CMP Associates Regulation Blog

There is additional information of the report of new house sales in Table IIB-2. The stock of unsold houses stabilized in Apr-Aug 2011 at average 6.6 monthly equivalent sales at current sales rates and then dropped to 4.6 in Jul-Aug 2012, increasing to 4.8 in Oct 2012, 4.5 in Nov 2012 and 4.5 percent in Dec 2012. Inventories dropped to 3.9 in Jan 2013 and 4.1 in Feb 2013. Inventories stabilized at 4.2-4.5 in Mar-Jun 2013 and increased to 5.5 in Jul 2013. Inventories fell to 5.4 in Aug 2013 and 5.4 in Sep 2013 but fell to 4.5 in Oct 2013. Inventories fell to 4.3 in Nov 2013. Robbie Whelan and Conor Dougherty, writing on “Builders fuel home sale rise,” on Feb 26, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324338604578327982067761860.html), find that inventories of houses have declined as investors acquire distressed houses of higher quality. Median and average house prices oscillate. In Nov 2013, median prices of new houses sold not seasonally adjusted (NSA) increased 4.5 percent after falling 2.6 percent in Oct 2013. Average prices increased 3.9 percent in Oct 2013 and 4.1 percent in Nov 2013. Between Dec 2010 and Nov 2013 median prices increased 12.3 percent and average prices increased 16.7 percent. Between Dec 2010 and Dec 2012, median prices increased 7.1 percent and average prices increased 2.6 percent. Price increases concentrated in 2012 with increase of median prices of 18.2 percent from Dec 2011 to Dec 2012 and of average prices of 13.8 percent. Median prices increased 4.9 percent from Dec 2012 to Nov 2013 while average prices increased 13.7 percent. Robbie Williams, writing on “New homes hit record as builders cap supply,” on May 24, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323475304578500973445311276.html?mod=WSJ_economy_LeftTopHighlights), finds that homebuilders are continuing to restrict the number of new homes for sale. Restriction of available new homes for sale increases prices paid by buyers.

Table IIB-2, US, New House Stocks and Median and Average New Homes Sales Price

	Unsold* Stocks in Equiv. Months of Sales SA %	Median New House Sales Price USD NSA	Month ∆%	Average New House Sales Price USD NSA	Month ∆%
Nov 2013	4.3	270,900	4.5	340,300	4.1
Oct	4.5	259,200	-2.6	326,800	3.9
Sep	5.4	266,100	4.2	314,500	1.2
Aug	5.4	255,300	-2.6	310,800	-5.8
Jul	5.5	262,200	0.9	329,900	7.8
Jun	4.3	259,800	-1.5	306,100	-2.5
May	4.5	263,700	-5.6	314,000	-6.8
Apr	4.3	279,300	8.5	337,000	12.3
Mar	4.2	257,500	-2.9	300,200	-3.9
Feb	4.1	265,100	5.4	312,500	1.8
Jan	3.9	251,500	-2.6	306,900	2.6
Dec 2012	4.5	258,300	5.4	299,200	2.9
Nov	4.5	245,000	-0.9	290,700	1.9
Oct	4.8	247,200	-2.9	285,400	-4.1
Sep	4.5	254,600	0.6	297,700	-2.6
Aug	4.6	253,200	6.7	305,500	8.2
Jul	4.6	237,400	2.1	282,300	3.9
Jun	4.8	232,600	-2.8	271,800	-3.2
May	4.7	239,200	1.2	280,900	-2.4
Apr	4.9	236,400	-1.4	287,900	1.5
Mar	5.0	239,800	0.0	283,600	3.5
Feb	4.8	239,900	8.2	274,000	3.1
Jan	5.3	221,700	1.4	265,700	1.1
Dec 2011	5.3	218,600	2.0	262,900	5.2
Nov	5.7	214,300	-4.7	250,000	-3.2
Oct	6.0	224,800	3.6	258,300	1.1
Sep	6.3	217,000	-1.2	255,400	-1.5
Aug	6.5	219,600	-4.5	259,300	-4.1
Jul	6.7	229,900	-4.3	270,300	-1.0
Jun	6.6	240,200	8.2	273,100	3.9
May	6.6	222,000	-1.2	262,700	-2.3
Apr	6.7	224,700	1.9	268,900	3.1
Mar	7.2	220,500	0.2	260,800	-0.8
Feb	8.1	220,100	-8.3	262,800	-4.7
Jan	7.3	240,100	-0.5	275,700	-5.5
Dec 2010	7.0	241,200	9.8	291,700	3.5

*Percent of new houses for sale relative to houses sold

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr051.html

The depressed level of residential construction and new house sales in the US is evident in Table IIB-3 providing new house sales not seasonally adjusted in Jan-Nov of various years. Sales of new houses in Jan-Nov 2013 are substantially lower than in any year between 1963 and 2013 with the exception of the years from 2009 to 2012. There are only four increases of 18.1 percent relative to Jan-Nov 2012, 42.6 percent relative to Jan-Nov 2011, 34.0 percent relative to Jan-Nov 2010 and 14.9 percent relative to Jan-Nov 2009. Sales of new houses in Jan-Nov 2013 are lower by 12.4 percent relative to Jan-Nov 2008, 45.1 percent relative to 2007, 59.0 percent relative to 2006 and 66.4 percent relative to 2005. The housing boom peaked in 2005 and 2006 when increases in fed funds rates to 5.25 percent in Jun 2006 from 1.0 percent in Jun 2004 affected subprime mortgages that were programmed for refinancing in two or three years on the expectation that price increases forever would raise home equity. Higher home equity would permit refinancing under feasible mortgages incorporating full payment of principal and interest (Gorton 2009EFM; see other references in http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Sales of new houses in Jan-Nov 2013 relative to the same period in 2004 fell 64.1 percent and 60.2 percent relative to the same period in 2003. Similar percentage declines are also observed for 2013 relative to years from 2000 to 2004. Sales of new houses in Jan-Oct 2013 fell 35.4 per cent relative to the same period in 1995. The population of the US was 179.3 million in 1960 and 281.4 million in 2000 (Hobbs and Stoops 2002, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table IIB-3 reveals catastrophic data: sales of new houses in Jan-Nov 2013 of 402 thousand units are lower by 24.0 percent relative to 529 thousand units of houses sold in Jan-Nov 1963, the first year when data become available. The civilian noninstitutional population increased from 123.192 million in Nov 1963 to 246.567 million in Nov 2013, or 100.1 percent (http://www.bls.gov/data/). The Bureau of Labor Statistics (BLS) defines the civilian noninstitutional population (http://www.bls.gov/lau/rdscnp16.htm#cnp): “The civilian noninstitutional population consists of persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.”

Table IIB-3, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %

	Not Seasonally Adjusted Thousands
Jan-Nov 2013	402
Jan-Nov 2012	340
∆% Jan-Nov 2013/Jan-Nov 2012	18.1*
Jan-Nov 2011	282
∆% Jan-Nov 2013/Jan-Nov 2011	42.6
Jan-Nov 2010	300
∆% Jan-Nov 2013/ Jan-Nov 2010	34.0
Jan-Nov 2009	350
∆% Jan-Nov 2013/ Jan-Nov 2009	14.9
Jan-Nov 2008	459
∆% Jan-Nov 2013/ Jan-Nov 2008	-12.4
Jan-Nov 2007	732
∆% Jan-Nov 2013/ Jan-Nov 2007	-45.1
Jan-Nov 2006	980
∆% Jan-Nov 2013/Jan-Nov 2006	-59.0
Jan-Nov 2005	1,196
∆% Jan-Nov 2013/Jan-Nov 2005	-66.4
Jan-Nov 2004	1,120
∆% Jan-Nov 2013/Jan-Nov 2004	-64.1
Jan-Nov 2003	1011
∆% Jan-Nov 2013/ Jan-Nov 2003	-60.2
Jan-Nov 2002	903
∆% Jan-Nov 2013/ Jan-Nov 2002	-55.5
Jan-Nov 2001	842
∆% Jan-Nov 2013/ Jan-Nov 2001	-52.3
Jan-Nov 2000	812
∆% Jan-Nov 2013/ Jan-Nov 2000	-50.5
Jan-Nov 1995	622
∆% Jan-Nov 2013/ Jan-Nov 1995	-35.4
Jan-Nov 1963	529
∆% Jan-Nov 2013/ Jan-Nov 1963	-24.0

*Computed using unrounded data

Source: US Census Bureau http://www.census.gov/construction/nrs/

Table IIB-4 provides the entire available annual series of new house sales from 1963 to 2012. The revised level of 306 thousand new houses sold in 2011 is the lowest since 560 thousand in 1963 in the 48 years of available data while the level of 368 thousand in 2012 is only higher than 323 thousand in 2010. The population of the US increased 129.4 million from 179.3 million in 1960 to 308.7 million in 2010, or 72.2 percent. The civilian noninstitutional population of the US increased from 122.416 million in 1963 to 243.284 million in 2012 or 98.7 percent (http://www.bls.gov/data/). The Bureau of Labor Statistics (BLS) defines the civilian noninstitutional population (http://www.bls.gov/lau/rdscnp16.htm#cnp): “The civilian noninstitutional population consists of persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.”

The civilian noninstitutional population is the universe of the labor force. In fact, there is no year from 1963 to 2012 in Table IIA-4 with sales of new houses below 400 thousand with the exception of the immediately preceding years of 2009, 2010, 2011 and 2012.

Table IIB-4, US, New Houses Sold, NSA Thousands

Year	Houses Sold Thousands
1963	560
1964	565
1965	575
1966	461
1967	487
1968	490
1969	448
1970	485
1971	656
1972	718
1973	634
1974	519
1975	549
1976	646
1977	819
1978	817
1979	709
1980	545
1981	436
1982	412
1983	623
1984	639
1985	688
1986	750
1987	671
1988	676
1989	650
1990	534
1991	509
1992	610
1993	666
1994	670
1995	667
1996	757
1997	804
1998	886
1999	880
2000	877
2001	908
2002	973
2003	1,086
2004	1,203
2005	1,283
2006	1,051
2007	776
2008	485
2009	375
2010	323
2011	306
2012	368

Source: US Census Bureau http://www.census.gov/construction/nrs/

Chart IIB-1 of the US Bureau of the Census shows the sharp decline of sales of new houses in the US. Sales rose temporarily until about mid 2010 but then declined to a lower plateau followed by increase and stability.

Chart IIB-1, US, New One-Family Houses Sold in the US, SAAR (Seasonally Adjusted Annual Rate)

Source: US Census Bureau

Percentage changes and average rates of growth of new house sales for selected periods are shown in Table IIB-5. The percentage change of new house sales from 1963 to 2012 is minus 34.3 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 5.9 percent. Between 1995 and 2005 sales of new houses increased 92.4 percent at the yearly rate of 6.8 percent. There are similar rates in all years from 2000 to 2005. The boom in housing construction and sales began in the 1980s and 1990s. The collapse of real estate culminated several decades of housing subsidies and policies to lower mortgage rates and borrowing terms (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 42-8). Sales of new houses sold in 2012 fell 44.8 percent relative to the same period in 1995 and 71.3 percent relative to 2005.

Table IIB-5, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses

	∆%	Average Yearly % Rate
1963-2012	-34.3	NA
1991-2001	78.4	5.9
1995-2005	92.4	6.8
2000-2005	46.3	7.9
1995-2012	-44.8	NA
2000-2012	-58.0	NA
2005-2012	-71.3	NA

NA: Not Applicable

Source: US Census Bureau http://www.census.gov/construction/nrs/

Chart IIB-2 of the US Bureau of the Census provides the entire monthly sample of new houses sold in the US between Jan 1963 and Nov 2013 without seasonal adjustment. The series is almost stationary until the 1990s. There is sharp upward trend from the early 1990s to 2005-2006 after which new single-family houses sold collapse to levels below those in the beginning of the series in the 1960s.

Chart IIB-2, US, New Single-family Houses Sold, NSA, 1963-2013

Source: US Census Bureau

The available historical annual data of median and average prices of new houses sold in the US between 1963 and 2012 is provided in Table IIB-6. On a yearly basis, median and average prices reached a peak in 2007 and then fell substantially.

Table IIB-6, US, Median and Average Prices of New Houses Sold, Annual Data

Period	Median	Average
1963	$18,000	$19,300
1964	$18,900	$20,500
1965	$20,000	$21,500
1966	$21,400	$23,300
1967	$22,700	$24,600
1968	$24,700	$26,600
1969	$25,600	$27,900
1970	$23,400	$26,600
1971	$25,200	$28,300
1972	$27,600	$30,500
1973	$32,500	$35,500
1974	$35,900	$38,900
1975	$39,300	$42,600
1976	$44,200	$48,000
1977	$48,800	$54,200
1978	$55,700	$62,500
1979	$62,900	$71,800
1980	$64,600	$76,400
1981	$68,900	$83,000
1982	$69,300	$83,900
1983	$75,300	$89,800
1984	$79,900	$97,600
1985	$84,300	$100,800
1986	$92,000	$111,900
1987	$104,500	$127,200
1988	$112,500	$138,300
1989	$120,000	$148,800
1990	$122,900	$149,800
1991	$120,000	$147,200
1992	$121,500	$144,100
1993	$126,500	$147,700
1994	$130,000	$154,500
1995	$133,900	$158,700
1996	$140,000	$166,400
1997	$146,000	$176,200
1998	$152,500	$181,900
1999	$161,000	$195,600
2000	$169,000	$207,000
2001	$175,200	$213,200
2002	$187,600	$228,700
2003	$195,000	$246,300
2004	$221,000	$274,500
2005	$240,900	$297,000
2006	$246,500	$305,900
2007	$247,900	$313,600
2008	$232,100	$292,600
2009	$216,700	$270,900
2010	$221,800	$272,900
2011	$227,200	$267,900
2012	$245,200	$292,200

Source: US Census Bureau

Percentage changes of median and average prices of new houses sold in selected years are shown in Table IIB-7. Prices rose sharply between 2000 and 2005. In fact, prices in 2012 are higher than in 2000. Between 2006 and 2012, median prices of new houses sold fell 0.5 percent and average prices fell 4.5 percent. Between 2011 and 2012, median prices increased 7.9 percent and average prices increased 9.1 percent.

Table IIB-7, US, Percentage Change of New Houses Median and Average Prices, NSA, ∆%

	Median New Home Sales Prices ∆%	Average New Home Sales Prices ∆%
∆% 2000 to 2003	15.4	18.9
∆% 2000 to 2005	42.5	43.5
∆% 2000 to 2012	45.1	41.2
∆% 2005 to 2012	1.8	-1.6
∆% 2000 to 2006	45.9	47.8
∆% 2006 to 2012	-0.5	-4.5
∆% 2009 to 2012	13.2	7.9
∆% 2010 to 2012	10.6	7.1
∆% 2011 to 2012	7.9	9.1

Source: US Census Bureau http://www.census.gov/construction/nrs/

Chart IIB-3 of the US Census Bureau provides the entire series of new single-family sales median prices from Jan 1963 to Nov 2013. There is long-term sharp upward trend with few declines until the current collapse. Median prices increased sharply during the Great Inflation of the 1960s and 1970s and paused during the savings and loans crisis of the late 1980s and the recession of 1991. Housing subsidies throughout the 1990s caused sharp upward trend of median new house prices that accelerated after the fed funds rate of 1 percent from 2003 to 2004. There was sharp reduction of prices after 2006 with recovery recently toward earlier prices.

Chart IIB-3, US, Median Sales Price of New Single-family Houses Sold, US Dollars, NSA, 1963-2013

Source: US Census Bureau

Chart IIB-4 of the US Census Bureau provides average prices of new houses sold from the mid-1970s to Nov 2013. There is similar behavior as with median prices of new houses sold in Chart IIB-3. The only stress occurred in price pauses during the savings and loans crisis of the late 1980s and the collapse after 2006 with recent recovery.

Chart IIB-4, US, Average Sales Price of New Single-family Houses Sold, US Dollars, NSA, 1975-2013

Source: US Census Bureau

http://www.federalreserve.gov/releases/H15/default.htm

Chart IIB-5 of the Board of Governors of the Federal Reserve System provides the rate for the 30-year conventional mortgage, the yield of the 30-year Treasury bond and the rate of the overnight federal funds rate, monthly, from 1971 to 2013. All rates decline throughout the period from the Great Inflation of the 1970s through the following Great Moderation and until currently. In Apr 1971, the fed funds rate was 4.15 percent and the conventional mortgage rate 7.31 percent. In November 2012, the fed funds rate was 0.16 percent, the yield of the 30-year Treasury 2.80 percent and the conventional mortgage rate 3.35. The final segment shows an increase in the yield of the 30-year Treasury to 3.61 percent in July 2013 with the fed funds rate at 0.09 percent and the conventional mortgage at 4.37 percent. The final data point shows increase of the conventional mortgage rate to 4.26 percent in Nov 2012 with the yield of the 30-year Treasury bond at 3.80 percent and overnight rate on fed funds at 0.08 percent. The recent increase in interest rates if sustained could affect the US real estate market.

Chart IIB-5, US, Thirty-year Conventional Mortgage, Thirty-year Treasury Bond and Overnight Federal Funds Rate, Monthly, 1971-2013

Source: Board of Governors of the Federal Reserve System

The Federal Housing Finance Agency (FHFA), which regulates Fannie Mae and Freddie Mac, provides the FHFA House Price Index (HPI) that “is calculated using home sales price information from Fannie Mae and Freddie Mac-acquired mortgages” (http://fhfa.gov/webfiles/24216/q22012hpi.pdf 1). Table IIA2-1 provides the FHFA HPI for purchases only, which shows behavior similar to that of the Case-Shiller index but with lower magnitudes. House prices catapulted from 2000 to 2003, 2005 and 2006. From IIIQ2000 to IIIQ2006, the index for the US as a whole rose 57.4 percent, with 68.4 percent for New England, 75.5 percent for Middle Atlantic, 72.1 percent for South Atlantic but only by 32.6 percent for East South Central. Prices fell relative to 2013 for all years from 2005 and from 2006. Prices for the US increased 8.5 percent in IIIQ2013 relative to IIIQ2012 and 12.9 percent from IIIQ2011 to IIIQ2013. From IIIQ2000 to IIIQ2013, prices rose for the US and the four regions in Table IIA2-1.

Table IIA2-1, US, FHFA House Price Index Purchases Only NSA ∆%

	United States	New England	Middle Atlantic	South Atlantic	East South Central
IIIQ2000 to IIIQ2003	23.5	40.4	35.3	25.1	10.7
IIIQ2000 to IIIQ2005	50.2	69.5	68.7	60.8	23.7
IIIQ2000 to IIIQ2006	57.4	68.4	75.5	72.1	32.5
IIIQ2005 t0 IIIQ2013	-3.9	-9.7	-1.9	-9.0	7.2
IIIQ2006 to IIIQ2013	-8.3	-9.2	-5.8	-15.0	0.1
IIIQ2007 to IIIQ2013	-8.1	-7.6	-6.6	-14.8	-3.1
IIIQ2011 to IIIQ2013	12.9	5.0	3.5	13.9	6.9
IIIQ2012 to IIIQ2013	8.5	5.0	3.8	8.7	4.8
IIIQ2000 to IIIQ2013	44.3	53.0	65.4	46.3	32.6

Source: Federal Housing Finance Agency

Data of the FHFA HPI for the remaining US regions are in Table IIA2-2. Behavior is not very different from that in Table IIA2-1 with the exception of East North Central. House prices in the Pacific region doubled between 2000 and 2006. Although prices of houses declined sharply from 2005 and 2006 to 2013 with exception of South Central, there was still appreciation relative to 2000.

Table IIA2-2, US, FHFA House Price Index Purchases Only NSA ∆%

	West South Central	West North Central	East North Central	Mountain	Pacific
IIIQ2000 to IIIQ2003	11.6	18.4	14.5	18.4	42.5
IIIQ2000 to IIIQ2005	22.9	31.3	24.4	55.3	109.5
IIIQ2000 to IIIQ2006	31.4	35.8	26.0	69.3	118.0
IIIQ2005 to IIIQ2013	21.7	3.0	-7.8	-5.3	-19.3
IIIQ2006 to IIIQ2013	13.8	-0.4	-8.9	-13.1	-22.5
IIIQ2007 to IIIQ2013	8.6	-1.3	-7.1	-14.1	-18
IIIQ2011 to IIIQ2013	11.5	9.5	9.2	24.0	26.7
IIIQ2012 to IIIQ2013	6.0	6.1	6.3	12.3	19.2
IIIQ2000 to IIIQ2013	49.5	35.2	14.6	47.0	69.2

Source: Federal Housing Finance Agency

Chart IIA2-1 of the Federal Housing Finance Agency shows the Housing Price Index four-quarter price change from IIIQ2003 to IIIQ2013. House prices appreciated sharply from 1998 to 2005 and then fell rapidly. Recovery began already after IIQ2008 but there was another decline after IIIQ2010. The rate of decline improved in the second half of 2011 and into 2012 with movement into positive territory in successive quarter from IIQ2012 to IIIQ2013.

Chart IIA2-1, US, Federal Housing Finance Agency House Price Index Four Quarter Price Change

Source: Federal Housing Finance Agency

Monthly and 12-month percentage changes of the FHFA House Price Index are in Table IIA2-3. Percentage monthly increases of the FHFA index were positive from Apr to Jul 2011 with exception of declines in May and Aug 2011 while 12 months percentage changes improved steadily from around minus 6 percent in Mar to May 2011 to minus 4.4 percent in Jun 2011. The FHFA house price index fell 0.6 percent in Oct 2011 and fell 3.1 percent in the 12 months ending in Oct. There was significant recovery in Nov 2012 with increase in the house price index of 0.5 percent and reduction of the 12-month rate of decline to 2.2 percent. The house price index rose 0.4 percent in Dec 2011 and the 12-month percentage change improved to minus 1.2 percent. There was further improvement with revised decline of 0.3 percent in Jan 2012 and decline of the 12-month percentage change to minus 1.0 percent. The index improved to positive change of 0.5 percent in Feb 2012 and increase of 0.4 percent in the 12 months ending in Feb 2012. There was strong improvement in Mar 2012 with gain in prices of 0.9 percent and 2.4 percent in 12 months. The house price index of FHFA increased 0.7 percent in Apr 2012 and 3.0 percent in 12 months and improvement continued with increase of 0.6 percent in May 2012 and 3.8 percent in the 12 months ending in May 2012. Improvement consolidated with increase of 0.5 percent in Jun 2012 and 3.8 percent in 12 months. In Jul 2012, the house price index increased 0.1 percent and 3.7 percent in 12 months. Strong increase of 0.5 percent in Aug 2012 pulled the 12-month change to 4.4 percent. There was another increase of 0.7 percent in Oct and 5.6 percent in 12 months followed by increase of 0.5 percent in Nov 2012 and 5.7 percent in 12 months. The FHFA house price index increased 0.6 percent in Jan 2013 and 6.6 percent in 12 months. Improvement continued with increase of 0.4 percent in Apr 2013 and 7.3 percent in 12 months. In May 2013, the house price indexed increased 0.9 percent and 7.7 percent in 12 months. The FHFA house price index increased 0.8 percent in Jun 2013 and 8.0 percent in 12 months. In Jul 2013, the FHFA house price index increased 0.7 percent and 8.7 percent in 12 months. Improvement continued with increase of 0.3 percent in Aug 2013 and 8.5 percent in 12 months. In Sep 2013, the house price index increased 0.2 percent and 8.4 percent in 12 months. The house price index increased 0.5 percent in Oct 2013 and 8.2 percent in 12 months.

Table IIA2-3, US, FHFA House Price Index Purchases Only SA. Month and NSA 12-Month ∆%

	Month ∆% SA	12 Month ∆% NSA
Oct 2013	0.5	8.2
Sep	0.2	8.4
Aug	0.3	8.5
Jul	0.7	8.7
Jun	0.8	8.0
May	0.9	7.7
Apr	0.4	7.3
Mar	1.4	7.6
Feb	0.9	7.0
Jan	0.6	6.6
Dec 2012	0.5	5.7
Nov	0.5	5.7
Oct	0.7	5.6
Sep	0.3	4.3
Aug	0.5	4.4
Jul	0.1	3.7
Jun	0.5	3.8
May	0.6	3.8
Apr	0.7	3.0
Mar	0.9	2.4
Feb	0.5	0.4
Jan	-0.3	-1.0
Dec 2011	0.4	-1.2
Nov 2011	0.5	-2.2
Oct 2011	-0.6	-3.1
Sep 2011	0.4	-2.4
Aug 2011	-0.3	-3.7
Jul 2011	0.3	-3.4
Jun 2011	0.5	-4.4
May 2011	-0.1	-5.9
Apr 2011	0.1	-5.8
Mar 2011	-0.9	-5.9
Feb 2011	-1.1	-5.1
Jan 2011	-0.5	-4.6
Dec 2010		-3.8
Dec 2009		-2.0
Dec 2008		-10.0
Dec 2007		-3.2
Dec 2006		2.5
Dec 2005		9.8
Dec 2004		10.2
Dec 2003		8.0
Dec 2002		7.8
Dec 2001		6.7
Dec 2000		7.2
Dec 1999		6.2
Dec 1998		5.9
Dec 1997		3.4
Dec 1996		2.8
Dec 1995		3.0
Dec 1994		2.6
Dec 1993		3.1
Dec 1992		2.4

Source: Federal Housing Finance Agency

The bottom part of Table IIA2-3 provides 12-month percentage changes of the FHFA house price index since 1992 when data become available for 1991. Table IIA2-4 provides percentage changes and average rates of percent change per year for various periods. Between 1992 and 2012, the FHFA house price index increased 84.5 percent at the yearly average rate of 3.1 percent. In the period 1992-2000, the FHFA house price index increased 39.4 percent at the average yearly rate of 4.2 percent. The rate of price increase accelerated to 7.5 percent in the period 2000-2003 and to 8.5 percent in 2000-2005 and 7.5 percent in 2000-2006. At the margin, the average rate jumped to 10.0 percent in 2003-2005 and 7.5 percent in 2003-2006. House prices measured by the FHFA house price index declined 14.2 percent between 2006 and 2012 and 12.0 percent between 2005 and 2012.

Table IIA2-4, US, FHFA House Price Index, Percentage Change and Average Rate of Percentage Change per Year, Selected Dates 1992-2012

Dec	∆%	Average ∆% per Year
1992-2012	84.5	3.1
1992-2000	39.4	4.2
2000-2003	24.2	7.5
2000-2005	50.4	8.5
2003-2005	21.1	10.0
2005-2012	-12.0	NA
2000-2006	54.2	7.5
2003-2006	24.1	7.5
2006-2012	-14.2	NA

Source: Source: Federal Housing Finance Agency

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

Table IIA-2 shows the euphoria of prices during the housing boom and the subsequent decline. House prices rose 95.5 percent in the 10-city composite of the Case-Shiller home price index and 80.5 percent in the 20-city composite between Sep 2000 and Sep 2005. Prices rose around 100 percent from Sep 2000 to Sep 2006, increasing 103.0 percent for the 10-city composite and 88.2 percent for the 20-city composite. House prices rose 39.2 percent between Sep 2003 and Sep 2005 for the 10-city composite and 34.9 percent for the 20-city composite propelled by low fed funds rates of 1.0 percent between Jun 2003 and Jun 2004. Fed funds rates increased by 0.25 basis points at every meeting of the Federal Open Market Committee (FOMC) until Jun 2006, reaching 5.25 percent. Simultaneously, the suspension of auctions of the 30-year Treasury bond caused decline of yields of mortgage-backed securities with intended decrease in mortgage rates. Similarly, between Sep 2003 and Sep 2006, the 10-city index gained 44.5 percent and the 20-city index increased 40.7 percent. House prices have fallen from Sep 2006 to Sep 2013 by 20.0 percent for the 10-city composite and 19.5 percent for the 20-city composite. Measuring house prices is quite difficult because of the lack of homogeneity that is typical of standardized commodities. In the 12 months ending in Sep 2013, house prices increased 13.3 percent in the 10-city composite and increased 13.3 percent in the 20-city composite. Table VA-5 also shows that house prices increased 62.3 percent between Sep 2000 and Sep 2013 for the 10-city composite and increased 51.5 percent for the 20-city composite. House prices are close to the lowest level since peaks during the boom before the financial crisis and global recession. The 10-city composite fell 20.4 percent from the peak in Jun 2006 to Sep 2013 and the 20-city composite fell 19.8 percent from the peak in Jul 2006 to Sep 2013. The final part of Table IIA2-2 provides average annual percentage rates of growth of the house price indexes of Standard & Poor’s Case-Shiller. The average annual growth rate between Dec 1987 and Dec 2012 for the 10-city composite was 3.3 percent. Data for the 20-city composite are available only beginning in Jan 2000. House prices accelerated in the 1990s with the average rate of the 10-city composite of 5.0 percent between Dec 1992 and Dec 2000 while the average rate for the period Dec 1987 to Dec 2000 was 3.8 percent. Although the global recession affecting the US between IVQ2007 (Dec) and IIQ2009 (Jun) caused decline of house prices of slightly above 30 percent, the average annual growth rate of the 10-city composite between Dec 2000 and Dec 2012 was 2.8 percent while the rate of the 20-city composite was 2.3 percent.

Table IIA-2, US, Percentage Changes of Standard & Poor’s Case-Shiller Home Price Indices, Not Seasonally Adjusted, ∆%

	10-City Composite	20-City Composite
∆% Sep 2000 to Sep 2003	40.5	33.8
∆% Sep 2000 to Sep 2005	95.5	80.5
∆% Sep 2003 to Sep 2005	39.2	34.9
∆% Sep 2000 to Sep 2006	103.0	88.2
∆% Sep 2003 to Sep 2006	44.5	40.7
∆% Sep 2005 to Sep 2013	-16.9	-16.1
∆% Sep 2006 to Sep 2013	-20.0	-19.5
∆% Sep 2009 to Sep 2013	-8.1	-14.5
∆% Sep 2010 to Sep 2013	11.8	12.5
∆% Sep 2011 to Sep 2013	15.7	16.7
∆% Sep 2012 to Sep 2013	13.3	13.3
∆% Sep 2000 to Sep 2013	62.3	51.5
∆% Peak Jun 2006 Sep 2013	-20.4
∆% Peak Jul 2006 Sep 2013		-19.8
Average ∆% Dec 1987-Dec 2012	3.3	NA
Average ∆% Dec 1987-Dec 2000	3.8	NA
Average ∆% Dec 1992-Dec 2000	5.0	NA
Average ∆% Dec 2000-Dec 2012	2.8	2.3

Source: http://us.spindices.com/index-family/real-estate/sp-case-shiller

Monthly house prices increased sharply from Feb to Sep 2013 for both the 10- and 20-city composites. In Sep 2013, the seasonally adjusted 10-city composite increased 0.9 percent and the 20-city 1.0 percent while the 10-city not seasonally adjusted increased 0.7 percent and the 20-city 0.7 percent. House prices increased at high monthly percentage rates from Feb to Sep 2013. With the exception of Feb through Apr 2012, house prices seasonally adjusted declined in every month for both the 10-city and 20-city Case-Shiller composites from Dec 2010 to Jan 2012, as shown in Table IIA-3. The most important seasonal factor in house prices is school changes for wealthier homeowners with more expensive houses. Without seasonal adjustment, house prices fell from Dec 2010 throughout Mar 2011 and then increased in every month from Apr to Aug 2011 but fell in every month from Sep 2011 to Feb 2012. The not seasonally adjusted index registers decline in Mar 2012 of 0.1 percent for the 10-city composite and is flat for the 20-city composite. Not seasonally adjusted house prices increased 1.4 percent in Apr 2012 and at high monthly percentage rates until Sep 2012. House prices not seasonally adjusted stalled from Oct 2012 to Jan 2013 and surged from Feb to Sep 2013. Declining house prices cause multiple adverse effects of which two are quite evident. (1) There is a disincentive to buy houses in continuing price declines. (2) More mortgages could be losing fair market value relative to mortgage debt. Another possibility is a wealth effect that consumers restrain purchases because of the decline of their net worth in houses.

Table IIA-3, US, Monthly Percentage Change of S&P Case-Shiller Home Price Indices, Seasonally Adjusted and Not Seasonally Adjusted, ∆%

	10-City Composite SA	10-City Composite NSA	20-City Composite SA	20-City Composite NSA
Sep 2013	0.9	0.7	1.0	0.7
Aug	0.9	1.3	0.9	1.3
Jul	0.7	1.9	0.6	1.8
Jun	1.0	2.2	0.9	2.2
May	1.0	2.5	1.0	2.5
Apr	1.8	2.6	1.7	2.6
Mar	1.9	1.3	1.9	1.3
Feb	1.3	0.3	1.2	0.2
Jan	0.8	0.0	0.9	0.0
Dec 2012	1.0	0.2	1.0	0.2
Nov	0.6	-0.3	0.7	-0.2
Oct	0.7	-0.2	0.7	-0.1
Sep	0.4	0.3	0.6	0.3
Aug	0.4	0.8	0.4	0.9
Jul	0.3	1.5	0.3	1.6
Jun	0.9	2.1	1.0	2.3
May	0.8	2.2	0.9	2.4
Apr	0.6	1.4	0.6	1.4
Mar	0.5	-0.1	0.6	0.0
Feb	0.1	-0.9	0.1	-0.8
Jan	-0.3	-1.1	-0.2	-1.0
Dec 2011	-0.5	-1.2	-0.4	-1.1
Nov	-0.6	-1.4	-0.5	-1.3
Oct	-0.5	-1.3	-0.5	-1.3
Sep	-0.4	-0.6	-0.4	-0.7
Aug	-0.3	0.1	-0.4	0.1
Jul	-0.2	0.9	-0.2	1.0
Jun	-0.1	1.0	-0.1	1.2
May	-0.3	1.0	-0.3	1.0
Apr	-0.1	0.6	-0.2	0.6
Mar	-0.3	-1.0	-0.4	-1.0
Feb	-0.3	-1.3	-0.3	-1.2
Jan	-0.3	-1.1	-0.3	-1.1
Dec 2010	-0.2	-0.9	-0.2	-1.0

Source: http://us.spindices.com/index-family/real-estate/sp-case-shiller

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 1.9 percent adjusted for inflation while growing 635.2 percent adjusted for inflation from IVQ1945 to IVQ2012 and unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes

(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 Dec 20 and daily values throughout the week ending on Dec 27, 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 Dec 20 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Dec 20, 2013”, first row “USD/EUR 1.3673 0.5% -0.1 %,” provides the information that the US dollar (USD) appreciated 0.5 percent to USD 1.3673/EUR in the week ending on Fri Dec 20 relative to the exchange rate on Fri Dec 13 and depreciated 0.1 percent relative to Thu Dec 19. 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 1.3673/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Dec 20, depreciating to USD 1.3696/EUR on Mon Dec 23, 2013, or by 0.2 percent. The dollar depreciated because more dollars, $1.3696, were required on Mon Dec 23 to buy one euro than $1.3673 on Fri Dec 20. 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 1.3673/EUR on Dec 20. 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 Dec 20, to the last business day of the current week, in this case Fri Dec 27, such as depreciation of 0.5 percent to USD 1.3746/EUR by Dec 27. The third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 0.5 percent from the rate of USD 1.3673/EUR on Fri Dec 20 to the rate of USD 1.3746/EUR on Fri Dec 27 {[(1.3746/1.3673) – 1]100 = -0.5%}. The dollar depreciated (denoted by negative sign) by 0.4 percent from the rate of USD 1.3691 on Dec 26 to USD 1.3746/EUR on Fri Dec 27 {[(1.3746/1.3691) -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.

Table III-I, Weekly Financial Risk Assets Dec 23 to Dec 27, 2013

Fri Dec 20

Mon 23

Tue 24

Wed 25

Thu 26

Fri 27

USD/ EUR

1.3673

0.5%

-0.1%

1.3696

-0.2%

1.3680

-0.1%

0.1%

1.3680

-0.1%

0.0%

1.3691

-0.1%

1.3746

-0.5%

-0.4%

JPY/ USD

104.09

-0.8%

0.1%

104.11

0.0%

104.29

-0.2%

104.35

-0.2%

-0.1%

104.81

-0.7%

-0.4%

105.16

-1.0%

-0.3%

CHF/ USD

0.8961

-0.8%

0.2%

0.8938

0.3%

0.8959

0.0%

-0.2%

0.8958

0.0%

0.8966

-0.1%

0.8916

0.5%

0.6%

CHF/ EUR

1.2253

-0.3%

0.1%

1.2244

0.1%

1.2257

0.0%

-0.1%

1.2257

0.0%

1.2274

-0.2%

-0.1%

1.2256

0.0%

0.1%

USD/ AUD

0.8922

1.1208

-0.5%

0.6%

0.8936

1.1191

0.2%

0.8922

1.1208

0.0%

-0.2%

0.8924

1.1206

0.0%

0.8896

1.1241

-0.3%

0.8869

1.1275

-0.6%

-0.3%

10Y Note

2.891

2.930

2.981

2.993

3.004

2Y Note

0.377

0.386

0.393

0.409

0.393

German Bond

2Y 0.22 10Y 1.87

2Y 0.22 10Y 1.88

2Y 0.22 10Y 1.89

2Y 0.24 10Y 1.95

DJIA

16221.14

3.0%

0.3%

16294.61

0.5%

16357.55

0.8%

0.4%

16357.55

0.8%

0.0%

16479.88

1.6%

0.7%

16478.41

1.6%

0.0%

Dow Global

2435.02

2.3%

0.4%

2450.45

0.6%

2454.04

0.8%

0.1%

2454.04

0.8%

0.0%

2463.86

1.2%

0.4%

2478.97

1.8%

0.6%

DJ Asia Pacific

1418.47

0.4%

0.2%

1423.34

0.3%

1423.14

0.3%

0.0%

1423.14

0.3%

0.0%

1430.01

0.8%

0.5%

1437.02

1.3%

0.5%

Nikkei

15870.42

3.0%

0.1%

15870.42

0.0%

15889.33

0.1%

16009.99

0.9%

0.8%

16174.44

1.9%

1.0%

16178.94

1.9%

0.0%

Shanghai

2084.79

-5.1%

-2.0%

2089.71

0.2%

2092.91

0.4%

0.2%

2106.35

1.0%

0.6%

2073.10

-0.6%

-1.6%

2101.25

0.8%

1.4%

DAX

9400.18

4.4%

0.7%

9488.82

0.9%

9488.82

0.9%

0.0%

9488.82

0.9%

0.0%

9488.82

0.9%

9589.39

2.0%

1.1%

DJ UBS Comm.

127.59

1.2%

0.7%

127.34

-0.2%

127.49

-0.1%

0.1%

127.49

-0.1%

0.0%

127.48

-0.1%

0.0%

127.61

0.0%

0.1%

WTI $/B

99.32

3.0%

0.6%

98.74

-0.6%

99.17

-0.2%

0.4%

99.17

-0.2%

0.0%

99.65

0.3%

0.5%

100.13

0.8%

0.5%

Brent $/B

111.17

2.2%

0.8%

111.61

0.4%

111.90

0.7%

0.3%

111.90

0.7%

0.0%

111.98

0.7%

0.1%

112.10

0.8%

0.1%

Gold $/OZ

1203.7

-2.8%

1.3%

1198.2

-0.5%

1204.4

0.1%

0.5%

1204.4

0.1%

0.0%

1210.5

0.6%

0.5%

1212.9

0.8%

0.2%

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

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

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

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.

1 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). At the meeting on Dec 18, 2013, the FOMC decided tapering monthly bond purchases. Earlier programs are continued with an additional lower open-ended $75 billion of bond purchases per month, increasing the stock of $2,739,919 million securities held outright and bank reserves deposited at the Fed of $2,465,932 million (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1) (http://www.federalreserve.gov/newsevents/press/monetary/20131218a.htm): “In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $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. The Committee's sizable and still-increasing holdings of longer-term securities 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.”

At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states needs and intentions of policy:

“We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve's goal of 2 percent and is expected to continue to do so for some time.

For these reasons, the Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.”

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 Oct 30, 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/20131218a.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. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent 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).

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).

Will the FOMC increase purchases of mortgage-backed securities if mortgage rates increase?

In his classic restatement of the Keynesian demand function in terms of “liquidity preference as behavior toward risk,” James Tobin (http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1981/tobin-bio.html) identifies the risks of low interest rates in terms of portfolio allocation (Tobin 1958, 86):

“The assumption that investors expect on balance no change in the rate of interest has been adopted for the theoretical reasons explained in section 2.6 rather than for reasons of realism. Clearly investors do form expectations of changes in interest rates and differfrom each other in their expectations. For the purposes of dynamic theory and of analysis of specific market situations, the theories of sections 2 and 3 are complementary rather than competitive. The formal apparatus of section 3 will serve just as well for a non-zero expected capital gain or loss as for a zero expected value of g. Stickiness of interest rate expectations would mean that the expected value of g is a function of the rate of interest r, going down when r goes down and rising when r goes up. In addition to the rotation of the opportunity locus due to a change in r itself, there would be a further rotation in the same direction due to the accompanying change in the expected capital gain or loss. At low interest rates expectation of capital loss may push the opportunity locus into the negative quadrant, so that the optimal position is clearly no consols, all cash. At the other extreme, expectation of capital gain at high interest rates would increase sharply the slope of the opportunity locus and the frequency of no cash, all consols positions, like that of Figure 3.3. The stickier the investor's expectations, the more sensitive his demand for cash will be to changes in the rate of interest (emphasis added).”

Tobin (1969) provides more elegant, complete analysis of portfolio allocation in a general equilibrium model. The major point is equally clear in a portfolio consisting of only cash balances and a perpetuity or consol. Let g be the capital gain, r the rate of interest on the consol and r^e the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+r^e). Thus, g = [(r/r^e) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dr^e>0, such that there is expectation of capital losses on the consol, dg<0. Investors move into positions combining only cash and no consols. Valuations of risk financial assets would collapse in reversal of long positions in carry trades with short exposures in a flight to cash. There is no exit from a central bank created liquidity trap without risks of financial crash and another global recession. The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent statement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:

W = Y/r (10

Equation (1) shows that as r goes to zero, r→0, W grows without bound, W→∞. Unconventional monetary policy lowers interest rates to increase the present value of cash flows derived from projects of firms, creating the impression of long-term increase in net worth. An attempt to reverse unconventional monetary policy necessarily causes increases in interest rates, creating the opposite perception of declining net worth. As r→∞, W = Y/r →0. There is no exit from unconventional monetary policy without increasing interest rates with resulting pain of financial crisis and adverse effects on production, investment and employment.

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 European Central Bank (ECB) lowered the policy rates on Nov 7, 2013 (http://www.ecb.europa.eu/press/pr/date/2013/html/pr131107.en.html):

“PRESS RELEASE

7 November 2013 - Monetary policy decisions

At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:

The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.25%, starting from the operation to be settled on 13 November 2013.
The interest rate on the marginal lending facility will be decreased by 25 basis points to 0.75%, with effect from 13 November 2013.
The interest rate on the deposit facility will remain unchanged at 0.00%.

The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 2.30 p.m. CET today.”

Mario Draghi, President of the ECB, explained as follows (http://www.ecb.europa.eu/press/pressconf/2013/html/is131107.en.html):

“Based on our regular economic and monetary analyses, we decided to lower the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.25% and the rate on the marginal lending facility by 25 basis points to 0.75%. The rate on the deposit facility will remain unchanged at 0.00%. These decisions are in line with our forward guidance of July 2013, given the latest indications of further diminishing underlying price pressures in the euro area over the medium term, starting from currently low annual inflation rates of below 1%. In keeping with this picture, monetary and, in particular, credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggests that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. Accordingly, our monetary policy stance will remain accommodative for as long as necessary. It will thereby also continue to assist the gradual economic recovery as reflected in confidence indicators up to October.”

The ECB decision together with the employment situation report on Fri Nov 8, 2013, influenced revaluation of the dollar. Market expectations were of relatively easier monetary policy in the euro area.

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 16,478.41 on Fri Dec 27, 2013, which is higher by 16.3 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 16.1 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.

In remarkable anticipation in 2005, Professor Raghuram G. Rajan (2005) warned of low liquidity and high risks of central bank policy rates approaching the zero bound (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 218-9). Professor Rajan excelled in a distinguished career as an academic economist in finance and was chief economist of the International Monetary Fund (IMF). Shefali Anand and Jon Hilsenrath, writing on Oct 13, 2013, on “India’s central banker lobbies Fed,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304330904579133530766149484?KEYWORDS=Rajan), interviewed Raghuram G Rajan, who is the current Governor of the Reserve Bank of India, which is India’s central bank (http://www.rbi.org.in/scripts/AboutusDisplay.aspx). In this interview, Rajan argues that central banks should avoid unintended consequences on emerging market economies of inflows and outflows of capital triggered by monetary policy. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows.

Professor Ronald I. McKinnon (2013Oct27), writing on “Tapering without tears—how to end QE3,” on Oct 27, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304799404579153693500945608?KEYWORDS=Ronald+I+McKinnon), finds that the major central banks of the world have fallen into a “near-zero-interest-rate trap.” World economic conditions are weak such that exit from the zero interest rate trap could have adverse effects on production, investment and employment. The maintenance of interest rates near zero creates long-term near stagnation. The proposal of Professor McKinnon is credible, coordinated increase of policy interest rates toward 2 percent. Professor John B. Taylor at Stanford University, writing on “Economic failures cause political polarization,” on Oct 28, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303442004579121010753999086?KEYWORDS=John+B+Taylor), analyzes that excessive risks induced by near zero interest rates in 2003-2004 caused the financial crash. Monetary policy continued in similar paths during and after the global recession with resulting political polarization worldwide.

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 4.220 percent on Dec 27, 2013, and that of the ten-year sovereign bond of Italy at 4.222 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 Dec 27, 2013, the yield of the two-year Treasury increased to 0.393 percent and that of the ten-year Treasury increased to 3.004 percent while the two-year bond of Germany increased to 0.24 percent and the ten-year increased to 1.95 percent; and the dollar depreciated to USD 1.3746/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 3.004 percent is higher than consumer price inflation of 1.2 percent in the 12 months ending in Nov 2013 (Section II and earlier http://cmpassocregulationblog.blogspot.com/2013/11/risks-of-zero-interest-rates-world.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.122 percent (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3002) is well below the 12-month consumer price inflation of 1.2 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
12/27/13	0.393	3.004	0.24	1.95	1.3746
12/20/13	0.377	2.891	0.22	1.87	1.3673
12/13/13	0.328	2.865	0.24	1.83	1.3742
12/6/13	0.304	2.858	0.21	1.84	1.3705
11/29/13	0.283	2.743	0.11	1.69	1.3592
11/22/13	0.280	2.746	0.13	1.74	1.3557
11/15/13	0.292	2.704	0.10	1.70	1.3497
11/8/13	0.316	2.750	0.10	1.76	1.3369
11/1/13	0.311	2.622	0.11	1.69	1.3488
10/25/13	0.305	2.507	0.18	1.75	1.3804
10/18/13	0.321	2.588	0.17	1.83	1.3686
10/11/13	0.344	2.688	0.18	1.86	1.3543
10/4/13	0.335	2.645	0.17	1.84	1.3557
9/27/13	0.335	2.626	0.16	1.78	1.3523
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://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata

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

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

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

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

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

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

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

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

“2 May 2013 - Monetary policy decisions

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

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

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

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

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

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

Jon Hilsenrath, writing on “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 Dec 26, 2013, with the one-month yield at 0.00 percent, the two-year at 0.42 percent, the ten-year at 3.00 percent, the fed funds rate at 0.08 percent and the corporate Baa bond at 5.37 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-Dec 26, 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 increased 0.8 percent from $2,605.2 billion of 2009 dollars in IVQ2007 to $2,627.2 billion in IIIQ2013. As shown in Table IAI-2, real private fixed investment fell 3.6 percent from $2,586.3 billion of 2009 dollars in IVQ2007 to $2,494.0 billion in IIIQ2013. Growth of real private investment is mediocre for all but four quarters from IIQ2011 to IQ2012 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html). 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 $66.8 billion in IIQ2013 and $39.2 billion in IIIQ2013. 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 $56.9 billion and $39.5 billion in IIIQ2013. 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 $273.5 billion in IIQ2013. Net dividends fell at $179.0 billion in IIIQ2013. 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 $216.6 billion in IIQ2013. Undistributed profits with IVA and CCA rose at $218.6 billion in IIIQ2013. Undistributed profits of US corporations swelled 382.4 percent from $107.7 billion IQ2007 to $519.5 billion in IIIQ2013 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 $66.8 billion from $2020.6 billion in IQ2013 to $2087.4 billion at the quarterly rate of 3.3 percent. Corporate profits with IVA and CCA increased $39.2 billion from $2087.4 billion in IIQ2013 to $2126.6 billion in IIIQ2013 at the annual rate of 1.9 percent (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp3q13_3rd.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. 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:

clip_image003

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

clip_image003

declines.

There is mostly stronger performance in equity indexes with several indexes in Table III-1 increasing in the week ending on Dec 27, 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 changed 0.0 percent on Dec 27, increasing 1.6 percent in the week. Germany’s Dax increased 1.1 percent on Fri Dec 27 and increased 2.0 percent in the week. Dow Global increased 0.6 percent on Dec 27 and increased 1.8 percent in the week. Japan’s Nikkei Average changed 0.0 percent on Dec 27 and increased 1.9 percent in the week as the yen continues oscillating but relatively weaker and the stock market gains in expectations of success of fiscal stimulus by a new administration and monetary stimulus by a new board of the Bank of Japan. Dow Asia Pacific TSM increased 0.5 percent on Dec 27 and increased 1.3 percent in the week. Shanghai Composite that decreased 0.2 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2101.25 on Dec 27 for increase of 1.4 percent and increase of 0.8 percent in the week of Dec 27. There is deceleration with oscillations of the world economy that could affect corporate revenue and equity valuations, causing fluctuations in equity markets with increases during favorable risk appetite.

Commodities were mixed in the week of Dec 20, 2013. The DJ UBS Commodities Index increased 0.1 percent on Fri Dec 27 and changed 0.0 percent in the week, as shown in Table III-1. WTI increased 0.8 percent in the week of Dec 27 while Brent increased 0.8 percent in the week. Gold increased 0.2 percent on Fri Dec 27 and increased 0.8 percent in the week.

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €723,303 million on Dec 20, 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 €1,308,587 million in the statement of Dec 20, 2013, with marginal reduction. There is high credit risk in these transactions with capital of only €90,420 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Dec 20, 2013
1 Gold and other Receivables	367,402	419,822	343,920
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	243,969
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	23,283
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	19,515
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	723,303
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	74,194
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	585,284
8 General Government Debt Denominated in Euro	34,954	33,928	28,326
9 Other Assets	278,719	336,574	245,739
TOTAL ASSETS	2,004, 432	2,733,235	2,287,531
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,308,587
Capital and Reserves	78,143	81,481	90,420

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/fs131224.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. Growth of the Italian economy would assure that success. 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 40.6 percent of the total in Jan-Oct 2013. Exports to the non-European Union area with share of 45.7 percent in Italy’s total exports are growing at 2.0 percent in Jan-Oct 2013 relative to Jan-Oct 2012 while those to EMU are growing at minus 2.9 percent.

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

Oct 2013	Exports % Share	∆% Jan-Oct 2013/ Jan-Oct 2012	Imports % Share	∆% Jan-Oct 2013/ Jan-Oct 2012
EU	54.3	-2.1	53.3	-2.1
EMU 17	40.6	-2.9	42.7	-2.2
France	11.1	-2.8	8.3	-4.7
Germany	12.5	-2.1	14.5	-4.6
Spain	4.7	-7.0	4.5	-4.3
UK	4.9	2.3	2.6	-2.1
Non EU	45.7	2.0	46.7	-10.1
Europe non EU	13.4	-1.9	10.9	3.6
USA	6.8	0.0	3.3	-12.4
China	2.3	11.1	6.6	-8.6
OPEC	5.7	7.2	10.8	-27.1
Total	100.0	-0.2	100.0	-5.9

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

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/107226

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €469 million with the 17 countries of the euro zone (EMU 17) in Oct 2013 and cumulative deficit of €3058 million in Jan-Oct 2013. Depreciation to parity could permit greater competitiveness in improving the trade surplus of €6665 million in Jan-Sep 2013 with Europe non-European Union, the trade surplus of €12,757 million with the US and trade surplus with non-European Union of €14,206 million in Jan-Oct 2013. There is significant rigidity in the trade deficits in Jan-Oct 2013 of €11,654 million with China and €6161 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 Oct 2013 Millions of Euro	Trade Balance Cumulative Jan-Oct 2013 Millions of Euro
EU	1,169	9,507
EMU 17	-469	-3,058
France	961	10,236
Germany	-347	-3,447
Spain	103	768
UK	964	8,382
Non EU	2,902	14,206
Europe non EU	971	6,665
USA	1,709	12,757
China	-1,119	-11,654
OPEC	-259	-6,161
Total	4,070	23,712

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/107226

Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Oct 2013 relative to Jan-Oct 2012. Growth rates of cumulative iports relative to a year earlier are negative for energy with minus 16.2 percent. Exports of durable goods grew 2.3 percent and exports of capital goods increased 1.6 percent. The higher rate of growth of exports of minus 0.2 percent in Jan-Oct 2013/Jan-Oct 2012 relative to imports of minus 5.9 percent may reflect weak demand in Italy with GDP declining during nine consecutive quarters from IIIQ2011 through IIIQ2013 together with softening commodity prices.

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

	Exports Share %	Exports ∆% Jan-Oct 2013/ Jan-Oct 2012	Imports Share %	Imports ∆% Jan-Oct 2013/ Jan-Oct 2012
Consumer Goods	29.3	6.1	25.6	0.6
Durable	5.8	2.3	2.9	-9.7
Non-Durable	23.5	7.0	22.6	1.9
Capital Goods	31.6	1.6	19.8	-3.4
Inter- mediate Goods	33.6	-4.0	32.4	-5.4
Energy	5.5	-21.0	22.2	-16.2
Total ex Energy	94.5	1.0	77.8	-2.9
Total	100.0	-0.2	100.0	-5.9

Note: % Share for 2012 total trade.

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/107226

Table III-6 provides Italy’s trade balance by product categories in Oct 2013 and cumulative Jan-Oct 2013. Italy’s trade balance excluding energy generated surplus of €8861 million in Oct 2013 and €69,651 million cumulative in Jan-Oct 2013 but the energy trade balance created deficit of €4791 million in Oct 2013 and cumulative €45,939 million in Jan-Oct 2013. The overall surplus in Oct 2013 was €4070 million with cumulative surplus of €23,172 million in Jan-Oct 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

	Oct 2013	Cumulative Jan-Oct 2013
Consumer Goods	2,678	18,614
Durable	1,302	10,682
Nondurable	1,376	7,932
Capital Goods	4,947	43,678
Intermediate Goods	1,236	7,360
Energy	-4,791	-45,939
Total ex Energy	8,861	69,651
Total	4,070	23,712

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/107226

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/2013/02/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	73,454
Euro Zone	12,685	-0.4	74.9
Portugal	219	0.1	119.3
Ireland	221	-3.3	105.5
Greece	243	--	172.6
Spain	1,356	-3.7	80.7
Major Advanced Economies G7	34,068	-3.8	91.5
United States	16,724	-3.6	87.4
UK	2,490	-4.7	84.8
Germany	3,593	1.7	56.3
France	2,739	-2.0	87.2
Japan	5,007	-8.8	139.9
Canada	1,825	-2.8	36.5
Italy	2,068	2.0	110.5
China	8,939	-2.5*	22.9**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/02/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 $4411.3 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 $4293.3 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 $8704.6 billion, which would be equivalent to 137.5 percent of their combined GDP in 2013. Under this arrangement, the entire debt of selected members 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 242.3 percent if including debt of France and 175.8 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

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	9,501.1
B Germany	2,022.9		$8704.6 as % of $3593 =242.3% $6316.2 as % of $3593 =175.8%
C France	2,388.4
B+C	4,411.3	GDP $6,332.0 Total Debt $8704.6 Debt/GDP: 137.5%
D Italy	2,285.1
E Spain	1,094.3
F Portugal	261.3
G Greece	419.4
H Ireland	233.2
Subtotal D+E+F+G+H	4,293.3

Source: calculation with IMF data IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/02/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 Oct 2013. German exports to other European Union (EU) members are 57.8 percent of total exports in Oct 2013 and 57.1 percent in cumulative Jan-Oct 2013. Exports to the euro area are 36.9 percent of the total in Oct and 36.8 percent cumulative in Jan-Oct. Exports to third countries are 42.1 percent of the total in Oct and 42.9 percent cumulative in Jan-Oct. There is similar distribution for imports. Exports to non-euro countries are increasing 6.2 percent in the 12 months ending in Oct 2013, increasing 1.7 percent cumulative in Jan-Oct 2013 while exports to the euro area are decreasing 0.1 percent in the 12 months ending in Ot 2013 and decreasing 1.8 percent cumulative in Jan-Oct 2013. Exports to third countries, accounting for 42.1 percent of the total in Oct 2013, are decreasing 1.3 percent in the 12 months ending in Oct 2013 and decreasing 0.8 percent cumulative in Jan-Oct 2013, accounting for 42.9 percent of the cumulative total in Jan-Oct 2013. Price competitiveness through devaluation could improve export performance and growth. Economic performance in Germany is closely related to Germany’s 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

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

German exports to other member states.

	Oct 2013 € Billions	Oct 12-Month ∆%	Cumulative Jan-Oct 2012 € Billions	Cumulative Jan-Oct 2013/ Jan-Oct 2012 ∆%
Total Exports	99.1	0.6	917.0	-0.7
A. EU Members	57.3 % 57.8	2.1	523.5 % 57.1	-0.6
Euro Area	36.6 % 36.9	-0.1	337.5 % 36.8	-1.8
Non-euro Area	20.7 % 20.9	6.2	185.9 % 20.3	1.7
B. Third Countries	41.7 % 42.1	-1.3	393.5 % 42.9	-0.8
Total Imports	81.2	-1.6	751.4	-1.5
C. EU Members	53.3 % 65.6	3.1	483.9 % 64.4	0.5
Euro Area	36.6 % 45.1	3.4	336.7 % 44.8	-0.4
Non-euro Area	16.7 % 20.6	2.6	147.2 % 19.6	2.6
D. Third Countries	27.9 % 34.4	-9.4	267.5 % 35.6	-4.8

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

Source: Statistisches Bundesamt Deutschland

https://www.destatis.de/EN/PressServices/Press/pr/2013/12/PE13_413_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	2.0	1.2	0.7	7.0
Japan	2.4	1.5	2.7	4.0
China	7.8	3.0	-2.0
UK	1.9	2.1* CPIH 1.9	0.8 output 0.7** input -1.0	7.4
Euro Zone	-0.4	0.9	-1.4	12.1
Germany	0.6	1.6	-0.7	5.2
France	0.2	0.8	-1.4	10.9
Nether-lands	-0.8	1.2	-3.7	7.0
Finland	-0.2	1.8	0.2	8.1
Belgium	0.4	0.9	-2.2	9.0
Portugal	-1.0	0.1	-1.7	15.7
Ireland	NA	0.3	1.6	12.6
Italy	-1.9	0.7	-2.7	12.5
Greece	-3.0	-2.9	-1.3	NA
Spain	-1.1	0.3	-0.2	26.7

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/november-2013/index.html*Core

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/november-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 2.0 percent in IIIQ2013 relative to IIIQ2012 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier, Table 8 in http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp3q13_3rd.pdf). Japan’s GDP grew 0.3 percent in IIIQ2013 relative to IIQ2013 and 2.4 percent relative to a year earlier. Japan’s grew at the seasonally adjusted annual rate (SAAR) of 1.1 percent in IIIQQ2013 (http://cmpassocregulationblog.blogspot.com/2013/12/theory-and-reality-of-secular.html and earlier http://cmpassocregulationblog.blogspot.com/2013/11/risks-of-unwinding-monetary-policy.html). The UK grew at 0.8 percent in IIIQ2013 relative to IIQ2013 and GDP increased 1.9 percent in IIIQ2013 relative to IIIQ2012 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/exit-risks-of-zero-interest-rates-world.html). The Euro Zone grew at 0.1 percent in IIIQ2013 and minus 0.4 percent in IIIQ2013 relative to IIIQ2012 (http://cmpassocregulationblog.blogspot.com/2013/12/theory-and-reality-of-secular.html and earlier http://cmpassocregulationblog.blogspot.com/2013/11/risks-of-unwinding-monetary-policy.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: 7.0 percent in the US but 17.2 percent for unemployment/underemployment or job stress of 28.1 million (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html and earlier http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html), 4.0 percent for Japan (Section VB and earlier http://cmpassocregulationblog.blogspot.com/2013/12/exit-risks-of-zero-interest-rates-world.html), 7.4 percent for the UK with high rates of unemployment for young people (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/11/risks-of-unwinding-monetary-policy.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.2 percent in the US, 1.5 percent for Japan, 3.0 percent for China, 0.9 percent for the Euro Zone and 2.1 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/2013/12/tapering-quantitative-easing-mediocre.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 (Section I), weak hiring with the loss of 10 million full-time jobs (http://cmpassocregulationblog.blogspot.com/2013/12/theory-and-reality-of-secular.html

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

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

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

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

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

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

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

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

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

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

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

Unconventional monetary policy will remain in perpetuity, or QE→∞, changing to a “growth mandate.” There are two reasons explaining unconventional monetary policy of QE→∞: insufficiency of job creation to reduce unemployment/underemployment at current rates of job creation; and growth of GDP at 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 2.3 percent on average in the cyclical expansion in the 17 quarters from IIIQ2009 to IIIQ2013. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) and the third estimate of GDP for IIIQ2013 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp3q13_3rd.pdf). The average of 7.7 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 2.7 percent obtained by diving GDP of $14,738.0 billion in IIQ2010 by GDP of $14,356.9 billion in IIQ2009 {[$14,738.0/$14,356.9 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.4 percent from IQ1983 to IVQ1986 and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html). As a result, there are 28.1 million unemployed or underemployed in the United States for an effective unemployment rate of 17.2 percent (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html). The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May).

First, total nonfarm payroll employment seasonally adjusted (SA) increased 203,000 in Nov 2013 and private payroll employment rose 196,000. The average number of nonfarm jobs created in Jan-Nov 2012 was 179,455 while the average number of nonfarm jobs created in Jan-Nov 2013 was 188,455, or increase by 5.0 percent. The average number of private jobs created in the US in Jan-Nov 2012 was 185,909 while the average in Jan-Nov 2013 was 190,091, or increase by 2.2 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 ten months from Jan to Nov 2013 was 188,455, 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 28.1 million unemployed or underemployed. The difference between the average increase of 188,455 new private nonfarm jobs per month in the US from Jan to Nov 2013 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 75,288 monthly new jobs net of absorption of new entrants in the labor force. There are 28.1 million in job stress in the US currently. Creation of 75,288 new jobs per month net of absorption of new entrants in the labor force would require 373 months to provide jobs for the unemployed and underemployed (28.111 million divided by 75,288) or 31 years (373 divided by 12). The civilian labor force of the US in Nov 2013 not seasonally adjusted stood at 155.046 million with 10.271 million unemployed or effectively 18.452 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 163.227 million. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 1.1 years (1 million divided by product of 75,288 by 12, which is 903,456). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.752 million (0.05 times labor force of 155.046 million) for new net job creation of 2.499 million (10.271 million unemployed minus 7.772 million unemployed at rate of 5 percent) that at the current rate would take 2.8 years (2.499 million divided by 0.903456). Under the calculation in this blog, there are 18.452 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 163.227 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 10.164 million jobs net of labor force growth that at the current rate would take 11.4 years (18.452 million minus 0.05(163.227 million) = 10.291 million divided by 0.903456, 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 Nov 2013 was 144.775 million (NSA) or 2.540 million fewer people with jobs relative to the peak of 147.315 million in Jul 2007 while the civilian noninstitutional population increased from 231.958 million in Jul 2007 to 246.567 million in Nov 2013 or by 14.609 million. The number employed fell 1.7 percent from Jul 2007 to Nov 2013 while population increased 6.3 percent. 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.

There is current interest in past theories of “secular stagnation.” Alvin H. Hansen (1939, 4, 7; see Hansen 1938, 1941; for an early critique see Simons 1942) argues:

“Not until the problem of full employment of our productive resources from the long-run, secular standpoint was upon us, were we compelled to give serious consideration to those factors and forces in our economy which tend to make business recoveries weak and anaemic (sic) and which tend to prolong and deepen the course of depressions. This is the essence of secular stagnation-sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment. Now the rate of population growth must necessarily play an important role in determining the character of the output; in other words, the composition of the flow of final goods. Thus a rapidly growing population will demand a much larger per capita volume of new residential building construction than will a stationary population. A stationary population with its larger proportion of old people may perhaps demand more personal services; and the composition of consumer demand will have an important influence on the quantity of capital required. The demand for housing calls for large capital outlays, while the demand for personal services can be met without making large investment expenditures. It is therefore not unlikely that a shift from a rapidly growing population to a stationary or declining one may so alter the composition of the final flow of consumption goods that the ratio of capital to output as a whole will tend to decline.”

The argument that anemic population growth causes “secular stagnation” in the US (Hansen 1938, 1939, 1941) is as misplaced currently as in the late 1930s (for early dissent see Simons 1942). There is currently population growth in the ages of 16 to 24 years but not enough job creation and discouragement of job searches for all ages (http://cmpassocregulationblog.blogspot.com/2013/12/theory-and-reality-of-secular.html). This is merely another case of theory without reality with dubious policy proposals.

Inferior performance of the US economy and labor markets is the critical current issue of analysis and policy design.

Second, there are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) and the third estimate of GDP for IIIQ2013 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp3q13_3rd.pdf). The average of 7.7 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 2.7 percent obtained by diving GDP of $14,738.0 billion in IIQ2010 by GDP of $14,356.9 billion in IIQ2009 {[$14,738.0/$14,356.9 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.4 percent from IQ1983 to IVQ1986 and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html). As a result, there are 28.1 million unemployed or underemployed in the United States for an effective unemployment rate of 17.2 percent (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html). The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May).

The economy of the US can be summarized in growth of economic activity or GDP as decelerating from mediocre growth of 2.5 percent on an annual basis in 2010 to 1.8 percent in 2011 to 2.8 percent in 2012. The following calculations show that actual growth is around 2.0 to 2.6 percent per year. This rate is well below 3 percent per year in trend from 1870 to 2010, which the economy of the US always attained for entire cycles in expansions after events such as wars and recessions (Lucas 2011May). 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) provide important information on long-term growth and cyclical behavior. Table Summary provides relevant data.

Long-term. US GDP grew at the average yearly rate of 3.3 percent from 1929 to 2012 and at 3.2 percent from 1947 to 2012. 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.
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 IIIQ1986 was 5.4 percent and 5.2 percent from IQ1983 to IVQ1986. In contrast, average annual equivalent growth in the expansion from IIIQ2009 to IIIQ2013 was only 2.3 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 IVQ1985 IQ1983-IQ1986 IQ1983-IIIQ1986 IQ1983-IVQ1986 IQ1983-IQ1987	5.9 5.7 5.4 5.2 5.0
First Four Quarters IQ1983 to IVQ1983	7.8
IIIQ2009 to IIIQ2013	2.3
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://www.bea.gov/iTable/index_nipa.cfm

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) also provide critical information in assessing the current rhythm of US economic growth. The economy appears to be moving at a pace from 2.0 to 2.6 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 three quarters of 2013 accumulated to 3.9 percent. This growth is equivalent to 2.2 percent per year, obtained by dividing GDP in IIIQ2013 of $15,839.3 billion by GDP in IVQ2011 of $15,242.1 billion and compounding by 4/7: {[($15,839.3/$15,242.1)^4/7 -1]100 = 2.2.

2. Average Annual Growth in the First Three Quarters of 2013. GDP growth in the first three quarters of 2013 accumulated to 1.9 percent that is equivalent to 2.6 percent in a year. This is obtained by dividing GDP in IIIQ2013 of $15,839.3 by GDP in IVQ2012 of $15,539.6 and compounding by 4/3: {[($15,839.3/$15,539.6)^4/3 -1]100 = 2.6%}. The US economy grew 2.0 percent in IIIQ2013 relative to the same quarter a year earlier in IIIQ2012. Another important revelation of the revisions and enhancements is that GDP was flat in IVQ2012, which is just at the borderline of contraction. The rate of growth of GDP in the third estimate of IIIQ2013 is 4.1 percent in seasonally adjusted annual rate (SAAR). Inventory accumulation contributed 1.67 percentage points to this rate of growth. The actual rate without this impulse of unsold inventories would have been 2.43 percent, or 0.6 percent in IIIQ2013, such that annual equivalent growth in 2013 is closer to 2.0 percent {[(1.003)(1.006)(1.006)^4/3-1]100 = 2.0%}, compounding the quarterly rates and converting into annual equivalent.

Table Summary GDP, US, Real GDP and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions Chained 2005 Dollars and ∆%

	Real GDP, Billions Chained 2009 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	15,679.7	4.6	0.6	1.6
IIIQ2013	15,839.3	5.6	1.0	2.0
Cumulative ∆% IQ2012 to IIIQ2013	3.9		3.9
Annual Equivalent ∆%	2.2		2.2

Source: US Bureau of Economic Analysis

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20131218.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 its meeting on Dec 18, 2013 with symbolic reduction of purchases of securities for the Fed’s balance sheet (http://www.federalreserve.gov/newsevents/press/monetary/20131218a.htm):

“Press Release

Release Date: December 18, 2013

For immediate release

Information received since the Federal Open Market Committee met in October indicates that economic activity is expanding at a moderate pace. Labor market conditions have shown further improvement; the unemployment rate has declined but remains elevated. Household spending and business fixed investment advanced, while the recovery in the housing sector slowed somewhat in recent months. Fiscal policy is restraining economic growth, although the extent of restraint may be diminishing. 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 risks to the outlook for the economy and the labor market as having become more nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

Taking into account the extent of federal fiscal retrenchment since the inception of its current asset purchase program, the Committee sees the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $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. The Committee's sizable and still-increasing holdings of longer-term securities 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. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's outlook for the labor market and inflation 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. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent 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. The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal. 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; Esther L. George; Jerome H. Powell; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Eric S. Rosengren, who believes that, with the unemployment rate still elevated and the inflation rate well below the target, changes in the purchase program are premature until incoming data more clearly indicate that economic growth is likely to be sustained above its potential rate.”

There are several important issues in this statement.

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

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

Open-ended Quantitative Easing or QE_∞ with Symbolic Tapering. Earlier programs are continued with an additional lower open-ended $75 billion of bond purchases per month, increasing the stock of $2,739,919 million securities held outright and bank reserves deposited at the Fed of $2,465,932 million (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1): “ In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $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. The Committee's sizable and still-increasing holdings of longer-term securities 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.”
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. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent 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.”
No Present Course of Policy Accommodation. Market participants focused on slightly different wording about asset purchases: “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. The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal. 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.”
Growth. “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 risks to the outlook for the economy and the labor market as having become more nearly balanced”

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 to $75 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 Dec 18, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20131218a.htm):

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? Will the FOMC increase purchases of mortgage-backed securities if mortgage rates increase?

W = Y/r (10

In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:

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.

Professor Ronald I. McKinnon (2013Oct27), writing on “Tapering without tears—how to end QE3,” on Oct 27, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304799404579153693500945608?KEYWORDS=Ronald+I+McKinnon), finds that the major central banks of the world have fallen into a “near-zero-interest-rate trap.” World economic conditions are weak such that exist from the zero interest rate trap could have adverse effects on production, investment and employment. The maintenance of interest rates near zero creates long-term near stagnation. The proposal of Professor McKinnon is credible, coordinated increase of policy interest rates toward 2 percent. Professor John B. Taylor at Stanford University, writing on “Economic failures cause political polarization,” on Oct 28, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303442004579121010753999086?KEYWORDS=John+B+Taylor), analyzes that excessive risks induced by near zero interest rates in 2003-2004 caused the financial crash. Monetary policy continued in similar paths during and after the global recession with resulting political polarization worldwide.

Table IV-2 provides economic projections of governors of the Board of Governors of the Federal Reserve and regional presidents of Federal Reserve Banks released at the meeting of Dec 18, 2013. The Fed releases the data with careful explanations (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20131218.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 IIIQ2013 is analyzed in Section I (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html). and the PCE inflation data from the report on personal income and outlays in Section IV (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html). The Bureau of Economic Analysis (BEA) provides the estimate of IIQ2013 GDP released on Sep 26 with revisions since 1929 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html). The BEA provides the first estimate of IIIQ2013 GDP released on Nov 8, 2013 and the third estimate of IIIQ2013 GDP on Dec 20, 2013 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.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/2013/12/risks-of-zero-interest-rates-mediocre.html http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html). The report on “Personal Income and Outlays” for Sep 2013 was released on Nov 8, 2013, the report for Oct 2013 was released on Dec 6, 2013 and the report for Nov 2013 was released on Dec 20, 2013 (Section IV and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html). 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). The report for Sep 2013 was released on Oct 22, 2013 (http://cmpassocregulationblog.blogspot.com/2013/10/twenty-eight-million-unemployed-or.html

and earlier http://cmpassocregulationblog.blogspot.com/2013/10/twenty-eight-million-unemployed-or.html). The report for Oct 2013 was released on Nov 8, 2013 and the report for Nov 2013 on Dec 6, 2013 (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.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, 2014 and 2015 because 2016 and longer term are too far away, and there is not much information even on what will happen in 2013-2015 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Dec 18, 2013 and the second row “PR” the projection of the Sep 18, 2013 meeting. There are three major changes in the view.

1. Growth “∆% GDP.” The FOMC has increased the forecast of GDP growth in 2013 from 2.0 to 2.3 percent at the meeting in Sep 2013 to 2.2 to 2.3 percent at the meeting on Dec 18, 2013. The FOMC increased GDP growth in 2014 from 2.9 to 3.1 percent at the meeting in Sep 2013 to 2.8 to 3.2 percent at the meeting in Dec 2013.

2. Rate of Unemployment “UNEM%.” The FOMC reduced the forecast of the rate of unemployment for 2013 from 7.1 to 7.3 percent at the meeting on Sep 18, 2013 to 7.0 to 7.1 percent at the meeting on Dec 18, 2013. The projection for 2014 decreased to the range of 6.3 to 6.6 in Dec 2013 from 6.4 to 6.8 in Sep 2013. Projections of the rate of unemployment are moving closer to the desire 6.5 percent or lower with 5.8 to 6.1 percent in 2015 after the meeting on Dec 18, 2013.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation for 2014 from 1.3 to 1.8 percent at the meeting on Sep 18, 2013 to 1.4 to 1.6 percent at the meeting on Dec 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 2016. 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 for 2014, changing from 1.5 to 1.7 percent at the meeting on Sep 18, 2013 to 1.4 to 1.6 percent at the meeting Dec 18, 2013. In 2015, there is minor change in the projection from 1.7 to 2.0 percent at the meeting on Sep 18, 2013 to 1.6 to 2.0 percent on Dec 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, Sep 18, 2013 and Dec 18, 2013

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2013 Sep PR	2.2 to 2.3 2.0 to 2.3	7.0 to 7.1 7.1 to 7.3	0.9 to 1.0 1.1 to 1.2	1.1 to 1.2 1.2 to 1.3
2014 Sep PR	2.8 to 3.2 2.9 to 3.1	6.3 to 6.6 6.4 to 6.8	1.4 to 1.6 1.3 to 1.8	1.4 to 1.6 1.5 to 1.7
2015 Sep PR	3.0 to 3.4 3.0 to 3.5	5.8 to 6.1 5.9 to 6.2	1.5 to 2.0 1.6 to 2.0	1.6 to 2.0 1.7 to 2.0
2016 Sep PR	2.5 to 3.2 2.5 to 3.3	5.3 to 5.8 5.4 to 5.9	1.7 to 2.0 1.7 to 2.0	1.8 to 2.0 1.9 to 2.0
Longer Run Sep PR	2.2 to 2.4 2.2 to 2.5	5.2 to 5.8 5.2 to 5.8	2.0 2.0
Range
2013 Sep PR	2.2 to 2.4 1.8 to 2.4	7.0 to 7.1 6.9 to 7.3	0.9 to 1.2 1.0 to 1.3	1.1 to 1.2 1.2 to 1.4
2014 Jun PR	2.2 to 3.3 2.2 to 3.3	6.2 to 6.7 6.2 to 6.9	1.3 to 1.8 1.2 to 2.0	1.3 to 1.8 1.4 to 2.0
2015 Sep PR	2.2 to 3.6 2.2 to 3.7	5.5 to 6.2 5.3 to 6.3	1.4 to 2.3 1.4 to 2.3	1.5 to 2.3 1.6 to 2.3
2016 Sep PR	2.1 to 3.5 2.2 to 3.5	5.0 to 6.0 5.2 to 6.0	1.6 to 2.2 1.5 to 2.3	1.6 to 2.2 1.7 to 2.3
Longer Run Jun PR	1.8 to 2.5 2.1 to 2.5	5.2 to 6.0 5.2 to 6.0	2.0 2.0

Notes: UEM: unemployment; PR: Projection

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

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 15 participants with one 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, ten participants expect rates to be below or at 1.0 percent while four expect rates from 1.0 to 2.0 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 four between 3.0 and 4.5 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, Dec 18, 2013

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

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20131218.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, Dec 18, 2013

Appropriate Year of Increasing Target Fed Funds Rate	Number of Participants
2014	2
2015	12
2016	3

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

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20131218.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) also provide critical information in assessing indexes of prices of personal consumption. There are waves of inflation similar to those worldwide (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html) in inflation of personal consumption expenditures (PCE) in Table IV-5. These waves are in part determined by commodity price shocks originating in the carry trade from zero interest rates to positions in risk financial assets, in particular in commodity futures, which increase the prices of food and energy when there is relaxed risk aversion. Return of risk aversion causes collapse in prices. Resulting fluctuations of prices confuse risk/return decisions, inducing financial instability with adverse financial and economic consequences. The first wave is in Jan-Apr 2011 when headline PCE inflation increased at the average annual equivalent rate of 3.7 percent and PCE inflation excluding food and energy (PCEX) at 1.5 percent. The drivers of inflation were increases in food prices (PCEF) at the annual equivalent rate of 7.8 percent and of energy prices (PCEE) at 26.4 percent. This behavior will prevail under zero interest rates and relaxed risk aversion because of carry trades from zero interest rates to leveraged positions in commodity futures. The second wave occurred in May-Jun 2011 when risk aversion from the European sovereign risk crisis interrupted the carry trade. PCE prices increased 2.4 percent in annual equivalent and 2.4 percent excluding food and energy. The third wave is captured by the annual equivalent rates in Jul-Sep 2011 of headline PCE inflation of 2.4 percent with subdued PCE inflation excluding food and energy of 2.0 percent while PCE food rose at 6.2 percent and PCE energy increased at 6.2 percent. In the fourth wave in Oct-Dec 2011, increased risk aversion explains the fall of the annual equivalent rate of inflation to 0.8 percent for headline PCE inflation and 2.0 percent for PCEX excluding food and energy. PCEF of prices of food rose at the annual equivalent rate of 1.2 percent in Oct-Dec 2011 while PCEE of prices of energy fell at the annual equivalent rate of 10.7 percent. In the fifth wave in Jan-Mar 2012, headline PCE in annual equivalent was 2.4 percent and 2.4 percent excluding food and energy (PCEX). Energy prices of personal consumption (PCEE) increased at the annual equivalent rate of 15.8 percent because of the jump of 2.3 percent in Feb 2012 followed by 1.3 percent in Mar 2012. In the sixth wave, renewed risk aversion caused reversal of carry trades with headline PCE inflation at the annual equivalent rate of 0.0 percent in Apr-May 2012 while PCE inflation excluding food and energy increased at the annual equivalent rate of 1.2 percent. In the seventh wave, further shocks of risk aversion resulted in headline PCE annual equivalent inflation at 1.2 percent in Jun-Jul 2012 with core PCE excluding food and energy at 1.8 percent. In the eighth wave, temporarily relaxed risk aversion with zero interest rates resulted in central PCE inflation at 3.7 percent annual equivalent in Aug-Sep 2012 with PCEX excluding food and energy at 0.6 percent while PCEE energy jumped at 67.6 percent annual equivalent. The program of outright monetary transactions (OTM) of the European Central Bank induced relaxed risk aversion (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). In the ninth wave, prices collapsed with reversal of carry trade positions in a new episode of risk aversion with central PCE at annual equivalent 0.6 percent in Oct 2012 to Jan 2013 and PCEX at 1.8 percent while energy prices fell at minus 16.9 percent. In the tenth wave, central PCE increased at annual equivalent 4.9 percent in Feb 2013, PCEX at 1.2 percent and PCEE at 92.3 percent. In the eleventh wave, renewed risk aversion resulted in decline in annual equivalent of general PCE prices at 2.4 percent in Mar-Apr 2013 while PCEX increased at 0.6 percent and energy prices fell at 34.8 percent. In the twelfth wave, central PCE increased at 1.4 percent annual equivalent in May-Nov 2013 with PCEX increasing at 1.4 percent, food PCEF increasing at 0.5 percent and energy PCEE increasing at 3.0 percent with the jump of 3.4 percent in Jun 2013. Commodity prices have moderated with reallocation of financial investments to carry trades in equities.

Table IV-5, US, Percentage Change from Prior Month of Prices of Personal Consumption Expenditures, Seasonally Adjusted Monthly ∆%

	PCE	PCEG	PCEG -D	PCES	PCEX	PCEF	PCEE
2013
Nov	0.0	-0.3	-0.3	0.2	0.1	-0.1	-1.0
Oct	0.0	-0.3	-0.2	0.1	0.1	0.1	-1.8
Sep	0.1	0.0	0.0	0.2	0.1	-0.1	0.8
Aug	0.1	0.0	-0.3	0.1	0.1	0.2	-0.2
Jul	0.1	0.1	-0.3	0.1	0.1	0.1	0.3
Jun	0.4	0.7	0.0	0.2	0.2	0.3	3.4
May	0.1	-0.1	-0.1	0.2	0.1	-0.2	0.3
∆% AE May-Nov	1.4	0.2	-2.0	1.9	1.4	0.5	3.0
Apr	-0.3	-0.9	-0.3	0.0	0.0	0.1	-4.4
Mar	-0.1	-0.6	-0.2	0.1	0.1	0.1	-2.6
∆% AE Mar-Apr	-2.4	-8.6	-3.0	0.6	0.6	1.2	-34.8
Feb	0.4	0.8	-0.1	0.2	0.1	0.2	5.6
∆% AE Feb	4.9	10.0	-1.2	2.4	1.2	2.4	92.3
Jan	0.1	-0.2	0.1	0.2	0.2	0.0	-1.8
2012
Dec	0.0	-0.3	-0.2	0.2	0.1	0.2	-0.9
Nov	-0.1	-0.7	-0.1	0.2	0.1	0.2	-3.5
Oct	0.2	0.1	-0.2	0.2	0.2	0.3	0.1
∆% AE Oct-Jan	0.6	-3.3	-1.2	2.4	1.8	2.1	-16.9
Sep	0.3	0.6	-0.2	0.1	0.1	-0.1	4.1
Aug	0.3	0.7	-0.2	0.1	0.0	0.1	4.7
∆% AE Aug-Sep	3.7	8.1	-2.4	1.2	0.6	0.0	67.6
Jul	0.0	-0.2	-0.3	0.1	0.1	0.0	-1.2
Jun	0.2	0.0	-0.1	0.3	0.2	0.2	-0.7
∆% AE Jun-Jul	1.2	-1.2	-2.4	2.4	1.8	1.2	-10.8
May	0.0	-0.5	0.0	0.2	0.1	0.0	-2.9
Apr	0.0	-0.3	-0.1	0.2	0.1	0.0	-1.9
∆% AE Apr- May	0.0	-4.7	-0.6	2.4	1.2	0.0	-25.3
Mar	0.2	0.3	-0.2	0.2	0.2	0.2	1.3
Feb	0.2	0.4	0.0	0.2	0.1	0.0	2.3
Jan	0.2	0.2	0.1	0.2	0.3	0.2	0.1
∆% AE Jan- Mar	2.4	3.7	-0.4	2.4	2.4	1.6	15.8
2011
Dec	0.1	-0.1	-0.2	0.2	0.1	0.2	-1.2
Nov	0.1	0.1	-0.2	0.2	0.2	-0.1	0.0
Oct	0.0	-0.2	0.0	0.1	0.1	0.2	-1.6
∆% AE Oct- Dec	0.8	-1.2	-1.6	2.0	2.0	1.2	-10.7
Sep	0.2	0.2	-0.4	0.2	0.1	0.5	1.3
Aug	0.2	0.3	-0.2	0.2	0.2	0.6	0.1
Jul	0.2	0.2	-0.1	0.2	0.2	0.4	0.1
∆% AE Jul-Sep	2.4	2.8	-2.8	2.4	2.0	6.2	6.2
Jun	0.1	0.1	0.2	0.1	0.2	0.2	-0.7
May	0.3	0.5	0.1	0.2	0.2	0.5	1.4
∆% AE May-Jun	2.4	3.7	1.8	1.8	2.4	4.3	4.2
Apr	0.3	0.5	0.3	0.2	0.2	0.4	1.8
Mar	0.4	0.8	-0.1	0.2	0.1	0.8	3.6
Feb	0.3	0.5	0.1	0.2	0.1	0.7	1.7
Jan	0.2	0.4	0.0	0.1	0.1	0.6	0.8
∆% AE Jan-Apr	3.7	6.8	0.9	2.1	1.5	7.8	26.4
2010
Dec	0.2	0.6	-0.3	0.1	0.0	0.1	4.1
Nov	0.2	0.2	-0.2	0.1	0.1	0.2	1.1
Oct	0.2	0.4	-0.2	0.1	0.1	0.1	3.1
Sep	0.1	0.2	-0.1	0.1	0.0	0.2	0.6
Aug	0.1	0.3	0.1	0.1	0.1	0.1	1.0
Jul	0.1	0.1	-0.3	0.1	0.1	0.1	1.2
Jun	0.1	-0.1	-0.4	0.1	0.1	-0.1	-0.5
May	0.0	-0.2	-0.2	0.2	0.1	0.1	-1.2
Apr	0.0	-0.3	-0.2	0.1	0.0	0.1	-0.8
Mar	0.1	-0.1	0.0	0.2	0.1	0.2	-0.5
Feb	0.0	-0.2	-0.3	0.1	0.1	0.1	-1.2
Jan	0.2	0.3	-0.1	0.1	0.1	0.1	1.7

Notes: percentage changes in price index relative to the same month a year earlier of PCE: personal consumption expenditures; PCEG: PCE goods; PCEG-D: PCE durable goods; PCES: PCE services; PCEX: PCE excluding food and energy; PCEF: PCE food; PCEE: PCE energy goods and services. AE: annual equivalent.

Source: US Bureau of Economic Analysis http://bea.gov/iTable/index_nipa.cfm

The charts of PCE inflation are also instructive. Chart IV-1 provides the monthly change of headline PCE price index. There is significant volatility in the monthly changes but excluding outliers fluctuations have been in a tight range between 1999 and 2013 around 0.2 percent per month.

Chart IV-1, US, Percentage Change of PCE Price Index from Prior Month, 1999-2013

Source: US Bureau of Economic Analysis

There is much less volatility in the PCE index excluding food and energy shown in Chart IV-2 with monthly percentage changes from 1999 to 2013. With the exception of 2001, there are no negative changes and again changes around 0.2 percent when excluding outliers.

Chart IV-2, US, Percentage Change of PCE Price Index Excluding Food and Energy from Prior Month, 1999-2013

Source: US Bureau of Economic Analysis

Fluctuations in the PCE index of food are much wider as shown in Chart IV-3 by monthly percentage changes from 1999 to 2013. There are also multiple negative changes and positive changes even exceeding 1.0 percent in three months.

Chart IV-3, US, Percentage Change of PCE Price Index Food from Prior Month, 1999-2013

Source: US Bureau of Economic Analysis

The band of fluctuation of the PCE price index of energy in Chart IV-4 is much wider. An interesting feature is the abundance of negative changes and large percentages.

Chart IV-4, US, Percentage Change of PCE Price Index Energy from Prior Month, 1999-2013

Source: US Bureau of Economic Analysis

Table IV-6 provides 12-month rates of PCE inflation from Jan 2012 to Nov 2013, annual inflation rates from 2000 to 2012 and average yearly rates of PCE inflation for various periods since 1929. Headline 12-month PCE inflation decreased from 2.5 percent in in the 12 months ending in Jan 2012 to 0.9 percent in the 12 months ending in Nov 2013. PCE inflation excluding food and energy (PCEX), used as indicator in monetary policy, decreased from 2.0 percent in the 12 months ending in Jan 2012 to 1.1 percent in the 12 months ending in Nov 2013, which is still below or at the tolerable maximum of 2.0-2.5 percent in monetary policy. The unintended effect of shocks of commodity prices from zero interest rates captured by PCE food prices (PCEF) and energy (PCEE) in the absence of risk aversion should be weighed in design and implementation of monetary policy. Annual PCE inflation in the second part of Table IV-6 shows significant fluctuations. Headline PCE inflation rose during the period of 1 percent interest rates from Jun 2003 to Jun 2005, reaching 2.9 percent in 2005. PCEE rose at very high two-digit rates after 2003. Headline PCE inflation increased 3.1 percent in 2008 while PCEE energy increased 14.3 percent in carry trades from zero interest rates to commodity derivatives during deep global recession. Flight away from risk financial assets to US government obligations fueled by proposals of TARP in Congress (Cochrane and Zingales 2009) caused decline of PCEE of 19.0 percent in 2009 and minus 0.1 percent in headline PCEE. There is no deflation in the US economy. Headline PCEE inflation increased at the average rate of 2.9 percent from 1929 to 2012, as shown in Table IV-6 using the revisions by the BEA. PCEE inflation was 6.8 percent on average during the Great Inflation episode from 1960 to 1981 (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). PCE inflation was 3.2 percent on average from 1947 to 2012 and 3.2 percent on average for PCEX. The long-term charts of PCEE and PCEX show almost identical behavior.

Table IV-6, US, Percentage Change in 12 Months of Prices of Personal Consumption Expenditures ∆%

	PCE	PCEG	PCEG -D	PCES	PCEX	PCEF	PCEE
2013
Nov	0.9	-1.0	-2.0	1.9	1.1	0.7	-2.7
Oct	0.7	-1.4	-1.8	1.8	1.1	1.0	-5.1
Sep	0.9	-1.0	-1.8	1.9	1.2	1.2	-3.3
Aug	1.1	-0.4	-2.0	1.9	1.2	1.2	-0.1
Jul	1.3	0.3	-1.8	1.9	1.1	1.2	4.8
Jun	1.3	0.0	-1.8	1.9	1.2	1.0	3.2
May	1.0	-0.7	-1.9	1.9	1.2	1.0	-0.9
Apr	0.9	-1.1	-1.8	1.9	1.2	1.2	-4.1
Mar	1.2	-0.5	-1.7	2.1	1.4	1.1	-1.6
Feb	1.5	0.4	-1.7	2.1	1.5	1.2	2.4
Jan	1.4	0.0	-1.6	2.1	1.5	1.1	-0.8
2012
Dec	1.5	0.4	-1.6	2.1	1.6	1.3	1.1
Nov	1.6	0.5	-1.5	2.1	1.7	1.3	0.8
Oct	1.8	1.3	-1.6	2.1	1.8	1.0	4.4
Sep	1.7	1.0	-1.5	2.0	1.7	0.9	2.7
Aug	1.6	0.6	-1.7	2.1	1.7	1.5	-0.2
Jul	1.5	0.2	-1.6	2.2	1.9	2.0	-4.6
Jun	1.6	0.5	-1.4	2.2	1.9	2.4	-3.3
May	1.6	0.7	-1.1	2.1	1.9	2.4	-3.3
Apr	2.0	1.6	-1.2	2.1	1.9	2.9	1.5
Mar	2.3	2.5	-0.6	2.0	2.0	3.3	4.9
Feb	2.4	2.9	-0.6	2.2	2.0	3.9	7.3
Jan	2.5	3.0	-0.4	2.2	2.0	4.7	6.8
Annual ∆%
2012	1.8	1.3	-1.2	2.2	1.8	2.3	1.4
2011	2.4	3.6	-1.0	1.8	1.4	4.0	15.8
2010	1.7	1.6	-1.4	1.7	1.3	0.3	10.1
2009	-0.1	-2.3	-1.7	1.1	1.2	1.2	-19.0
2008	3.1	3.0	-1.9	3.1	2.1	5.6	14.3
2007	2.5	1.1	-2.0	3.2	2.2	3.9	6.0
2006	2.7	1.4	-1.6	3.4	2.2	3.1	11.3
2005	2.9	2.0	-1.0	3.3	2.2	1.7	17.3
2004	2.4	1.4	-1.9	3.0	1.9	3.1	11.3
2003	2.0	-0.1	-3.6	3.1	1.5	1.9	12.6
2002	1.3	-0.9	-2.5	2.6	1.7	1.5	-5.8
2001	1.9	-0.1	-2.0	3.1	1.8	2.9	2.5
2000	2.5	2.0	-1.8	2.8	1.7	2.3	18.3
Average ∆%
2000-2012	2.0	1.0	-19.8*	2.6	1.8	2.5	6.0
1929-2012	2.9	3.4	1.4	3.3	2.9	2.9	3.4
1947-2012	3.2	2.4	1.2	3.9	3.2	3.1	4.3
1960-1981	6.8	6.4	4.9	7.2	6.3	7.3	11.1

*Percentage change from 2000 to 2012.

Source: US Bureau of Economic Analysis http://bea.gov/iTable/index_nipa.cfm

The headline PCE index is shown in Chart IV-5 from 1999 to 2013. There is an evident upward trend with the carry-trade bump in 2008-2009 during the global recession.

Chart IV-5, US, Price Index of Personal Consumption Expenditures 1999-2013

Source: US Bureau of Economic Analysis

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

The consumer price index in Chart IV-6 mirrors the behavior of the PCE price index in Chart IV-6. There is the same upward trend with the carry-trade bump in 2008 during the global recession.

Chart IV-6, US, Consumer Price Index, NSA, 1999-2013

Source: US Bureau of Labor Statistics

Chart IV-7 provides the PCE price index excluding food and energy. There is milder upward trend with fewer oscillations.

Chart IV-7, US, Price Index of Personal Consumption Expenditures Excluding Food and Energy 1999-2013

Source: US Bureau of Economic Analysis

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

The core consumer price index, excluding food and energy, is shown in Chart IV-8. There is also an upward trend but with fluctuations.

Chart IV-8, US, Consumer Price Index Excluding Food and Energy, NSA, 1999-2012

Source: US Bureau of Labor Statistics

The PCE price index of food is shown in Chart IV-9. There is a more pronounced upward trend and sharper fluctuations.

Chart IV-9, US, Price Index of Personal Consumption Expenditures Food 1999-2013

Source: US Bureau of Economic Analysis

There is similar behavior in the consumer price index of food in Chart IV-10. There is an upward trend from 1999 to 2011 with a major bump in 2009 when commodity futures positions were unwound. Zero interest rates with bouts of risk aversion dominate the trend into 2011. Risk aversion softens the trend toward the end of 2011 and in 2012-2013.

Chart IV-10, US, Consumer Price Index, Food, NSA, 1999-2013

Source: US Bureau of Labor Statistics

The most pronounced trend of PCE price indexes is that of energy in Chart IV-11. It is impossible to explain the hump in 2008 in the middle of the global recession without the carry trade from zero interest rates to leveraged positions in commodity futures. Risk aversion after Sep 2008 caused flight to the safe haven of government obligations. The return of risk appetite with zero interest rates caused a first wave of carry trades with another upward trend interrupted by the first European sovereign risk crisis in Apr-Jul 2010. Zero interest rates with risk appetite caused another sharp upward trend of commodity prices interrupted by risk aversion from the second sovereign crisis. In the absence of risk aversion, carry trades from zero interest rates to positions in risk financial assets will continue to cause distortions such as commodity price trends and fluctuations.

Chart IV-11, US, Price Index of Personal Consumption Expenditures Energy Goods and Services 1999-2013

Source: US Bureau of Economic Analysis

http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D

Chart IV-12 provides the consumer price index of energy commodities. Unconventional monetary policy of zero or near zero interest rates causes upward trends in commodity prices reflected in (1) increase from 2003 to 2007; (2) sharp increase during the global contraction in 2008; (3) collapse from 2008 into 2009 as positions in commodity futures were unwound in a flight to government obligations; (4) new upward trend after 2010; and (5) episodes of decline during risk aversion shocks such as the more recent segment during the worsening European debt crisis in Nov and Dec of 2011 and with new strength of commodity prices in the beginning of 2012 followed by softness in another episode of risk aversion and increases during risk appetite.

Chart IV-12, US, Consumer Price Index, Energy, NSA, 1999-2013

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

Chart IV-13 of the US Energy Information Administration provides prices of the crude oil futures contract. Unconventional monetary policy of very low interest rates and quantitative easing with suspension of the 30-year bond to lower mortgage rates caused a sharp upward trend of oil prices. There is no explanation for the jump of oil prices to $149/barrel in 2008 during a sharp global recession other than carry trades from zero interest rates to commodity futures. The peak in Chart IV-13 is $145.18 on Jul 14, 2008, in the midst of deep global recession, falling to $33.87/barrel on Dec 19, 2008 (data from the US Energy Information Administration (http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D). Prices collapsed in the flight to government obligations caused by proposals for withdrawing “toxic assets” in the Troubled Asset Relief Program (TARP) as analyzed by Cochrane and Zingales (2009). Risk appetite with zero interest rates after stress tests of US banks resulted in another upward trend of commodity prices after 2009 with fluctuations during periods of risk aversion. All price indexes are affected by unconventional monetary policy.

Chart IV-13, US, Crude Oil Futures Contract

Source: US Energy Information Administration

Table IV-14 provides the annual PCE price index from the revised and enhanced dataset of the Bureau of Economic Analysis (BEA). The annual PCEE index increased at the average rate of 3.2 percent from 1929 to 2012. There is no support for fear of deflation.

Chart IV-14, US, Price Index of Personal Consumption Expenditures, Annual, 1929-2012

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

Chart IV-15 of the Bureau of Labor Statistics (BLS) provides the consumer price index from 1914 to 2012. There is long-term inflation and no evidence in support of fear of deflation.

Chart IV-15, US, Consumer Price Index, Annual, 1914-2012

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

Chart IV-16 provides the BEA annual index of PCE prices excluding food and energy. The average rate of increase from 1929 to 2012 is 3.2 percent.

Chart IV-16, US, Price Index of Personal Consumption Expenditures Excluding Food and Energy, Annual, 1929-2013

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

Chart IV-17 of the Bureau of Labor Statistics (BLS) provides the annual consumer price index excluding food and energy from 1957 to 2012. There is long-term, fluctuating inflation.

Chart IV-17, US, Consumer Price Index Excluding Food and Energy, Annual, 1957-2012

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

Unconventional monetary policy of zero interest rates and quantitative easing has been used in Japan and now also in the US. Table IV-7 provides the consumer price index of Japan, with inflation of 1.5 percent in 12 months ending in Nov 2013 and change of 0.0 percent NSA (not-seasonally-adjusted) in Nov 2013. Inflation of consumer prices in the first three months of 2012 annualizes at 0.0 percent NSA. Inflation in Mar-Nov 2013 not seasonally adjusted annualizes at 2.0 percent. There are negative percentage changes in most of the 12-month rates in 2011 with the exception of Jul and Aug both with 0.2 percent and stability in Sep. All 12-month rates of inflation in the first five months of 2013 are negative. Inflation in the 12 months ending in Jun 2013 was 0.2 percent and 0.7 percent in the 12 months ending in Jul 2013. Inflation increased to 0.9 percent in the 12 months ending in Aug 2013 and 1.1 percent in the 12 months ending in Sep 2013. Inflation was 1.1 percent in the 12 months ending in Oct 2013 and 1.5 percent in the 12 months ending in Nov 2013. There are ten years of deflation, three of zero inflation and only five of inflation in the annual rate of inflation from 1995 to 2012. This experience is entirely different from that of the US that shows long-term inflation. There is only one annual negative change of the CPI all items of the US in Table IV-5, minus 0.4 percent in 2009 but following 3.8 percent in 2008 because of carry trades from policy rates moving to zero in 2008 during a global contraction that were reversed because of risk aversion in late 2008 and early 2009, causing decreasing commodity prices. Both the US and Japan experienced high rates of inflation during the US Great Inflation of the 1970s (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). It is difficult to justify unconventional monetary policy because of risks of deflation similar to that experienced in Japan. Fear of deflation as had occurred during the Great Depression and in Japan was used as an argument for the first round of unconventional monetary policy with 1 percent interest rates from Jun 2003 to Jun 2004. The 1 percent interest rate combined with quantitative easing in the form of withdrawal of supply of 30-year securities by suspension of the auction of 30-year Treasury bonds with the intention of reducing mortgage rates. For fear of deflation, see Pelaez and Pelaez, International Financial Architecture (2005), 18-28, and Pelaez and Pelaez, The Global Recession Risk (2007), 83-95. The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html

Table IV-7, Japan, Consumer Price Index, All Items ∆%

	∆% Month NSA	∆% 12-Month NSA
Nov 2013	0.0	1.5
Oct	0.1	1.1
Sep	0.3	1.1
Aug	0.3	0.9
Jul	0.2	0.7
Jun	0.0	0.2
May	0.1	-0.3
Apr	0.3	-0.7
Mar	0.2	-0.9
Feb	-0.2	-0.7
Jan	0.0	-0.3
Dec 2012	0.0	-0.1
Nov	-0.4	-0.2
Oct	0.0	-0.4
Sep	0.1	-0.3
Aug	0.1	-0.4
Jul	-0.3	-0.4
Jun	-0.5	-0.2
May	-0.3	0.2
Apr	0.1	0.4
Mar	0.5	0.5
Feb	0.2	0.3
Jan	0.2	0.1
Dec 2011	0.0	-0.2
Nov	-0.6	-0.5
Oct	0.1	-0.2
Sep	0.0	0.0
Aug	0.1	0.2
Jul	0.0	0.2
Jun	-0.2	-0.4
May	0.0	-0.4
Apr	0.1	-0.5
Mar	0.3	-0.5
Feb	0.0	-0.5
Jan	-0.1	-0.6
Dec 2010	–0.3	0.0
	CPI All Items USA	CPI All Items Japan
Annual
2012	2.1	0.0
2011	3.2	-0.3
2010	1.6	-0.7
2009	-0.4	-1.4
2008	3.8	1.4
2007	2.8	0.0
2006	3.2	0.3
2005	3.4	-0.3
2004	2.7	0.0
2003	2.3	-0.3
2002	1.6	-0.9
2001	2.8	-0.7
2000	3.4	-0.7
1999	2.2	-0.3
1998	1.6	0.6
1997	2.3	1.8
1996	3.0	0.1
1995	2.8	-0.1
1994	2.6	0.7
1993	3.0	1.3
1992	3.0	1.6
1991	4.2	3.3
1990	5.4	3.1
1989	4.8	2.3
1988	4.1	0.7
1987	3.6	0.1
1986	1.9	0.6
1985	3.6	2.0
1984	4.3	2.3
1983	3.2	1.9
1982	6.2	2.8
1981	10.3	4.9
1980	13.5	7.7
1979	11.3	3.7
1978	7.6	4.2
1977	6.5	8.1
1976	5.8	9.4
1975	9.1	11.7
1974	11.0	23.2
1973	6.2	11.7
1972	3.2	4.9
1971	4.4	6.3

Source: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications

Japan’s Statistics Bureau at the Ministry of Internal Affairs and Communications provides the consumer price index for all items and regions of Japan monthly from 1971 to 2013 with 2010=100, shown in Chart IV-18. There was inflation in Japan during the 1970s and 1980s similar to other countries and regions. The index shows stability after the 1990s with sporadic cases of deflation. Slower growth with sporadic inflation has been characterized as a “lost decade” in Japan (see Pelaez and Pelaez, The Global Recession Risk (2007), 82-115).

Chart IV-18, Japan, Consumer Price Index All Items, All Japan, Index 2010=100, Monthly, 1970-2013

Source: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications

Chart IV-19 provides the US consumer price index NSA from 1914 to 2013. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

Chart IV-19, US, Consumer Price Index, All Items, NSA, 1914-2013

Source: US Bureau of Labor Statistics

Chart IV-20 of the Statistics Bureau of the Ministry of Internal Affairs and Communications of Japan provides 12-month percentage changes of the consumer price index for all items and regions of Japan monthly from 1971 to 2013. Japan experienced the same inflation waves of the United States during the Great Inflation of the 1970s followed by similar low inflation after the inflation-control increase of interest rates in the early 1980s. Numerous cases of negative inflation or deflation are observed after the 1990s.

Chart IV-20, Japan, CPI All Items, All Japan, 12-Month ∆%, 1971-2013

Sources: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications

Chart IV-21 provides 12-month percentage changes of the US consumer price index from 1914 to 2013. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Table IV-5 provides similar inflation waves in the economy of Japan with 11.7 percent in 1973, 23.1 percent in 1974 and 11.7 percent in 1975. The Great Inflation of the 1970s is analyzed in various comments of this blog (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and in Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). Inflation rates then stabilized in the US in a range with only two episodes above 5 percent. There are isolated cases of deflation concentrated over extended periods only during the 1930s. There is no case in United States economic history for unconventional monetary policy because of fear of deflation. There are cases of long-term deflation without lost decades or depressions.

Delfim Netto (1958) partly reprinted in Pelaez (1973) conducted two classical nonparametric tests (Mann 1945, Wallis and Moore 1941; see Kendall and Stuart 1968) with coffee-price data in the period of free markets from 1857 to 1906 with the following conclusions (Pelaez, 1976a, 280):

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

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

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

Imlah (1958) provides decline of British export prices at 0.5 percent in the nineteenth century and there were no lost decades, depressions or unconventional monetary policies in the highly dynamic economy of England that provided the world’s growth impulse. The experience of the United Kingdom with deflation and economic growth is relevant and rich. Yearly percentage changes of the composite index of prices of the United Kingdom of O’Donoghue and Goulding (2004) provide strong evidence. There are 73 declines of inflation in the 145 years from 1751 to 1896. Prices declined in 50.3 percent of 145 years. Some price declines were quite sharp and many occurred over several years. O’Donoghue and Goulding (2004) also provide inflation data for the UK from 1929 to 1934. Deflation was much sharper in continuous years in earlier periods than during the Great Depression. The United Kingdom could not have led the world in modern economic growth if there were meaningful causality from deflation to depression.

Chart IV-21, US, Consumer Price Index, All Items, NSA, 12-Month Percentage Change 1914-2013

Source: US Bureau of Labor Statistics

Chart IV-22 provides the US consumer price index excluding food and energy from 1957 (when it first becomes available) to 2013. There is long-term inflation in the US without episodes of deflation that would justify symmetric inflation targets to increase inflation from low levels.

Chart IV-22, US, Consumer Price Index Excluding Food and Energy, NSA, 1957-2013

Source: US Bureau of Labor Statistics

Chart IV-23 provides 12-month percentage changes of the consumer price index excluding food and energy from 1958 (when it first becomes available) to 2013. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.

Chart IV-23, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1958-2013

Source: US Bureau of Labor Statistics

More detail on the consumer price index of Japan in Apr is in Table IV-8. Items rich in commodities, such as 5.7 percent in fuel, light and water charges in 12 months with decrease of 0.3 percent in the month of Nov, have driven inflation in the 12 months ending in Nov 2013. Fiscal and monetary policies promoting devaluation of the yen are causing inflation in Japan. There is similar behavior in the preliminary estimate for Dec for the Ku Area of Tokyo with decrease of 0.9 percent of fuel, light and water charges and increase of 3.8 percent in 12 months. There is 12-month increase of 2.3 percent of CPI transport and communications. The CPI excluding fresh food, which is the inflation indicator of the Bank of Japan, increased 0.8 percent in the 12 months ending in Aug 2013. There is mild deflation in the CPI excluding food, alcoholic beverages and energy with minus 0.1 percent in the 12 months ending in Aug 2013 and increase of 0.2 percent in Aug 2013. The CPI excluding imputed rent changed 0.0 percent in Nov 2013 and increased 1.9 percent in 12 months. The all-items CPI estimate for Dec 2013 of the Ku-Area of Tokyo shows change of 0.0 percent in Dec 2013 and 0.9 percent in 12 months.

Table IV-8, Japan, Consumer Price Index, ∆%

2013	Nov 2013/Oct 2013 ∆%	Year ∆%
CPI All Items	0.0	1.5
CPI Excluding Fresh Food	0.0	1.2
CPI Excluding Food, Alcoholic Beverages and Energy	0.0	0.6
CPI Goods	0.1	2.5
CPI Services	-0.1	0.6
CPI Excluding Imputed Rent	0.0	1.9
CPI Fuel, Light, Water Charges	-0.3	5.7
CPI Transport & Communications	-0.1	2.3
CPI Ku-Area Tokyo All Items	0.0	0.9
Fuel, Light, Water Charges Ku Area Tokyo	-0.9	3.8

Note: Ku-area Tokyo CPI data preliminary for Dec 2013

Sources: Japan, Statistics Bureau, Ministry of Internal Affairs and Communications