Interest Rate Risks, Duration Dumping and Peaking Valuations of Risk Financial Assets, Collapse of United States Dynamism of Income Growth and Employment Creation, United States Commercial Banks Assets and Liabilities, United States Housing Collapse, World Economic Slowdown and Global Recession Risk
Carlos M. Pelaez
© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013
Executive Summary
IA United States Commercial Banks Assets and Liabilities
IA1 Transmission of Monetary Policy
IA2 Functions of Banks
IA3 United States Commercial Banks Assets and Liabilities
IA4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation
IB Collapse of United States Dynamism of Income Growth and Employment Creation
II United States Housing Collapse
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 1980
II United States Housing Collapse. The objective of this section is to provide the latest data and analysis of US housing. Subsection IIA1 United New House Sales analyzes the collapse of US new house sales. Subsection IIA2 United States House Prices considers the latest available data on house prices. Subsection IIA3 Factors of US Housing Collapse provides the analysis of the causes of the housing crisis of the US.
IIA1 United States New House Sales. Data and other information continue to provide depressed conditions in the US housing market in a longer perspective, with recent improvement at the margin. Table IIA-1 shows sales of new houses in the US at seasonally adjusted annual equivalent rate (SAAR). House sales fell in fifteen of thirty-one months from Jan 2011 to Jul 2013 but mostly concentrated in Jan-Feb 2011 and May-Aug 2011. In Jan-Apr 2012, house sales increased at the annual equivalent rate of 10.3 percent and at 23.5 percent in May-Sep 2012. There was significant strength in Sep-Dec 2011 with annual equivalent rate of 48.4 percent. Sales of new houses fell 0.5 percent in Dec 2012 and 4.9 percent in Oct 2012 with increase of 9.0 percent in Nov 2012. Sales of new houses rebounded 15.7 percent in Jan 2013 with annual equivalent rate of 69.9 percent from Oct 2012 to Jan 2013 because of the increase of 15.7 percent in Jan 2013. New house sales fell at annual equivalent 17.7 percent in Feb-Mar 2013. New house sales weakened with decline of 29.7 percent in annual equivalent from Apr to Jul 2013, mostly because of the decline of 13.4 percent in Jul 2013. Robbie Whelan and Conor Dougherty, writing on “Builders fuel home sale rise,” on Feb 26, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324338604578327982067761860.html), analyze how builders have provided financial assistance to home buyers, including those short of cash and with weaker credit background, explaining the rise in new home sales and the highest gap between prices of new and existing houses. The 30-year conventional mortgage rate increased from 3.40 on Apr 25, 2013 to 4.58 percent on Aug 22, 2013 (http://www.federalreserve.gov/releases/h15/data.htm), which could also be a factor in recent weakness. The conventional mortgage rate measured in a survey by Freddie Mac (http://www.freddiemac.com/pmms/release.html) is the “contract interest rate on commitments for fixed-rate first mortgages” (http://www.federalreserve.gov/releases/h15/data.htm).
Table IIA-1, US, Sales of New Houses at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %
| SA Annual Rate | ∆% | |
| Jul 2013 | 394 | -13.4 |
| Jun | 455 | 3.6 |
| May | 439 | -1.6 |
| Apr | 446 | 0.7 |
| AE ∆% Apr-Jul | -29.7 | |
| Mar | 443 | -0.4 |
| Feb | 445 | -2.8 |
| AE ∆% Feb-Mar | -17.7 | |
| Jan | 458 | 15.7 |
| Dec 2012 | 396 | -0.5 |
| Nov | 398 | 9.0 |
| Oct | 365 | -4.9 |
| AE ∆% Oct-Jan | 69.9 | |
| Sep | 384 | 2.7 |
| Aug | 374 | 1.4 |
| Jul | 369 | 2.5 |
| Jun | 360 | -2.4 |
| May | 369 | 4.8 |
| AE ∆% May-Sep | 23.5 | |
| Apr | 352 | 0.9 |
| Mar | 349 | -4.6 |
| Feb | 366 | 8.3 |
| Jan | 338 | -0.9 |
| AE ∆% Jan-Apr | 10.3 | |
| Dec 2011 | 341 | 4.0 |
| Nov | 328 | 3.8 |
| Oct | 316 | 3.9 |
| Sep | 304 | 1.7 |
| AE ∆% Sep-Dec | 48.4 | |
| Aug | 299 | -1.7 |
| Jul | 296 | -2.3 |
| Jun | 301 | -1.3 |
| May | 305 | -1.6 |
| AE ∆% May-Aug | -18.9 | |
| Apr | 310 | 3.3 |
| Mar | 300 | 11.1 |
| Feb | 270 | -12.1 |
| Jan | 307 | -5.8 |
| AE ∆% Jan-Apr | -14.2 | |
| Dec 2010 | 326 | 13.6 |
AE: Annual Equivalent
Source: US Census Bureau http://www.census.gov/construction/nrs/
There is additional information of the report of new house sales in Table IIA-2. The stock of unsold houses stabilized in Apr-Aug 2011 at average 6.6 monthly equivalent sales at current sales rates and then dropped to 4.6 in Jul-Aug 2012, increasing to 4.8 in Oct 2012, 4.5 in Nov 2012 and 4.5 percent in Dec 2012. Inventories dropped to 3.9 in Jan 2013 and 4.1 in Feb 2013. Inventories stabilized at 4.3-4.5 in Mar-Jun 2013 and increased to 5.2 in Jul 2013. Robbie Whelan and Conor Dougherty, writing on “Builders fuel home sale rise,” on Feb 26, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324338604578327982067761860.html), find that inventories of houses have declined as investors acquire distressed houses of higher quality. Median and average house prices oscillate. In Jul 2013, median prices of new houses sold not seasonally adjusted (NSA) decreased 0.5 percent. Average prices increased 6.8 percent in Jul 2013. Between Dec 2010 and Jul 2013 median prices increased 6.6 percent and average prices increased 10.6 percent. Between Dec 2010 and Dec 2012, median prices increased 7.1 percent and average prices increased 2.6 percent. Price increases concentrated in 2012 with increase of median prices of 18.2 percent from Dec 2011 to Dec 2012 and of average prices of 13.8 percent. Robbie Williams, writing on “New homes hit record as builders cap supply,” on May 24, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323475304578500973445311276.html?mod=WSJ_economy_LeftTopHighlights), finds that homebuilders are continuing to restrict the number of new homes for sale. Restriction of available new homes for sale increases prices paid by buyers.
Table IIA-2, US, New House Stocks and Median and Average New Homes Sales Price
| Unsold* | Median | Month | Average New House Sales Price USD | Month | |
| Jul 2013 | 5.2 | 257,200 | -0.5 | 322,700 | 6.8 |
| Jun | 4.3 | 258,500 | -1.6 | 302,200 | -2.7 |
| May | 4.5 | 262,600 | -6.0 | 310,700 | -7.8 |
| Apr | 4.3 | 279,300 | 8.5 | 337,000 | 12.3 |
| Mar | 4.2 | 257,500 | -2.9 | 300,200 | -3.9 |
| Feb | 4.1 | 265,100 | 5.4 | 312,500 | 1.8 |
| Jan | 3.9 | 251,500 | -2.6 | 306,900 | 2.6 |
| Dec 2012 | 4.5 | 258,300 | 5.4 | 299,200 | 2.9 |
| Nov | 4.5 | 245,000 | -0.9 | 290,700 | 1.9 |
| Oct | 4.8 | 247,200 | -2.9 | 285,400 | -4.1 |
| Sep | 4.5 | 254,600 | 0.6 | 297,700 | -2.6 |
| Aug | 4.6 | 253,200 | 6.7 | 305,500 | 8.2 |
| Jul | 4.6 | 237,400 | 2.1 | 282,300 | 3.9 |
| Jun | 4.8 | 232,600 | -2.8 | 271,800 | -3.2 |
| May | 4.7 | 239,200 | 1.2 | 280,900 | -2.4 |
| Apr | 4.9 | 236,400 | -1.4 | 287,900 | 1.5 |
| Mar | 5.0 | 239,800 | 0.0 | 283,600 | 3.5 |
| Feb | 4.8 | 239,900 | 8.2 | 274,000 | 3.1 |
| Jan | 5.3 | 221,700 | 1.4 | 265,700 | 1.1 |
| Dec 2011 | 5.3 | 218,600 | 2.0 | 262,900 | 5.2 |
| Nov | 5.7 | 214,300 | -4.7 | 250,000 | -3.2 |
| Oct | 6.0 | 224,800 | 3.6 | 258,300 | 1.1 |
| Sep | 6.3 | 217,000 | -1.2 | 255,400 | -1.5 |
| Aug | 6.5 | 219,600 | -4.5 | 259,300 | -4.1 |
| Jul | 6.7 | 229,900 | -4.3 | 270,300 | -1.0 |
| Jun | 6.6 | 240,200 | 8.2 | 273,100 | 3.9 |
| May | 6.6 | 222,000 | -1.2 | 262,700 | -2.3 |
| Apr | 6.7 | 224,700 | 1.9 | 268,900 | 3.1 |
| Mar | 7.2 | 220,500 | 0.2 | 260,800 | -0.8 |
| Feb | 8.1 | 220,100 | -8.3 | 262,800 | -4.7 |
| Jan | 7.3 | 240,100 | -0.5 | 275,700 | -5.5 |
| Dec 2010 | 7.0 | 241,200 | 9.8 | 291,700 | 3.5 |
*Percent of new houses for sale relative to houses sold
Source: US Census Bureau http://www.census.gov/construction/nrs/
The depressed level of residential construction and new house sales in the US is evident in Table IIA-3 providing new house sales not seasonally adjusted in Jan-Jul of various years. Sales of new houses in Jan-Jul 2013 are substantially lower than in any year between 1963 and 2013 with the exception of the years from 2009 to 2012. There are only four increases of 21.8 percent relative to Jan-Jul 2012, 47.0 percent relative to Jan-Jul 2011, 30.8 percent relative to Jan-Jul 2010 and 20.9 percent relative to Jan-Jul 2009. Sales of new houses in Jan-Jul 2013 are lower by 16.8 percent relative to Jan-Jul 2008, 47.3 percent relative to 2007, 59.3 percent relative to 2006 and 65.8 percent relative to 2005. The housing boom peaked in 2005 and 2006 when increases in fed funds rates to 5.25 percent in Jun 2006 from 1.0 percent in Jun 2004 affected subprime mortgages that were programmed for refinancing in two or three years on the expectation that price increases forever would raise home equity. Higher home equity would permit refinancing under feasible mortgages incorporating full payment of principal and interest (Gorton 2009EFM; see other references in http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Sales of new houses in Jan-Jul 2013 relative to the same period in 2004 fell 63.2 percent and 58.3 percent relative to the same period in 2003. Similar percentage declines are also observed for 2013 relative to years from 2000 to 2004. Sales of new houses in Jan-Jun 2013 fell 32.7 per cent relative to the same period in 1995. The population of the US was 179.3 million in 1960 and 281.4 million in 2000 (Hobbs and Stoops 2002, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table IIB-3 reveals catastrophic data: sales of new houses in Jan-Jul 2013 of 341 thousand units are lower by 20.2 percent relative to 272 thousand units of houses sold in Jan-Jun 1963, the first year when data become available. The civilian noninstitutional population increased from 122.521 million in Jul 1963 to 245.756 million in Jul 2013, or 100.6 percent (http://www.bls.gov/data/). The Bureau of Labor Statistics (BLS) defines the civilian noninstitutional population (http://www.bls.gov/lau/rdscnp16.htm#cnp): “The civilian noninstitutional population consists of persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.”
The civilian noninstitutional population is the universe of the labor force.
Table IIA-3, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %
| Not Seasonally Adjusted Thousands | |
| Jan-Jul 2013 | 272 |
| Jan-Jul 2012 | 223 |
| ∆% Jan-Jul 2013/Jan-Jul 2012 | 21.8* |
| Jan-Jul 2011 | 185 |
| ∆% Jan-Jul 2013/Jan-Jul 2011 | 47.0 |
| Jan-Jul 2010 | 208 |
| ∆% Jan-Jul 2013/ | 30.8 |
| Jan-Jul 2009 | 225 |
| ∆% Jan-Jul 2013/ | 20.9 |
| Jan-Jul 2008 | 327 |
| ∆% Jan-Jul 2013/ | -16.8 |
| Jan-Jul 2007 | 516 |
| ∆% Jan-Jul 2013/ | -47.3 |
| Jan-Jun 2006 | 668 |
| ∆% Jan-Jul 2013/Jan-Jul 2006 | -59.3 |
| Jan-Jul 2005 | 796 |
| ∆% Jan-Jul 2013/Jan-Jul 2005 | -65.8 |
| Jan-Jul 2004 | 739 |
| ∆% Jan-Jul 2013/Jan-Jul 2004 | -63.2 |
| Jan-Jul 2003 | 653 |
| ∆% Jan-Jul 2013/ | -58.3 |
| Jan-Jul 2002 | 581 |
| ∆% Jan-Jul 2013/ | -53.2 |
| Jan-Jul 2001 | 569 |
| ∆% Jan-Jul 2013/ | -52.2 |
| Jan-Jul 2000 | 536 |
| ∆% Jan-Jul 2013/ | -49.3 |
| Jan-Jul 1995 | 404 |
| ∆% Jan-Jul 2013/ | -32.7 |
| Jan-Jul 1963 | 341 |
| ∆% Jan-Jul 2013/ | -20.2 |
*Computed using unrounded data
Source: US Census Bureau http://www.census.gov/construction/nrs/
Table IIA-4 provides the entire available annual series of new house sales from 1963 to 2012. The revised level of 306 thousand new houses sold in 2011 is the lowest since 560 thousand in 1963 in the 48 years of available data while the level of 368 thousand in 2012 is only higher than 323 thousand in 2010. The population of the US increased 129.4 million from 179.3 million in 1960 to 308.7 million in 2010, or 72.2 percent. The civilian noninstitutional population of the US increased from 122.416 million in 1963 to 243.284 million in 2012 or 98.7 percent (http://www.bls.gov/data/). The Bureau of Labor Statistics (BLS) defines the civilian noninstitutional population (http://www.bls.gov/lau/rdscnp16.htm#cnp): “The civilian noninstitutional population consists of persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.”
The civilian noninstitutional population is the universe of the labor force. In fact, there is no year from 1963 to 2012 in Table IIA-4 with sales of new houses below 400 thousand with the exception of the immediately preceding years of 2009, 2010, 2011 and 2012.
Table IIA-4, US, New Houses Sold, NSA Thousands
| 1963 | 560 |
| 1964 | 565 |
| 1965 | 575 |
| 1966 | 461 |
| 1967 | 487 |
| 1968 | 490 |
| 1969 | 448 |
| 1970 | 485 |
| 1971 | 656 |
| 1972 | 718 |
| 1973 | 634 |
| 1974 | 519 |
| 1975 | 549 |
| 1976 | 646 |
| 1977 | 819 |
| 1978 | 817 |
| 1979 | 709 |
| 1980 | 545 |
| 1981 | 436 |
| 1982 | 412 |
| 1983 | 623 |
| 1984 | 639 |
| 1985 | 688 |
| 1986 | 750 |
| 1987 | 671 |
| 1988 | 676 |
| 1989 | 650 |
| 1990 | 534 |
| 1991 | 509 |
| 1992 | 610 |
| 1993 | 666 |
| 1994 | 670 |
| 1995 | 667 |
| 1996 | 757 |
| 1997 | 804 |
| 1998 | 886 |
| 1999 | 880 |
| 2000 | 877 |
| 2001 | 908 |
| 2002 | 973 |
| 2003 | 1,086 |
| 2004 | 1,203 |
| 2005 | 1,283 |
| 2006 | 1,051 |
| 2007 | 776 |
| 2008 | 485 |
| 2009 | 375 |
| 2010 | 323 |
| 2011 | 306 |
| 2012 | 368 |
Source: US Census Bureau http://www.census.gov/construction/nrs/
Chart IIA-1 of the US Bureau of the Census shows the sharp decline of sales of new houses in the US. Sales rose temporarily until about mid 2010 but then declined to a lower plateau followed by increase and stability.
Chart IIA-1, US, New One-Family Houses Sold in the US, SAAR (Seasonally Adjusted Annual Rate)
Source: US Census Bureau
http://www.census.gov/briefrm/esbr/www/esbr051.html
Percentage changes and average rates of growth of new house sales for selected periods are shown in Table IIA-5. The percentage change of new house sales from 1963 to 2012 is minus 34.3 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 5.9 percent. Between 1995 and 2005 sales of new houses increased 92.4 percent at the yearly rate of 6.8 percent. There are similar rates in all years from 2000 to 2005. The boom in housing construction and sales began in the 1980s and 1990s. The collapse of real estate culminated several decades of housing subsidies and policies to lower mortgage rates and borrowing terms (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 42-8). Sales of new houses sold in 2012 fell 44.8 percent relative to the same period in 1995 and 71.3 percent relative to 2005.
Table IIA-5, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses
| ∆% | Average Yearly % Rate | |
| 1963-2012 | -34.3 | NA |
| 1991-2001 | 78.4 | 5.9 |
| 1995-2005 | 92.4 | 6.8 |
| 2000-2005 | 46.3 | 7.9 |
| 1995-2012 | -44.8 | NA |
| 2000-2012 | -58.0 | NA |
| 2005-2012 | -71.3 | NA |
NA: Not Applicable
Source: US Census Bureau http://www.census.gov/construction/nrs/
Chart IIA-2 of the US Bureau of the Census provides the entire monthly sample of new houses sold in the US between Jan 1963 and Jul 2013 without seasonal adjustment. The series is almost stationary until the 1990s. There is sharp upward trend from the early 1990s to 2005-2006 after which new single-family houses sold collapse to levels below those in the beginning of the series in the 1960s.
Chart IIA-2, US, New Single-family Houses Sold, NSA, 1963-2013
Source: US Census Bureau
http://www.census.gov/construction/nrs/
The available historical annual data of median and average prices of new houses sold in the US between 1963 and 2012 is provided in Table IIA-6. On a yearly basis, median and average prices reached a peak in 2007 and then fell substantially.
Table IIA-6, US, Median and Average Prices of New Houses Sold, Annual Data
| Period | Median | Average |
| 1963 | $18,000 | $19,300 |
| 1964 | $18,900 | $20,500 |
| 1965 | $20,000 | $21,500 |
| 1966 | $21,400 | $23,300 |
| 1967 | $22,700 | $24,600 |
| 1968 | $24,700 | $26,600 |
| 1969 | $25,600 | $27,900 |
| 1970 | $23,400 | $26,600 |
| 1971 | $25,200 | $28,300 |
| 1972 | $27,600 | $30,500 |
| 1973 | $32,500 | $35,500 |
| 1974 | $35,900 | $38,900 |
| 1975 | $39,300 | $42,600 |
| 1976 | $44,200 | $48,000 |
| 1977 | $48,800 | $54,200 |
| 1978 | $55,700 | $62,500 |
| 1979 | $62,900 | $71,800 |
| 1980 | $64,600 | $76,400 |
| 1981 | $68,900 | $83,000 |
| 1982 | $69,300 | $83,900 |
| 1983 | $75,300 | $89,800 |
| 1984 | $79,900 | $97,600 |
| 1985 | $84,300 | $100,800 |
| 1986 | $92,000 | $111,900 |
| 1987 | $104,500 | $127,200 |
| 1988 | $112,500 | $138,300 |
| 1989 | $120,000 | $148,800 |
| 1990 | $122,900 | $149,800 |
| 1991 | $120,000 | $147,200 |
| 1992 | $121,500 | $144,100 |
| 1993 | $126,500 | $147,700 |
| 1994 | $130,000 | $154,500 |
| 1995 | $133,900 | $158,700 |
| 1996 | $140,000 | $166,400 |
| 1997 | $146,000 | $176,200 |
| 1998 | $152,500 | $181,900 |
| 1999 | $161,000 | $195,600 |
| 2000 | $169,000 | $207,000 |
| 2001 | $175,200 | $213,200 |
| 2002 | $187,600 | $228,700 |
| 2003 | $195,000 | $246,300 |
| 2004 | $221,000 | $274,500 |
| 2005 | $240,900 | $297,000 |
| 2006 | $246,500 | $305,900 |
| 2007 | $247,900 | $313,600 |
| 2008 | $232,100 | $292,600 |
| 2009 | $216,700 | $270,900 |
| 2010 | $221,800 | $272,900 |
| 2011 | $227,200 | $267,900 |
| 2012 | $245,200 | $292,200 |
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Percentage changes of median and average prices of new houses sold in selected years are shown in Table IIA-7. Prices rose sharply between 2000 and 2005. In fact, prices in 2012 are higher than in 2000. Between 2006 and 2012, median prices of new houses sold fell 0.5 percent and average prices fell 4.5 percent. Between 2011 and 2012, median prices increased 7.9 percent and average prices increased 9.1 percent.
Table IIA-7, US, Percentage Change of New Houses Median and Average Prices, NSA, ∆%
| Median New | Average New Home Sales Prices ∆% | |
| ∆% 2000 to 2003 | 15.4 | 18.9 |
| ∆% 2000 to 2005 | 42.5 | 43.5 |
| ∆% 2000 to 2012 | 45.1 | 41.2 |
| ∆% 2005 to 2012 | 1.8 | -1.6 |
| ∆% 2000 to 2006 | 45.9 | 47.8 |
| ∆% 2006 to 2012 | -0.5 | -4.5 |
| ∆% 2009 to 2012 | 13.2 | 7.9 |
| ∆% 2010 to 2012 | 10.6 | 7.1 |
| ∆% 2011 to 2012 | 7.9 | 9.1 |
Source: US Census Bureau http://www.census.gov/construction/nrs/
Chart IIA-3 of the US Census Bureau provides the entire series of new single-family sales median prices from Jan 1963 to Jul 2013. There is long-term sharp upward trend with few declines until the current collapse. Median prices increased sharply during the Great Inflation of the 1960s and 1970s and paused during the savings and loans crisis of the late 1980s and the recession of 1991. Housing subsidies throughout the 1990s caused sharp upward trend of median new house prices that accelerated after the fed funds rate of 1 percent from 2003 to 2004. There was sharp reduction of prices after 2006 with recovery recently toward earlier prices.
Chart IIA-3, US, Median Sales Price of New Single-family Houses Sold, US Dollars, NSA, 1963-2013
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Chart IIA-4 of the US Census Bureau provides average prices of new houses sold from the mid-1970s to Jul 2013. There is similar behavior as with median prices of new houses sold in Chart IIA-3. The only stress occurred in price pauses during the savings and loans crisis of the late 1980s and the collapse after 2006 with recent recovery.
Chart IIA-4, US, Average Sales Price of New Single-family Houses Sold, US Dollars, NSA, 1975-2013
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Chart IIA-5 of the Board of Governors of the Federal Reserve System provides the rate for the 30-year conventional mortgage, the yield of the 30-year Treasury bond and the rate of the overnight federal funds rate, monthly, from 1971 to 2013. All rates decline throughout the period from the Great Inflation of the 1970s through the following Great Moderation and until currently. In Apr 1971, the fed funds rate was 4.15 percent and the conventional mortgage rate 7.31 percent. In November 2012, the fed funds rate was 0.16 percent, the yield of the 30-year Treasury 2.80 percent and the conventional mortgage rate 3.35. The final segment shows an increase in the yield of the 30-year Treasury to 3.61 percent in July 2013 with the fed funds rate at 0.09 percent and the conventional mortgage at 4.37 percent. The recent increase in interest rates if sustained could affect the US real estate market.
Chart IIA-5, US, Thirty-year Conventional Mortgage, Thirty-year Treasury Bond and Overnight Federal Funds Rate, Monthly, 1971-2013
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/H15/default.htm
IIA2 United States House Prices. The Federal Housing Finance Agency (FHFA), which regulates Fannie Mae and Freddie Mac, provides the FHFA House Price Index (HPI) that “is calculated using home sales price information from Fannie Mae and Freddie Mac-acquired mortgages” (http://fhfa.gov/webfiles/24216/q22012hpi.pdf 1). Table IIA2-1 provides the FHFA HPI for purchases only, which shows behavior similar to that of the Case-Shiller index but with lower magnitudes. House prices catapulted from 2000 to 2003, 2005 and 2006. From IIQ2000 to IIQ2006, the index for the US as a whole rose 59.5 percent, with 75.1 percent for New England, 79.1 percent for Middle Atlantic, 73.7 percent for South Atlantic but only by 31.6 percent for East South Central. Prices fell relative to 2013 for all years from 2005 and from 2006 with exception of 0.7 percent for Middle Atlantic from 2005. Prices for the US increased 7.3 percent in IIQ2013 relative to IIQ2012 and 11.0 percent from IIQ2011 to IIQ2013. From IIQ2000 to IIQ2013, prices rose for the US and the four regions in Table IIA2-1.
Table IIA2-1, US, FHFA House Price Index Purchases Only NSA ∆%
| United States | New England | Middle Atlantic | South Atlantic | East South Central | |
| IIQ2000 | 22.9 | 40.7 | 34.0 | 24.3 | 9.9 |
| 1IQ2000 | 48.7 | 71.9 | 66.4 | 57.4 | 21.9 |
| IIQ2000 to | 59.5 | 75.1 | 79.1 | 73.7 | 31.6 |
| IIQ2005 t0 | -3.4 | -9.9 | 0.7 | -7.7 | 8.6 |
| IIQ2006 | -10.0 | -11.6 | -6.5 | -16.4 | 0.6 |
| IIQ2007 to | -11.1 | -10.2 | -8.1 | -18.0 | -3.9 |
| IIQ2011 to | 11.0 | 3.3 | 2.4 | 12.4 | 7.3 |
| IIQ2012 to | 7.3 | 3.9 | 2.6 | 7.5 | 3.5 |
| IIQ2000 to | 43.6 | 54.8 | 67.5 | 45.3 | 32.4 |
Source: Federal Housing Finance Agency http://fhfa.gov/Default.aspx?Page=14
Data of the FHFA HPI for the remaining US regions are in Table IIA2-2. Behavior is not very different from that in Table IIA2-1 with the exception of East North Central. House prices in the Pacific region doubled between 2000 and 2006. Although prices of houses declined sharply from 2005 and 2006 to 2013 with exception of South Central, there was still appreciation relative to 2000.
Table IIA2-2, US, FHFA House Price Index Purchases Only NSA ∆%
| West South Central | West North Central | East North Central | Mountain | Pacific | |
| IIQ2000 | 12.0 | 18.1 | 14.6 | 17.4 | 40.7 |
| IIQ2000 | 22.4 | 31.8 | 25.2 | 50.7 | 104.7 |
| IIQ2000 to IIQ2006 | 31.2 | 37.1 | 27.9 | 69.9 | 125.0 |
| IIQ2005 to | 22.8 | 1.6 | -9.2 | -4.3 | -19.0 |
| IIQ2006 | 14.5 | -2.3 | -11.2 | -15.1 | -26.4 |
| IIQ2007 to | 8.7 | -3.9 | -10.4 | -17.7 | -24.3 |
| IIQ2011 to | 10.1 | 8.3 | 8.1 | 21.1 | 21.1 |
| IIQ2012 to | 5.9 | 4.6 | 5.0 | 12.5 | 16.3 |
| IIQ2000 to IIQ2013 | 50.3 | 33.9 | 13.6 | 44.2 | 65.7 |
Source: Federal Housing Finance Agency http://fhfa.gov/Default.aspx?Page=14
Chart IIA2-1 of the Federal Housing Finance Agency shows the Housing Price Index four-quarter price change from IIQ2003 to IIQ2013. House prices appreciated sharply from 1998 to 2005 and then fell rapidly. Recovery began already after IIQ2008 but there was another decline after IIIQ2010. The rate of decline improved in the second half of 2011 and into 2012 with movement into positive territory in IIQ2012, IIIQ2012, IVQ2012, IQ2013 and IIQ2013.
Chart IIA2-1, US, Federal Housing Finance Agency House Price Index Four Quarter Price Change
Source: Federal Housing Finance Agency
http://fhfa.gov/Default.aspx?Page=14
Monthly and 12-month percentage changes of the FHFA House Price Index are in Table IIA2-3. Percentage monthly increases of the FHFA index were positive from Apr to Jul 2011 with exception of declines in May and Aug 2011 while 12 months percentage changes improved steadily from more or equal to minus 6 percent in Mar to May 2011 to minus 4.4 percent in Jun 2011. The FHFA house price index fell 0.7 percent in Oct 2011 and fell 3.1 percent in the 12 months ending in Oct. There was significant recovery in Nov 2012 with increase in the house price index of 0.5 percent and reduction of the 12-month rate of decline to 2.2 percent. The house price index rose 0.4 percent in Dec 2011 and the 12-month percentage change improved to minus 1.3 percent. There was further improvement with revised decline of 0.3 percent in Jan 2012 and decline of the 12-month percentage change to minus 1.1 percent. The index changed to positive change of 0.5 percent in Feb 2012 and increase of 0.4 percent in the 12 months ending in Feb 2012. There was strong improvement in Mar 2012 with gain in prices of 1.0 percent and 2.4 percent in 12 months. The house price index of FHFA increased 0.8 percent in Apr 2012 and 3.1 percent in 12 months and improvement continued with increase of 0.6 percent in May 2012 and 3.9 percent in the 12 months ending in May 2012. Improvement consolidated with increase of 0.5 percent in Jun 2012 and 3.9 percent in 12 months. In Jul 2012, the house price index increased 0.2 percent and 3.8 percent in 12 months. Strong increase of 0.4 percent in Aug 2012 pulled the 12-month change to 4.5 percent. There was another increase of 0.6 percent in Oct and 5.6 percent in 12 months followed by increase of 0.6 percent in Nov 2012 and 5.7 percent in 12 months. The FHFA house price index increased 0.6 percent in Jan 2013 and 6.6 percent in 12 months. Improvement continued with increase of 0.5 percent in Apr 2013 and 7.3 percent in 12 months. In May 2013, the house price indexed increased 0.8 percent in May 2013 and 7.6 percent in 12 months. The FHFA house price index increased 0.6 percent in Jun 2013 and 7.8 percent in 12 months.
Table IIA2-3, US, FHFA House Price Index Purchases Only SA. Month and NSA 12-Month ∆%
| Month ∆% SA | 12 Month ∆% NSA | |
| Jun 2013 | 0.6 | 7.8 |
| May | 0.8 | 7.6 |
| Apr | 0.5 | 7.3 |
| Mar | 1.5 | 7.5 |
| Feb | 0.9 | 7.0 |
| Jan | 0.6 | 6.6 |
| Dec 2012 | 0.5 | 5.7 |
| Nov | 0.6 | 5.7 |
| Oct | 0.6 | 5.6 |
| Sep | 0.2 | 4.3 |
| Aug | 0.4 | 4.5 |
| Jul | 0.2 | 3.8 |
| Jun | 0.5 | 3.9 |
| May | 0.6 | 3.9 |
| Apr | 0.8 | 3.1 |
| Mar | 1.0 | 2.4 |
| Feb | 0.5 | 0.4 |
| Jan | -0.3 | -1.1 |
| Dec 2011 | 0.4 | -1.3 |
| Nov | 0.5 | -2.2 |
| Oct | -0.7 | -3.1 |
| Sep | 0.4 | -2.4 |
| Aug | -0.2 | -3.7 |
| Jul | 0.3 | -3.5 |
| Jun | 0.4 | -4.4 |
| May | -0.1 | -6.0 |
| Apr | 0.2 | -5.9 |
| Mar | -0.9 | -6.0 |
| Feb | -1.0 | -5.1 |
| Jan | -0.5 | -4.6 |
| Dec 2010 | -3.9 | |
| Dec 2009 | -2.0 | |
| Dec 2008 | -9.9 | |
| Dec 2007 | -3.1 | |
| Dec 2006 | 2.5 | |
| Dec 2005 | 9.8 | |
| Dec 2004 | 10.2 | |
| Dec 2003 | 8.0 | |
| Dec 2002 | 7.8 | |
| Dec 2001 | 6.7 | |
| Dec 2000 | 7.2 | |
| Dec 1999 | 6.2 | |
| Dec 1998 | 5.9 | |
| Dec 1997 | 3.4 | |
| Dec 1996 | 2.8 | |
| Dec 1995 | 2.9 | |
| Dec 1994 | 2.6 | |
| Dec 1993 | 3.1 | |
| Dec 1992 | 2.4 |
Source: Federal Housing Finance Agency http://fhfa.gov/Default.aspx?Page=14
The bottom part of Table IIA2-3 provides 12-month percentage changes of the FHFA house price index since 1992 when data become available for 1991. Table IIA2-4 provides percentage changes and average rates of percent change per year for various periods. Between 1992 and 2012, the FHFA house price index increased 84.6 percent at the yearly average rate of 3.1 percent. In the period 1992-2000, the FHFA house price index increased 39.4 percent at the average yearly rate of 4.2 percent. The rate of price increase accelerated to 7.5 percent in the period 2000-2003 and to 8.5 percent in 2000-2005 and 7.5 percent in 2000-2006. At the margin, the average rate jumped to 10.0 percent in 2003-2005 and 7.5 percent in 2003-2006. House prices measured by the FHFA house price index declined 14.2 percent between 2006 and 2012 and 11.9 percent between 2005 and 2012.
Table IIA2-4, US, FHFA House Price Index, Percentage Change and Average Rate of Percentage Change per Year, Selected Dates 1992-2012
| Dec | ∆% | Average ∆% per Year |
| 1992-2012 | 84.6 | 3.1 |
| 1992-2000 | 39.4 | 4.2 |
| 2000-2003 | 24.3 | 7.5 |
| 2000-2005 | 50.4 | 8.5 |
| 2003-2005 | 21.0 | 10.0 |
| 2005-2012 | -11.9 | NA |
| 2000-2006 | 54.3 | 7.5 |
| 2003-2006 | 24.1 | 7.5 |
| 2006-2012 | -14.2 | NA |
Source: Source: Federal Housing Finance Agency http://fhfa.gov/Default.aspx?Page=14
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 5.2 percent adjusted for inflation while growing 651.8 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 debt crisis of the euro area. 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 Aug 16 and daily values throughout the week ending on Aug 23, 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 Aug 16 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Aug 16, 2013”, first row “USD/EUR 1.3328 0.1 %,” provides the information that the US dollar (USD) appreciated 0.51percent to USD 1.3328/EUR in the week ending on Fri Aug 16 relative to the exchange rate on Fri Aug 9. 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 1.3328/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Aug 16, depreciating to USD 1.3335/EUR on Mon Aug 19, 2013, or by 0.1 percent. The dollar depreciated because more dollars, $1.3335, were required on Mon Aug 19 to buy one euro than $1.3328 on Aug 16. 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 1.3328/EUR on Aug 16; 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 Aug 16, to the last business day of the current week, in this case Fri Aug 23, such as depreciation by 0.4 percent to USD 1.3380/EUR by Aug 23; 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 0.4 percent from the rate of USD 1.3328/EUR on Fri Aug 16 to the rate of USD 1.3380/EUR on Fri Aug 23 {[(1.3380/1.3328) – 1]100 = 0.4%} and depreciated (denoted by negative sign) by 0.2 percent from the rate of USD 1.3356 on Thu Aug 22 to USD 1.3380/EUR on Fri Aug 23 {[(1.3380/1.3356) -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 Jul 19 to Jul 23, 2013
| Fri Jul 16, 2013 | M 19 | Tue 20 | W 21 | Thu 22 | Fri 23 |
| USD/EUR 1.3328 0.1% | 1.3335 -0.1% -0.1% | 1.3418 -0.7% -0.6% | 1.3356 -0.2% 0.5% | 1.3356 -0.2% 0.0% | 1.3380 -0.4% -0.2% |
| JPY/ USD 97.53 -1.4% | 97.57 0.0% 0.0% | 97.27 0.3% 0.3% | 97.70 -0.2% -0.4% | 98.72 -1.2% -1.0% | 98.72 -1.2% 0.0% |
| CHF/ USD 0.9265 -0.5% | 0.9241 0.3% 0.3% | 0.9174 1.0% 0.7% | 0.9224 0.4% -0.5% | 0.9232 0.4% -0.1% | 0.9218 0.5% 0.2% |
| CHF/ EUR 1.2349 -0.4% | 1.2321 0.2% 0.2% | 1.2308 0.3% 0.1% | 1.2318 0.3% -0.1% | 1.2333 0.1% -0.1% | 1.2332 0.1% 0.0% |
| USD/ AUD 0.9185 1.0887 -0.1% | 0.9112 1.0995 -0.8% -0.8% | 0.9072 1.1023 -1.2% -0.4% | 0.8973 1.1145 -2.4% -1.1% | 0.9007 1.1103 -2.0% 0.4% | 0.9026 1.1079 -1.8% 0.2% |
| 10 Year T Note 2.829 | 2.878 | 2.815 | 2.889 | 2.888 | 2.818 |
| 2 Year T Note 0.341 | 0.357 | 0.341 | 0.369 | 0.39 | 0.374 |
| German Bond 2Y 0.22 10Y 1.88 | 2Y 0.23 10Y 1.90 | 2Y 0.20 10Y 1.84 | 2Y 0.25 10Y 1.87 | 2Y 0.26 10Y 1.92 | 2Y 0.28 10Y 1.93 |
| Spain Bond 2Y 1.68 10Y 4.37 | 2Y 1.75 10Y 4.43 | 2Y 1.80 10Y 4.48 | 2Y 1.83 10Y 4.54 | 2Y 1.78 10Y 4.48 | 2Y 1.77 10Y 4.46 |
| DJIA 15081.47 -2.2% | 15010.74 -0.5% -0.5% | 15002.99 -0.5% -0.1% | 14897.55 -1.2% -0.7% | 14963.74 -0.8% 0.4% | 15010.51 -0.5% 0.3% |
| DJ Global 2252.09 -0.7% | 2232.93 -0.9% -0.9% | 2224.60 -1.2% -0.4% | 2209.34 -1.9% -0.7% | 2223.60 -1.3% -0.6% | 2241.30 -0.5% 0.8% |
| DJ Asia Pacific 1374.56 0.2% | 1368.78 -0.4% -0.4% | 1347.90 -1.9% -1.5% | 1338.60 -2.6% -0.7% | 1328.41 -3.4% -0.8% | 1345.76 -2.1% 1.3% |
| Nikkei 13650.11 0.3% | 13758.13 0.8% 0.8% | 13396.38 -1.9% -2.6% | 13424.33 -1.7% 0.2% | 13365.17 -2.1% -0.4% | 13660.55 0.1% 2.2% |
| Shanghai 2068.45 0.8% | 2085.60 0.8% 0.8% | 2072.59 0.2% -0.6% | 2072.96 0.2% 0.0% | 2067.12 -0.1% -0.3% | 2057.46 -0.5% -0.5% |
| DAX 8391.94 0.6% | 8366.29 -0.3% -0.3% | 8300.03 -1.1% -0.8% | 8285.41 -1.3% -0.2% | 8397.89 0.1% 1.4% | 8416.99 0.3% 0.2% |
| DJ UBS Comm. 129.61 3.2% | 130.20 0.5% 0.5% | 129.49 -0.1% -0.5% | 129.07 -0.4% -0.3% | 129.00 -0.5% -0.1% | 130.18 0.4% 0.9% |
| WTI $ B 107.76 1.6% | 106.98 -0.7% -0.7% | 104.96 -2.6% -1.9% | 103.87 -3.6% -1.0% | 105.09 -2.5% 1.2% | 106.40 -1.3% 1.2% |
| Brent $/B 110.66 1.6% | 109.72 -0.8% -0.8% | 110.04 -0.6% 0.3% | 109.72 -0.8% -0.3% | 109.99 -0.6% 0.2% | 111.03 0.3% 0.9% |
| Gold $/OZ 1373.8 4.6% | 1365.4 -0.6% -0.6% | 1370.8 -0.2% 0.4% | 1366.2 -0.6% -0.3% | 1374.4 0.0% 0.6% | 1397.3 1.7% 1.7% |
Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss
Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce
Sources: http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
There is initial discussion of current and recent risk-determining events followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate.
First, risk determining events. Prior risk determining events are in an appendix below following Table III-1A. Current focus is on “tapering” quantitative easing by the Federal Open Market Committee (FOMC). There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. Market are overreacting to the so-called “tapering” of outright purchases of $85 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight as evident in the FOMC statement for Jul 31, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130731a.htm):
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view 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.” (emphasis added).
In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:
“Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve's portfolio of longer-term Treasury securities and agency mortgage-backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries. We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized. We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.
The Committee's decisions regarding the asset purchase program (and the overall stance of monetary policy) depend on our assessment of the economic outlook and of the cumulative progress toward our objectives. Of course, economic forecasts must be revised when new information arrives and are thus necessarily provisional.”
Friedman (1953) argues there are three lags in effects of monetary policy: (1) between the need for action and recognition of the need; (2) the recognition of the need and taking of actions; and (3) taking of action and actual effects. Friedman (1953) finds that the combination of these lags with insufficient knowledge of the current and future behavior of the economy causes discretionary economic policy to increase instability of the economy or standard deviations of real income σy and prices σp. Policy attempts to circumvent the lags by policy impulses based on forecasts. We are all naïve about forecasting. Data are available with lags and revised to maintain high standards of estimation. Policy simulation models estimate economic relations with structures prevailing before simulations of policy impulses such that parameters change as discovered by Lucas (1977). Economic agents adjust their behavior in ways that cause opposite results from those intended by optimal control policy as discovered by Kydland and Prescott (1977). Advance guidance attempts to circumvent expectations by economic agents that could reverse policy impulses but is of dubious effectiveness. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities).
The President of the European Central Bank (ECB) Mario Draghi explained the indefinite period of low policy rates during the press conference following the meeting on Jul 4, 2013 (http://www.ecb.int/press/pressconf/2013/html/is130704.en.html):
“Yes, that is why I said you haven’t listened carefully. The Governing Council has taken the unprecedented step of giving forward guidance in a rather more specific way than it ever has done in the past. In my statement, I said “The Governing Council expects the key…” – i.e. all interest rates – “…ECB interest rates to remain at present or lower levels for an extended period of time.” It is the first time that the Governing Council has said something like this. And, by the way, what Mark Carney [Governor of the Bank of England] said in London is just a coincidence.”
The statement of the meeting of the Monetary Policy Committee of the Bank of England on Jul 4, 2013, may be leading toward the same forward guidance (http://www.bankofengland.co.uk/publications/Pages/news/2013/007.aspx):
“At its meeting today, the Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report. The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”
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 15,010.51
on Fri Aug 23, 2013, which is higher by 6.0 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 5.7 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs.
The key policy is maintaining fed funds rate between 0 and ¼ percent. An increase in fed funds rates could cause flight out of risk financial markets worldwide. There is no exit from this policy without major financial market repercussions. There are high costs and risks of this policy because indefinite financial repression induces carry trades with high leverage, risks and illiquidity.
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 4.447 percent on Aug 23, 2013, and that of the ten-year sovereign bond of Italy at 4.331 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 Aug 23, 2013, the yield of the two-year Treasury increased to 0.374 percent and that of the ten-year Treasury decreased to 2.818 percent while the two-year bond of Germany increased to 0.28 percent and the ten-year increased to 1.93 percent; and the dollar depreciated marginally to USD 1.3380/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 of 2.818 is higher than consumer price inflation of 2.0 percent in the 12 months ending in Jul 2013 (http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations_18.html and earlier http://cmpassocregulationblog.blogspot.com/2013/07/tapering-quantitative-easing-policy-and.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.135 percent is well below the 12-month consumer price inflation of 2.0 percent. 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 | |
| 8/23/13 | 0.374 | 2.818 | 0.28 | 1.93 | 1.3380 |
| 8/16/13 | 0.341 | 2.829 | 0.22 | 1.88 | 1.3328 |
| 8/9/13 | 0.30 | 2.579 | 0.16 | 1.68 | 1.3342 |
| 8/2/13 | 0.299 | 2.597 | 0.15 | 1.65 | 1.3281 |
| 7/26/13 | 0.315 | 2.565 | 0.15 | 1.66 | 1.3279 |
| 7/19/13 | 0.300 | 2.480 | 0.08 | 1.52 | 1.3141 |
| 7/12/13 | 0.345 | 2.585 | 0.10 | 1.56 | 1.3068 |
| 7/5/13 | 0.397 | 2.734 | 0.11 | 1.72 | 1.2832 |
| 6/28/13 | 0.357 | 2.486 | 0.19 | 1.73 | 1.3010 |
| 6/21/13 | 0.366 | 2.542 | 0.26 | 1.72 | 1.3122 |
| 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
Appendix: Prior 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.
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.
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.
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 economic recovery strengthens.”
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).
Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields together with the overnight fed funds rate, and the yield of the corporate bond with Moody’s rating of Baa. The riskier yield of the Baa corporate bond exceeds the relatively riskless yields of the Treasury securities. The beginning yields in Chart III-1A for July 31, 2001, are 3.67 percent for one month, 3.79 percent for two years, 5.07 percent for ten years, 3.82 percent for the fed funds rate and 7.85 percent for the Baa corporate bond. On July 30, 2007, yields inverted with the one month at 4.95 percent, the two-year at 4.59 percent and the ten year at 5.82 percent with the yield of the Baa corporate bond at 6.70 percent. Another interesting point is for Oct 31, 2008, with the yield of the Baa jumping to 9.54 percent and the Treasury yields declining: one month 0.12 percent, two years 1.56 percent and ten years 4.01 percent during a flight to the dollar and government securities analyzed by Cochrane and Zingales (2009). Another spike in the series is for Apr 4, 2006 with the yield of the corporate Baa bond at 8.63 and the Treasury yields of 0.12 percent for one month, 0.94 for two years and 2.95 percent for ten years. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield 1.64 percent and the ten-year yield 3.41. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe. The final point of Chart III1-A is for Aug 22, 2013, with the one-month yield at 0.01 percent, the two-year at 0.42 percent, the ten-year at 2.90 percent, the fed funds rate at 0.09 percent and the corporate Baa bond at 5.58 percent. There is an evident increase in the yields of the 10-year Treasury constant maturity and the Moody’s Baa corporate bond.
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-Aug 15, 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 from $2,586.3 billion in IVQ2007 to $2,457.2 billion in IIQ2013 or by 5.0 percent compared with growth of 19.7 percent of gross private domestic investment from IQ1980 to IIIQ1986 (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html). Undistributed profits of US corporations swelled 306.9 percent from $118.0 billion IQ2007 to $480.2 billion in IQ2013 and changed signs from minus $22.1 billion in IVQ2007 (http://cmpassocregulationblog.blogspot.com/2013/06/tapering-quantitative-easing-policy-and.html). Corporate profits with inventory valuation and capital consumption adjustment fell $27.8 billion relative to IVQ2012 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp1q13_3rd.pdf), from $2013.0 billion in IVQ2012 to $1985.2 billion in IQ2013 at the quarterly rate of minus 1.4 percent. Uncertainty originating in fiscal, regulatory and monetary policy causes wide swings in expectations and decisions by the private sector with adverse effects on investment, real economic activity and employment. 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 Rτ is expected revenue in the time horizon from τ =1 to T; Cτ 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 mixed performance in equity indexes with several indexes in Table III-1 increasing in the week ending on Aug 16, 2013, after wide swings caused by reallocations of investment portfolios worldwide. 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 increased 0.3 percent on Aug 23, decreasing 0.5 percent in the week. Germany’s Dax increased 0.2 percent on Fri Aug 16 and increased 0.6 percent in the week. Dow Global increased 0.8 percent on Aug 23 and decreased 0.5 percent in the week. Japan’s Nikkei Average increased 2.2 percent on Fri Aug 23 and increased 0.1 percent in the week as the yen continues 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 1.3 percent on Aug 23 and decreased 2.1 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 2057.46 on Fri Aug 23 for decrease of 0.5 percent and decrease of 0.5 percent in the week of Aug 23. There is 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 Aug 23, 2013. The DJ UBS Commodities Index increased 0.9 percent on Fri Aug 23 and increased 0.4 percent in the week, as shown in Table III-1. WTI decreased 1.3 percent in the week of Aug 23 while Brent increased 0.3 percent in the week. Gold increased 1.7 percent on Fri Aug 23 and increased 1.7 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 €790,931 million on Aug 16, 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 €2,368,521 million in the statement of Aug 16, 2013, with marginal reduction. There is high credit risk in these transactions with capital of only €90,419 million as analyzed by Cochrane (2012Aug31).
Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | Aug 16, 2013 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 319,968 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 250,113 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 22,691 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 21,876 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 790,931 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 82,123 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 603,863 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 28,356 |
| 9 Other Assets | 278,719 | 336,574 | 248,601 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 2,368,521 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 1,394,794 |
| Capital and Reserves | 78,143 | 81,481 | 90,419 |
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.europa.eu/press/pr/wfs/2013/html/fs130820.en.html
IIIE Appendix Euro Zone Survival Risk. Resolution of the European sovereign debt crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common euro currency prevents Italy from devaluing the exchange 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. 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 in Jan-Jun 2013. Exports to the non-European Union area with share of 46.3 percent in Italy’s total exports are growing at 3.0 percent in Jan-Jun 2013 relative to Jan-Jun 2012 while those to EMU are growing at minus 4.1 percent.
Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%
| Jun 2013 | Exports | ∆% Jan-Jun 2013/ Jan-Jun 2012 | Imports | ∆% Jan-Jun 2013/ Jan-Jun 2012 |
| EU | 53.7 | -3.1 | 52.9 | -3.0 |
| EMU 17 | 40.5 | -4.1 | 42.7 | -3.1 |
| France | 11.1 | -3.1 | 8.3 | -6.2 |
| Germany | 12.5 | -4.5 | 14.6 | -7.4 |
| Spain | 4.7 | -8.0 | 4.4 | -3.0 |
| UK | 4.9 | 1.0 | 2.5 | -1.4 |
| Non EU | 46.3 | 3.0 | 47.1 | -11.3 |
| Europe non EU | 13.9 | 0.0 | 11.3 | 6.9 |
| USA | 6.8 | -2.3 | 3.3 | -18.6 |
| China | 2.3 | 6.7 | 6.5 | -10.4 |
| OPEC | 5.7 | 10.5 | 10.8 | -27.4 |
| Total | 100.0 | -0.4 | 100.0 | -7.0 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/97574
Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €356 million with the 17 countries of the euro zone (EMU 17) in Jun 2013 and cumulative deficit of €2393 million in Jan-Jun 2013. Depreciation to parity could permit greater competitiveness in improving the trade surplus of 3752 million in Jan-Jun 2013 with Europe non European Union, the trade surplus of €7593 million with the US and trade surplus with non-European Union of €8020 million in Jan-Jun 2013. There is significant rigidity in the trade deficits in Jan-Jun 2013 of €6726 million with China and €3998 million with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.
Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro
| Regions and Countries | Trade Balance Jun 2013 Millions of Euro | Trade Balance Cumulative Jan-Jun 2013 Millions of Euro |
| EU | 1,124 | 4,268 |
| EMU 17 | -356 | -2,393 |
| France | 1,080 | 6,207 |
| Germany | -391 | -2,437 |
| Spain | 22 | 391 |
| UK | 1,070 | 4,671 |
| Non EU | 2,494 | 8,020 |
| Europe non EU | 1,066 | 3,752 |
| USA | 1,333 | 7,593 |
| China | -906 | -6,726 |
| OPEC | -315 | -3,998 |
| Total | 3,618 | 12,288 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/97574
Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Jun 2013 relative to Jan-Jun 2012. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 17.4 percent and minus 11.3 percent for durable goods. The higher rate of growth of exports of minus 0.4 percent in Jan-Jun 2013/Jan-Jun 2012 relative to imports of minus 7.0 percent may reflect weak demand in Italy with GDP declining during eight consecutive quarters from IIIQ2011 through IIQ2013 together with softening commodity prices.
Table III-5, Italy, Exports and Imports % Share of Products in Total and ∆%
| Exports | Exports | Imports | Imports | |
| Consumer | 29.3 | 6.2 | 25.6 | 0.1 |
| Durable | 5.8 | 0.8 | 2.9 | -11.3 |
| Non-Durable | 23.5 | 7.5 | 22.7 | 1.6 |
| Capital Goods | 31.6 | 0.7 | 19.5 | -7.7 |
| Inter- | 33.6 | -3.9 | 32.6 | -4.7 |
| Energy | 5.5 | -18.7 | 22.3 | -17.4 |
| Total ex Energy | 94.5 | 0.6 | 77.7 | -4.0 |
| Total | 100.0 | -0.4 | 100.0 | -7.0 |
Note: % Share for 2012 total trade.
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/97574
Table III-6 provides Italy’s trade balance by product categories in Jun 2013 and cumulative Jan-Jun 2013. Italy’s trade balance excluding energy generated surplus of €8285 million in Jun 2013 and €39,687 million cumulative in Jan-Jun 2013 but the energy trade balance created deficit of €4667 million in Jun 2013 and cumulative €27,399 million in Jan-Jun 2013. The overall surplus in Jun 2013 was €3618 million with cumulative surplus of €12,288 million in Jan-Jun 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
| Jun 2013 | Cumulative Jan-Jun 2013 | |
| Consumer Goods | 2,017 | 10,262 |
| Durable | 1,155 | 6,323 |
| Nondurable | 862 | 3,939 |
| Capital Goods | 5,419 | 26,173 |
| Intermediate Goods | 849 | 3,252 |
| Energy | -4,667 | -27,399 |
| Total ex Energy | 8,285 | 39,687 |
| Total | 3,618 | 12,288 |
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/97574
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 | Primary Net Lending Borrowing | General Government Net Debt | |
| 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 VE-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Jun 2013. German exports to other European Union (EU) members are 57.8 percent of total exports in Jun 2013 and 57.3 percent in cumulative Jan-Jun 2013. Exports to the euro area are 37.7 percent in Jun and 37.4 percent cumulative in Jan-Jun. Exports to third countries are 42.2 percent of the total in Jun and 42.7 percent cumulative in Jan-Jun. There is similar distribution for imports. Exports to non-euro countries are increasing 2.2 percent in the 12 months ending in Jun 2013, increasing 1.1 percent cumulative in Jan-Jun 2013 while exports to the euro area are decreasing 1.4 percent in the 12 months ending in Jun 2013 and decreasing 3.1 percent cumulative in Jan-Jun 2013. Exports to third countries, accounting for 42.2 percent of the total in Jun 2013, are decreasing 4.6 percent in the 12 months ending in Jun 2013 and increasing 1.0 percent cumulative in Jan-Jun 2013, accounting for 42.7 percent of the cumulative total in Jan-Jun 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 ∆%
| Jun 2013 | Jun 12-Month | Cumulative Jan-Jun 2012 € Billions | Cumulative Jan-Jun 2013/ | |
| Total | 92.8 | -2.1 | 547.4 | -0.6 |
| A. EU | 53.6 % 57.8 | -0.1 | 313.7 % 57.3 | -1.7 |
| Euro Area | 35.0 % 37.7 | -1.4 | 205.0 % 37.4 | -3.1 |
| Non-euro Area | 18.6 % 20.0 | 2.2 | 108.7 % 19.9 | 1.1 |
| B. Third Countries | 39.2 % 42.2 | -4.6 | 233.7 % 42.7 | 1.0 |
| Total Imports | 75.9 | -1.2 | 449.7 | -1.6 |
| C. EU Members | 49.1 % 64.7 | -0.3 | 291.0 % 64.7 | 0.1 |
| Euro Area | 34.8 % 45.8 | -0.5 | 203.5 % 45.3 | -0.8 |
| Non-euro Area | 14.3 % 18.8 | 0.0 | 87.4 % 19.4 | 2.1 |
| D. Third Countries | 26.7 % 35.2 | -2.7 | 158.7 % 35.3 | -4.6 |
Notes: Total Exports = A+B; Total Imports = C+D
Source: Statistisches Bundesamt Deutschland
https://www.destatis.de/EN/PressServices/Press/pr/2013/08/PE13_262_
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:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+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 Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (5)
Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):
“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”
An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.
There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:
(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress
(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality
(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.
IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table IV-1, updated with every blog comment, provides the latest annual data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of sovereign risk issues (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table IV-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table IV-1. Data for other countries in Table IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.
Table IV-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 1.6 | 2.0 | 2.1 | 7.6 |
| Japan | 0.4 | 0.2 | 2.2 | 3.9 |
| China | 7.5 | 2.7 | -2.3 | |
| UK | 1.5 | 2.8* CPIH 2.5 | 2.1 output | 7.8 |
| Euro Zone | -0.7 | 1.6 | 0.3 | 12.1 |
| Germany | 0.5 | 1.9 | 0.6 | 5.3 |
| France | 0.3 | 1.2 | 0.2 | 10.4 |
| Nether-lands | -1.8 | 3.1 | -0.2 | 6.6 |
| Finland | 0.0 | 2.5 | 1.7 | 8.4 |
| Belgium | -0.1 | 1.6 | 0.9 | 8.6 |
| Portugal | -2.0 | 0.8 | 1.4 | 17.6 |
| Ireland | NA | 0.7 | 1.8 | 13.6 |
| Italy | -2.0 | 1.2 | -0.7 | 12.2 |
| Greece | -4.6 | -0.5 | 0.8 | NA |
| Spain | -1.7 | 1.9 | 1.3 | 26.9 |
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/july-2013/index.html **Core
PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2013/index.html
Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/; country statistical sources http://www.census.gov/aboutus/stat_int.html
Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.4 percent in IIQ2013 relative to IIQ2012 (Table 8 in http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html and earlier http://cmpassocregulationblog.blogspot.com/2013/06/tapering-quantitative-easing-policy-and.html). Japan’s GDP grew 0.6 percent in IIQ2013 relative to IQ2013 and 0.9 percent relative to a year earlier. Japan’s grew at the seasonally adjusted annual rate (SAAR) of 2.6 percent in IIQQ2013 (Section VB and earlier http://cmpassocregulationblog.blogspot.com/2013/06/recovery-without-hiring-seven-million.html). The UK grew at 0.7 percent in IIQ2013 relative to IQ2013 and GDP increased 1.5 percent in IIQ2013 relative to IIQ2012 (Section VH and earlier http://cmpassocregulationblog.blogspot.com/2013/07/duration-dumping-steepening-yield-curve.html). The Euro Zone grew at 0.3 percent in IIQ2013 and minus 0.7 percent in IIQ2013 relative to IIQ2012 (Section VD and earlier http://cmpassocregulationblog.blogspot.com/2013/07/twenty-nine-million-unemployed-or.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: 7.4 percent in the US but 17.4 percent for unemployment/underemployment or job stress of 28.3 million (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html
and earlier http://cmpassocregulationblog.blogspot.com/2013/07/twenty-nine-million-unemployed-or.html), 3.9 percent for Japan (http://cmpassocregulationblog.blogspot.com/2013/08/recovery-without-hiring-loss-of-full.html
and earlier http://cmpassocregulationblog.blogspot.com/2013/06/tapering-quantitative-easing-policy-and.html), 7.8 percent for the UK with high rates of unemployment for young people (Section VH and earlier http://cmpassocregulationblog.blogspot.com/2013/07/tapering-quantitative-easing-policy-and.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 2.00 percent in the US, 0.2 percent for Japan, 2.7 percent for China, 1.6 percent for the Euro Zone and 2.8 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/2013/08/duration-dumping-and-peaking-valuations.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/2013/08/risks-of-steepening-yield-curve-and.html and earlier http://cmpassocregulationblog.blogspot.com/2013/06/tapering-quantitative-easing-policy-and.html), weak hiring with the loss of 10 million full-time jobs (http://cmpassocregulationblog.blogspot.com/2013/08/recovery-without-hiring-loss-of-full.html
and earlier http://cmpassocregulationblog.blogspot.com/2013/07/recovery-without-hiring-tapering.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/2013/08/risks-of-steepening-yield-curve-and.html and earlier http://cmpassocregulationblog.blogspot.com/2013/07/twenty-nine-million-unemployed-or.html); (4) The timing, dose, impact and instruments of normalizing monetary and fiscal policies (see http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html http://cmpassocregulationblog.blogspot.com/2012/08/expanding-bank-cash-and-deposits-with.html http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies. (5) The Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) geopolitical events in the Middle East.
In the effort to increase transparency, the Federal Open Market Committee (FOMC) provides both economic projections of its participants and views on future paths of the policy rate that in the US is the federal funds rate or interest on interbank lending of reserves deposited at Federal Reserve Banks. These projections and views are discussed initially followed with appropriate analysis.
Charles Evans, President of the Federal Reserve Bank of Chicago, proposed an “economic state-contingent policy” or “7/3” approach (Evans 2012 Aug 27):
“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):
“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.
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 around 1.8 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 2.2 percent on average in the cyclical expansion in the 15 quarters from IIIQ2009 to IIQ2013. 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). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf). The average of 7.7 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 2.7 percent obtained by diving GDP of $14,738.0 billion in IIQ2010 by GDP of $14,356.9 billion in IIQ2009 {[$14,738.0/$14,356.9 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html). Zero interest rates and quantitative easing have not provided the impulse for growth and were not required in past successful cyclical expansions.
First, the average number of nonfarm jobs created in Jan-Jul 2012 was 185,571 while the average number of nonfarm jobs created in Jan-Jul 2013 was 192,429, or increase by 3.7 percent. The average number of private jobs created in the US in Jan-Jul 2012 was 189,000 while the average in Jan-Jul 2013 was 195,571, or increase by 3.5 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 Jul 2013 was 192,429, which is a rate of job creation inadequate to reduce significantly unemployment and underemployment in the United States because of 113,167 new entrants in the labor force per month with 28.3 million unemployed or underemployed. The difference between the average increase of 192,429 new private nonfarm jobs per month in the US from Jan to Jul 2013 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 79,262 monthly new jobs net of absorption of new entrants in the labor force. There are 28.3 million in job stress in the US currently. Creation of 79,622 new jobs per month net of absorption of new entrants in the labor force would require 357 months to provide jobs for the unemployed and underemployed (28.315 million divided by 79,262) or 30 years (357 divided by 12). The civilian labor force of the US in Jul 2013 not seasonally adjusted stood at 157.196 million with 12.083 million unemployed or effectively 17.577 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 162.690 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 79,262 by 12, which is 951,144). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.860 million (0.05 times labor force of 157.196 million) for new net job creation of 4.223 million (12.083 million unemployed minus 7.860 million unemployed at rate of 5 percent) that at the current rate would take 4.4 years (4.223 million divided by 0.951144). Under the calculation in this blog, there are 17.577 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 162.690 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 9.586 million jobs net of labor force growth that at the current rate would take 9.9 years (17.577 million minus 0.05(162.690 million) = 9.443 million divided by 0.951144, 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 145.113 million in Jul 2013, by 2.202 million, or decline of 1.5 percent, while the civilian noninstitutional or economically active population increased from 231.958 million in Jul 2007 to 245.756 million in Jul 2013, by 13.798 million or increase of 5.9 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. The United States economy has grown at the average yearly rate of 3 percent per year and 2 percent per year in per capita terms from 1870 to 2010, as measured by Lucas (2011May). An important characteristic of the economic cycle in the US has been rapid growth in the initial phase of expansion after recessions.
Second, revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html
http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf) provide important information on long-term growth and cyclical behavior. Table Summary provides relevant data.
- Long-term. US GDP grew at the average yearly rate of 3.3 percent from 1929 to 2012 and at 3.2 percent from 1947 to 2012.
- Cycles. The combined contraction of GDP in the two almost consecutive recessions in the early 1980s is 4.6 percent. The contraction of US GDP from IVQ2007 to IIQ2009 during the global recession was 4.3 percent. The critical difference in the expansion is growth at average 7.8 percent in annual equivalent in the first four quarters of recovery from IQ1983 to IVQ1983. The average rate of growth of GDP in four cyclical expansions in the postwar period is 7.7 percent. In contrast, the rate of growth in the first four quarters from IIIQ2009 to IIQ2010 was only 2.7 percent. Average annual equivalent growth in the expansion from IQ1983 to IQ1986 was 5.7 percent. In contrast, average annual equivalent growth in the expansion from IIIQ2009 to IIQ2013 was only 2.7 percent. The US appears to have lost its dynamism of income growth and employment creation.
Table Summary, Long-term and Cyclical Growth of GDP, Real Disposable Income and Real Disposable Income per Capita
| GDP | ||
| Long-Term | ||
| 1929-2012 | 3.3 | |
| 1947-2012 | 3.2 | |
| Cyclical Contractions ∆% | ||
| IQ1980 to IIIQ1980, IIIQ1981 to IVQ1982 | -4.6 | |
| IVQ2007 to IIQ2009 | -4.3 | |
| Cyclical Expansions Average Annual Equivalent ∆% | ||
| IQ1983 to IQ1986 | 5.7 | |
| First Four Quarters IQ1983 to IVQ1983 | 7.8 | |
| IIIQ2009 to IIQ2013 | 2.2 | |
| First Four Quarters IIIQ2009 to IIQ2010 | 2.7 | |
| Real Disposable Income | Real Disposable Income per Capita | |
| Long-Term | ||
| 1929-2012 | 3.2 | 2.0 |
| 1947-1999 | 3.7 | 2.3 |
| Whole Cycles | ||
| 1980-1989 | 3.5 | 2.6 |
| 2006-2012 | 1.4 | 0.6 |
Source: Bureau of Economic Analysis http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf
The revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html
http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf) also provide critical information in assessing the current rhythm of US economic growth. The economy appears to be moving at a pace from 1.4 to 1.8 percent per year. Table Summary GDP provides the data.
1. Average Annual Growth in the Past Six Quarters. GDP growth in the four quarters of 2012 to IIQ2013 accumulated to 2.7 percent. This growth is equivalent to 1.8 percent per year, obtained by dividing GDP in IIQ2013 of $16,648.7 by GDP in IVQ2011 of $15,242.1 and compounding by 4/6: {[($15,648.7/$15,242.1)4/6 -1]100 = 1.8.
2. Average Annual Growth in the First Two Quarters of 2013. GDP growth in the first two quarters of 2013 accumulated to 0.7 percent that is equivalent to 1.4 percent in a year. This is obtained by dividing GDP in IIQ2013 of $15648.7 by GDP in IVQ2012 to $15,583.9 and compounding by 4/2: {[($15,648.7/$15,539.6)4/2 -1]100 =1.4%}. The US economy grew 1.4 percent in IIQ2013 relative to the same quarter a year earlier in IIQ2012. Another important revelation of the revisions and enhancements is that GDP was flat in IVQ2012.
Table Summary GDP, US, Real GDP and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions Chained 2005 Dollars and ∆%
| Real GDP, Billions Chained 2005 Dollars | ∆% Relative to IVQ2007 | ∆% Relative to Prior Quarter | ∆% | |
| IVQ2007 | 14,996.1 | NA | NA | 1.9 |
| IVQ2011 | 15,242.1 | 1.6 | 1.2 | 2.0 |
| IQ2012 | 15,381.6 | 2.6 | 0.9 | 3.3 |
| IIQ2012 | 15,427.7 | 2.9 | 0.3 | 2.8 |
| IIIQ2012 | 15,534.0 | 3.6 | 0.7 | 3.1 |
| IVQ2012 | 15,539.6 | 3.6 | 0.0 | 2.0 |
| IQ2013 | 15,583.9 | 3.9 | 0.3 | 1.3 |
| IIQ2013 | 15,648.7 | 4.4 | 0.4 | 1.4 |
| Cumulative ∆% IQ2012 to IIQ2013 | 2.7 | 2.6 | ||
| Annual Equivalent ∆% | 1.8 | 1.7 |
Source: US Bureau of Economic Analysis http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf
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 Jul 31, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130731a.htm):
“Release Date: July 31, 2013
For immediate release
Information received since the Federal Open Market Committee met in June suggests that economic activity expanded at a modest pace during the first half of the year. Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen somewhat and fiscal policy is restraining economic growth. Partly reflecting transitory influences, inflation has been running below the Committee's longer-run objective, but 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 pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.
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 today reaffirmed its view 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 today reaffirmed its view 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.”
Current focus is on tapering quantitative easing by the Federal Open Market Committee (FOMC). There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. Market are overreacting to the so-called “paring” of outright purchases of $85 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight as evident in the FOMC statement for Jul 31, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130731a.htm):
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view 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.” (emphasis added).
In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:
“Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve's portfolio of longer-term Treasury securities and agency mortgage-backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries. We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized. We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.
The Committee's decisions regarding the asset purchase program (and the overall stance of monetary policy) depend on our assessment of the economic outlook and of the cumulative progress toward our objectives. Of course, economic forecasts must be revised when new information arrives and are thus necessarily provisional.”
Friedman (1953) argues there are three lags in effects of monetary policy: (1) between the need for action and recognition of the need; (2) the recognition of the need and taking of actions; and (3) taking of action and actual effects. Friedman (1953) finds that the combination of these lags with insufficient knowledge of the current and future behavior of the economy causes discretionary economic policy to increase instability of the economy or standard deviations of real income σy and prices σp. Policy attempts to circumvent the lags by policy impulses based on forecasts. We are all naïve about forecasting. Data are available with lags and revised to maintain high standards of estimation. Policy simulation models estimate economic relations with structures prevailing before simulations of policy impulses such that parameters change as discovered by Lucas (1977). Economic agents adjust their behavior in ways that cause opposite results from those intended by optimal control policy as discovered by Kydland and Prescott (1977). Advance guidance attempts to circumvent expectations by economic agents that could reverse policy impulses but is of dubious effectiveness. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities).
The key policy is maintaining fed funds rate between 0 and ¼ percent. An increase in fed funds rates could cause flight out of risk financial markets worldwide. There is no exit from this policy without major financial market repercussions. Indefinite financial repression induces carry trades with high leverage, risks and illiquidity.
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 IIQ2013 is analyzed in Section I (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html
and earlier http://cmpassocregulationblog.blogspot.com/2013/06/tapering-quantitative-easing-policy-and.html) and the PCE inflation data from the report on personal income and outlays in Section IV (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html http://cmpassocregulationblog.blogspot.com/2013/06/tapering-quantitative-easing-policy-and.html). The Bureau of Economic Analysis (BEA) provides the first estimate of IIQ2013 GDP released on Jul 31 with revisions since 1929 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html
http://cmpassocregulationblog.blogspot.com/2013/06/tapering-quantitative-easing-policy-and.html http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed in Section IV (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html http://cmpassocregulationblog.blogspot.com/2013/06/tapering-quantitative-easing-policy-and.html http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). The report on “Personal Income and Outlays” for Jun was released at 8:30 AM on Aug 2, 2013 with revisions from 1959 to May 2013 (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html
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 Jul 2013 was released on Aug 2 and analyzed in this blog (http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html
http://cmpassocregulationblog.blogspot.com/2013/07/twenty-nine-million-unemployed-or.html and earlier 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, 2013 and the second row “PR” the projection of the Jun 19, 2013 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 2.8 percent at the meeting in Mar 2013 to 2.3 to 2.6 percent at the meeting on Jun 20, 2013. The FOMC increased GDP growth in 2014 from 2.9 to 3.4 percent at the meeting in Mar 2013 to 3.0 to 3.5 percent at the meeting in Jun 2013.
2. Rate of Unemployment “UNEM%.” The FOMC reduced the forecast of the rate of unemployment from 7.3 to 7.5 percent at the meeting on Mar 20, 2013 to 7.2 to 7.3 percent at the meeting on Jun 19, 2013. The projection for 2014 decreased to the range of 6.5 to 6.8 in Jun 2013 from 6.7 to 7.0 in Mar 2013. Projections of the rate of unemployment are moving closer to the desire 6.5 percent or lower with 5.8 to 6.2 percent in 2015 after the meeting on Jun 19, 2013.
3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.3 to 1.7 percent at the meeting on Mar 20, 2012 to 0.8 to 1.2 percent at the meeting on Jun 19, 2013. There are no projections exceeding 2.0 percent.
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 1.5 to 1.6 percent at the meeting on Mar 20, 2013 to 1.2 to 1.3 percent at the meeting on Jun 19, 2013.
Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, Mar 2013 and Jun 19, 2013
| ∆% GDP | UNEM % | ∆% PCE Inflation | ∆% Core PCE Inflation | |
| Central | ||||
| 2013 | 2.3 to 2.6 | 7.2 to 7.3 | 0.8 to 1.2 | 1.2 to 1.3 1.5 to 1.6 |
| 2014 | 3.0 to 3.5 | 6.5 to 6.8 | 1.4 to 2.0 | 1.5 to 1.8 |
| 2015 Mar PR | 2.9 to 3.6 2.9 to 3.7 | 5.8 to 6.2 6.0 to 6.5 | 1.6 to 2.0 1.7 to 2.0 | 1.7 to 2.0 1.8 to 2.1 |
| Longer Run Mar 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 | 2.0 to 2.6 | 6.9 to 7.5 | 0.8 to 1.5 | 1.1 to 1.5 |
| 2014 | 2.2 to 3.6 | 6.2 to 6.9 | 1.4 to 2.0 | 1.5 to 2.1 |
| 2015 Mar PR | 2.3 to 3.8 2.5 to 3.8 | 5.7 to 6.4 5.7 to 6.5 | 1.6 to 2.3 1.6 to 2.6 | 1.7 to 2.3 1.7 to 2.6 |
| Longer Run Mar PR | 2.0 to 3.0 2.0 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/fomcprojtabl20130619.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 2013, 2014, 2015 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 15 participants with three expecting the rate to be in the range of 0.5 to 1.0 percent and one participant expecting rates at 1.0 to 1.5 percent. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014. For 2015, six participants expect rates to be below or at 1.0 percent while nine expect rates from 1.0 to 1.5 percent and four expecting rates in excess of 2.0 percent. In the long term, 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, Jun 19, 2013
| 0 to 0.25 | 0.5 to 1.0 | 1.0 to 1.5 | 1.0 to 2.0 | 2.0 to 3.0 | 3.0 to 4.5 | |
| 2013 | 18 | 1 | ||||
| 2014 | 15 | 3 | 1 | |||
| 2015 | 1 | 5 | 9 | 1 | 3 | |
| Longer Run | 19 |
Source: Board of Governors of the Federal Reserve System, FOMC http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130619.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. The FOMC states that rates will continue to be low even after return of the economy to potential growth.
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 19, 2013
| Appropriate Year of Increasing Target Fed Funds Rate | Number of Participants |
| 2013 | 1 |
| 2014 | 3 |
| 2015 | 14 |
| 2016 | 1 |
Source: Board of Governors of the Federal Reserve System, FOMC http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130619.pdf
The producer price index of Germany decreased 0.1 percent in Jul 2013, calendar and seasonally adjusted (CSA), decreased 0.1 percent not seasonally adjusted (NSA) in Jul 2013 and increased 0.5 percent in the 12 months ending in Jul 2013, as shown in Table IV-5. The producer price index of Germany has similar waves of inflation as in many other countries (http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations_18.html). In the first wave from Jan to Apr 2011, the annual equivalent rate of producer price inflation was 10.4 percent NSA and 6.5 percent CSA, propelled by carry trades from zero interest rates to exposures in commodity futures in a mood of risk appetite. In the second wave in May and Jun 2011, the annual equivalent rate of producer price inflation was only 0.6 percent NSA because of the collapse of the carry trade in fear of risks of European sovereign debt but 4.3 percent CSA. In the third wave from Jul to Sep 2011, annual-equivalent producer price inflation in Germany was 2.8 percent NSA and 2.8 percent CSA with fluctuations in commodity prices resulting from perceptions of the sovereign risk crisis in Europe. In the fourth wave from Oct to Nov 2011, annual equivalent inflation was 1.8 percent NSA and 3.0 percent CSA. In the fifth wave from Dec 2011 to Jan 2012, annual equivalent inflation was at 1.2 percent NSA and minus 0.6 percent CSA in return of risk aversion. In the sixth wave, annual equivalent inflation increased to 6.2 percent in Feb-Mar 2012 NSA and 4.9 percent in Feb-Apr and 2.4 percent CSA. In the seventh wave, annual equivalent inflation was minus 2.8 percent in May-Jul 2012 NSA and minus 1.2 percent SA. In the eighth wave, annual equivalent inflation was 4.9 percent in Aug-Sep 2012 NSA and 4.3 percent SA. In the ninth wave, renewed risk aversion resulted in annual equivalent inflation NSA of minus 1.6 percent in Oct-Dec 2012 and 1.2 percent CSA. In the tenth wave, annual equivalent inflation was 10.0 percent NSA and 2.4 percent CSA in Jan 2013. In the eleventh wave, annual equivalent inflation NSA was minus 2.0 percent in Feb-Apr 2013 and minus 2.8 percent CSA. In the twelfth wave, annual equivalent inflation was minus 1.6 percent in May-Jul 2013 and 1.2 percent CSA. Data in the bottom of Table IV-5 show that the producer price index fell 5.2 percent in the 12 months ending in Dec 2009 because of the fall of commodity prices originating in risk aversion after the panic beginning in late 2008.
Table IV-5, Germany, Index of Producer Prices for Industrial Products ∆%
| 12 Months ∆% NSA | Month ∆% NSA | Month ∆% Calendar and SA | |
| Jul 2013 | 0.5 | -0.1 | -0.1 |
| Jun | 0.6 | 0.0 | 0.3 |
| May | 0.2 | -0.3 | 0.1 |
| AE ∆% May-Jul | -1.6 | 1.2 | |
| Apr | 0.1 | -0.2 | -0.2 |
| Mar | 0.4 | -0.2 | -0.3 |
| Feb | 1.2 | -0.1 | -0.2 |
| AE ∆% Feb-Apr | -2.0 | -2.8 | |
| Jan | 1.7 | 0.8 | 0.2 |
| AE ∆% Jan | 10.0 | 2.4 | |
| Dec 2012 | 1.5 | -0.3 | 0.2 |
| Nov | 1.4 | -0.1 | 0.0 |
| Oct | 1.5 | 0.0 | 0.1 |
| AE ∆% Oct-Dec | -1.6 | 1.2 | |
| Sep | 1.7 | 0.3 | 0.2 |
| Aug | 1.6 | 0.5 | 0.5 |
| AE ∆% Aug-Sep | 4.9 | 4.3 | |
| Jul | 0.9 | 0.0 | -0.1 |
| Jun | 1.6 | -0.4 | -0.1 |
| May | 2.1 | -0.3 | 0.1 |
| AE ∆% May-Jul | -2.8 | -1.2 | |
| Apr | 2.4 | 0.2 | 0.0 |
| Mar | 3.3 | 0.6 | 0.4 |
| Feb | 3.2 | 0.4 | 0.2 |
| AE ∆% Feb-Apr | 4.9 | 2.4 | |
| Jan | 3.4 | 0.6 | 0.0 |
| Dec 2011 | 4.0 | -0.4 | -0.1 |
| AE ∆% Dec-Jan | 1.2 | -0.6 | |
| Nov | 5.2 | 0.1 | 0.2 |
| Oct | 5.3 | 0.2 | 0.2 |
| AE ∆% Oct-Nov | 1.8 | 2.4 | |
| Sep | 5.5 | 0.3 | 0.2 |
| Aug | 5.5 | -0.3 | 0.0 |
| Jul | 5.8 | 0.7 | 0.5 |
| AE ∆% Jul-Sep | 2.8 | 2.8 | |
| Jun | 5.6 | 0.1 | 0.3 |
| May | 6.1 | 0.0 | 0.4 |
| AE ∆% May-Jun | 0.6 | 4.3 | |
| Apr | 6.4 | 1.0 | 0.6 |
| Mar | 6.2 | 0.4 | 0.3 |
| Feb | 6.4 | 0.7 | 0.6 |
| Jan | 5.7 | 1.2 | 0.6 |
| AE ∆% Jan-Apr | 10.4 | 6.5 | |
| Dec 2010 | 5.3 | 0.7 | 0.8 |
| Nov | 4.4 | 0.2 | 0.4 |
| Oct | 4.3 | 0.4 | 0.4 |
| Sep | 3.9 | 0.3 | 0.5 |
| Aug | 3.2 | 0.0 | 0.2 |
| Jul | 3.7 | 0.5 | 0.6 |
| Jun | 1.7 | 0.6 | 0.5 |
| May | 0.9 | 0.3 | 0.3 |
| Apr | 0.6 | 0.8 | 0.5 |
| Mar | -1.5 | 0.7 | 0.6 |
| Feb | -2.9 | 0.0 | 0.1 |
| Jan | -3.4 | 0.8 | 0.4 |
| Dec 2009 | -5.2 | -0.1 | 0.2 |
| Dec 2008 | 4.0 | -0.8 | -0.2 |
| Dec 2007 | 1.9 | -0.1 | 0.4 |
| Dec 2006 | 4.2 | 0.1 | 0.3 |
| Dec 2005 | 4.8 | 0.3 | 0.5 |
| Dec 2004 | 2.9 | 0.1 | 0.3 |
| Dec 2003 | 1.8 | 0.0 | |
| Dec 2002 | 0.5 | 0.1 | |
| Dec 2001 | 0.1 | -0.2 |
Source: Statistiche Bundesamt Deutschland https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html
Chart IV-1 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the producer price index of Germany from 2005 to 2013. Producer price inflation peaked in 2008 with the rise of commodity prices induced by the carry trade from zero interest rates to commodity futures during a global contraction. Prices then declined with the flight away from risk financial assets to government obligations after the financial panic in Sep 2008. With zero interest rates and no risk aversion, the carry trade pushed commodity futures prices upwardly resulting in new rising trend of the producer price index. The right-hand side of the chart shows moderation and even decline in prices because of severe risk aversion frustrating carry trades from zero interest rates to commodity futures. There is return of risk appetite with another surge of the index in annual equivalent rate at 6.2 percent in Feb-Mar 2012 and 4.9 percent annual equivalent in Feb-Apr 2012. Inflation declines by 0.3 percent in May 2012 and 0.4 percent in Jun 2012 with flat prices in Jul 2012 with the pace at annual equivalent rate of minus 4.1 percent in May-Jun 2012 and flat prices in Jul 2012. Inflation returned in Aug and Sep 2012 with carry trades into commodity futures with 4.9 percent annual equivalent. Inflation then collapsed to zero in Oct 2012 NSA, minus 0.1 percent in Nov 2012 and minus 0.3 percent in Dec 2012 with increases of 0.8 percent in Jan 2013 but declines of 0.1 in Feb 2013 and 0.2 percent in Mar-Apr 2013. Inflation declines 0.3 percent in May 2013 and is flat in Jun 2013. Inflation decreased 0.1 percent in Jul 2013.
Chart IV-1, Germany, Index of Producer Prices for Industrial Products, 2005=100
Source: Statistisches Bundesamt Deutschland
https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html
Chart IV-2 provides the index of producer finished goods in the US from 2005 to 2013. Chart IV-4 of the US mirrors behavior in Chart IV-3 of Germany. Carry trades from zero interest rates to exposures in commodity futures and risk financial assets have synchronized worldwide inflation during periods of risk appetite and disinflation during periods of risk aversion
Chart IV-2, US, Producer Price Index, Finished Goods, NSA, 2005-2013
Source: US Bureau of Labor Statistics
Chart IV-3 of the Federal Statistical Agency of Germany Statistiche Bundesamt Deutschland provides the unadjusted producer price index, trend and trend ends. There is a clear upward trend of prices after the end of risk aversion with zero interest rates in 2009. The actual curve fell below trend in the current episode of severe risk aversion but rose again in Feb-Apr 2012, falling in May-Jun 2012 with flat prices in Jul 2012. There was another increase in Aug-Sep 2012 and flat prices in Oct 2012 with declines of 0.1 percent in Nov 2012 and 0.3 percent in Dec 2012. There was sharp increase of 0.8 percent in Jan 2013 and declines of 0.1 percent in Feb 2013 and 0.2 percent in Mar-Apr 2013. Prices fell 0.3 percent in May 2013 and remained unchanged in Jun 2013. Prices declined 0.1 percent in Jul 2013 Trend suggests stability.
Chart IV-3, Germany, Producer Price Index, Non-adjusted Value and Trend, 2005=100
Source: Statistiche Bundesamt Deutschland
https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html
© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013
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