Duration Dumping and Peaking Valuations of Risk Financial Assets, World Inflation Waves, Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates, Unresolved US Balance of Payments Deficits and Fiscal Imbalance, Household Income at 1995 Levels, Forty-six Million in Poverty and Forty-eight Million without Health Insurance, United States Industrial Production, World Economic Slowdown and Global Recession Risk: Part III

 

Duration Dumping and Peaking Valuations of Risk Financial Assets, World Inflation Waves, Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates, Unresolved US Balance of Payments Deficits and Fiscal Imbalance, Household Income at 1995 Levels, Forty-six Million in Poverty and Forty-eight Million without Health Insurance, United States Industrial Production, World Economic Slowdown and Global Recession Risk

Carlos M. Pelaez

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013

Executive Summary

I World Inflation Waves

IA Appendix: Transmission of Unconventional Monetary Policy

IA1 Theory

IA2 Policy

IA3 Evidence

IA4 Unwinding Strategy

IB United States Inflation

IC Long-term US Inflation

ID Current US Inflation

IE Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation

II United States Industrial Production

IIA Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities

IIA1 United States Unsustainable Deficit/Debt

IIA2 Unresolved US Balance of Payments Deficits

IIB Household Income at 1995 Levels, 46 Million in Poverty and 48 Million without Health Insurance

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

IIB Household Income at 1995 Levels, 46 Million in Poverty and 48 Million without Health Insurance. The objective of this section is to analyze newly released data by the US Census Bureau on income, poverty and health insurance (DeNavas-Walt, Proctor and Smith 2013). This report depicts 2012 household income of the US in constant 2012 dollars regressing to the level of 1995. The number of people in poverty in the US in 2012 is 46.496 million, equivalent to 15.0 percent of the population, which is the same as 15.0 percent in 1982 and higher than any percentage since 17.3 percent in 1965 with exception of isolated years in the range of 15.1 to 15.2 percent. The number of people without health insurance in 2012 is 47.951 million, which is equivalent to 15.7 percent of the population. Although the economy recovered throughout 2011 and 2012, income and poverty deteriorated while lack of health insurance remained nearly unchanged. Increasing poverty and lack of health insurance challenge the social and health safety net because of a sudden jump of needs for social and health services on capacity that provide those needs that is fixed in the short run while growth of the economy requires absorbing labor input and maintaining health of the stock of human capital. Part of the explanation of the dramatically poor socio-economic indicators of the US could be explained by the sharp economic contraction from IV2007 to IIQ2009 but part originates in the worst recovery in a cyclical expansion during the postwar period (http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html).

The report of the US Bureau of the Census on Income, poverty and health insurance coverage in the United States: 2012 provides highly valuable socio-economic information and analysis (DeNavas-Walt, Proctor and Smith 2013). Table IIB-1 provides years of high percentage of people below poverty in the US. Data for 2006 to 2009 are included to provide a framework of reference for the current deterioration. The series has two high points of 15.1 percent of the population in poverty in 2010 and 1993 exceeded only by 15.2 percent in 1983. The prior high numbers of poverty are found in 1960 to 1965 with 17.3 percent in 1965 and higher numbers going to 22.4 percent in 1959. The number of people in poverty in the US in 2012 was 46.496 million, which has increased by 10.036 million from 36.460 million in 2006. The fractured job market with 28.3 million unemployed or underemployed because they cannot find full-time jobs (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html) and decline of hiring by 11.8 million (http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-million.html) prevents exit from poverty. Inflation-adjusted average weekly wages stagnated.

Table IIB-1, US, Historical High Percentage of People below Poverty, Thousands and Percent

	Total Population	Number Below Poverty	Percent Below Poverty
2012	310,648	46,496	15.0
2011	308,456	46,247	15.0
2010	306,130	46,343	15.1
2009	303,820	43,569	14.3
1993	259,278	39,265	15.1
1983	231,700	35,303	15.2
1982	229,412	34,398	15.0
1965	191,413	33,185	17.3
1964	189,710	36,055	19.0
1963	187,258	36,436	19.5
1962	184,276	38,625	21.0
1961	181,277	39,628	21.9
1960	179,503	39,851	22.2
1959	176,557	39,490	22.4
Memo
2009	303,820	43,569	14.3
2008	301,041	38,829	13.2
2007	298,699	37,276	12.5
2006	296,450	36,460	12.3

Source: DeNavas-Walt, Proctor and Smith (2013).

Millions in poverty in the calendar year in which the recession ended and in the first calendar year after the recession are provided in Table IIB-2. There have been increases in the number of people in poverty in the first calendar years after the recessions since 1980. The brief recession of Jan to Jul 1980 experienced the highest increase in the first calendar year of 1.0 percent and 2.550 million more in poverty. In the three recessions before 1980 shown in Table IIB-2, the number of people in poverty fell in the first calendar year after the end of the recession.

Table IIB-2, US, Millions in Poverty in the Calendar Year in which Recession Ended and in the First Calendar Year after Recession, Millions and ∆%

	Millions	%	Millions	%	Change Millions	% Points
Dec 2007 to Jun 2009
2009	43.569	14.3
2010			46.343	15.1	2.774	0.8
Mar 2001 to Nov 2001
2001	32.907	11.7
2002			34.570	12.1	1.663	0.4
Jul 1990 to  Mar 1991
1991	35.708	14.2
1992			38.014	14.8	2.306	0.6
Jul 1981 to Nov 1982
1982	34.398	15.0
1983			35.303	15.2	0.905	0.2
Jan 1980 to July 1980
1980	29.272	13.0
1981			31.822	14.0	2.550	1.0
Nov 1973 to Mar 1975
1975	25.877	12.3
1976			24.975	11.8	-0.902	-0.5
Dec 1960 to Nov 1970
1970	25.420	12.6
1971			25.559	12.5	-0.139	-0.1
Apr 1960 to Feb 1961
1961	39.628	21.9
1962			38.625	21.0	-1.003	-0.9

Source: DeNavas-Walt, Proctor and Smith (2013).

Another dramatic fact revealed by DeNavas-Walt, Proctor and Smith (2013) is the increase in the number people without health insurance shown in Table IIB-3 at 49.951 million for 2010. Approximately 16.3 percent of the US population did not have health insurance in 2010. There was marginal improvement with 47.951 million without health insurance in 2012, corresponding to 15.4 percent of the population.

Table IIB-3, US, People without Health Insurance in the Final Year of Recession and in the First Calendar Year after Recession Ended, Millions and Percent

	Millions Without Health Insurance	Percent of Population
Recession Dec 2007 to Jun 2009
2009	49.985	16.4
2010	49.951	16.3
Change/2009	0.919	-0.1 % Points
2012	47.951	15.7
Change/2009	-2.034	-0.7 % Points
Recession Mar 2001 to Nov 2001
2001	38.023	13.5
2002	39.776	13.9
Change	1.753	0.4
Recession Jul 1990 to Mar 1991
1991	35.445	14.1
1992	38.641	15.0
Change	3.196	0.9

Source: DeNavas-Walt, Proctor and Smith (2013).

The population of the US increased by 14.292 million from 296.824 million in 2006 to 311.116 million in 2012, as shown in Table IIB-4. The number uncovered by health insurance increased by 2.737 million between 2006 and 2012. The loss of private health insurance coverage by 5.130 million from 2006 to 2012 was partially compensated by an increase in government coverage by 21.150 million.

Table IIB-4, US, Population, Private and Government Health Insurance and Uncovered by Health Insurance, Thousands and Percent, 2006-2011

	Population	Private Health Insurance	Govern- ment Health Insurance	Uncovered
2012	311,116	198,812	101,493	47,951
2011	308,827	197,323	99,497	48,614
2010	306,553	196,147	95,525	49,951
2009	304,280	196,245	93,245	48,985
2008	301,483	202,626	87,586	44,780
2007	299,106	203,903	83,147	44,088
2006	296,824	203,942	80,343	45,214

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Median household income in the US fell 8.3 percent from $55,627 in 2007 to $51,017 in 2012, as shown in Table IIB-5. Median income fell in all years. Median income fell 4.3 percent in 2012 relative to 2009 even after three years of recovery of the economy.

Table IIB-5, US, Median Household Income, 2012 Dollars and ∆%

	2012	2011	2010	2009	2007
Total Number of Households	122,459	121,084	119,927	117,538	116,783
Median Income Dollars	51,017	51,100	51,892	53,285	55,627
∆% 2012/2009		-4.3
∆% 2011/2009		-4.1
∆% 2012/2007		-8.3
∆% 2011/2007		-8.1

Source: DeNavas-Walt, Proctor and Smith (2013).

Numbers of households in the US, median income in constant 2012 dollars and mean income also in 2012 dollars are provided in Table IIB-6. There is a dramatic fact in Table IIB-6: inflation-adjusted median household income in the US is higher in all years from 1996 to 2011 than the $51,017 of 2012. The contraction and low rate of growth in the expansion have resulted in the destruction of the progress in household income accomplished in 17 years of technological advance and use of humans, machines and natural resources in economic activity. The median measures the center of the middle class of the US that is no better off after 17 years of efforts. There is sharp contrast with the 1980s. Rapid economic growth after the contraction from Jul 1981 to Nov 1982 (http://www.nber.org/cycles.html) resulted in an increase of household median income from $45,760 in 1983 to $51,681 in 1989, or by 12.9 percent. Another fact of Table IA-6 is that household income in 2012 of $51,017 is virtually the same as $51,681 in 1989. The typical household in the US is not better off than in 1989, which is separated from the present by 23 years of efforts.

Table IIB-6, Median and Mean Household Income in 2011 Adjusted Dollars

Year	# Households	Median Income 2012 Dollars	Mean Income 2012 Dollars
2012	122,459	51,017	71,274
2011	121,084	51,100	71,133
2010	119,927	51,892	70,970
2009	117,538	53,285	72,767
2008	117,181	53,644	72,968
2007	116,783	55,627	74,869
2006	116,011	54,892	75,810
2005	114,384	54,486	74,502
2004	113,343	53,891	73,501
2003	112,000	54,079	73,741
2002	111,278	54,127	73,837
2001	109,297	54,766	75,491
2000	108,209	55,987	76,180
1999	106,434	56,080	75,428
1998	103,874	54,702	72,947
1997	102,528	52,784	70,880
1996	101,018	51,720	68,668
1995	99,627	50,978	67,228
1994	98,990	49,429	66,081
1993	97,107	48,884	64,824
1992	96,426	49,122	62,277
1991	95,669	49,529	62,347
1990	94,312	50,994	63,698
1989	93,347	51,681	65,295
1988	92,830	50,776	63,443
1987	91,124	50,389	62,664
1986	89,479	49,764	61,482
1985	88,458	48,063	59,149
1984	86,789	47,181	57,808
1983	85,407	45,760	55,654
1982	83,918	46,082	55,535
1981	83,527	46,205	55,200
1980	82,368	46,985	55,881

Source: DeNavas-Walt, Proctor and Smith (2013).

The percentage change in median household income and the change in number of workers with earnings in the first calendar years after recessions are provided in Table IIB-7. The first calendar year after the end of recession in 2010 is by far the worst of any such year in recessions since 1970. Household median income fell 2.6 percent from 2009 to 2010 and the number of workers with earnings fell by 1.334 million. The first calendar year 2010 after the end of recession in 2009 is the only in the recessions back to 1970 in which there was decline of the number of workers with earnings and the one with lowest increase in full-time year-round workers.

Table IIB-7, Percentage Change in Median Household Income and Change in Number of Workers with Earnings in First Calendar Years after Recessions, ∆% and Thousands

	Median Household Income ∆%	Change in Number of Workers with Earnings Thousands	Change in Full-time Year-round Workers  Thousands
Recession Dec 2007 to June 2009
2010	-2.6	-1,334	192
Recession Mar 2001 to Nov 2001
2002	-1.2	470	286
Recession Jul 1990 to Mar 1991
1992	-0.8	1,692	1,468
Recession Jul 1981 to Nov 1982
1983	-0.7	1,696	2,887
Recession Jan 1980 to Jul 1980
1981	-1.7	995	362
Recession Nov 1973 to Mar 1975
1976	1.7	2,821	1,538
Recession Dec 1960 to Nov 1970
1971	-1.0	1,277	1,213

Source:

DeNavas-Walt, Proctor and Smith (2013).

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

(4) 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 Sep 13 and daily values throughout the week ending on Sep 20, 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 Sep 13 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Sep 13, 2013”, first row “USD/EUR 1.3297 -0.9 %,” provides the information that the US dollar (USD) depreciated 0.9 percent to USD 1.3526/EUR in the week ending on Fri Sep 13 relative to the exchange rate on Fri Sep 6. 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. An 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 most important source of financial turbulence is shifting toward increasing interest rates. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3297/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Sep 13, depreciating to USD 1.3334/EUR on Mon Sep 16, 2013, or by 0.3 percent. The dollar depreciated because more dollars, $1.3334, were required on Mon Sep 16 to buy one euro than $1.3297 on Sep 13. 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 1.3297/EUR on Sep 13. 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 Sep 13, to the last business day of the current week, in this case Fri Sep 20, such as depreciation by 1.7 percent to USD 1.3256/EUR by Sep 20. 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 1.7 percent from the rate of USD 1.3297/EUR on Fri Sep 13 to the rate of USD 1.3526/EUR on Fri Sep 20 {[(1.3526/1.3279) – 1]100 = 1.7%}. The dollar depreciated (denoted by negative sign) by 0.1 percent from the rate of USD 1.3522 on Wed Sep 18 to USD 1.3529/EUR on Thu Sep 19 {[(1.3529/1.3522) -1]100 = -0.1%}. 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 Sep 16 to Sep 20, 2013

Fri Sep 13, 2013	Mon 16	Tue 17	Wed 18	Thu 19	Fri 20
USD/EUR 1.3297 -0.9%	1.3334 -0.3% -0.3%	1.3359 -0.5% -0.2%	1.3522 -1.7% -1.2%	1.3529 -1.7% -0.1%	1.3526 -1.7% 0.0%
JPY/  USD 99.37 -0.3%	99.06 0.3% 0.3%	99.13 0.2% -0.1%	97.93 1.4% 1.2%	99.47 -0.1% -1.6%	99.33 0.0% 0.1%
CHF/  USD 0.9295 0.9%	0.9274 0.2% 0.2%	0.9259 0.4% 0.2%	0.9120 1.9% 1.5%	0.9106 2.0% 0.2%	0.9105 2.0% 0.0%
CHF/ EUR 1.2360 0.0%	1.2368 -0.1% -0.1%	1.2369 -0.1% 0.0%	1.2332 0.2% 0.3%	1.2322 0.3% 0.1%	1.2315 0.4% 0.1%
USD/  AUD 0.9246 1.0816 0.7%	0.9317 1.0733 0.8% 0.8%	0.9355 1.0689 1.2% 0.4%	0.9522 1.0502 2.9% 1.7%	0.9440 1.0593 2.1% -0.9%	0.9397 1.0642 1.6% -0.5%
10 Year  T Note 2.890	2.872	2.845	2.697	2.749	2.734
2 Year     T Note 0.433	0.397	0.373	0.327	0.333	0.333
German Bond 2Y 0.22 10Y 1.97	2Y 0.21 10Y 1.94	2Y 0.21 10Y 1.96	2Y 0.23 10Y 2.00	2Y 0.18 10 1.92	2Y 0.21 10Y 1.94
DJIA 15376.06 3.0%	15494.78 0.8% 0.8%	15529.73 1.0% 0.2%	15676.94 2.0% 0.9%	15636.55 1.7% -0.3%	15451.09 0.5% -1.2%
DJ Global 2298.29 2.6%	2320.33 1.0% 1.0%	2318.62 0.9% -0.1%	2336.48 1.7% 0.8%	2360.82 2.7% 1.0%	2347.66 2.1% -0.6%
DJ Asia Pacific 1400.81 2.6%	1416.18 1.1% 1.1%	1410.96 0.7% -0.4%	1417.88 1.2% 0.5%	1444.03 3.1% 1.8%	1437.84 2.6% -0.4%
Nikkei 14404.67 3.9%	14404.67 0.0% 0.0%	14311.67 -0.6% -0.6%	14505.36 0.7% 1.4%	14766.18 2.5% 1.8%	14742.42 2.3% -0.2%
Shanghai 2236.22 4.5%	2231.40 -0.2% -0.2%	2185.56 -2.3% -2.1%	2191.85 -2.0% 0.3%	2191.85 -2.0% 0.0%	2191.85 -2.0% 0.0%
DAX 8509.42 2.8%	8613.00 1.2% 1.2%	8596.95 1.0% -0.2%	8636.06 1.5% 0.5%	8694.18 2.2% 0.7%	8675.73 2.0% -0.2%
DJ UBS Comm. 129.32 -1.1%	128.89 -0.3% -0.3%	128.02 -1.0% -0.7%	128.92 -0.3% 0.7%	130.0 0.5% 0.8%	128.29 -0.8% -1.3%
WTI $ B 108.51 -1.6%	106.16 -2.2% -2.2%	105.51 -2.8% -0.6%	108.14 -0.3% 2.5%	106.39 -2.0% -1.6%	104.67 -3.5% -1.6%
Brent    $/B 112.78 -2.8%	109.61 -2.8% -2.8%	107.79 -4.4% -1.7%	110.55 -2.0% 2.6%	108.64 -3.7% -1.7%	109.28 -3.1% 0.6%
Gold  $/OZ 1324.6 -4.7%	1309.0 -1.2% -1.2%	1310.2 -1.1% 0.1%	1364.1 3.0% 4.1%	1365.1 3.1% 0.1%	1325.8 0.1% -2.9%

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. What really matters in the statement of the Federal Open Market Committee (FOMC) on Sep 18, 2013, is interest rates of fed funds at 0 to ¼ percent for the foreseeable future, even with paring of purchases of longer term bonds for the portfolio of the Fed (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.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).

Another critical concern in the statement of the FOMC on Sep 18, 2013, is on the effects of tapering expectations on interest rates (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm):

“Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth” (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 σ_y and prices σ_p. 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 15,451.09

on Fri Sep 13, 2013, which is higher by 9.1 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 8.8 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 4.291 percent on Sep 20, 2013, and that of the ten-year sovereign bond of Italy at 4.290 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. In the week of Sep 20, 2013, the yield of the two-year Treasury decreased to 0.333 percent and that of the ten-year Treasury decreased to 2.734 percent while the two-year bond of Germany decreased to 0.21 percent and the ten-year decreased to 1.94 percent; and the dollar depreciated to USD 1.3526/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 2.743 is higher than consumer price inflation of 1.5 percent in the 12 months ending in Aug 2013 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations_18.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.107 percent is well below the 12-month consumer price inflation of 1.5 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
9/20/13	0.333	2.734	0.21	1.94	1.3526
9/13/13	0.433	2.890	0.22	1.97	1.3297
9/6/13	0.461	2.941	0.26	1.95	1.3179
8/23/13	0.401	2.784	0.23	1.85	1.3221
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:

1. 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.
2. The interest rate on the marginal lending facility will be decreased by 50 basis points to 1.00%, with effect from 8 May 2013.
3. 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:

1. 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).
2. 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.
3. 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).
4. 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 Jan 2, 1962, are 2.75 percent for the fed fund rates and 4.06 percent for the ten-year Treasury constant maturity. On July 31, 2001, the yields in Chart III-1A 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 Sep 19, 2013, with the one-month yield at 0.00 percent, the two-year at 0.34 percent, the ten-year at 2.76 percent, the fed funds rate at 0.09 percent and the corporate Baa bond at 5.48 percent. There is an evident increase in the yields of the 10-year Treasury constant maturity and the Moody’s Baa corporate bond with marginal reduction.

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, Jan 2, 1962-Sep 19, 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. In IQ1980, gross private domestic investment in the US was $951.6 billion of 2009 dollars, growing to $1,143.0 billion in IVQ1986 or 20.1 percent. Real gross private domestic investment in the US decreased 2.9 percent from $2,605.2 billion of 2009 dollars in IVQ2007 to $2,529.2 billion in IIQ2013. Real private fixed investment fell 5.0 percent from $2,586.3 billion of 2009 dollars in IVQ2007 to $2,455.8 billion in IIQ2013. Growth of real private investment in is mediocre for all but four quarters from IIQ2011 to IQ2012 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html). Profits after taxes with inventory valuation adjustment (IVA) and capital consumption adjustment (CCA) increased by 100.3 percent in nominal terms from IVQ2007 to IQ2013 while net dividends increased 24.6 percent and undistributed corporate profits swelled 280.2 percent from $107.7 billion in IQ2007 to $409.5 billion in IIQ2013 and changed signs from minus $55.9 billion in current dollars in IVQ2007. The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Corporate profits with IVA and CCA fell $26.6 billion in IQ2013 after increasing $34.9 billion in IVQ2012 and $13.9 billion in IIIQ2012. Corporate profits with IVA and CCA rebounded with $78.3 billion in IIQ2013. Profits after tax with IVA and CCA fell $1.7 billion in IQ2013 after increasing $40.8 billion in IVQ2012 and $4.5 billion in IIIQ2012. In IIQ2013, profits after tax with IVA and CCA increased $67.8 billion. Anticipation of higher taxes in the “fiscal cliff” episode caused increase of $120.9 billion in net dividends in IVQ2012 followed with adjustment in the form of decrease of net dividends by $103.8 billion in IQ2013, rebounding with $273.8 billion in IIQ2013. There is similar decrease of $80.1 billion in undistributed profits with IVA and CCA in IVQ2012 followed by increase of $102.1 billion in IQ2013 and decline of $205.9 billion in IIQ2013. Undistributed profits of US corporations swelled 280.2 percent from $107.7 billion IQ2007 to $409.5 billion in IIQ2013 and changed signs from minus $55.9 billion in billion in IVQ2007 (Section IA2). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $26.6 billion relative to IVQ2012, from $2047.2 billion to $2020.6 billion at the quarterly rate of minus 1.3 percent. In IIQ2013, corporate profits with IVA and CCA increased $78.3 billion from $2020.6 billion in IQ2013 to $2098.9 billion at the quarterly rate of 3.9 percent (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_2nd.pdf). 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 R_τ is expected revenue in the time horizon from τ =1 to T; C_τ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that interest rates increase without bound, then V → 0, or

declines.

There was mostly strong performance in equity indexes with several indexes in Table III-1 increasing in the week ending on Sep 20, 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 decreased 1.2 percent on Sep 20, increasing 0.5 percent in the week. Germany’s Dax decreased 0.2 percent on Fri Sep 20 and increased 2.0 percent in the week. Dow Global decreased 0.6 percent on Sep 20 and increased 2.1 percent in the week. Japan’s Nikkei Average decreased 0.2 percent on Fri Sep 20 and increased 2.3 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 decreased 0.4 percent on Sep 20 and increased 2.6 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 2236.22 on Fri Sep 13 for change of 0.0 percent and decrease of 2.0 percent in the week of Sep 20. 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 weaker in the week of Sep 20, 2013. The DJ UBS Commodities Index decreased 1.3 percent on Fri Sep 20 and decreased 0.8 percent in the week, as shown in Table III-1. WTI decreased 3.5 percent in the week of Sep 20 while Brent decreased 3.1 percent in the week. Gold decreased 2.9 percent on Fri Sep 20 and increased 0.1 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 €779,495 million on Sep 13, 2013 with some repayment of loans already occurring. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has reached €1,383,770 million in the statement of Sep 13, 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	Sep 13, 2013
1 Gold and other Receivables	367,402	419,822	319,969
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	251,016
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	23,735
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	22,308
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	779,495
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	77,097
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	604,275
8 General Government Debt Denominated in Euro	34,954	33,928	28,361
9 Other Assets	278,719	336,574	243,870
TOTAL ASSETS	2,004, 432	2,733,235	2,350,127
Memo Items
Sum of 5 and  7	1,004,174	1,489,759	1,383,770
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/fs130917.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-Jul 2013. Exports to the non-European Union area with share of 46.3 percent in Italy’s total exports are growing at 3.2 percent in Jan-Jul 2013 relative to Jan-Jul 2012 while those to EMU are growing at minus 3.2 percent.

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

Jul 2013	Exports % Share	∆% Jan-Jul 2013/ Jan-Jul 2012	Imports % Share	∆% Jan-Jul 2013/ Jan-Jul 2012
EU	54.2	-2.3	53.2	-2.4
EMU 17	40.5	-3.2	42.7	-2.7
France	11.1	-2.4	8.3	-6.0
Germany	12.5	-3.5	14.6	-6.5
Spain	4.7	-7.7	4.4	-2.5
UK	4.9	1.6	2.5	-0.2
Non EU	46.3	3.2	46.8	-10.0
Europe non EU	13.4	0.3	11.0	7.7
USA	6.8	-2.0	3.3	-14.6
China	2.3	9.3	6.5	-9.9
OPEC	5.7	10.7	10.8	-27.5
Total	100.0	0.2	100.0	-6.0

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/98796

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade surplus of €1335 million with the 17 countries of the euro zone (EMU 17) in Jul 2013 and cumulative deficit of €1058 million in Jan-Jul 2013. Depreciation to parity could permit greater competitiveness in improving the trade surplus of 4657 million in Jan-Jul 2013 with Europe non European Union, the trade surplus of €8930 million with the US and trade surplus with non-European Union of €10,497 million in Jan-Jul 2013. There is significant rigidity in the trade deficits in Jan-Jul 2013 of €8066 million with China and €4366 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 Jul 2013 Millions of Euro	Trade Balance Cumulative Jan-Jul 2013 Millions of Euro
EU	3,152	7,739
EMU 17	1,335	-1,058
France	1,640	7,846
Germany	151	-2,286
Spain	153	544
UK	1,083	5,756
Non EU	2,796	10,497
Europe non EU	1,224	4,657
USA	1,336	8,930
China	-1,339	-8,066
OPEC	-368	-4,366
Total	5,948	18,237

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/98796

Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Jul 2013 relative to Jan-Jul 2012. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 15.2 percent and minus 9.9 percent for durable goods. The higher rate of growth of exports of 0.2 percent in Jan-Jul 2013/Jan-Jul 2012 relative to imports of minus 6.0 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 Share %	Exports ∆% Jan-Jul 2013/ Jan-Jul 2012	Imports Share %	Imports ∆% Jan-Jul 2013/ Jan-Jul 2012
Consumer Goods	29.3	6.4	25.6	1.2
Durable	5.8	1.4	2.9	-9.9
Non-Durable	23.5	7.7	22.7	2.7
Capital Goods	31.6	1.3	19.5	-7.2
Inter- mediate Goods	33.6	-3.3	32.6	-4.6
Energy	5.5	-18.0	22.3	-15.2
Total ex Energy	94.5	1.2	77.7	-3.4
Total	100.0	0.2	100.0	-6.0

Note: % Share for 2012 total trade.

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/98796

Table III-6 provides Italy’s trade balance by product categories in Jul 2013 and cumulative Jan-Jul 2013. Italy’s trade balance excluding energy generated surplus of €10,928 million in Jul 2013 and €50,616 million cumulative in Jan-Jul 2013 but the energy trade balance created deficit of €4980 million in Jul 2013 and cumulative €32,379 million in Jan-Jul 2013. The overall surplus in Jul 2013 was €5948 million with cumulative surplus of €18,237 million in Jan-Jul 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

	Jul 2013	Cumulative Jan-Jul 2013
Consumer Goods	2,899	13,160
Durable	1,374	7,697
Nondurable	1,524	5,463
Capital Goods	6,255	32,428
Intermediate Goods	1,775	5,028
Energy	-4,980	-32,379
Total ex Energy	10,928	50,616
Total	5,948	18,237

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/98796

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

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

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

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

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

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

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

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

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

*Net Lending/borrowing**Gross Debt

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

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2013” to the column “GDP USD Billions.” The total debt of France and Germany in 2013 is $4315.7 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $4087.3 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8403.0 billion, which would be equivalent to 132.6 percent of their combined GDP in 2013. Under this arrangement, the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 233.5 percent if including debt of France and 167.7 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.

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

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	9,423.7
B Germany	1,946.5		$8403.0 as % of $3598 =233.5% $6033.8 as % of $3598 =167.7%
C France	2,369.2
B+C	4,315.7	GDP $6,337.0 Total Debt $8403.0 Debt/GDP: 132.6%
D Italy	2,123.7
E Spain	1,097.9
F Portugal	250.7
G Greece	379.2
H Ireland	235.8
Subtotal D+E+F+G+H	4,087.3

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

There is extremely important information in Table III-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Jul 2013. German exports to other European Union (EU) members are 56.0 percent of total exports in Jul 2013 and 57.3 percent in cumulative Jan-Jul 2013. Exports to the euro area are 36.0 percent in Jul and 37.2 percent cumulative in Jan-Jul. Exports to third countries are 44.1 percent of the total in Jul and 42.7 percent cumulative in Jan-Jul. There is similar distribution for imports. Exports to non-euro countries are increasing 3.6 percent in the 12 months ending in Jul 2013, increasing 1.5 percent cumulative in Jan-Jul 2013 while exports to the euro area are decreasing 0.7 percent in the 12 months ending in Jul 2013 and decreasing 2.9 percent cumulative in Jan-Jul 2013. Exports to third countries, accounting for 44.1 percent of the total in Jun 2013, are decreasing 1.0 percent in the 12 months ending in Jul 2013 and decreasing 0.7 percent cumulative in Jan-Jul 2013, accounting for 42.7 percent of the cumulative total in Jan-Jul 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 ∆%

	Jul 2013  € Billions	Jun 12-Month ∆%	Cumulative Jan-Jul 2012 € Billions	Cumulative Jan-Jul 2013/ Jan-Jul 2012 ∆%
Total Exports	93.4	0.0	640.8	-0.5
A. EU Members	52.3 % 56.0	0.8	367.1 % 57.3	-1.4
Euro Area	33.6 % 36.0	-0.7	238.5 % 37.2	-2.9
Non-euro Area	18.6 % 19.9	3.6	128.6 % 20.1	1.5
B. Third Countries	41.2 % 44.1	-1.0	273.8 % 42.7	0.7
Total Imports	77.3	0.9	526.8	-1.3
C. EU Members	49.6 % 64.2	0.6	340.8 % 64.7	0.1
Euro Area	35.3 % 45.7	1.5	238.8 % 45.3	-0.4
Non-euro Area	14.3 % 18.5	-1.7	102.0 % 19.4	1.4
D. Third Countries	27.7 % 35.8	1.6	186.1 % 35.3	-3.7

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

Source: Statistisches Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2013/09/PE13_298_51.html

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

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

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

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

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

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

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

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

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

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

(M_t + B_t)/P_t = E_t∫(1/R_{t, t+τ})s_t+τdτ (4)

Equation (4) expresses the monetary, M_t, and debt, B_t, liabilities of the government, divided by the price level, P_t, in terms of the expected value discounted by the ex-post rate on government debt, R_{t, t+τ}, of the future primary surpluses s_t+τ, which are equal to T_t+τ – G_t+τ or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post R_{t, t+τ}. The second equation of Cochrane (2011Jan, 5) is:

M_tV(i_t, ·) = P_tY_t (5)

Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):

“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”

An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.

There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:

(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress

(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality

(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.

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

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

	GDP	CPI	PPI	UNE
US	1.6	1.5	1.4	7.3
Japan	1.2	0.7	2.4	3.8
China	7.5	2.6	-1.6
UK	1.5	2.7* CPIH 2.5	1.6 output 1.0** input 2.8	7.7
Euro Zone	-0.5	1.3	0.2	12.1
Germany	0.5	1.6	0.6	5.3
France	0.3	1.0	0.3	11.0
Nether-lands	-1.8	2.8	-0.4	7.0
Finland	0.0	2.0	1.6	7.9
Belgium	-0.1	1.1	1.6	8.9
Portugal	-2.0	0.2	1.3	16.5
Ireland	NA	0.0	3.1	13.8
Italy	-2.0	1.2	-1.0	12.0
Greece	-4.6	-1.0	-0.4	NA
Spain	-1.6	1.6	0.8	26.3

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/august-2013/index.html **Core

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

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

Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.6 percent in IIQ2013 relative to IIQ2012 (Table 8 in http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_2nd.pdf http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html). Japan’s GDP grew 0.9 percent in IIQ2013 relative to IQ2013 and 1.2 percent relative to a year earlier. Japan’s grew at the seasonally adjusted annual rate (SAAR) of 3.8 percent in IIQQ2013 (http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-million.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations_3896.html). The UK grew at 0.7 percent in IIQ2013 relative to IQ2013 and GDP increased 1.5 percent in IIQ2013 relative to IIQ2012 (http://cmpassocregulationblog.blogspot.com/2013/08/interest-rate-risks-duration-dumping.html 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 0.5 percent in IIQ2013 relative to IIQ2012 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations_3896.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: 7.3 percent in the US but 17.4 percent for unemployment/underemployment or job stress of 28.3 million (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html), 3.8 percent for Japan (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/recovery-without-hiring-loss-of-full.html), 7.7 percent for the UK with high rates of unemployment for young people (http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-million.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations_3896.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.5 percent in the US, 0.7 percent for Japan, 2.6 percent for China, 1.3 percent for the Euro Zone and 2.7 percent for the UK. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. Six key interrelated vulnerabilities in the world economy 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/2013/09/recovery-without-hiring-ten-million.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/2013/09/increasing-interest-rate-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html), weak hiring with the loss of 10 million full-time jobs (http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-million.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/recovery-without-hiring-loss-of-full.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/2013/09/twenty-eight-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.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 had repercussions throughout the world economy. Japan has 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 16 quarters from IIIQ2009 to IIQ2013 (http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/interest-rate-risks-duration-dumping.html). Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). The average of 7.7 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/2013/09/increasing-interest-rate-risk.html and earlier 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/2013/09/increasing-interest-rate-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html). As a result, there are 28.3 million unemployed or underemployed in the United States for an effective unemployment rate of 17.4 percent (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html and earlier 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, total nonfarm payroll employment seasonally adjusted (SA) increased 169,000 in Aug 2013 and private payroll employment rose 152,000. The average number of nonfarm jobs created in Jan-Aug 2012 was 178,625 while the average number of private jobs created in Jan-Aug 2013 was 180,250, or increase by 0.9 percent. The average number of private jobs created in the US in Jan-Aug 2012 was 181,750 while the average in Jan-Aug 2013 was 185,625, or increase by 2.1 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 eight months from Jan to Aug 2013 was 178,625, 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 178,625 new private nonfarm jobs per month in the US from Jan to Aug 2013 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 65,458 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 65,458 new jobs per month net of absorption of new entrants in the labor force would require 433 months to provide jobs for the unemployed and underemployed (28.348 million divided by 65,458) or 36 years (433 divided by 12). The civilian labor force of the US in Aug 2013 not seasonally adjusted stood at 155.971 million with 11.462 million unemployed or effectively 18.316 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 162.825 million. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 1.3 years (1 million divided by product of 65,458 by 12, which is 785,496). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.799 million (0.05 times labor force of 155.971 million) for new net job creation of 3.663 million (11.462 million unemployed minus 7.799 million unemployed at rate of 5 percent) that at the current rate would take 4.7 years (3.663 million divided by 0.785496). Under the calculation in this blog, there are 18.316 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 162.825 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 12.9 years (18.316 million minus 0.05(162.825 million) = 10.175 million divided by 0.785596, using LF PART 66.2% and Total UEM in Table I-4). These calculations assume that there are no more recessions, defying United States economic history with periodic contractions of economic activity when unemployment increases sharply. The number employed in the US fell from 147.315 million in Jul 2007 to 144.509 million in Aug 2013, by 2.806 million, or decline of 1.9 percent, while the civilian noninstitutional or economically active population increased from 231.958 million in Jul 2007 to 245.959 million in Aug 2013, by 14.001 million or increase of 6.0 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. Inferior performance of the US economy and labor markets is the critical current issue of analysis and policy design.

Second, revisions and enhancements of United States GDP and personal income accounts 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://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_2nd.pdf http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0713.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.

1. 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. There were periodic contractions or recessions in this period but the economy grew at faster rates in the subsequent expansions, maintaining long-term economic growth at trend.
2. Cycles. The combined contraction of GDP in the two almost consecutive recessions in the early 1980s is 4.7 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	-4.7
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://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_2nd.pdf

The revisions and enhancements of United States GDP and personal income accounts 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://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_2nd.pdf http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0713.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 1.8 to 1.9 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 and the first two quarters of 2013 accumulated to 2.9 percent. This growth is equivalent to 1.9 percent per year, obtained by dividing GDP in IIQ2013 of $15,681.0 by GDP in IVQ2011 of $15,242.1 and compounding by 4/6: {[($15,681.0/$15,242.1)^4/6 -1]100 = 1.9.

2. Average Annual Growth in the First Two Quarters of 2013. GDP growth in the first two quarters of 2013 accumulated to 0.9 percent that is equivalent to 1.8 percent in a year. This is obtained by dividing GDP in IIQ2013 of $15,681.0 by GDP in IVQ2012 of $15,539.6 and compounding by 4/2: {[($15,681.0/$15,539.6)^4/2 -1]100 =1.8%}. The US economy grew 1.6 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, which is just at the borderline of contraction.

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	∆% over Year Earlier
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	15,681.0	4.6	0.6	1.6
Cumulative ∆% IQ2012 to IIQ2013	2.9		2.8
Annual Equivalent ∆%	1.9		1.9

Source: US Bureau of Economic Analysis http://bea.gov/iTable/index_nipa.cfm http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_2nd.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 Sep 18, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm):

“Press Release

Release Date: September 18, 2013

For immediate release

Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace. Some indicators of labor market conditions have shown further improvement in recent months, 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 further and fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, 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, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market. 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.

Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, 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, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.

The Committee will closely monitor incoming information on economic and financial developments in coming months and 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. In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases.

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; Charles L. Evans; Jerome H. Powell; 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.

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

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

1. Open-ended Quantitative Easing or QE_∞. Earlier programs are continued with an additional open-ended $85 billion of bond purchases per month: “However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, 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, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.”
2. 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.”
3. 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.”
4. No Present Course of Asset Purchases. Market participants focused on slightly different wording about asset purchases: “In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases.”
5. Concern with Mortgage Rates. “Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth.”

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 Sep 18, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.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” (emphasis added).

There is a critical phrase in the statement of Sep 19, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm): “but mortgage rates have risen further.” Did the increase of mortgage rates influence the decision of the FOMC not to taper? Is FOMC “communication” and “guidance” successful?

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 σ_y and prices σ_p. 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/2013/09/increasing-interest-rate-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html) and the PCE inflation data from the report on personal income and outlays in Section IV (http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html). The Bureau of Economic Analysis (BEA) provides the second estimate of IIQ2013 GDP released on Aug 29, 2013 with revisions since 1929 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html

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/2013/09/increasing-interest-rate-risk.html

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 30, 2013 with revisions from 1959 to May 2013 and the report for Jul 2013 was released on

Aug 30, 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html http://cmpassocregulationblog.blogspot.com/2013/08/risks-of-steepening-yield-curve-and.html http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm) and the report for Aug 2012 was released on . 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 and the report for Aug 2013 was released on Sep 6, 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html

and earlier 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 because 2015, 2016 and longer term are too far away, and there is not much information even on what will happen in 2013-2014 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 Sep 18, 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 2.6 percent at the meeting in Jun 2013 to 2.0 to 2.3 percent at the meeting on Sep 18, 2013. The FOMC decreased GDP growth in 2014 from 3.0 to 3.5 percent at the meeting in Jun 2013 to 2.9 to 3.1 percent at the meeting in Sep 2013.

2. Rate of Unemployment “UNEM%.” The FOMC reduced the forecast of the rate of unemployment from 7.2 to 7.3 percent at the meeting on Jun 19, 2013 to 7.1 to 7.3 percent at the meeting on Sep 18, 2013. The projection for 2014 decreased to the range of 6.4 to 6.8 in Sep 2013 from 6.5 to 6.8 in Jun 2013. Projections of the rate of unemployment are moving closer to the desire 6.5 percent or lower with 5.9 to 6.2 percent in 2015 after the meeting on Sep 18, 2013.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 0.8 to 1.2 percent at the meeting on Jun 19, 2012 to 1.1 to 1.2 percent at the meeting on Sep 18, 2013. There are no projections exceeding 2.0 percent in the central tendency but some in the range reach 2.3 percent in 2015 and 2015. The longer run projection is at 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, changing from 1.2 to 1.3 percent at the meeting on Jun 19, 2013 to 1.2 to 1.3 percent at the meeting Sep 13, 2013. In 2014, there is minor change in the projection from 1.5 to 1.8 percent in Jun 19, 2013 to 1.5 to 1.7 percent in Sep 18, 2013. The rate of change of the core PCE is below 2.0 percent in the central tendency with 2.3 percent at the top of the range in 2015 and 2016.

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 Tendency
2013  Jun PR	2.0 to 2.3 2.3 to 2.6	7.1 to 7.3 7.2 to 7.3	1.1 to 1.2 0.8 to 1.2	1.2 to 1.3 1.2 to 1.3
2014  Jun PR	2.9 to 3.1 3.0 to 3.5	6.4 to 6.8 6.5 to 6.8	1.3 to 1.8 1.4 to 2.0	1.5 to 1.7 1.5 to 1.8
2015 Jun PR	3.0 to 3.5 2.9 to 3.6	5.9 to 6.2 5.8 to 6.2	1.6 to 2.0 1.7 to 2.0	1.7 to 2.0 1.7 to 2.0
2016 Jun PR	2.5 to 3.3 NA	5.4 to 5.9 NA	1.7 to 2.0 NA	1.9 to 2.0 NA
Longer Run Jun PR	2.2 to 2.5 2.3 to 2.5	5.2 to 5.8 5.2 to 6.0	2.0 2.0
Range
2013 Jun PR	1.8 to 2.4 2.0 to 2.6	6.9 to 7.3 6.9 to 7.5	1.0 to 1.3 0.8 to 1.5	1.2 to 1.4 1.1 to 1.5
2014 Jun PR	2.2 to 3.3 2.2 to 3.6	6.2 to 6.9 6.2 to 6.9	1.2 to 2.0 1.4 to 2.0	1.4 to 2.0 1.5 to 2.0
2015 Jun PR	2.2 to 3.7 2.3 to 3.8	5.3 to 6.3 5.7 to 6.4	1.4 to 2.3 1.6 to 2.3	1.6 to 2.3 1.7 to 2.3
2016 Jun PR	2.2 to 3.5 NA	5.2 to 6.0 NA	1.5 to 2.3 NA	1.7 to 2.3 NA
Longer Run Jun PR	2.1 to 2.5 2.0 to 3.0	5.2 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/fomcprojtabl20130918.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, 2016 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 17 participants expecting the rate to remain at 0 to ¼ percent in 2013. The rate would still remain at 0 to ¼ percent in 2014 for 13 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. For 2015, eight participants expect rates to be below or at 1.0 percent while six expect rates from 1.0 to 1.5 percent and three expecting rates in excess of 2.0 percent. For 2016, nine participants expect rates between 1.0 and 2.0 percent, four between 2.0 and 3.0 percent and three between 3.0 and 4.4 percent. In the long term, all 17 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	17
2014	13	3	1
2015		8	6		3
2016		1		9	4	3
Longer Run						17

Source: Board of Governors of the Federal Reserve System, FOMC

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf

Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2013 to 2016. 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
2014	3
2015	12
2016	2

Source: Board of Governors of the Federal Reserve System, FOMC

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf

There are two categories of responses in the Empire State Manufacturing Survey of the Federal Reserve Bank of New York (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html): current conditions and expectations for the next six months. There are responses in the survey for two types of prices: prices received or inputs of production and prices paid or sales prices of products. Table IV-5 provides indexes for the two categories and within them for the two types of prices from Jan 2011 to Sep 2013. The index of current prices paid or costs of inputs increased from 16.13 in Dec 2012 to 21.51 in Sep 2013 while the index of current prices received or sales prices increased from 1.08 in Dec 2012 to 8.6 in Sep 2013. The index of future prices paid or expectations of costs of inputs in the next six months fell from 51.61 in Dec 2012 to 39.78 in Sep 2013 while the index of future prices received or expectation of sales prices in the next six months fell from 25.81 in Dec 2012 to 24.73 in Sep 2013. Prices of sales of finished products are less dynamic than prices of costs of inputs during waves of increases. Prices of costs of costs of inputs fall less rapidly than prices of sales of finished products during waves of price decreases. As a result, margins of prices of sales less costs of inputs oscillate with typical deterioration against producers, forcing companies to manage tightly costs and labor inputs.

Table IV-5, US, FRBNY Empire State Manufacturing Survey, Diffusion Indexes, Prices Paid and Prices Received, SA

	Current Prices Paid	Current Prices Received	Six Months Prices Paid	Six Months Prices Received
Sep 2013	21.51	8.6	39.78	24.73
Aug	20.48	3.61	40.96	19.28
Jul	17.39	1.09	28.26	11.96
Jun	20.97	11.29	45.16	17.74
May	20.45	4.55	29.55	14.77
Apr	28.41	5.68	44.32	14.77
Mar	25.81	2.15	50.54	23.66
Feb	26.26	8.08	44.44	13.13
Jan	22.58	10.75	38.71	21.51
Dec 2012	16.13	1.08	51.61	25.81
Nov	14.61	5.62	39.33	15.73
Oct	17.20	4.30	44.09	24.73
Sep	19.15	5.32	40.43	23.40
Aug	16.47	2.35	31.76	14.12
Jul	7.41	3.70	35.80	16.05
Jun	19.59	1.03	34.02	17.53
May	37.35	12.05	57.83	22.89
Apr	45.78	19.28	50.60	22.89
Mar	50.62	13.58	66.67	32.10
Feb	25.88	15.29	62.35	34.12
Jan	26.37	23.08	53.85	30.77
Dec 2011	24.42	3.49	56.98	36.05
Nov	18.29	6.10	36.59	25.61
Oct	22.47	4.49	40.45	17.98
Sep	32.61	8.70	53.26	22.83
Aug	28.26	2.17	42.39	15.22
Jul	43.33	5.56	51.11	30.00
Jun	56.12	11.22	55.10	19.39
May	69.89	27.96	68.82	35.48
Apr	57.69	26.92	56.41	38.46
Mar	53.25	20.78	71.43	36.36
Feb	45.78	16.87	55.42	27.71
Jan	35.79	15.79	60.00	42.11

Source: http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html

Price indexes of the Federal Reserve Bank of Philadelphia Outlook Survey are provided in Table IV-6. As inflation waves throughout the world (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations.html), indexes of both current and expectations of future prices paid and received were quite high until May 2011. Prices paid, or inputs, were more dynamic, reflecting carry trades from zero interest rates to commodity futures. All indexes softened after May 2011 with even decline of prices received in Aug 2011 during the first round of risk aversion. Current and future price indexes have increased again but not back to the levels in the beginning of 2011 because of risk aversion frustrating carry trades even under zero interest rates. The index of prices paid or prices of inputs increased from 23.5 in Dec 2012 to 25.3 in Sep 2013. The index of current prices received was minus 3.3 in May 2013, indicating decrease of prices received. The index of current prices received increased from 12.4 in Dec 2012 to 12.7 in Sep 2013. The index of future prices paid fell to 43.1 in Sep 2013 from 45.8 in Dec 2012, indicating expectation of lower pressure of increases of input prices, while the index of future prices received increased from 25.6 in Dec 2012 to 31.7 in Sep 2013. Expectations are incorporating faster increases in prices of inputs or costs of production than of sales of produced goods, forcing companies to manage tightly costs and labor inputs.

Table IV-6, US, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current and Future Prices Paid and Prices Received, SA

	Current Prices Paid	Current Prices Received	Future Prices Paid	Future Prices Received
Dec-10	44.3	6.6	59.6	25.3
Jan-11	48.9	11.9	58.3	34.4
Feb-11	58.9	13.1	62.1	33.3
Mar-11	57.5	16.8	60.2	31.8
Apr-11	49.4	19.8	54.2	32.4
May-11	47.7	18.5	52.7	27.6
Jun-11	38.9	8.1	38.3	6.8
Jul-11	35.6	6.0	49.6	16.7
Aug-11	23.3	-4.7	44.3	22.7
Sep-11	31.6	7.6	41.8	21.8
Oct-11	25.4	4.1	44.5	28.4
Nov-11	26.3	7.6	39.0	29.1
Dec-11	27.5	8.2	46.7	23.5
Jan-12	27.1	7.9	47.2	21.9
Feb-12	30.2	9.7	43.5	28.6
Mar-12	14.3	5.4	35.9	22
Apr-12	16.0	5.3	33.3	18.6
May-12	5.4	-2.2	37.2	8.3
Jun-12	5.4	-3.4	29.6	16.6
Jul-12	10.3	4.2	29.3	19.6
Aug-12	15.7	4.7	38.0	23.9
Sep-12	15.4	4.0	42.8	27.4
Oct-12	20.6	8.4	48.1	16.1
Nov-12	27.9	7.5	50.7	14
Dec-12	23.5	12.4	45.8	25.6
Jan-13	14.7	-1.1	34.3	21.7
Feb-13	8.9	-0.5	26.4	25.4
Mar-13	8.5	-0.8	30.9	16.6
Apr-13	3.1	-7.5	26.6	8.3
May-13	6.9	-3.3	30.7	18.2
Jun-13	22.5	14.6	26.4	23.5
Jul-13	21.5	7.0	42.1	23.9
Aug-13	17.3	9.9	38.7	23.0
Sep-13	25.3	12.7	43.1	31.7

Source:

Source: Federal Reserve Bank of Philadelphia

http://philadelphiafed.org/index.cfm

Chart IV-1 of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia Outlook Survey provides the diffusion index of current prices paid or prices of inputs from 2006 to 2013. Recession dates are in shaded areas. In the middle of deep global contraction after IVQ2007, input prices continued to increase in speculative carry trades from central bank policy rates falling toward zero into commodities futures. The index peaked above 70 in the second half of 2008. Inflation of inputs moderated significantly during the shock of risk aversion in late 2008, even falling briefly into contraction territory below zero during several months in 2009 in the flight away from risk financial assets into US government securities (Cochrane and Zingales 2009) that unwound carry trades. Return of risk appetite induced carry trade with significant increase until return of risk aversion in the first round of the European sovereign debt crisis in Apr 2010. Carry trades returned during risk appetite in expectation that the European sovereign debt crisis was resolved. The various inflation waves originating in carry trades induced by zero interest rates with alternating episodes of risk aversion are mirrored in the prices of inputs after 2011, in particular after Aug 2012 with the announcement of the Outright Monetary Transactions Program of the European Central Bank (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). Subsequent risk aversion and flows of capital away from commodities into stocks and high-yield bonds caused sharp decline in the index of prices paid followed by another recent rebound.

Chart IV-1, Federal Reserve Bank of Philadelphia Business Outlook Survey Current Prices Paid Diffusion Index SA

Source: Federal Reserve Bank of Philadelphia

http://www.philadelphiafed.org/index.cfm

Chart IV-2 of the Federal Reserve Bank of Philadelphia Outlook Survey provides the diffusion index of current prices received from 2006 to 2013. The significant difference between the index of current prices paid in Chart IV-1 and the index of current prices received in Chart IV-2 is that increases in prices paid are significantly sharper than increases in prices received. There were several periods of negative readings of prices received from 2010 to 2013 but none of prices paid. Prices paid relative to prices received deteriorate most of the time largely because of the carry trades from zero interest rates to commodity futures. Profit margins of business are compressed intermittently by fluctuations of commodity prices induced by unconventional monetary policy of zero interest rates, frustrating production, investment and hiring decisions of business, which is precisely the opposite outcome desired by unconventional monetary policy.

Chart IV-2, Federal Reserve Bank of Philadelphia Business Outlook Survey Current Prices Received Diffusion Index SA

Source: Federal Reserve Bank of Philadelphia

http://www.philadelphiafed.org/index.cfm

The harmonized index of consumer prices of the euro area in Table IV-7 has similar inflation waves as in most countries (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations.html). In the first wave, consumer prices in the euro area increased at the annual equivalent rate of 5.2 percent in Jan-Apr 2011. In the second wave, risk aversion caused unwinding of commodity carry trades with inflation decreasing at the annual equivalent rate of minus 2.4 percent in May-Jul 2011. In the third wave, improved risk appetite resulted in annual equivalent inflation in Aug-Nov 2011 at 4.3 percent. In the fourth wave, return of risk aversion caused decline of consumer prices at the annual equivalent rate of minus 3.0 percent in Dec 2011 to Jan 2012. In the fifth wave, improved attitudes toward risk aversion resulted in higher consumer price inflation at the high annual equivalent rate of 9.6 percent in Feb-Apr 2012. In the sixth wave, annual equivalent inflation fell to minus 2.8 percent in May-Jul 2012. In the seventh wave, increasing risk appetite caused new carry trade exposures that resulted in annual equivalent inflation of 6.8 percent in Aug-Sep 2012 and 5.3 percent in Aug-Oct 2012. In the eighth wave, annual-equivalent inflation was minus 2.4 percent in Nov 2012. In the ninth wave, annual equivalent inflation was 4.9 percent in Dec 2012. In the tenth wave, annual equivalent inflation was minus 11.4 percent in Jan 2013. In the eleventh wave, annual equivalent inflation was 10.0 percent in Feb-Mar 2013. In the twelfth wave, annual equivalent inflation was minus 1.2 percent in Apr 2013. In the thirteenth wave, annual equivalent inflation rose to 1.2 percent in May-Jun 2013. In the fourteenth wave, annual equivalent inflation was minus 5.8 percent in Jul 2013. In the fifteenth wave, annual equivalent inflation was 1.2 percent in Aug 2013. Inflation volatility around the world is confusing the information required in investment and consumption decisions. The bottom part of Table IV-7 provides annual inflation in the euro area from 1999 to 2012. HICP inflation was 3.3 percent in 2008 mostly because of carry trades from interest rates falling to zero into commodity futures. Exposures in commodity futures were reversed in the flight to US government obligations with resulting inflation of 0.3 percent in 2009. Reallocations of portfolios of financial investors according to risk aversion caused high volatility of inflation in 2011 and 2013.

Table IV-7, Euro Area Harmonized Index of Consumer Prices Month and 12 Months ∆%

	Month ∆%	12 Months ∆%
Aug 2013	0.1	1.3
AE ∆% Aug	1.2
Jul 2013	-0.5	1.6
AE ∆% Jul	-5.8
Jun	0.1	1.6
May	0.1	1.4
AE ∆% May-Jun	1.2
Apr	-0.1	1.2
AE ∆% Apr	-1.2
Mar	1.2	1.7
Feb	0.4	1.9
AE ∆% Feb-Mar	10.0
Jan	-1.0	2.0
AE ∆% Jan	-11.4
Dec 2012	0.4	2.2
AE ∆% Dec	4.9
Nov	-0.2	2.2
AE ∆% Nov	-2.4
Oct	0.2	2.5
Sep	0.7	2.6
Aug	0.4	2.6
AE ∆% Aug-Oct	5.3
Jul 2012	-0.5	2.4
Jun	-0.1	2.4
May	-0.1	2.4
AE ∆% May-Jul	-2.8
Apr	0.5	2.6
Mar	1.3	2.7
Feb	0.5	2.7
AE ∆%  Feb-Apr	9.6
Jan	-0.8	2.7
Dec 2011	0.3	2.7
AE ∆%  Dec-Jan	-3.0
Nov	0.1	3.0
Oct	0.4	3.0
Sep	0.7	3.0
Aug	0.2	2.6
AE ∆%  Aug-Nov	4.3
Jul	-0.6	2.6
Jun	0.0	2.7
May	0.0	2.7
AE ∆%  May-Jul	-2.4
Apr	0.6	2.8
Mar	1.4	2.7
Feb	0.4	2.4
Jan	-0.7	2.3
AE ∆% Jan-Apr	5.2
Dec 2010	0.6	2.2

AE: annual equivalent Source: EUROSTAT

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

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

Table IV-8 provides weights and inflation of selected components of the HICP of the euro area. Inflation of all items excluding energy increased 1.6 percent in Aug 2013 relative to Aug 2012 and increased 0.1 percent in Aug 2013 relative to Jul 2013. Prices of non-energy industrial goods increased 0.4 percent in Aug 2013 relative to a year earlier and changed 0.0 percent in Aug 2013. Inflation of services was 1.4 percent in Aug 2013 relative to a year earlier and increased 0.3 percent in Aug 2013.

Table IV-8, Euro Area, HICP Inflation and Selected Components, ∆%

	Weight % 2013	Aug 2013/ Aug 2012	12-month Average Rate Aug 2013-2012/ Aug 2012-2011	∆% Aug 2013/Jul 2013
All Items	1000.0	1.3	1.8	0.1
All Items ex Energy	890.4	1.6	1.7	0.1
All Items ex Energy, Food, Alcohol & Tobacco	696.7	1.1	1.3	0.2
All Items ex Energy & Unprocessed Food	816.9	1.3	1.4	0.2
All Items ex Seasonal Food	852.7	1.4	1.5	0.2
All Items ex Tobacco	975.8	1.2	1.8	0.1
Energy	109.6	-0.3	3.2	0.5
Food, Alcohol & Tobacco	193.7	3.2	3.1	-0.3
Non-energy Industrial Goods	273.6	0.4	0.8	0.0
Services	423.0	1.4	1.6	0.3

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

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

Inflation in the UK is somewhat higher than in many advanced economies, deserving more detailed analysis. Table IV-9 provides 12-month percentage changes of UK output prices for all manufactured products, excluding food, beverage and petroleum and excluding duty. The 12-month rates rose significantly in 2011 in all three categories, reaching 6.3 percent for all manufactured products in Sep 2011 but declining to 5.7 percent in Oct 2011, 5.4 percent in Nov 2011 and down to 1.8 percent in Jul 2012. Inflation of all manufactured products increased marginally to 2.3 percent in Aug 2012, 2.5 percent in Sep, 2.6 in Oct, 2.1 percent in Nov-Jan 2012, 2.3 percent in Feb 2013, 1.9 percent in Mar 2013 and 1.0 percent in Apr 2013. Output prices increased 1.2 percent in the 12 months ending in May 2013, 2.0 percent in Jun 2013 and 2.1 percent in Jul 2013. Output price inflation was 1.6 percent in the 12 months ending in Aug 2013. Output price inflation is highly sensitive to commodity prices as shown by the increase by 6.7 percent in 2008 when oil prices rose over $140/barrel even in the midst of a global recession driven by the carry trade from zero interest rates to oil futures. The mirage episode of false deflation in 2001 and 2002 is also captured by output prices for the UK, which was originated in decline of commodity prices (see Barsky and Killian 2004) but was used as an argument for unconventional monetary policy of zero interest rates and quantitative easing during the past decade.

Table IV-9, UK Output Prices 12 Months ∆% NSA

	All Manufactured Products	Excluding Food, Beverage, Tobacco and Petroleum	All Excluding Duty
Aug 2013	1.6	1.0	1.7
Jul	2.1	1.1	2.2
Jun	2.0	0.9	2.0
May	1.2	0.8	1.4
Apr	1.0	0.7	1.1
Mar	1.9	1.3	1.7
Feb	2.3	1.3	2.1
Jan	2.1	1.4	1.9
Dec 2012	2.1	1.5	1.8
Nov	2.1	1.4	1.8
Oct	2.6	1.4	2.3
Sep	2.5	1.2	2.2
Aug	2.3	1.2	1.9
Jul	1.8	1.2	1.5
Jun	2.0	1.7	1.7
May	2.8	2.1	2.5
Apr	3.3	2.3	3.1
Mar	3.7	2.5	3.5
Feb	4.1	3.0	4.1
Jan	4.0	2.4	4.0
Dec 2011	4.8	3.0	4.8
Nov	5.4	3.1	5.6
Oct	5.7	3.3	5.9
Sep	6.3	3.7	6.4
Aug	6.0	3.5	6.2
Jul	6.1	3.4	6.2
Jun	5.8	3.2	5.9
May	5.4	3.4	5.5
Apr	5.6	3.6	5.8
Mar	5.6	3.1	5.5
Feb	5.3	3.1	5.2
Jan	5.0	3.3	5.0
Dec 2010	4.2	2.7	4.0
Year ∆%
2012	2.8	1.8	2.5
2011	5.6	3.4	5.7
2010	4.2	3.0	3.9
2009	1.6	2.5	1.0
2008	6.7	3.7	6.7
2007	2.4	1.4	2.1
2006	2.0	1.5	2.0
2005	1.9	1.0	1.9
2004	1.0	-0.3	0.6
2003	0.6	0.1	0.5
2002	-0.1	-0.4	-0.1
2001	-0.3	-0.6	-0.3
2000	1.4	-0.5	0.8
1999	0.6	-1.0	-0.3
1998	0.0	-0.9	-0.9
1997	0.9	0.3	0.1

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/august-2013/index.html

Monthly and annual equivalent rates of change of output prices are shown in Table IV-10. There are waves of inflation similar to those in other countries (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations.html). In the first wave, annual equivalent inflation was 12.0 percent in Jan-Apr 2011 with relaxed risk aversion in commodity markets. In the second wave, intermittent risk aversion resulted in annual equivalent inflation of 2.0 percent in May-Oct 2011. In the third wave, alternation of risk aversion resulted in annual equivalent inflation of 1.6 percent in Nov 2011 to Jan 2012. In the fourth wave, the energy commodity shock processed through carry trades caused the jump of annual equivalent inflation to 7.9 percent in Feb-Apr 2012. A fifth wave occurred in May-Jun 2012 with decline of output inflation by 5.3 percent annual equivalent in an environment of risk aversion that caused decline of commodity prices. A sixth wave under commodity shocks induced by carry trades from zero interest rates resulted in annual equivalent inflation of 4.5 percent in Jul-Sep 2012 and 4.0 percent in Jul-Oct 2012. In the seventh wave, annual equivalent inflation in Nov-Dec 2012 fell to minus 3.0 percent. In the eighth wave, annual equivalent inflation returned at 5.3 percent in Jan-Mar 2013. In the ninth wave, risk aversion returned with annual equivalent inflation of minus 1.8 percent in Apr-May 2013. In the tenth wave, annual equivalent inflation was 1.2 percent in Jun-Aug 2013.

Table IV-10, UK Output Prices Month ∆% NSA

	All Manufactured Products	Excluding Food, Beverage and Petroleum	All Excluding Duty
Aug 2013	0.1	0.0	0.1
Jul	0.2	0.1	0.3
Jun	0.1	-0.1	0.0
∆% AE Jun-Aug	1.2	0.0	1.8
May	-0.1	0.1	-0.1
Apr	-0.2	0.0	-0.2
∆% AE Apr-May	-1.8	0.6	-1.8
Mar	0.2	0.1	0.2
Feb	0.7	0.3	0.8
Jan	0.4	0.3	0.4
∆% AE Jan-Mar	5.3	2.8	5.7
Dec 2012	-0.2	0.0	-0.2
Nov	-0.3	-0.1	-0.2
∆% AE Nov-Dec	-3.0	-0.6	-2.4
Oct	0.2	0.1	0.2
Sep	0.5	0.3	0.5
Aug	0.5	0.1	0.6
Jul	0.1	-0.1	0.1
∆% AE Jul-Oct	4.0	1.2	4.3
Jun	-0.6	-0.2	-0.6
May	-0.3	-0.1	-0.4
∆% AE May-Jun	-5.3	-1.8	-5.8
Apr	0.7	0.6	0.5
Mar	0.6	0.1	0.5
Feb	0.6	0.5	0.6
∆% AE Feb-Apr	7.9	4.9	6.6
Jan	0.4	0.3	0.3
Dec 2011	-0.2	-0.1	-0.2
Nov	0.2	-0.1	0.2
∆% AE Nov-Jan	1.6	0.4	1.2
Oct	0.0	-0.1	0.1
Sep	0.3	0.3	0.2
Aug	0.0	0.1	0.1
Jul	0.3	0.4	0.3
Jun	0.2	0.2	0.2
May	0.2	0.2	0.2
∆% AE May-Oct	2.0	2.2	2.2
Apr	1.1	0.8	0.9
Mar	1.1	0.5	1.1
Feb	0.5	0.0	0.5
Jan	1.1	0.8	1.1
Jan-Apr ∆% AE	12.0	6.5	11.4
Dec 2010	0.5	0.0	0.6

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/august-2013/index.html

Input prices in the UK have been more dynamic than output prices until the current event of risk aversion, as shown by Table IV-11, but with sharp oscillations because of the commodity and raw material content. The 12-month rates of increase of input prices, even excluding food, tobacco, beverages and petroleum, are very high, reaching 18.1 percent in Sep 2011 for materials and fuels purchased and 13.3 percent excluding food, beverages and petroleum. Inflation in 12 months of materials and fuels purchased moderated to 5.4 percent in Mar 2012 and 4.1 percent excluding food, tobacco, beverages and petroleum with the rates falling further in Apr 2012 to 1.1 percent for materials and fuels purchased and 2.2 percent excluding food, tobacco, beverages and petroleum. Input-price inflation collapsed in the 12 months ending in Jul 2012 to minus 2.6 percent for materials and fuels purchased and minus 1.5 percent excluding food, beverages and tobacco. Inflation returned at 1.2 percent in the 12 months ending in Aug 2012 but minus 0.5 percent excluding food, tobacco, beverages and petroleum. Inflation of input prices in Sep 2012 was minus 0.8 percent and minus 0.8 percent excluding food, beverages and petroleum. In Nov 2012, inflation of input prices of all manufacturing and materials purchased was minus 0.1 percent in 12 months and minus 0.2 percent in 12 months excluding food, tobacco, beverages and petroleum. Inflation of materials and fuels purchased in 12 months was 0.6 percent in Dec 2012 and 0.1 percent excluding tobacco, beverages and petroleum. Inflation of inputs returned with 1.9 percent in the 12 months ending in Jan 2013 and 0.7 percent excluding various items, increasing to 2.2 percent in Feb 2013 and 1.8 percent excluding various items. In Mar 2013, inflation of all manufacturing materials and fuels increased 0.7 percent in 12 months and 2.0 percent excluding various items. Prices of all manufacturing materials and fuels fell 0.2 percent in the 12 months ending in Apr 2013 and increased 1.3 percent excluding food and other items. Prices of all manufacturing increased 1.6 percent in the 12 months ending in May 2013 and 1.4 percent excluding various items. In Jul 2013, prices of manufactured products increased 5.0 percent in 12 months and 3.9 percent excluding food, tobacco, beverages and petroleum. In Aug 2013, prices of manufactured products increased 2.8 percent in 12 months and 3.1 percent excluding items. There is comparable experience with 22.2 percent inflation of materials and fuels purchased in 2008 and 16.9 percent excluding food, beverages and petroleum followed in 2009 by decline of 3.8 percent by materials and fuels purchased and increase of 1.6 percent for the index excluding items. UK input and output inflation is sensitive to commodity price increases driven by carry trades from zero interest rates. The mirage of false deflation is also observed in input prices in 1997-9 and then again from 2001 to 2003.

Table IV-11, UK, Input Prices 12-Month ∆% NSA

	All Manufacturing Materials and Fuels Purchased	Excluding Food, Tobacco, Beverages and Petroleum
Aug 2013	2.8	3.1
Jul	5.1	3.9
Jun	4.0	2.1
May	1.6	1.4
Apr	-0.2	1.3
Mar	0.7	2.0
Feb	2.2	1.8
Jan	1.9	0.7
Dec 2012	0.6	0.1
Nov	-0.1	-0.2
Oct	0.2	-0.4
Sep	-0.8	-0.8
Aug	1.2	-0.5
Jul	-2.6	-1.5
Jun	-2.2	-0.3
May	0.1	1.1
Apr	1.1	2.2
Mar	5.4	4.1
Feb	7.7	5.7
Jan	6.5	5.6
Dec 2011	8.9	7.2
Nov	13.8	10.2
Oct	14.5	11.0
Sep	18.1	13.3
Aug	16.3	13.0
Jul	18.5	13.3
Jun	16.8	12.6
May	16.3	11.4
Apr	17.9	12.2
Mar	14.8	10.3
Feb	14.9	10.7
Jan	14.2	10.5
Dec 2010	13.1	9.0
Year ∆%
2012	1.4	1.1
2011	15.4	11.5
2010	9.9	5.7
2009	-3.8	1.6
2008	22.2	16.9
2007	2.9	2.3
2006	9.8	7.3
2005	11.0	6.9
2004	3.3	1.6
2003	1.2	-0.6
2002	-4.4	-4.8
2001	-1.2	-1.2
2000	7.4	3.7
1999	-1.3	-3.6
1998	-9.1	-4.6
1997	-8.2	-6.3

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/august-2013/index.html

Table IV-12 provides monthly percentage changes of UK input prices for materials and fuels purchased and excluding food, tobacco, beverages and petroleum. There are strong waves of inflation of input prices in the UK similar to those worldwide (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations.html). In the first wave, input prices rose at the high annual equivalent rate of 35.6 percent in Jan-Apr 2011, driven by carry trades from unconventional monetary policy into commodity exposures. In the second wave, alternating risk aversion caused annual equivalent inflation of minus 3.1 percent in May-Oct 2011. In the third wave, renewed risk aversion resulted in annual equivalent inflation of minus 1.2 percent in Nov-Dec 2011. In the fourth wave, annual equivalent inflation of input prices in the UK surged at 18.1 percent in Jan-Mar 2012 under relaxed risk aversion. In the fifth wave, annual equivalent inflation was minus 21.9 percent in Apr-Jun 2012 because of collapse of commodity prices during increasing risk aversion. In the sixth wave, annual equivalent inflation of materials and fuels purchased jumped to 14.0 percent in Jul-Aug 2012. In the seventh wave, annual equivalent inflation moderated to 1.5 percent in Sep-Dec 2012. In the eighth wave, annual equivalent inflation in Jan-Feb 2013 jumped to 28.3 percent. In the eighth wave, annual equivalent inflation of materials and fuels purchased was minus 11.4 percent in Mar-May 2013. In the ninth wave, annual equivalent inflation returned at 8.7 percent in annual equivalent in Jun-Jul 2013. In the tenth wave, annual equivalent inflation was minus 2.4 percent in Aug 2013.

Table IV-12, UK Input Prices Month ∆% 

	All Manufacturing Materials and Fuels Purchased NSA	Excluding Food, Tobacco, Beverages and Petroleum SA
Aug 2013	-0.2	0.1
∆% Aug	-2.4	1.2
Jul	1.2	0.9
Jun	0.2	0.4
∆% Jun-Jul	8.7	8.1
May	-0.7	-0.3
Apr	-2.4	-0.5
Mar	0.1	-0.3
∆% Mar-May	-11.4	-4.3
Feb	2.8	1.6
Jan	1.4	0.4
∆% Jan-Feb	28.3	12.7
Dec 2012	0.1	-0.2
Nov	0.1	0.2
Oct	0.2	0.3
Sep	0.1	0.3
∆% Sep-Dec	1.5	1.8
Aug	2.0	1.0
Jul	0.2	-0.5
∆% Jul-Aug	14.0	3.0
Jun	-2.1	-0.3
May	-2.6	-0.8
Apr	-1.4	0.1
∆% Apr-Jun	-21.9	-3.9
Mar	1.6	-0.5
Feb	2.5	0.7
Jan	0.1	-0.1
∆% AE Jan-Mar	18.1	0.4
Dec 2011	-0.6	-0.7
Nov	0.4	0.1
∆% AE Nov-Dec	-1.2	-3.6
Oct	-0.8	-0.5
Sep	2.1	0.6
Aug	-1.9	0.1
Jul	0.6	0.9
Jun	0.1	1.0
May	-1.6	-0.1
∆% AE May-Oct	-3.1	4.1
Apr	2.8	2.0
Mar	3.8	1.0
Feb	1.4	1.0
Jan	2.3	1.5
∆% AE Jan-Apr	35.6	17.8
Dec 2010	3.9	1.9

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/august-2013/index.html

The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12-month rates of inflation of manufactured products, shown in Table IV-13. There are high contributions to 12-month percentage changes of 0.71 percentage points by food products, 0.27 percentage points by tobacco and alcohol, 0.10 percentage points by computer, electrical and optical and 0.19 percentage points by other manufactured products. There are diversified sources of contributions to 12 months output price inflation such as 0.10 percentage points by clothing, textile and leather and 0.12 percentage points by transport equipment. Petroleum deducted 0.2 percentage points. In general, contributions by products rich in commodities are the drivers of price changes. There were diversified contributions in percentage points to monthly inflation: 0.4 percentage points by chemical products and 0.5 percentage points by petroleum.

Table IV-13, UK, Contributions to Month and 12-Month Change in Prices of All Manufactured Products, Percentage Points, NSA

Aug 2013	12 Months % Points	12 Months ∆%	Month  % Points	Month ∆%
Total %		1.6		0.1
Food Products	0.71	4.4	-0.02	-0.1
Tobacco & Alcohol	0.27	2.4	-0.02	-0.1
Clothing, Textile & Leather	0.10	0.9	-0.04	-0.2
Paper and Printing	0.00	0.0	0.00	-0.1
Petroleum	-0.02	-0.2	0.10	0.5
Chemicals & Pharmaceutical	0.06	0.7	0.06	0.4
Metal, Machinery & Equipment	0.03	0.8	0.00	0.1
Computer, Electrical & Optical	0.10	1.1	-0.01	-0.1
Transport Equipment	0.12	1.1	-0.01	-0.1
Other Manufactured Products	0.19	1.1	0.03	0.2

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/august-2013/index.html

The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12-month rates of inflation of input prices in Jun 2013, shown in Table IV-14. Crude oil is a large factor with contribution of 0.28 percentage points to the 12-month rate and 0.35 percentage points to the monthly rate in Aug 2013. Price changes also transfer to the domestic economy through the prices of imported inputs: imported metals deducted 0.19 percentage points from the 12-month rate and 0.11 percentage points from the Aug rate. Domestic food materials added 0.55 percentage points to the 12-month rate and deducted 0.13 percentage points from the Aug rate. Exposures and reversals of commodity exposures in carry trades during risk aversion are a major source of financial instability.

Table IV-14, UK, Contributions to Month and 12-Month Change in Prices of Inputs, Percentage Points NSA

Aug 2013	12 Months % Points	12 Months ∆%	Month % Points	Month ∆%
Total		2.8		-0.2
Fuel	0.85	9.3	0.02	0.2
Crude Oil	0.28	1.0	0.35	1.2
Domestic Food Materials	0.55	5.1	-0.13	-1.2
Imported Food Materials	0.34	6.3	-0.07	-1.1
Other Domestic Produced Materials	0.09	2.5	0.01	0.2
Imported Metals	-0.19	-2.7	-0.11	-1.4
Imported Chemicals	0.19	1.9	-0.04	-0.4
Imported Parts and Equipment	0.38	2.5	-0.14	-0.9
Other Imported Materials	0.33	3.4	-0.09	-0.8

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/august-2013/index.html

Consumer price inflation in the UK is shown in Table IV-15. The CPI index increased 0.4 percent in Aug 2013 and increased 2.7 percent in 12 months. The same inflation waves (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations.html) are present in UK CPI inflation. In the first wave in Jan-Apr 2011, annual equivalent inflation was at a high 6.5 percent. In the second wave in May-Jul 2011, annual equivalent inflation fell to only 0.4 percent. In the third wave in Aug-Nov 2011, annual equivalent inflation returned at 4.6 percent. In the fourth wave in Dec 2011 to Jan 2012, annual equivalent inflation was minus 0.6 percent because of decline of 0.5 percent in Jan 2012. In the fifth wave, annual equivalent inflation increased to 6.2 percent in Feb-Apr 2012. In the seventh wave, annual equivalent inflation was minus 3.0 percent in May-Jun 2012. In the eighth wave, annual equivalent inflation in Jul-Dec 2012 was 4.5 percent and 6.2 percent in Oct 2012 with the rate in Oct caused mostly by increases in university tuition payments. In the ninth wave, annual equivalent inflation was minus 5.8 percent in Jan 2013. In the tenth wave, annual equivalent inflation jumped to 4.3 percent in Feb-May 2013. In the eleventh wave, annual equivalent inflation was minus 1.2 percent in Jun-Jul 2013. In the twelfth wave, annual equivalent inflation was 4.9 percent in Aug 2013.

Table IV-15, UK, Consumer Price Index All Items, Month and 12-Month ∆%

	Month ∆%	12 Months ∆%
Aug 2013	0.4	2.7
AE ∆% Aug	4.9
Jul	0.0	2.8
Jun	-0.2	2.9
AE ∆% Jun-Jul	-1.2
May	0.2	2.7
Apr	0.2	2.4
Mar	0.3	2.8
Feb	0.7	2.8
AE ∆% Feb-May	4.3
Jan 2013	-0.5	2.7
AE ∆% Jan	-5.8
Dec 2012	0.5	2.7
Nov	0.2	2.7
Oct	0.5	2.7
Sep	0.4	2.2
Aug	0.5	2.5
Jul	0.1	2.6
AE ∆% Jul-Dec	4.5
Jun	-0.4	2.4
May	-0.1	2.8
AE ∆% May-Jun	-3.0
Apr	0.6	3.0
Mar	0.3	3.5
Feb	0.6	3.4
AE ∆% Feb-Apr	6.2
Jan	-0.5	3.6
Dec 2011	0.4	4.2
AE ∆% Dec-Jan	-0.6
Nov	0.2	4.8
Oct	0.1	5.0
Sep	0.6	5.2
Aug	0.6	4.5
AE ∆% Aug-Nov	4.6
Jul	0.0	4.4
Jun	-0.1	4.2
May	0.2	4.5
May-Jul	0.4
Apr	1.0	4.5
Mar	0.3	4.0
Feb	0.7	4.4
Jan	0.1	4.0
AE ∆% Jan-Apr	6.5
Dec 2010	1.0	3.7
Nov	0.4	3.3
Oct	0.3	3.2
Sep	0.0	3.1
Aug	0.5	3.1
Jul	-0.2	3.1
Jun	0.1	3.2
May	0.2	3.4
Apr	0.6	3.7
Mar	0.6	3.4
Feb	0.4	3.0
Jan	-0.2	3.5

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/august-2013/index.html

Inflation has been unusually high in the UK since 2006, as shown in Table IV-16. There were no rates of inflation close to 2.0 percent in the period from 1997 to 2004. Inflation has exceeded 2 percent since 2005, reaching 3.6 percent in 2008, 3.3 percent in 2010, 4.5 percent in 2011 and 2.8 percent in 2012.

Table IV-16, UK, Consumer Price Index, Annual ∆%

	Annual
	change
2005=100
1997	1.8
1998	1.6
1999	1.3
2000	0.8
2001	1.2
2002	1.3
2003	1.4
2004	1.3
2005	2.1
2006	2.3
2007	2.3
2008	3.6
2009	2.2
2010	3.3
2011	4.5
2012	2.8

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/august-2013/index.html

Table IV-17 provides the analysis of inflation in Aug 2013 by the UK Office for National Statistics. In the rate of 0.4 percent for Aug, clothing and footwear added 0.13 percentage points, furniture and household goods added 0.10 percentage points and transport added 0.14 percentage points. Contributions of percentage points to the 12-month rate of consumer price inflation of 2.7 percent are in the second column in Table IV-17. Food and nonalcoholic beverages added 0.45 percentage points, alcohol and tobacco added 0.287 percentage points, housing and household goods added 0.59 percentage points and transport added 0.16 percentage points.

Table IV-17, UK, Consumer Price Index Month and Twelve-month Percentage Point Contributions to Change by Components

Aug 2013	Percentage Point Contribution 12 M Aug	Percentage Point Contribution Aug
CPI All Items ∆%	2.7	0.4
Food & Non-Alcoholic Beverages	0.45	0.05
Alcohol & Tobacco	0.27	0.00
Clothing & Footwear	0.11	0.13
Housing & Household Services	0.59	0.00
Furniture & Household Goods	0.07	0.10
Health	0.07	0.01
Transport	0.16	0.14
Communication	0.08	0.00
Recreation & Culture	0.12	0.00
Education	0.37	0.00
Restaurants & Hotels	0.28	-0.01
Miscellaneous Goods & Services	0.12	0.01
Rounding Effects	0.01	-0.03

Note: there are rounding effects in contributions

Source: UK Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/august-2013/index.html

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013