governors of the Federal Reserve System provides the overnight Fed funds rate on business days from Jul 1, 1954 at 1.13 percent through Jan 10, 1979, at 9.91 percent per year, to Jun 6, 2013, at 0.10 percent per year and 0.09 percent on Jun 13, 2013. US recessions are in shaded areas according to the reference dates of the NBER (http://www.nber.org/cycles.html). In the Fed effort to control the “Great Inflation” of the 1930s (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), the fed funds rate increased from 8.34 percent on Jan 3, 1979 to a high in Chart VI-10 of 22.36 percent per year on Jul 22, 1981 with collateral adverse effects in the form of impaired savings and loans associations in the United States, emerging market debt and money-center banks (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 72-7; Pelaez 1986, 1987). Another episode in Chart VI-10 is the increase in the fed funds rate from 3.15 percent on Jan 3, 1994, to 6.56 percent on Dec 21, 1994, which also had collateral effects in impairing emerging market debt in Mexico and Argentina and bank balance sheets in a world bust of fixed income markets during pursuit by central banks of non-existing inflation (Pelaez and Pelaez, International Financial Architecture (2005), 113-5). Another interesting policy impulse is the reduction of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of equally non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85), followed by increments of 25 basis points from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006 in Chart VI-10. Central bank commitment to maintain the fed funds rate at 1.00 percent induced adjustable-rate mortgages (ARMS) linked to the fed funds rate. Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment but the exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at interest rates close to zero, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV).

The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper with the objective of purchasing default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). A final episode in Chart VI-10 is the reduction of the fed funds rate from 5.41 percent on Aug 9, 2007, to 2.97 percent on October 7, 2008, to 0.12 percent on Dec 5, 2008 and close to zero throughout a long period with the final point at 0.12 percent on May 9, 2013. Evidently, this behavior of policy would not have occurred had there been theory, measurements and forecasts to avoid these violent oscillations that are clearly detrimental to economic growth and prosperity without inflation. Current policy consists of forecast mandate of maintaining policy accommodation until the forecast of the rate of unemployment reaches 6.5 percent and the rate of personal consumption expenditures excluding food and energy reaches 2.5 percent (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm). It is a forecast mandate because of the lags in effect of monetary policy impulses on income and prices (Romer and Romer 2004). The intention is to reduce unemployment close to the “natural rate” (Friedman 1968, Phelps 1968) of around 5 percent and inflation at or below 2.0 percent. If forecasts were reasonably accurate, there would not be policy errors. A commonly analyzed risk of zero interest rates is the occurrence of unintended inflation that could precipitate an increase in interest rates similar to the Himalayan rise of the fed funds rate from 9.91 percent on Jan 10, 1979, at the beginning in Chart VI-10, to 22.36 percent on Jul 22, 1981. There is a less commonly analyzed risk of the development of a risk premium on Treasury securities because of the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). There is not a fiscal cliff or debt limit issue ahead but rather free fall into a fiscal abyss. The combination of the fiscal abyss with zero interest rates could trigger the risk premium on Treasury debt or Himalayan hike in interest rates.

Chart IIA-1, US, Fed Funds Rate, Business Days, Jul 1, 1954 to Jun 13, 2013, Percent per Year

Source: Board of Governors of the Federal Reserve System

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

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

Table IIB-3, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994

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

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

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

The Congressional Budget Office (CBO 2013BEOFeb5) estimates potential GDP, potential labor force and potential labor productivity provided in Table IC-4. The average rate of growth of potential GDP from 1950 to 2012 is estimated at 3.3 percent per year. The projected path is significantly lower at 2.2 percent per year from 2012 to 2023. The legacy of the economic cycle with expansion from IIIQ2009 to IVQ2012 at 2.1 percent on average in contrast with 6.2 percent in prior expansions of the economic cycle in the postwar (http://cmpassocregulationblog.blogspot.com/2013/03/mediocre-gdp-growth-at-16-to-20-percent.html) may perpetuate unemployment and underemployment estimated at 30.9 million or 19.2 percent of the effective labor force in Feb 2013 (http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.html) with much lower hiring than in the period before the current cycle (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/02/recovery-without-hiring-united-states.html).

Table IIB-4, US, Congressional Budget Office History and Projections of Potential GDP of US Overall Economy, ∆%

	Potential GDP	Potential Labor Force	Potential Labor Productivity*
Average Annual ∆%
1950-1973	3.9	1.6	2.3
1974-1981	3.3	2.5	0.8
1982-1990	3.1	1.6	1.5
1991-2001	3.1	1.3	1.8
2002-2012	2.2	0.8	1.4
Total 1950-2012	3.3	1.5	1.7
Projected Average Annual ∆%
2013-2018	2.2	0.6	1.6
2019-2023	2.3	0.5	1.8
2012-2023	2.2	0.5	1.7

*Ratio of potential GDP to potential labor force

Source: Congressional Budget Office, CBO (2013BEOFeb5).

Chart IIB-2 of the Congressional Budget Office (CBO 2013BEOFeb5) provides actual and potential GDP of the United States from 2000 to 2011 and projected to 2024. Lucas (2011May) estimates trend of United States real GDP of 3.0 percent from 1870 to 2010 and 2.2 percent for per capita GDP. The United States successfully returned to trend growth of GDP by higher rates of growth during cyclical expansion as analyzed by Bordo (2012Sep27, 2012Oct21) and Bordo and Haubrich (2012DR). Growth in expansions following deeper contractions and financial crises was much higher in agreement with the plucking model of Friedman (1964, 1988). The main problem in recovery of the US labor market has been the low rate of growth of 2.1 percent in the fifteen quarters of expansion of the economy from IIIQ2009 to IQ2013 (see table I-5 in http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). There is extraordinary contrast between the mediocre average annual equivalent growth rate of 2.1 percent of the US economy in the fifteen quarters of the current cyclical expansion from IIIQ2009 to IQ2013 and the average of 5.7 percent in the first thirteen quarters of expansion from IQ1983 to IQ1986 and 5.3 percent in the first fifteen quarters of expansion from IQ1983 to IIIQ1986 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). Mediocre growth cannot be explained by the contraction of 4.7 of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 27.8 million or 17.1 percent of the labor as estimated for Jan 2013 (http://cmpassocregulationblog.blogspot.com/2013/03/thirty-one-million-unemployed-or.html) and the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html).

Chart IIB-2, US, Congressional Budget Office, Actual and Projections of Potential GDP, 2000-2024, Trillions of Dollars

Source: Congressional Budget Office, CBO (2013BEOFeb5).

Chart IIB-3 of the Bureau of Economic Analysis of the Department of Commerce shows on the lower negative panel the sharp increase in the deficit in goods and the deficits in goods and services from 1960 to 2012. The upper panel shows the increase in the surplus in services that was insufficient to contain the increase of the deficit in goods and services. The adjustment during the global recession has been in the form of contraction of economic activity that reduced demand for goods.

Chart IIB-3, US, Balance of Goods, Balance on Services and Balance on Goods and Services, 1960-2012, Millions of Dollars

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

Chart IIB-4 of the Bureau of Economic Analysis shows exports and imports of goods and services from 1960 to 2012. Exports of goods and services in the upper positive panel have been quite dynamic but have not compensated for the sharp increase in imports of goods. The US economy apparently has become less competitive in goods than in services.

Chart IIB-4, US, Exports and Imports of Goods and Services, 1960-2012, Millions of Dollars

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

Chart IIB-5 of the Bureau of Economic Analysis shows the US balance on current account from 1960 to 2012. The sharp devaluation of the dollar resulting from unconventional monetary policy of zero interest rates and elimination of auctions of 30-year Treasury bonds did not adjust the US balance of payments. Adjustment only occurred after the contraction of economic activity during the global recession.

Chart IIB-5, US, Balance on Current Account, 1960-2012, Millions of Dollars

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

Chart IIB-5 of the Bureau of Economic Analysis provides real GDP in the US from 1960 to 2012. The contraction of economic activity during the global recession was a major factor in the reduction of the current account deficit as percent of GDP.

Chart IIB-6, US, Real GDP, 1960-2012, Billions of Chained 2005 Dollars

Source: Bureau of Economic Analysis

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

Chart IIB-6 provides the US current account deficit on a quarterly basis from 1980 to IQ1983. The deficit is at a lower level because of growth below potential not only in the US but worldwide. The combination of high government debt and deficit with external imbalance restricts potential prosperity in the US.

Chart IIB-7, US, Balance on Current Account, Quarterly, 1980-2013

Source: Bureau of Economic Analysis

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

Risk aversion channels funds toward US long-term and short-term securities that finance the US balance of payments and fiscal deficits benefitting currently from risk flight to US dollar denominated assets. There are now temporary interruptions because of fear of rising interest rates that erode prices of US government securities because of mixed signals on monetary policy and exit from the Fed balance sheet of three trillion dollars of securities held outright. Net foreign purchases of US long-term securities (row C in Table IIB-5) deteriorated from minus $13.4 billion in Mar 2013 to minus $37.3 billion in Apr 2013. Foreign (residents) purchases minus sales of US long-term securities (row A in Table IIB-5) in Mar 2013 of $15.3 billion decreased to minus $24.8 billion in Apr 2013. Net US (residents) purchases of long-term foreign securities (row B in Table IIB-5) increased from minus $28.8 billion in Mar 2013 to minus $12.6 billion in Apr 2013. In Apr 2013,

C = A + B = -$24.8 billion - $12.6 billion = -$37.3 billion

There are minor rounding errors. There is decreasing demand in Table IIB-5 in Jan in A1 private purchases by residents overseas of US long-term securities of $17.8 billion of which decreases in A11 Treasury securities of $30.8 billion, increase in A12 of $6.9 billion in agency securities, decrease by $4.4 billion of corporate bonds and increase of $10.4 billion in equities. Worldwide risk aversion causes flight into US Treasury obligations with significant oscillations. Official purchases of securities in row A2 decreased $6.9 billion with decrease of Treasury securities of $23.7 billion in Apr 2013. Official purchases of agency securities increased $16.0 billion in Apr and decreased $17.3 billion in Mar. Row D shows decrease in Apr 2013 of 30.1 billion in purchases of short-term dollar denominated obligations. Foreign private holdings of US Treasury bills decreased $15.1 billion (row D11) with foreign official holdings increasing $10.3 billion while the category “other” decreased $15.0 billion. Risk aversion of default losses in foreign securities dominates decisions to accept zero interest rates in Treasury securities with no perception of principal losses. In the case of long-term securities, investors prefer to sacrifice inflation and possible duration risk to avoid principal losses with significant oscillations in risk perceptions.

Table IIB-5, Net Cross-Borders Flows of US Long-Term Securities, Billion Dollars, NSA

	Apr 2012 12 Months	Apr 2013 12 Months	Mar 2013	Apr 2013
A Foreign Purchases less Sales of US LT Securities	469.8	497.4	15.3	-24.8
A1 Private	292.2	309.2	9.7	-17.8
A11 Treasury	288.6	121.9	22.1	-30.8
A12 Agency	72.4	106.3	-7.8	6.9
A13 Corporate Bonds	-54.1	-16.2	-8.2	-4.4
A14 Equities	-14.6	97.1	3.6	10.4
A2 Official	177.6	188.2	5.6	-6.9
A21 Treasury	173.0	116.1	-16.8	-23.7
A22 Agency	-1.1	45.7	17.3	16.0
A23 Corporate Bonds	1.3	12.7	2.0	-0.1
A24 Equities	4.5	13.7	3.2	0.8
B Net US Purchases of LT Foreign Securities	-9.3	-120.8	-28.8	-12.6
B1 Foreign Bonds	20.6	-16.7	-2.0	4.2
B2 Foreign Equities	-29.9	-104.1	-26.8	-16.8
C Net Foreign Purchases of US LT Securities	460.5	376.5	-13.4	-37.3
D Increase in Foreign Holdings of Dollar Denominated Short-term	-55.4	80.7	35.6	-30.1
D1 US Treasury Bills	-34.6	84.8	34.2	-15.1
D11 Private	39.2	33.5	15.8	-10.3
D12 Official	-73.7	51.3	18.5	-4.8
D2 Other	-20.8	-4.1	1.3	-15.0

C = A + B;

A = A1 + A2

A1 = A11 + A12 + A13 + A14

A2 = A21 + A22 + A23 + A24

B = B1 + B2

D = D1 + D2

Sources: http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/ticpress.aspx

Table IIB-6 provides major foreign holders of US Treasury securities. China is the largest holder with $1264.9 billion in Apr 2013, increasing 8.6 percent from $1164.4 billion in Apr 2012. Japan increased its holdings from $1087.9 billion in Apr 2012 to $1100.3 billion in Apr 2013 or by 1.1 percent likely in part by intervention to buy dollars against the yen to depreciate the overvalued yen/dollar rate that diminishes the competitiveness of Japan. Total foreign holdings of Treasury securities rose from $5217.0 billion in Apr 2012 to $5670.8 billion in Apr 2013, or 8.7 percent. Foreign holdings of Treasury securities fell from $5740.4 in Mar 2013 to $5670.8 in Apr 2013 or 1.2 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Pelaez and Pelaez, The Global Recession Risk (2007)). A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt. In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

Table IIB-6, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Apr 2013	Mar 2013	Apr 2012
Total	5670.8	5740.4	5217.0
China	1264.9	1270.3	1164.4
Japan	1100.3	1114.3	1087.9
Caribbean Banking Centers	273.1	283.9	237.3
Oil Exporters	272.7	265.1	262.2
Brazil	252.6	257.9	245.9
Taiwan	186.7	188.9	187.4
Belgium	185.7	188.4	132.1
Switzerland	183.3	183.6	150.4
United Kingdom	163.4	159.1	136.7
Russia	151.1	153.0	155.4
Luxembourg	147.0	155.0	129.2
Hong Kong	141.8	146.6	145.2
Foreign Official Holdings	4062.2	4090.7	3783.6
A. Treasury Bills	399.2	404.0	347.9
B. Treasury Bonds and Notes	3663.0	3686.7	3435.5

Source: http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/ticsec2.aspx#ussecs

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 8.4 percent adjusted for inflation while growing 617.2 percent adjusted for inflation from IVQ1945 to IVQ2012 and unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes; and (4) 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. Financial turbulence, attaining unusual magnitude in recent months, characterized the expansion from the global recession since IIIQ2009. Table III-1, updated with every comment in this blog, provides beginning values on Fri Jun 7 and daily values throughout the week ending on Jun 14, 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 Jun 7 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Jun 7, 2013”, first row “USD/EUR 1.3219 -1.7%,” provides the information that the US dollar (USD) depreciated 1.7 percent to USD 1.3219/EUR in the week ending on Fri Jun 7 relative to the exchange rate on Fri Mar 31. 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 1.3219/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jun 7, depreciating to USD 1.3257/EUR on Mon Jun 10, 2013, or by 0.3 percent. The dollar depreciated because more dollars, $1.3257, were required on Mon Jun 10 to buy one euro than $1.3219 on Jun 7. 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 1.3219/EUR on Jun 7; 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 Jun 7, to the last business day of the current week, in this case Fri Jun 14, such as depreciation to USD 1.3345/EUR by Jun 14; 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 0.9 percent from the rate of USD 1.3219/EUR on Fri Jun 7 to the rate of USD 1.3345/EUR on Fri Jun 14 {[(1.3345/1.3219) – 1]100 = 0.9%} and appreciated (denoted by positive sign) by 0.2 percent from the rate of USD 1.3375 on Thu Jun 13 to USD 1.3345/EUR on Fri Jun 14 {[(1.3345/1.3375) -1]100 = -0.2%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk assets to the safety of dollar-denominated assets during risk aversion and return to higher yielding risk assets during risk appetite.

III-I, Weekly Financial Risk Assets Jun 10 to Jun 14, 2013

Fri Jun 7, 2013

M 10

Tue 11

W 12

Thu 13

Fri 14

USD/EUR

1.3219

-1.7%

1.3257

-0.3%

1.3313

-0.7%

-0.4%

1.3337

-0.9%

-0.2%

1.3375

-1.2%

-0.3%

1.3345

-0.9%

0.2%

JPY/ USD

97.54

2.9%

98.74

-1.2%

96.02

1.6%

2.8%

96.01

1.6%

0.0%

95.37

2.2%

0.7%

94.08

3.5%

1.4%

CHF/ USD

0.9359

2.0%

0.9338

0.2%

0.9247

1.2%

1.0%

0.9207

1.6%

0.4%

0.9220

1.5%

-0.1%

0.9211

1.6%

0.1%

CHF/ EUR

1.2377

0.3%

1.2376

0.0%

1.2311

0.5%

1.2279

0.8%

0.3%

1.2333

0.4%

-0.4%

1.2290

0.7%

0.3%

USD/ AUD

0.9497

1.053

0.9465

1.0565

-0.3%

0.9426

1.0609

-0.8%

-0.4%

0.9484

1.0544

-0.1%

0.6%

0.9640

1.0373

1.5%

1.6%

0.9570

1.0449

0.8%

-0.7%

10 Year T Note

2.174

2.203

2.184

2.226

2.14

2.125

2 Year T Note

0.304

0.312

0.32

0.288

0.276

German Bond

2Y 0.18 10Y 1.54

2Y 0.20 10Y 1.60

2Y 0.17 10Y 1.58

2Y 0.15 10Y 1.56

2Y 0.12 10Y 1.51

DJIA

15248.12

9.9%

15238.59

-0.1%

15,122.02

-0.8%

14995.23

-1.7%

-0.8%

15176.08

-0.5%

1.2%

15070.18

-1.2%

-0.7%

DJ Global

2165.00

-0.9%

2169.57

0.2%

2155.52

-0.4%

-0.6%

2146.15

-0.9%

-0.4%

2148.31

-0.8%

0.1%

2148.22

-0.8%

0.0%

DJ Asia Pacific

1334.54

-3.5%

1349.58

1.1%

1346.85

0.9%

-0.2%

1351.42

1.3%

0.3%

1322.49

-0.9%

-2.1%

1338.27

0.3%

1.2%

Nikkei

12877.53

-6.5%

13512.30

4.9%

13317.62

3.4%

-1.4%

13289.32

3.2%

-0.2%

12445.38

-3.4%

-6.4%

12686.52

-1.5%

1.9%

Shanghai

2210.90

-3.9%

2210.90

0.0%

2210.90

0.0%

2210.90

0.0%

2148.36

-2.8%

2162.04

-2.2%

0.6%

DAX

8254.68

-1.1%

8307.69

0.6%

8222.46

-0.4%

-1.0%

8143.27

-1.3%

-1.0%

8095.39

-1.9%

-0.6%

8127.96

-1.5%

0.4%

DJ UBS

Comm.

131.30

0.5%

-0.3%

130.59

-0.5%

129.95

-1.0%

-0.5%

130.11

-0.9%

0.1%

130.080

-0.9%

0.0%

130.37

-0.7%

0.2%

WTI $ B

96.21

5.0%

95.74

-0.5%

94.92

-1.3%

-0.9%

95.88

-0.3%

1.0%

96.69

0.5%

0.8%

97.89

1.7%

1.2%

Brent $/B

104.74

4.6%

103.77

-0.9%

102.52

-2.1%

-1.2%

103.53

-1.2%

1.0%

104.25

-0.5%

0.7%

105.88

1.1%

1.6%

Gold $/OZ

1381.2

-0.4%

1385.6

0.3%

1377.1

-0.3%

-0.6%

1392.0

0.8%

1.1%

1377.8

-0.2%

-1.0%

1389.4

0.6%

0.8%

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

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

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

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

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.

First, risk determining events. Current risk analysis concentrates on deciphering what the Federal Open Market Committee (FOMC) may decide on quantitative easing. The week of May 24 was dominated by the testimony of Chairman Bernanke to the Joint Economic Committee of the US Congress on May 22, 2013 (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm), followed by questions and answers and the release on May 22, 2013 of the minutes of the meeting of the Federal Open Market Committee (FOMC) from Apr 30 to May 1, 2013 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm). Monetary policy emphasizes communication of policy intentions to avoid that expectations reverse outcomes in reality (Kydland and Prescott 1977). Jon Hilsenrath, writing on “In bid for clarity, Fed delivers opacity,” on May 23, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath), analyzes discrepancies in communication by the Fed. The annotated chart of values of the Dow Jones Industrial Average (DJIA) during trading on May 23, 2013 provided by Hinselrath, links the prepared testimony of Chairman Bernanke at 10:AM, following questions and answers and the release of the minutes of the FOMC at 2PM. Financial markets strengthened between 10 and 10:30AM on May 23, 2013, perhaps because of the statement by Chairman Bernanke in prepared testimony (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm):

“A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further. Such outcomes tend to be associated with extended periods of lower, not higher, interest rates, as well as poor returns on other assets. Moreover, renewed economic weakness would pose its own risks to financial stability.”

In that testimony, Chairman Bernanke (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm) also analyzes current weakness of labor markets:

“Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers' skills and--particularly relevant during this commencement season--by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.”

Hilsenrath (op. cit. http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath) analyzes the subsequent decline of the market from 10:30AM to 10:40AM as Chairman Bernanke responded questions with the statement that withdrawal of stimulus would be determined by data but that it could begin in one of the “next few meetings.” The DJIA recovered part of the losses between 10:40AM and 2PM. The minutes of the FOMC released at 2PM on May 23, 2013, contained a phrase that troubled market participants (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm): “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.” The DJIA closed at 15,387.58 on May 21, 2013 and fell to 15,307.17 at the close on May 22, 2013, with the loss of 0.5 percent occurring after release of the minutes of the FOMC at 2PM when the DJIA stood at around 15,400. The concern about exist of the Fed from stimulus affected markets worldwide as shown in declines of equity indexes in Table III-1 with delays because of differences in trading hours. This behavior shows the trap of unconventional monetary policy with no exit from zero interest rates without risking financial crash and likely adverse repercussions on economic activity.

Financial markets worldwide were affected by the reduction of policy rates of the European Central Bank (ECB) on May 2, 2013. (http://www.ecb.int/press/pr/date/2013/html/pr130502.en.html):

“2 May 2013 - Monetary policy decisions

At today’s meeting, which was held in Bratislava, the Governing Council of the ECB took the following monetary policy decisions:

The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.50%, starting from the operation to be settled on 8 May 2013.
The interest rate on the marginal lending facility will be decreased by 50 basis points to 1.00%, with effect from 8 May 2013.
The interest rate on the deposit facility will remain unchanged at 0.00%.”

Financial markets in Japan and worldwide were shocked by new bold measures of “quantitative and qualitative monetary easing” by the Bank of Japan (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The objective of policy is to “achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The main elements of the new policy are as follows:

Monetary Base Control. Most central banks in the world pursue interest rates instead of monetary aggregates, injecting bank reserves to lower interest rates to desired levels. The Bank of Japan (BOJ) has shifted back to monetary aggregates, conducting money market operations with the objective of increasing base money, or monetary liabilities of the government, at the annual rate of 60 to 70 trillion yen. The BOJ estimates base money outstanding at “138 trillion yen at end-2012) and plans to increase it to “200 trillion yen at end-2012 and 270 trillion yen at end 2014” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
Maturity Extension of Purchases of Japanese Government Bonds. Purchases of bonds will be extended even up to bonds with maturity of 40 years with the guideline of extending the average maturity of BOJ bond purchases from three to seven years. The BOJ estimates the current average maturity of Japanese government bonds (JGB) at around seven years. The BOJ plans to purchase about 7.5 trillion yen per month (http://www.boj.or.jp/en/announcements/release_2013/rel130404d.pdf). Takashi Nakamichi, Tatsuo Ito and Phred Dvorak, wiring on “Bank of Japan mounts bid for revival,” on Apr 4, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323646604578401633067110420.html ), find that the limit of maturities of three years on purchases of JGBs was designed to avoid views that the BOJ would finance uncontrolled government deficits.
Seigniorage. The BOJ is pursuing coordination with the government that will take measures to establish “sustainable fiscal structure with a view to ensuring the credibility of fiscal management” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
Diversification of Asset Purchases. The BOJ will engage in transactions of exchange traded funds (ETF) and real estate investment trusts (REITS) and not solely on purchases of JGBs. Purchases of ETFs will be at an annual rate of increase of one trillion yen and purchases of REITS at 30 billion yen.

The European sovereign debt crisis continues to shake financial markets and the world economy. Debt resolution within the international financial architecture requires that a country be capable of borrowing on its own from the private sector. Mechanisms of debt resolution have included participation of the private sector (PSI), or “bail in,” that has been voluntary, almost coercive, agreed and outright coercive (Pelaez and Pelaez, International Financial Architecture: G7, IMF, BIS, Creditors and Debtors (2005), Chapter 4, 187-202). Private sector involvement requires losses by the private sector in bailouts of highly indebted countries. The essence of successful private sector involvement is to recover private-sector credit of the highly indebted country. Mary Watkins, writing on “Bank bailouts reshuffle risk hierarchy,” published on Mar 19, 2013, in the Financial Times (http://www.ft.com/intl/cms/s/0/7666546a-9095-11e2-a456-00144feabdc0.html#axzz2OSpbvCn8) analyzes the impact of the bailout or resolution of Cyprus banks on the hierarchy of risks of bank liabilities. Cyprus banks depend mostly on deposits with less reliance on debt, raising concerns in creditors of fixed-income debt and equity holders in banks in the euro area. Uncertainty remains as to the dimensions and structure of losses in private sector involvement or “bail in” in other rescue programs in the euro area. Alkman Granitsas, writing on “Central bank details losses at Bank of Cyprus,” on Mar 30, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324000704578392502889560768.html), analyzes the impact of the agreement with the €10 billion agreement with IMF and the European Union on the banks of Cyprus. The recapitalization plan provides for immediate conversion of 37.5 percent of all deposits in excess of €100,000 to shares of special class of the bank. An additional 22.5 percent will be frozen without interest until the plan is completed. The overwhelming risk factor is the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). Another rising risk is division within the Federal Open Market Committee (FOMC) on risks and benefits of current policies as expressed in the minutes of the meeting held on Jan 29-30, 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130130.pdf 13):

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

A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2013/01/peaking-valuation-of-risk-financial.html). Matt Jarzemsky, writing on Dow industrials set record,” on Mar 5, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324156204578275560657416332.html), analyzes that the DJIA broke the closing high of 14,164.53 set on Oct 9, 2007, and subsequently also broke the intraday high of 14,198.10 reached on Oct 11, 2007. The DJIA closed at 15,070.18

on Fri Jun 14, 2013, which is higher by 6.4 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 6.1 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):

“To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

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 4.560 percent on Jun 14, 2013, and that of the ten-year sovereign bond of Italy at 4.290 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 Jun 14, 2013, the yield of the two-year Treasury fell to 0.276 percent and that of the ten-year Treasury to 2.125 percent while the two-year bond of Germany decreased to 0.12 percent and the ten-year to 1.51 percent; and the dollar depreciated to USD 1.3345/EUR. The zero interest rates for the monetary policy rate of the US, or fed funds rate, induce carry trades that ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield is higher than consumer price inflation of 1.1 percent in the 12 months ending in Apr 2013 (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.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
6/14/13	0.276	2.125	0.12	1.51	1.3345
6/7/13	0.304	2.174	0.18	1.54	1.3219
5/31/13	0.299	2.132	0.06	1.50	1.2996
5/24/13	0.249	2.009	0.00	1.43	1.2932
5/17/13	0.248	1.952	-0.03	1.32	1.2837
5/10/13	0.239	1.896	0.05	1.38	1.2992
5/3/13	0.22	1.742	0.00	1.24	1.3115
4/26/13	0.209	1.663	0.00	1.21	1.3028
4/19/13	0.232	1.702	0.02	1.25	1.3052
4/12/13	0.228	1.719	0.02	1.26	1.3111
4/5/13	0.228	1.706	0.01	1.21	1.2995
3/29/13	0.244	1.847	-0.02	1.29	1.2818
3/22/13	0.242	1.931	0.03	1.38	1.2988
3/15/13	0.246	1.992	0.05	1.46	1.3076
3/8/13	0.256	2.056	0.09	1.53	1.3003
3/1/13	0.236	1.842	0.03	1.41	1.3020
2/22/13	0.252	1.967	0.13	1.57	1.3190
2/15/13	0.268	2.007	0.19	1.65	1.3362
2/8/13	0.252	1.949	0.18	1.61	1.3365
2/1/13	0.26	2.024	0.25	1.67	1.3642
1/25/13	0.278	1.947	0.26	1.64	1.3459
1/18/13	0.252	1.84	0.18	1.56	1.3321
1/11/13	0.247	1.862	0.13	1.58	1.3343
1/4/13	0.262	1.898	0.08	1.54	1.3069
12/28/12	0.252	1.699	-0.01	1.31	1.3218
12/21/12	0.272	1.77	-0.01	1.38	1.3189
12/14/12	0.232	1.704	-0.04	1.35	1.3162
12/7/12	0.256	1.625	-0.08	1.30	1.2926
11/30/12	0.248	1.612	0.01	1.39	1.2987
11/23/12	0.273	1.691	0.00	1.44	1.2975
11/16/12	0.24	1.584	-0.03	1.33	1.2743
11/9/12	0.256	1.614	-0.03	1.35	1.2711
11/2/12	0.274	1.715	0.01	1.45	1.2838
10/26/12	0.299	1.748	0.05	1.54	1.2942
10/19/12	0.296	1.766	0.11	1.59	1.3023
10/12/12	0.264	1.663	0.04	1.45	1.2953
10/5/12	0.26	1.737	0.06	1.52	1.3036
9/28/12	0.236	1.631	0.02	1.44	1.2859
9/21/12	0.26	1.753	0.04	1.60	1.2981
9/14/12	0.252	1.863	0.10	1.71	1.3130
9/7/12	0.252	1.668	0.03	1.52	1.2816
8/31/12	0.225	1.543	-0.03	1.33	1.2575
8/24/12	0.266	1.684	-0.01	1.35	1.2512
8/17/12	0.288	1.814	-0.04	1.50	1.2335
8/10/12	0.267	1.658	-0.07	1.38	1.2290
8/3/12	0.242	1.569	-0.02	1.42	1.2387
7/27/12	0.244	1.544	-0.03	1.40	1.2320
7/20/12	0.207	1.459	-0.07	1.17	1.2158
7/13/12	0.24	1.49	-0.04	1.26	1.2248
7/6/12	0.272	1.548	-0.01	1.33	1.2288
6/29/12	0.305	1.648	0.12	1.58	1.2661
6/22/12	0.309	1.676	0.14	1.58	1.2570
6/15/12	0.272	1.584	0.07	1.44	1.2640
6/8/12	0.268	1.635	0.04	1.33	1.2517
6/1/12	0.248	1.454	0.01	1.17	1.2435
5/25/12	0.291	1.738	0.05	1.37	1.2518
5/18/12	0.292	1.714	0.05	1.43	1.2780
5/11/12	0.248	1.845	0.09	1.52	1.2917
5/4/12	0.256	1.876	0.08	1.58	1.3084
4/6/12	0.31	2.058	0.14	1.74	1.3096
3/30/12	0.335	2.214	0.21	1.79	1.3340
3/2/12	0.29	1.977	0.16	1.80	1.3190
2/24/12	0.307	1.977	0.24	1.88	1.3449
1/6/12	0.256	1.957	0.17	1.85	1.2720
12/30/11	0.239	1.871	0.14	1.83	1.2944
8/26/11	0.20	2.202	0.65	2.16	1.450
8/19/11	0.192	2.066	0.65	2.11	1.4390
6/7/10	0.74	3.17	0.49	2.56	1.192
3/5/09	0.89	2.83	1.19	3.01	1.254
12/17/08	0.73	2.20	1.94	3.00	1.442
10/27/08	1.57	3.79	2.61	3.76	1.246
7/14/08	2.47	3.88	4.38	4.40	1.5914
6/26/03	1.41	3.55	NA	3.62	1.1423

Note: DE: Germany

Source:

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

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

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

Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year, 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 Jun 13, 2013, with the one-month yield at 0.04 percent, the two-year at 0.32 percent, the ten-year at 2.19 percent, the fed funds rate at 0.09 percent and the corporate Baa bond at 5.11 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-Jun 13, 2013

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Alexandra Scaggs, writing on “Tepid profits, roaring stocks,” on May 16, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323398204578487460105747412.html), analyzes stabilization of earnings growth: 70 percent of 458 reporting companies in the S&P 500 stock index reported earnings above forecasts but sales fell 0.2 percent relative to forecasts of increase of 0.5 percent. Paul Vigna, writing on “Earnings are a margin story but for how long,” on May 17, 2013, published in the Wall Street Journal (http://blogs.wsj.com/moneybeat/2013/05/17/earnings-are-a-margin-story-but-for-how-long/), analyzes that corporate profits increase with stagnating sales while companies manage costs tightly. More than 90 percent of S&P components reported moderate increase of earnings of 3.7 percent in IQ2013 relative to IQ2012 with decline of sales of 0.2 percent. Earnings and sales have been in declining trend. In IVQ2009, growth of earnings reached 104 percent and sales jumped 13 percent. Net margins reached 8.92 percent in IQ2013, which is almost the same at 8.95 percent in IIIQ2006. Operating margins are 9.58 percent. There is concern by market participants that reversion of margins to the mean could exert pressure on earnings unless there is more accelerated growth of sales. Vigna (op. cit.) finds sales growth limited by weak economic growth. Kate Linebaugh, writing on “Falling revenue dings stocks,” on Oct 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444592704578066933466076070.html?mod=WSJPRO_hpp_LEFTTopStories), identifies a key financial vulnerability: falling revenues across markets for United States reporting companies. Global economic slowdown is reducing corporate sales and squeezing corporate strategies. Linebaugh quotes data from Thomson Reuters that 100 companies of the S&P 500 index have reported declining revenue only 1 percent higher in Jun-Sep 2012 relative to Jun-Sep 2011 but about 60 percent of the companies are reporting lower sales than expected by analysts with expectation that revenue for the S&P 500 will be lower in Jun-Sep 2012 for the entities represented in the index. Results of US companies are likely repeated worldwide. Future company cash flows derive from investment projects. Real private fixed investment fell 8.8 percent from $2,111.5 billion in IVQ2007 to $1925.6 billion in IQ2013 or by 8.8 percent compared with growth of 24.1 percent of gross private domestic investment from IQ1980 to IVQ1985 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). Undistributed profits of US corporations swelled 205 percent from $118.0 billion IQ2007 to $359.9 billion in IQ2013 and minus $22.1 billion in billion in IVQ2007 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $43.8 billion relative to IVQ2012 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp1q13_2nd.pdf), from $2013.0 billion to $1969.2 billion at the quarterly rate of minus 2.2 percent. The investment decision of US business is fractured. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

Where 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 weak performance in equity indexes with several indexes in Table III-1 decreasing in the week ending on Jun 14, 2013. Stagnating revenues, corporate cash hoarding and declining investment are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. DJIA decreased 0.7 percent on Jun 14, decreasing 1.2 percent in the week. Germany’s Dax increased 0.4 percent on Fri Jun 14 and decreased 1.5 percent in the week. Dow Global changed 0.0 percent on Jun 14 and decreased 0.8 percent in the week. Japan’s Nikkei Average increased 1.9 percent on Fri Jun 14 and decreased 1.5 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 1.2 percent on Jun 14 and increased 0.3 percent in the week. Shanghai Composite that decreased 0.2 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2162.04 on Fri Jun 14 for increase of 0.6 percent and decrease of 2.2 percent in the week of Jun 14. 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 mixed in the week of Jun 14, 2013. The DJ UBS Commodities Index increased 0.2 percent on Fri Jun 14 and decreased 0.7 percent in the week, as shown in Table III-1. WTI increased 1.7 percent in the week of Jun 14 while Brent increased 1.1 percent in the week. Gold increased 0.8 percent on Fri Jun 14 and increased 0.6 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 €821,899 million on Jun 7, 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 reached €1,426,150 million in the statement of Jun 7, 2013, with marginal reduction. There is high credit risk in these transactions with capital of only €89,754 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Jun 7, 2013
1 Gold and other Receivables	367,402	419,822	435,315
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	255,147
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	28,167
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	18,917
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	821,899
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	90,204
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	604,251
8 General Government Debt Denominated in Euro	34,954	33,928	29,012
9 Other Assets	278,719	336,574	263,686
TOTAL ASSETS	2,004, 432	2,733,235	2,546,600
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,426,150
Capital and Reserves	78,143	85,748	89,754

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/fs130611.en.html

Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. Growth of the Italian economy would ensure that success. A critical problem is that the common euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surpluses that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU), or euro area, are only 40.5 percent of the total. Exports to the non-European Union area with share of 46.3 percent in Italy’s total exports are growing at 5.0 percent in Jan-Mar 2013 relative to Jan-Mar 2012 while those to EMU are growing at minus 5.7 percent.

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

Mar 2013	Exports % Share	∆% Jan-Mar 2013/ Jan-Mar 2012	Imports % Share	∆% Jan-Mar 2013/ Jan-Mar 2012
EU	53.7	-5.1	52.9	-4.2
EMU 17	40.5	-5.7	42.7	-4.1
France	11.1	-3.3	8.3	-6.9
Germany	12.5	-6.7	14.6	-6.7
Spain	4.7	-12.5	4.4	-4.7
UK	4.9	-3.1	2.5	-2.6
Non EU	46.3	5.0	47.1	-10.9
Europe non EU	13.9	1.2	11.3	8.7
USA	6.8	4.7	3.3	-22.6
China	2.3	2.3	6.5	-5.8
OPEC	5.7	15.7	10.8	-20.5
Total	100.0	-0.7	100.0	-7.4

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

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/90206

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €473 million with the 17 countries of the euro zone (EMU 17) in Mar 2013 and cumulative deficit of €1159 million in Jan-Mar 2013. Depreciation to parity could permit greater competitiveness in improving the trade surplus of €1054 million in Jan-Mar 2013 with Europe non European Union, the trade surplus of €3230 million with the US and trade surplus with non-European Union of €1054 million in Jan-Mar 2013. There is significant rigidity in the trade deficits in Jan-Mar of €3792 million with China and €3099 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 Mar 2013 Millions of Euro	Trade Balance Cumulative Jan-Mar 2013 Millions of Euro
EU	607	1,661
EMU 17	-473	-1,159
France	1,085	3,120
Germany	-771	-1,428
Spain	57	308
UK	762	2,031
Non EU	2,630	1,054
Europe non EU	828	1,168
USA	1,340	3,230
China	-946	-3,792
OPEC	-429	-3,099
Total	3,237	2,716

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

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/90206

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Mar 2013 relative to Jan-Mar 2012. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 19.0 percent and minus 13.4 percent for durable goods. The higher rate of growth of exports of minus 0.7 percent in Jan-Mar 2013/Jan-Mar 2012 relative to imports of minus 7.4 percent may reflect weak demand in Italy with GDP declining during seven consecutive quarters from IIIQ2011 through IQ2013 together with softening commodity prices.

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

	Exports Share %	Exports ∆% Jan-Mar 2013/ Jan-Mar 2012	Imports Share %	Imports ∆% Jan-Mar 2013/ Jan-Mar 2012
Consumer Goods	29.3	5.4	25.6	-0.5
Durable	5.8	0.7	2.9	-13.4
Non-Durable	23.5	6.5	22.7	1.1
Capital Goods	31.6	0.3	19.5	-8.5
Inter- mediate Goods	33.6	-3.9	32.6	-3.7
Energy	5.5	-18.4	22.3	-19.0
Total ex Energy	94.5	0.4	77.7	-3.9
Total	100.0	-0.7	100.0	-7.4

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/90206

Table III-6 provides Italy’s trade balance by product categories in Mar 2013 and cumulative Jan-Mar 2013. Italy’s trade balance excluding energy generated surplus of €7473 million in Mar 2013 and €16,976 million cumulative in Jan-Mar 2013 but the energy trade balance created deficit of €4236 million in Mar 2013 and cumulative €14,261 million in Jan-Mar 2013. The overall surplus in Mar 2013 was €3237 million with cumulative surplus of €2716 million in Jan-Mar 2013. 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

	Mar 2013	Cumulative Jan-Mar 2013
Consumer Goods	2,384	5,048
Durable	1,249	3,041
Nondurable	1,135	2,007
Capital Goods	4,175	10,887
Intermediate Goods	913	1,041
Energy	-4,236	-14,261
Total ex Energy	7,473	16,976
Total	3,237	2,716

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/90206

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

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

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

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

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

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

The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2013.

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

	GDP 2013 USD Billions	Primary Net Lending Borrowing % GDP 2013	General Government Net Debt % GDP 2013
World	74,172
Euro Zone	12,752	-0.04	73.9
Portugal	218	-1.4	115.0
Ireland	222	-3.2	106.2
Greece	244	--	155.4
Spain	1,388	-3.5	79.1
Major Advanced Economies G7	34,068	-3.8	91.5
United States	16,238	-4.6	89.0
UK	2,423	-5.0	86.1
Germany	3,598	1.8	54.1
France	2,739	-1.4	86.5
Japan	5,150	-9.0	143.4
Canada	1,844	-2.4	35.9
Italy	2,076	2.7	102.3
China	9,020	-2.1*	21.3**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2013” to the column “GDP USD Billions.” The total debt of France and Germany in 2013 is $4315.7 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 $4087.3 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8403.0 billion, which would be equivalent to 132.6 percent of their combined GDP in 2013. 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 233.5 percent if including debt of France and 167.7 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	9,423.7
B Germany	1,946.5		$8403.0 as % of $3598 =233.5% $6033.8 as % of $3598 =167.7%
C France	2,369.2
B+C	4,315.7	GDP $6,337.0 Total Debt $8403.0 Debt/GDP: 132.6%
D Italy	2,123.7
E Spain	1,097.9
F Portugal	250.7
G Greece	379.2
H Ireland	235.8
Subtotal D+E+F+G+H	4,087.3

Source: calculation with IMF data IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx

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 Apr 2013. German exports to other European Union (EU) members are 55.9 percent of total exports in Apr 2013 and 57.4 percent in cumulative Jan-Apr 2013. Exports to the euro area are 34.5 percent in Apr and 37.6 percent cumulative in Jan-Apr. Exports to third countries are 41.7 percent of the total in Apr and 42.6 percent cumulative in Jan-Apr. There is similar distribution for imports. Exports to non-euro countries are increasing 5.6 percent in Apr 2013, increasing 1.7 percent cumulative in Jan-Apr 2013 while exports to the euro area are increasing 4.3 percent in Apr 2013, and decreasing 2.0 percent cumulative in Jan-Apr 2013. Exports to third countries, accounting for 44.1 percent of the total in Apr 2013, are increasing 13.6 percent in Apr 2013 and increasing 3.1 percent cumulative in Jan-Apr 2013, accounting for 42.6 percent of the cumulative total in Jan-Apr 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 ∆%

	Apr 2013 € Billions	Apr 12-Month ∆%	Cumulative Jan-Apr 2012 € Billions	Cumulative Jan-Apr 2013/ Jan-Apr 2012 ∆%
Total Exports	94.5	8.5	366.3	0.2
A. EU Members	52.8 % 55.9	4.7	210.1 % 57.4	-0.8
Euro Area	34.5 % 36.5	4.3	137.7 % 37.6	-2.0
Non-euro Area	18.4 % 19.5	5.6	72.3 % 19.7	1.7
B. Third Countries	41.7 % 44.1	13.6	156.2 % 42.6	3.1
Total Imports	76.4	5.2	298.9	-1.4
C. EU Members	49.4 % 64.7	6.8	193.0 % 64.6	0.5
Euro Area	34.5 % 45.2	5.4	134.4 % 44.9	-0.7
Non-euro Area	14.9 % 19.5	10.1	58.6 % 19.6	3.5
D. Third Countries	27.1 % 35.5	2.4	105.9 % 35.4	-4.8

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

Source: Statistisches Bundesamt Deutschland

https://www.destatis.de/EN/PressServices/Press/pr/2013/06/PE13_189_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	1.8	1.5	1.1	7.6
Japan	0.4	-0.7	0.6	4.1
China	7.7	2.1	-2.6
UK	0.6	2.4* CPIH 2.2	1.1 output 0.8** input -0.1	7.8
Euro Zone	-1.1	1.4	-0.2	12.2
Germany	-0.3	1.6	0.1	5.4
France	-0.4	0.9	0.6	11.0
Nether-lands	-1.3	3.1	-1.5	6.5
Finland	-2.0	2.5	0.7	8.2
Belgium	-0.5	1.1	1.9	8.4
Portugal	-4.0	0.9	0.6	17.8
Ireland	NA	0.5	1.2	13.5
Italy	-2.3	1.3	-1.1	12.0
Greece	-5.3	-0.3	-2.4	NA
Spain	-2.0	1.8	-0.5	26.8

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

*Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/april-2013/index.html **Core

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/april-2013/stb-producer-price-index--april-2013.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 1.8 percent in IQ2013 relative to IQ2012 (Table 8 in http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp1q13_2nd.pdf http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). Japan’s GDP grew 0.1 percent in IQ2013 relative to IQ2012 and 0.2 percent relative to a year earlier. Japan’s grew at the seasonally adjusted annual rate (SAAR) of 4.1 percent in IQQ2013 (Section VB and earlier http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). The UK grew at 0.3 percent in IQ2013 relative to IVQ2012 and GDP increased 0.6 percent in IQ2013 relative to IQ2012 (http://cmpassocregulationblog.blogspot.com/2013/05/united-states-commercial-banks-assets.html and earlier http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). The Euro Zone grew at minus 0.2 percent in IQ2013 and minus 1.1 percent in IQ2013 relative to IQ2012 (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.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: 7.5 percent in the US but 17.6 percent for unemployment/underemployment or job stress of 27.8 million (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2013/05/twenty-nine-million-unemployed-or.html), 4.1 percent for Japan (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2013/05/twenty-nine-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 and earlier at http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.1 percent in the US, -0.7 percent for Japan, 2.1 percent for China, 1.4 percent for the Euro Zone and 2.4 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/2013/06/twenty-eight-million-unemployed-or.html). (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/2013/06/mediocre-united-states-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html), weak hiring with the loss of 10 million full-time jobs (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/05/recovery-without-hiring-collapse-of.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/2013/06/twenty-eight-million-unemployed-or.html

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):

“I think the best way to provide forward guidance is by tying our policy actions to explicit measures of economic performance. There are many ways of doing this, including setting a target for the level of nominal GDP. But recognizing the difficult nature of that policy approach, I have a more modest proposal: I think the Fed should make it clear that the federal funds rate will not be increased until the unemployment rate falls below 7 percent. Knowing that rates would stay low until significant progress is made in reducing unemployment would reassure markets and the public that the Fed would not prematurely reduce its accommodation.

Based on the work I have seen, I do not expect that such policy would lead to a major problem with inflation. But I recognize that there is a chance that the models and other analysis supporting this approach could be wrong. Accordingly, I believe that the commitment to low rates should be dropped if the outlook for inflation over the medium term rises above 3 percent.

The economic conditionality in this 7/3 threshold policy would clarify our forward policy intentions greatly and provide a more meaningful guide on how long the federal funds rate will remain low. In addition, I would indicate that clear and steady progress toward stronger growth is essential.”

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

“I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Price Index) inflation over the next two to three years, would be appropriate.”

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

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

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

Jon Hilsenrath, writing on “Fed maps exit from stimulus,” on May 11, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324744104578475273101471896.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the development of strategy for unwinding quantitative easing and how it can create uncertainty in financial markets. Jon Hilsenrath and Victoria McGrane, writing on “Fed slip over how long to keep cash spigot open,” published on Feb 20, 2013 in the Wall street Journal (http://professional.wsj.com/article/SB10001424127887323511804578298121033876536.html), analyze the minutes of the Fed, comments by members of the FOMC and data showing increase in holdings of riskier debt by investors, record issuance of junk bonds, mortgage securities and corporate loans. Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.

Unconventional monetary policy will remain in perpetuity, or QE→∞, changing to a “growth mandate.” There are two reasons explaining unconventional monetary policy of QE→∞: insufficiency of job creation to reduce unemployment/underemployment at current rates of job creation; and growth of GDP at 1.6 to 2.1 percent, which is well below 3.0 percent estimated by Lucas (2011May) from 1870 to 2010. Unconventional monetary policy interprets the dual mandate of low inflation and maximum employment as mainly a “growth mandate” of forcing economic growth in the US at a rate that generates full employment. A hurdle to this “growth mandate” is that US economic growth has been at only 2.1 percent on average in the cyclical expansion in the 15 quarters from IIIQ2009 to IQ2013. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). The average of 7.8 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 3.2 percent obtained by diving GDP of $13,103.5 billion in IIIQ2010 by GDP of $12,701.0 billion in IIQ2009 {[$13.103.5/$12,701.0 -1]100 = 3.2%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.7 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). Zero interest rates and quantitative easing have not provided the impulse for growth and were not required in past successful cyclical expansions.

First, total nonfarm payroll employment seasonally adjusted (SA) increased 175,000 in May 2013 and private payroll employment rose 178,000. The average number of nonfarm jobs created in Jan-May 2012 was 204,800 while the average number of nonfarm jobs created in Jan-May 2013 was 189,200, or decline by 7.6 percent. The average number of private jobs created in the US in Jan-May 2012 was 213,600 while the average in Jan-May 2013 was 194,400, or decline by 9.0 percent. The US labor force increased from 153.617 million in 2011 to 154.975 million in 2012 by 1.358 million or 113,167 per month. The average increase of nonfarm jobs in the five months from Jan to May 2013 was 189,200, which is an inadequate rate of job creation to reduce significantly unemployment and underemployment in the United States because of 113,167 new entrants in the labor force per month with 27.8 million unemployed or underemployed. The difference between the average increase of 189,200 new private nonfarm jobs per month in the US from Jan to May 2013 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 76,033 monthly new jobs net of absorption of new entrants in the labor force. There are 27.8 million in job stress in the US currently. Creation of 76,033 new jobs per month net of absorption of new entrants in the labor force would require 365 months to provide jobs for the unemployed and underemployed (27.780 million divided by 76,033) or 30.4 years (365 divided by 12). The civilian labor force of the US in May 2013 not seasonally adjusted stood at 155.734 million with 11.302 million unemployed or effectively 17.998 million unemployed in this blog’s calculation by inferring those who are not searching because they believe there is no job for them for effective labor force of 162.430 million. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 1.1 years (1 million divided by product of 76,033 by 12, which is 912,396). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.787 million (0.05 times labor force of 155.734 million) for new net job creation of 3.515 million (11.302 million unemployed minus 7.787 million unemployed at rate of 5 percent) that at the current rate would take 3.9 years (3.515 million divided by 0.912396). Under the calculation in this blog, there are 17.998 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 162.430 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 9.876 million jobs net of labor force growth that at the current rate would take 10.8 years (17.998 million minus 0.05(162.430 million) = 9.876 million divided by 0.912396, using LF PART 66.2% and Total UEM in Table I-4). These calculations assume that there are no more recessions, defying United States economic history with periodic contractions of economic activity when unemployment increases sharply. The number employed in the US fell from 147.315 million in Jul 2007 to 144.432 million in May 2013, by 2.883 million, or decline of 2.0 percent, while the noninstitutional population increased from 231.958 million in Jul 2007 to 245.363 million in May 2013, by 13.405 million or increase of 5.8 percent, using not seasonally adjusted data. There is actually not sufficient job creation in merely absorbing new entrants in the labor force because of those dropping from job searches, worsening the stock of unemployed or underemployed in involuntary part-time jobs.

Second, the economy of the US can be summarized in growth of economic activity or GDP as decelerating from mediocre growth of 2.4 percent on an annual basis in 2010 and 1.8 percent in 2011 to 2.2 percent in 2012. Calculations below show that actual growth is around 1.9 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). United States real GDP grew at the rate of 3.2 percent between 1929 and 2012 and at 3.2 percent between 1947 and 2012 (http://www.bea.gov/iTable/index_nipa.cfm see http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). Growth is not only mediocre but also sharply decelerating to a rhythm that is not consistent with reduction of unemployment and underemployment of 28.6 million people corresponding to 17.6 percent of the effective labor force of the United States (http://cmpassocregulationblog.blogspot.com/2013/05/twenty-nine-million-unemployed-or.html). In the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013, 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, revised 3.1 percent in IIIQ2012, 0.4 percent in IVQ2012 and revised 2.4 percent in IQ2013. The annual equivalent rate of growth of GDP for the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 is 1.9 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); discounting 0.4 percent to one quarter is 0.1 percent {[(1.004)^1/4 – 1]100}; and discounting 2.4 percent to one quarter is 0.59 percent {[(1.024)^1/4 -1}100}. Real GDP growth in the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 accumulated to 4.3 percent {[(1.00025 x 1.0062 x 1.0032 x 1.010 x 1.005 x 1.0032 x 1.0077 x 1.001 x 1.0059) - 1]100 = 4.3%}. This is equivalent to growth from IQ2011 to IQ2013 obtained by dividing the seasonally-adjusted annual rate (SAAR) of IQ2013 of $13,746.2 billion by the SAAR of IVQ2010 of $13,181.2 (http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1 and Table I-6 below) and expressing as percentage {[($13,746.2/$13,181.2) - 1]100 = 4.3%}. The growth rate in annual equivalent for the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 is 1.9 percent {[(1.00025 x 1.0062 x 1.0032 x 1.010 x 1.005 x 1.0032 x 1.0077 x 1.001 x 1.0059)^4/9 -1]100 = 1.9%], or {[($13,746.2/$13,181.2)]^4/9-1]100 = 1.9%} dividing the SAAR of IVQ2012 by the SAAR of IVQ2010 in Table I-6 below, obtaining the average for nine quarters and the annual average for one year of four quarters. Growth in the four quarters of 2012 accumulates to 1.7 percent {[(1.02)^1/4(1.013)^1/4(1.031)^1/4(1.004)^1/4 -1]100 = 1.7%}. This is equivalent to dividing the SAAR of $13,665.4 billion for IVQ2012 in Table I-6 by the SAAR of $13,441.0 billion in IVQ2011 except for a rounding discrepancy to obtain 1.7 percent {[($13,665.4/$13,441.0) – 1]100 = 1.7%}. The US economy is still close to a standstill especially considering the GDP report in detail.

In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is concern of the production and employment costs of controlling future inflation. Even if there is no inflation, QE→∞ cannot be abandoned because of the fear of rising interest rates. The economy would operate in an inferior allocation of resources and suboptimal growth path, or interior point of the production possibilities frontier where the optimum of productive efficiency and wellbeing is attained, because of the distortion of risk/return decisions caused by perpetual financial repression. Not even a second-best allocation is feasible with the shocks to efficiency of financial repression in perpetuity.

The statement of the FOMC at the conclusion of its meeting on Dec 12, 2012, revealed policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm) practically unchanged in the statement at the conclusion of its meeting on Jan 30, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130130a.htm) and at its meeting on May 1, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130501a.htm):

“Release Date: May 1, 2013

For immediate release

Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. 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 expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee continues to see 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 decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities 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 of 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. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

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.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Charles L. Evans; Jerome H. Powell; Sarah Bloom Raskin; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.“

There are several important issues in this statement.

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

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

Open-ended Quantitative Easing or QE_∞. 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 decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”

Advance Guidance on “6 ¼ 2 ½ “Rule. Policy will be accommodative even after the economy recovers satisfactorily: “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.”

Monitoring and Policy Focus on Jobs. The FOMC reconsiders its policy continuously in accordance with available information: “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.”

Increase or Reduction of Asset Purchases. Market participants focused on slightly different wording about increasing asset purchases: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.” Will there be an increase in asset purchases?

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 Mar 20, 2013. The Fed releases the data with careful explanations (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130320.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 IQ2013 is analyzed in Section I (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.htm) and the PCE inflation data from the report on personal income and outlays in Section IV (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html http://cmpassocregulationblog.blogspot.com/2013/05/twenty-nine-million-unemployed-or.html). The Bureau of Economic Analysis (BEA) provides the second estimate of IQ2013 GDP with the third estimate for IQ2013 to be released on Jun 26 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm See Section I (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.htm). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed in Section IV (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/05/twenty-nine-million-unemployed-or.html). The next report on “Personal Income and Outlays” for May will be released at 8:30 AM on Jun 27, 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 May 13 was released on Jun 7 and analyzed in this blog (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html). “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 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 Mar 20, 2012 and the second row “PR” the projection of the Dec 12, 2012 meeting. There are three major changes in the view.

1. Growth “∆% GDP.” The FOMC has reduced the forecast of GDP growth in 2013 from 2.3 to 3.0 percent at the meeting in Dec 2012 to 2.3 to 2.8 percent at the meeting on Mar 20, 2013.

2. Rate of Unemployment “UNEM%.” The FOMC reduced the forecast of the rate of unemployment from 7.4 to 7.7 percent at the meeting on Dec 12, 2012 to 7.3 to 7.5 percent at the meeting on Mar 20, 2013.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.3 to 2.0 percent at the meeting on Dec 12, 2012 to 1.3 to 1.7 percent at the meeting on Mar 20, 2013.

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 that changed from 1.6 to 1.9 percent at the meeting on Dec 12, 2012 to 1.5 to 1.6 percent at the meeting on Mar 20, 2013.

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

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2013 Dec PR	2.3 to 2.8 2.3 to 3.0	7.3 to 7.5 7.4 to 7.7	1.3 to 1.7 1.3 to 2.0	1.5 to 1.6 1.6 to 1.9
2014 Dec PR	2.9 to 3.4 3.0 to 3.5	6.7 to 7.0 6.8 to 7.3	1.5 to 2.0 1.5 to 2.0	1.7 to 2.0 1.6 to 2.0
2015 Dec	2.9 to 3.7 3.0 to 3.7	6.0 to 6.5 6.0 to 6.6	1.7 to 2.0 1.7 to 2.0	1.8 to 2.1 1.8 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
2013 Dec PR	2.0 to 3.0 2.0 to 3.2	6.9 to 7.6 6.9 to 7.8	1.3 to 2.0 1.3 to 2.0	1.5 to 2.0 1.5 to 2.0
2014 Dec PR	2.6 to 3.8 2.8 to 4.0	6.1 to 7.1 6.1 to 7.4	1.4 to 2.1 1.4 to 2.2	1.5 to 2.1 1.5 to 2.0
2015 Dec PR	2.5 to 3.8 2.5 to 4.2	5.7 to 6.5 5.7 to 6.8	1.6 to 2.6 1.5 to 2.2	1.7 to 2.6 1.7 to 2.2
Longer Run Dec PR	2.0 to 3.0 2.2 to 3.0	5.0 to 6.0 5.0 to 6.0	2.0 2.0

Notes: UEM: unemployment; PR: Projection

Source: Board of Governors of the Federal Reserve System, FOMC http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130320.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/fomcprojtabl20130320.pdf). There are 18 participants expecting the rate to remain at 0 to ¼ percent in 2013 and one to be higher in the interval below 1.0 percent. 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 the fed funds rate in the range of 3.0 to 4.5 percent.

Table IV-3, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board

Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012

Source: Board of Governors of the Federal Reserve System, FOMC http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130320.pdf

Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2013 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
2013	1
2014	4
2015	13
2016	1

Source: Board of Governors of the Federal Reserve System, FOMC http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130320.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-5 provides month and 12-month percentage rates of inflation of Japan’s corporate goods price index (CGPI). Inflation measured by the CGPI increased 0.1 percent in May 2013 and 0.6 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 0.6 percent in Apr 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 (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.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 2.0 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 3.0 percent in Aug-Sep 2012. In the eighth wave, annual equivalent inflation was minus 3.0 percent in Oct-Nov 2012 in a new round of risk aversion. In the ninth wave, annual equivalent inflation returned at 3.5 percent in Dec 2012-May 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
May 2013	0.1	0.6
Apr	0.4	0.1
Mar	0.1	-0.5
Feb	0.5	-0.1
Jan	0.2	-0.4
Dec 2012	0.4	-0.7
AE ∆% Dec-May	3.5
Nov	-0.1	-1.1
Oct	-0.4	-1.1
AE ∆% Oct-Nov	-3.0
Sep	0.3	-1.5
Aug	0.2	-2.0
AE ∆% Aug-Sep	3.0
Jul	-0.5	-2.3
Jun	-0.6	-1.5
May	-0.4	-0.9
AE ∆% May-Jul	-5.8
Apr	-0.2	-0.7
Mar	0.5	0.3
Feb	0.2	0.4
AE ∆% Feb-Apr	2.0
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.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1305.pdf http://www.boj.or.jp/en/statistics/index.htm/

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 for 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 because 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

http://www.boj.or.jp/en/statistics/pi/cgpi_2010/index.htm/

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

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

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

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

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

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

There was milder increase in Japan’s export corporate goods price index during the global recession in 2008 but similar sharp decline during the bank balance sheets effect in late 2008, as shown in Chart IV-5 of the Bank of Japan. Japan exports industrial goods whose prices have been less dynamic than those of commodities and raw materials. As a result, the export CGPI on the yen basis in Chart IV-5 trends down with oscillations after a brief rise in the final part of the recession in 2009. The export corporate goods price index on the yen basis fell from 104.9 in Jun 2009 to 94.0 in Jan 2012 or minus 10.4 percent and increased to 109.3 in May 2013 for a gain of 16.3 percent relative to Jan 2012 and 4.2 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

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

Chart IV-5A provides the export corporate goods price index on the basis of the contract currency. The export corporate goods price index on the basis of the contract currency increased from 97.9 in Jun 2009 to 103.1 in Apr 2012 or 5.3 percent but dropped to 99.8 in Apr 2013 or minus 3.2 percent relative to Apr 2012 and gained 1.9 percent relative to Jun 2009.

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

Source: Bank of Japan

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

Japan imports primary commodities and raw materials. As a result, the import corporate goods price index on the yen basis in Chart IV-6 shows an upward trend after 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 113.1 in Apr 2012 or 21.0 percent and to 125.5 in May 2013 or gain of 11.0 percent relative to Apr 2012 and 34.2 percent relative to Jun 2009.

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

Source: Bank of Japan

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

Chart IV-6A provides the import corporate goods price index on the contract currency basis. The import corporate goods price index on the basis of the contract currency increased from 86.2 in Jun 2009 to 119.5 in Apr 2012 or 38.6 percent and to 112.8 in May 2013 or minus 5.6 percent relative to Apr 2012 and gain of 30.9 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 5.3 percent from Jun 2009 to Apr 2012 while the import corporate goods price index increased 38.6 percent. Prices of Japan’s exports of corporate goods, mostly industrial products, increased only 5.3 percent from Jun 2009 to Apr 2012, while imports of corporate goods, mostly commodities and raw materials increased 38.6 percent. Unconventional monetary policy induces carry trades from zero interest rates to exposures in commodities that squeeze economic activity of industrial countries by increases in prices of imported commodities and raw materials during periods without risk aversion. Reversals of carry trades during periods of risk aversion decrease prices of exported commodities and raw materials that squeeze economic activity in economies exporting commodities and raw materials. Devaluation of the dollar by unconventional monetary policy could increase US competitiveness in world markets but economic activity is squeezed by increases in prices of imported commodities and raw materials. Unconventional monetary policy causes instability worldwide instead of the mission of central banks of promoting financial and economic stability.

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

Source: Bank of Japan

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

Table IV-6 provides the Bank of Japan’s Corporate Goods Price indexes of exports and imports on the yen and contract bases from Jan 2008 to May 2013. There are oscillations of the indexes that are shown vividly in the four charts above. For the entire period from Jan 2008 to May 2013, the export index on the contract currency basis increased 0.6 percent and decreased 5.4 percent on the yen basis. For the entire period from Jan 2008 to May 2013, the import index increased 12.0 percent on the contract currency basis and increased 5.5 percent on the yen basis. The charts show sharp deteriorations in relative prices of exports to prices of imports during multiple periods. Price margins of Japan’s producers are subject to periodic squeezes resulting from carry trades from zero interest rates of monetary policy to exposures in commodities.

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

Month	Exports Contract Currency	Exports Yen	Imports Contract Currency	Imports Yen
2008/01	99.2	115.5	100.7	119.0
2008/02	99.8	116.1	102.4	120.6
2008/03	100.5	112.6	104.5	117.4
2008/04	101.6	115.3	110.1	125.2
2008/05	102.4	117.4	113.4	130.4
2008/06	103.5	120.7	119.5	140.3
2008/07	104.7	122.1	122.6	143.9
2008/08	103.7	122.1	123.1	147.0
2008/09	102.7	118.3	117.1	137.1
2008/10	100.2	109.6	109.1	121.5
2008/11	98.6	104.5	97.8	105.8
2008/12	97.9	100.6	89.3	93.0
2009/01	98.0	99.5	85.6	88.4
2009/02	97.5	100.1	85.7	89.7
2009/03	97.3	104.2	85.2	93.0
2009/04	97.6	105.6	84.4	93.0
2009/05	97.5	103.8	84.0	90.8
2009/06	97.9	104.9	86.2	93.5
2009/07	97.5	103.1	89.2	95.0
2009/08	98.3	104.4	89.6	95.8
2009/09	98.3	102.1	91.0	94.7
2009/10	98.0	101.2	91.0	94.0
2009/11	98.4	100.8	92.8	94.8
2009/12	98.3	100.7	95.4	97.5
2010/01	99.4	102.2	97.0	100.0
2010/02	99.7	101.6	97.6	99.8
2010/03	99.7	101.8	97.0	99.2
2010/04	100.5	104.6	99.9	104.6
2010/05	100.7	102.9	101.7	104.9
2010/06	100.1	101.6	100.0	102.3
2010/07	99.4	99.0	99.9	99.8
2010/08	99.1	97.3	99.5	97.5
2010/09	99.4	97.0	100.0	97.2
2010/10	100.1	96.4	100.5	95.8
2010/11	100.7	97.4	102.6	98.2
2010/12	101.2	98.3	104.4	100.6
2011/01	102.1	98.6	107.2	102.6
2011/02	102.9	99.5	109.0	104.3
2011/03	103.5	99.6	111.8	106.3
2011/04	104.1	101.7	115.9	111.9
2011/05	103.9	99.9	118.8	112.4
2011/06	103.8	99.3	117.5	110.5
2011/07	103.6	98.3	118.3	110.2
2011/08	103.6	96.6	118.6	108.1
2011/09	103.7	96.1	117.0	106.2
2011/10	103.0	95.2	116.6	105.6
2011/11	101.9	94.8	115.4	105.4
2011/12	101.5	94.5	116.1	106.2
2012/01	101.8	94.0	115.0	104.2
2012/02	102.4	95.8	115.8	106.4
2012/03	102.9	99.2	118.3	112.9
2012/04	103.1	98.7	119.5	113.1
2012/05	102.2	96.3	118.1	109.9
2012/06	101.4	95.0	115.2	106.7
2012/07	100.6	94.0	112.0	103.6
2012/08	100.8	94.1	112.4	103.6
2012/09	100.9	94.0	114.7	105.2
2012/10	101.0	94.7	113.8	105.2
2012/11	100.9	95.9	113.3	106.6
2012/12	100.7	98.0	113.6	109.7
2013/01	101.0	102.5	114.0	115.5
2013/02	101.5	105.9	114.9	120.4
2013/03	101.3	106.7	115.2	122.2
2013/04	100.2	107.5	114.3	124.0
2013/05	99.8	109.3	112.8	125.5

Source: Bank of Japan http://www.boj.or.jp/en/statistics/pi/cgpi_2010/index.htm/

Chart IV-7 provides the monthly corporate goods price index (CGPI) of Japan from 1970 to 2013. 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

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

The producer price index of the US from 1970 to 2013 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

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

Further insight into inflation of the corporate goods price index (CGPI) of Japan is provided in Table IV-7. Petroleum and coal with weight of 5.7 percent decreased 1.6 percent in May 2013 and decreased 2.1 percent in 12 months. Japan exports manufactured products and imports raw materials and commodities such that the country’s terms of trade, or export prices relative to import prices, deteriorate during commodity price increases. In contrast, prices of production machinery, with weight of 3.1 percent, increased 0.2 percent in May 2013 and decreased 0.8 percent in 12 months. In general, most manufactured products have been experiencing negative or low increases in prices while inflation rates have been high in 12 months for products originating in raw materials and commodities. Ironically, unconventional monetary policy of zero interest rates and quantitative easing that intended to increase aggregate demand and GDP growth deteriorated the terms of trade of advanced economies with adverse effects on real income.

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

May 2013	Weight	Month ∆%	12 Month ∆%
Total	1000.0	0.1	0.6
Food, Beverages, Tobacco, Feedstuffs	137.5	0.0	0.7
Petroleum & Coal	57.4	-1.6	2.1
Production Machinery	30.8	0.2	-0.8
Electronic Components	31.0	0.1	-1.4
Electric Power, Gas & Water	52.7	2.5	9.3
Iron & Steel	56.6	0.1	-4.5
Chemicals	92.1	0.5	2.9
Transport Equipment	136.4	0.0	-1.3

Source: Bank of Japan http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1305.pdf

Percentage point contributions to change of the corporate goods price index (CGPI) in Apr 2013 are provided in Table IV-8 divided into domestic, export and import segments. In the domestic CGPI, increasing 0.1 percent in May 2013, the energy shock is evident in the contribution of 0.15 percentage points by electric power, gas and water in new carry trades of exposures in commodity futures. The exports CGPI decreased 0.4 percent on the basis of the contract currency with deduction of 0.25 percentage points by metals and related products. The imports CGPI decreased 1.3 percent on the contract currency basis. Petroleum, coal & natural gas deducted 1.03 percentage points because of reversals of carry trades into energy commodity exposures. Shocks of risk aversion cause unwinding carry trades that result in declining commodity prices with resulting downward pressure on price indexes. The volatility of inflation adversely affects financial and economic decisions worldwide.

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

Groups May 2013	Contribution to Change Percentage Points
A. Domestic Corporate Goods Price Index	Monthly Change: 0.1%
Electric Power, Gas & Water	0.15
Chemicals & Related Products	0.04
Nonferrous Metals	0.03
Iron & Steel	0.01
Petroleum & Coal Products	-0.11
B. Export Price Index	Monthly Change: -0.4% contract currency
Metals & Related Products	-0.25
Chemicals & Related Products	-0.12
Other Primary Products & Manufactured Goods	-0.09
Transportation Equipment	0.05
C. Import Price Index	Monthly Change: -1.3 % contract currency basis
Petroleum, Coal & Natural Gas	-1.03
Metals & Related Products	-0.17
Electric & Electronic Products	-0.06
Chemicals & Related Products	0.01
Foodstuffs & Feedstuffs	0.01

Source: Bank of Japan http://www.boj.or.jp/en/statistics/pi/cgpi_release/cgpi1305.pdf

China is experiencing similar inflation behavior as the advanced economies in prior months in the form of declining commodity prices but differs in decreasing inflation of producer prices relative to a year earlier. As shown in Table IV-9, inflation of the price indexes for industry in May 2013 is minus 0.6 percent; 12-month inflation is minus 2.9 percent in May; and cumulative inflation in Jan-May 2013 relative to Jan-May 2012 is minus 2.1 percent. Inflation of segments in May 2013 in China is provided in Table IV-9 in column “Month May 2013 ∆%.” There were decreases of prices of mining & quarrying of 2.3 percent in May and decrease of 9.0 percent in 12 months. Prices of consumer goods decreased 0.1 percent in Apr and increased 0.3 percent in 12 months. Prices of inputs in the purchaser price index decreased 0.6 percent in May and declined 3.0 percent in 12 months. Fuel and power decreased 1.1 percent in May and declined 5.6 percent in 12 months. An important category of inputs for exports is textile raw materials, changing 0.0 percent in May and declining 0.4 percent in 12 months.

Table IV-9, China, Price Indexes for Industry ∆%

	Month May 2013 ∆%	12-Month May 2013 ∆%	Jan-May 2013/Jan-May 2012 ∆%
I Producer Price Indexes	-0.6	-2.9	-2.1
Means of Production	-0.7	-3.8	-2.9
Mining & Quarrying	-2.3	-9.0	-6.6
Raw Materials	-1.1	-5.1	-3.6
Processing	-0.4	-2.7	-2.3
Consumer Goods	-0.2	0.1	0.5
Food	-0.3	0.4	1.0
Clothing	0.0	1.2	1.4
Daily Use Articles	-0.2	-0.3	0.3
Durable Consumer Goods	-0.3	-0.8	-0.8
II Purchaser Price Indexes	-0.6	-3.0	-2.3
Fuel and Power	-1.1	-5.6	-3.8
Ferrous Metals	-1.0	-5.9	-5.6
Nonferrous Metals	-1.1	-5.0	-3.5
Raw Chemical Materials	-0.5	-3.8	-3.3
Wood & Pulp	-0.1	-0.8	-0.5
Building Materials	0.0	-1.6	-1.8
Other Industrial Raw Materials	-0.3	-1.0	-0.9
Agricultural	-0.3	0.6	1.7
Textile Raw Materials	0.0	-0.4	-0.8

Source: National Bureau of Statistics of China http://www.stats.gov.cn/english/

China’s producer price inflation follows waves similar to those around the world but with declining trend since May 2012, as shown in Table IV-10. In the first wave, annual equivalent inflation was 6.4 percent in Jan-Jun 2011, driven by carry trades from zero interest rates to commodity futures. In the second wave, risk aversion unwound carry trades, resulting in annual equivalent inflation of minus 3.1 percent in Jul-Nov 2011. In the third wave, renewed risk aversion resulted in annual equivalent inflation of minus 2.4 percent in Dec 2011-Jan 2012. In the fourth wave, new carry trades resulted in annual equivalent inflation of 2.4 percent in Feb-Apr 2012. In the fifth wave, annual equivalent inflation is minus 5.8 percent in May-Sep 2012. There are declining producer prices in China in Aug-Sep 2012 in contrast with increases worldwide. In a sixth wave, producer prices increased 0.2 percent in Oct 2012, which is equivalent to 2.4 percent in a year. In an eighth wave, annual equivalent inflation was minus 1.2 percent in Nov-Dec 2012. In the ninth wave, annual equivalent inflation in Jan-Feb 2013 is 2.4 percent. In the tenth wave, annual equivalent inflation was minus 4.7 percent in Mar-May 2013.

Table IV-10, China, Month and 12-Month Rate of Change of Producer Price Index, ∆%

	12-Month ∆%	Month ∆%
May 2013	-2.9	-0.6
Apr 2013	-2.6	-0.6
Mar 2013	-1.9	0.0
AE ∆% Mar-May		-4.7
Feb	-1.6	0.2
Jan	-1.6	0.2
AE ∆% Jan-Feb		2.4
Dec 2012	-1.9	-0.1
Nov	-2.2	-0.1
AE ∆% Nov-Dec		-1.2
Oct	-2.8	0.2
AE ∆% Oct		2.4
Sep	-3.6	-0.1
Aug	-3.5	-0.5
Jul	-2.9	-0.8
Jun	-2.1	-0.7
May	-1.4	-0.4
AE ∆% May-Sep		-5.8
Apr	-0.7	0.2
Mar	-0.3	0.3
Feb	0.0	0.1
AE ∆% Feb-Apr		2.4
Jan	0.7	-0.1
Dec 2011	1.7	-0.3
AE ∆% Dec-Jan		-2.4
Nov	2.7	-0.7
Oct	5.0	-0.7
Sep	6.5	0.0
Aug	7.3	0.1
Jul	7.5	0.0
AE ∆% Jul-Nov		-3.1
Jun	7.1	0.0
May	6.8	0.3
Apr	6.8	0.5
Mar	7.3	0.6
Feb	7.2	0.8
Jan	6.6	0.9
AE ∆% Jan-Jun		6.4
Dec 2010	5.9	0.7

AE: Annual Equivalent

Source: National Bureau of Statistics of China http://www.stats.gov.cn/english/

Chart IV-8 of the National Bureau of Statistics of China provides monthly and 12-month rates of inflation of the price indexes for the industrial sector. Negative monthly rates in Oct, Nov, Dec 2011, Jan, Mar, Apr, May, Jun, Jul, Aug, Sep, Nov and Dec 2012 pulled down the 12-month rates to 5.0 percent in Oct 2011, 2.7 percent in Nov, 1.7 percent in Dec, 0.7 percent in Jan 2012, 0.0 percent in Feb, minus 0.3 percent in Mar, minus 0.7 percent in Apr, minus 1.4 percent in May, 2.1 in Jun, minus 2.9 percent in Jul, minus 3.5 percent in Aug, minus 3.6 percent in Sep. The increase of 0.2 percent in Oct 2012 pulled up the 12-month rate to minus 2.8 percent and the rate eased to minus 2.2 percent in Nov 2012 and minus 1.9 percent in Dec 2012. Increases of 0.2 percent in Jan and Feb 2013 pulled the 12-month rate to minus 1.6 percent while no change in Mar 2013 brought down the 12-month rate to minus 1.9 percent. Declines of prices of 0.6 percent in Apr and May 2013 pushed the 12-month rate to minus 2.9 percent.

Chart IV-8, China, Producer Prices for the Industrial Sector Month and 12 months ∆%

Source: National Bureau of Statistics of China http://www.stats.gov.cn/english/

Chart IV-10 of the National Bureau of Statistics of China provides monthly and 12-month inflation of the purchaser product indices for the industrial sector. Decreasing monthly inflation with four successive contractions from Oct 2011 to Jan 2012 and May-Aug 2012 pulled down the 12-month rate to minus 4.1 percent in Aug and Sep. Consecutive increases of 0.1 percent in Sep and Oct 2012 raised the 12-month rate to minus 3.3 percent in Oct 2012. The rate eased to minus 2.8 in Nov 2012 with decrease of 0.2 percent in Nov 2012 and minus 2.4 percent in Dec 2012 with monthly decrease of 0.1 percent. Increase of 0.3 percent in Jan 2013 and 0.2 in Feb 2013 pulled the 12-month rate to minus 1.9 percent. Decrease of prices of 0.1 percent in Mar 2013 brought down the 12-month rate to minus 2.0 percent. Declining prices of 0.6 percent in Apr and May 2013 pushed down the 12-month rate to minus 3.0 percent.

Chart IV-9, China, Purchaser Product Indices for Industrial Sector

Source: National Bureau of Statistics of China

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

China is highly conscious of food price inflation because of its high weight in the basket of consumption of the population. Consumer price inflation in China in May 2013 was minus 0.6 percent and 2.4 percent in 12 months, as shown in Table IV-11. Food prices increased 0.4 percent in Apr 2013, increasing 4.0 percent in 12 months because of inclement winter weather in prior months. Adjustment occurred in May with decline of food prices by 1.6 percent and increase of 3.8 percent in 12 months and 3.8 percent in Jan-May 2013 relative to a year earlier. Another area of concern is housing inflation, which was 0.1 in May but increased 3.0 percent in 12 months. Prices of services changed 0.0 percent in May and gained 2.8 percent in 12 months.

Table IV-11, China, Consumer Price Index

2013	May 2013 Month ∆%	May 2013 12-Month ∆%	Jan-May 2013 ∆% Jan-May 2012
Consumer Prices	-0.6	2.1	2.4
Urban	-0.6	2.1	2.3
Rural	-0.5	2.2	2.5
Food	-1.6	3.2	3.8
Non-food	-0.1	1.6	1.7
Consumer Goods	-0.8	1.8	2.2
Services	0.0	2.8	2.8
Commodity Categories:
Food	-1.6	3.2	3.8
Tobacco, Liquor	-0.1	0.5	1.0
Clothing	0.1	2.5	2.4
Household	0.1	1.6	1.6
Healthcare & Personal Articles	0.1	1.5	1.6
Transportation & Communication	-0.4	-1.2	-0.5
Recreation, Education, Culture & Services	-0.3	1.3	1.4
Residence	0.1	3.0	2.9

Source: National Bureau of Statistics of China http://www.stats.gov.cn/english/

Month and 12-month rates of change of consumer prices are provided in Table IV-12. There are waves of consumer price inflation in China similar to those around the world (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). In the first wave, consumer prices increased at the annual equivalent rate of 8.3 percent in Jan-Mar 2011, driven by commodity price increases resulting from unconventional monetary policy of zero interest rates. In the second wave, risk aversion unwound carry trades with annual equivalent inflation falling to the rate of 2.0 percent in Apr-Jun 2011. In the third wave, inflation returned at 2.9 percent with renewed interest in commodity exposures in Jul-Nov 2011. In the fourth wave, inflation returned at a high 5.8 percent annual equivalent in Dec 2011 to Mar 2012. In the fifth wave, annual equivalent inflation was minus 3.9 percent in Apr to Jun 2012. In the sixth wave, annual equivalent inflation rose to 4.1 percent in Jul-Sep 2012. In the seventh wave, inflation was minus 1.2 percent annual equivalent in Oct 2012 and 0.0 percent in Oct-Nov 2012. In the eighth wave, annual equivalent inflation was 12.2 percent in Dec 2012-Feb 2013 primarily because of winter weather that caused increases in food prices. In the ninth wave, collapse of food prices resulted in annual equivalent inflation of minus 10.3 percent in Mar 2013. In the tenth wave, annual equivalent inflation returned at 2.4 percent in Apr 2013. In the eleventh wave, annual equivalent inflation was minus 7.0 percent in May 2013. Inflation volatility originating in unconventional monetary policy clouds investment and consumption decisions by business and households.

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

	Month ∆%	12-Month ∆%
May 2013	-0.6	2.1
AE ∆% May	-7.0
Apr	0.2	2.4
AE ∆% Apr	2.4
Mar 2013	-0.9	2.1
AE ∆% Mar	-10.3
Feb	1.1	3.2
Jan	1.0	2.0
Dec 2012	0.8	2.5
AE ∆% Dec-Feb	12.2
Nov	0.1	2.0
Oct	-0.1	1.7
AE ∆% Oct-Nov	0.0
Sep	0.3	1.9
Aug	0.6	2.0
Jul	0.1	1.8
AE ∆% Jul-Sep	4.1
Jun	-0.6	2.2
May	-0.3	3.0
Apr	-0.1	3.4
AE ∆% Apr to Jun	-3.9
Mar	0.2	3.6
Feb	-0.1	3.2
Jan	1.5	4.5
Dec 2011	0.3	4.1
AE ∆% Dec to Mar	5.8
Nov	-0.2	4.2
Oct	0.1	5.5
Sep	0.5	6.1
Aug	0.3	6.2
Jul	0.5	6.5
AE ∆% Jul to Nov	2.9
Jun	0.3	6.4
May	0.1	5.5
Apr	0.1	5.3
AE ∆% Apr to Jun	2.0	2.0
Mar	-0.2	5.4
Feb	1.2	4.9
Jan	1.0	4.9
AE ∆% Jan to Mar	8.3
Dec 2010	0.5	4.6

AE: Annual Equivalent

Source: National Bureau of Statistics of China http://www.stats.gov.cn/english/

Chart IV-11 of the National Bureau of Statistics of China provides monthly and 12-month rates of consumer price inflation. In contrast with producer prices, consumer prices had not moderated at the monthly marginal rates. Consumer prices fell 0.2 percent in Nov 2011 after increasing only 0.1 percent in Oct but increased 0.3 percent in Dec and a high 1.5 percent in Jan 2012, declining 0.1 percent in Feb, rising 0.2 percent in Mar and declining 0.1 percent in Apr, 0.3 percent in May and 0.6 percent in Jun 2012 but increasing 0.1 percent in Jul, 0.6 percent in Aug 2012 and 0.3 percent in Sep 2012. Consumer prices fell 0.1 percent in Oct 2012. The decline of 0.1 percent in Feb 2012 pulled down the 12-month rate to 3.2 percent, which bounced back to 3.6 percent in Mar with the monthly increase of 0.2 percent and fell to 2.2 percent in Jun with increasing pace of monthly decline from Apr to Jun 2012. Even with increase of 0.1 percent in Jul 2012, consumer price inflation in 12 months fell to 1.8 percent in Jul 2012 but bounced back to 2.0 percent with increase of 0.6 percent in Aug. In Sep, increase of 0.3 percent still maintained 12-month inflation at 1.9 percent. The decline of 0.1 percent in Oct 2012 pulled down the 12-month rate to 1.7 percent, which is the lowest in Chart IV-3. Increase of 0.1 percent in Nov 2012 pulled up the 12-month rate to 2.0 percent. Abnormal increase of 0.8 percent in Dec 2012 because of winter weather pulled up the 12-month rate to 2.5 percent. Even with increase of 1.0 percent in Jan 2013 12-month inflation fell to 2.0 percent. Inflation of 1.1 percent in Feb 2013 pulled the 12-month rate to 3.2 percent. Collapse of food prices with decline of consumer prices by 0.9 percent in Mar 2013 brought down the 12-month rate to 2.1 percent. Renewed inflation of 0.2 percent in Apr 2013 raised the 12-month rate to 2.4 percent. Decline of inflation by 0.6 percent in May reduced 12-month inflation to 2.1 percent.

Chart IV-10, China, Consumer Prices ∆% Month and 12 Months Oct 2011 to Oct 2012

Source: National Bureau of Statistics of China

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

The harmonized index of consumer prices of the euro area in Table IV-13 has similar inflation waves as in most countries (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). In the first wave, consumer prices in the euro area increased at the annual equivalent rate of 5.2 percent in Jan-Apr 2011. In the second wave, risk aversion caused unwinding of commodity carry trades with inflation decreasing at the annual equivalent rate of minus 2.4 percent in May-Jul 2011. In the third wave, improved risk appetite resulted in annual equivalent inflation in Aug-Nov at 4.3 percent. In the fourth wave, return of risk aversion caused decline of consumer prices at the annual equivalent rate of minus 3.0 percent in Dec 2011 to Jan 2012. In the fifth wave, improved attitudes toward risk aversion resulted in higher consumer price inflation at the high annual equivalent rate of 9.6 percent in Feb-Apr 2012. In the sixth wave, annual equivalent inflation fell to minus 2.8 percent in May-Jul 2012. In the seventh wave, increasing risk appetite caused new carry trade exposures that resulted in annual equivalent inflation of 6.8 percent in Aug-Sep 2012 and 5.3 percent in Aug-Oct 2012. In the eighth wave, annual-equivalent inflation was minus 2.4 percent in Nov 2012. In the ninth wave, annual equivalent inflation was 4.9 percent in Dec 2012. In the tenth wave, annual equivalent inflation was minus 11.4 percent in Jan 2013. In the eleventh wave, annual equivalent inflation was 10.0 percent in Feb-Mar 2013. In the twelfth wave, annual equivalent inflation was minus 1.2 percent in Apr 2013. In the thirteenth wave, annual equivalent inflation rose to 1.2 percent in May 2013. Inflation volatility around the world is confusing the information required in investment and consumption decisions. In the twelfth wave, annual equivalent inflation was minus 1.2 in Apr 2013.

Table IV-13, Euro Area Harmonized Index of Consumer Prices Month and 12 Months ∆%

	Month ∆%	12 Months ∆%
May 2013	0.1	1.4
AE ∆% May	1.2
Apr	-0.1	1.2
AE ∆% Apr	-1.2
Mar	1.2	1.7
Feb	0.4	1.9
AE ∆% Feb-Mar	10.0
Jan	-1.0	2.0
AE ∆% Jan	-11.4
Dec 2012	0.4	2.2
AE ∆% Dec	4.9
Nov	-0.2	2.2
AE ∆% Nov	-2.4
Oct	0.2	2.5
Sep	0.7	2.6
Aug	0.4	2.6
AE ∆% Aug-Oct	5.3
Jul 2012	-0.5	2.4
Jun	-0.1	2.4
May	-0.1	2.4
AE ∆% May-Jul	-2.8
Apr	0.5	2.6
Mar	1.3	2.7
Feb	0.5	2.7
AE ∆% Feb-Apr	9.6
Jan	-0.8	2.7
Dec 2011	0.3	2.7
AE ∆% Dec-Jan	-3.0
Nov	0.1	3.0
Oct	0.4	3.0
Sep	0.7	3.0
Aug	0.2	2.6
AE ∆% Aug-Nov	4.3
Jul	-0.6	2.6
Jun	0.0	2.7
May	0.0	2.7
AE ∆% May-Jul	-2.4
Apr	0.6	2.8
Mar	1.4	2.7
Feb	0.4	2.4
Jan	-0.7	2.3
AE ∆% Jan-Apr	5.2
Dec 2010	0.6	2.2

AE: annual equivalent Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/ http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

Table IV-14 provides weights and inflation of selected components of the HICP of the euro area. Inflation of all items excluding energy increased 1.6 percent in May 2013 relative to May 2012 and increased 0.3 percent in May 2013 relative to Apr 2013. Prices of non-energy industrial goods increased 0.8 percent in May 2013 relative to a year earlier and changed 0.0 percent in May 2013. Inflation of services was 1.5 percent in May 2013 relative to a year earlier and increased 0.3 percent in May 2013.

Table IV-14, Euro Area, HICP Inflation and Selected Components, ∆%

	Weight % 2013	May 2013/ May 2012	12-month Average Rate May 2013-2012/ May 2012-2011	∆% May 2013/Apr 2013
All Items	1000.0	1.4	2.1	0.1
All Items ex Energy	890.4	1.6	1.8	0.3
All Items ex Energy, Food, Alcohol & Tobacco	696.7	1.2	1.4	0.2
All Items ex Energy & Unprocessed Food	816.9	1.3	1.6	0.2
All Items ex Seasonal Food	852.7	1.4	1.6	0.2
All Items ex Tobacco	975.8	1.4	2.0	0.1
Energy	109.6	-0.4	4.7	-1.2
Food, Alcohol & Tobacco	193.7	3.2	3.0	0.5
Non-energy Industrial Goods	273.6	0.8	1.0	0.0
Services	423.0	1.5	1.7	0.3

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

Table IV-15 provides weights and inflation of selected components of the HICP of the euro area with highest annual impact. Inflation of electricity with weight of 25.9 increased 8.5 percent in May 2013 relative to a year earlier and contributed 0.09 percentage points. Fuels for transport with weight of 50.0 fell 3.8 percent relative to a year earlier, deducting 0.28 percent in reversal of energy carry trades.

Table IV-15, Euro Area, Components with Highest Impact on Annual Inflation

	Weight % 2013	Annual Rate May 2013 ∆%	Impact Percentage Points May 2013
Fruit	11.8	10.6	0.11
Vegetables	15.2	8.5	0.11
Electricity	25.9	4.9	0.09
Medical and Paramedical Services	11.3	-5.2	-0.08
Telecommunications	29.4	-4.6	-0.18
Fuels for Transport	50.0	-3.8	-0.28

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

The estimate of consumer price inflation in Germany in Table IV-16 is 1.5 percent in 12 months ending in May 2013, 0.4 percent NSA in May 2013 relative to Apr 2013 and 0.4 percent SA in May 2013 relative to Apr 2013. There are waves of consumer price inflation in Germany similar to those worldwide (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html), as shown in Table IV-16. In the first wave, annual equivalent inflation was 3.0 percent in Feb-Apr 2011 NSA and 2.4 percent SA during risk appetite in carry trades from zero interest rates to commodity futures. In the second wave, annual equivalent consumer price inflation collapsed to 0.6 percent NSA and 3.0 percent SA in May-Jun 2011 because of risk aversion caused by European sovereign debt event. In the third wave, annual equivalent consumer price inflation was 1.7 percent NSA and 1.9 percent SA in Jul-Nov 2011 because of relaxed risk aversion. In the fourth wave, annual equivalent inflation was 0.6 percent NSA and 1.8 percent SA in Dec 2011 to Jan 2012. In the fifth wave, annual equivalent inflation rose to 4.5 percent NSA and 2.0 percent SA in Feb-Apr 2012 during another energy-commodity carry trade shock. In the sixth wave, annual equivalent inflation in May-Jun 2012 is minus 1.2 percent NSA and 0.6 percent SA. In the seventh wave, annual equivalent inflation NSA is 4.9 percent in Jul-Aug 2012 and 3.7 percent SA. In the eighth wave in Sep-Dec 2012, annual equivalent inflation is 1.5 percent NSA and 1.8 percent SA. In the ninth wave, annual equivalent inflation fell to minus 5.8 percent NSA in Jan 2013 and minus 1.2 percent SA. In the eleventh wave, annual equivalent inflation rose to 6.8 percent NSA in Feb-Mar 2013 and 1.2 percent CSA. In the twelfth wave, annual equivalent inflation fell to minus 5.8 percent NSA and minus 1.2 percent SA in reversal of carry trades into commodity futures. In the thirteenth wave, annual equivalent inflation returned at 4.9 percent in May 2013 both NSA and SA. Under unconventional monetary policy of zero interest rates and quantitative easing inflation becomes highly volatile during alternative shocks of risk aversion and risk appetite, preventing sound investment and consumption decisions.

Table IV-16, Germany, Consumer Price Index ∆%

	12-Month ∆%	Month ∆% NSA	Month ∆% CSA
May 2013	1.5	0.4	0.4
AE ∆% May		4.9	4.9
Apr	1.2	-0.5	-0.1
AE ∆% Apr		-5.8	-1.2
Mar	1.4	0.5	0.1
Feb	1.5	0.6	0.1
AE ∆% Feb-Mar		6.8	1.2
Jan	1.7	-0.5	-0.1
AE ∆% Jan		-5.8	-1.2
Dec 2012	2.0	0.3	0.2
Nov	1.9	0.1	0.1
Oct	2.0	0.0	0.2
Sep	2.0	0.1	0.1
AE ∆% Sep-Dec		1.5	1.8
Aug	2.2	0.4	0.3
Jul	1.9	0.4	0.3
AE ∆% Jul-Aug		4.9	3.7
Jun	1.7	-0.2	0.0
May	2.0	0.0	0.1
AE ∆% May-Jun		-1.2	0.6
Apr	2.0	-0.2	0.1
Mar	2.2	0.6	0.2
Feb	2.2	0.7	0.2
AE ∆% Feb-Apr		4.5	2.0
Jan	2.1	-0.1	0.3
Dec 2011	2.0	0.2	0.0
AE ∆% Dec-Jan		0.6	1.8
Nov	2.4	0.2	0.2
Oct	2.3	0.0	0.1
Sep	2.4	0.2	0.3
Aug	2.1	0.1	0.1
Jul	2.1	0.2	0.1
AE ∆% Jul-Nov		1.7	1.9
Jun	2.1	0.1	0.3
May	2.0	0.0	0.2
AE ∆% May-Jun		0.6	3.0
Apr	1.9	0.0	0.2
Mar	2.0	0.6	0.2
Feb	1.9	0.6	0.2
Jan	1.7	-0.2	0.2
AE ∆% Feb-Apr		3.0	2.4
Dec 2010	1.3	0.6	0.2
Nov	1.5	0.1	0.2
Oct	1.3	0.1	0.2
Sep	1.2	-0.1	0.1
Aug	1.0	0.1	0.1
Annual Average ∆%
2012	2.0
2011	2.1
2010	1.1
2009	0.4
2008	2.6
Dec 2009	0.8
Dec 2008	1.1
Dec 2007	3.2
Dec 2006	1.4
Dec 2005	1.4
Dec 2004	2.2
Dec 2003	1.1
Dec 2002	1.1
Dec 2001	1.6

AE: Annual Equivalent

Source: Statistisches Bundesamt Deutschland https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html

Chart IV-11 of the Statistisches Bundesamt Deutschland, or federal statistical office of Germany, provides the unadjusted consumer price index of Germany from 2005 to 2013. There is evident acceleration in the form of sharper slope in the first months of 2011 and then a flattening in subsequent months with renewed strength in Dec 2011, decline in Jan 2012 and another upward spike from Feb to Apr 2012, new drop in May-Jun 2012 and increases in Jul and Aug 2012 relaxed in Sep-Nov 2012. Inflation returned in Dec 2012 and fell in Jan 2013, rebounding in Feb-Mar 2013. Inflation fell in Apr 2013 and rebounded in May 2013. Reversals of commodity exposures caused the decline in Apr 2013. If risk aversion declines, new carry trades from zero interest rates to commodity futures could again result in higher inflation.

Chart IV-11, Germany, Consumer Price Index, Unadjusted, 2005=100

Source: Statistisches Bundesamt Deutschland

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

Chart IV-11A provides the consumer price index NSA of the US from 2005 to 2013. The salient similarity is the hump in 2008 caused by commodity carry trades driven by the movement to zero interest rates. Inflation communicated worldwide through carry trade from zero interest rates to exposures in commodity futures, creating instability in financial and economic decisions.

Chart IV-11A, US, Consumer Price Index, All Items, NSA, 2005-2013

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

Chart IV-12, of the Statistisches Bundesamt Deutschland, or Federal Statistical Agency of Germany, provides the unadjusted consumer price index and trend of Germany from 2009 to 2013. Chart IV-12 captures inflation waves with alternation of periods of positive and negative slopes resulting from zero interest rates with shocks of risk appetite and risk aversion. For example, the negative slope of decline of inflation by 0.2 percent in Jun 2012 and 0.0 percent in May 2012 follows an upward slope of price increases in Feb-Apr 2012 after decline of inflation by 0.1 percent in Jan 2012. The final segment shows another positive slope caused by inflation of 0.4 percent in Jul 2012, which is followed by 0.4 percent in Aug 2012 and flattening segment as inflation remains almost unchanged with 0.1 percent in Sep and 0.0 percent in Oct 2012, increasing 0.1 percent in Nov 2012 and increasing 0.3 percent in Dec 2012. Inflation fell 0.5 percent in Jan 2013 and jumped 0.6 percent in Feb 2013 and 0.5 percent in Mar 2013. The final declining segment indicates the decline of 0.5 percent in Apr 2013 followed by the increase in May 2013. The waves occur around an upward trend of prices, disproving the proposition of fear of deflation.

Chart IV-12, Germany, Consumer Price Index, Unadjusted and Trend, 2005=100

Source: Statistisches Bundesamt Deutschland

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

Table IV-17 provides the monthly and 12-month rate of inflation for segments of the consumer price index of Germany in May 2013. Inflation excluding energy increased 0.6 percent in May 2013 and rose 1.7 percent in 12 months. Excluding household energy inflation was 0.4 percent in May 2013 and rose 0.6 percent in 12 months. Food prices increased 1.0 percent in May 2013 and increased 5.4 percent in 12 months. There were differences in inflation of energy-related prices. Heating oil fell 5.9 percent in 12 months and decreased 1.2 percent in May in reversal of carry trades. Motor fuels decreased 0.9 percent in May and decreased 3.7 percent in 12 months.

Table IV-17, Germany, Consumer Price Index ∆%

May 2013	Weight	12- Month ∆%	Month ∆%
Total	1,000.00	1.5	0.4
Excluding heating oil and motor fuels	950.52	1.9	0.5
Excluding household energy	931.81	1.4	0.4
Excluding Energy	893.44	1.7	0.6
Total Goods	479.77	1.9	0.0
Nondurable Consumer Goods	307.89	2.5	0.1
Medium-Term Life Consumer Goods	91.05	1.5	-0.5
Durable Consumer Goods	80.83	-0.5	0.0
Services	520.23	1.4	0.8
Energy Components
Motor Fuels	38.37	-3.7	-0.9
Household Energy	68.19	4.5	-0.2
Heating Oil	11.11	-5.9	-1.2
Food	90.52	5.4	1.0

Source: Statistisches Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2013/06/PE13_192_611.html;jsessionid=905FE26F447088BB722AC14C2F3AA2DC.cae1

Table IV-18 provides monthly and 12 months consumer price inflation in France. There are the same waves as in inflation worldwide (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). In the first wave, annual equivalent inflation in Jan-Apr 2011 was 4.3 percent driven by the carry trade from zero interest rates to commodity futures positions in an environment of risk appetite. In the second wave, risk aversion caused the reversal of carry trades into commodity futures, resulting in the fall of the annual equivalent inflation rate to minus 1.2 percent in May-Jul 2011. In the third wave, annual equivalent inflation rose to 3.0 percent in Aug-Nov 2011 with alternations of risk aversion and risk appetite. In the fourth wave, risk aversion originating in the European debt crisis caused annual equivalent inflation of 0.0 percent from Dec 2011 to Jan 2012. In the fifth wave, annual equivalent inflation increased to 5.3 percent in Feb-Apr 2012. In the sixth wave, annual equivalent inflation was minus 2.4 percent in May-Jul 2012 during another bout of risk aversion causing reversal of carry trades from zero interest rates to commodity price futures exposures. In the seventh wave, annual equivalent inflation jumped to 8.7 percent in Aug 2012, 3.0 percent in Aug-Sep 2012 and 2.8 percent in Aug-Oct 2012. In the eighth wave, annual equivalent inflation was minus 2.4 percent in Nov 2012 and minus 1.6 percent in Nov 2012 to Jan 2013. In the ninth wave, annual equivalent inflation was 6.8 percent in Feb-Mar 2013. In the tenth wave, annual equivalent inflation was minus 1.2 percent in Apr because of reversal of commodity carry trades and 0.0 percent in annual equivalent in Apr-May 2013.

Table IV-18, France, Consumer Price Index, Month and 12-Month ∆%

	Month ∆%	12-Month ∆%
May 2013	0.1	0.8
Apr	-0.1	0.7
AE ∆% Apr-May	0.0
Mar	0.8	1.0
Feb	0.3	1.0
AE ∆% Feb-Mar	6.8
Jan	-0.5	1.2
Dec 2012	0.3	1.3
Nov	-0.2	1.4
AE ∆% Nov-Jan	-1.6
Oct	0.2	1.9
Sep	-0.2	1.9
Aug	0.7	2.1
AE ∆% Aug-Oct	2.8
Jul	-0.5	1.9
Jun	0.0	1.9
May	-0.1	2.0
AE ∆% May-Jul	-2.4
Apr	0.1	2.1
Mar	0.8	2.3
Feb	0.4	2.3
AE ∆% Feb-Apr	5.3
Jan	-0.4	2.4
Dec 2011	0.4	2.5
AE ∆% Dec-Jan	0.0
Nov	0.3	2.5
Oct	0.3	2.4
Sep	-0.1	2.2
Aug	0.5	2.2
AE ∆% Aug-Nov	3.0
Jul	-0.5	1.9
Jun	0.1	2.1
May	0.1	2.0
AE ∆% May-Jul	-1.2
Apr	0.3	2.1
Mar	0.8	2.0
Feb	0.5	1.6
Jan	-0.2	1.8
AE ∆% Jan-Apr	4.3
Dec 2010	0.4	1.8
Annual
2012		2.0
2011		2.1
2010		1.5
2009		0.1
2008		2.8
2007		1.5
2006		1.6
2005		1.8
2004		2.1
2003		2.1
2002		1.9
2001		1.7
2000		1.7
1999		0.5
1998		0.7
1997		1.2
1996		2.0
1995		1.8
1994		1.6
1993		2.1
1992		2.4
1991		3.2

AE: Annual Equivalent Metropolitan France

Source: Institut National de la Statistique et des Études Économiques http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20130612

Chart IV-13 of Institut National de la Statistique et des Études Économiques provides the consumer price index in France since Jan 1998. There is the same jump and decline of inflation during the global recession from 2008 to 2009 caused by carry trades from zero interest rates into commodity exposures. The index also captures the waves of inflation around an upward trend.

Chart IV-11, France, Consumer Price Index, Jan 1998-Apr 2013, 1998=100

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20130612

Table IV-19 provides consumer price inflation in France and of various items in May 2013 and in the 12 months ending in May 2013. Inflation of all items was 0.1 percent in May 2013 and 0.8 percent in 12 months. Energy prices decreased 1.8 percent in May 2013 and decreased 0.4 percent in 12 months. Transport and communications increased 0.7 percent in May 2013 and fell 5.3 percent in 12 months. Food and rentals and dwellings show the higher 12-month increases of 1.7 percent and 1.8 percent, respectively.

Table IV-19, France, Consumer Price Index, Month and 12-Month Percentage Changes of Index and Components, ∆%

May 2013	Weights	Month ∆%	12-Month ∆%
All Items	10000	0.1	0.8
Food	1658	0.6	1.8
Manufactured Products	2738	0.0	-0.3
Energy	822	-1.8	-0.4
Petroleum Products	495	--3.2	-4.5
Services	4576	0.2	1.1
Rentals, Dwellings	748	-0.6	1.7
Transport and Communications	506	0.7	-5.3

Source: Institut National de la Statistique et des Études Économiques http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20130612

Chart IV-12 of the Institut National de la Statistique et des Études Économiques (INSEE) of France shows headline and core consumer price inflation of France. Inflation rose during the commodity price shock of unconventional monetary policy. Risk aversion in late 2008 and beginning of 2009 caused collapse of valuation of commodity futures with resulting decline in inflation. The current downward trend of inflation originates in concentration of carry trades in equities and high-yield bonds with reversal of exposures in commodities.

Chart IV-12, France, Consumer Price Index (IPC) and Core Consumer Price Index (ISJ) 12 Months Rates of Change

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20130612

The first wave of commodity price increases in the first four months of Jan-Apr 2011 also influenced the surge of consumer price inflation in Italy shown in Table IV-20. Annual equivalent inflation in the first four months of 2011 was 4.9 percent. The crisis of confidence or risk aversion resulted in reversal of carry trades on commodity positions. Consumer price inflation in Italy was subdued in the second wave in Jun and May 2011 at 0.1 percent for annual equivalent 1.2 percent. In the third wave in Jul-Sep 2011, annual equivalent inflation increased to 2.4 percent. In the fourth wave, annual equivalent inflation in Oct-Nov 2011 jumped again at 3.0 percent. Inflation returned in the fifth wave from Dec 2011 to Jan 2012 at annual equivalent 4.3 percent. In the sixth wave, annual equivalent inflation rose to 5.7 percent in Feb-Apr 2012. In the seventh wave, annual equivalent inflation was 1.2 percent in May-Jun 2012. In the eighth wave, annual equivalent inflation increased to 3.0 percent in Jul-Aug 2012. In the ninth wave, inflation collapsed to zero in Sep-Oct 2012 and was minus 0.8 percent in annual equivalent in Sep-Nov 2012. In the tenth wave, annual equivalent inflation in Dec 2012 to May 2013 was 1.4 percent. Economies are shocked worldwide by intermittent waves of inflation originating in combination of zero interest rates and quantitative easing with alternation of risk appetite and risk aversion (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html).

Table IV-20, Italy, Consumer Price Index

	Month	12 Months
May 2013	0.0	1.1
Apr	0.0	1.1
Mar	0.2	1.6
Feb	0.1	1.9
Jan	0.2	2.2
Dec 2012	0.2	2.3
AE ∆% Dec 2012-May 2013	1.4
Nov 2012	-0.2	2.5
Oct	0.0	2.6
Sep	0.0	3.2
AE ∆% Sep-Nov	-0.8
Aug	0.4	3.2
Jul	0.1	3.1
AE ∆% Jul-Aug	3.0
June	0.2	3.3
May	0.0	3.2
AE ∆% May-Jun	1.2
Apr	0.5	3.3
Mar	0.5	3.3
Feb	0.4	3.3
AE ∆% Feb-Apr	5.7
Jan	0.3	3.2
Dec 2011	0.4	3.3
AE ∆% Dec-Jan	4.3
Nov	-0.1	3.3
Oct	0.6	3.4
AE ∆% Oct-Nov	3.0
Sep	0.0	3.0
Aug	0.3	2.8
Jul	0.3	2.7
AE ∆% Jul-Sep	2.4
Jun	0.1	2.7
May	0.1	2.6
AE ∆% May-Jun	1.2
Apr	0.5	2.6
Mar	0.4	2.5
Feb	0.3	2.4
Jan	0.4	2.1
AE ∆% Jan-Apr	4.9
Dec 2010	0.4	1.9
Annual
2012		3.0
2011		2.8
2010		1.5
2009		0.8
2008		3.3
2007		1.8
2006		2.1

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/92964

Consumer price inflation in Italy by segments in the estimate by ISTAT for Feb 2013 is provided in Table IV-21. Total consumer price inflation in May 2013 was 0.0 percent and 1.1 percent in 12 months. Inflation of goods was minus 0.1 percent in May 2013 and 0.8 percent in 12 months. Prices of durable goods decreased 0.2 percent in May and decreased 0.1 percent in 12 months, as typical in most countries. Prices of energy decreased 1.7 percent in May and decreased 2.4 percent in 12 months. Food prices increased 0.6 percent in May and increased 3.0 percent in 12 months. Prices of services increased 0.2 percent in May and rose 1.7 percent in 12 months. Transport prices, also influenced by commodity prices, increased 0.5 percent in May and increased 3.3 percent in 12 months. Carry trades from zero interest rates to positions in commodity futures cause increases in commodity prices. Waves of inflation originate in periods when there is no risk aversion and commodity prices decline during periods of risk aversion (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html).

Table IV-21, Italy, Consumer Price Index and Segments, Month and 12-Month ∆%

May 2013	Weights	Month ∆%	12-Month ∆%
General Index	1,000,000	0.0	1.1
I Goods	559,402	-0.1	0.8
Food	168,499	0.6	3.0
Energy	94,758	-1.7	-2.4
Durable	89,934	-0.2	-0.1
Nondurable	71,031	0.1	1.5
II Services	440,598	0.2	1.7
Housing	71,158	0.1	2.0
Communications	20,227	-0.2	-2.7
Transport	81,266	0.5	3.3

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/92964

Chart IV-17 of the Istituto Nazionale di Statistica shows moderation in 12-month percentage changes of the consumer price index of Italy with marginal increase followed by decline to 2.5 percent in Nov 2012, 2.3 percent in Dec 2012, 2.2 percent in Jan 2013, 1.9 percent in Feb 2013 and 1.6 percent in Mar 2013. Consumer prices increased 1.1 percent in the 12 months ending in Apr-May 2013.

Chart, IV-13, Italy, Consumer Price Index, 12-Month Percentage Changes

Source: Istituto Nazionale di Statistica

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

Longer Run