Competitive Monetary Policy and Competitive Devaluations, Rules, Discretionary Authorities and Slow Productivity Growth, Twenty Seven Million Unemployed or Underemployed, Stagnating Real Wages, United States International Trade, World Cyclical Slow Growth and Global Recession Risk: Part III

 

Competitive Monetary Policy and Competitive Devaluations, Rules, Discretionary Authorities and Slow Productivity Growth, Twenty Seven Million Unemployed or Underemployed, Stagnating Real Wages, United States International Trade, World Cyclical Slow Growth and Global Recession Risk

Carlos M. Pelaez

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014

I Twenty Seven Million Unemployed or Underemployed

IA1 Summary of the Employment Situation

IA2 Number of People in Job Stress

IA3 Long-term and Cyclical Comparison of Employment

IA4 Job Creation

IIB Stagnating Real Wages

II Rules, Discretionary Authorities and Slow Productivity Growth

IIA United States International Trade

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

IIA United States International Trade. Table IIA-1 provides the trade balance of the US and monthly growth of exports and imports seasonally adjusted with the latest release and revisions (http://www.census.gov/foreign-trade/). Because of heavy dependence on imported oil, fluctuations in the US trade account originate largely in fluctuations of commodity futures prices caused by carry trades from zero interest rates into commodity futures exposures in a process similar to world inflation waves (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html). The Census Bureau revised data for 2014, 2013 and 2012. Exports increased 2.1 percent from May to Jul 2014 while imports fell 0.5 percent. The trade deficit fell from $43.465 million in May 2014 to $40.546 million in Jul 2014. The US trade balance improved from deficits of $39,083 million in Oct 2013 and $42,263 million in Sep 2013 to deficit of $35,972 million in Nov 2013 but higher deficit of $37,393 million in Dec 2013. The trade deficit increased to $39,181 million in Jan 2014 and deficit of $42,230 million in Feb 2014. The trade deficit increased to $43,124 million in Mar 2014 and $45,977 million in May 2014. The deficit improved to $43,465 million in May 2014 and $40,810 million in Jun 2014. The trade deficit improved to $40,546 million in Jul 2014. Exports increased 0.5 percent in Nov 2013 while imports fell 0.9 percent. Exports fell 1.1 percent in Dec 2013 while imports decreased 0.3 percent. Exports decreased 0.2 percent in Jan 2014 and imports increased 0.6 percent. In Feb 2014, exports fell 2.4 percent while imports decreased 0.7 percent. Exports increased 3.3 percent in Mar 2013 while imports increased 3.1 percent. In Apr 2014, exports changed 0.0 percent while imports increased 1.2 percent. Exports increased 1.2 percent in May 2014 while imports fell 0.1 percent. Exports changed 0.0 percent in Jun 2014 while imports fell 1.1 percent. In Jul 2014, exports increased 0.9 percent while imports increased 0.7 percent. The trade balance deteriorated from cumulative deficit of $494,658 million in Jan-Dec 2010 to deficit of $548,625 million in Jan-Dec 2011 and improved to marginally lower deficit of $537,605 million in Jan-Dec 2012. The trade deficit improved to $476,392 million in Jan-Dec 2013.

Table IIA-1, US, Trade Balance of Goods and Services Seasonally Adjusted Millions of Dollars and ∆%  

	Trade Balance	Exports	Month ∆%	Imports	Month ∆%
Jul 2014	-40,546	198,023	0.9	238,568	0.7
Jun	-40,810	196,203	0.0	237,013	-1.1
May	-43,465	196,173	1.2	239,637	-0.1
Apr	-45,977	193,881	0.0	239,858	1.2
Mar	-43,124	193,940	3.3	237,064	3.1
Feb	-42,230	187,773	-2.4	230,003	-0.7
Jan	-39,181	192,475	-0.2	231,655	0.6
Dec 2013	-37,393	192,799	-1.1	230,193	-0.3
Nov	-35,972	194,922	0.5	230,894	-0.9
Oct	-39,083	193,971	2.0	233,053	0.2
Sep	-42,263	190,249	-0.2	232,512	1.0
Aug	-39,515	190,606	0.4	230,121	0.3
Jul	-39,419	189,902	-0.2	229,321	1.1
Jun	-36,552	190,366	1.7	226,918	-2.2
May	-44,831	187,206	-0.3	232,037	1.7
Apr	-40,417	187,763	0.5	228,180	1.9
Mar	-36,973	186,903	-0.6	223,876	-2.6
Feb	-41,770	188,030	0.3	229,800	0.1
Jan	-42,205	187,478	-1.2	229,683	1.0
Jan-Dec 2013	-476,392	2,280,194		2,756,586
Dec 2012	-37,634	189,765	1.9	227,399	-2.4
Nov	-46,604	186,286	1.5	232,891	3.1
Oct	-42,358	183,512	-2.7	225,870	-1.3
Sep	-40,150	188,696	3.2	228,846	0.6
Aug	-44,536	182,845	-0.5	227,380	-0.1
Jul	-43,834	183,673	-0.9	227,507	-0.4
Jun	-43,078	185,330	0.6	228,408	-1.3
May	-47,184	184,306	-0.1	231,490	-0.4
Apr	-47,773	184,543	-0.9	232,317	-1.6
Mar	-49,850	186,257	2.5	236,107	4.9
Feb	-43,338	181,720	1.2	225,058	-2.5
Jan	-51,266	179,606	0.2	230,873	0.2
Jan-Dec 2012	-537,605	2,216,540		2,754,145
Jan-Dec 2011	-548,625	2,127,021		2,675,646
Jan-Dec 2010	-494,658	1,853,606		2,348,263

Note: Trade Balance of Goods = Exports of Goods less Imports of Goods. Trade balance may not add exactly because of errors of rounding and seasonality. Source: US Census Bureau, Foreign Trade Division

http://www.census.gov/foreign-trade/

Table IIA-1B provides US exports, imports and the trade balance of goods. The US has not shown a trade surplus in trade of goods since 1976. The deficit of trade in goods deteriorated sharply during the boom years from 2000 to 2007. The deficit improved during the contraction in 2009 but deteriorated in the expansion after 2009. The deficit could deteriorate sharply with growth at full employment.

Table IIA-1B, US, International Trade Balance of Goods, Exports and Imports of Goods, Millions of Dollars, Census Basis

	Balance	∆%	Exports	∆%	Imports	∆%
1960	4,608	(X)	19,626	(X)	15,018	(X)
1961	5,476	18.8	20,190	2.9	14,714	-2.0
1962	4,583	-16.3	20,973	3.9	16,390	11.4
1963	5,289	15.4	22,427	6.9	17,138	4.6
1964	7,006	32.5	25,690	14.5	18,684	9.0
1965	5,333	-23.9	26,699	3.9	21,366	14.4
1966	3,837	-28.1	29,379	10.0	25,542	19.5
1967	4,122	7.4	30,934	5.3	26,812	5.0
1968	837	-79.7	34,063	10.1	33,226	23.9
1969	1,289	54.0	37,332	9.6	36,043	8.5
1970	3,224	150.1	43,176	15.7	39,952	10.8
1971	-1,476	-145.8	44,087	2.1	45,563	14.0
1972	-5,729	288.1	49,854	13.1	55,583	22.0
1973	2,389	-141.7	71,865	44.2	69,476	25.0
1974	-3,884	-262.6	99,437	38.4	103,321	48.7
1975	9,551	-345.9	108,856	9.5	99,305	-3.9
1976	-7,820	-181.9	116,794	7.3	124,614	25.5
1977	-28,352	262.6	123,182	5.5	151,534	21.6
1978	-30,205	6.5	145,847	18.4	176,052	16.2
1979	-23,922	-20.8	186,363	27.8	210,285	19.4
1980	-19,696	-17.7	225,566	21.0	245,262	16.6
1981	-22,267	13.1	238,715	5.8	260,982	6.4
1982	-27,510	23.5	216,442	-9.3	243,952	-6.5
1983	-52,409	90.5	205,639	-5.0	258,048	5.8
1984	-106,702	103.6	223,976	8.9	330,678	28.1
1985	-117,711	10.3	218,815	-2.3	336,526	1.8
1986	-138,279	17.5	227,159	3.8	365,438	8.6
1987	-152,119	10.0	254,122	11.9	406,241	11.2
1988	-118,526	-22.1	322,426	26.9	440,952	8.5
1989	-109,399	-7.7	363,812	12.8	473,211	7.3
1990	-101,719	-7.0	393,592	8.2	495,311	4.7
1991	-66,723	-34.4	421,730	7.1	488,453	-1.4
1992	-84,501	26.6	448,164	6.3	532,665	9.1
1993	-115,568	36.8	465,091	3.8	580,659	9.0
1994	-150,630	30.3	512,626	10.2	663,256	14.2
1995	-158,801	5.4	584,742	14.1	743,543	12.1
1996	-170,214	7.2	625,075	6.9	795,289	7.0
1997	-180,522	6.1	689,182	10.3	869,704	9.4
1998	-229,758	27.3	682,138	-1.0	911,896	4.9
1999	-328,821	43.1	695,797	2.0	1,024,618	12.4
2000	-436,104	32.6	781,918	12.4	1,218,022	18.9
2001	-411,899	-5.6	729,100	-6.8	1,140,999	-6.3
2002	-468,263	13.7	693,103	-4.9	1,161,366	1.8
2003	-532,350	13.7	724,771	4.6	1,257,121	8.2
2004	-654,830	23.0	814,875	12.4	1,469,704	16.9
2005	-772,373	18.0	901,082	10.6	1,673,455	13.9
2006	-827,971	7.2	1,025,967	13.9	1,853,938	10.8
2007	-808,763	-2.3	1,148,199	11.9	1,956,962	5.6
2008	-816,199	0.9	1,287,442	12.1	2,103,641	7.5
2009	-503,582	-38.3	1,056,043	-18.0	1,559,625	-25.9
2010	-635,362	26.2	1,278,495	21.1	1,913,857	22.7
2011	-725,447	14.2	1,482,508	16.0	2,207,954	15.4
2012	-730,599	0.7	1,545,703	4.3	2,276,302	3.1
2013	-688,728	-5.7	1,579,593	2.2	2,268,321	-0.4

Source: US Census Bureau, Foreign Trade Division

http://www.census.gov/foreign-trade/

Chart IIA-1 of the US Census Bureau of the Department of Commerce shows that the trade deficit (gap between exports and imports) fell during the economic contraction after 2007 but has grown again during the expansion. The low average rate of growth of GDP of 2.2 percent during the expansion beginning since IIIQ2009 does not deteriorate further the trade balance. Higher rates of growth may cause sharper deterioration.

Chart IIA-1, US, International Trade Balance, Exports and Imports of Goods and Services USD Billions

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr042.html

Table IIA-2B provides the US international trade balance, exports and imports of goods and services on an annual basis from 1992 to 2013. The trade balance deteriorated sharply over the long term. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US not seasonally adjusted increased from $81.0 billion in IQ2013 to $86.1 billion in IQ2014. The current account deficit seasonally adjusted at annual rate fell from 2.6 percent of GDP in IQ2013 to 2.0 percent of GDP in IVQ2013, increasing to 2.6 percent of GDP in IQ2014 (http://cmpassocregulationblog.blogspot.com/2014/06/valuation-risks-world-inflation-waves.html). The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71). The last row of Table IIA-2B shows marginal improvement of the trade deficit from $548,625 million in 2011 to lower $537,605 million in 2012 with exports growing 4.2 percent and imports 2.9 percent. The trade balance improved further to deficit of $476,392 million in 2013 with growth of exports of 2.9 percent while imports stagnated. Growth and commodity shocks under alternating inflation waves (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html) have deteriorated the trade deficit from the low of $383,774 million in 2009.

Table IIA-2B, US, International Trade Balance of Goods and Services, Exports and Imports of Goods and Services, SA, Millions of Dollars, Balance of Payments Basis

	Balance	Exports	∆%	Imports	∆%
1960	3,508	25,940	NA	22,432	NA
1961	4,195	26,403	1.8	22,208	-1.0
1962	3,370	27,722	5.0	24,352	9.7
1963	4,210	29,620	6.8	25,410	4.3
1964	6,022	33,341	12.6	27,319	7.5
1965	4,664	35,285	5.8	30,621	12.1
1966	2,939	38,926	10.3	35,987	17.5
1967	2,604	41,333	6.2	38,729	7.6
1968	250	45,543	10.2	45,293	16.9
1969	91	49,220	8.1	49,129	8.5
1970	2,254	56,640	15.1	54,386	10.7
1971	-1,302	59,677	5.4	60,979	12.1
1972	-5,443	67,222	12.6	72,665	19.2
1973	1,900	91,242	35.7	89,342	23.0
1974	-4,293	120,897	32.5	125,190	40.1
1975	12,404	132,585	9.7	120,181	-4.0
1976	-6,082	142,716	7.6	148,798	23.8
1977	-27,246	152,301	6.7	179,547	20.7
1978	-29,763	178,428	17.2	208,191	16.0
1979	-24,565	224,131	25.6	248,696	19.5
1980	-19,407	271,834	21.3	291,241	17.1
1981	-16,172	294,398	8.3	310,570	6.6
1982	-24,156	275,236	-6.5	299,391	-3.6
1983	-57,767	266,106	-3.3	323,874	8.2
1984	-109,072	291,094	9.4	400,166	23.6
1985	-121,880	289,070	-0.7	410,950	2.7
1986	-138,538	310,033	7.3	448,572	9.2
1987	-151,684	348,869	12.5	500,552	11.6
1988	-114,566	431,149	23.6	545,715	9.0
1989	-93,141	487,003	13.0	580,144	6.3
1990	-80,864	535,233	9.9	616,097	6.2
1991	-31,135	578,344	8.1	609,479	-1.1
1992	-39,212	616,882	6.7	656,094	7.6
1993	-70,311	642,863	4.2	713,174	8.7
1994	-98,493	703,254	9.4	801,747	12.4
1995	-96,384	794,387	13.0	890,771	11.1
1996	-104,065	851,602	7.2	955,667	7.3
1997	-108,273	934,453	9.7	1,042,726	9.1
1998	-166,140	933,174	-0.1	1,099,314	5.4
1999	-258,617	969,867	3.9	1,228,485	11.8
2000	-372,517	1,075,321	10.9	1,447,837	17.9
2001	-361,511	1,005,654	-6.5	1,367,165	-5.6
2002	-418,955	978,706	-2.7	1,397,660	2.2
2003	-493,890	1,020,418	4.3	1,514,308	8.3
2004	-609,883	1,161,549	13.8	1,771,433	17.0
2005	-714,245	1,286,022	10.7	2,000,267	12.9
2006	-761,716	1,457,642	13.3	2,219,358	11.0
2007	-705,375	1,653,548	13.4	2,358,922	6.3
2008	-708,726	1,841,612	11.4	2,550,339	8.1
2009	-383,774	1,583,053	-14.0	1,966,827	-22.9
2010	-494,658	1,853,606	17.1	2,348,263	19.4
2011	-548,625	2,127,021	14.8	2,675,646	13.9
2012	-537,605	2,216,540	4.2	2,754,145	2.9
2013	-476,392	2,280,194	2.9	2,756,586	0.1

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr042.html

Chart IIA-2 of the US Census Bureau provides the US trade account in goods and services SA from Jan 1992 to Jul 2014. There is long-term trend of deterioration of the US trade deficit shown vividly by Chart IIA-2. The global recession from IVQ2007 to IIQ2009 reversed the trend of deterioration. Deterioration resumed together with incomplete recovery and was influenced significantly by the carry trade from zero interest rates to commodity futures exposures (these arguments are elaborated in 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 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). Earlier research focused on the long-term external imbalance of the US in the form of trade and current account deficits (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). US external imbalances have not been fully resolved and tend to widen together with improving world economic activity and commodity price shocks.

Chart IIA-2, US, Balance of Trade SA, Monthly, Millions of Dollars, Jan 1992-Jul 2014

Source: US Census Bureau

http://www.census.gov/foreign-trade/

Chart IIA-3 of the US Census Bureau provides US exports SA from Jan 1992 to Jul 2014. There was sharp acceleration from 2003 to 2007 during worldwide economic boom and increasing inflation. Exports fell sharply during the financial crisis and global recession from IVQ2007 to IIQ2009. Growth picked up again together with world trade and inflation but stalled in the final segment with less rapid global growth and inflation.

Chart IIA-3, US, Exports SA, Monthly, Millions of Dollars Jan 1992-Jul 2014

Source: US Census Bureau

http://www.census.gov/foreign-trade/

Chart IIA-4 of the US Census Bureau provides US imports SA from Jan 1992 to Jul 2014. Growth was stronger between 2003 and 2007 with worldwide economic boom and inflation. There was sharp drop during the financial crisis and global recession. There is stalling import levels in the final segment resulting from weaker world economic growth and diminishing inflation because of risk aversion and portfolio reallocations from commodity exposures to equities.

Chart IIA-4, US, Imports SA, Monthly, Millions of Dollars Jan 1992-Jul 2014

Source: US Census Bureau

http://www.census.gov/foreign-trade/

There is deterioration of the US trade balance in goods from deficit of $58,021 million in Jul 2013 to deficit of $60,191 million in Jul 2014. The nonpetroleum deficit increased by $6,706 million while the petroleum deficit shrank by $4,518 million. Total exports of goods increased 24.3 percent in Jul 2014 relative to a year earlier while total imports increased 4.1 percent. Nonpetroleum exports increased 3.5 percent from Jul 2013 to Jul 2014 while nonpetroleum imports increased 6.9 percent. Petroleum imports fell 9.0 percent.

Table IIA-3, US, International Trade in Goods Balance, Exports and Imports $ Millions and ∆% SA

	Jul 2014	Jul 2013	∆%
Total Balance	-60,191	-58,021
Petroleum	-14,472	-18,990
Non Petroleum	-44,737	-38,031
Total Exports	138,574	132,830	4.3
Petroleum	13,820	12,093	14.3
Non Petroleum	123,765	119,563	3.5
Total Imports	198,765	190,851	4.1
Petroleum	28,292	31,083	-9.0
Non Petroleum	168,502	157,594	6.9

Details may not add because of rounding and seasonal adjustment

Source: US Census Bureau

http://www.census.gov/foreign-trade/

US exports and imports of goods not seasonally adjusted in Jan-Jul 2014 and Jan-Jul 2013 are in Table IIA-4. The rate of growth of exports was 3.2 percent and 3.3 percent for imports. The US has partial hedge of commodity price increases in exports of agricultural commodities that increased 9.3 percent and of mineral fuels that increased 16.4 percent both because prices of raw materials and commodities increase and fall recurrently as a result of shocks of risk aversion and portfolio reallocations. The US exports an insignificant amount of crude oil. US exports and imports consist mostly of manufactured products, with less rapidly increasing prices. US manufactured exports increased 0.8 percent while manufactured imports rose 4.5 percent. Significant part of the US trade imbalance originates in imports of mineral fuels decreasing 4.8 percent and petroleum decreasing 6.2 percent with wide oscillations in oil prices. The limited hedge in exports of agricultural commodities and mineral fuels compared with substantial imports of mineral fuels and crude oil results in waves of deterioration of the terms of trade of the US, or export prices relative to import prices, originating in commodity price increases caused by carry trades from zero interest rates. These waves are similar to those in worldwide inflation (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html).

Table IIA-4, US, Exports and Imports of Goods, Not Seasonally Adjusted Millions of Dollars and %, Census Basis

	Jan-Jul 2014 $ Millions	Jan-Jul 2014 $ Millions	∆%
Exports	936,890	908,087	3.2
Manufactured	690,407	684,844	0.8
Agricultural Commodities	85,393	78,121	9.3
Mineral Fuels	92,905	79,782	16.4
Petroleum	75,943	65,718	15.6
Imports	1,350,310	1,306,999	3.3
Manufactured	1,096,547	1,049,772	4.5
Agricultural Commodities	66,376	62,876	5.6
Mineral Fuels	214,378	225,103	-4.8
Petroleum	201,938	215,341	-6.2

Source: US Census Bureau

http://www.census.gov/foreign-trade/

http://www.census.gov/foreign-trade/

The current account of the US balance of payments is provided in Table IIA-5 for IQ2013 and IQ2014. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US not seasonally adjusted increased from $81.0 billion in IQ2013 to $86.1 billion in IQ2014. The current account deficit seasonally adjusted at annual rate fell from 2.6 percent of GDP in IQ2013 to 2.0 percent of GDP in IVQ2013, increasing to 2.6 percent of GDP in IQ2014. The ratio of the current account deficit to GDP has stabilized below 3 percent of GDP compared with much higher percentages before the recession but is combined now with much higher imbalance in the Treasury budget (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71).

Table IIA-5, US, Balance of Payments, Millions of Dollars NSA

	IQ2013	IQ2014	Difference
Goods Balance	-156,922	-158,746	-1,824
X Goods	386,924	396,135	2.4 ∆%
M Goods	-543,846	-554,881	2.0 ∆%
Services Balance	58,560	57,565	-995
X Services	166,192	170,588	2.6 ∆%
M Services	-107,632	-113,023	5.0 ∆%
Balance Goods and Services	-98,362	-101,181	-2,819
Exports of Goods and Services and Income Receipts	772,204	794,134
Imports of Goods and Services and Income Payments	-853,226	-880,265
Current Account Balance	-81,022	-86,131	-5,109
% GDP	IQ2013	IQ2014	IVQ2013
	2.6	2.6	2.0

X: exports; M: imports

Balance on Current Account = Exports of Goods and Services – Imports of Goods and Services and Income Payments

Source: Bureau of Economic Analysis

http://www.bea.gov/international/index.htm#bop

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

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

The alternative fiscal scenario of the CBO (2012NovCDR, 2013Sep17) resembles an economic world in which eventually the placement of debt reaches a limit of what is proportionately desired of US debt in investment portfolios. This unpleasant environment is occurring in various European countries.

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

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.

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

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

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

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

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

The BEA introduced new concepts and methods (http://www.bea.gov/international/concepts_methods.htm) in comprehensive restructuring on Jun 18, 2014 (http://www.bea.gov/international/modern.htm):

“BEA introduced a new presentation of the International Transactions Accounts on June 18, 2014 and will introduce a new presentation of the International Investment Position on June 30, 2014. These new presentations reflect a comprehensive restructuring of the international accounts that enhances the quality and usefulness of the accounts for customers and bring the accounts into closer alignment with international guidelines.”

Table IIA-6 provides data on the US fiscal and balance of payments imbalances incorporating all revisions and methods. In 2007, the federal deficit of the US was $161 billion corresponding to 1.1 percent of GDP while the Congressional Budget Office estimates the federal deficit in 2012 at $1087 billion or 6.8 percent of GDP. The estimate of the deficit for 2013 is $680 billion or 4.1 percent of GDP. The combined record federal deficits of the US from 2009 to 2012 are $5090 billion or 31.6 percent of the estimate of GDP for fiscal year 2012 implicit in the CBO (CBO 2013Sep11) estimate of debt/GDP. The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5.090 trillion in four years, using the fiscal year deficit of $1087 billion for fiscal year 2012, which is the worst fiscal performance since World War II. Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5090 billion. Federal debt in 2012 was 70.1 percent of GDP (CBO 2013Sep11) and 72.1 percent of GDP in 2013 (http://www.cbo.gov/). This situation may worsen in the future (CBO 2013Sep17):

“Between 2009 and 2012, the federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing federal debt to soar. Federal debt held by the public is now about 73 percent of the economy’s annual output, or gross domestic product (GDP). That percentage is higher than at any point in U.S. history except a brief period around World War II, and it is twice the percentage at the end of 2007. If current laws generally remained in place, federal debt held by the public would decline slightly relative to GDP over the next several years, CBO projects. After that, however, growing deficits would ultimately push debt back above its current high level. CBO projects that federal debt held by the public would reach 100 percent of GDP in 2038, 25 years from now, even without accounting for the harmful effects that growing debt would have on the economy. Moreover, debt would be on an upward path relative to the size of the economy, a trend that could not be sustained indefinitely.

The gap between federal spending and revenues would widen steadily after 2015 under the assumptions of the extended baseline, CBO projects. By 2038, the deficit would be 6½ percent of GDP, larger than in any year between 1947 and 2008, and federal debt held by the public would reach 100 percent of GDP, more than in any year except 1945 and 1946. With such large deficits, federal debt would be growing faster than GDP, a path that would ultimately be unsustainable.

Incorporating the economic effects of the federal policies that underlie the extended baseline worsens the long-term budget outlook. The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. With those effects included, debt under the extended baseline would rise to 108 percent of GDP in 2038.”

Table IIA-6, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2007	2008	2009	2010	2011	2012	2013
Goods & Services	-705	-709	-384	-495	-549	-538	-476
Primary Income	101	146	124	178	221	203	200
Second-ary Income	-114	-124	-121	-127	-132	-126	-124
Current Account	-719	-687	-381	-444	-459	-461	-400
NGDP	14480	14720	14418	14958	15534	16245	16799
Current Account % GDP	-4.9	-4.7	-2.6	-3.0	-2.9	-2.8	-2.4
NIIP	-1279	-3995	-2628	-2512	-4455	-4578	-5383
US Owned Assets Abroad	20705	19423	19426	21768	22209	22520	23710
Foreign Owned Assets in US	21984	23418	22054	24280	26664	27098	29093
NIIP % GDP	-8.8	-27.1	-18.2	-16.8	-28.7	-28.2	-32.0
Exports Goods, Services and Income	2569	2751	2286	2631	2988	3085	3179
NIIP % Exports Goods, Services and Income	-50	-145	-115	-95	-149	-148	-169
DIA MV	5858	3707	4945	5486	5215	5938	7080
DIUS MV	4134	3091	3619	4099	4199	4671	5791
Fiscal Balance	-161	-459	-1413	-1294	-1300	-1087	-680
Fiscal Balance % GDP	-1.1	-3.1	-9.8	-8.8	-8.4	-6.8	-4.1
Federal   Debt	5035	5803	7545	9019	10128	11281	11982
Federal Debt % GDP	35.1	39.3	52.3	61.0	65.8	70.1	72.1
Federal Outlays	2729	2983	3518	3457	3603	3537	3455
∆%	2.8	9.3	17.9	-1.7	4.2	-1.8	-2.3
% GDP	19.0	20.2	24.4	23.4	23.4	22.0	20.8
Federal Revenue	2568	2524	2105	2163	2304	2450	2775
∆%	6.7	-1.7	-16.6	2.7	6.5	6.3	13.3
% GDP	17.9	17.1	14.6	14.6	15.0	15.2	16.7

Sources: 

Notes: NGDP: nominal GDP or in current dollars; NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value. There are minor discrepancies in the decimal point of percentages of GDP between the balance of payments data and federal debt, outlays, revenue and deficits in which the original number of the CBO source is maintained. See Bureau of Economic Analysis, US International Economic Accounts: Concepts and Methods. 2014. Washington, DC: BEA, Department of Commerce, Jun 2014 http://www.bea.gov/international/concepts_methods.htm These discrepancies do not alter conclusions. Budget http://www.cbo.gov/ Balance of Payments and NIIP http://www.bea.gov/international/index.htm#bop Gross Domestic Product, Bureau of Economic Analysis (BEA) http://www.bea.gov/iTable/index_nipa.cfm

Table IIA-7 provides quarterly estimates NSA of the external imbalance of the United States. The current account deficit seasonally adjusted falls from 2.6 percent of GDP in IVQ2012 to 2.6 percent in IQ2013, 2.5 percent in IIQ2013, 2.4 percent of GDP in IIIQ2013 and 2.0 percent of GDP in IVQ2013. The deficit increases to 2.6 percent of GDP in IQ2014. The net international investment position increases from $4.6 trillion in IVQ2012 to $5.1 trillion in IQ2013 and $5.5 trillion in IIQ2013, decreasing to $5.0 trillion in IIIQ2013 but increasing to $5.4 trillion in IVQ2013 and $5.5 trillion in IQ2014.

Table IIA-7, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and % NSA

	IQ2013	IIQ2013	IIIQ2013	IVQ2013	IQ2014
Goods & Services	-98	-130	-137	-111	-101
Primary Income	48	47	51	53	47
Secondary Income	-31	-30	-33	-29	-32
Current Account	-81	-113	-119	-87	-86
Current Account % GDP	-2.6	-2.5	-2.4	-2.0	-2.6
NIIP	-5111	-5524	-4995	-5383	-5539
US Owned Assets Abroad	22650	21904	22954	23710	23601
Foreign Owned Assets in US	-27761	-27428	-27949	-29093	-29141
DIA MV	6185	6147	6690	7080	7143
DIA MV Equity	5237	5162	5699	6070	6135
DIUS MV	5019	5132	5342	5791	5698
DIUS MV Equity	3753	3845	4041	4462	4393

Notes: NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value. See Bureau of Economic Analysis, US International Economic Accounts: Concepts and Methods. 2014. Washington, DC: BEA, Department of Commerce, Jun 2014 http://www.bea.gov/international/concepts_methods.htm

Sources: US Bureau of Economic Analysis http://www.bea.gov/international/index.htm#bop

Chart VI-10 of the Board of Governors of the Federal Reserve System provides the overnight Fed funds rate on business days from Jul 1, 1954 at 1.13 percent through Jan 10, 1979, at 9.91 percent per year, to Sep 4, 2014, at 0.09 percent per year. US recessions are in shaded areas according to the reference dates of the NBER 4 (http://www.nber.org/cycles.html). In the Fed effort to control the “Great Inflation” of the 1930s (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html), the fed funds rate increased from 8.34 percent on Jan 3, 1979 to a high in Chart VI-10 of 22.36 percent per year on Jul 22, 1981 with collateral adverse effects in the form of impaired savings and loans associations in the United States, emerging market debt and money-center banks (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 72-7; Pelaez 1986, 1987). Another episode in Chart VI-10 is the increase in the fed funds rate from 3.15 percent on Jan 3, 1994, to 6.56 percent on Dec 21, 1994, which also had collateral effects in impairing emerging market debt in Mexico and Argentina and bank balance sheets in a world bust of fixed income markets during pursuit by central banks of non-existing inflation (Pelaez and Pelaez, International Financial Architecture (2005), 113-5). Another interesting policy impulse is the reduction of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of equally non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85), followed by increments of 25 basis points from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006 in Chart VI-10. Central bank commitment to maintain the fed funds rate at 1.00 percent induced adjustable-rate mortgages (ARMS) linked to the fed funds rate. Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment but the exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at interest rates close to zero, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV).

The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper with the objective of purchasing default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever-increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). A final episode in Chart VI-10 is the reduction of the fed funds rate from 5.41 percent on Aug 9, 2007, to 2.97 percent on October 7, 2008, to 0.12 percent on Dec 5, 2008 and close to zero throughout a long period with the final point at 0.09 percent on Sep 4, 2014. Evidently, this behavior of policy would not have occurred had there been theory, measurements and forecasts to avoid these violent oscillations that are clearly detrimental to economic growth and prosperity without inflation. Current policy consists of forecast mandate of maintaining policy accommodation until the forecast of the rate of unemployment reaches 6.5 percent and the rate of personal consumption expenditures excluding food and energy reaches 2.5 percent (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm). The FOMC dropped the numbers but affirmed guidance (http://www.federalreserve.gov/newsevents/press/monetary/20140319a.htm): “With the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward guidance. The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements.” It is a forecast mandate because of the lags in effect of monetary policy impulses on income and prices (Romer and Romer 2004). The intention is to reduce unemployment close to the “natural rate” (Friedman 1968, Phelps 1968) of around 5 percent and inflation at or below 2.0 percent. If forecasts were reasonably accurate, there would not be policy errors. A commonly analyzed risk of zero interest rates is the occurrence of unintended inflation that could precipitate an increase in interest rates similar to the Himalayan rise of the fed funds rate from 9.91 percent on Jan 10, 1979, at the beginning in Chart VI-10, to 22.36 percent on Jul 22, 1981. There is a less commonly analyzed risk of the development of a risk premium on Treasury securities because of the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html

and earlier http://cmpassocregulationblog.blogspot.com/2014/02/theory-and-reality-of-cyclical-slow.html and earlier (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html) together with unresolved external imbalances (http://cmpassocregulationblog.blogspot.com/2014/06/valuation-risks-world-inflation-waves.html). There is not a fiscal cliff or debt limit issue ahead but rather free fall into a fiscal abyss. The combination of the fiscal abyss with zero interest rates could trigger the risk premium on Treasury debt or Himalayan hike in interest rates.

Chart VI-10, US, Fed Funds Rate, Business Days, Jul 1, 1954 to Sep 4, 2014, Percent per Year

Source: Board of Governors of the Federal Reserve System

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

There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table VI-7G when monetary policy pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table VI-7G shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.

Table VI-7G, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994

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

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

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

Chart VI-14 provides the overnight fed funds rate, the yield of the 10-year Treasury constant maturity bond, the yield of the 30-year constant maturity bond and the conventional mortgage rate from Jan 1991 to Dec 1996. In Jan 1991, the fed funds rate was 6.91 percent, the 10-year Treasury yield 8.09 percent, the 30-year Treasury yield 8.27 percent and the conventional mortgage rate 9.64 percent. Before monetary policy tightening in Oct 1993, the rates and yields were 2.99 percent for the fed funds, 5.33 percent for the 10-year Treasury, 5.94 for the 30-year Treasury and 6.83 percent for the conventional mortgage rate. After tightening in Nov 1994, the rates and yields were 5.29 percent for the fed funds rate, 7.96 percent for the 10-year Treasury, 8.08 percent for the 30-year Treasury and 9.17 percent for the conventional mortgage rate.

Chart VI-14, US, Overnight Fed Funds Rate, 10-Year Treasury Constant Maturity, 30-Year Treasury Constant Maturity and Conventional Mortgage Rate, Monthly, Jan 1991 to Dec 1996

Source: Board of Governors of the Federal Reserve System

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

Chart VI-15 of the Bureau of Labor Statistics provides the all items consumer price index from Jan 1991 to Dec 1996. There does not appear acceleration of consumer prices requiring aggressive tightening.

Chart VI-15, US, Consumer Price Index All Items, Jan 1991 to Dec 1996

Source: Bureau of Labor Statistics

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

Chart IV-16 of the Bureau of Labor Statistics provides 12-month percentage changes of the all items consumer price index from Jan 1991 to Dec 1996. Inflation collapsed during the recession from Jul 1990 (III) and Mar 1991 (I) and the end of the Kuwait War on Feb 25, 1991 that stabilized world oil markets. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). Policy tightening had adverse collateral effects in the form of emerging market crises in Mexico and Argentina and fixed income markets worldwide.

Chart VI-16, US, Consumer Price Index All Items, Twelve-Month Percentage Change, Jan 1991 to Dec 1996

Source: Bureau of Labor Statistics

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

The Congressional Budget Office (CBO 2014BEOFeb4) estimates potential GDP, potential labor force and potential labor productivity provided in Table IB-3. The CBO estimates average rate of growth of potential GDP from 1950 to 2012 at 3.3 percent per year. The projected path is significantly lower at 2.1 percent per year from 2013 to 2024. The legacy of the economic cycle expansion from IIIQ2009 to IVQ2013 at 2.1 percent on average is in contrast with 5.0 percent on average in the expansion from IQ1983 to IIQ1987 (http://cmpassocregulationblog.blogspot.com/2014/06/financial-indecision-mediocre-cyclical.html). Subpar economic growth may perpetuate unemployment and underemployment estimated at 26.8 million or 16.2 percent of the effective labor force in Jun 2014 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financial-risks-rules-discretionary.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2014/06/financialgeopolitical-risks-recovery.html).

Table IB-3, US, Congressional Budget Office History and Projections of Potential GDP of US Overall Economy, ∆%

	Potential GDP	Potential Labor Force	Potential Labor Productivity*
Average Annual ∆%
1950-1973	3.9	1.6	2.3
1974-1981	3.2	2.5	0.8
1982-1990	3.2	1.6	1.6
1991-2001	3.2	1.3	1.9
2002-2012	2.2	0.8	1.4
2007-2012	1.7	0.6	1.1
Total 1950-2012	3.3	1.5	1.8
Projected Average Annual ∆%
2013-2018	2.1	0.6	1.5
2019-2024	2.1	0.5	1.6
2013-2024	2.1	0.5	1.6

*Ratio of potential GDP to potential labor force

Source: CBO (2014BEOFeb4), CBO, Key assumptions in projecting potential GDP—February 2014 baseline. Washington, DC, Congressional Budget Office, Feb 4, 2014.

Chart IB-1 of the Congressional Budget Office (CBO 2013BEOFeb5) provides actual and potential GDP of the United States from 2000 to 2011 and projected to 2024. Lucas (2011May) estimates trend of United States real GDP of 3.0 percent from 1870 to 2010 and 2.2 percent for per capita GDP. The United States successfully returned to trend growth of GDP by higher rates of growth during cyclical expansion as analyzed by Bordo (2012Sep27, 2012Oct21) and Bordo and Haubrich (2012DR). Growth in expansions following deeper contractions and financial crises was much higher in agreement with the plucking model of Friedman (1964, 1988). The unusual weakness of growth at 2.2 percent on average from IIIQ2009 to IIQ2014 during the current economic expansion in contrast with 5.0 percent on average in the cyclical expansion from IQ1983 to IQ1987 (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html) cannot be explained by the contraction of 4.3 percent of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 26.9 million or 16.4 percent of the labor force as estimated for Aug 2014 (Section I and earlier (http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). There is no exit from unemployment/underemployment and stagnating real wages because of the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2014/08/weakening-world-economic-growth.html). The US economy and labor markets collapsed without recovery. Abrupt collapse of economic conditions can be explained only with cyclic factors (Lazear and Spletzer 2012Jul22) and not by secular stagnation (Hansen 1938, 1939, 1941 with early dissent by Simons 1942).

Chart IB-1, US, Congressional Budget Office, Actual and Projections of Potential GDP, 2000-2024, Trillions of Dollars

Source: Congressional Budget Office, CBO (2013BEOFeb5). The last year in common in both projections is 2017. The revision lowers potential output in 2017 by 7.3 percent relative to the projection in 2007.

Chart IB-2 provides differences in the projections of potential output by the CBO in 2007 and more recently on Feb 4, 2014, which the CBO explains in CBO (2014Feb28).

Chart IB-2, Congressional Budget Office, Revisions of Potential GDP

Source: Congressional Budget Office, 2014Feb 28. Revisions to CBO’s Projection of Potential Output since 2007. Washington, DC, CBO, Feb 28, 2014.

Chart IB-3 provides actual and projected potential GDP from 2000 to 2024. The gap between actual and potential GDP disappears at the end of 2017 (CBO2014Feb4). GDP increases in the projection at 2.5 percent per year.

Chart IB-3, Congressional Budget Office, GDP and Potential GDP

Source: CBO (2013BEOFeb5), CBO, Key assumptions in projecting potential GDP—February 2014 baseline. Washington, DC, Congressional Budget Office, Feb 4, 2014.

Chart IIA2-3 of the Bureau of Economic Analysis of the Department of Commerce shows on the lower negative panel the sharp increase in the deficit in goods and the deficits in goods and services from 1960 to 2012. The upper panel shows the increase in the surplus in services that was insufficient to contain the increase of the deficit in goods and services. The adjustment during the global recession has been in the form of contraction of economic activity that reduced demand for goods.

Chart IIA2-3, US, Balance of Goods, Balance on Services and Balance on Goods and Services, 1960-2013, Millions of Dollars

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

Chart IIA2-4 of the Bureau of Economic Analysis shows exports and imports of goods and services from 1960 to 2012. Exports of goods and services in the upper positive panel have been quite dynamic but have not compensated for the sharp increase in imports of goods. The US economy apparently has become less competitive in goods than in services.

Chart IIA2-4, US, Exports and Imports of Goods and Services, 1960-2013, Millions of Dollars

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

Chart IIA2-5 of the Bureau of Economic Analysis shows the US balance on current account from 1960 to 2012. The sharp devaluation of the dollar resulting from unconventional monetary policy of zero interest rates and elimination of auctions of 30-year Treasury bonds did not adjust the US balance of payments. Adjustment only occurred after the contraction of economic activity during the global recession.

Chart IIA2-5, US, Balance on Current Account, 1960-2013, Millions of Dollars

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

Chart IIA2-6 of the Bureau of Economic Analysis provides real GDP in the US from 1960 to 2013. The contraction of economic activity during the global recession was a major factor in the reduction of the current account deficit as percent of GDP.

Chart IIA2-6, US, Real GDP, 1960-2013, Billions of Chained 2009 Dollars

Source: Bureau of Economic Analysis

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

Chart IIA-7 provides the US current account deficit on a quarterly basis from 1980 to IQ2013. The deficit is at a lower level because of growth below potential not only in the US but worldwide. The combination of high government debt and deficit with external imbalance restricts potential prosperity in the US.

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

Source: Bureau of Economic Analysis

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

Risk aversion channels funds toward US long-term and short-term securities that finance the US balance of payments and fiscal deficits benefitting from risk flight to US dollar denominated assets. There are now temporary interruptions because of fear of rising interest rates that erode prices of US government securities because of mixed signals on monetary policy and exit from the Fed balance sheet of four trillion dollars of securities held outright. Net foreign purchases of US long-term securities (row C in Table VA-4) decreased from $18.6 billion in May 2014 to minus $18.7 billion in Jun 2014. Foreign (residents) purchases minus sales of US long-term securities (row A in Table VA-4) in May 2014 of $34.6 billion decreased to minus $18.4 billion in Jun 2014. Net US (residents) purchases of long-term foreign securities (row B in Table VA-4) improved from minus $16.0 billion in May 2014 to minus $0.4 billion in Jun 2014. In Jun 2014,

C = A + B = -$18.4 billion - $0.4 billion = $18.7 billion

There are minor rounding errors. There is weakening demand in Table VA-4 in Jun in A1 private purchases by residents overseas of US long-term securities of minus $44.6 billion of which deterioration in A11 Treasury securities of minus $40.8 billion, deterioration in A12 of minus $1.6 billion in agency securities, improvement of minus $3.3 billion of corporate bonds and deterioration of $1.1 billion in equities. Worldwide risk aversion causes flight into US Treasury obligations with significant oscillations. Official purchases of securities in row A2 increased $26/3 billion with increase of Treasury securities of $20.0 billion in Jun 2014. Official purchases of agency securities increased $5.0 billion in Jun. Row D shows decrease in Jun 2014 of $5.7 billion in purchases of short-term dollar denominated obligations. Foreign private holdings of US Treasury bills decreased $4.3 billion (row D11) with foreign official holdings decreasing $20.2 billion while the category “other” increased $10.2 billion. Foreign private holdings of US Treasury bills increased $4.3 billion in what could be arbitrage of duration exposures. Risk aversion of default losses in foreign securities dominates decisions to accept zero interest rates in Treasury securities with no perception of principal losses. In the case of long-term securities, investors prefer to sacrifice inflation and possible duration risk to avoid principal losses with significant oscillations in risk perceptions.

Table VA-4, Net Cross-Borders Flows of US Long-Term Securities, Billion Dollars, NSA

	Jun 2013 12 Months	Jun 2014 12 Months	May 2014	Jun 2014
A Foreign Purchases less Sales of US LT Securities	323.7	199.7	34.6	-18.4
A1 Private	132.5	149.4	10.2	-44.6
A11 Treasury	-12.7	179.9	5.3	-40.8
A12 Agency	69.3	2.8	2.8	-1.6
A13 Corporate Bonds	8.0	-23.8	-9.0	-3.3
A14 Equities	68.0	-9.5	11.0	1.1
A2 Official	191.2	50.3	24.4	26.3
A21 Treasury	110.0	17.1	19.7	20.0
A22 Agency	53.6	41.1	3.7	5.0
A23 Corporate Bonds	19.5	6.7	1.2	-0.3
A24 Equities	8.2	-14.5	-0.2	1.5
B Net US Purchases of LT Foreign Securities	-145.8	-195.0	-16.0	-0.4
B1 Foreign Bonds	-35.2	-21.7	0.2	-13.2
B2 Foreign Equities	-110.6	-173.3	-16.2	12.8
C Net Foreign Purchases of US LT Securities	178.0	4.7	18.6	-18.7
D Increase in Foreign Holdings of Dollar Denominated Short-term	48.5	-39.0	2.3	-5.7
D1 US Treasury Bills	45.3	-48.5	-5.0	-15.9
D11 Private	47.0	-26.8	-1.8	4.3
D12 Official	-1.7	-21.7	-3.2	-20.2
D2 Other	3.2	9.5	7.2	10.2

C = A + B;

A = A1 + A2

A1 = A11 + A12 + A13 + A14

A2 = A21 + A22 + A23 + A24

B = B1 + B2

D = D1 + D2

Sources: United States Treasury

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

Table VA-5 provides major foreign holders of US Treasury securities. China is the largest holder with $1268.4 billion in Jun 2014, decreasing 0.6 percent from $1275.8 billion in Jun 2013 while decreasing $2.5 billion from May 2014 or 0.2 percent. The United States Treasury estimates US government debt held by private investors at $9800 billion in Mar 2014. China’s holding of US Treasury securities represent 12.9 percent of US government marketable interest-bearing debt held by private investors (http://www.fms.treas.gov/bulletin/index.html). Min Zeng, writing on “China plays a big role as US Treasury yields fall,” on Jul 16, 2004, published in the Wall Street Journal (http://online.wsj.com/articles/china-plays-a-big-role-as-u-s-treasury-yields-fall-1405545034?tesla=y&mg=reno64-wsj), finds that acceleration in purchases of US Treasury securities by China has been an important factor in the decline of Treasury yields in 2014. Japan increased its holdings from $1083.3 billion in Jun 2013 to $1219.5 billion in Jun 2014 or 12.6 percent. The combined holdings of China and Japan in Jun 2014 add to $2488 billion, which is equivalent to 25.4 percent of US government marketable interest-bearing securities held by investors of $9800 billion in Mar 2014 (http://www.fms.treas.gov/bulletin/index.html). Total foreign holdings of Treasury securities rose from $5595.0 billion in Jun 2013 to $6013.0 billion in Jun 2014, or 7.5 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Pelaez and Pelaez, The Global Recession Risk (2007)). A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt. In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

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

Table VA-5, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Jun 2014	May 2014	Jun 2013
Total	6013.2	5976.5	5595.0
China	1268.4	1270.9	1275.8
Japan	1219.5	1220.1	1083.3
Belgium	364.1	362.4	176.2
Caribbean Banking Centers	308.3	310.9	286.3
Oil Exporters	262.1	257.9	256.9
Brazil	253.7	250.1	253.7
Taiwan	179.4	174.4	186.1
Switzerland	175.9	174.0	180.3
United Kingdom	173.7	179.9	162.6
Hong Kong	158.2	155.8	124.2
Luxembourg	146.2	142.0	150.5
Russia	113.9	111.4	138.0
Ireland	113.0	108.0	121.2
Foreign Official Holdings	4108.2	4092.2	4012.2
A. Treasury Bills	341.0	361.2	362.7
B. Treasury Bonds and Notes	3767.2	3731.0	3649.5

Source: United States Treasury

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

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, increase of wealth of households over the business cycle by total 7.3 percent adjusted for inflation from IVQ2007 to IVQ2013 while growing at 3.1 percent per year adjusted for inflation from IVQ1945 to IVQ2013 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 Aug 29 and daily values throughout the week ending on Sep 7, 2014 of various financial assets. Section VI Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Aug 29 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Aug 29, 2014”, first row “USD/EUR 1.3133 0.8% 0.4%,” provides the information that the US dollar (USD) appreciated 0.8 percent to USD 1.3242/EUR in the week ending on Fri Aug 29 relative to the exchange rate on Fri Aug 22 and appreciated 0.4 percent relative to Thu Aug 28. 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 fluctuating interest rates. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3133/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Aug 29, depreciating to USD 1.3150/EUR on Wed Sep 3, 2014, or by 0.1 percent. The dollar appreciated because more dollars, 1.3150, were required on Wed Sep 3 to buy one euro than $1.3133 on Fri Aug 29. 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 1.3133/EUR on Aug 29. The second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Aug 29, to the last business day of the current week, in this case Fri Sep 5, such as appreciation of 1.4 percent to USD 1.2952/EUR by Sep 5. The third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (denoted by positive sign) by 1.4 percent from the rate of USD 1.3133/EUR on Fri Aug 29 to the rate of USD 1.2952/EUR on Fri Sep 5 {[(1.2952/1.3133) – 1]100 = -1.4%}. The dollar depreciated (denoted by negative sign) by 0.1 percent from the rate of USD 1.2944 on Thu Sep 4 to USD 1.2952/EUR on Fri Sep 5 {[(1.2952/1.2944) -1]100 = -0.4 %}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European and global 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 Sep 1 to Sep 5, 2014

Fri Aug  29 2014	Mon 1	Tue 2	Wed 3	Thu 4	Fri 5
USD/ EUR 1.3133 0.8% 0.4%	1.3129 0.0% 0.0%	1.3134 0.0% 0.0%	1.3150 -0.1% -0.1%	1.2944 1.4% 1.6%	1.2952 1.4% -0.1%
JPY/ USD 104.07 -0.1% -0.3%	104.35 -0.3% -0.3%	105.09 -1.0% -0.7%	104.80 -0.7% 0.3%	105.26 -1.1% -0.4%	105.09 -1.0% 0.2%
CHF/ USD 0.9183 -0.5% -0.3%	0.9196 -0.1% -0.1%	0.9190 -0.1% 0.1%	0.9177 0.1% 0.1%	0.9319 -1.5% -1.5%	0.9311 -1.4% 0.1%
CHF/ EUR 1.2060 0.3% 0.0%	1.2073 -0.1% -0.1%	1.2070 -0.1% 0.0%	1.2067 -0.1% 0.0%	1.2063 0.0% 0.0%	1.2059 0.0% 0.0%
USD/ AUD 0.9338 1.0709 0.2% -0.2%	0.9332 1.0716 -0.1% -0.1%	0.9276 1.0781 -0.7% -0.6%	0.9346 1.0700 0.1% 0.7%	0.9350 1.0695 0.1% 0.0%	0.9377 1.0664 0.4% 0.3%
10Y Note 2.342	2.342	2.421	2.398	2.451	2.457
2Y Note 0.490	0.490	0.526	0.518	0.534	0.510
German Bond 2Y -0.04 10Y 0.89	2Y -0.05 10Y 0.88	2Y -0.04 10Y 0.93	2Y -0.03 10Y 0.95	2Y -0.08 10Y 0.97	2Y -0.08 10Y 0.93
DJIA 17098.45 0.6% 0.1%	17098.45 0.0% 0.0%	17067.56 -0.2% -0.2%	17078.28 -0.1% 0.1%	17069.58 -0.2% -0.1%	17137.36 0.2% 0.4%
Dow Global 2620.67 0.6% 0.2%	2620.67 0.0% 0.0%	2620.58 0.0% 0.0%	2636.73 0.6% 0.6%	2631.41 0.4% -0.2%	2631.96 0.4% 0.0%
DJ Asia Pacific 1530.14 -0.3% -0.2%	1530.14 0.0% 0.0%	1530.99 0.1% 0.1%	1542.04 0.8% 0.7%	1538.79 0.6% -0.2%	1535.82 0.4% -0.2%
Nikkei 15424.59 -0.7% -0.2%	15476.60 0.3% 0.3%	15668.60 1.6% 1.2%	15728.35 2.0% 0.4%	15676.18 1.6% -0.3%	15668.68 1.6% 0.0%
Shanghai 2217.20 -1.1% 1.0%	2235.51 0.8% 0.8%	2266.05 2.2% 1.4%	2288.63 3.2% 1.0%	2306.86 4.0% 0.8%	2326.43 4.9% 0.8%
DAX 9470.17 1.4% 0.1%	9479.03 0.1% 0.1%	9507.02 0.4% 0.3%	9626.49 1.7% 1.3%	9724.26 2.7% 1.0%	9747.02 2.9% 0.2%
DJ UBS Comm. NA	NA	NA	NA	NA	NA
WTI $/B 95.96 2.5% 1.5%	95.96 0.0% 0.0%	92.88 -3.2% -3.2%	95.54 -0.4% 2.9%	94.45 -1.6% -1.1%	93.29 -2.8% -1.2%
Brent $/B 103.19 0.9% 0.7%	103.19 0.0% 0.0%	100.34 -2.8% -2.8%	102.77 -0.4% 2.4%	101.83 -1.3% -0.9%	100.82 -2.3% -1.0%
Gold $/OZ 1285.8 0.6% -0.2%	1285.8 0.0% 0.0%	1263.7 -1.7% -1.7%	1268.90 -1.3% 0.4%	1265.1 -1.6% -0.3%	1265.8 -1.6% 0.1%

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

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

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

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

There is initial discussion of current and recent risk-determining events followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate.

1 First, risk determining events. Jon Hilsenrath, writing on “New view into Fed’s response to crisis,” on Feb 21, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303775504579396803024281322?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes 1865 pages of transcripts of eight formal and six emergency policy meetings at the Fed in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm). If there were an infallible science of central banking, models and forecasts would provide accurate information to policymakers on the future course of the economy in advance. Such forewarning is essential to central bank science because of the long lag between the actual impulse of monetary policy and the actual full effects on income and prices many months and even years ahead (Romer and Romer 2004, Friedman 1961, 1953, Culbertson 1960, 1961, Batini and Nelson 2002). The transcripts of the Fed meetings in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm) analyzed by Jon Hilsenrath demonstrate that Fed policymakers frequently did not understand the current state of the US economy in 2008 and much less the direction of income and prices. The conclusion of Friedman (1953) is that monetary impulses increase financial and economic instability because of lags in anticipating needs of policy, taking policy decisions and effects of decisions. This is a fortiori true when untested unconventional monetary policy in gargantuan doses shocks the economy and financial markets.

In testimony on the Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, US House of Representatives, on Feb 11, 2014, Chair Janet Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm):

“Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and 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. That said, purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. In December of last year and again this January, the Committee said that its current expectation--based on its assessment of a broad range of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments--is 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 2 percent goal. I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level (emphasis added).”

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 Jul 30, 2014, the FOMC decided additional tapering monthly bond purchases. Earlier programs are continued with an additional lower open-ended $25 billion of bond purchases per month, increasing the stock of $4,139,056 million “securities held outright” and bank reserves deposited at the Fed of $2,789,406 million (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1) (http://www.federalreserve.gov/newsevents/press/monetary/20140730a.htm):

“The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in August, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $10 billion per month rather than $15 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than $20 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 as evident in the FOMC statement for Jul 30, 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20140730a.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 remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored” (emphasis added).

Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):

So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly” (emphasis added).

How long is “considerable time”? At the press conference following the meeting on Mar 19, 2014, Chair Yellen answered a question of Jon Hilsenrath of the Wall Street Journal explaining “In particular, the Committee has endorsed the view that it anticipates that will be a considerable period after the asset purchase program ends before it will be appropriate to begin to raise rates. And of course on our present path, well, that's not utterly preset. We would be looking at next, next fall. So, I think that's important guidance” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140319.pdf). Many focused on “next fall,” ignoring that the path of increasing rates is not “utterly preset.”

At a speech on Mar 31, 2014, Chair Yellen analyzed labor market conditions as follows (http://www.federalreserve.gov/newsevents/speech/yellen20140331a.htm):

“And based on the evidence available, it is clear to me that the U.S. economy is still considerably short of the two goals assigned to the Federal Reserve by the Congress. The first of those goals is maximum sustainable employment, the highest level of employment that can be sustained while maintaining a stable inflation rate. Most of my colleagues on the Federal Open Market Committee and I estimate that the unemployment rate consistent with maximum sustainable employment is now between 5.2 percent and 5.6 percent, well below the 6.7 percent rate in February.

Let me explain what I mean by that word "slack" and why it is so important.

Slack means that there are significantly more people willing and capable of filling a job than there are jobs for them to fill. During a period of little or no slack, there still may be vacant jobs and people who want to work, but a large share of those willing to work lack the skills or are otherwise not well suited for the jobs that are available. With 6.7 percent unemployment, it might seem that there must be a lot of slack in the U.S. economy, but there are reasons why that may not be true.”

Yellen (2014Aug22) provides comprehensive review of the theory and measurement of labor markets. Monetary policy 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”

Yellen (2014Aug22) finds that the unemployment rate is not sufficient in determining slack:

“One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.”

Yellen (2014Aug22) restates that the FOMC determines monetary policy on newly available information and interpretation of labor markets and inflation and does not follow a preset path:

“But if progress in the labor market continues to be more rapid than anticipated by the Committee or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter. Of course, if economic performance turns out to be disappointing and progress toward our goals proceeds more slowly than we expect, then the future path of interest rates likely would be more accommodative than we currently anticipate. As I have noted many times, monetary policy is not on a preset path. The Committee will be closely monitoring incoming information on the labor market and inflation in determining the appropriate stance of monetary policy.”

Yellen (2014Aug22) states that “Historically, slack has accounted for only a small portion of the fluctuations in inflation. Indeed, unusual aspects of the current recovery may have shifted the lead-lag relationship between a tightening labor market and rising inflation pressures in either direction.”

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?

Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):

So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly” (emphasis added).

In a speech at the IMF on Jul 2, 2014, Chair Yellen analyzed the link between monetary policy and financial risks (http://www.federalreserve.gov/newsevents/speech/yellen20140702a.htm):

“Monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

Yellen (2014Jul14) warned again at the Committee on Banking, Housing and Urban Affairs on Jul 15, 2014:

“The Committee recognizes that low interest rates may provide incentives for some investors to “reach for yield,” and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance. More broadly, the financial sector has continued to become more resilient, as banks have continued to boost their capital and liquidity positions, and growth in wholesale short-term funding in financial markets has been modest” (emphasis added).

Greenspan (1996) made similar warnings:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy” (emphasis added).

Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. What is the success in evaluating deviations of valuations of risk financial assets from “historical norms”? What are the consequences on economic activity and employment of deviations of valuations of risk financial assets from those “historical norms”? What are the policy tools and their effectiveness in returning valuations of risk financial assets to their “historical norms”?

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.

Professor Raguram G Rajan, governor of the Reserve Bank of India, which is India’s central bank, warned about risks in high valuations of asset prices in an interview with Christopher Jeffery of Central Banking Journal on Aug 6, 2014 (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). Professor Rajan demystifies in the interview “competitive easing” by major central banks as equivalent to competitive devaluation. Rajan (2005) anticipated the risks of the world financial crisis. Professor John B. Taylor (2014Jul15, 2014Jun26) building on advanced research (Taylor (1993, 1998LB, 1999, 1998LB, 1999, 2007JH, 2008Nov, 2009, 2012JMCB, 2014Jan3) finds that a monetary policy rule would function best in promoting an environment of low inflation and strong economic growth with stability of financial markets. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html).

In testimony before the Committee on the Budget of the US Senate on May 8, 2014, Chair Yellen provides analysis of the current economic situation and outlook (http://www.federalreserve.gov/newsevents/testimony/yellen20140507a.htm):

“The economy has continued to recover from the steep recession of 2008 and 2009. Real gross domestic product (GDP) growth stepped up to an average annual rate of about 3-1/4 percent over the second half of last year, a faster pace than in the first half and during the preceding two years. Although real GDP growth is currently estimated to have paused in the first quarter of this year, I see that pause as mostly reflecting transitory factors, including the effects of the unusually cold and snowy winter weather. With the harsh winter behind us, many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter. One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.

Conditions in the labor market have continued to improve. The unemployment rate was 6.3 percent in April, about 1-1/4 percentage points below where it was a year ago. Moreover, gains in payroll employment averaged nearly 200,000 jobs per month over the past year. During the economic recovery so far, payroll employment has increased by about 8-1/2 million jobs since its low point, and the unemployment rate has declined about 3-3/4 percentage points since its peak.

While conditions in the labor market have improved appreciably, they are still far from satisfactory. Even with recent declines in the unemployment rate, it continues to be elevated. Moreover, both the share of the labor force that has been unemployed for more than six months and the number of individuals who work part time but would prefer a full-time job are at historically high levels. In addition, most measures of labor compensation have been rising slowly--another signal that a substantial amount of slack remains in the labor market.

Inflation has been quite low even as the economy has continued to expand. Some of the factors contributing to the softness in inflation over the past year, such as the declines seen in non-oil import prices, will probably be transitory. Importantly, measures of longer-run inflation expectations have remained stable. That said, the Federal Open Market Committee (FOMC) recognizes that inflation persistently below 2 percent--the rate that the Committee judges to be most consistent with its dual mandate--could pose risks to economic performance, and we are monitoring inflation developments closely.

Looking ahead, I expect that economic activity will expand at a somewhat faster pace this year than it did last year, that the unemployment rate will continue to decline gradually, and that inflation will begin to move up toward 2 percent. A faster rate of economic growth this year should be supported by reduced restraint from changes in fiscal policy, gains in household net worth from increases in home prices and equity values, a firming in foreign economic growth, and further improvements in household and business confidence as the economy continues to strengthen. Moreover, U.S. financial conditions remain supportive of growth in economic activity and employment.”

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 differ from 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 http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html).

There is concern of declining inflation and appreciation of the euro. In the “Introductory statement to the press conference,” on May 8, 2014, the President of the European Central Bank Mario Draghi states (http://www.ecb.europa.eu/press/pressconf/2014/html/is140508.en.html):

“We will maintain a high degree of monetary accommodation and act swiftly, if required, with further monetary policy easing. We firmly reiterate that we continue to expect the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation is based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy, the high degree of unutilised capacity, and subdued money and credit creation. The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation. Further information and analysis concerning the outlook for inflation and the availability of bank loans to the private sector will be available in early June.”

The President of the ECB Mario Draghi analyzed unemployment in the euro area and the policy response policy in a speech at the Jackson Hole meeting of central bankers on Aug 22, 2014 (http://www.ecb.europa.eu/press/key/date/2014/html/sp140822.en.html):

“We have already seen exchange rate movements that should support both aggregate demand and inflation, which we expect to be sustained by the diverging expected paths of policy in the US and the euro area (Figure 7). We will launch our first Targeted Long-Term Refinancing Operation in September, which has so far garnered significant interest from banks. And our preparation for outright purchases in asset-backed security (ABS) markets is fast moving forward and we expect that it should contribute to further credit easing. Indeed, such outright purchases would meaningfully contribute to diversifying the channels for us to generate liquidity.”

On Sep 4, 2014, the European Central Bank lowered policy rates (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140904.en.html):

“4 September 2014 - Monetary policy decisions

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

1. The interest rate on the main refinancing operations of the Eurosystem will be decreased by 10 basis points to 0.05%, starting from the operation to be settled on 10 September 2014.
2. The interest rate on the marginal lending facility will be decreased by 10 basis points to 0.30%, with effect from 10 September 2014.
3. The interest rate on the deposit facility will be decreased by 10 basis points to -0.20%, with effect from 10 September 2014.”

The President of the European Central Bank announced on Sep 4, 2014, the decision to expand the balance sheet by purchases of asset-backed securities (ABS) in a new ABS Purchase Program (ABSPP) and covered bonds (http://www.ecb.europa.eu/press/pressconf/2014/html/is140904.en.html):

“Based on our regular economic and monetary analyses, the Governing Council decided today to lower the interest rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.05% and the rate on the marginal lending facility by 10 basis points to 0.30%. The rate on the deposit facility was lowered by 10 basis points to -0.20%. In addition, the Governing Council decided to start purchasing non-financial private sector assets. The Eurosystem will purchase a broad portfolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme (ABSPP). This reflects the role of the ABS market in facilitating new credit flows to the economy and follows the intensification of preparatory work on this matter, as decided by the Governing Council in June. In parallel, the Eurosystem will also purchase a broad portfolio of euro-denominated covered bonds issued by MFIs domiciled in the euro area under a new covered bond purchase programme (CBPP3). Interventions under these programmes will start in October 2014. The detailed modalities of these programmes will be announced after the Governing Council meeting of 2 October 2014. The newly decided measures, together with the targeted longer-term refinancing operations which will be conducted in two weeks, will have a sizeable impact on our balance sheet.”

On Jun 5, 2014, the European Central Bank introduced cuts in interest rates and a negative rate paid on deposits of banks (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140605.en.html):

“5 June 2014 - Monetary policy decisions

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

1. The interest rate on the main refinancing operations of the Eurosystem will be decreased by 10 basis points to 0.15%, starting from the operation to be settled on 11 June 2014.
2. The interest rate on the marginal lending facility will be decreased by 35 basis points to 0.40%, with effect from 11 June 2014.
3. The interest rate on the deposit facility will be decreased by 10 basis points to -0.10%, with effect from 11 June 2014. A separate press release to be published at 3.30 p.m. CET today will provide details on the implementation of the negative deposit facility rate.”

The ECB also introduced new measures of monetary policy on Jun 5, 2014 (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140605_2.en.html):

“5 June 2014 - ECB announces monetary policy measures to enhance the functioning of the monetary policy transmission mechanism

In pursuing its price stability mandate, the Governing Council of the ECB has today announced measures to enhance the functioning of the monetary policy transmission mechanism by supporting lending to the real economy. In particular, the Governing Council has decided:

1. To conduct a series of targeted longer-term refinancing operations (TLTROs) aimed at improving bank lending to the euro area non-financial private sector ^[1], excluding loans to households for house purchase, over a window of two years.
2. To intensify preparatory work related to outright purchases of asset-backed securities (ABS).”

The President of the European Central Bank (ECB) Mario Draghi analyzed the measures at a press conference (http://www.ecb.europa.eu/press/pressconf/2014/html/is140605.en.html).

The President of the European Central Bank (ECB) Mario Draghi reaffirmed the policy stance at the press conference following the meeting on Feb 6, 2014 (http://www.ecb.europa.eu/press/pressconf/2014/html/is140206.en.html): “As I have said several times we are willing to act and we stand ready to act. We confirmed our forward guidance, so interest rates will stay at the present or lower levels for an extended period of time.”

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:

1. 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.
2. The interest rate on the marginal lending facility will be decreased by 25 basis points to 0.75%, with effect from 13 November 2013.
3. 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 17,137.36 on Fr Sep 5, 2014, which is higher by 21.0 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 20.7 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs. Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):

So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly” (emphasis added).

In a speech at the IMF on Jul 2, 2014, Chair Yellen analyzed the link between monetary policy and financial risks (http://www.federalreserve.gov/newsevents/speech/yellen20140702a.htm):

“Monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

Yellen (2014Jul14) warned again at the Committee on Banking, Housing and Urban Affairs on Jul 15, 2014:

“The Committee recognizes that low interest rates may provide incentives for some investors to “reach for yield,” and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance. More broadly, the financial sector has continued to become more resilient, as banks have continued to boost their capital and liquidity positions, and growth in wholesale short-term funding in financial markets has been modest” (emphasis added).

Greenspan (1996) made similar warnings:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy” (emphasis added).

Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. What is the success in evaluating deviations of valuations of risk financial assets from “historical norms”? What are the consequences on economic activity and employment of deviations of valuations of risk financial assets from those “historical norms”? What are the policy tools and their effectiveness in returning valuations of risk financial assets to their “historical norms”?

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.

Professor Raguram G Rajan, governor of the Reserve Bank of India, which is India’s central bank, warned about risks in high valuations of asset prices in an interview with Christopher Jeffery of Central Banking Journal on Aug 6, 2014 (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). Professor Rajan demystifies in the interview “competitive easing” by major central banks as equivalent to competitive devaluation. Rajan (2005) anticipated the risks of the world financial crisis. Professor John B. Taylor (2014Jul15, 2014Jun26) building on advanced research (Taylor (1993, 1998LB, 1999, 1998LB, 1999, 2007JH, 2008Nov, 2009, 2012JMCB, 2014Jan3) finds that a monetary policy rule would function best in promoting an environment of low inflation and strong economic growth with stability of financial markets. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html).

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. Professor Rajan, in an interview with Kartik Goyal of Bloomberg (http://www.bloomberg.com/news/2014-01-30/rajan-warns-of-global-policy-breakdown-as-emerging-markets-slide.html), warns of breakdown of global policy coordination. 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 2.056 percent on Sep 5, 2014, and that of the ten-year sovereign bond of Italy at 2.256 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. In the week of Sep 5, 2014, the yield of the two-year Treasury increased to 0.510 percent and that of the ten-year Treasury increased to 2.457 percent while the yield of the two-year bond of Germany decreased to minus 0.08 percent and the ten-year yield increased to 0.93 percent; and the dollar appreciated at USD 1.2952/EUR. The zero interest rates for the monetary policy rate of the US, or fed funds rate, induce carry trades that ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield of 2.457 percent is higher than consumer price inflation of 2.0 percent in the 12 months ending in Jul 2014 (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2014/06/valuation-risks-world-inflation-waves.html and earlier http://cmpassocregulationblog.blogspot.com/2014/05/world-inflation-waves-squeeze-of.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.094 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 2.0 percent. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.

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

	US 2Y	US 10Y	DE 2Y	DE 10Y	USD/ EUR
09/05/14	0.510	2.457	-0.08	0.93	1.2952
08/29/14	0.490	2.342	-0.04	0.89	1.3133
08/22/14	0.490	2.399	0.00	0.98	1.3242
08/15/14	0.405	2.341	-0.02	0.95	1.3400
08/08/14	0.446	2.420	0.00	1.05	1.3411
08/01/14	0.470	2.497	0.02	1.13	1.3430
07/25/14	0.494	2.464	0.02	1.15	1.3431
07/18/14	0.478	2.484	0.02	1.15	1.3525
07/11/14	0.446	2.516	0.01	1.20	1.3608
07/04/14	0.502	2.641	0.02	1.26	1.3595
06/27/14	0.463	2.536	0.03	1.26	1.3649
06/20/14	0.458	2.609	0.03	1.34	1.3600
06/13/14	0.451	2.605	0.02	1.36	1.3540
06/06/14	0.405	2.598	0.05	1.35	1.3643
05/30/14	0.373	2.473	0.06	1.36	1.3632
05/23/14	0.345	2.532	0.06	1.41	1.3630
05/16/14	0.357	2.520	0.09	1.33	1.3694
05/09/14	0.385	2.624	0.13	1.45	1.3760
05/02/14	0.421	2.583	0.12	1.45	1.3873
04/25/14	0.432	2.668	0.17	1.48	1.3833
04/18/14	0.401	2.724	0.17	1.51	1.3813
04/11/14	0.357	2.628	0.16	1.50	1.3885
04/04/14	0.413	2.724	0.16	1.55	1.3704
03/28/14	0.448	2.721	0.14	1.55	1.3752
03/21/14	0.431	2.743	0.20	1.63	1.3793
03/14/14	0.340	2.654	0.15	1.54	1.3912
03/07/14	0.367	2.792	0.17	1.65	1.3877
02/28/14	0.323	2.655	0.13	1.62	1.3801
02/21/14	0.316	2.730	0.12	1.66	1.3739
02/14/14	0.313	2.743	0.11	1.68	1.3693
02/07/14	0.305	2.681	0.09	1.66	1.3635
1/31/14	0.330	2.645	0.07	1.66	1.3488
1/24/14	0.342	2.720	0.12	1.66	1.3677
1/17/14	0.373	2.818	0.17	1.75	1.3541
1/10/14	0.372	2.858	0.18	1.84	1.3670
1/3/14	0.398	2.999	0.20	1.94	1.3588
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:

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

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

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

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

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

Jon Hilsenrath, writing on “Fed maps exit from stimulus,” on May 11, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324744104578475273101471896.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the development of strategy for unwinding quantitative easing and how it can create uncertainty in financial markets. Jon Hilsenrath and Victoria McGrane, writing on “Fed slip over how long to keep cash spigot open,” published on Feb 20, 2013 in the Wall street Journal (http://professional.wsj.com/article/SB10001424127887323511804578298121033876536.html), analyze the minutes of the Fed, comments by members of the FOMC and data showing increase in holdings of riskier debt by investors, record issuance of junk bonds, mortgage securities and corporate loans.

Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.

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

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

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

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

The major risk event during earlier weeks was sharp decline of sovereign yields with the yield on the ten-year bond of Spain falling to 5.309 percent and that of the ten-year bond of Italy falling to 4.473 percent on Fri Nov 30, 2012 and 5.366 percent for the ten-year of Spain and 4.527 percent for the ten-year of Italy on Fri Nov 14, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Vanessa Mock and Frances Robinson, writing on “EU approves Spanish bank’s restructuring plans,” on Nov 28, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578146520774638316.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the European Union regulators approved restructuring of four Spanish banks (Bankia, NCG Banco, Catalunya Banc and Banco de Valencia), which helped to calm sovereign debt markets. Harriet Torry and James Angelo, writing on “Germany approves Greek aid,” on Nov 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578150532603095790.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the German parliament approved the plan to provide Greece a tranche of €44 billion in promised financial support, which is subject to sustainability analysis of the bond repurchase program later in Dec 2012. A hurdle for sustainability of repurchasing debt is that Greece’s sovereign bonds have appreciated significantly from around 24 percent for the bond maturing in 21 years and 20 percent for the bond maturing in 31 years in Aug 2012 to around 17 percent for the 21-year maturity and 15 percent for the 31-year maturing in Nov 2012. Declining years are equivalent to increasing prices, making the repurchase more expensive. Debt repurchase is intended to reduce bonds in circulation, turning Greek debt more manageable. Ben McLannahan, writing on “Japan unveils $11bn stimulus package,” on Nov 30, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/adc0569a-3aa5-11e2-baac-00144feabdc0.html#axzz2DibFFquN), informs that the cabinet in Japan approved another stimulus program of $11 billion, which is twice larger than another stimulus plan in late Oct and close to elections in Dec. Henry Sender, writing on “Tokyo faces weak yen and high bond yields,” published on Nov 29, 2012 in the Financial Times (http://www.ft.com/intl/cms/s/0/9a7178d0-393d-11e2-afa8-00144feabdc0.html#axzz2DibFFquN), analyzes concerns of regulators on duration of bond holdings in an environment of likelihood of increasing yields and yen depreciation.

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

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

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

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

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

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

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

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

“6 September 2012 - Technical features of Outright Monetary Transactions

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

Conditionality

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

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

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

Coverage

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

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

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

Creditor treatment

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

Sterilisation

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

Transparency

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

Securities Markets Programme

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

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

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

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

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

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

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

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

Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields together with the overnight fed funds rate, and the yield of the corporate bond with Moody’s rating of Baa. The riskier yield of the Baa corporate bond exceeds the relatively riskless yields of the Treasury securities. The beginning yields in Chart III-1A for Jan 2, 1962, are 2.75 percent for the fed fund rates and 4.06 percent for the ten-year Treasury constant maturity. On July 31, 2001, the yields in Chart III-1A are 3.67 percent for one month, 3.79 percent for two years, 5.07 percent for ten years, 3.82 percent for the fed funds rate and 7.85 percent for the Baa corporate bond. On July 30, 2007, yields inverted with the one-month at 4.95 percent, the two-year at 4.59 percent and the ten-year at 5.82 percent with the yield of the Baa corporate bond at 6.70 percent. Another interesting point is for Oct 31, 2008, with the yield of the Baa jumping to 9.54 percent and the Treasury yields declining: one month 0.12 percent, two years 1.56 percent and ten years 4.01 percent during a flight to the dollar and government securities analyzed by Cochrane and Zingales (2009). Another spike in the series is for Apr 4, 2006 with the yield of the corporate Baa bond at 8.63 and the Treasury yields of 0.12 percent for one month, 0.94 for two years and 2.95 percent for ten years. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield 1.64 percent and the ten-year yield 3.41. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe. The final point of Chart III1-A is for Sep 4, 2014, with the one-month yield at 0.02 percent, the two-year at 0.54 percent, the ten-year at 2.45 percent, the fed funds rate at 0.09 percent and the corporate Baa bond at 4.70 percent. There is an evident increase in the yields of the 10-year Treasury constant maturity and the Moody’s Baa corporate bond with subsequent decline in wide swings of portfolio reallocations.

Chart III-1A, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields, Overnight Fed Funds Rate and Yield of Moody’s Baa Corporate Bond, Jan 2, 1962-Sep 4, 2014

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Inyoung Hwang, writing on “Fed optimism spurs record bets against stock volatility,” on Aug 21, 2014, published in Bloomberg.com (http://www.bloomberg.com/news/2014-08-21/fed-optimism-spurs-record-bets-against-stock-voalitlity.html), informs that the S&P 500 is trading at 16.6 times estimated earnings, which is higher than the five-year average of 14.3 Tom Lauricella, writing on Mar 31, 2014, on “Stock investors see hints of a stronger quarter,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304157204579473513864900656?mod=WSJ_smq0314_LeadStory&mg=reno64-wsj), finds views of stronger earnings among many money managers with positive factors for equity markets in continuing low interest rates and US economic growth. There is important information in the Quarterly Markets review of the Wall Street Journal (http://online.wsj.com/public/page/quarterly-markets-review-03312014.html) for IQ2014. 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, real gross private domestic investment in the US was $951.6 billion of chained 2009 dollars, growing to $1,254.6 billion in IVQ1987 or 31.8 percent. Real gross private domestic investment in the US increased 3.4 percent from $2,605.2 billion of chained 2009 dollars in IVQ2007 to $2,694.7 billion in IIQ2014, which is stagnation in comparison with growth of 31.8 percent in the comparable first twenty quarters of expansion from IQ1983 to IVQ1987. As shown in Table IAI-2, real private fixed investment changed 0.0 percent from $2,586.3 billion of chained 2009 dollars in IVQ2007 to $2,586.3 billion in IIQ2014. There is a statistical coincidence that the value of private fixed investment in the US is exactly equal in chained 2009 dollars at $2586.3 billion in IVQ2007 and in IIQ2014. Growth of real private investment is mediocre for all but four quarters from IIQ2011 to IQ2012.

The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Undistributed corporate profits swelled 250.8 percent from $107.7 billion in IQ2007 to $377.8 billion in IIQ2014 and changed signs from minus $55.9 billion in current dollars in IVQ2007. Corporate profits with IVA and CCA rebounded with $37.1 billion in IIIQ2013 and $3.1 billion in IVQ2013. Corporate profits with IVA and CCA increased $154.9 billion in IIQ2014. In IIIQ2013, profits after tax with IVA and CCA increased $28.7 billion and decreased $24.7 billion in IVQ2013. In IQ2014, profits after tax with IVA and CCA decreased $268.6 billion. Profits after tax with IVA and CCA increased at $115.2 billion in IIQ2014. Net dividends fell at $187.0 billion in IIIQ2013 and increased at $80.6 billion in IVQ2013. Net dividends fell at $89.5 billion in IIQ2014 and fell at $1.3 billion in IIQ2014. Undistributed profits with IVA and CCA rose at $215.8 billion in IIIQ2013 and fell at $105.5 billion in IVQ2013. Undistributed corporate profits swelled 250.8 percent from $107.7 billion in IQ2007 to $377.8 billion in IIQ2014 and changed signs from minus $55.9 billion in current dollars in IVQ2007. Uncertainty originating in fiscal, regulatory and monetary policy causes wide swings in expectations and decisions by the private sector with adverse effects on investment, real economic activity and employment. The investment decision of US business is fractured. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

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

declines. Equally, decline in expected revenue from the stock or project, R_τ, causes decline in valuation.

There is mixed performance in equity indexes with several indexes in Table III-1 increasing in the week ending on Sep 5, 2014, after wide swings caused by reallocations of investment portfolios worldwide. Stagnating revenues, corporate cash hoarding and declining investment are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. DJIA increased 0.4 percent on Sep 5, increasing 0.2 percent in the week. Germany’s DAX increased 0.2 percent on Sep 5 and increased 2.9 percent in the week. Dow Global increased 0.2 percent on Aug 29 and increased 0.4 percent in the week. Japan’s Nikkei Average changed 0.0 percent on Sep 5 and increased 1.6 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 decreased 0.2 percent on Sep 5 and increased 0.4 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 2326.43 on Sep 5 for increase of 0.8 percent and increasing 4.9 percent in the week. 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 Sep 5, 2014. Table III-1 shows that WTI decreased 2.8 percent in the week of Sep 5 while Brent decreased 1.0 percent in the week with turmoil in the Middle East. Gold increased 0.1 percent on Sep 5 and decreased 1.6 percent in the week.

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €517,578 million on Aug 29, 2014, 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 €1,077,431 million in the statement of Aug 29, 2014, with marginal reduction. There is high credit risk in these transactions with capital of only €95,312 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Aug 29, 2014
1 Gold and other Receivables	367,402	419,822	334,433
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	249,547
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	24,229
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	20,881
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	517,578
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	62,628
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	559,853
8 General Government Debt Denominated in Euro	34,954	33,928	26,709
9 Other Assets	278,719	336,574	242,857
TOTAL ASSETS	2,004, 432	2,733,235	2,038,716
Memo Items
Sum of 5 and  7	1,004,174	1,489,759	1,077,431
Capital and Reserves	78,143	81,481	95,312

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/2014/html/fs140902.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 39.8 percent of the total in May 2014. Exports to the non-European Union area with share of 46.3 percent in Italy’s total exports are growing at minus 5.2 percent in Jan-May 2014 relative to Jan-May 2013 while those to EMU are growing at minus 1.1 percent.

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

May 2014	Exports % Share	∆% Jan-May 2014/ Jan-May 2013	Imports % Share	∆% Jan-May 2014/ Jan-May 2013
EU	53.7	4.1	55.3	-0.2
EMU 17	39.8	3.1	44.3	-1.1
France	10.8	-0.4	8.4	-1.5
Germany	12.4	4.7	14.7	1.6
Spain	4.4	3.0	4.5	2.0
UK	5.0	6.6	2.7	-1.0
Non EU	46.3	-2.0	44.7	-5.2
Europe non EU	13.0	-9.9	12.1	-6.4
USA	6.9	6.2	3.2	10.0
China	2.5	10.6	6.4	1.8
OPEC	6.0	-7.3	8.1	-32.4
Total	100.0	1.3	100.0	-2.5

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

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/128657

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €56 million with the 17 countries of the euro zone (EMU 17) in May 2014 and cumulative surplus of €570 million in Jan-May 2014. Depreciation to parity could permit greater competitiveness in improving the trade surplus of €1546 million in Jan-May 2014 with Europe non-European Union, the trade surplus of €6455 million with the US and the trade surplus with non-European Union of €7279 million in Jan-Apr 2014. There is significant rigidity in the trade deficits in Jan-May 2014 of €5554 million with China and €87 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 May 2014 Millions of Euro	Trade Balance Cumulative Jan-May 2014 Millions of Euro
EU	1,223	6,791
EMU 17	-56	570
France	1,070	5,212
Germany	-313	-1,469
Spain	-16	423
UK	871	4,141
Non EU	2,453	7,279
Europe non EU	146	1,546
USA	1,995	6,455
China	-1,065	-5,554
OPEC	68	-87
Total	3,676	14,070

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

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/128657

Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-May 2014 relative to Jan-May 2013. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 16.7 percent. Exports of durable goods grew 3.8 percent and exports of capital goods increased 4.8 percent. The higher rate of growth of exports of 1.3 percent in Jan-May 2014/Jan-May 2013 relative to that of imports of minus 2.5 percent may reflect weak demand in Italy with GDP declining during nine consecutive quarters from IIIQ2011 through IIIQ2013 together with softening commodity prices. GDP increased marginally 0.1 percent in IVQ2013 and fell 0.1 percent in IQ2014.

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

	Exports Share %	Exports ∆% Jan-May 2014/ Jan-May 2013	Imports Share %	Imports ∆% Jan-May 2014/ Jan-May 2013
Consumer Goods	31.0	3.3	27.3	1.8
Durable	6.0	3.8	2.9	7.6
Non-Durable	25.1	3.2	24.4	1.1
Capital Goods	32.3	4.8	20.3	2.8
Inter- mediate Goods	32.3	-1.5	32.5	-0.6
Energy	4.4	-15.8	19.9	-16.7
Total ex Energy	95.6	2.1	80.1	1.0
Total	100.0	1.3	100.0	-2.5

Note: % Share for 2012 total trade.

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/128657

Table III-6 provides Italy’s trade balance by product categories in May 2014 and cumulative Jan-May 2014. Italy’s trade balance excluding energy, generated surplus of €7912 million in May 2014 and €33,161 million cumulative in Jan-May 2014 but the energy trade balance created deficit of €4237 million in May 2014 and cumulative €19,091 million in Jan-May 2014. The overall surplus in May 2014 was €3676 million with cumulative surplus of €14,070 million in Jan-May 2014. 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

	May 2014	Cumulative Jan-May 2014
Consumer Goods	1,811	9,006
Durable	1,135	5,190
Nondurable	676	3,816
Capital Goods	5,365	21,720
Intermediate Goods	736	2,435
Energy	-4,237	-19,091
Total ex Energy	7,912	33,161
Total	3,676	14,070

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/128657

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/ns/cs.aspx?id=28) 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 2014.

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

	GDP 2014 USD Billions	Primary Net Lending Borrowing % GDP 2014	General Government Net Debt % GDP 2014
World	76,776
Euro Zone	13,416	-0.1	73.2
Portugal	231	0.3	119.9
Ireland	230	-0.7	103.5
Greece	249	1.5	169.3
Spain	1,415	-2.8	65.7
Major Advanced Economies G7	35,904	-2.7	87.0
United States	17,528	-3.2	82.3
UK	2,828	-3.5	84.4
Germany	3,876	1.6	52.9
France	2,886	-1.7	89.5
Japan	4,846	-6.4	137.1
Canada	1,769	-2.2	39.5
Italy	2,172	2.3	112.4
China	10,028	-2.0*	20.2**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook http://www.imf.org/external/ns/cs.aspx?id=28

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions 2014” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2014” to the column “GDP 2014 USD Billions.” The total debt of France and Germany in 2014 is $4633.4 billion, as shown in row “B+C” in column “Net Debt USD Billions 2014” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $4307.7 billion, adding rows D+E+F+G+H in column “Net Debt USD billions 2014.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table I-9. 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 $8941.1 billion, which would be equivalent to 132.2 percent of their combined GDP in 2014. 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 230.7 percent if including debt of France and 164.0 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks. Analysis of fiscal stress is quite difficult without including another global recession in an economic cycle that is already mature by historical experience.

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 2014	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	9,820.5
B Germany	2,050.4		$8941.1 as % of $3876 =230.7% $6358.1 as % of $3876 =164.0%
C France	2,583.0
B+C	4,633.4	GDP $6,762.0 Total Debt $8941.1 Debt/GDP: 132.2%
D Italy	2,441.3
E Spain	929.7
F Portugal	277.0
G Greece	421.6
H Ireland	238.1
Subtotal D+E+F+G+H	4,307.7

Source: calculation with IMF data IMF World Economic Outlook databank

http://www.imf.org/external/ns/cs.aspx?id=28

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 Jun 2014. German exports to other European Union (EU) members are 58.7 percent of total exports in Jun 2014 and 58.6 percent in cumulative Jan-Jun 2014. Exports to the euro area are 37.3 percent of the total in Jun and 37.4 percent cumulative in Jan-Jun. Exports to third countries are 41.3 percent of the total in Jun and 41.4 percent cumulative in Jan-Jun. There is similar distribution for imports. Exports to non-euro countries are increasing 7.1 percent in the 12 months ending in Jun 2014, increasing 9.2 percent cumulative in Jan-Jun 2014 while exports to the euro area are increasing 0.3 percent in the 12 months ending in Jun 2014 and increasing 2.2 percent cumulative in Jan-Jun 2014. Exports to third countries, accounting for 41.3 percent of the total in Jun 2014, are decreasing 0.9 percent in the 12 months ending in Jun 2014 and decreasing 0.7 percent cumulative in Jan-Jun 2014, accounting for 41.4 percent of the cumulative total in Jan-Jun 2014. 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 German exports to other member states.

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

	Jun 2014  € Billions	Jun 12-Month ∆%	Cumulative Jan-Jun 2014 € Billions	Cumulative Jan-Jun 2014/ Jan-Jun 2013 ∆%
Total Exports	93.4	1.1	558.3	2.4
A. EU Members	54.8 % 58.7	2.6	327.3 % 58.6	4.7
Euro Area	34.8 % 37.3	0.3	208.6 % 37.4	2.2
Non-euro Area	20.0 % 21.4	7.1	118.7 % 21.3	9.2
B. Third Countries	38.6 % 41.3	-0.9	231.0 % 41.4	-0.7
Total Imports	77.0	2.1	459.0	2.6
C EU Members	51.1 % 66.4	5.0	301.1 % 65.6	4.2
Euro Area	35.7 % 46.4	4.0	207.3 % 45.2	2.5
Non-euro Area	15.4 % 20.0	7.5	93.8 % 20.4	8.0
D Third Countries	25.8 % 33.5	-3.2	157.9 % 34.4	-0.3

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

Source: Statistisches Bundesamt Deutschland

https://www.destatis.de/EN/PressServices/Press/pr/2014/07/PE14_244_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	2.5	2.0	2.9 FD 1.7	6.1
Japan	-0.1	3.4	4.3	3.8
China	7.5	2.3	-0.9
UK	3.2	1.6* CPIH 1.5	-0.1 output 0.9** input -7.3	6.4
Euro Zone	0.7	0.4	-1.1	11.5
Germany	1.2	0.8	-0.7	4.9
France	0.1	0.6	-0.6	10.3
Nether-lands	0.9	0.3	-2.5	6.7
Finland	-0.1	1.0	-0.4	8.7
Belgium	1.0	0.6	-5.7	8.5
Portugal	0.8	-0.7	-0.8	14.0
Ireland	NA	0.5	0.1	11.5
Italy	-0.2	0.0	-1.7	12.6
Greece	-0.3	-0.8	1.6	27.2
Spain	1.2	-0.4	-0.4	24.5

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

*Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/july-2014/index.html**Core

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/july-2014/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 2.5 percent in IIQ2014 relative to IIQ2013 (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html

and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financial-indecision-mediocre-cyclical.html and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financial-instability-mediocre-cyclical.html, Table 8 in http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp2q14_2nd.pdf). Japan’s GDP fell 1.7 percent in IIQ2014 relative to IQ2014 and fell 0.1 percent relative to a year earlier. Japan’s GDP grew at the seasonally adjusted annual rate (SAAR) of minus 6.8 percent in IIQ2014 (http://cmpassocregulationblog.blogspot.com/2014/08/weakening-world-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financialgeopolitical-risks-recovery.html and earlier http://cmpassocregulationblog.blogspot.com/2014/05/world-inflation-waves-squeeze-of.html). The UK grew at 0.8 percent in IIQ2014 relative to IVQ2013 and GDP increased 3.2 percent in IIQ2014 relative to IIQ2013 (http://cmpassocregulationblog.blogspot.com/2014/08/weakening-world-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financial-indecision-mediocre-cyclical.html). The Euro Zone grew at 0.0 percent in IIQ2014 and 0.7 percent in IIQ2014 relative to IIQ2013 (Section VD and earlier http://cmpassocregulationblog.blogspot.com/2014/08/weakening-world-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-valuations-twenty-seven.html and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financial-risks-rules-discretionary.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: 6.1 percent in the US but 16.4 percent for unemployment/underemployment or job stress of 27.9 million (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-valuations-twentyseven.html), 3.8 percent for Japan (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html

and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financial-indecision-mediocre-cyclical.html), 6.4 percent for the UK with high rates of unemployment for young people (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financialgeopolitical-risks-recovery.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 2.0 percent in the US, 3.4 percent for Japan, 2.3 percent for China, 0.4 percent for the Euro Zone and 1.6 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/2014/09/geopolitical-and-financial-risks.html). (2) The tradeoff of growth and inflation in China now with change in growth strategy to domestic consumption instead of investment, high debt and political developments in a decennial transition. (3) Slow growth by repression of savings with de facto interest rate controls (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html), weak hiring with the loss of 10 million full-time jobs (http://cmpassocregulationblog.blogspot.com/2014/08/weakening-world-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-risk-recovery-without-hiring.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-valuations-twenty-seven.html) (4) The timing, dose, impact and instruments of normalizing monetary and fiscal policies (http://cmpassocregulationblog.blogspot.com/2014/08/weakening-world-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2014/02/theory-and-reality-of-cyclical-slow.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/duration-dumping-and-peaking-valuations.html http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html http://cmpassocregulationblog.blogspot.com/2012/08/expanding-bank-cash-and-deposits-with.html http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies. (5) The Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 had repercussions throughout the world economy. Japan has share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) geopolitical events in the Middle East.

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

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

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

Unconventional monetary policy will remain in perpetuity, or QE→∞, changing to a “growth mandate.” There are two reasons explaining unconventional monetary policy of QE→∞: insufficiency of job creation to reduce unemployment/underemployment at current rates of job creation; and growth of GDP at around 2.0 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 Long-term economic performance in the United States consisted of trend growth of GDP at 3 percent per year and of per capita GDP at 2 percent per year as measured for 1870 to 2010 by Robert E Lucas (2011May). The economy returned to trend growth after adverse events such as wars and recessions. The key characteristic of adversities such as recessions was much higher rates of growth in expansion periods that permitted the economy to recover output, income and employment losses that occurred during the contractions. Over the business cycle, the economy compensated the losses of contractions with higher growth in expansions to maintain trend growth of GDP of 3 percent and of GDP per capita of 2 percent. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 20 quarters from IIIQ2009 to IIQ2014. 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 second estimate of GDP for IIQ2014 (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp2q14_2nd.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 $14,745.9 billion in IIQ2010 by GDP of $14,355.6 billion in IIQ2009 {[$14,745.9/$14,355.6 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.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, 5.2 percent from IQ1983 to IVQ1986, 5.0 percent from IQ1983 to IQ1987, 5.0 percent from IQ1983 to IIQ1987, 4.9 percent from IQ1983 to IIIQ1987, 5.0 percent from IQ1983 to IVQ1987 and at 7.8 percent from IQ1983 to IVQ1983 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIQ2014 would have accumulated to 22.1 percent. GDP in IIQ2014 would be $18,305.0 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2,310.7 billion than actual $15,994.3 billion. There are about two trillion dollars of GDP less than at trend, explaining the 26.9 million unemployed or underemployed equivalent to actual unemployment of 16.4 percent of the effective labor force (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-valuations-twenty-seven.html). US GDP in IIQ2014 is 12.6 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $15,994.3 billion in IIQ2014 or 6.7 percent at the average annual equivalent rate of 1.0 percent. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. 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). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. The long-term trend is growth at average 3.3 percent per year from Jan 1919 to Jul 2014. Growth at 3.3 percent per year would raise the NSA index of manufacturing output from 99.2392 in Dec 2007 to 122.8881 in Jul 2014. The actual index NSA in Jul 2014 is 98.4978, which is 19.8 percent below trend. Manufacturing output grew at average 2.3 percent between Dec 1986 and Dec 2013, raising the index at trend to 115.2650 in Jul 2014. The output of manufacturing at 98.4978 in Jul 2014 is 14.5 percent below trend under this alternative calculation.

First, total nonfarm payroll employment seasonally adjusted (SA) increased 142,000 in Aug 2014 and private payroll employment increased 134,000. The average monthly number of nonfarm jobs created from Aug 2012 to Aug 2013 was 197,917 using seasonally adjusted data, while the average number of nonfarm jobs created from Aug 2013 to Aug 2014 was 206,833, or increase by 4.5 percent. The average number of private jobs created in the US from Aug 2012 to Aug 2013 was 203,917, using seasonally adjusted data, while the average from Aug 2013 to Aug 2014 was 203,167, or decrease by 0.4 percent. This blog calculates the effective labor force of the US at 162.825 million in Aug 2013 and 164.327 million in Aug 2014 (Table I-4), for growth of 1.502 million at average 125,167 per month. The difference between the average increase of 203,167 new private nonfarm jobs per month in the US from Aug 2013 to Aug 2014 and the 125,167 average monthly increase in the labor force from Aug 2013 to Aug 2014 is 78,000 monthly new jobs net of absorption of new entrants in the labor force. There are 26.904 million in job stress in the US currently. Creation of 78,000 new jobs per month net of absorption of new entrants in the labor force would require 345 months to provide jobs for the unemployed and underemployed (26.904 million divided by 78,000) or 29 years (345 divided by 12). The civilian labor force of the US in Aug 2014 not seasonally adjusted stood at 156.434 million with 9.787 million unemployed or effectively 17.680 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 164.327 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 78,000 by 12, which is 936,000). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.822 million (0.05 times labor force of 156.434 million) for new net job creation of 1.965 million (9.787 million unemployed minus 7.822 million unemployed at rate of 5 percent) that at the current rate would take 2.1 years (1.965 million divided by 0.936000). Under the calculation in this blog, there are 17.680 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 164.327 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 9.464 million jobs net of labor force growth that at the current rate would take 10.1 years (17.680 million minus 0.05(164.327 million) = 9.464 million divided by 0.936000, 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 Aug 2014 was 146.647 million (NSA) or 0.668 million fewer people with jobs relative to the peak of 147.315 million in Jul 2007 while the civilian noninstitutional population of ages 16 years and over increased from 231.958 million in Jul 2007 to 248.229 million in Aug 2014 or by 16.271 million. The number employed fell 0.5 percent from Jul 2007 to Aug 2014 while the noninstitutional civilian population of ages of 16 years and over, or those available for work, increased 7.0 percent. The ratio of employment to population in Jul 2007 was 63.5 percent (147.315 million employment as percent of population of 231.958 million). The same ratio in Aug 2014 would result in 157.625 million jobs (0.635 multiplied by noninstitutional civilian population of 248.229 million). There are effectively 10.978 million fewer jobs in Aug 2014 than in Jul 2007, or 157.625 million minus 146.647 million. 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 them-selves 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 com-position 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/2014/08/weakening-world-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-risk-recovery-without-hiring.html).

Second, long-term economic performance in the United States consisted of trend growth of GDP at 3 percent per year and of per capita GDP at 2 percent per year as measured for 1870 to 2010 by Robert E Lucas (2011May). The economy returned to trend growth after adverse events such as wars and recessions. The key characteristic of adversities such as recessions was much higher rates of growth in expansion periods that permitted the economy to recover output, income and employment losses that occurred during the contractions. Over the business cycle, the economy compensated the losses of contractions with higher growth in expansions to maintain trend growth of GDP of 3 percent and of GDP per capita of 2 percent. The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 20 quarters from IIIQ2009 to IIQ2014. 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 second estimate of GDP for IIQ2014 (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp2q14_2nd.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 $14,745.9 billion in IIQ2010 by GDP of $14,355.6 billion in IIQ2009 {[$14,745.9/$14,355.6 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.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, 5.2 percent from IQ1983 to IVQ1986, 5.0 percent from IQ1983 to IQ1987, 5.0 percent from IQ1983 to IIQ1987, 4.9 percent from IQ1983 to IIIQ1987, 5.0 percent from IQ1983 to IVQ1987 and at 7.8 percent from IQ1983 to IVQ1983 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIQ2014 would have accumulated to 22.1 percent. GDP in IIQ2014 would be $18,305.0 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2,310.7 billion than actual $15,994.3 billion. There are about two trillion dollars of GDP less than at trend, explaining the 26.9 million unemployed or underemployed equivalent to actual unemployment of 16.4 percent of the effective labor force (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-valuations-twenty-seven.html). US GDP in IIQ2014 is 12.6 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $15,994.3 billion in IIQ2014 or 6.7 percent at the average annual equivalent rate of 1.0 percent. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. 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). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. The long-term trend is growth at average 3.3 percent per year from Jan 1919 to Jul 2014. Growth at 3.3 percent per year would raise the NSA index of manufacturing output from 99.2392 in Dec 2007 to 122.8881 in Jul 2014. The actual index NSA in Jul 2014 is 98.4978, which is 19.8 percent below trend. Manufacturing output grew at average 2.3 percent between Dec 1986 and Dec 2013, raising the index at trend to 115.2650 in Jul 2014. The output of manufacturing at 98.4978 in Jul 2014 is 14.5 percent below trend under this alternative calculation. The economy of the US can be summarized in growth of economic activity or GDP as fluctuating from mediocre growth of 2.5 percent on an annual basis in 2010 to 1.6 percent in 2011, 2.3 percent in 2012 and 2.2 percent in 2013. The following calculations show that actual growth is around 2.1 to 2.5 percent per year. The rate of growth of 0.9 percent in the entire cycle from 2007 to 2013 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.

Table Summary, Long-term and Cyclical Growth of GDP, Real Disposable Income and Real Disposable Income per Capita

	GDP
Long-Term
1929-2013	3.3
1947-2013	3.2
Whole Cycles
1980-1989	3.5
2006-2013	1.0
2007-2013	0.9
Cyclical Contractions ∆%
IQ1980 to IIIQ1980, IIIQ1981 to IVQ1982	-4.7
IVQ2007 to IIQ2009	-4.2
Cyclical Expansions Average Annual Equivalent ∆%
IQ1983 to IVQ1985 IQ1983-IQ1986 IQ1983-IIIQ1986 IQ1983-IVQ1986 IQ1983-IQ1987 IQ1983-IIQ1987 IQ1983-IIIQ1987 IQ1983 to IVQ1987	5.9 5.7 5.4 5.2 5.0 5.0 4.9 5.0
First Four Quarters IQ1983 to IVQ1983	7.8
IIIQ2009 to IIQ2014	2.2
First Four Quarters IIIQ2009 to IIQ2010	2.7
	Real Disposable Income	Real Disposable Income per Capita
Long-Term
1929-2013	3.2	2.0
1947-1999	3.7	2.3
Whole Cycles
1980-1989	3.5	2.6
2006-2013	1.4	0.5

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 2.1 to 2.5 percent per year. Table Summary GDP provides the data.

1. Average Annual Growth in the Past Eight Quarters. GDP growth in the four quarters of 2012, the four quarters of 2013 and the first two quarters of 2014 accumulated to 5.3 percent. This growth is equivalent to 2.1 percent per year, obtained by dividing GDP in IIQ2014 of $15,994.3 billion by GDP in IVQ2011 of $15,190.3 billion and compounding by 4/10: {[($15,994.3/$15,190.3)^4/10 -1]100 = 2.1 percent.

2. Average Annual Growth in the Past Four Quarters. GDP growth in the four quarters of IIQ2013 to IIQ2014 accumulated to 2.5 percent that is equivalent to 2.5 percent in a year. This is obtained by dividing GDP in IIQ2014 of $15,994.3 billion by GDP in IIQ2013 of $15,606.6 billion and compounding by 4/4: {[($15,994.3/$15,606.6)^4/4 -1]100 = 2.5%}. The US economy grew 2.4 percent in IIQ2014 relative to the same quarter a year earlier in IIQ2013. Another important revelation of the revisions and enhancements is that GDP was flat in IVQ2012, which is in the borderline of contraction, and negative in IQ2014. US GDP fell 0.5 percent in IQ2014. The rate of growth of GDP in the revision of IIIQ2013 is 4.5 percent in seasonally adjusted annual rate (SAAR). Inventory accumulation contributed 1.49 percentage points to this rate of growth. The actual rate without this impulse of unsold inventories would have been 3.0 percent, or 0.74 percent in IIIQ2013, such that annual equivalent growth in 2013 is closer to 2.8 percent {[(1.007)(1.004)(1.0074)(1.009)^4/4-1]100 = 2.8%}, compounding the quarterly rates and converting into annual equivalent. Inventory divestment deducted 1.16 percentage points from GDP growth in IQ2014. Without this deduction of inventory divestment, GDP growth would have been minus 0.9 percent in IQ2014, such that the actual growth rates in the four quarters ending in IQ2014 is closer to 2.2 percent {[(1.004)(1.011)(1.009)(0.9977)]^4/4 -1]100 = 2.2%}.

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	14,991.8	NA	NA	1.9
IVQ2011	15,190.3	1.3	1.1	1.7
IQ2012	15,275.0	1.9	0.6	2.6
IIQ2012	15,336.7	2.3	0.4	2.3
IIIQ2012	15,431.3	2.9	0.6	2.7
IVQ2012	15,433.7	2.9	0.0	1.6
IQ2013	15,538.4	3.6	0.7	1.7
IIQ2013	15,606.6	4.1	0.4	1.8
IIIQ2013	15,779.9	5.3	1.1	2.3
IVQ2013	15,916.2	6.2	0.9	3.1
IQ2014	15,831.7	5.6	-0.5	1.9
IIQ2014	15,994.3	6.7	1.0	2.5
Cumulative ∆% IQ2012 to IQ2014	5.3		5.3
Annual Equivalent ∆%	2.1		2.1

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

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 Jul 30, 2014 with symbolic reduction of purchases of securities for the Fed’s balance sheet (http://www.federalreserve.gov/newsevents/press/monetary/20140730a.htm):

“Press Release

Release Date: July 30, 2014

For immediate release

Information received since the Federal Open Market Committee met in June indicates that growth in economic activity rebounded in the second quarter. Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources. Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has moved somewhat closer to the Committee's longer-run objective. 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 activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.

The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in August, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $10 billion per month rather than $15 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than $20 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 remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

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. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo. Voting against was Charles I. Plosser who objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for "a considerable time after the asset purchase program ends," because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee's goals.”

There are several important issues in this statement.

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

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

1. Open-ended Quantitative Easing or QE_∞ with Symbolic Tapering. Earlier programs are continued with an additional lower open-ended $25 billion of bond purchases per month, increasing the stock of $4,136,776 million securities held outright and bank reserves deposited at the Fed of $2,785,792 million (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1): “The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in August, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $10 billion per month rather than $15 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than $20 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.”
2. New Advance Guidance.” 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 remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored” (emphasis added).
3. Policy Commitment with Unemployment Rate. The emphasis of policy is in maintaining full employment: “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. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

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 $25 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight as evident in the FOMC statement for Jul 30, 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20140730a.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 remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored” (emphasis added).

How long is “considerable time”? At the press conference following the meeting on Mar 19, 2014, Chair Yellen answered a question of Jon Hilsenrath of the Wall Street Journal explaining “In particular, the Committee has endorsed the view that it anticipates that will be a considerable period after the asset purchase program ends before it will be appropriate to begin to raise rates. And of course on our present path, well, that's not utterly preset. We would be looking at next, next fall. So, I think that's important guidance” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140319.pdf). Many focused on “next fall,” ignoring that the path of increasing rates is not “utterly preset.”

At a speech on Mar 31, 2014, Chair Yellen analyzed labor market conditions as follows (http://www.federalreserve.gov/newsevents/speech/yellen20140331a.htm):

“And based on the evidence available, it is clear to me that the U.S. economy is still considerably short of the two goals assigned to the Federal Reserve by the Congress. The first of those goals is maximum sustainable employment, the highest level of employment that can be sustained while maintaining a stable inflation rate. Most of my colleagues on the Federal Open Market Committee and I estimate that the unemployment rate consistent with maximum sustainable employment is now between 5.2 percent and 5.6 percent, well below the 6.7 percent rate in February.

Let me explain what I mean by that word "slack" and why it is so important.

Slack means that there are significantly more people willing and capable of filling a job than there are jobs for them to fill. During a period of little or no slack, there still may be vacant jobs and people who want to work, but a large share of those willing to work lack the skills or are otherwise not well suited for the jobs that are available. With 6.7 percent unemployment, it might seem that there must be a lot of slack in the U.S. economy, but there are reasons why that may not be true.”

Yellen (2014Aug22) provides comprehensive review of the theory and measurement of labor markets. Monetary policy 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”

Yellen (2014Aug22) finds that the unemployment rate is not sufficient in determining slack:

“One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.”

Yellen (2014Aug22) restates that the FOMC determines monetary policy on newly available information and interpretation of labor markets and inflation and does not follow a preset path:

“But if progress in the labor market continues to be more rapid than anticipated by the Committee or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter. Of course, if economic performance turns out to be disappointing and progress toward our goals proceeds more slowly than we expect, then the future path of interest rates likely would be more accommodative than we currently anticipate. As I have noted many times, monetary policy is not on a preset path. The Committee will be closely monitoring incoming information on the labor market and inflation in determining the appropriate stance of monetary policy.”

Yellen (2014Aug22) states that “Historically, slack has accounted for only a small portion of the fluctuations in inflation. Indeed, unusual aspects of the current recovery may have shifted the lead-lag relationship between a tightening labor market and rising inflation pressures in either direction.”

Chair Yellen analyzes the view of inflation (http://www.federalreserve.gov/newsevents/speech/yellen20140416a.htm):

“Inflation, as measured by the price index for personal consumption expenditures, has slowed from an annual rate of about 2-1/2 percent in early 2012 to less than 1 percent in February of this year. This rate is well below the Committee's 2 percent longer-run objective. Many advanced economies are observing a similar softness in inflation.

To some extent, the low rate of inflation seems due to influences that are likely to be temporary, including a deceleration in consumer energy prices and outright declines in core import prices in recent quarters. Longer-run inflation expectations have remained remarkably steady, however. We anticipate that, as the effects of transitory factors subside and as labor market gains continue, inflation will gradually move back toward 2 percent.”

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?

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 17,137.36 on Fr Sep 5, 2014, which is higher by 21.0 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 20.7 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs.

Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):

So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly” (emphasis added).

In a speech at the IMF on Jul 2, 2014, Chair Yellen analyzed the link between monetary policy and financial risks (http://www.federalreserve.gov/newsevents/speech/yellen20140702a.htm):

“Monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

Yellen (2014Jul14) warned again at the Committee on Banking, Housing and Urban Affairs on Jul 15, 2014:

“The Committee recognizes that low interest rates may provide incentives for some investors to “reach for yield,” and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance. More broadly, the financial sector has continued to become more resilient, as banks have continued to boost their capital and liquidity positions, and growth in wholesale short-term funding in financial markets has been modest” (emphasis added).

Greenspan (1996) made similar warnings:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy” (emphasis added).

Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. What is the success in evaluating deviations of valuations of risk financial assets from “historical norms”? What are the consequences on economic activity and employment of deviations of valuations of risk financial assets from those “historical norms”? What are the policy tools and their effectiveness in returning valuations of risk financial assets to their “historical norms”?

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.

Professor Raguram G Rajan, governor of the Reserve Bank of India, which is India’s central bank, warned about risks in high valuations of asset prices in an interview with Christopher Jeffery of Central Banking Journal on Aug 6, 2014 (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). Professor Rajan demystifies in the interview “competitive easing” by major central banks as equivalent to competitive devaluation. Rajan (2005) anticipated the risks of the world financial crisis. Professor John B. Taylor (2014Jul15, 2014Jun26) building on advanced research (Taylor (1993, 1998LB, 1999, 1998LB, 1999, 2007JH, 2008Nov, 2009, 2012JMCB, 2014Jan3) finds that a monetary policy rule would function best in promoting an environment of low inflation and strong economic growth with stability of financial markets. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html).

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 testimony on the Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, US House of Representatives, on Feb 11, 2014, Chair Janet Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm):

“Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and 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. That said, purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.  In December of last year and again this January, the Committee said that its current expectation--based on its assessment of a broad range of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments--is 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 2 percent goal. I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level (emphasis added).”

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.”

In testimony before the Committee on the Budget of the US Senate on May 8, 2004, Chair Yellen provides analysis of the current economic situation and outlook (http://www.federalreserve.gov/newsevents/testimony/yellen20140507a.htm):

“The economy has continued to recover from the steep recession of 2008 and 2009. Real gross domestic product (GDP) growth stepped up to an average annual rate of about 3-1/4 percent over the second half of last year, a faster pace than in the first half and during the preceding two years. Although real GDP growth is currently estimated to have paused in the first quarter of this year, I see that pause as mostly reflecting transitory factors, including the effects of the unusually cold and snowy winter weather. With the harsh winter behind us, many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter. One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.

Conditions in the labor market have continued to improve. The unemployment rate was 6.3 percent in April, about 1-1/4 percentage points below where it was a year ago. Moreover, gains in payroll employment averaged nearly 200,000 jobs per month over the past year. During the economic recovery so far, payroll employment has increased by about 8-1/2 million jobs since its low point, and the unemployment rate has declined about 3-3/4 percentage points since its peak.

While conditions in the labor market have improved appreciably, they are still far from satisfactory. Even with recent declines in the unemployment rate, it continues to be elevated. Moreover, both the share of the labor force that has been unemployed for more than six months and the number of individuals who work part time but would prefer a full-time job are at historically high levels. In addition, most measures of labor compensation have been rising slowly--another signal that a substantial amount of slack remains in the labor market.

Inflation has been quite low even as the economy has continued to expand. Some of the factors contributing to the softness in inflation over the past year, such as the declines seen in non-oil import prices, will probably be transitory. Importantly, measures of longer-run inflation expectations have remained stable. That said, the Federal Open Market Committee (FOMC) recognizes that inflation persistently below 2 percent--the rate that the Committee judges to be most consistent with its dual mandate--could pose risks to economic performance, and we are monitoring inflation developments closely.

Looking ahead, I expect that economic activity will expand at a somewhat faster pace this year than it did last year, that the unemployment rate will continue to decline gradually, and that inflation will begin to move up toward 2 percent. A faster rate of economic growth this year should be supported by reduced restraint from changes in fiscal policy, gains in household net worth from increases in home prices and equity values, a firming in foreign economic growth, and further improvements in household and business confidence as the economy continues to strengthen. Moreover, U.S. financial conditions remain supportive of growth in economic activity and employment.”

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 differ from 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 http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html).

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. Jon Hilsenrath, writing on “New view into Fed’s response to crisis,” on Feb 21, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303775504579396803024281322?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes 1865 pages of transcripts of eight formal and six emergency policy meetings at the Fed in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm). If there were an infallible science of central banking, models and forecasts would provide accurate information to policymakers on the future course of the economy in advance. Such forewarning is essential to central bank science because of the long lag between the actual impulse of monetary policy and the actual full effects on income and prices many months and even years ahead (Romer and Romer 2004, Friedman 1961, 1953, Culbertson 1960, 1961, Batini and Nelson 2002). The transcripts of the Fed meetings in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm) analyzed by Jon Hilsenrath demonstrate that Fed policymakers frequently did not understand the current state of the US economy in 2008 and much less the direction of income and prices. The conclusion of Friedman (1953) is that monetary impulses increase financial and economic instability because of lags in anticipating needs of policy, taking policy decisions and effects of decisions. This is a fortiori true when untested unconventional monetary policy in gargantuan doses shocks the economy and financial markets.

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 Rajan, in an interview with Kartik Goyal of Bloomberg (http://www.bloomberg.com/news/2014-01-30/rajan-warns-of-global-policy-breakdown-as-emerging-markets-slide.html), warns of breakdown of global policy coordination. Professor Raguram G Rajan, governor of the Reserve Bank of India, which is India’s central bank, warned about risks in high valuations of asset prices in an interview with Christopher Jeffery of Central Banking Journal on Aug 6, 2014 (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). Professor Rajan demystifies in the interview “competitive easing” by major central banks as equivalent to competitive devaluation.

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.

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 Jun 18, 2014. 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 IQ2014 is analyzed in Section I (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html) and the PCE inflation data from the report on personal income and outlays in Section IV (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). The Bureau of Economic Analysis provides the estimate of IIQ2014 GDP (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html and earlier http://cmpassocregulationblog.blogspot.com/2014/06/financial-indecision-mediocre-cyclical.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/2014/09/geopolitical-and-financial-risks.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). The report on “Personal Income and Outlays” was released on Aug 29, 2014 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.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 2014 was released on Sep 5, 2014 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-valuations-twenty-seven.html). “The longer-run projections are the rates of growth, unemployment, and inflation to which a policymaker expects the economy to converge over time—maybe in five or six years—in the absence of further shocks and under appropriate monetary policy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20131218.pdf).

It is instructive to focus on 2014 and 2015 because 2016 and longer term are too far away, and there is not much information even on what will happen in 2014-2015 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 Jun 18, 2014 and the second row “PR” the projection of the Mar 19, 2014 meeting. There are three changes in the view.

1. Growth “∆% GDP.” The FOMC has changed the forecast of GDP growth in 2014. The FOMC decreased GDP growth in 2014 from 2.8 to 3.0 percent at the meeting in Mar 2014 to 2.1 to 2.3 percent at the meeting in Jun 2014.

2. Rate of Unemployment “UNEM%.” The FOMC reduced the forecast of the rate of unemployment for 2014 from 6.1 to 6.3 percent at the meeting on Mar 19, 2014 to 6.0 to 6.1 percent at the meeting on Jun 18, 2014. The projection for 2015 decreased to the range of 5.4 to 5.7 in Jun 2014 from 5.6 to 5.9 in Mar 2014. Projections of the rate of unemployment are moving closer to the desire 6.5 percent or lower with 5.1 to 5.5 percent in 2016 after the meeting on Jun 18, 2014.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation for 2014 from 1.5 to 1.6 percent at the meeting on Mar 19, 2014 to 1.5 to 1.7 percent at the meeting on Jun 18, 2014. There are no projections exceeding 2.0 percent in the central tendency but some in the range reach 2.4 percent in 2015. The longer run projection is at 2.0 percent.

4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2014, not changing significantly from 1.4 to 1.6 percent at the meeting on Mar 19, 20134 to 1.5 to 1.6 percent at the meeting Jun 18, 2014. In 2015, there is minor change in the projection from 1.7 to 2.0 percent at the meeting on Mar 19, 2014 to 1.6 to 2.0 percent on Jun 18, 2014. The rate of change of the core PCE is below 2.0 percent in the central tendency with 2.4 percent at the top of the range in 2015.

Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, Mar 19, 2013 and Jun 18, 2014 

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2014  Mar PR	2.1 to 2.3 2.8 to 3.0	6.0 to 6.1 6.1 to 6.3	1.5 to 1.7 1.5 to 1.6	1.5 to 1.6 1.4 to 1.6
2015 Mar PR	3.0 to 3.2 3.0 to 3.2	5.4 to 5.7 5.6 to 5.9	1.5 to 2.0 1.5 to 2.0	1.6 to 2.0 1.7 to 2.0
2016 Mar PR	2.5 to 3.0 2.5 to 3.0	5.1 to 5.5 5.2 to 5.6	1.6 to 2.0 1.7 to 2.0	1.7 to 2.0 1.8 to 2.0
Longer Run Mar PR	2.1 to 2.3 2.2 to 2.3	5.2 to 5.5 5.2 to 5.6	2.0 2.0
Range
2014 Mar PR	1.9 to 2.4 2.1 to 3.0	5.8 to 6.2 6.0 to 6.5	1.4 to 2.0 1.3 to 1.8	1.4 to 1.8 1.3 to 1.8
2015 Mar PR	2.2 to 3.6 2.2 to 3.5	5.2 to 5.9 5.4 to 5.9	1.4 to 2.4 1.5 to 2.4	1.5 to 2.4 1.5 to 2.4
2016 Mar PR	2.2 to 3.2 2.2 to 3.4	5.0 to 5.6 5.1 to 5.8	1.5 to 2.0 1.6 to 2.0	1.6 to 2.0 1.6 to 2.2
Longer Run Mar PR	1.8 to 2.5 1.8 to 2.4	5.0 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

http://www.federalreserve.gov/newsevents/press/monetary/20140618b.htm

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140618.pdf

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

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

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

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

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

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

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

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

The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table IV-3 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 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/fomcprojtabl20140618.pdf). 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. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels. For 2015, 8 participants expect the rate to remain between 0.5 and 1.0 percent, 6 to be between 1.0 and 1.5 percent, 9 between 1 and 2 percent and 3 between 2 and 3 percent. For 2016, 2 participant expects the rate between 0.5 and 1 percent, 2 between 1 and 2 percent, 9 between 2 and 3 percent and 6 between 3 and 4.5 percent. In the long term, all 16 participants expect the fed funds rate in the range of 3.0 to 4.5 percent.

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

Members and Federal Reserve Bank Presidents Participating in FOMC, Jun 18, 2014

	0 to 0.25	0.5 to 1.0	1.0 to 1.5	1.0 to 2.0	2.0 to 3.0	3.0 to 4.5
2014	15	1
2015		8	6	9	3
2016		2		2	9	6
Longer Run						16

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

http://www.federalreserve.gov/newsevents/press/monetary/20140618b.htm

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140618.pdf

Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2014 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 until 2015. 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, Mar 19, 2014

Appropriate Year of Increasing Target Fed Funds Rate	Number of Participants
2014	1
2015	12
2016	3

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

http://www.federalreserve.gov/newsevents/press/monetary/20140618b.htm

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140618.pdf

The producer price index of the euro zone decreased 0.1 percent in Jul 2014 and increased 0.2 percent in Jun 2014, as shown in Table IV-5. The producer price index of the euro zone decreased in five consecutive months in 2014: 0.1 percent in May, 0.1 percent in Apr, 0.2 percent in Mar, 0.2 percent in Feb and 0.3 percent in Jan. Energy inflation has oscillated with the shocks of risk aversion, and alternating portfolio reallocations, that cause unwinding of carry trade positions from zero interest rates to commodity futures. Energy prices fell 0.8 percent in Dec 2012 but increased 0.3 percent in Feb 2013 and 0.9 percent in Jan 2013. Energy prices fell 0.8 percent in Dec 2012, 0.5 percent in Nov 2012 and fell 0.4 percent in Oct 2012 after -0.1 percent in Sep 2012, increased 2.4 percent in Aug, and 1.4 percent in Jul 2012 or at the annual equivalent rate of 16.2 percent in the quarter Jul-Sep 2012 and at 25.3 percent in Jul-Aug 2012. Energy prices increased 5.2 percent cumulatively in Jan-Mar 2012 or at the annual equivalent rate of 22.5 percent. Energy prices increased 0.7 percent in Jul 2013, 0.1 percent in Aug 2013 and 0.6 percent in Sep 2013. Energy prices fell 1.3 percent in Oct 2013 and increased 0.1 percent in Nov 2013. Energy prices increased 0.5 percent in Dec 2013 and fell 1.2 percent in Jan 2014. Energy prices fell 0.7 percent in Feb 2014 and decreased 0.8 percent in Mar 2014. Energy prices fell 0.7 percent in Apr 2014 and fell 0.2 percent in May 2014. Energy prices increased 0.6 percent in Jun 2014 and fell 0.6 percent in Jul 2014. During periods of relaxed risk aversion, carry trades from zero interest rates to commodity exposures drive high inflation waves. Portfolio reallocations created exposures in equities while reversing exposures in commodities. Prices of capital goods have barely moved. Prices of durable consumer goods have been subdued in 2013-2014. Purchasing managers’ indexes worldwide reflect increasing prices of inputs for business while sales prices are stagnant or declining, squeezing economic activity (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html). Unconventional monetary policy causes uncertainty in business decisions with shocks of declining net revenue margins during worldwide inflation waves (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html).

Table IV-5, Euro Area, Industrial Producer Prices Month ∆%

	Jul    2014	Jun    2013	May  2014	Apr  2014	Mar  2014	Feb  2014
Industry ex Construction	-0.1	0.2	-0.1	-0.1	-0.2	-0.2
Industry ex Construction & Energy	0.0	0.1	0.0	0.1	0.0	-0.1
Intermediate Goods	0.0	0.0	0.1	0.0	-0.2	-0.1
Energy	-0.6	0.6	-0.2	-0.7	-0.8	-0.7
Capital Goods	0.0	0.1	0.0	0.0	0.1	0.0
Durable Consumer Goods	0.0	0.1	0.0	0.1	0.1	0.0
Nondurable Consumer Goods	0.0	0.0	0.0	0.2	0.0	-0.1

Source: EUROSTAT

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

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

Twelve-month percentage changes of industrial prices in the euro zone have moderated significantly, as shown in Table IV-6. The 12-month percentage change of industrial prices excluding construction fell from 4.4 percent in Dec 2011 to minus 0.3 percent in Apr 2013 and minus 0.3 percent in May 2013. The 12-month percentage change of industrial producer prices increased 0.2 percent in Jun 2013 but was flat in Jul 2013 and fell 0.9 percent in Aug 2013. Industrial producer prices in the euro area fell 0.9 percent in the 12 months ending in Sep 2013 and fell 1.3 percent in the 12 months ending in Oct 2013. Industrial producer prices fell 1.2 percent in the 12 months ending in Nov 2013. Industrial producer prices fell 0.7 percent in the 12 months ending in Dec 2013 and fell 1.3 percent in the 12 months ending in Jan 2014. Industrial producer prices in the euro zone fell 1.7 percent in the 12 months ending in Feb 2014 and decreased 1.6 percent in the 12 months ending in Mar 2014. Producer prices in the euro area fell 1.2 percent in the 12 months ending in Apr 2014 and fell 1.0 percent in the 12 months ending in May 2014. Producer prices in the euro area fell 0.8 percent in the 12 months ending in Jun 2014 and declined 1.1 percent in the 12 months ending in Jul 2014. Energy prices increased 9.7 percent in the 12 months ending in Dec 2011 and Jan 2011 but the rate fell to 4.5 percent in the 12 months ending in Jul 2012, increasing to 7.5 percent in Aug 2012 and 6.4 percent in Sep 2012. Energy prices fell 5.2 percent in the 12 months ending in Oct 2012, 3.9 percent in Nov 2012, 3.6 percent in Dec 2012, 2.2 percent in Jan 2013 and 1.6 percent in Feb 2013. Energy prices fell 0.6 in the 12 months ending in Mar 2013, minus 2.3 percent in Apr 2013, minus 2.2 percent in May 2013 and minus 1.0 percent in Jun 2013. The 12-month percentage change of energy prices was minus 1.5 percent in Jul 2013 and minus 3.7 percent in Aug 2013. Energy prices fell 2.9 percent in the 12 months ending in Sep 2013, 3.6 percent in the 12 months ending in Oct 2013 and 3.1 percent in the 12 months ending in Nov 2013. Energy prices fell 1.8 percent in the 12 months ending in Dec 2013 and fell 3.5 percent in the 12 months ending in Jan 2014. Energy prices fell 4.4 percent in the 12 months ending in Feb 2014 and decreased 4.4 percent in the 12 months ending in Mar 2014. Energy prices fell 3.4 percent in the 12 months ending in Apr 2014 and fell 2.7 percent in the 12 months ending in May 2014. Energy prices fell 2.2 percent in the 12 months ending in Jun 2013 and decreased 3.5 percent in the 12 months ending in Jul 2014. There is major vulnerability in producer price inflation that can return together with long positions in commodity futures with carry trades from zero interest during relaxation of risk aversion. Business net revenue or prices of goods sold less costs of inputs suffer wide oscillation preventing sound calculation of risk/returns and capital budgeting (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html).

Table IV-6, Euro Area, Industrial Producer Prices 12-Month ∆%

	Jul  2014	Jun    2013	May  2014	Apr  2014	Mar  2014	Feb  2014
Industry ex Construction	-1.1	-0.8	-1.0	-1.2	-1.6	-1.7
Industry ex Construction & Energy	-0.1	-0.1	-0.2	-0.3	-0.5	-0.5
Intermediate Goods	-0.7	-0.9	-1.2	-1.5	-1.9	-1.8
Energy	-3.5	-2.2	-2.7	-3.4	-4.4	-4.4
Capital Goods	0.4	0.4	0.3	0.3	0.3	0.3
Durable Consumer Goods	1.0	1.0	0.8	0.8	0.8	0.8
Nondurable Consumer Goods	0.1	0.3	0.5	0.7	0.4	0.5

Source: EUROSTAT

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

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

Industrial producer prices in the euro area are following similar inflation waves as in the rest of the world (http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html), as shown in Table IV-7. In the first wave in Jan-Apr 2011, annual equivalent producer price inflation was 11.3 percent driven by carry trades from zero interest rates into commodity futures. In the second wave in May-Jun 2011, annual equivalent inflation of producer prices declined at 0.6 percent. In the third wave in Jul-Sep 2011, annual equivalent inflation increased at 2.4 percent. In the fourth wave in Oct-Dec 2011, risk aversion originating in the European sovereign debt crisis interrupted commodity carry trades, resulting in annual equivalent inflation of only 0.4 percent. In the fifth wave in Jan-Mar 2012, annual equivalent inflation jumped to 7.9 percent with a high annual equivalent rate of 8.7 percent in Jan-Feb 2012. In the sixth wave, risk aversion from the European sovereign debt event caused reversal of commodity carry trades with equivalent annual inflation of minus 2.4 percent in Apr-Jun 2012. In the seventh wave, annual equivalent inflation jumped to 6.8 percent in Jul-Aug 2012 while energy prices driven by carry trades increased at the annual equivalent rate of 25.3 percent. In the eighth wave, annual equivalent inflation retreated to 0.6 percent in Sep-Oct 2012. In the ninth wave, annual equivalent inflation was minus 2.4 percent in Nov-Dec 2012. In the tenth wave, annual equivalent inflation was 2.4 percent in Jan-Feb 2013. In the eleventh wave, annual equivalent inflation was minus 3.5 percent in Mar-Jun 2013. In the twelfth wave, annual equivalent inflation was 1.6 percent in Jul-Sep 2013. In the thirteenth wave, annual equivalent inflation was minus 3.0 percent in Oct-Nov 2013. In the fourteenth wave, annual equivalent inflation returned at 2.4 percent in Dec 2013. In the fifteenth wave, annual equivalent inflation was minus 2.1 percent in Jan-May 2014.In the sixteenth wave, annual equivalent inflation was 2.4 percent in Jun 2014. In the seventeenth wave, annual equivalent inflation was minus 1.2 percent in Jul 2014. The bottom part of Table IV-7 provides 12-month percentage changes from 1999 to 2013. The final row of Table IV-10 provides the average annual rate of producer-price inflation in the euro area at 2.3 percent in Dec from 1999 to 2013.

Table IV-7, Euro Area, Industrial Producer Prices Excluding Construction, Month and 12-Month ∆%

	Month ∆%	12-Month ∆%
Jul 2014	-0.1	-1.1
AE ∆% Jul	-1.2
Jun	0.2	-0.8
AE ∆% Jun	2.4
May	-0.1	-1.0
Apr	-0.1	-1.2
Mar	-0.2	-1.6
Feb	-0.2	-1.7
Jan	-0.3	-1.3
AE ∆% Jan-May	-2.1
Dec 2013	0.2	-0.7
AE ∆% Dec	2.4
Nov	0.0	-1.2
Oct	-0.5	-1.3
AE ∆% Oct-Nov	-3.0
Sep	0.2	-0.9
Aug	0.0	-0.9
Jul	0.2	0.0
AE ∆% Jul-Sep	1.6
Jun	0.0	0.2
May	-0.3	-0.3
Apr	-0.6	-0.3
Mar	-0.3	0.5
AE ∆% Mar-Jun	-3.5
Feb	0.1	1.3
Jan	0.3	1.7
AE ∆% Jan-Feb	2.4
Dec 2012	-0.2	2.2
Nov	-0.2	2.3
AE ∆% Nov-Dec	-2.4
Oct	0.0	2.6
Sep	0.1	2.8
AE ∆% Sep-Oct	0.6
Aug	0.8	2.9
Jul	0.3	1.9
AE ∆% Jul-Aug	6.8
Jun	-0.5	2.1
May	-0.3	2.7
Apr	0.2	2.9
AE ∆% Apr-Jun	-2.4
Mar	0.5	3.6
Feb	0.6	3.9
Jan	0.8	4.0
AE ∆% Jan-Mar	7.9
Dec 2011	-0.2	4.4
Nov	0.2	5.4
Oct	0.1	5.5
AE ∆% Oct-Dec	0.4
Sep	0.2	5.6
Aug	-0.1	5.7
Jul	0.5	5.8
AE ∆% Jul-Sep	2.4
Jun	0.0	5.5
May	-0.1	5.9
AE ∆% May-Jun	-0.6
Apr	0.9	6.4
Mar	0.8	6.4
Feb	0.7	6.1
Jan	1.2	5.4
AE ∆% Jan-Apr	11.3
Dec 2013		-0.7
Dec 2012		2.2
Dec 2011		4.4
Dec 2010		5.1
Dec 2009		-3.0
Dec 2008		1.5
Dec 2007		4.4
Dec 2006		3.8
Dec 2005		4.5
Dec 2004		3.7
Dec 2003		1.0
Dec 2002		1.5
Dec 2001		-0.5
Dec 2000		4.6
Dec 1999		2.5
Average ∆% 1999-2013		2.3

Source: EUROSTAT

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

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

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014.