Sunday, May 21, 2017

Dollar Devaluation, World Inflation Waves, United States Industrial Production, Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates, World Cyclical Slow Growth and Global Recession Risk: Part II

 

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Dollar Devaluation, World Inflation Waves, United States Industrial Production, Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates, World Cyclical Slow Growth and Global Recession Risk

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017

I World Inflation Waves

IA Appendix: Transmission of Unconventional Monetary Policy

IB1 Theory

IB2 Policy

IB3 Evidence

IB4 Unwinding Strategy

IC United States Inflation

IC Long-term US Inflation

ID Current US Inflation

IE Theory and Reality of Economic History, Cyclical Slow Growth Not Secular Stagnation

IIA United States Industrial Production

IIC Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates

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 Industrial Production. There is socio-economic stress in the combination of adverse events and cyclical performance:

  Industrial production increased 1.0 percent in Apr 2017 and increased 0.4 percent in Mar 2017 after increasing 0.2 percent in Feb 2017, with all data seasonally adjusted, as shown in Table I-1. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Mar 31, 2017 (https://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

“The Federal Reserve has revised its index of industrial production (IP) and the related measures of capacity and capacity utilization.[1] On net, the revisions were small, and the contour of total IP is little changed. Total IP is still reported to have moved up about 22 percent from the end of the recession in mid-2009 through late 2014, to have declined in 2015, and to have moved sideways in 2016. The most notable difference between the current and the previous estimates is that total IP is now reported to have decreased about 2 3/4 percent in 2015, whereas it previously showed a decline of about 1 3/4 percent.[2] The incorporation of detailed data for manufacturing from the U.S. Census Bureau's 2015 Annual Survey of Manufactures (ASM) accounts for the majority of the differences between the current and the previously published estimates.

Capacity for total industry is now reported to have expanded about 1 percent in 2015, a lower rate of increase than was reported earlier. Capacity was little changed in 2016 and is expected to increase 1 percent in 2017. Compared with prior reports, the rates of change in 2016 and 2017 are now a little smaller.

In the fourth quarter of 2016, capacity utilization for total industry stood at 75.8 percent, a rate 0.4 percentage point higher than previously published but still 4.1 percentage points below its long-run (1972–2016) average. Relative to earlier estimates, the utilization rates in recent years are now a little higher.”

The report of the Board of Governors of the Federal Reserve System states (https://www.federalreserve.gov/releases/g17/Current/default.htm):

“Industrial production advanced 1.0 percent in April for its third consecutive monthly increase and its largest gain since February 2014. Manufacturing output rose 1.0 percent as a result of widespread increases among its major industries. The indexes for mining and utilities posted gains of 1.2 percent and 0.7 percent, respectively. At 105.1 percent of its 2012 average, total industrial production in April was 2.2 percent above its year-earlier level. Capacity utilization for the industrial sector increased 0.6 percentage point in April to 76.7 percent, a rate that is 3.2 percentage points below its long-run (1972–2016) average.” In the six months ending in Apr 2017, United States national industrial production accumulated change of 1.9 percent at the annual equivalent rate of 3.9 percent, which is higher than growth of 2.2 percent in the 12 months ending in Apr 2017. Excluding growth of 0.8 percent in Dec 2016, growth in the remaining five months from Nov to Apr 2017 accumulated to 1.1 percent or 2.7 percent annual equivalent. Industrial production declined in two of the past six months and increased 0.2 percent in one month, 0.8 percent in another month, 0.4 percent in one month and 1.0 percent in one month. Industrial production grew at annual equivalent 6.6 percent in the most recent quarter from Feb 2017 to Apr and increased at 1.2 percent in the prior quarter Nov 2016 to Jan 2017. Business equipment accumulated change of 1.7 percent in the six months from Nov 2016 to Apr 2017, at the annual equivalent rate of 3.4 percent, which is higher than growth of 1.3 percent in the 12 months ending in Mar 2017. The Fed analyzes capacity utilization of total industry in its report (https://www.federalreserve.gov/releases/g17/Current/default.htm): “Capacity utilization for the industrial sector increased 0.6 percentage point in April to 76.7 percent, a rate that is 3.2 percentage points below its long-run (1972–2016) average.” United States industry apparently decelerated to a lower growth rate followed by possible acceleration and weakening growth in past months. There could renewed growth.

Table I-1, US, Industrial Production and Capacity Utilization, SA, ∆% 

 

Apr 

17

Mar 

17

Feb  

17

Jan 

17

Dec 

16

Nov 

16

Apr 17 

16/

Apr 16 

Total

1.0

0.4

0.2

-0.3

0.8

-0.2

2.2

Market
Groups

              

Final Products

1.4

1.0

-0.7

-0.7

1.3

-0.7

1.7

Consumer Goods

1.5

1.4

-1.1

-1.1

1.4

-1.0

1.4

Business Equipment

1.2

-0.3

0.0

0.0

0.9

-0.1

1.3

Non
Industrial Supplies

0.4

0.0

0.5

0.1

0.3

0.4

1.7

Construction

-0.1

-1.2

1.7

1.7

-0.1

0.9

2.2

Materials

0.8

0.0

0.8

0.0

0.5

0.0

2.8

Industry Groups

              

Manufacturing

1.0

-0.4

0.3

0.4

0.2

0.2

1.7

Mining

1.2

-0.4

3.8

1.4

-0.3

-0.1

7.3

Utilities

0.7

8.2

-5.2

-6.8

6.9

-3.3

-0.5

Capacity

76.7

76.1

75.8

75.8

76.0

75.5

0.7

Sources: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/default.htm

Manufacturing increased 1.0 percent in Apr and decreased 0.4 percent in Mar 2017 after increasing 0.3 percent in Feb 2017, seasonally adjusted, changing 0.0 percent not seasonally adjusted in the 12 months ending in Apr 2017, as shown in Table I-2. Manufacturing increased cumulatively 1.7 percent in the six months ending in Apr 2017 or at the annual equivalent rate of 3.4 percent. Excluding the increase of 0.4 percent in Jan 2017, manufacturing increased 1.3 percent from Nov 2016 to Apr 2017 or at the annual equivalent rate of 3.2 percent. Table I-2 provides a longer perspective of manufacturing in the US. There has been evident deceleration of manufacturing growth in the US from 2010 and the first three months of 2011 with recovery followed by renewed deterioration/improvement in more recent months as shown by 12 months’ rates of growth. Growth rates appeared to be increasing again closer to 5 percent in Apr-Jun 2012 but deteriorated. The rates of decline of manufacturing in 2009 are quite high with a drop of 18.5 percent in the 12 months ending in Apr 2009. Manufacturing recovered from this decline and led the recovery from the recession. Rates of growth appeared to be returning to the levels at 3 percent or higher in the annual rates before the recession but the pace of manufacturing fell steadily with some strength at the margin. There is renewed deterioration and improvement. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Mar 31, 2017 (https://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

“The Federal Reserve has revised its index of industrial production (IP) and the related measures of capacity and capacity utilization.[1] On net, the revisions were small, and the contour of total IP is little changed. Total IP is still reported to have moved up about 22 percent from the end of the recession in mid-2009 through late 2014, to have declined in 2015, and to have moved sideways in 2016. The most notable difference between the current and the previous estimates is that total IP is now reported to have decreased about 2 3/4 percent in 2015, whereas it previously showed a decline of about 1 3/4 percent.[2] The incorporation of detailed data for manufacturing from the U.S. Census Bureau's 2015 Annual Survey of Manufactures (ASM) accounts for the majority of the differences between the current and the previously published estimates.

Capacity for total industry is now reported to have expanded about 1 percent in 2015, a lower rate of increase than was reported earlier. Capacity was little changed in 2016 and is expected to increase 1 percent in 2017. Compared with prior reports, the rates of change in 2016 and 2017 are now a little smaller. In the fourth quarter of 2016, capacity utilization for total industry stood at 75.8 percent, a rate 0.4 percentage point higher than previously published but still 4.1 percentage points below its long-run (1972–2016) average. Relative to earlier estimates, the utilization rates in recent years are now a little higher.”

The bottom part of Table I-2 shows decline of manufacturing by 22.3 from the peak in Jun 2007 to the trough in Apr 2009 and increase of 15.5 percent from the trough in Apr 2009 to Dec 2016. Manufacturing grew 17.2 percent from the trough in Apr 2009 to Apr 2017. Manufacturing in Apr 2017 is lower by 9.0 percent relative to the peak in Jun 2007. 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 IQ2017 would have accumulated to 31.4 percent. GDP in IQ2017 would be $19,699.2 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2856.8 billion than actual $16,842.4 billion. There are about two trillion dollars of GDP less than at trend, explaining the 21.9 million unemployed or underemployed equivalent to actual unemployment/underemployment of 13.0 percent of the effective labor force (https://cmpassocregulationblog.blogspot.com/2017/05/twenty-two-million-unemployed-or.html and earlier https://cmpassocregulationblog.blogspot.com/2017/04/twenty-three-million-unemployed-or.html). US GDP in IQ2017 is 14.5 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,842.4 billion in IQ2017 or 12.3 percent at the average annual equivalent rate of 1.3 percent. Professor John H. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. Cochrane (2016May02) measures GDP growth in the US at average 3.5 percent per year from 1950 to 2000 and only at 1.76 percent per year from 2000 to 2015 with only at 2.0 percent annual equivalent in the current expansion. Cochrane (2016May02) proposes drastic changes in regulation and legal obstacles to private economic activity. 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. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.2 percent per year from Apr 1919 to Apr 2017. Growth at 3.2 percent per year would raise the NSA index of manufacturing output from 108.2393 in Dec 2007 to 145.2318 in Apr 2017. The actual index NSA in Apr 2017 is 102.4662, which is 29.4 percent below trend. Manufacturing output grew at average 2.0 percent between Dec 1986 and Apr 2017. Using trend growth of 2.0 percent per year, the index would increase to 130.2126 in Apr 2017. The output of manufacturing at 102.4662 in Apr 2017 is 21.3 percent below trend under this alternative calculation.

Table I-2, US, Monthly and 12-Month Rates of Growth of Manufacturing ∆%

 

Month SA ∆%

12-Month NSA ∆%

Apr 2017

1.0

0.0

Mar

-0.4

1.2

Feb

0.3

0.8

Jan

0.4

0.4

Dec 2016

0.2

0.6

Nov

0.2

0.1

Oct

0.2

0.0

Sep

0.2

0.3

Aug

-0.4

-0.8

Jul

0.1

-0.5

Jun

0.2

0.2

May

-0.2

-0.3

Apr

0.0

0.5

Mar

-0.2

-0.7

Feb

-0.2

0.4

Jan

0.6

0.2

Dec 2015

-0.3

-0.9

Nov

-0.1

-0.7

Oct

0.2

0.2

Sep

-0.3

-0.8

Aug

-0.1

0.1

Jul

0.6

0.3

Jun

-0.3

-0.6

May

-0.1

0.2

Apr

0.1

0.3

Mar

0.3

0.3

Feb

-0.5

0.7

Jan

-0.4

2.1

Dec 2014

-0.4

1.7

Nov

0.9

1.9

Oct

0.0

1.1

Sep

0.0

1.2

Aug

-0.4

1.4

Jul

0.2

2.0

Jun

0.3

1.5

May

0.2

1.3

Apr

0.0

0.9

Mar

0.8

1.5

Feb

1.1

0.2

Jan

-1.0

-0.7

Dec 2013

0.0

0.0

Nov

0.0

1.0

Oct

0.1

1.7

Sep

0.1

1.1

Aug

1.0

1.3

Jul

-1.1

0.2

Jun

0.2

0.7

May

0.2

0.9

Apr

-0.4

1.1

Mar

-0.2

0.7

Feb

0.5

0.9

Jan

-0.3

1.0

Dec 2012

0.7

2.0

Nov

0.8

2.0

Oct

-0.2

0.9

Sep

0.0

1.7

Aug

-0.2

2.2

Jul

-0.1

2.5

Jun

0.2

3.3

May

-0.4

3.2

Apr

0.6

3.6

Mar

-0.5

2.5

Feb

0.4

3.8

Jan

0.9

3.2

Dec 2011

0.6

2.8

Nov

-0.4

2.3

Oct

0.6

2.5

Sep

0.3

2.3

Aug

0.4

1.9

Jul

0.5

2.2

Jun

0.1

1.8

May

0.1

1.6

Apr

-0.6

2.9

Mar

0.6

4.5

Feb

0.1

5.1

Jan

0.2

5.2

Dec 2010

0.4

5.8

Nov

0.0

4.9

Oct

0.1

6.1

Sep

0.1

6.4

Aug

0.2

7.0

Jul

0.6

7.5

Jun

-0.1

9.2

May

1.4

8.7

Apr

0.9

6.9

Mar

1.2

4.6

Feb

-0.1

1.2

Jan

1.1

1.1

Dec 2009

-0.2

-3.4

Nov

1.0

-6.3

Oct

0.2

-9.3

Sep

0.8

-10.7

Aug

1.2

-13.7

Jul

1.4

-15.4

Jun

-0.4

-18.0

May

-1.1

-17.8

Apr

-0.8

-18.5

Mar

-1.9

-17.4

Feb

-0.2

-16.3

Jan

-3.0

-16.6

Dec 2008

-3.5

-14.1

Nov

-2.3

-11.4

Oct

-0.6

-8.9

Sep

-3.4

-8.7

Aug

-1.1

-5.2

Jul

-1.2

-3.7

Jun

-0.6

-3.3

May

-0.5

-2.6

Apr

-1.1

-1.3

Mar

-0.3

-0.8

Feb

-0.6

0.8

Jan

-0.4

2.1

Dec 2007

0.1

1.8

Nov

0.5

3.3

Oct

-0.4

2.7

Sep

0.4

2.9

Aug

-0.3

2.7

Jul

0.1

3.6

Jun

0.3

3.1

May

-0.1

3.2

Apr

0.7

3.7

Mar

0.8

2.6

Feb

0.4

1.6

Jan

-0.5

1.3

Dec 2006

  

2.7

Dec 2005

  

3.5

Dec 2004

  

4.0

Dec 2003

  

2.2

Dec 2002

  

2.4

Dec 2001

  

-5.4

Dec 2000

  

0.8

Dec 1999

  

5.2

Average ∆% Dec 1986-Dec 2016

  

2.0

Average ∆% Dec 1986-Dec 2015

  

2.0

Average ∆% Dec 1986-Dec 2014

  

2.1

Average ∆% Dec 1986-Dec 2013

  

2.2

Average ∆% Dec 1986-Dec 1999

  

4.3

Average ∆% Dec 1999-Dec 2006

  

1.4

Average ∆% Dec 1999-Dec 2016

  

0.3

∆% Peak 112.5742 in 06/2007 to 100.9304 in 12/2016

  

-10.3

∆% Peak 112.5742 in 06/2007 to Trough 87.4229 in 4/2009

  

-22.3

∆% Trough 87.4229 in 04/2009 to 100.9304 in 12/2016

  

15.5

∆% Trough 87.4229 in 04/2009 to 102.4662 in 4/2017

  

17.2

∆% Peak 112.5742 on 06/2007 to 102.4662 in 4/2017

  

-9.0

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/default.htm

Chart I-1 of the Board of Governors of the Federal Reserve System provides industrial production, manufacturing and capacity since the 1970s. There was acceleration of growth of industrial production, manufacturing and capacity in the 1990s because of rapid growth of productivity in the US (Cobet and Wilson (2002); see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). The slopes of the curves flatten in the 2000s. Production and capacity have not recovered sufficiently above levels before the global recession, remaining like GDP below historical trend. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.2 percent per year from Apr 1919 to Apr 2017. Growth at 3.2 percent per year would raise the NSA index of manufacturing output from 108.2393 in Dec 2007 to 145.2318 in Apr 2017. The actual index NSA in Apr 2017 is 102.4662, which is 29.4 percent below trend. Manufacturing output grew at average 2.0 percent between Dec 1986 and Apr 2017. Using trend growth of 2.0 percent per year, the index would increase to 130.2126 in Apr 2017. The output of manufacturing at 102.4662 in Apr 2017 is 21.3 percent below trend under this alternative calculation.

Chart I-1, US, Industrial Production, Capacity and Utilization

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/ipg1.gif

The modern industrial revolution of Jensen (1993) is captured in Chart I-2 of the Board of Governors of the Federal Reserve System (for the literature on M&A and corporate control see Pelaez and Pelaez, Regulation of Banks and Finance (2009a), 143-56, Globalization and the State, Vol. I (2008a), 49-59, Government Intervention in Globalization (2008c), 46-49). The slope of the curve of total industrial production accelerates in the 1990s to a much higher rate of growth than the curve excluding high-technology industries. Growth rates decelerate into the 2000s and output and capacity utilization have not recovered fully from the strong impact of the global recession. Growth in the current cyclical expansion has been more subdued than in the prior comparably deep contractions in the 1970s and 1980s. Chart I-2 shows that the past recessions after World War II are the relevant ones for comparison with the recession after 2007 instead of common comparisons with the Great Depression (https://cmpassocregulationblog.blogspot.com/2017/04/dollar-devaluation-mediocre-cyclical.html and earlier https://cmpassocregulationblog.blogspot.com/2017/04/mediocre-cyclical-economic-growth-with.html). The bottom left-hand part of Chart II-2 shows the strong growth of output of communication equipment, computers and semiconductor that continued from the 1990s into the 2000s. Output of semiconductors has already surpassed the level before the global recession.

Chart I-2, US, Industrial Production, Capacity and Utilization of High Technology Industries

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/ipg3.gif

Additional detail on industrial production and capacity utilization is in Chart I-3 of the Board of Governors of the Federal Reserve System. Production of consumer durable goods fell sharply during the global recession by more than 30 percent and is oscillating above the level before the contraction. Output of nondurable consumer goods fell around 10 percent and is some 5 percent below the level before the contraction. Output of business equipment fell sharply during the contraction of 2001 but began rapid growth again after 2004. An important characteristic is rapid growth of output of business equipment in the cyclical expansion after sharp contraction in the global recession, stalling in the final segment. Output of defense and space only suffered reduction in the rate of growth during the global recession and surged ahead of the level before the contraction, declining in the final segment. Output of construction supplies collapsed during the global recession and is well below the level before the contraction. Output of energy materials was stagnant before the contraction but recovered sharply above the level before the contraction with recent decline.

Chart I-3, US, Industrial Production and Capacity Utilization

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/ipg2.gif

United States manufacturing output from 1919 to 2017 on a monthly basis is in Chart I-4 of the Board of Governors of the Federal Reserve System. The second industrial revolution of Jensen (1993) is quite evident in the acceleration of the rate of growth of output given by the sharper slope in the 1980s and 1990s. Growth was robust after the shallow recession of 2001 but dropped sharply during the global recession after IVQ2007. Manufacturing output recovered sharply but has not reached earlier levels and is losing momentum at the margin. Current output is well below extrapolation of trend. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.2 percent per year from Apr 1919 to Apr 2017. Growth at 3.2 percent per year would raise the NSA index of manufacturing output from 108.2393 in Dec 2007 to 145.2318 in Apr 2017. The actual index NSA in Apr 2017 is 102.4662, which is 29.4 percent below trend. Manufacturing output grew at average 2.0 percent between Dec 1986 and Apr 2017. Using trend growth of 2.0 percent per year, the index would increase to 130.2126 in Apr 2017. The output of manufacturing at 102.4662 in Apr 2017 is 21.3 percent below trend under this alternative calculation.

Chart I-4, US, Manufacturing Output, 1919-2017

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/default.htm

Manufacturing jobs not seasonally adjusted increased 34,000 from Apr 2016 to
Apr 2017 or at the average monthly rate of 2833.   Industrial production increased 1.0 percent in Apr 2017 and increased 0.4 percent in Mar 2017 after increasing 0.2 percent in Feb 2017, with all data seasonally adjusted. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Mar 31, 2017 (https://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

“The Federal Reserve has revised its index of industrial production (IP) and the related measures of capacity and capacity utilization.[1] On net, the revisions were small, and the contour of total IP is little changed. Total IP is still reported to have moved up about 22 percent from the end of the recession in mid-2009 through late 2014, to have declined in 2015, and to have moved sideways in 2016. The most notable difference between the current and the previous estimates is that total IP is now reported to have decreased about 2 3/4 percent in 2015, whereas it previously showed a decline of about 1 3/4 percent.[2] The incorporation of detailed data for manufacturing from the U.S. Census Bureau's 2015 Annual Survey of Manufactures (ASM) accounts for the majority of the differences between the current and the previously published estimates.

Capacity for total industry is now reported to have expanded about 1 percent in 2015, a lower rate of increase than was reported earlier. Capacity was little changed in 2016 and is expected to increase 1 percent in 2017. Compared with prior reports, the rates of change in 2016 and 2017 are now a little smaller.

In the fourth quarter of 2016, capacity utilization for total industry stood at 75.8 percent, a rate 0.4 percentage point higher than previously published but still 4.1 percentage points below its long-run (1972–2016) average. Relative to earlier estimates, the utilization rates in recent years are now a little higher.”

The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Mar 31, 2017 (https://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

“The Federal Reserve has revised its index of industrial production (IP) and the related measures of capacity and capacity utilization.[1] On net, the revisions were small, and the contour of total IP is little changed. Total IP is still reported to have moved up about 22 percent from the end of the recession in mid-2009 through late 2014, to have declined in 2015, and to have moved sideways in 2016. The most notable difference between the current and the previous estimates is that total IP is now reported to have decreased about 2 3/4 percent in 2015, whereas it previously showed a decline of about 1 3/4 percent.[2] The incorporation of detailed data for manufacturing from the U.S. Census Bureau's 2015 Annual Survey of Manufactures (ASM) accounts for the majority of the differences between the current and the previously published estimates.

Capacity for total industry is now reported to have expanded about 1 percent in 2015, a lower rate of increase than was reported earlier. Capacity was little changed in 2016 and is expected to increase 1 percent in 2017. Compared with prior reports, the rates of change in 2016 and 2017 are now a little smaller. In the fourth quarter of 2016, capacity utilization for total industry stood at 75.8 percent, a rate 0.4 percentage point higher than previously published but still 4.1 percentage points below its long-run (1972–2016) average. Relative to earlier estimates, the utilization rates in recent years are now a little higher.”

Manufacturing fell 22.3 from the peak in Jun 2007 to the trough in Apr 2009 and increased 15.5 percent from the trough in Apr 2009 to Dec 2016. Manufacturing grew 17.2 percent from the trough in Apr 2009 to Apr 2017. Manufacturing in Apr 2017 is lower by 9.0 percent relative to the peak in Jun 2007. 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 IQ2017 would have accumulated to 31.4 percent. GDP in IQ2017 would be $19,699.2 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2856.8 billion than actual $16,842.4 billion. There are about two trillion dollars of GDP less than at trend, explaining the 21.9 million unemployed or underemployed equivalent to actual unemployment/underemployment of 13.0 percent of the effective labor force (https://cmpassocregulationblog.blogspot.com/2017/05/twenty-two-million-unemployed-or.html and earlier https://cmpassocregulationblog.blogspot.com/2017/04/twenty-three-million-unemployed-or.html). US GDP in IQ2017 is 14.5 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,842.4 billion in IQ2017 or 12.3 percent at the average annual equivalent rate of 1.3 percent. Professor John H. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. Cochrane (2016May02) measures GDP growth in the US at average 3.5 percent per year from 1950 to 2000 and only at 1.76 percent per year from 2000 to 2015 with only at 2.0 percent annual equivalent in the current expansion. Cochrane (2016May02) proposes drastic changes in regulation and legal obstacles to private economic activity. 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. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.2 percent per year from Apr 1919 to Apr 2017. Growth at 3.2 percent per year would raise the NSA index of manufacturing output from 108.2393 in Dec 2007 to 145.2318 in Apr 2017. The actual index NSA in Apr 2017 is 102.4662, which is 29.4 percent below trend. Manufacturing output grew at average 2.0 percent between Dec 1986 and Apr 2017. Using trend growth of 2.0 percent per year, the index would increase to 130.2126 in Apr 2017. The output of manufacturing at 102.4662 in Apr 2017 is 21.3 percent below trend under this alternative calculation.

Table I-13 provides national income by industry without capital consumption adjustment (WCCA). “Private industries” or economic activities have share of 87.0 percent in IVQ2016. Most of US national income is in the form of services. In Mar 2017, there were 145.979 million nonfarm jobs NSA in the US, according to estimates of the establishment survey of the Bureau of Labor Statistics (BLS) (http://www.bls.gov/news.release/empsit.nr0.htm Table B-1). Total private jobs of 123.256 million NSA in Apr 2017 accounted for 84.4 percent of total nonfarm jobs of 145.979 million, of which 12.333 million, or 10.0 percent of total private jobs and 8.4 percent of total nonfarm jobs, were in manufacturing. Private service-providing jobs were 103.461 million NSA in Apr 2017, or 70.9 percent of total nonfarm jobs and 83.9 percent of total private-sector jobs. Manufacturing has share of 10.2 percent in US national income in IVQ2016 and durable goods 6.0 percent, as shown in Table I-13. Most income in the US originates in services. Subsidies and similar measures designed to increase manufacturing jobs will not increase economic growth and employment and may actually reduce growth by diverting resources away from currently employment-creating activities because of the drain of taxation.

Table I-13, US, National Income without Capital Consumption Adjustment by Industry, Seasonally Adjusted Annual Rates, Billions of Dollars, % of Total

 

SAAR IIIQ2016

% Total

SAAR
IVQ2016

% Total

National Income WCCA

16,173.7

100.0

16,335.7

100.0

Domestic Industries

15,969.7

98.7

16,092.7

98.5

Private Industries

14,095.4

87.2

14,207.5

87.0

Agriculture

122.0

0.8

113.3

0.7

Mining

187.7

1.2

189.4

1.2

Utilities

172.0

1.1

173.9

1.1

Construction

771.3

4.8

788.6

4.8

Manufacturing

1676.5

10.4

1665.7

10.2

Durable Goods

977.4

6.0

980.7

6.0

Nondurable Goods

699.2

4.3

685.0

4.2

Wholesale Trade

957.9

5.9

951.8

5.8

Retail Trade

1136.2

7.0

1138.5

7.0

Transportation & WH

505.7

3.1

502.5

3.1

Information

596.0

3.7

593.0

3.6

Finance, Insurance, RE

2862.6

17.7

2922.5

17.9

Professional & Business Services

2293.6

14.2

2313.0

14.2

Education, Health Care

1651.7

10.2

1666.1

10.2

Arts, Entertainment

688.0

4.3

706.9

4.3

Other Services

474.2

2.9

482.4

3.0

Government

1874.3

11.6

1885.1

11.5

Rest of the World

204.0

1.3

243.0

1.5

Notes: SSAR: Seasonally-Adjusted Annual Rate; WCCA: Without Capital Consumption Adjustment by Industry; WH: Warehousing; RE, includes rental and leasing: Real Estate; Art, Entertainment includes recreation, accommodation and food services; BS: business services

Source: US Bureau of Economic Analysis

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

Motor vehicle sales and production in the US have been in long-term structural change. Table VA-1A provides the data on new motor vehicle sales and domestic car production in the US from 1990 to 2010. New motor vehicle sales grew from 14,137 thousand in 1990 to the peak of 17,806 thousand in 2000 or 29.5 percent. In that same period, domestic car production fell from 6,231 thousand in 1990 to 5,542 thousand in 2000 or -11.1 percent. New motor vehicle sales fell from 17,445 thousand in 2005 to 11,772 in 2010 or 32.5 percent while domestic car production fell from 4,321 thousand in 2005 to 2,840 thousand in 2010 or 34.3 percent. In Apr 2017, light vehicle sales accumulated to 5,458,914 million, which is lower by 2.4 percent relative to 5,591,153 a year earlier (http://motorintelligence.com/m_frameset.html). The seasonally adjusted annual rate of light vehicle sales in the US reached 16.88 million in Apr 2017, higher than 16.62 million in Mar 2017 and lower than 17.40 million in Apr 2016. (http://motorintelligence.com/m_frameset.html).

Table VA-1A, US, New Motor Vehicle Sales and Car Production, Thousand Units 7

 

New Motor Vehicle Sales

New Car Sales and Leases

New Truck Sales and Leases

Domestic Car Production

1990

14,137

9,300

4,837

6,231

1991

12,725

8,589

4,136

5,454

1992

13,093

8,215

4,878

5,979

1993

14,172

8,518

5,654

5,979

1994

15,397

8,990

6,407

6,614

1995

15,106

8,536

6,470

6,340

1996

15,449

8,527

6,922

6,081

1997

15,490

8,273

7,218

5,934

1998

15,958

8,142

7,816

5,554

1999

17,401

8,697

8,704

5,638

2000

17,806

8,852

8,954

5,542

2001

17,468

8,422

9,046

4,878

2002

17,144

8,109

9,036

5,019

2003

16,968

7,611

9,357

4,510

2004

17,298

7,545

9,753

4,230

2005

17,445

7,720

9,725

4,321

2006

17,049

7,821

9,228

4,367

2007

16,460

7,618

8,683

3,924

2008

13,494

6,814

6.680

3,777

2009

10,601

5,456

5,154

2,247

2010

11,772

5,729

6,044

2,840

Source: US Census Bureau

http://www.census.gov/compendia/statab/cats/wholesale_retail_trade/motor_vehicle_sales.html

Chart I-5 of the Board of Governors of the Federal Reserve provides output of motor vehicles and parts in the United States from 1972 to 2017. Output virtually stagnated since the late 1990s with recent increase.

Chart 1-5, US, Motor Vehicles and Parts Output, 1972-2017

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/default.htm

Chart I-6 of the Board of Governors of the Federal Reserve System provides output of computers and electronic products in the United States from 1972 to 2017. Output accelerated sharply in the 1990s and 2000s and surpassed the level before the global recession beginning in IVQ2007.

Chart I-6, US, Output of Computers and Electronic Products, 1972-2017

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/default.htm

Chart I-7 of the Board of Governors of the Federal Reserve System shows that output of durable manufacturing accelerated in the 1980s and 1990s with slower growth in the 2000s perhaps because processes matured. Growth was robust after the major drop during the global recession but appears to vacillate in the final segment.

Chart I-7, US, Output of Durable Manufacturing, 1972-2017

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/default.htm

Chart I-8 of the Board of Governors of the Federal Reserve System provides output of aerospace and miscellaneous transportation equipment from 1972 to 2017. There is long-term upward trend with oscillations around the trend and cycles of large amplitude.

Chart I-8, US, Output of Aerospace and Miscellaneous Transportation Equipment, 1972-2017

Source: Board of Governors of the Federal Reserve System

https://www.federalreserve.gov/releases/g17/Current/default.htm

The Empire State Manufacturing Survey Index in Table VA-1 provides continuing deterioration that started in Jun 2012 well before Hurricane Sandy in Oct 2012. The current general index has been in negative contraction territory from minus 2.2 in Aug 2012 to minus 7.6 in Jan 2013 and minus 2.1 in May 2013. The current general index changed to minus 1.0 in May 2017. The index of current orders has also been in negative contraction territory from minus 2.9 in Aug 2012 to minus 9.8 in Jan 2013 and minus 7.9 in Jun 2013. The index of current new orders changed minus 4.4 in May 2017. Number of workers and hours worked have registered negative or declining readings since Sep 2012 with 11.9 for number of workers in May 2017 and 7.5 for average workweek. There is improvement in the general index for the next six months at 39.3 in May 2017 and new orders at 33.2.

Table VA-1, US, New York Federal Reserve Bank Empire State Manufacturing Survey Index SA

Current

Current Index

New Orders

Shipments

Number of Workers

Average Workweek

9/30/2011

-4.0

-3.6

-6.7

-5.4

-2.2

10/31/2011

-5.1

2.8

3.9

3.4

-4.5

11/30/2011

4.9

1.2

12.4

-3.7

2.4

12/31/2011

11.5

9.4

23.3

2.3

-2.3

1/31/2012

11.4

9.2

18.9

12.1

6.6

2/29/2012

17.4

7

18.1

11.8

7.1

3/31/2012

15.4

4.2

15

13.6

18.5

4/30/2012

7.6

4.5

6.1

19.3

6

5/31/2012

13.6

7.7

20.7

20.5

12

6/30/2012

1.5

1.5

10.7

12.4

3.1

7/31/2012

2.5

-4

9

18.5

0

8/31/2012

-2.2

-2.9

6.8

16.5

3.5

9/30/2012

-6.4

-9.4

5.2

4.3

-1.1

10/31/2012

-3.5

-5.5

-3

-1.1

-4.3

11/30/2012

-0.8

5.6

15.9

-14.6

-7.9

12/31/2012

-6

-1

11.3

-9.7

-10.8

1/31/2013

-7.6

-9.8

-3.2

-4.3

-5.4

2/28/2013

8.9

12.6

11.5

8.1

-4

3/31/2013

5.3

4.9

6.3

3.2

0

4/30/2013

4.2

1.6

2.6

6.8

5.7

5/31/2013

-2.1

-2.4

-2.8

5.7

-1.1

6/30/2013

4.8

-7.9

-7.6

0

-11.3

7/31/2013

4.3

2.1

5.2

3.3

-7.6

8/31/2013

10.7

2.5

1.5

10.8

4.8

9/30/2013

8.3

4.1

14.1

7.5

1.1

10/31/2013

5.3

10.1

19.6

3.6

3.6

11/30/2013

2.2

-2.8

0.9

0

-5.3

12/31/2013

2.5

-0.8

6.6

0

-10.8

1/31/2014

12.3

9

15.6

12.2

1.2

2/28/2014

6.1

2.4

4.1

11.3

3.8

3/31/2014

3.6

2.1

4.5

5.9

4.7

4/30/2014

3.5

-2.5

5.4

8.2

2

5/31/2014

16.3

8.5

15.4

20.9

2.2

6/30/2014

16.4

13.6

12.9

10.8

9.7

7/31/2014

19.5

16.7

18.7

17

2.3

8/31/2014

17.6

15.2

20.8

13.6

8

9/30/2014

30.2

19.2

25.1

3.3

3.3

10/31/2014

8.4

2

8.9

10.2

-1.1

11/30/2014

12

10

11.2

8.5

-7.4

12/31/2014

-3.4

-1

1.8

8.3

-11.5

1/31/2015

11.8

6.6

12.1

13.7

-8.4

2/28/2015

9.6

3.5

16.6

10.1

-1.1

3/31/2015

4.5

-3.9

5.5

18.6

5.2

4/30/2015

-0.8

-7.5

12.1

9.6

-4.3

5/31/2015

2.3

2.1

13.7

5.2

-2.1

6/30/2015

-4.1

-5.4

9

8.7

3.8

7/31/2015

0.1

-4.9

5.1

3.2

4.3

8/31/2015

-12

-14.7

-14.6

1.8

-1.8

9/30/2015

-12.2

-10.2

-6.7

-6.2

-10.3

10/31/2015

-10.4

-15

-6.1

-8.5

-7.5

11/30/2015

-9.6

-11.2

-3.2

-7.3

-14.5

12/31/2015

-7.3

-6.7

4.7

-16.2

-27.3

1/31/2016

-16.8

-22.4

-11.5

-13

-6

2/29/2016

-14.5

-9.7

-8.8

-1

-5.9

3/31/2016

-1.5

6.4

10.3

-2

2

4/30/2016

8.4

7.9

6.8

1.9

1.9

5/31/2016

-9

-4.7

-1.5

2.1

-8.3

6/30/2016

3.7

8.2

8.5

0

-5.1

7/31/2016

-0.5

-1.7

0.6

-4.4

-5.5

8/31/2016

-3.2

1

5.8

-1

2.1

9/30/2016

-1.2

-5

-8.1

-14.3

-11.6

10/31/2016

-5.5

-3.1

2.8

-4.7

-10.4

11/30/2016

2.2

4

8.6

-10.9

-10.9

12/31/2016

7.6

10.4

8.6

-12.2

-7

1/31/2017

6.5

3.1

7.3

-1.7

-4.2

2/28/2017

18.7

13.5

18.2

2

4.1

3/31/2017

16.4

21.3

11.3

8.8

15

4/30/2017

5.2

7

13.7

13.9

8.8

5/31/2017

-1

-4.4

10.6

11.9

7.5

Six Months

General Index

New Orders

Shipments

Number of Workers

Average Workweek

9/30/2011

22.1

23.5

22.2

0

-6.5

10/31/2011

14.3

19.7

23.4

6.7

-2.2

11/30/2011

35.5

31.2

33.1

14.6

8.5

12/31/2011

46.2

43.6

41

24.4

22.1

1/31/2012

51.3

44.6

44.3

28.6

17.6

2/29/2012

46.7

38.7

41.6

29.4

18.8

3/31/2012

43.9

37.8

39.6

32.1

21

4/30/2012

40.2

37.4

37

27.7

10.8

5/31/2012

31.9

31.1

26.3

12

8.4

6/30/2012

27.5

28.4

24.1

16.5

2.1

7/31/2012

23.7

20.9

22.2

6.2

-4.9

8/31/2012

19.3

14.1

21.8

3.5

-8.2

9/30/2012

26.3

28

22.8

8.5

2.1

10/31/2012

20

22.6

18

0

-11.8

11/30/2012

18.4

16.9

26.3

-1.1

0

12/31/2012

19.8

19.3

23.1

10.8

5.4

1/31/2013

22

23.8

24.9

7.5

3.2

2/28/2013

32.9

28.6

28.1

15.2

11.1

3/31/2013

35

33

39

19.4

2.2

4/30/2013

30

34.3

34.8

25

8

5/31/2013

25.7

29.2

26.4

11.4

1.1

6/30/2013

27.6

22.5

22.8

1.6

-9.7

7/31/2013

33

32.1

34.8

1.1

-1.1

8/31/2013

36.5

30.3

31.1

8.4

-6

9/30/2013

39.5

38.2

37.6

4.3

-2.2

10/31/2013

41.2

37.1

33.4

7.2

2.4

11/30/2013

38.5

41.4

38.3

22.4

-3.9

12/31/2013

37.6

27.9

32.4

9.6

1.2

1/31/2014

36.4

37.6

30.8

20.7

9.8

2/28/2014

41.1

45.6

43.8

25

7.5

3/31/2014

35.1

36.4

34.2

17.6

9.4

4/30/2014

37.8

32.9

36.3

22.4

1

5/31/2014

42.6

37.1

35.8

17.6

-3.3

6/30/2014

41.2

44.5

46.4

20.4

0

7/31/2014

29.4

26.1

25.2

17

-4.5

8/31/2014

46.5

50

54.4

22.7

0

9/30/2014

45.6

45.9

47.3

14.1

5.4

10/31/2014

42

42.4

42.3

12.5

-2.3

11/30/2014

48.1

49.6

45.9

24.5

8.5

12/31/2014

36.9

35.9

36.9

20.8

12.5

1/31/2015

47.3

40.9

40.2

31.6

11.6

2/28/2015

29

31.8

32

24.7

1.1

3/31/2015

30.8

26.1

27.2

28.9

3.1

4/30/2015

36.1

31.9

29.6

22.3

-1.1

5/31/2015

29.8

33.3

32.4

16.7

-1

6/30/2015

26

27.2

25

13.5

0

7/31/2015

27.9

31.8

25.4

9.6

-3.2

8/31/2015

34

30.4

32.4

3.6

1.8

9/30/2015

22.1

24

25.7

7.2

-9.3

10/31/2015

22.3

23

23.6

10.4

0.9

11/30/2015

23.6

23.7

22.9

16.4

5.5

12/31/2015

35.2

24.8

33.1

15.2

10.1

1/31/2016

10.4

14

18.6

4

11

2/29/2016

17.1

24.1

24.9

16.8

0

3/31/2016

25.3

36.8

31.7

12.9

5

4/30/2016

28.9

34.8

34.5

13.5

10.6

5/31/2016

27.7

21.9

25.4

10.4

5.2

6/30/2016

33.3

37.6

29.1

-2

2

7/31/2016

29.5

29.5

29.7

1.1

-6.6

8/31/2016

26.9

28.4

28.3

-6.2

-5.2

9/30/2016

33

32.5

22.3

7.1

-9.8

10/31/2016

35.3

38

35.5

9.4

4.7

11/30/2016

31.1

31.3

26.9

10.9

10

12/31/2016

49.7

46.3

41

23.5

12.2

1/31/2017

49.7

39.8

43.4

27.7

19.3

2/28/2017

41.7

43.8

41.7

28.6

19.4

3/31/2017

37.4

33.9

35.5

14.2

11.5

4/30/2017

39.9

31

29.2

19.7

17.5

5/31/2017

39.3

33.2

37.8

17.2

5.2

Source: Federal Reserve Bank of New York

http://www.ny.frb.org/survey/empire/empiresurvey_overview.html

Chart VA-1 of the Federal Reserve Bank of New York provides indexes of current and expected economic activity. There were multiple contractions in current activity after the global recession shown in shade. Current activity is weakening relative to strong recovery in the initial expansion in 2010 and 2011 with recent recovery.

Chart VA-1, US, US, Federal Reserve Bank of New York, Diffusion Index of Current and Expected Activity, Seasonally Adjusted

Source: Federal Reserve Bank of New York

http://www.ny.frb.org/survey/empire/empiresurvey_overview.html

Table VA-1 shows improvement after prior deterioration followed by current soft improvement of the Business Outlook survey of the Federal Reserve Bank of Philadelphia. The general index moved out of contraction of 4.8 in Feb 2013 to expansion at 38.8 in May 2017. New orders moved from 0.1 in Feb 2013 to 25.4 in May 2017.

Table VA-2, US, Federal Reserve Bank of Philadelphia Business Outlook Survey, SA

 

Current General Index

Current New Orders

Current Shipments

Future General Index

Future New Orders

Future Shipments

Jan-11

16.5

20.7

11.2

43.9

36.2

38.1

Feb-11

29.0

21.0

24.4

41.9

38.8

43.9

Mar-11

36.5

34.7

28.6

57.0

55.6

54.8

Apr-11

12.9

14.4

21.4

35.7

30.8

36.5

May-11

6.2

8.5

9.4

26.2

25.1

28.7

Jun-11

-0.3

-4.5

7.5

8.4

8.4

8.4

Jul-11

7.2

2.8

7.2

28.6

32.2

27.6

Aug-11

-19.4

-17.9

-2.4

12.5

26.6

23.4

Sep-11

-11.5

-6.5

-9

17.9

19.6

21.8

Oct-11

6.2

5.1

8.5

26.4

28.6

29.6

Nov-11

4.0

0.3

6.3

36.5

36.3

33.8

Dec-11

2.4

4.7

5.2

33.8

38.7

31.7

Jan-12

7.4

11.1

4.4

43.8

44

43.9

Feb-12

10.7

12.1

8.7

30.2

32.4

28.4

Mar-12

8.9

1.3

1.5

30.5

37.3

31.1

Apr-12

5.6

1.6

-2.7

39.9

42

35

May-12

-0.7

2.8

9

24.7

35.4

30.6

Jun-12

-12.4

-16.7

-10.8

25.2

33.6

36.7

Jul-12

-12.6

-5.4

-11.7

21.4

25.5

19.1

Aug-12

-2.3

0.5

-2.6

19.8

25.3

17.6

Sep-12

-0.9

0.3

-12.2

31.3

42.6

34.7

Oct-12

-1.2

-4.9

-6.9

17.4

20.6

20.6

Nov-12

-10.6

-9.1

-6.7

17

23.3

24.2

Dec-12

2.4

2.9

12.3

22.7

29.2

27.4

Jan-13

-1.6

-2

0

29.5

32.4

37.4

Feb-13

-4.8

0.1

2.3

32.1

39.4

34.1

Mar-13

2.3

2.6

6

35.7

38.5

34.4

Apr-13

0.6

1.8

5.5

30.7

34.1

34.3

May-13

0.5

-2.9

-0.2

38.9

42.1

38.3

Jun-13

12.9

12.9

8.7

36.6

38.7

39

Jul-13

15.9

4.9

7.4

41.2

51.9

43.6

Aug-13

8.4

8

2.7

38

38.3

39.4

Sep-13

19.2

19.4

20.8

48.3

51.1

47.9

Oct-13

12.9

22.4

16.5

55.6

60.6

51.3

Nov-13

4.4

7

4.8

42.7

47.5

41.2

Dec-13

3.2

11.9

8.7

41.6

44.9

39.5

Jan-14

14.9

7.8

11.5

39

41.9

38.9

Feb-14

3.3

4.2

-5.8

44.6

40.6

43.2

Mar-14

13.4

10.3

12.1

43.3

39.6

47.3

Apr-14

17.5

18.3

25.5

39.5

38.6

41.2

May-14

19.3

15.7

20.2

42

42

42.7

Jun-14

14.3

11.6

16.4

51.6

52.7

46.4

Jul-14

20.7

25.3

24.3

52.8

47.4

50.2

Aug-14

23

14.8

14.7

61.2

50.3

58.4

Sep-14

20.4

14.7

21.4

46

44.2

50.8

Oct-14

17.7

15.5

16.1

50.7

48.2

49.3

Nov-14

34.8

27.2

28.3

51.5

47

48.2

Dec-14

20.3

13.9

11

48.4

44.9

44.3

Jan-15

12.5

9.9

-7.3

55.6

48.7

47.8

Feb-15

12.5

8.9

9.2

36.6

48

44.9

Mar-15

8.6

6.5

-1.9

39.6

39.5

38.5

Apr-15

10.4

5.3

4.9

39.9

34.1

39.5

May-15

8.2

6.2

5.6

35

33.9

32.9

Jun-15

8.1

11.7

13.2

40

43.1

54

Jul-15

2.9

-1.6

-3.9

38.8

42.2

44.3

Aug-15

5.4

5.6

11.7

33.7

37.9

28

Sep-15

-4.8

11.9

17.7

37.6

40.9

38.9

Oct-15

-4.9

-8.6

-5.2

34.4

35.5

33.8

Nov-15

-4.3

-10.5

-5.3

39.3

48.3

41.6

Dec-15

-11.3

-9.9

-1.9

20.7

32.1

32

Jan-16

-5.3

-2.7

2.3

20

23.6

26.1

Feb-16

-3.8

-3.9

3.7

18.6

22.6

22.8

Mar-16

10.6

12.7

16.7

29.7

37.6

34.2

Apr-16

-1.2

-0.4

-7.9

39.7

44.2

40

May-16

-1.5

-1.5

0.1

34.9

38.2

35.6

Jun-16

4.1

-1.1

2

31

31.3

33.8

Jul-16

-0.9

6.1

2.3

34.4

30.9

28.6

Aug-16

4.3

-3.4

8.7

40.8

41.3

45.4

Sep-16

11.6

5.3

1.4

38.4

37.3

32.8

Oct-16

11.1

17.3

15.5

35.7

39.6

39.8

Nov-16

8.7

15.2

16.6

32.2

41.1

31.7

Dec-16

19.7

14.9

21.7

48.7

48.8

46.7

Jan-17

23.6

26

20.5

56.6

54.5

59.1

Feb-17

43.3

38

28.6

53.5

51.5

51.7

Mar-17

32.8

38.6

32.9

59.5

61

54.8

Apr-17

22

27.4

23.4

45.4

55.9

44.7

May-17

38.8

25.4

39.1

34.8

47.2

38.5

Source: Federal Reserve Bank of Philadelphia

https://www.philadelphiafed.org/

Chart VA-2 of the Federal Reserve Bank of Philadelphia is very useful, providing current and future general activity indexes from Jan 2006 to May 2016. The shaded areas are the recession cycle dates of the National Bureau of Economic Research (NBER) (http://www.nber.org/cycles.html). The Philadelphia Fed index dropped during the initial period of recession and then led the recovery, as industry overall. There was a second decline of the index into 2011 followed now by what appeared as renewed strength from late 2011 into Jan 2012. There is decline to negative territory of the current activity index in Nov 2012 and return to positive territory in Dec 2012 with decline of current conditions into contraction in Jan-Feb 2013 and rebound to mild expansion in Mar-Apr 2013. The index of current activity moved into expansion in Jun-Oct 2013 with weakness in Nov-Dec 2013, improving in Jan 2014. There is renewed deterioration in Feb 2014 with rebound in Apr-Sep 2014 and mild deterioration in Oct 2014 followed by improvement in Nov 2014. The index deteriorated in Jan-Feb 2015, stabilizing in Mar-May 2015 and improving in Jun 2015. The index deteriorated in Jul 2015, improved in Aug 2015 and deteriorated in Sep-Oct 2015. The index shows contraction in Nov 2015 to Feb 2016 with recovery in Mar 2016. There is deterioration in Apr-May 2016 with improvement in Jun 2016 and deterioration in Jul 2016. There is improvement in Aug-Sep 2016 with moderate weakening in Oct-Nov 2016. The indexes improved sharply in Dec 2016 and Jan-Feb 2017, softening in Mar-Apr 2017. The current index improved in May 2017 with deterioration in the six-month forecast.

Chart VA-2, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current and Future Activity Indexes

Source: Federal Reserve Bank of Philadelphia

https://www.philadelphiafed.org/

The index of current new orders of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia in Chart VA-2 illustrates the weakness of the cyclical expansion. The index weakened in 2006 and 2007 and then fell sharply into contraction during the global recession. There have been twelve readings into contraction from Jan 2012 to May 2013 and generally weak readings with some exceptions. The index of new orders moved into expansion in Jun-Oct 2013 with moderation in Nov-Dec 2013 and into Jan 2014. The index fell into contraction in Feb 2014, recovering in Mar-Apr 2014 but weaker reading in May 2014. There is marked improvement in Jun-Jul 2014 with slowing in Aug-Oct 2014 followed by acceleration in Nov 2014. New orders deteriorated in Jan-Apr 2015, improving in May-Jun 2015. New orders deteriorated in Jul-Aug 2015 and improved in Sep 2015. New orders deteriorated in Oct-2015 to Dec 2015, contracting at slower pace in Jan 2016. There is sharper contraction in Feb 2016 and an upward jump in Mar 2016 followed by deterioration in Apr-Jun 2016. New orders improved in Jul 2016, deteriorating in Aug 2016 and improving in Sep 2016. Improvement continued in Oct-Nov 2016 with mild deterioration in Dec 2016 followed by improvement in Jan-Feb 2017, softening in Mar-May 2017.

Chart VA-3, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current New Orders Diffusion Index SA

Source: Federal Reserve Bank of Philadelphia

https://www.philadelphiafed.org/

II B. Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates. Long-term economic growth in Japan significantly improved by increasing competitiveness in world markets. Net trade of exports and imports is an important component of the GDP accounts of Japan. Table VB-3 provides quarterly data for net trade, exports and imports of Japan. Net trade had strong positive contributions to GDP growth in Japan in all quarters from IQ2007 to IIQ2009 with exception of IVQ2008 and IQ2009. The US recession is dated by the National Bureau of Economic Research (NBER) as beginning in IVQ2007 (Dec) and ending in IIQ2009 (Jun) (http://www.nber.org/cycles/cyclesmain.html). Net trade contributions helped to cushion the economy of Japan from the global recession. Net trade deducted from GDP growth in six of the nine quarters from IVQ2010 to IQ2012. The only strong contribution of net trade was 3.5 percent in IIIQ2011. Net trade added 1.4 percentage points to GDP growth in IQ2013 but subtracted 0.1 percentage points in IIQ2013, deducting 1.4 percentage points in IIIQ2013 and 2.1 percentage points in IVQ2013. Net trade deducted 0.7 percentage points from GDP growth in IQ2014. Net trade added 3.9 percentage points to GDP growth in IIQ2014 and deducted 0.2 percentage points in IIIQ2014. Net trade added 1.5 percentage points to GDP growth in IVQ2014. Net trade contributed 0.2 percentage points to GDP growth in IQ2015 and deducted 0.8-percentage points in IIQ2015. Net trade deducted 0.4 percentage points from GDP growth in IIIQ2015. Net trade contributed 0.1 percentage points to GDP growth in IVQ2015 and added 1.8 percentage points in IQ2016. Net trade deducted 0.2 percentage points from GDP growth in IIQ2016. Net trade added 1.5 percentage points to GDP growth in IIIQ2016 and contributed 1.5 percentage points in IVQ2016.  Net trade contributed 0.6 percentage points to GDP growth in IQ2017. Private consumption assumed the role of driver of Japan’s economic growth but should moderate as in most mature economies.

Table VB-3, Japan, Contributions to Changes in Real GDP, Seasonally Adjusted Annual Rates (SAAR), %

 

Net Trade

Exports

Imports

2017

      

I

0.6

1.4

-0.8

2016

      

I

1.8

0.4

1.4

II

-0.2

-1.0

0.8

III

1.5

1.3

0.2

IV

1.5

2.4

-0.9

2015

      

I

0.2

1.1

-0.9

II

-0.8

-2.9

2.1

III

-0.4

1.6

-1.9

IV

0.1

-0.2

0.3

2014

      

I

-0.7

3.9

-4.7

II

3.9

0.6

3.3

III

-0.2

1.0

-1.2

IV

1.5

2.4

-0.9

2013

      

I

1.4

1.7

-0.4

II

-0.1

1.9

-2.0

III

-1.4

-0.1

-1.3

IV

-2.1

-0.1

-2.0

2012

      

I

0.6

1.8

-1.1

II

-1.9

-0.6

-1.3

III

-2.0

-2.2

0.2

IV

-0.3

-1.9

1.6

2011

      

I

-1.4

-0.6

-0.8

II

-4.3

-4.6

0.4

III

3.5

5.4

-1.9

IV

-2.7

-1.7

-1.0

2010

      

I

1.9

3.3

-1.4

II

0.3

2.8

-2.5

III

0.6

1.7

-1.1

IV

0.0

0.2

-0.3

2009

      

I

-4.8

-16.2

11.4

II

7.5

4.6

2.8

III

2.1

5.2

-3.2

IV

3.0

4.2

-1.3

2008

      

I

0.8

1.8

-1.0

II

0.4

-1.4

1.9

III

-0.2

0.1

-0.2

IV

-10.3

-9.2

-1.0

2007

      

I

1.0

1.6

-0.5

II

0.7

1.6

-0.8

III

2.2

1.7

0.5

IV

1.3

2.0

-0.7

Source: Japan Economic and Social Research Institute, Cabinet Office

http://www.esri.cao.go.jp/index-e.html

http://www.esri.cao.go.jp/en/sna/sokuhou/sokuhou_top.html

There was milder increase in Japan’s export corporate goods price index during the global recession in 2008 but similar sharp decline during the bank balance sheets effect in late 2008, as shown in Chart IV-5 of the Bank of Japan. Japan exports industrial goods whose prices have been less dynamic than those of commodities and raw materials. As a result, the export CGPI on the yen basis in Chart IV-5 trends down with oscillations after a brief rise in the final part of the recession in 2009. The export corporate goods price index on the yen basis fell from 93.9 in Jun 2009 to 84.1 in Jan 2012 or minus 10.4 percent and increased to 93.7 in Apr 2017 for gain of 11.4 percent relative to Jan 2012 and decrease of 0.2 percent relative to Jun 2009. The choice of Jun 2009 is designed to capture the reversal of risk aversion beginning in Sep 2008 with the announcement of toxic assets in banks that would be withdrawn with the Troubled Asset Relief Program (TARP) (Cochrane and Zingales 2009). Reversal of risk aversion in the form of flight to the USD and obligations of the US government opened the way to renewed carry trades from zero interest rates to exposures in risk financial assets such as commodities. Japan exports industrial products and imports commodities and raw materials. The recovery from the global recession began in the third quarter of 2009.

Chart IV-5, Japan, Export Corporate Goods Price Index, Monthly, Yen Basis, 2008-2017

Source: Bank of Japan

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

Chart IV-5A provides the export corporate goods price index on the basis of the contract currency. The export corporate goods price index on the basis of the contract currency increased from 105.9 in Jun 2009 to 111.5 in Apr 2012 or 5.3 percent but dropped to 99.9 in Apr 2017 or minus 10.4 percent relative to Apr 2012 and fell 5.7 percent to 99.9 in Apr 2017 relative to Jun 2009.

Chart IV-5A, Japan, Export Corporate Goods Price Index, Monthly, Contract Currency Basis, 2008-2017

Source: Bank of Japan

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

Japan imports primary commodities and raw materials. As a result, the import corporate goods price index on the yen basis in Chart IV-6 shows an upward trend after declining from the increase during the global recession in 2008 driven by carry trades from fed funds rates. The index increases with carry trades from zero interest rates into commodity futures and declines during risk aversion from late 2008 into beginning of 2008 originating in doubts about soundness of US bank balance sheets. Measurement that is more careful should show that the terms of trade of Japan, export prices relative to import prices, declined during the commodity shocks originating in unconventional monetary policy. The decline of the terms of trade restricted potential growth of income in Japan (for the relation of terms of trade and growth see Pelaez 1979, 1976a). The import corporate goods price index on the yen basis increased from 82.4 in Jun 2009 to 99.6 in Apr 2012 or 20.9 percent and to 91.4 in Apr 2017 or decline of 8.2 percent relative to Apr 2012 and increase of 10.9 percent relative to Jun 2009.

Chart IV-6, Japan, Import Corporate Goods Price Index, Monthly, Yen Basis, 2008-2017

Source: Bank of Japan

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

Chart IV-6A provides the import corporate goods price index on the contract currency basis. The import corporate goods price index on the basis of the contract currency increased from 95.0 in Jun 2009 to 131.6 in Apr 2012 or 38.5 percent and to 98.3 in Apr 2017 or minus 25.3 percent relative to Apr 2012 and increase of 3.5 percent relative to Jun 2009. There is evident deterioration of the terms of trade of Japan: the export corporate goods price index on the basis of the contract currency decreased 5.7 percent from Jun 2009 to Apr 2017 while the import corporate goods price index increased 3.5 percent. Prices of Japan’s exports of corporate goods, mostly industrial products, increased only 5.3 percent from Jun 2009 to Apr 2012, while imports of corporate goods, mostly commodities and raw materials increased 38.5 percent. Unconventional monetary policy induces carry trades from zero interest rates to exposures in commodities that squeeze economic activity of industrial countries by increases in prices of imported commodities and raw materials during periods without risk aversion. Reversals of carry trades during periods of risk aversion decrease prices of exported commodities and raw materials that squeeze economic activity in economies exporting commodities and raw materials. Devaluation of the dollar by unconventional monetary policy could increase US competitiveness in world markets but economic activity is squeezed by increases in prices of imported commodities and raw materials. Unconventional monetary policy causes instability worldwide instead of the mission of central banks of promoting financial and economic stability.

Chart IV-6A, Japan, Import Corporate Goods Price Index, Monthly, Contract Currency Basis, 2008-2017

Source: Bank of Japan

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

Table IV-6B provides the Bank of Japan’s Corporate Goods Price indexes of exports and imports on the yen and contract bases from Jan 2008 to Apr 2017. There are oscillations of the indexes that are shown vividly in the four charts above. For the entire period from Jan 2008 to Apr 2017, the export index on the contract currency basis decreased 6.9 percent and decreased 9.3 percent on the yen basis. For the entire period from Jan 2008 to Apr 2017, the import price index decreased 11.4 percent on the contract currency basis and decreased 12.8 percent on the yen basis. During significant part of the expansion period, prices of Japan’s exports of corporate goods on the contract currency, mostly industrial products, increased only 5.3 percent from Jun 2009 to Apr 2012, while prices of imports of corporate goods on the contract currency, mostly commodities and raw materials, increased 38.5 percent. The charts show sharp deteriorations in relative prices of exports to prices of imports during multiple periods. Price margins of Japan’s producers are subject to periodic squeezes resulting from carry trades from zero interest rates of monetary policy to exposures in commodities.

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

 

X-CC

X-Y

M-CC

M-Y

2008/01

107.3

103.3

110.9

104.8

2008/02

107.9

103.9

112.8

106.2

2008/03

108.7

100.7

115.1

103.4

2008/04

109.9

103.2

121.3

110.3

2008/05

110.7

105

124.9

114.9

2008/06

111.9

108

131.6

123.6

2008/07

113.2

109.2

135

126.8

2008/08

112.1

109.2

135.6

129.5

2008/09

111

105.8

129

120.8

2008/10

108.3

98.1

120.2

107

2008/11

106.6

93.5

107.7

93.2

2008/12

105.9

90

98.4

81.9

2009/01

106

89

94.3

77.9

2009/02

105.4

89.6

94.4

79

2009/03

105.2

93.2

93.8

81.9

2009/04

105.5

94.5

93

81.9

2009/05

105.4

92.9

92.5

80

2009/06

105.9

93.9

95

82.4

2009/07

105.4

92.2

98.3

83.7

2009/08

106.3

93.4

98.7

84.4

2009/09

106.3

91.4

100.2

83.4

2009/10

106

90.5

100.2

82.8

2009/11

106.4

90.2

102.2

83.5

2009/12

106.3

90.1

105.1

85.9

2010/01

107.5

91.4

106.8

88.1

2010/02

107.8

90.9

107.5

87.9

2010/03

107.8

91.1

106.8

87.4

2010/04

108.7

93.6

110

92.1

2010/05

108.9

92.1

112

92.4

2010/06

108.2

90.9

110.2

90.1

2010/07

107.5

88.6

110

87.9

2010/08

107.2

87.1

109.6

85.9

2010/09

107.5

86.8

110.2

85.6

2010/10

108.2

86.3

110.7

84.4

2010/11

108.9

87.1

113

86.5

2010/12

109.4

88

115

88.6

2011/01

110.4

88.2

118.1

90.4

2011/02

111.3

89

120.1

91.9

2011/03

111.9

89.1

123.2

93.6

2011/04

112.6

91

127.7

98.6

2011/05

112.3

89.4

130.9

99

2011/06

112.2

88.8

129.4

97.3

2011/07

112

88

130.3

97.1

2011/08

112

86.4

130.6

95.2

2011/09

112.1

86

128.9

93.6

2011/10

111.4

85.2

128.4

93

2011/11

110.2

84.8

127.1

92.8

2011/12

109.7

84.6

127.9

93.6

2012/01

110.1

84.1

126.7

91.8

2012/02

110.7

85.7

127.6

93.7

2012/03

111.3

88.8

130.3

99.5

2012/04

111.5

88.3

131.6

99.6

2012/05

110.6

86.2

130.1

96.7

2012/06

109.6

85

126.9

94

2012/07

108.8

84.1

123.4

91.2

2012/08

109.1

84.2

123.8

91.3

2012/09

109.2

84.2

126.3

92.7

2012/10

109.3

84.7

125.4

92.7

2012/11

109.1

85.8

124.7

93.8

2012/12

108.9

87.7

124.9

96.5

2013/01

109.2

91.6

125.4

101.7

2013/02

109.7

94.8

126.5

105.9

2013/03

109.5

95.4

126.8

107.5

2013/04

108.3

96.2

125.7

109.1

2013/05

107.7

97.6

124

110.4

2013/06

107.3

94.9

123.4

106.8

2013/07

107.2

96.2

122.9

108.2

2013/08

107

94.9

123.2

106.9

2013/09

107

95.9

124.5

109.2

2013/10

107.3

95.5

124.6

108.3

2013/11

107.2

96.6

124.6

110

2013/12

107.2

98.8

125.4

113.6

2014/01

107.3

99

126

114.6

2014/02

106.9

97.7

125.4

112.5

2014/03

106.6

97.6

124.9

112.2

2014/04

106.3

97.5

124.1

111.8

2014/05

106.2

96.8

123.8

110.9

2014/06

105.9

96.7

123.9

111.2

2014/07

106

96.5

123.9

110.9

2014/08

106.1

97.3

123.7

111.6

2014/09

105.9

99.3

122.8

114

2014/10

105.2

99.1

120.7

112.7

2014/11

104.8

103.4

117.8

115.9

2014/12

103.8

104.1

113.8

114

2015/01

102.2

101.2

108.2

106.6

2015/02

101.2

100.1

102.1

100.7

2015/03

101.3

100.9

103.1

102.6

2015/04

101.1

100.2

102

101

2015/05

101.4

101.4

101.6

101.5

2015/06

101.3

102.9

102.5

104.3

2015/07

100.6

101.7

101.5

102.9

2015/08

99.8

100.9

99

100.4

2015/09

98.6

98.2

96.6

96.2

2015/10

97.9

97.3

95.5

95

2015/11

97.5

98

94.9

95.7

2015/12

97.1

97.3

92.9

93.2

2016/01

96.4

94.7

89.9

88.3

2016/02

95.9

92.7

87.6

84.4

2016/03

96.1

92

87.3

83.2

2016/04

96.5

91

88.2

82.4

2016/05

96.6

90.6

88.6

82.4

2016/06

96.5

88.8

89.9

81.5

2016/07

96.9

88.2

90.8

81.4

2016/08

96.9

87

90.6

79.9

2016/09

97

87.4

91.1

80.7

2016/10

97.5

88.5

91.1

81.6

2016/11

98.2

91.1

93.9

86.4

2016/12

98.7

95.5

93.8

90.7

2017/01

99.3

95.5

96.2

92.3

2017/02

99.7

95.1

97.7

92.7

2017/03

100.2

95.5

98.6

93.5

2017/04

99.9

93.7

98.3

91.4

Note: X-CC: Exports Contract Currency; X-Y: Exports Yen; M-CC: Imports Contract; M-Y: Imports Yen

Source: Bank of Japan

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

Chart IV-7 provides the monthly corporate goods price index (CGPI) of Japan from 1970 to 2017. Japan also experienced sharp increase in inflation during the 1970s as in the episode of the Great Inflation in the US. Monetary policy focused on accommodating higher inflation, with emphasis solely on the mandate of promoting employment, has been blamed as deliberate or because of model error or imperfect measurement for creating the Great Inflation (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html  and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2017/01/rules-versus-discretionary-authorities.html and earlier http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). A remarkable similarity with US experience is the sharp rise of the CGPI of Japan in 2008 driven by carry trades from policy interest rates rapidly falling to zero to exposures in commodity futures during a global recession. Japan had the same sharp waves of consumer price inflation during the 1970s as in the US (see Chart IV-5A and associated table at 04/30/2017 (https://cmpassocregulationblog.blogspot.com/2017/04/dollar-devaluation-mediocre-cyclical.html https://cmpassocregulationblog.blogspot.com/2017/04/mediocre-cyclical-economic-growth-with.html https://cmpassocregulationblog.blogspot.com/2017/03/rising-valuations-of-risk-financial.html http://cmpassocregulationblog.blogspot.com/2017/01/rising-valuations-of-risk-financial.html http://cmpassocregulationblog.blogspot.com/2017/01/rules-versus-discretionary-authorities.html http://cmpassocregulationblog.blogspot.com/2016/11/dollar-revaluation-rising-yields-and.html http://cmpassocregulationblog.blogspot.com/2016/10/mediocre-cyclical-united-states_30.html http://cmpassocregulationblog.blogspot.com/2016/10/mediocre-cyclical-united-states.html http://cmpassocregulationblog.blogspot.com/2016/08/and-as-ever-economic-outlook-is.html http://cmpassocregulationblog.blogspot.com/2016/07/business-fixed-investment-has-been-soft.html http://cmpassocregulationblog.blogspot.com/2016/07/financial-asset-values-rebound-from.html http://cmpassocregulationblog.blogspot.com/2016/05/appropriate-for-fed-to-increase.html http://cmpassocregulationblog.blogspot.com/2016/03/contraction-of-united-states-corporate.html http://cmpassocregulationblog.blogspot.com/2016/02/mediocre-cyclical-united-states.html http://cmpassocregulationblog.blogspot.com/2016/01/closely-monitoring-global-economic-and.html http://cmpassocregulationblog.blogspot.com/2015/12/dollar-revaluation-and-decreasing.html http://cmpassocregulationblog.blogspot.com/2015/11/dollar-revaluation-constraining.html http://cmpassocregulationblog.blogspot.com/2015/11/interest-rate-increase-considered.html http://cmpassocregulationblog.blogspot.com/2015/11/interest-rate-increase-considered.htmlhttp://cmpassocregulationblog.blogspot.com/2015/09/monetary-policy-designed-on-measurable.html

http://cmpassocregulationblog.blogspot.com/2015/08/fluctuations-of-global-financial.html http://cmpassocregulationblog.blogspot.com/2015/08/turbulence-of-valuations-of-financial_77.html http://cmpassocregulationblog.blogspot.com/2015/06/international-valuations-of-financial_29.html http://cmpassocregulationblog.blogspot.com/2015/06/dollar-revaluation-squeezing-corporate_97.html http://cmpassocregulationblog.blogspot.com/2015/05/dollar-devaluation-and-carry-trade.html http://cmpassocregulationblog.blogspot.com/2015/03/dollar-revaluation-and-financial-risk.html http://cmpassocregulationblog.blogspot.com/2015/03/irrational-exuberance-mediocre-cyclical.html http://cmpassocregulationblog.blogspot.com/2015/02/financial-and-international.html http://cmpassocregulationblog.blogspot.com/2014/12/valuations-of-risk-financial-assets.html http://cmpassocregulationblog.blogspot.com/2014/09/financial-volatility-mediocre-cyclical.html http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks_71.html http://cmpassocregulationblog.blogspot.com/2014/03/financial-uncertainty-mediocre-cyclical_8145.html http://cmpassocregulationblog.blogspot.com/2014/03/financial-risks-slow-cyclical-united.html http://cmpassocregulationblog.blogspot.com/2014/02/mediocre-cyclical-united-states.html http://cmpassocregulationblog.blogspot.com/2013/12/collapse-of-united-states-dynamism-of.html http://cmpassocregulationblog.blogspot.com/2013/12/exit-risks-of-zero-interest-rates-world_1.html and earlier http://cmpassocregulationblog.blogspot.com/2013/10/twenty-eight-million-unemployed-or_561.html and at http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk_1.html http://cmpassocregulationblog.blogspot.com/2012/07/recovery-without-jobs-stagnating-real_09.html).

Chart IV-7, Japan, Domestic Corporate Goods Price Index, Monthly, 1970-2017

Source: Bank of Japan

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

The producer price index of the US from 1970 to 2017 in Chart IV-8 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

Chart IV-8, US, Producer Price Index Finished Goods, Monthly, 1970-2016

Source: US Bureau of Labor Statistics

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

Further insight into inflation of the corporate goods price index (CGPI) of Japan is in Table IV-7. The increase in the tax on value added of consumption caused sharp increases in prices across all segments. Petroleum and coal with weight of 6.0 percent decreased 1.3 percent in Apr 2017 and increased 23.8 percent in 12 months. Japan exports manufactured products and imports raw materials and commodities such that the country’s terms of trade, or export prices relative to import prices, deteriorate during commodity price increases. In contrast, prices of production machinery, with weight of 4.1 percent, increased 0.1 percent in Apr 2017 and decreased 0.9 percent in 12 months. In general, most manufactured products had been experiencing negative or low increases in prices while inflation rates have been high in 12 months for products originating in raw materials and commodities. The reversal of carry trades in commodity futures caused decrease in prices of commodities and raw materials while prices of manufactures stabilized. Ironically, unconventional monetary policy of zero interest rates and quantitative easing that intended to increase aggregate demand and GDP growth deteriorated the terms of trade of advanced economies with adverse effects on real income (for analysis of terms of trade and growth see Pelaez (1979, 1976a). There are now inflation effects of the intentional policy of devaluing the yen and recent collapse of commodity prices followed by increases.

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

Apr 2017

Weight

Month ∆%

12 Month ∆%

Total

1000.0

0.2

2.1

Food, Beverages

141.6

0.1

-0.2

Petroleum & Coal

59.5

-1.3

23.8

Production Machinery

41.1

0.1

-0.9

Electronic Components

24.5

0.1

1.1

Electric Power, Gas & Water

67.1

1.6

0.2

Iron & Steel

51.7

2.1

10.3

Chemicals

89.2

-0.3

2.8

Transport
Equipment

140.7

0.0

-0.8

Source: Bank of Japan

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

Percentage point contributions to change of the corporate goods price index (CGPI) in Apr 2017 are in Table IV-8, divided into domestic, export and import segments. In the domestic CGPI, increasing 0.2 percent in Apr 2017, the energy shock is evident in the contribution of 0.09 percentage points by electric power, gas and water in renewed carry trades of exposures in commodity futures. The exports CGPI decreased 0.3 percent on the basis of the contract currency with deduction of 0.25 percentage points by chemicals and related products. The imports CGPI decreased 0.3 percent on the contract currency basis. Petroleum, coal and natural gas deducted 0.63 percentage points. Shocks of risk aversion cause unwinding carry trades that result in declining commodity prices with resulting downward pressure on price indexes. The volatility of inflation adversely affects financial and economic decisions worldwide.

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

Groups Apr 2017

Contribution to Change Percentage Points

A. Domestic Corporate Goods Price Index

Monthly Change: 
0.2%

Iron & Steel

0.11

Electric Power, Gas & Water

0.09

Metal Products

0.02

Beverages & Foods

0.02

Electrical Machinery & Equipment

0.02

Petroleum & Coal Products

-0.08

Chemicals & Related Products

-0.03

Scrap & Waste

-0.02

B. Export Price Index

Monthly Change:   
-0.3% contract currency

Chemicals & Related Products

-0.25

Metals & Related Products

-0.09

Other Primary Products & Manufactured Goods

-0.06

Transportation Equipment

-0.03

General Purpose, Production & Business Oriented Machinery

0.06

Electric & Electronic Products

0.05

C. Import Price Index

Monthly Change: -0.3% contract currency basis

Petroleum, Coal & Natural Gas

-0.63

Metals & Related Products

-0.04

Electric & Electronic Products

0.26

Other Primary Products & Manufactured Goods

0.04

Chemicals & Related Products

0.02

Source: Bank of Japan

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

There are two categories of responses in the Empire State Manufacturing Survey of the Federal Reserve Bank of New York (https://www.newyorkfed.org/survey/empire/empiresurvey_overview.html): current conditions and expectations for the next six months. There are responses in the survey for two types of prices: prices received or inputs of production and prices paid or sales prices of products. Table IV-5 provides indexes for the two categories and within them for the two types of prices from Jan 2011 to May 2017. The index of current prices paid or costs of inputs moved from 16.1 in Dec 2012 to 20.9 in May 2017 while the index of current prices received or sales prices moved from 1.1 in Dec 2012 to 4.5 in May 2017. The farther the index is from the area of no change at zero, the faster the rate of change. Prices paid or costs of inputs at 20.9 in May 2017 are expanding at faster pace than prices received or of sales of products at 4.5. The index of future prices paid or expectations of costs of inputs in the next six months fell from 51.6 in Dec 2012 to 38.1 in May 2017 while the index of future prices received or expectation of sales prices in the next six months decreased from 25.8 in Dec 2012 to 22.4 in May 2017. Prices paid or of inputs at 38.1 in Apr 2017 are expected to increase at a faster pace in the next six months than prices received or prices of sales products at 22.4 in May 2017. Prices of sales of finished products are less dynamic than prices of costs of inputs during waves of increases. Prices of costs of costs of inputs fall less rapidly than prices of sales of finished products during waves of price decreases. As a result, margins of prices of sales less costs of inputs oscillate with typical deterioration against producers, forcing companies to manage tightly costs and labor inputs. Instability of sales/costs margins discourages investment and hiring.

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

Source: Federal Reserve Bank of New York

 

Current Prices Paid

Current Prices Received

Six Months Prices Paid

Six Months Prices Received

1/31/2011

35.8

15.8

60

42.1

2/28/2011

45.8

16.9

55.4

27.7

3/31/2011

53.2

20.8

71.4

36.4

4/30/2011

57.7

26.9

56.4

38.5

5/31/2011

69.9

28

68.8

35.5

6/30/2011

56.1

11.2

55.1

19.4

7/31/2011

43.3

5.6

51.1

30

8/31/2011

28.3

2.2

42.4

15.2

9/30/2011

32.6

8.7

53.3

22.8

10/31/2011

22.5

4.5

40.4

18

11/30/2011

18.3

6.1

36.6

25.6

12/31/2011

24.4

3.5

57

36

1/31/2012

26.4

23.1

53.8

30.8

2/29/2012

25.9

15.3

62.4

34.1

3/31/2012

50.6

13.6

66.7

32.1

4/30/2012

45.8

19.3

50.6

22.9

5/31/2012

37.3

12

57.8

22.9

6/30/2012

19.6

1

34

17.5

7/31/2012

7.4

3.7

35.8

16

8/31/2012

16.5

2.4

31.8

14.1

9/30/2012

19.1

5.3

40.4

23.4

10/31/2012

17.2

4.3

44.1

24.7

11/30/2012

14.6

5.6

39.3

15.7

12/31/2012

16.1

1.1

51.6

25.8

1/31/2013

22.6

10.8

38.7

21.5

2/28/2013

26.3

8.1

44.4

13.1

3/31/2013

25.8

2.2

50.5

23.7

4/30/2013

28.4

5.7

44.3

14.8

5/31/2013

20.5

4.5

29.5

14.8

6/30/2013

21

11.3

45.2

17.7

7/31/2013

17.4

1.1

28.3

12

8/31/2013

20.5

3.6

41

19.3

9/30/2013

21.5

8.6

39.8

24.7

10/31/2013

21.7

2.4

45.8

25.3

11/30/2013

17.1

-3.9

42.1

17.1

12/31/2013

15.7

3.6

48.2

27.7

1/31/2014

36.6

13.4

45.1

23.2

2/28/2014

25

15

40

23.8

3/31/2014

21.2

2.4

43.5

25.9

4/30/2014

22.4

10.2

33.7

14.3

5/31/2014

19.8

6.6

31.9

14.3

6/30/2014

17.2

4.3

36.6

16.1

7/31/2014

25

6.8

37.5

18.2

8/31/2014

27.3

8

42

21.6

9/30/2014

23.9

17.4

43.5

32.6

10/31/2014

11.4

6.8

42

26.1

11/30/2014

10.6

0

41.5

25.5

12/31/2014

10.4

6.3

40.6

32.3

1/31/2015

12.6

12.6

33.7

15.8

2/28/2015

14.6

3.4

27

5.6

3/31/2015

12.4

8.2

32

12.4

4/30/2015

19.1

4.3

38.3

13.8

5/31/2015

9.4

1

26

7.3

6/30/2015

9.6

1

24

5.8

7/31/2015

7.4

5.3

27.7

6.4

8/31/2015

7.3

0.9

34.5

10.9

9/30/2015

4.1

-5.2

28.9

7.2

10/31/2015

0.9

-8.5

27.4

7.5

11/30/2015

4.5

-4.5

29.1

11.8

12/31/2015

4

-4

27.3

20.2

1/31/2016

16

4

31

12

2/29/2016

3

-5

14.9

4

3/31/2016

3

-5.9

19.8

7.9

4/30/2016

19.2

2.9

27.9

5.8

5/31/2016

16.7

-3.1

28.1

6.3

6/30/2016

18.4

-1

29.6

7.1

7/31/2016

18.7

1.1

26.4

7.7

8/31/2016

15.5

2.1

25.8

9.3

9/30/2016

17

1.8

41.1

20.5

10/31/2016

22.6

4.7

35.8

30.2

11/30/2016

15.5

2.7

39.1

20.9

12/31/2016

22.6

3.5

42.6

22.6

1/31/2017

36.1

17.6

50.4

27.7

2/28/2017

37.8

19.4

38.8

25.5

3/31/2017

31

8.8

41.6

19.5

4/30/2017

32.8

12.4

37.2

25.5

5/31/2017

20.9

4.5

38.1

22.4

https://www.newyorkfed.org/survey/empire/empiresurvey_overview.html

Price indexes of the Federal Reserve Bank of Philadelphia Outlook Survey are in Table IV-5A. As in inflation waves throughout the world (Section I and earlier https://cmpassocregulationblog.blogspot.com/2017/04/world-inflation-waves-united-states.html) indexes of both current and expectations of future prices paid and received were quite high until May 2011. Prices paid, or inputs, were more dynamic, reflecting carry trades from zero interest rates to commodity futures. All indexes softened after May 2011 with even decline of prices received in Aug 2011 during the first round of risk aversion. Current and future price indexes have increased again but not back to the intensity in the beginning of 2011 because of risk aversion frustrating carry trades even induced by zero interest rates. The index of prices paid or prices of inputs moved from 20.6 in Dec 2012 to 24.2 in May 2017. The index of current prices received was minus 2.2 in Apr 2013, indicating decrease of prices received. The index of current prices received decreased from 9.1 in Dec 2012 to minus 5.7 in Sep 2015, decreasing to minus 4.8 in Feb 2016. The index of current prices received was 15.3 in May 2017. The farther the index is from the area of no change at zero, the faster the rate of change. The index of current prices paid or costs of inputs at 24.2 in May 2017 indicates faster expansion than the index of current prices received or sales prices of production in May 2017, showing 15.3. Prices paid indicate faster expansion than prices received during most of the history of the index. The index of future prices paid increased to 42.7 in May 2017 from 42.1 in Dec 2012 while the index of future prices received increased from 21.7 in Dec 2012 to 22.9 in May 2017. Expectations are incorporating faster increases in prices of inputs or costs of production, 42.7 in May 2017, than of sales prices of produced goods, 22.9 in May 2017, forcing companies to manage tightly costs and labor inputs. Volatility of margins of sales/costs discourages investment and hiring.

Table IV-5A, US, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current and Future Prices Paid and Prices Received, SA

 

Current Prices Paid

Current Prices Received

Six Months Prices paid

Six Months Prices Received

Dec-10

42.7

5.3

56.2

24.2

Jan-11

48.2

12.6

59.0

34.6

Feb-11

61.4

13.7

69.1

31.6

Mar-11

59.2

17.9

61.5

33.5

Apr-11

52.8

22.9

56.4

36.3

May-11

51.2

20.6

54.8

28.4

Jun-11

36

6.4

40.7

6.8

Jul-11

34.1

5.6

47.8

17.3

Aug-11

23.6

-3.4

42.6

22.8

Sep-11

30.1

6.4

38.1

20.4

Oct-11

22.7

1.6

41.3

27.8

Nov-11

21.8

5.2

34.4

26.4

Dec-11

24.9

5.6

42.7

21.1

Jan-12

26.1

9.2

48.1

21.9

Feb-12

33.3

10.4

52.5

26.4

Mar-12

17.6

6.9

38.7

24.8

Apr-12

21.9

9.7

37

25.1

May-12

10.2

1.1

39.9

9

Jun-12

1.2

-5.9

32.7

16.8

Jul-12

8.1

3.3

26.8

20.6

Aug-12

16.3

6.6

34.7

23.9

Sep-12

12.9

2.7

38.1

24.6

Oct-12

17.3

4.6

44.1

15.2

Nov-12

22.2

4.7

45.8

10.7

Dec-12

20.6

9.1

42.1

21.7

Jan-13

13

0.8

35.4

21.8

Feb-13

12.7

0.2

36.9

23.1

Mar-13

13.8

1.3

35.2

20.5

Apr-13

11.7

-2.2

31.2

16.7

May-13

12.6

0.5

34.5

19

Jun-13

17.2

11.8

29.4

23.9

Jul-13

18.9

5.6

39.6

25

Aug-13

17.9

12.6

33.6

23.4

Sep-13

22.1

11.5

37.1

26.8

Oct-13

17.4

8.9

41.4

34.5

Nov-13

23.3

6.5

41

36.3

Dec-13

16.5

8.8

40.6

28.2

Jan-14

20.4

8.6

38.2

13.8

Feb-14

16.1

9.7

31.1

19.6

Mar-14

22.6

7.5

33.9

20.7

Apr-14

21.3

10.8

38.2

21.1

May-14

26.7

17.2

37.7

28.9

Jun-14

26.6

10.5

41.9

29.4

Jul-14

29.8

13.9

35.9

21.8

Aug-14

21.5

5.8

44

28.6

Sep-14

21.7

7.5

38.7

25.3

Oct-14

23.6

16.9

31

21.7

Nov-14

14.2

8

32.7

18.4

Dec-14

14.4

11.1

26.1

20.1

Jan-15

12.3

3

31.6

21.1

Feb-15

6

2.3

37.4

22.3

Mar-15

3.4

-4.6

30.8

10.2

Apr-15

1.7

-2

19.6

13.6

May-15

-14.1

-7.1

22.3

19

Jun-15

10.4

1.4

38

11.5

Jul-15

16.6

0.3

32.9

15.9

Aug-15

2.8

-3.7

33.5

9.9

Sep-15

-2.8

-5.7

24.7

4.1

Oct-15

-1.7

-1.2

17.7

8.7

Nov-15

-7

-3.4

23.6

10.5

Dec-15

-9.5

-6.8

25.5

13.8

Jan-16

-1.2

-2.2

20.4

11.5

Feb-16

-2.8

-4.8

16.4

4.1

Mar-16

1.5

2.9

25.1

15.3

Apr-16

13.7

6.1

35.3

21.4

May-16

13.5

11.5

23.9

12.5

Jun-16

21.2

4.1

34.4

17.1

Jul-16

11.9

1.3

27.4

22.3

Aug-16

18.7

6.6

29.7

15.5

Sep-16

20.8

9.4

39.8

31.2

Oct-16

8.9

-1.9

41.5

27.9

Nov-16

27.6

16.4

38.3

30.6

Dec-16

28.1

8

46.5

29.1

Jan-17

32.5

26.8

49

27.5

Feb-17

29.9

10.6

51.1

23.5

Mar-17

40.7

20.6

55.7

40.2

Apr-17

33.7

16.6

34.7

28.6

May-17

24.2

15.3

42.7

22.9

Source: Federal Reserve Bank of Philadelphia

https://www.philadelphiafed.org/

Chart IV-1 of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia Outlook Survey provides the diffusion index of current prices paid or prices of inputs from 2006 to 2017. Recession dates are in shaded areas. In the middle of deep global contraction after IVQ2007, input prices continued to increase in speculative carry trades from central bank policy rates falling toward zero into commodities futures. The index peaked above 70 in the second half of 2008. Inflation of inputs moderated significantly during the shock of risk aversion in late 2008, even falling briefly into contraction territory below zero during several months in 2009 in the flight away from risk financial assets into US government securities (Cochrane and Zingales 2009) that unwound carry trades. Return of risk appetite induced carry trade with significant increase until return of risk aversion in the first round of the European sovereign debt crisis in Apr 2010. Carry trades returned during risk appetite in expectation that the European sovereign debt crisis was resolved. The various inflation waves originating in carry trades induced by zero interest rates with alternating episodes of risk aversion are mirrored in the prices of inputs after 2011, in particular after Aug 2012 with the announcement of the Outright Monetary Transactions Program of the European Central Bank (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). Subsequent risk aversion and flows of capital away from commodities into stocks and high-yield bonds caused sharp decline in the index of prices paid followed by another recent rebound with marginal decline and new increase. The index falls, rebounds and falls again in the final segment but there are no episodes of contraction after 2009 with exception of minus 14.1 in May 2015, minus 2.8 in Sep 2015, minus 1.7 in Oct 2015, minus 7.0 in Nov 2015 and minus 9.5 in Dec 2015. The reading for the index in Jan 2016 is minus 1.2 and minus 2.8 for Feb 2016. The index is 1.5 in Mar 2016 and 13.7 in Apr 2016, increasing at 13.5 in May 2016 and 21.2 in Jun 2016. The index reached 11.9 in Jul 2016, 18.7 in Aug 2016 and 20.8 in Sep 2016. The index was 8.9 in Oct 2016 and 24.2 in May 2017.

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

Source: Federal Reserve Bank of Philadelphia

https://www.philadelphiafed.org/

Chart IV-2 of the Federal Reserve Bank of Philadelphia Outlook Survey provides the diffusion index of current prices received from 2006 to 2017. The significant difference between the index of current prices paid in Chart IV-1 and the index of current prices received in Chart IV-2 is that increases in prices paid are significantly sharper than increases in prices received. There were several periods of negative readings of prices received from 2010 to 2016. Prices paid increased at 3.4 in Mar 2015 while prices received contracted at 4.6. There were several contractions of prices paid: 14.1 in May 2015 with milder contraction of 7.1 of prices received; minus 2.8 for prices paid in Sep 2015 with minus 5.7 for prices received; and minus 1.7 for prices paid in Oct 2015 with minus 1.2 for prices received. The index of prices received fell to minus 7.0 in Nov 2015 with minus 3.4 for prices paid and to minus 9.5 in Dec 2015 with minus 6.8 for prices paid. The index of prices received fell to minus 2.8 in Feb 2016 with minus 4.8 for prices paid. The index of prices received increased at 1.5 in Mar 2016 with 2.9 for prices paid. Prices paid moved to 24.2 in May 2017 while prices received moved to 15.3. Prices received relative to prices paid deteriorate most of the time largely because of the carry trades from zero interest rates to commodity futures. Profit margins of business are compressed intermittently by fluctuations of commodity prices induced by unconventional monetary policy of zero interest rates, frustrating production, investment and hiring decisions of business, which is precisely the opposite outcome pursued by unconventional monetary policy.

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

Source: Federal Reserve Bank of Philadelphia

https://www.philadelphiafed.org/

Chart IV-2A of the Federal Reserve Bank of Philadelphia shows current prices paid and current prices received from Jan 2007 to Mar 2017. Current prices paid jumped ahead of current prices received during the contraction from IVQ2007 to IIQ2009 through the carry trade from zero interest rates to exposures in commodity derivatives. There is the same behavior during most of the cyclical expansion after IIIQ2009. Rebalancing of financial investment portfolios away from commodities into equities explains the recent weakness of prices paid. There is a new ongoing carry trade into commodity futures.

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

Source: Federal Reserve Bank of Philadelphia

https://www.philadelphiafed.org/

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 and loss of ten million full-time jobs. Wealth of households increased over the business cycle by total 21.4 percent adjusted for inflation from IVQ2007 to IVQ2016, while growing at 3.1 percent per year adjusted for inflation from IVQ1945 to IVQ2016 with unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes. Growth of inflation-adjusted wealth at historical trend would have been 31.6 percent between 2007 and IVQ2016, which is much higher than actual 21.4 percent

(4) Outcome of the sovereign debt crisis in Europe with complex financial, economic and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times).

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 May 12 and daily values throughout the week ending on May 19, 2017, 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 the close of business. The first column provides the value on Fri May 12 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri May 12, 2017”, first row “USD/EUR 1.0932 0.6% -0.6%,” provides the information that the US dollar (USD) appreciated 0.6 percent to USD 1.0932/EUR in the week ending on Fri May 12 relative to the exchange rate on Fri May 5 and depreciated 0.6 percent relative to Thu May 11. 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). There are complex economic, financial and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times). 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 1.0932/EUR in the first row, first column in the block for currencies in Table III-1 for Fri May 12, depreciating to USD 1.0975/EUR on Mon May 15, 2017, or by 0.4 percent. The dollar depreciated because more dollars, $1.0975, were required on Mon 15 to buy one euro than $1.0932 on Fri May 12. 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 1.0932/EUR on May 12. 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 May 12, to the last business day of the current week, in this case May 19, such as depreciation of 2.5 percent to USD 1.1207/EUR by May 12. The third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 2.5 percent from the rate of USD 1.0932/EUR on Fri May 12 to the rate of USD 1.1207/EUR on May 19 {[(1.1207/1.0932) - 1]100 = 2.5%}. The dollar depreciated (denoted by negative sign) by 0.9 percent from the rate of USD 1.1103 on

Thu May 18 to USD 1.1207/EUR on Fri May 19 {[(1.1207/1.1103) -1]100 = 0.9%}. Other factors constant, increasing risk aversion causes appreciation of the dollar relative to the euro, 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.

Table III-I, Weekly Financial Risk Assets May 8 to May 12, 2017

Fri 12

Mon 15

Tue 16

Wed 18

Thu 18

Fri 19

USD/ EUR

1.0932

0.6%

-0.6%

1.0975

-0.4%

-0.4%

1.1083

-1.4%

-1.0%

1.1159

-2.1%

-0.7%

1.1103

-1.6%

0.5%

1.1207

-2.5%

-0.9%

JPY/ USD

113.35

-0.6%

0.5%

113.79

-0.4%

-0.4%

113.12

0.2%

0.6%

110.81

2.2%

2.0%

111.49

1.6%

-0.6%

111.26

1.8%

0.2%

CHF/ USD

1.0009

-1.4%

0.7%

0.9966

0.4%

0.4%

0.9859

1.5%

1.1%

0.9787

2.2%

0.7%

0.9800

2.1%

-0.1%

0.9728

2.8%

0.7%

CHF/ EUR

1.0941

-0.8%

0.1%

1.0937

0.0%

0.0%

1.0926

0.1%

0.1%

1.0921

0.2%

0.0%

1.0880

0.6%

0.4%

1.0902

0.4%

-0.2%

USD/ AUD

0.7386

1.3539

-0.5%

0.1%

0.7414

1.3488

0.4%

0.4%

0.7426

1.3466

0.5%

0.2%

0.7432

1.3455

0.6%

0.1%

0.7419

1.3479

0.4%

-0.2%

0.7458

1.3408

1.0%

0.5%

10Y Note

2.333

2.339

2.328

2.215

2.234

2.243

2Y Note

1.299

1.299

1.303

1.242

1.262

1.279

German Bond

2Y -0.67 10Y 0.39

2Y -0.68 10Y 0.42

2Y -0.66 10Y 0.44

2Y -0.68 10Y 0.38

2Y -0.70 10Y 0.35

2Y -0.69 10Y 0.37

DJIA

20896.61

-0.5%

-0.1%

20981.94

0.4%

0.4%

20979.75

0.4%

0.0%

20606.93

-1.4%

-1.8%

20663.02

-1.1%

0.3%

20804.84

-0.4%

0.7%

Dow Global

2745.02

-0.3%

0.1%

2759.56

0.5%

0.5%

2767.88

0.8%

0.3%

2738.33

-0.2%

-1.1%

2722.96

-0.8%

-0.6%

2748.33

0.1%

0.9%

DJ Asia Pacific

1586.09

1.4%

-0.1%

1588.72

0.2%

0.2%

1596.89

0.7%

0.5%

1598.88

0.8%

0.1%

1584.36

-0.1%

-0.9%

1586.08

0.0%

0.1%

Nikkei

19883.90

2.3%

-0.4%

19869.85

-0.1%

-0.1%

19919.82

0.2%

0.3%

19814.88

-0.3%

-0.5%

19553.86

-1.7%

-1.3%

19590.76

-1.5%

0.2%

Shanghai

3083.51

-0.6%

0.7%

3090.23

0.2%

0.2%

3112.96

1.0%

0.7%

3104.44

0.7%

-0.3%

3090.14

0.2%

-0.5%

3090.63

0.2%

0.0%

DAX

12770.41

0.4%

0.5%

12807.04

0.3%

0.3%

12804.53

0.3%

0.0%

12631.61

-1.1%

-1.4%

12590.06

-1.4%

-0.3%

12638.69

-1.0%

0.4%

DJ UBS Comm.

NA

NA

NA

NA

NA

NA

WTI $/B

47.84

3.5%

0.0%

48.85

2.1%

2.1%

48.66

1.7%

-0.4%

49.07

2.6%

0.8%

49.35

3.2%

0.6%

50.33

5.2%

2.0%

Brent $/B

50.84

3.5%

0.1%

51.82

1.9%

1.9%

51.65

1.6%

-0.3%

52.21

2.7%

1.1%

52.51

3.3%

0.6%

53.61

5.4%

2.1%

44Gold

1226.2

0.1%

0.3%

1228.6

0.2%

0.2%

1235.0

0.7%

0.5%

1257.5

2.6%

1.8%

1251.7

2.1%

-0.5%

1253.6

2.2%

0.2%

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

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

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

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 the Semiannual Monetary Policy Report to Congress on Feb 24, 2015, Chair Yellen analyzes the timing of interest rate increases (http://www.federalreserve.gov/newsevents/testimony/yellen20150224a.htm):

“The FOMC's assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings. If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting. Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the Committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.”

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).”

The minutes of the meeting of the Federal Open Market Committee (FOMC) on Sep 16-17, 2014, reveal concern with global economic conditions (http://www.federalreserve.gov/monetarypolicy/fomcminutes20140917.htm):

“Most viewed the risks to the outlook for economic activity and the labor market as broadly balanced. However, a number of participants noted that economic growth over the medium term might be slower than they expected if foreign economic growth came in weaker than anticipated, structural productivity continued to increase only slowly, or the recovery in residential construction continued to lag.”

There is similar concern in the minutes of the meeting of the FOMC on Dec 16-17, 2014 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20141217.htm):

“In their discussion of the foreign economic outlook, participants noted that the implications of the drop in crude oil prices would differ across regions, especially if the price declines affected inflation expectations and financial markets; a few participants said that the effect on overseas employment and output as a whole was likely to be positive. While some participants had lowered their assessments of the prospects for global economic growth, several noted that the likelihood of further responses by policymakers abroad had increased. Several participants indicated that they expected slower economic growth abroad to negatively affect the U.S. economy, principally through lower net exports, but the net effect of lower oil prices on U.S. economic activity was anticipated to be positive.”

Prior risk determining events are in an appendix below following Table III-1A. Focus is shifting from 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. Markets overreacted 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 ¾ to 1 percent with gradual consideration of further rate increases (https://www.federalreserve.gov/newsevents/pressreleases/monetary20170503a.htm). In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to 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 and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data” (emphasis added).

There is concern at the Federal Open Market Committee (FOMC) with the world economy and financial markets (http://www.federalreserve.gov/newsevents/press/monetary/20160127a.htm): “The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook” (emphasis added). This concern should include the effects on dollar revaluation of competitive easing by other central banks such as quantitative and qualitative easing with negative nominal interest rates (https://www.boj.or.jp/en/announcements/release_2016/k160129a.pdf).

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. Focus is shifting from 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. Markets overreacted to the so-called “paring” of outright purchases to $25 billion of securities per month for the balance sheet of the Fed.

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 the press conference following the meeting on Dec 17, 2014, Chair Yellen answered a question by Jon Hilseranth of the Wall Street Journal explaining “patience” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20141217.pdf):

“So I did say that this statement that the committee can be patient should be interpreted as meaning that it is unlikely to begin the normalization process, for at least the next couple of meetings. Now that doesn't point to any preset or predetermined time at which normalization is -- will begin. There are a range of views on the committee, and it will be dependent on how incoming data bears on the progress, the economy is making. First of all, I want to emphasize that no meeting is completely off the table in the sense that if we do see faster progress toward our objectives than we currently expect, then it is possible that the process of normalization would occur sooner than we now anticipated. And of course the converse is also true. So at this point, we think it unlikely that it will be appropriate, that we will see conditions for at least the next couple of meetings that will make it appropriate for us to decide to begin normalization. A number of committee participants have indicated that in their view, conditions could be appropriate by the middle of next year. But there is no preset time.”

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.”

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

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 ¾ and 1 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.

The Communiqué of the Istanbul meeting of G20 Finance Ministers and Central Bank Governors on February 10, 2015, sanctions the need of unconventional monetary policy with warning on collateral effects (http://www.g20.utoronto.ca/2015/150210-finance.html):

“We agree that consistent with central banks' mandates, current economic conditions require accommodative monetary policies in some economies. In this regard, we welcome that central banks take appropriate monetary policy action. The recent policy decision by the ECB aims at fulfilling its price stability mandate, and will further support the recovery in the euro area. We also note that some advanced economies with stronger growth prospects are moving closer to conditions that would allow for policy normalization. In an environment of diverging monetary policy settings and rising financial market volatility, policy settings should be carefully calibrated and clearly communicated to minimize negative spillovers.”

Professor Raguram G Rajan, former 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 (2016Dec 7, 2016Dec20), in Testimony to the Subcommittee on Monetary Policy and Trade Committee on Financial Services, on Dec 7, 2016, analyzes the adverse effects of unconventional monetary policy:

“My research and that of others over the years shows that these policies were not effective, and may have been counterproductive. Economic growth was consistently below the Fed’s forecasts with the policies, and was much weaker than in earlier U.S. recoveries from deep recessions. Job growth has been insufficient to raise the percentage of the population that is working above pre-recession levels. There is a growing consensus that the extra low interest rates and unconventional monetary policy have reached diminishing or negative returns. Many have argued that these policies widen the income distribution, adversely affect savers, and increase the volatility of the dollar exchange rate. Experienced market participants have expressed concerns about bubbles, imbalances, and distortions caused by the policies. The unconventional policies have also raised public policy concerns about the Fed being transformed into a multipurpose institution, intervening in particular sectors and allocating credit, areas where Congress may have a role, but not a limited-purpose independent agency of government.”

Professor John B. Taylor (2014Jul15, 2014Jun26) building on advanced research (Taylor 2007, 2008Nov, 2009, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB, 2015, 2012 Oct 25; 2013Oct28, 2014 Jan01, 2014Jan3, 2014Jun26, 2014Jul15, 2015, 2016Dec7, 2016Dec20 http://www.johnbtaylor.com/) 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/2017/01/rules-versus-discretionary-authorities.html and earlier http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.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 re the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+re). Thus, g = [(r/re) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dre>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 σy and prices σp. Policy attempts to circumvent the lags by policy impulses based on forecasts. We are all naïve about forecasting. Data are available with lags and revised to maintain high standards of estimation. Policy simulation models estimate economic relations with structures prevailing before simulations of policy impulses such that parameters change as discovered by Lucas (1977). Economic agents adjust their behavior in ways that cause opposite results from those intended by optimal control policy as discovered by Kydland and Prescott (1977). Advance guidance attempts to circumvent expectations by economic agents that could reverse policy impulses but is of dubious effectiveness. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/2017/01/rules-versus-discretionary-authorities.html and earlier http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html).

The Swiss National Bank (SNB) announced on Jan 15, 2015, the termination of its peg of the exchange rate of the Swiss franc to the euro (http://www.snb.ch/en/mmr/speeches/id/ref_20150115_tjn/source/ref_20150115_tjn.en.pdf):

“The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate of

CHF 1.20 per euro with immediate effect and to cease foreign currency purchases associated with enforcing it.”

The SNB also lowered interest rates to nominal negative percentages (http://www.snb.ch/en/mmr/speeches/id/ref_20150115_tjn/source/ref_20150115_tjn.en.pdf):

“At the same time as discontinuing the minimum exchange rate, the SNB will be lowering the interest rate for balances held on sight deposit accounts to –0.75% from 22 January. The exemption thresholds remain unchanged. Further lowering the interest rate makes Swiss-franc investments considerably less attractive and will mitigate the effects of the decision to discontinue the minimum exchange rate. The target range for the three-month Libor is being lowered by 0.5 percentage points to between –1.25% and –0.25%.”

The Swiss franc rate relative to the euro (CHF/EUR) appreciated 18.7 percent on Jan 15, 2015. The Swiss franc rate relative to the dollar (CHF/USD) appreciated 17.7 percent. Central banks are taking measures in anticipation of the quantitative easing program of the European Central Bank.

On Jan 22, 2015, the European Central Bank (ECB) decided to implement an “expanded asset purchase program” with combined asset purchases of €60 billion per month “until at least Sep 2016 (http://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html). The objective of the program is that (http://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html):

“Asset purchases provide monetary stimulus to the economy in a context where key 3ECB interest rates are at their lower bound. They further ease monetary and financial conditions, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately contributes to a return of inflation rates towards 2%.”

The President of the ECB, Mario Draghi, explains the coordination of asset purchases with NCBs (National Central Banks) of the euro area and risk sharing (http://www.ecb.europa.eu/press/pressconf/2015/html/is150122.en.html):

“In March 2015 the Eurosystem will start to purchase euro-denominated investment-grade securities issued by euro area governments and agencies and European institutions in the secondary market. The purchases of securities issued by euro area governments and agencies will be based on the Eurosystem NCBs’ shares in the ECB’s capital key. Some additional eligibility criteria will be applied in the case of countries under an EU/IMF adjustment programme. As regards the additional asset purchases, the Governing Council retains control over all the design features of the programme and the ECB will coordinate the purchases, thereby safeguarding the singleness of the Eurosystem’s monetary policy. The Eurosystem will make use of decentralised implementation to mobilise its resources. With regard to the sharing of hypothetical losses, the Governing Council decided that purchases of securities of European institutions (which will be 12% of the additional asset purchases, and which will be purchased by NCBs) will be subject to loss sharing. The rest of the NCBs’ additional asset purchases will not be subject to loss sharing. The ECB will hold 8% of the additional asset purchases. This implies that 20% of the additional asset purchases will be subject to a regime of risk sharing.”

The President of the ECB, Mario Draghi, rejected the possibility of seigniorage in the new asset purchase program, or central bank financing of fiscal expansion (http://www.ecb.europa.eu/press/pressconf/2015/html/is150122.en.html):

“As I just said, it would be a big mistake if countries were to consider that the presence of this programme might be an incentive to fiscal expansion. They would undermine the confidence, so it’s not directed to monetary financing at all. Actually, it’s been designed as to avoid any monetary financing.”

The President of the ECB, Mario Draghi, does not find effects of monetary policy in inflating asset prices (http://www.ecb.europa.eu/press/pressconf/2015/html/is150122.en.html):

“On the first question, we monitor closely any potential instance of risk to financial stability. So we're very alert to that risk. So far we don't see bubbles. There may be some local episodes of certain specific markets where prices are going up fast. But to have a bubble, besides having that, one should also identify, detect an increase, dramatic increase in leverage or in bank credit, and we don't see that now. However, we, as I said, we are alert. If bubbles are of a local nature, they should be addressed by local instruments, namely macro-prudential instruments rather than by monetary policy.”

The DAX index of German equities increased 1.3 percent on Jan 22, 2015 and 2.1 percent on Jan 23, 2015. The euro depreciated from EUR 1.1611/USD (EUR 0.8613/USD) on Wed Jan 21, 2015, to EUR 1.1206/USD (EUR 0.8924/USD) on Fri Jan 23, 2015, or 3.6 percent. Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment. Risk aversion erodes devaluation of the dollar.

Dan Strumpf and Pedro Nicolaci da Costa, writing on “Fed’s Yellen: Stock Valuations ‘Generally are Quite High,’” on May 6, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/feds-yellen-cites-progress-on-bank-regulation-1430918155?tesla=y ), quote Chair Yellen at open conversation with Christine Lagarde, Managing Director of the IMF, finding “equity-market valuations” as “quite high” with “potential dangers” in bond valuations. The DJIA fell 0.5 percent on May 6, 2015, after the comments and then increased 0.5 percent on May 7, 2015 and 1.5 percent on May 8, 2015.

Fri May 1

Mon 4

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DJIA

18024.06

-0.3%

1.0%

18070.40

0.3%

0.3%

17928.20

-0.5%

-0.8%

17841.98

-1.0%

-0.5%

17924.06

-0.6%

0.5%

18191.11

0.9%

1.5%

There are two approaches in theory considered by Bordo (2012Nov20) and Bordo and Lane (2013). The first approach is in the classical works of Milton Friedman and Anna Jacobson Schwartz (1963a, 1987) and Karl Brunner and Allan H. Meltzer (1973). There is a similar approach in Tobin (1969). Friedman and Schwartz (1963a, 66) trace the effects of expansionary monetary policy into increasing initially financial asset prices: “It seems plausible that both nonbank and bank holders of redundant balances will turn first to securities comparable to those they have sold, say, fixed-interest coupon, low-risk obligations. But as they seek to purchase these they will tend to bid up the prices of those issues. Hence they, and also other holders not involved in the initial central bank open-market transactions, will look farther afield: the banks, to their loans; the nonbank holders, to other categories of securities-higher risk fixed-coupon obligations, equities, real property, and so forth.”

The second approach is by the Austrian School arguing that increases in asset prices can become bubbles if monetary policy allows their financing with bank credit. Professor Michael D. Bordo provides clear thought and empirical evidence on the role of “expansionary monetary policy” in inflating asset prices (Bordo2012Nov20, Bordo and Lane 2013). Bordo and Lane (2013) provide revealing narrative of historical episodes of expansionary monetary policy. Bordo and Lane (2013) conclude that policies of depressing interest rates below the target rate or growth of money above the target influences higher asset prices, using a panel of 18 OECD countries from 1920 to 2011. Bordo (2012Nov20) concludes: “that expansionary money is a significant trigger” and “central banks should follow stable monetary policies…based on well understood and credible monetary rules.” Taylor (2007, 2009) explains the housing boom and financial crisis in terms of expansionary monetary policy. Professor Martin Feldstein (2016), at Harvard University, writing on “A Federal Reserve oblivious to its effects on financial markets,” on Jan 13, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/a-federal-reserve-oblivious-to-its-effect-on-financial-markets-1452729166), analyzes how unconventional monetary policy drove values of risk financial assets to high levels. Quantitative easing and zero interest rates distorted calculation of risks with resulting vulnerabilities in financial markets.

Another hurdle of exit from zero interest rates is “competitive easing” that Professor Raghuram Rajan, former governor of the Reserve Bank of India, characterizes as disguised “competitive devaluation” (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). The fed has been considering increasing interest rates. The European Central Bank (ECB) announced, on Mar 5, 2015, the beginning on Mar 9, 2015 of its quantitative easing program denominated as Public Sector Purchase Program (PSPP), consisting of “combined monthly purchases of EUR 60 bn [billion] in public and private sector securities” (http://www.ecb.europa.eu/mopo/liq/html/pspp.en.html). Expectation of increasing interest rates in the US together with euro rates close to zero or negative cause revaluation of the dollar (or devaluation of the euro and of most currencies worldwide). US corporations suffer currency translation losses of their foreign transactions and investments (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318) while the US becomes less competitive in world trade (Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), Government Intervention in Globalization (2008c)). The DJIA fell 1.5 percent on Mar 6, 2015 and the dollar revalued 2.2 percent from Mar 5 to Mar 6, 2015. The euro has devalued 41.9 percent relative to the dollar from the high on Jul 15, 2008 to May 19, 2017.

Fri 27 Feb

Mon 3/2

Tue 3/3

Wed 3/4

Thu 3/5

Fri 3/6

USD/ EUR

1.1197

1.6%

0.0%

1.1185

0.1%

0.1%

1.1176

0.2%

0.1%

1.1081

1.0%

0.9%

1.1030

1.5%

0.5%

1.0843

3.2%

1.7%

Chair Yellen explained the removal of the word “patience” from the advanced guidance at the press conference following the FOMC meeting on Mar 18, 2015 (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150318.pdf):

“In other words, just because we removed the word “patient” from the statement doesn’t mean we are going to be impatient. Moreover, even after the initial increase in the target funds rate, our policy is likely to remain highly accommodative to support continued progress toward our objectives of maximum employment and 2 percent inflation.”

Exchange rate volatility is increasing in response of “impatience” in financial markets with monetary policy guidance and measures:

Fri Mar 6

Mon 9

Tue 10

Wed 11

Thu 12

Fri 13

USD/ EUR

1.0843

3.2%

1.7%

1.0853

-0.1%

-0.1%

1.0700

1.3%

1.4%

1.0548

2.7%

1.4%

1.0637

1.9%

-0.8%

1.0497

3.2%

1.3%

Fri Mar 13

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.0497

3.2%

1.3%

1.0570

-0.7%

-0.7%

1.0598

-1.0%

-0.3%

1.0864

-3.5%

-2.5%

1.0661

-1.6%

1.9%

1.0821

-3.1%

-1.5%

Fri Apr 24

Mon 27

Tue 28

Wed 29

Thu 30

May Fri 1

USD/ EUR

1.0874

-0.6%

-0.4%

1.0891

-0.2%

-0.2%

1.0983

-1.0%

-0.8%

1.1130

-2.4%

-1.3%

1.1223

-3.2%

-0.8%

1.1199

-3.0%

0.2%

In a speech at Brown University on May 22, 2015, Chair Yellen stated (http://www.federalreserve.gov/newsevents/speech/yellen20150522a.htm):

“For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term. After we begin raising the federal funds rate, I anticipate that the pace of normalization is likely to be gradual. The various headwinds that are still restraining the economy, as I said, will likely take some time to fully abate, and the pace of that improvement is highly uncertain.”

The US dollar appreciated 3.8 percent relative to the euro in the week of May 22, 2015:

Fri May 15

Mon 18

Tue 19

Wed 20

Thu 21

Fri 22

USD/ EUR

1.1449

-2.2%

-0.3%

1.1317

1.2%

1.2%

1.1150

2.6%

1.5%

1.1096

3.1%

0.5%

1.1113

2.9%

-0.2%

1.1015

3.8%

0.9%

The Managing Director of the International Monetary Fund (IMF), Christine Lagarde, warned on Jun 4, 2015, that: (http://blog-imfdirect.imf.org/2015/06/04/u-s-economy-returning-to-growth-but-pockets-of-vulnerability/):

“The Fed’s first rate increase in almost 9 years is being carefully prepared and telegraphed. Nevertheless, regardless of the timing, higher US policy rates could still result in significant market volatility with financial stability consequences that go well beyond US borders. I weighing these risks, we think there is a case for waiting to raise rates until there are more tangible signs of wage or price inflation than are currently evident. Even after the first rate increase, a gradual rise in the federal fund rates will likely be appropriate.”

The President of the European Central Bank (ECB), Mario Draghi, warned on Jun 3, 2015 that (http://www.ecb.europa.eu/press/pressconf/2015/html/is150603.en.html):

“But certainly one lesson is that we should get used to periods of higher volatility. At very low levels of interest rates, asset prices tend to show higher volatility…the Governing Council was unanimous in its assessment that we should look through these developments and maintain a steady monetary policy stance.”

The Chair of the Board of Governors of the Federal Reserve System, Janet L. Yellen, stated on Jul 10, 2015 that (http://www.federalreserve.gov/newsevents/speech/yellen20150710a.htm):

“Based on my outlook, I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy. But I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step. I currently anticipate that the appropriate pace of normalization will be gradual, and that monetary policy will need to be highly supportive of economic activity for quite some time. The projections of most of my FOMC colleagues indicate that they have similar expectations for the likely path of the federal funds rate. But, again, both the course of the economy and inflation are uncertain. If progress toward our employment and inflation goals is more rapid than expected, it may be appropriate to remove monetary policy accommodation more quickly. However, if progress toward our goals is slower than anticipated, then the Committee may move more slowly in normalizing policy.”

There is essentially the same view in the Testimony of Chair Yellen in delivering the Semiannual Monetary Policy Report to the Congress on Jul 15, 2015 (http://www.federalreserve.gov/newsevents/testimony/yellen20150715a.htm).

At the press conference after the meeting of the FOMC on Sep 17, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150917.pdf 4):

“The outlook abroad appears to have become more uncertain of late, and heightened concerns about growth in China and other emerging market economies have led to notable volatility in financial markets. Developments since our July meeting, including the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads, have tightened overall financial conditions to some extent. These developments may restrain U.S. economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Given the significant economic and financial interconnections between the United States and the rest of the world, the situation abroad bears close watching.”

Some equity markets fell on Fri Sep 18, 2015:

Fri Sep 11

Mon 14

Tue 15

Wed 16

Thu 17

Fri 18

DJIA

16433.09

2.1%

0.6%

16370.96

-0.4%

-0.4%

16599.85

1.0%

1.4%

16739.95

1.9%

0.8%

16674.74

1.5%

-0.4%

16384.58

-0.3%

-1.7%

Nikkei 225

18264.22

2.7%

-0.2%

17965.70

-1.6%

-1.6%

18026.48

-1.3%

0.3%

18171.60

-0.5%

0.8%

18432.27

0.9%

1.4%

18070.21

-1.1%

-2.0%

DAX

10123.56

0.9%

-0.9%

10131.74

0.1%

0.1%

10188.13

0.6%

0.6%

10227.21

1.0%

0.4%

10229.58

1.0%

0.0%

9916.16

-2.0%

-3.1%

Frank H. Knight (1963, 233), in Risk, uncertainty and profit, distinguishes between measurable risk and unmeasurable uncertainty. Chair Yellen, in a lecture on “Inflation dynamics and monetary policy,” on Sep 24, 2015 (http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm), states that (emphasis added):

· “The economic outlook, of course, is highly uncertain”

· “Considerable uncertainties also surround the outlook for economic activity”

· “Given the highly uncertain nature of the outlook…”

Is there a “science” or even “art” of central banking under this extreme uncertainty in which policy does not generate higher volatility of money, income, prices and values of financial assets?

Lingling Wei, writing on Oct 23, 2015, on China’s central bank moves to spur economic growth,” published in the Wall Street Journal (http://www.wsj.com/articles/chinas-central-bank-cuts-rates-1445601495), analyzes the reduction by the People’s Bank of China (http://www.pbc.gov.cn/ http://www.pbc.gov.cn/english/130437/index.html) of borrowing and lending rates of banks by 50 basis points and reserve requirements of banks by 50 basis points. Paul Vigna, writing on Oct 23, 2015, on “Stocks rally out of correction territory on latest central bank boost,” published in the Wall Street Journal (http://blogs.wsj.com/moneybeat/2015/10/23/stocks-rally-out-of-correction-territory-on-latest-central-bank-boost/), analyzes the rally in financial markets following the statement on Oct 22, 2015, by the President of the European Central Bank (ECB) Mario Draghi of consideration of new quantitative measures in Dec 2015 (https://www.youtube.com/watch?v=0814riKW25k&rel=0) and the reduction of bank lending/deposit rates and reserve requirements of banks by the People’s Bank of China on Oct 23, 2015. The dollar revalued 2.8 percent from Oct 21 to Oct 23, 2015, following the intended easing of the European Central Bank. The DJIA rose 2.8 percent from Oct 21 to Oct 23 and the DAX index of German equities rose 5.4 percent from Oct 21 to Oct 23, 2015.

Fri Oct 16

Mon 19

Tue 20

Wed 21

Thu 22

Fri 23

USD/ EUR

1.1350

0.1%

0.3%

1.1327

0.2%

0.2%

1.1348

0.0%

-0.2%

1.1340

0.1%

0.1%

1.1110

2.1%

2.0%

1.1018

2.9%

0.8%

DJIA

17215.97

0.8%

0.4%

17230.54

0.1%

0.1%

17217.11

0.0%

-0.1%

17168.61

-0.3%

-0.3%

17489.16

1.6%

1.9%

17646.70

2.5%

0.9%

Dow Global

2421.58

0.3%

0.6%

2414.33

-0.3%

-0.3%

2411.03

-0.4%

-0.1%

2411.27

-0.4%

0.0%

2434.79

0.5%

1.0%

2458.13

1.5%

1.0%

DJ Asia Pacific

1402.31

1.1%

0.3%

1398.80

-0.3%

-0.3%

1395.06

-0.5%

-0.3%

1402.68

0.0%

0.5%

1396.03

-0.4%

-0.5%

1415.50

0.9%

1.4%

Nikkei 225

18291.80

-0.8%

1.1%

18131.23

-0.9%

-0.9%

18207.15

-0.5%

0.4%

18554.28

1.4%

1.9%

18435.87

0.8%

-0.6%

18825.30

2.9%

2.1%

Shanghai

3391.35

6.5%

1.6%

3386.70

-0.1%

-0.1%

3425.33

1.0%

1.1%

3320.68

-2.1%

-3.1%

3368.74

-0.7%

1.4%

3412.43

0.6%

1.3%

DAX

10104.43

0.1%

0.4%

10164.31

0.6%

0.6%

10147.68

0.4%

-0.2%

10238.10

1.3%

0.9%

10491.97

3.8%

2.5%

10794.54

6.8%

2.9%

Ben Leubsdorf, writing on “Fed’s Yellen: December is “Live Possibility” for First Rate Increase,” on Nov 4, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/feds-yellen-december-is-live-possibility-for-first-rate-increase-1446654282) quotes Chair Yellen that a rate increase in “December would be a live possibility.” The remark of Chair Yellen was during a hearing on supervision and regulation before the Committee on Financial Services, US House of Representatives (http://www.federalreserve.gov/newsevents/testimony/yellen20151104a.htm) and a day before the release of the employment situation report for Oct 2015 (http://cmpassocregulationblog.blogspot.com/2015/11/live-possibility-of-interest-rates.html). The dollar revalued 2.4 percent during the week. The euro has devalued 41.9 percent relative to the dollar from the high on Jul 15, 2008 to May 19, 2017.

Fri Oct 30

Mon 2

Tue 3

Wed 4

Thu 5

Fri 6

USD/ EUR

1.1007

0.1%

-0.3%

1.1016

-0.1%

-0.1%

1.0965

0.4%

0.5%

1.0867

1.3%

0.9%

1.0884

1.1%

-0.2%

1.0742

2.4%

1.3%

The release on Nov 18, 2015 of the minutes of the FOMC (Federal Open Market Committee) meeting held on Oct 28, 2015 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20151028.htm) states:

“Most participants anticipated that, based on their assessment of the current economic situation and their outlook for economic activity, the labor market, and inflation, these conditions [for interest rate increase] could well be met by the time of the next meeting. Nonetheless, they emphasized that the actual decision would depend on the implications for the medium-term economic outlook of the data received over the upcoming intermeeting period… It was noted that beginning the normalization process relatively soon would make it more likely that the policy trajectory after liftoff could be shallow.”

Markets could have interpreted a symbolic increase in the fed funds rate at the meeting of the FOMC on Dec 15-16, 2015 (http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm) followed by “shallow” increases, explaining the sharp increase in stock market values and appreciation of the dollar after the release of the minutes on Nov 18, 2015:

Fri Nov 13

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.0774

-0.3%

0.4%

1.0686

0.8%

0.8%

1.0644

1.2%

0.4%

1.0660

1.1%

-0.2%

1.0735

0.4%

-0.7%

1.0647

1.2%

0.8%

DJIA

17245.24

-3.7%

-1.2%

17483.01

1.4%

1.4%

17489.50

1.4%

0.0%

17737.16

2.9%

1.4%

17732.75

2.8%

0.0%

17823.81

3.4%

0.5%

DAX

10708.40

-2.5%

-0.7%

10713.23

0.0%

0.0%

10971.04

2.5%

2.4%

10959.95

2.3%

-0.1%

11085.44

3.5%

1.1%

11119.83

3.8%

0.3%

In testimony before The Joint Economic Committee of Congress on Dec 3, 2015 (http://www.federalreserve.gov/newsevents/testimony/yellen20151203a.htm), Chair Yellen reiterated that the FOMC (Federal Open Market Committee) “anticipates that even after employment and inflation are near mandate-consistent levels, economic condition may, for some time, warrant keeping the target federal funds rate below the Committee views as normal in the longer run.” Todd Buell and Katy Burne, writing on “Draghi says ECB could step up stimulus efforts if necessary,” on Dec 4, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/draghi-says-ecb-could-step-up-stimulus-efforts-if-necessary-1449252934), analyze that the President of the European Central Bank (ECB), Mario Draghi, reassured financial markets that the ECB will increase stimulus if required to raise inflation the euro area to targets. The USD depreciated 3.1 percent on Thu Dec 3, 2015 after weaker than expected measures by the European Central Bank. DJIA fell 1.4 percent on Dec 3 and increased 2.1 percent on Dec 4. DAX fell 3.6 percent on Dec 3.

Fri Nov 27

Mon 30

Tue 1

Wed 2

Thu 3

Fri 4

USD/ EUR

1.0594

0.5%

0.2%

1.0565

0.3%

0.3%

1.0634

-0.4%

-0.7%

1.0616

-0.2%

0.2%

1.0941

-3.3%

-3.1%

1.0885

-2.7%

0.5%

DJIA

17798.49

-0.1%

-0.1%

17719.92

-0.4%

-0.4%

17888.35

0.5%

1.0%

17729.68

-0.4%

-0.9%

17477.67

-1.8%

-1.4%

17847.63

0.3%

2.1%

DAX

11293.76

1.6%

-0.2%

11382.23

0.8%

0.8%

11261.24

-0.3%

-1.1%

11190.02

-0.9%

-0.6%

10789.24

-4.5%

-3.6%

10752.10

-4.8%

-0.3%

At the press conference following the meeting of the FOMC on Dec 16, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20151216.pdf page 8):

“And we recognize that monetary policy operates with lags. We would like to be able to move in a prudent, and as we've emphasized, gradual manner. It's been a long time since the Federal Reserve has raised interest rates, and I think it's prudent to be able to watch what the impact is on financial conditions and spending in the economy and moving in a timely fashion enables us to do this.”

The implication of this statement is that the state of the art is not accurate in analyzing the effects of monetary policy on financial markets and economic activity. The US dollar appreciated and equities fluctuated:

Fri Dec 11

Mon 14

Tue 15

Wed 16

Thu 17

Fri 18

USD/ EUR

1.0991

-1.0%

-0.4%

1.0993

0.0%

0.0%

1.0932

0.5%

0.6%

1.0913

0.7%

0.2%

1.0827

1.5%

0.8%

1.0868

1.1%

-0.4%

DJIA

17265.21

-3.3%

-1.8%

17368.50

0.6%

0.6%

17524.91

1.5%

0.9%

17749.09

2.8%

1.3%

17495.84

1.3%

-1.4%

17128.55

-0.8%

-2.1%

DAX

10340.06

-3.8%

-2.4%

10139.34

-1.9%

-1.9%

10450.38

-1.1%

3.1%

10469.26

1.2%

0.2%

10738.12

3.8%

2.6%

10608.19

2.6%

-1.2%

The Bank of Japan decided on Jan 29, 2016 to determine “a negative interest rate of minus 0.1 percent to current accounts that financial institutions hold at the Bank” and “will cut the interest rate further into negative territory if judged as necessary” (https://www.boj.or.jp/en/announcements/release_2016/k160129b.pdf). The new policy is quantitative and qualitative (QQE) with a negative interest rate “designed to enable the Bank to pursue additional monetary easing in terms of three dimensions, combining a negative interest rate with quantity and quality” (https://www.boj.or.jp/en/announcements/release_2016/k160129b.pdf). The yen devalued sharply relative to the dollar and world equity markets soared after the new policy announced on Jan 29, 2016:

Fri 22

Mon 25

Tue 26

Wed 27

Thu 28

Fri 29

JPY/ USD

118.77

-1.5%

-0.9%

118.30

0.4%

0.4%

118.42

0.3%

-0.1%

118.68

0.1%

-0.2%

118.82

0.0%

-0.1%

121.13

-2.0%

-1.9%

DJIA

16093.51

0.7%

1.3%

15885.22

-1.3%

-1.3%

16167.23

0.5%

1.8%

15944.46

-0.9%

-1.4%

16069.64

-0.1%

0.8%

16466.30

2.3%

2.5%

Nikkei

16958.53

-1.1%

5.9%

17110.91

0.9%

0.9%

16708.90

-1.5%

-2.3%

17163.92

1.2%

2.7%

17041.45

0.5%

-0.7%

17518.30

3.3%

2.8%

Shanghai

2916.56

0.5%

1.3

2938.51

0.8%

0.8%

2749.79

-5.7%

-6.4%

2735.56

-6.2%

-0.5%

2655.66

-8.9%

-2.9%

2737.60

-6.1%

3.1%

DAX

9764.88

2.3%

2.0%

9736.15

-0.3%

-0.3%

9822.75

0.6%

0.9%

9880.82

1.2%

0.6%

9639.59

-1.3%

-2.4%

9798.11

0.3%

1.6%

In testimony on the Semiannual Monetary Policy Report to the Congress on Feb 10-11, 2016, Chair Yellen (http://www.federalreserve.gov/newsevents/testimony/yellen20160210a.htm) states: “U.S. real gross domestic product is estimated to have increased about 1-3/4 percent in 2015. Over the course of the year, subdued foreign growth and the appreciation of the dollar restrained net exports. In the fourth quarter of last year, growth in the gross domestic product is reported to have slowed more sharply, to an annual rate of just 3/4 percent; again, growth was held back by weak net exports as well as by a negative contribution from inventory investment.”

Jon Hilsenrath, writing on “Yellen Says Fed Should Be Prepared to Use Negative Rates if Needed,” on Feb 11, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/yellen-reiterates-concerns-about-risks-to-economy-in-senate-testimony-1455203865), analyzes the statement of Chair Yellen in Congress that the FOMC (Federal Open Market Committee) is considering negative interest rates on bank reserves. The Wall Street Journal provides yields of two and ten-year sovereign bonds with negative interest rates on shorter maturities where central banks pay negative interest rates on excess bank reserves:

Sovereign Yields 2/12/16

Japan

Germany

USA

2 Year

-0.168

-0.498

0.694

10 Year

0.076

0.262

1.744

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

On Mar 10, 2016, the European Central Bank (ECB) announced (1) reduction of the refinancing rate by 5 basis points to 0.00 percent; decrease the marginal lending rate to 0.25 percent; reduction of the deposit facility rate to 0,40 percent; increase of the monthly purchase of assets to €80 billion; include nonbank corporate bonds in assets eligible for purchases; and new long-term refinancing operations (https://www.ecb.europa.eu/press/pr/date/2016/html/pr160310.en.html). The President of the ECB, Mario Draghi, stated in the press conference (https://www.ecb.europa.eu/press/pressconf/2016/html/is160310.en.html): “How low can we go? Let me say that rates will stay low, very low, for a long period of time, and well past the horizon of our purchases…We don’t anticipate that it will be necessary to reduce rates further. Of course, new facts can change the situation and the outlook.”

The dollar devalued relative to the euro and open stock markets traded lower after the announcement on Mar 10, 2016, but stocks rebounded on Mar 11:

Fri 4

Mon 7

Tue 8

Wed 9

Thu10

Fri 11

USD/ EUR

1.1006

-0.7%

-0.4%

1.1012

-0.1%

-0.1%

1.1013

-0.1%

0.0%

1.0999

0.1%

0.1%

1.1182

-1.6%

-1.7%

1.1151

-1.3%

0.3%

DJIA

17006.77

2.2%

0.4%

17073.95

0.4%

0.4%

16964.10

-0.3%

-0.6%

17000.36

0.0%

0.2%

16995.13

-0.1%

0.0%

17213.31

1.2%

1.3%

DAX

9824.17

3.3%

0.7%

9778.93

-0.5%

0.5%

9692.82

-1.3%

-0.9%

9723.09

-1.0%

0.3%

9498.15

-3.3%

-2.3%

9831.13

0.1%

3.5%

At the press conference after the FOMC meeting on Sep 21, 2016, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20160921.pdf ): “However, the economic outlook is inherently uncertain.” In the address to the Jackson Hole symposium on Aug 26, 2016, Chair Yellen states: “I believe the case for an increase in in federal funds rate has strengthened in recent months…And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course” (http://www.federalreserve.gov/newsevents/speech/yellen20160826a.htm). In a speech at the World Affairs Council of Philadelphia, on Jun 6, 2016 (http://www.federalreserve.gov/newsevents/speech/yellen20160606a.htm), Chair Yellen finds that “there is considerable uncertainty about the economic outlook.” There are fifteen references to this uncertainty in the text of 18 pages double-spaced. In the Semiannual Monetary Policy Report to the Congress on Jun 21, 2016, Chair Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20160621a.htm), “Of course, considerable uncertainty about the economic outlook remains.” Frank H. Knight (1963, 233), in Risk, uncertainty and profit, distinguishes between measurable risk and unmeasurable uncertainty. Is there a “science” or even “art” of central banking under this extreme uncertainty in which policy does not generate higher volatility of money, income, prices and values of financial assets?

“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.”

In a speech on “Monetary Policy in the Euro Area,” on Nov 21, 2014, the President of the European Central Bank, Mario Draghi, advised of the determination to bring inflation back to normal levels by aggressive holding of securities in the balance sheet (http://www.ecb.europa.eu/press/key/date/2014/html/sp141121.en.html):

“In short, there is a combination of policies that will work to bring growth and inflation back on a sound path, and we all have to meet our responsibilities in achieving that. For our part, we will continue to meet our responsibility – we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us.

If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialise, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases.”

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/2017/01/unconventional-monetary-policy-and.html and earlier http://cmpassocregulationblog.blogspot.com/2016/01/unconventional-monetary-policy-and.html and earlier http://cmpassocregulationblog.blogspot.com/2015/01/peaking-valuations-of-risk-financial.html and earlier http://cmpassocregulationblog.blogspot.com/2014/01/theory-and-reality-of-secular.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 20,804.84 on May 19, 2017, which is higher by 46.9 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 46.5 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial assets have been approaching or exceeding historical highs. Perhaps one of the most critical statements on policy is the answer to a question of 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, former 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 2007, 2008Nov, 2009, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB, 2015, 2012 Oct 25; 2013Oct28, 2014 Jan01, 2014Jan3, 2014Jun26, 2014Jul15, 2015, 2016Dec7, 2016Dec20 http://www.johnbtaylor.com/) 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/2017/01/rules-versus-discretionary-authorities.html and earlier http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.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.

Banking was important in facilitating economic growth in historical periods (Cameron 1961, 1967, 1972; Cameron et al. 1992). Banking is also important currently because small- and medium-size business may have no other form of financing than banks in contrast with many options for larger and more mature companies that have access to capital markets. Calomiris and Haber (2014) find that broad voting rights and institutions restricting coalitions of bankers and populists ensure stable banking systems and access to credit. Summerhill (2015) finds compelling evidence that sovereign credibility is insufficient to develop financial intermediation required for economic growth in the presence of inadequate political institutions.

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 17, 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 1.559 percent on May 19, 2017 compared with 1.604 percent a year earlier, and that of the ten-year sovereign bond of Italy at 2.131 percent compared with 1.508 percent a year earlier (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 May 19, 2017, the yield of the two-year Treasury decreased to 1.279 percent and that of the ten-year Treasury decreased to 2.243 percent while the yield of the two-year bond of Germany decreased at minus 0.69 percent and the ten-year yield decreased at 0.37 percent; and the dollar depreciated at USD 1.1207/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 2.243 percent is higher than consumer price inflation of 2.2 percent in the 12 months ending in Apr 2017 (Section I and earlier https://cmpassocregulationblog.blogspot.com/2017/04/world-inflation-waves-united-states.html and earlier https://cmpassocregulationblog.blogspot.com/2017/03/fomc-increases-interest-rates-world.html and earlier https://cmpassocregulationblog.blogspot.com/2017/02/world-inflation-waves-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2017/01/world-inflation-waves-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2016/12/of-course-economic-outlook-is-highly.html and earlier http://cmpassocregulationblog.blogspot.com/2016/11/interest-rate-increase-could-well.html and earlier http://cmpassocregulationblog.blogspot.com/2016/10/dollar-revaluation-world-inflation.html and earlier http://cmpassocregulationblog.blogspot.com/2016/09/interest-rates-and-volatility-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/08/interest-rate-policy-uncertainty-and.html and earlier http://cmpassocregulationblog.blogspot.com/2016/07/oscillating-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/06/fomc-projections-world-inflation-waves.html and earlier http://cmpassocregulationblog.blogspot.com/2016/05/most-fomc-participants-judged-that-if.html and earlier (http://cmpassocregulationblog.blogspot.com/2016/04/contracting-united-states-industrial.html and earlier (http://cmpassocregulationblog.blogspot.com/2016/03/monetary-policy-and-competitive.html and earlier http://cmpassocregulationblog.blogspot.com/2016/02/squeeze-of-economic-activity-by-carry.html and earlier http://cmpassocregulationblog.blogspot.com/2016/01/uncertainty-of-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2015/12/liftoff-of-interest-rates-with-monetary.html and earlier http://cmpassocregulationblog.blogspot.com/2015/11/interest-rate-liftoff-followed-by.html and earlier http://cmpassocregulationblog.blogspot.com/2015/10/interest-rate-policy-quagmire-world.html and earlier http://cmpassocregulationblog.blogspot.com/2015/09/interest-rate-increase-on-hold-because.html and earlier http://cmpassocregulationblog.blogspot.com/2015/08/global-decline-of-values-of-financial.html and earlier http://cmpassocregulationblog.blogspot.com/2015/07/fluctuating-risk-financial-assets.html and earlier http://cmpassocregulationblog.blogspot.com/2015/06/fluctuating-financial-asset-valuations.html and earlier http://cmpassocregulationblog.blogspot.com/2015/05/interest-rate-policy-and-dollar.html and earlier http://cmpassocregulationblog.blogspot.com/2015/04/global-portfolio-reallocations-squeeze.html and earlier http://cmpassocregulationblog.blogspot.com/2015/03/dollar-revaluation-and-financial-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2015/03/irrational-exuberance-mediocre-cyclical.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 1.099 percent (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3002) is lower than the 12-month consumer price inflation of 2.2 percent, which appears to be temporary. 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

05/19/17

1.279

2.243

-0.69

0.37

1.1207

05/12/17

1.299

2.333

-0.67

0.39

1.0932

05/05/17

1.322

2.352

-0.68

0.42

1.0999

04/28/17

1.266

2.286

-0.73

0.32

1.0897

04/21/17

1.184

2.233

-0.79

0.26

1.0727

04/14/17

1.210

2.234

-0.86

0.19

1.0614

04/07/17

1.282

2.373

-0.81

0.23

1.0591

03/31/17

1.262

2.396

-0.74

0.33

1.0656

03/24/17

1.248

2.399

-0.74

0.41

1.0800

03/17/17

1.317

2.502

-0.77

0.43

1.0738

03/10/17

1.364

2.584

-0.84

0.49

1.0674

03/03/17

1.305

2.492

-0.81

0.35

1.0623

02/24/17

1.157

2.314

-0.95

0.19

1.0562

02/17/17

1.203

2.425

-0.81

0.31

1.0615

02/10/17

1.198

2.408

-0.80

0.32

1.0642

02/03/17

1.201

2.488

-0.74

0.42

1.0786

01/27/17

1.224

2.479

-0.66

0.46

1.0699

01/20/17

1.189

2.466

-0.68

0.43

1.0703

01/13/17

1.189

2.381

-0.72

0.34

1.0645

01/06/17

1.226

2.416

-0.73

0.30

1.0533

12/30/16

1.210

2.447

-0.79

0.21

1.0520

12/23/16

1.202

2.542

-0.79

0.26

1.0456

12/16/16

1.269

2.597

-0.80

0.32

1.0451

12/09/16

1.129

2.466

-0.76

0.37

1.0563

12/02/16

1.120

2.389

-0.73

0.28

1.0668

11/25/16

1.115

2.358

-0.74

0.24

1.0591

11/18/16

1.052

2.340

-0.66

0.28

1.0591

11/11/16

0.919

2.152

-0.60

0.31

1.0857

11/04/16

0.810

1.784

-0.64

0.14

1.1141

10/28/16

0.861

1.843

-0.62

0.17

1.0987

10/21/16

0.844

1.738

-0.66

0.01

1.0884

10/14/16

0.835

1.791

-0.66

0.06

1.0972

10/07/16

0.834

1.732

-0.66

-0.02

1.1203

09/30/16

0.766

1.602

-0.68

-0.12

1.1240

09/23/16

0.758

1.614

-0.67

-0.08

1.1228

09/16/16

0.774

1.699

-0.65

0.01

1.1157

09/09/16

0.790

1.675

-0.63

-0.01

1.1234

09/02/16

0.798

1.597

-0.63

-0.04

1.1156

08/26/16

0.845

1.635

-0.61

-0.07

1.1197

08/19/16

0.742

1.580

-0.61

-0.03

1.1326

08/12/16

0.722

1.514

-0.63

-0.11

1.1163

08/05/16

0.722

1.583

-0.62

-0.06

1.1088

07/29/16

0.671

1.458

-0.63

-0.12

1.1176

07/22/16

0.703

1.567

-0.61

-0.03

1.0980

07/15/16

0.706

1.595

-0.65

0.01

1.1037

07/08/16

0.613

1.366

-0.69

-0.19

1.1052

07/01/16

0.597

1.443

-0.65

-0.12

1.1140

06/24/16

0.641

1.575

-0.64

-0.04

1.1117

06/17/16

0.697

1.618

-0.59

0.02

1.1277

06/10/16

0.751

1.638

-0.54

0.02

1.1252

06/03/16

0.784

1.704

-0.53

0.07

1.1364

05/27/16

0.915

1.851

-0.50

0.14

1.1115

05/20/16

0.893

1.849

-0.50

0.17

1.1226

05/13/16

0.746

1.706

-0.51

0.13

1.1309

05/06/16

0.738

1.780

-0.51

0.15

1.1405

04/29/16

0.774

1.820

-0.47

0.27

1.1450

04/22/17

0.826

1.886

-0.50

0.23

1.1227

04/15/17

0.734

1.752

-0.51

0.13

1.1285

04/08/16

0.707

1.722

-0.51

0.10

1.1399

03/25/16

0.885

1.900

-0.48

0.18

1.1168

03/18/16

0.843

1.871

-0.47

0.21

1.1270

03/11/16

0.960

1.977

-0.46

0.27

1.1151

03/04/16

0.878

1.884

-0.52

0.24

1.1006

02/26/16

0.793

1.766

-0.52

0.15

1.0933

02/19/16

0.746

1.748

-0.52

0.21

1.1131

02/12/16

0.694

1.744

-0.50

0.26

1.1256

02/05/16

0.726

1.848

-0.49

0.30

1.1158

01/29/16

0.778

1.923

-0.48

0.33

1.0833

01/22/16

0.881

2.048

-0.44

0.42

1.0799

01/15/16

0.858

2.036

-0.38

0.48

1.0917

01/08/16

0.948

2.135

-0.39

0.52

1.0926

01/01/16

1.060

2.269

-0.34

0.63

1.0861

12/25/15

0.998

2.242

-0.33

0.63

1.0965

12/18/15

0.944

2.197

-0.35

0.55

1.0868

12/11/15

0.903

2.134

-0.34

0.54

1.0991

12/04/15

0.951

2.276

-0.29

0.68

1.0885

11/27/15

0.922

2.223

-0.42

0.46

1.0594

11/20/15

0.905

2.260

-0.39

0.48

1.0647

11/13/15

0.855

2.278

-0.37

0.56

1.0774

11/06/15

0.890

2.332

-0.27

0.70

1.0742

10/30/15

0.736

2.150

-0.33

0.52

1.1007

10/23/15

0.645

2.083

-0.31

0.52

1.1018

10/16/15

0.605

2.024

-0.26

0.55

1.1350

10/09/15

0.641

2.096

-0.24

0.62

1.1359

10/02/15

0.578

1.998

-0.27

0.51

1.1214

09/25/15

0.688

2.168

-0.24

0.65

1.1199

09/18/15

0.678

2.131

-0.24

0.67

1.1303

09/11/15

0.701

2.181

-0.25

0.66

1.1338

09/04/15

0.709

2.127

-0.23

0.67

1.1153

08/28/15

0.716

2.182

-0.21

0.75

1.1185

08/21/15

0.633

2.052

-0.25

0.57

1.1389

08/14/15

0.738

2.196

-0.27

0.66

1.1109

08/07/15

0.729

2.164

-0.25

0.62

1.0967

07/31/15

0.669

2.207

-0.23

0.61

1.0984

07/24/15

0.682

2.268

-0.21

0.65

1.0985

07/17/15

0.666

2.346

-0.22

0.74

1.0831

07/10/15

0.653

2.414

-0.21

0.90

1.1156

07/03/15

0.629

2.383

-0.25

0.80

1.1115

06/26/15

0.704

2.473

-0.18

0.93

1.1167

06/19/15

0.629

2.270

-0.20

0.76

1.1352

06/12/15

0.726

2.388

-0.18

0.83

1.1268

06/05/15

0.733

2.400

-0.17

0.85

1.1166

05/29/15

0.605

2.092

-0.22

0.49

1.0993

05/22/15

0.618

2.211

-0.22

0.61

1.1015

05/15/15

0.544

2.136

-0.20

0.63

1.1449

05/08/15

0.580

2.153

-0.21

0.55

1.1202

05/01/15

0.607

2.118

-0.21

0.37

1.1199

04/24/15

0.512

1.917

-0.25

0.16

1.0874

04/17/15

0.512

1.864

-0.28

0.08

1.0807

04/10/15

0.560

1.950

-0.28

0.16

1.0603

04/02/15

0.544

1.911

-0.26

0.17

1.0973

03/27/15

0.590

1.951

-0.25

0.18

1.0890

03/20/15

0.589

1.927

-0.24

0.15

1.0821

03/13/15

0.660

2.103

-0.24

0.22

1.0497

03/06/15

0.723

2.238

-0.21

0.35

1.0843

02/27/15

0.634

2.016

-0.23

0.28

1.1197

02/20/15

0.642

2.119

-0.23

0.33

1.1381

02/13/15

0.640

2.043

-0.23

0.31

1.1391

02/06/15

0.640

1.941

-0.21

0.34

1.1316

01/30/15

0.450

1.683

-0.19

0.27

1.1291

01/23/15

0.495

1.804

-0.18

0.39

1.1206

01/16/15

0.488

1.826

-0.17

0.41

1.1567

01/09/15

0.577

1.973

-0.12

0.49

1.1843

01/02/15

0.670

2.126

-0.12

0.50

1.2003

12/26/14

0.739

2.248

-0.10

0.59

1.2182

12/19/14

0.654

2.185

-0.09

0.59

1.2229

12/12/14

0.546

2.086

-0.05

0.62

1.2464

12/05/14

0.641

2.306

-0.02

1.04

1.2285

11/28/14

0.470

2.165

-0.04

0.70

1.2452

11/21/14

0.507

2.307

-0.04

0.77

1.2390

11/14/21

0.510

2.319

-0.04

0.78

1.2525

11/7/14

0.501

2.302

-0.06

0.82

1.2455

10/31/14

0.495

2.332

-0.06

0.84

1.2773

10/24/14

0.380

2.263

-0.04

0.89

1.2671

10/17/14

0.373

2.197

-0.06

0.86

1.2760

10/10/14

0.434

2.292

-0.06

0.89

1.2629

10/03/14

0.562

2.437

-0.07

0.92

1.2514

09/26/14

0.581

2.527

-0.07

0.97

1.2683

09/19/14

0.567

2.576

-0.07

1.04

1.2829

09/12/14

0.562

2.606

-0.06

1.08

1.2965

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

90.232

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 Jul 7, 2016, with the one-month yield at 0.27 percent, the two-year at 0.58 percent, the ten-year at 1.40 percent, the fed funds rate at 0.40 percent and the corporate Baa bond at 4.19 percent.

Chart III-1A, Yield of Moody’s Baa Corporate Bond and US Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields and Overnight Fed Funds Rate, Jan 2, 1962-Jul 21, 2016

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Chart III-1B provides the same data as Chart III-1A from Jan 3, 2001 to Oct 6, 2016. The last point of Chart III1-A is for Oct 6, 2016, with the one-month yield at 0.26 percent, the two-year at 0.86 percent, the ten-year at 1.75 percent, the fed funds rate at 0.40 percent and the corporate Baa bond at 4.36 percent.

Chart III-1B, Yield of Moody’s Baa Corporate Bond and US Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields and Overnight Fed Funds Rate, Jan 1, 2001-Oct 6, 2016

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Chart III-1C provides the yields of the ten-year, two-year, one-month Treasury Constant Maturity, and the overnight Fed funds rate from Jan 2, 1962 to May 18, 2017. The final data point is for May 18, 2017 with the Fed funds rate at 0.91 percent, the one-month Treasury constant maturity at 0.73 percent, the two-year at 1.27 percent and the ten-year at 2.23 percent.

Chart III-1C, Yield US Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields and Overnight Fed Funds Rate, Jan 2, 1962-May 18, 2016

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Sharp and continuing strengthening of the dollar is affecting balance sheets of US corporations with foreign operations (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318). The Federal Open Market Committee (FOMC) is following “financial and international developments” as part of the process of framing interest rate policy (http://www.federalreserve.gov/newsevents/press/monetary/20150128a.htm). Kate Linebaugh, writing on “Corporate profits set to shrink for fourth consecutive quarter,” on Jul 17, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/corporate-profits-set-to-shrink-for-fourth-consecutive-quarter-1468799278), quotes forecasts of Thomson Reuters of 4.7 decline of adjusted earnings per share in the S&P 500 index in IIQ2016 relative to a year earlier. That would be the fourth consecutive quarterly decline. Theo Francis and Kate Linebaugh, writing on “US corporate profits on pace for third straight decline,” on Apr 28, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/u-s-corporate-profits-on-pace-for-third-straight-decline-1461872242), analyze three consecutive quarters of decline of corporate earnings and revenue in companies in S&P 500. They quote Thomson Reuters on expected decline of earnings of 6.1 percent in IQ2016 based on 55 percent of reporting companies. Weakness of economic activity shows in decline of revenues in IQ2016 of 1.4 percent, increasing 1.7 percent excluding energy, and contraction of profits of 0.5 percent. Justin Lahart, writing on “S&P 500 Earnings: far worse than advertised,” on Feb 24, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/s-p-500-earnings-far-worse-than-advertised-1456344483), analyzes S&P 500 earnings in 2015. Under data provided by companies, earnings increased 0.4 percent in 2015 relative to 2014 but under GAAP (Generally Accepted Accounting Principles), earnings fell 12.7 percent, which is the worst decrease since 2008. Theo Francis e Kate Linebaugh, writing on Oct 25, 2015, on “US Companies Warn of Slowing Economy, published in the Wall Street Journal (http://www.wsj.com/articles/u-s-companies-warn-of-slowing-economy-1445818298) analyze the first contraction of earnings and revenue of big US companies. Production, sales and employment are slowing in a large variety of companies with some contracting. Corporate profits also suffer from revaluation of the dollar that constrains translation of foreign profits into dollar balance sheets. Francis and Linebaugh quote Thomson Reuters that analysts expect decline of earnings per share of 2.8 percent in IIIQ2015 relative to IIIQ2014 based on reports by one third of companies in the S&P 500. Sales would decline 4.0% in a third quarter for the first joint decline of earnings per share and revenue in the same quarter since IIIQ2009. Dollar revaluation also constrains corporate results.

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 $1,245.6 billion in IIIQ1990 or 30.9 percent. The National Bureau of Economic Research (NBER) dates a contraction of the US from IQ1990 (Jul) to IQ1991 (Mar) (http://www.nber.org/cycles.html). The expansion lasted until another contraction beginning in IQ2001 (Mar). US GDP contracted 1.3 percent from the pre-recession peak of $8983.9 billion of chained 2009 dollars in IIIQ1990 to the trough of $8865.6 billion in IQ1991 (http://www.bea.gov/iTable/index_nipa.cfm). Real gross private domestic investment in the US increased 11.3 percent from $2605.2 billion in IVQ2007 to $2,898.4 billion in IQ2017. Real private fixed investment increased 10.9 percent from $2,586.3 billion of chained 2009 dollars in IVQ2007 to $2,869.1 billion in IQ2017. Private fixed investment fell relative to IVQ2007 in all quarters preceding IQ2014 and changed 0.0 percent in IIIQ2016, declining 0.3 percent in IIQ2016 and falling 0.2 percent in IQ2016. Private fixed investment changed 0.0 percent in IIIQ2016 and increased 0.7 percent in IVQ2016. Growth of real private investment is mediocre for all but four quarters from IIQ2011 to IQ2012. The investment decision of United States corporations is fractured in the current economic cycle in preference of cash. There are three aspects. First, there is fluctuation in corporate profits. Corporate profits with IVA and CCA increased at $66.0 billion in IQ2016. Corporate profits with IVA and CCA fell at $12.5 billion in IIQ2016 and increased at $117.8 billion in IIIQ2016. Corporate profits increased at $11.2 billion in IVQ2016. Profits after tax with IVA and CCA increased at $113.4 billion in IQ2016. Profits after tax with IVA and CCA fell at $28.9 billion in IIQ2016 and increased at $98.3 billion in IIIQ2016. Profits after tax with IVA and CCA increased at $36.0 billion in IVQ2016. Net dividends increased at $7.3 billion in IQ2016. Net dividends fell at $9.3 billion in IIQ2016. Net dividends increased at $18.5 billion in IIIQ2016 and increased at $9.5 billion in IVQ2016. Undistributed profits with IVA and CCA increased at $106.1 billion in IQ2016. Undistributed corporate profits fell at $19.6 billion in IIQ2016. Undistributed corporate profits increased at $79.8 billion in IIIQ2016 and increased at $26.5 billion in IVQ2016. Undistributed corporate profits swelled 212.7 percent from $107.7 billion in IQ2007 to $336.8 billion in IVQ2016 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. Second, sharp and continuing strengthening of the dollar is affecting balance sheets of US corporations with foreign operations (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318) and the overall US economy. The bottom part of Table IA1-9 provides the breakdown of corporate profits with IVA and CCA in domestic industries and the rest of the world. Corporate profits with IVA and CCA increased at $66.0 billion in IQ2016 with increase of domestic industries at $92.9 billion. Profits from operations from the rest of the world fell at $26.9 billion and payments to the rest of the world increased at $35.6 billion. Corporate profits with IVA and CCA decreased at $12.5 billion in IIQ2016. Profits from domestic industries fell at $50.5 billion and profits from nonfinancial business fell at $56.1 billion. Profits from the rest of the world increased at $38.0 billion. Corporate profits with IVA and CCA increased at $117.8 billion in IIIQ2016. Profits from domestic industries increased at $116.5 billion and profits from nonfinancial business increased at $66.4 billion. Profits from the rest of the world increased at $1.3 billion. Corporate profits with IVA and CCA increased at $11.2 billion in IVQ2016. Profits from domestic industries decreased at $33.9 billion and profits from nonfinancial business decreased at $60.4 billion. Profits from the rest of the world increased at $45.1 billion. Total corporate profits with IVA and CCA were $2150.0 billion in IVQ2016 of which $1696.0 billion from domestic industries, or 78.9 percent of the total, and $454.0 billion, or 21.1 percent, from the rest of the world. Nonfinancial corporate profits of $1176.5 billion account for 54.7 percent of the total. Third, there is reduction in the use of corporate cash for investment. Vipal Monga, David Benoit and Theo Francis, writing on “Companies send more cash back to shareholders,” published on May 26, 2015 in the Wall Street Journal (http://www.wsj.com/articles/companies-send-more-cash-back-to-shareholders-1432693805?tesla=y), use data of a study by Capital IQ conducted for the Wall Street Journal. This study shows that companies in the S&P 500 reduced investment in plant and equipment to median 29 percent of operating cash flow in 2013 from 33 percent in 2003 while increasing dividends and buybacks to median 36 percent in 2013 from 18 percent in 2003.

The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

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

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

There is mixed performance in equity indexes with several indexes in Table III-1 decreasing in the week ending on May 19, 2017, after wide swings caused by reallocations of investment portfolios worldwide. Stagnating revenues, corporate cash hoarding, effects of currency oscillations on corporate earnings 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. There are complex economic, financial and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times). DJIA increased 0.7 percent on May 19, decreasing 0.4 percent in the week. Germany’s DAX increased 0.4 percent on May 19 and decreased 1.0 percent in the week. Dow Global increased 0.9 percent on May 19 and increased 0.1 percent in the week. Japan’s Nikkei Average increased 0.2 percent on May 19 and decreased 1.5 percent in the week as the yen continues oscillating but relatively weaker and the stock market gains in expectations of success of fiscal stimulus by a new administration and monetary stimulus by a new board of the Bank of Japan. Dow Asia Pacific TSM increased 0.1 percent on May 19 and changed 0.0 percent in the week. Shanghai Composite that decreased 1.0 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 at 1974.38 on Mar 12, 2014 but closing at 3090.63 on May 19, 2017, for change of 0.0 percent and increasing 0.2 percent in the week. The Shanghai Composite increased 56.5 percent from March 12, 2014 to May 19, 2017. 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. The global hunt for yield induced by central bank policy rates of near zero percent motivates wide portfolio reshufflings among classes of risk financial assets.

Commodities were mixed in the week of May 19, 2017. Table III-1 shows that WTI increased 5.2 percent in the week of May 19 while Brent increased 5.4 percent in the week with turmoil in oil producing regions but oscillating action by OPEC. Gold increased 0.2 percent on May 19 and increased 2.2 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 €781,232 million on May 12, 2017, with decrease of loans from €782,030 million in the prior week of May 5, 2017. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has reached €3,052,680 million in the statement of May 12, 2017, with increase from €3,039,557 million in the prior week of May 5. There is high credit risk in these transactions with capital of only €102,195 million as analyzed by Cochrane (2012Aug31).

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

 

Dec 31, 2010

Dec 28, 2011

May 12, 2017

1 Gold and other Receivables

367,402

419,822

404,102

2 Claims on Non-Euro Area Residents Denominated in Foreign Currency

223,995

236,826

320,923

3 Claims on Euro Area Residents Denominated in Foreign Currency

26,941

95,355

32,253

4 Claims on Non-Euro Area Residents Denominated in Euro

22,592

25,982

17,039

5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro

546,747

879,130

781,232

05/05/17:

782,030

04/28/17:

782,075

04/21/17:

784,153

04/14/17:

783,134

04/07/17:

782,487

03/31/17:

784,224

6 Other Claims on Euro Area Credit Institutions Denominated in Euro

45,654

94,989

79,618

7 Securities of Euro Area Residents Denominated in Euro

457,427

610,629

2,271,448

05/05/17:

2,257,527

04/28/17:

2,247,422

04/21/17:

2,236,213

04/14/17:

2,225,886

8 General Government Debt Denominated in Euro

34,954

33,928

26,372

9 Other Assets

278,719

336,574

237,602

TOTAL ASSETS

2,004, 432

2,733,235

4,170,588

Memo Items

      

Sum of 5 and 7

1,004,174

1,489,759

3,052,680

05/05/17:

3,039,557

04/28/17:

3,029,497

04/21/17:

3,020,366

04/14/17:

3,009,020

04/07/17:

2,993,817

03/31/17:

2,977,062

03/24/17:

2,775,358

Capital and Reserves

78,143

81,481

102,195

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

https://www.ecb.europa.eu/press/pr/wfs/2017/html/ecb.fs170516.en.html

IIIE Appendix Euro Zone Survival Risk. 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 41.0 percent of the total in Mar 2017. Exports to the non-European Union area with share of 44.1 percent in Italy’s total exports are increasing at 12.4 percent in Jan-Mar 2017 relative to Jan-Mar 2016 while those to EMU are growing at 8.2 percent.

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

Mar 2017

Exports
% Share

∆% Jan-Mar 2017/ Mar-Feb 2016

Imports
% Share

∆% Jan-Mar 2017/ Jan-Mar 2016

EU

55.9

8.2

60.5

11.0

EMU 19

41.0

8.2

47.7

11.6

France

10.5

3.7

8.9

9.5

Germany

12.6

9.2

16.3

12.1

Spain

5.0

15.5

5.3

18.9

UK

5.4

4.9

3.0

6.7

Non EU

44.1

12.4

39.5

17.7

Europe non EU

10.4

10.1

9.7

17.6

USA

8.9

14.6

3.8

15.9

China

2.7

33.1

7.5

0.9

OPEC

5.0

-7.5

5.1

56.9

Total

100.0

10.0

100.0

13.7

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

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/199915

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €364 million with the 19 countries of the euro zone (EMU 19) in Mar 2017 and cumulative deficit of €1947 million in Jan-Mar 2017. Depreciation to parity could permit greater competitiveness in improving the trade surplus of €522 million in Jan-Mar 2017 with Europe non-European Union, the trade surplus of €5910 million with the US and the trade surplus with non-European Union of €4994 million in Jan-Mar 2017. There is significant rigidity in the trade deficit in Jan-Mar 2017 of €4,230 million with China. There is a trade deficit of €1518 million in Jan-Mar 2017 with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.

Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro 

Regions and Countries

Trade Balance Mar 2017 Millions of Euro

Trade Balance Cumulative Jan-Mar 2017 Millions of Euro

EU

1,250

1,729

EMU 19

-364

-1,947

France

1,023

2,697

Germany

-760

-1,948

Spain

76

191

UK

1,103

2,769

Non-EU

4,168

4,994

Europe non-EU

674

522

USA

2,383

5,910

China

-1,001

-4,230

OPEC

-417

-1,518

Total

5,418

6,722

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

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/199915

Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Mar 2017 relative to Jan-Mar 2016. Growth rates of cumulative imports relative to a year earlier are positive for energy with 54.7 percent. Exports of durable goods increased 4.7 percent and exports of capital goods increased 8.3 percent. The rate of growth of exports of 10.0 percent in Jan-Mar 2017/Jan-Mar 2016 relative to that of imports of 13.7 percent may partly reflect weak demand in Italy with GDP declining during seven consecutive quarters from IIIQ2011 through IQ2013 together with softening commodity prices. GDP increased 0.3 percent in IIIQ2013, changed 0.0 percent in IVQ2013, increased 0.1 percent in IQ2014 and changed 0.0 percent in IIQ2014. Italy’s GDP increased 0.1 percent in IIIQ2014 and changed 0.0 percent in IVQ2014. Italy’s GDP increased 0.3 percent in IQ2015 and increased 0.4 percent in IIQ2015. Italy’s GDP increased 0.1 percent in IIIQ2015 and increased 0.2 percent in IVQ2015. GDP increased 0.4 percent in IQ2016. The GDP of Italy increased 0.1 percent in IIQ2016 and increased 0.3 percent in IIIQ2016. GDP increased 0.2 percent in IVQ2016 and increased 0.2 percent in IQ2017.

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

 

Exports
Share %

Exports
∆% Jan-Mar 2017/ Jan-Mar 2016

Imports
Share %

Imports
∆% Jan-Mar 2017/ Jan-Mar 2016

Consumer
Goods

32.2

8.1

30.2

5.8

Durable

6.0

4.7

3.7

5.0

Non-Durable

26.2

8.8

26.5

5.9

Capital Goods

34.2

8.3

26.7

11.8

Inter-
mediate Goods

31.1

9.7

33.0

11.3

Energy

2.5

65.4

10.1

54.7

Total ex Energy

97.5

8.7

89.9

9.6

Total

100.0

10.0

100.0

13.7

Note: % Share for 2014 total trade.

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/199915

Table III-6 provides Italy’s trade balance by product categories in Mar and cumulative Jan-Mar 2017. Italy’s trade balance excluding energy, generated surplus of €8,305 million in Mar 2017 and €15,629 million cumulative in Jan-Mar 2017 but the energy trade balance created deficit of €2,887 million in Mar 2016 and cumulative deficit of €8,906 million in Jan-Mar 2017. The overall surplus in Mar 2016 was €5,418 million with cumulative surplus of €6,722 million in Jan-Mar 2017. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.

Table III-6, Italy, Trade Balance by Product Categories, € Millions

 

Mar 2017

Cumulative Jan-Mar 2017

Consumer Goods

2,668

5,779

  Durable

1,274

2,862

  Nondurable

1,394

2,917

Capital Goods

4,782

9,994

Intermediate Goods

855

-145

Energy

-2,887

-8,906

Total ex Energy

8,305

15,629

Total

5,418

6,722

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/199915

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 I-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2017/01/weodata/index.aspx) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2017.

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

 

GDP 2017
USD Billions

Primary Net Lending Borrowing
% GDP 2017

General Government Net Debt
% GDP 2017

World

77,988

    

Euro Zone

11,729

0.3

66.3

Portugal

203

2.1

121.1

Ireland

294

1.6

67.8

Greece

193

1.8

180.7**

Spain

1,232

-0.9

80.4

Major Advanced Economies G7

36,007

-1.6

83.1

United States

19,417

-1.9

82.4

UK

2,497

-1.0

80.4

Germany

3,423

1.5

42.7

France

2,420

-1.6

89.1

Japan

4,841

-3.9

119.9

Canada

1,600

-1.7

26.4

Italy

1,807

1.1

113.8

China

11,795

-2.7

49.3***

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook

http://www.imf.org/external/pubs/ft/weo/2017/01/weodata/index.aspx

The data in Table I-7 are used for some very simple calculations in Table I-8. The column “Net Debt USD Billions 2017” in Table I-8 is generated by applying the percentage in Table I-7 column “General Government Net Debt % GDP 2017” to the column “GDP 2017 USD Billions.” The total debt of France and Germany in 2017 is $3617.8 billion, as shown in row “B+C” in column “Net Debt USD Billions 2017.” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3840.8 billion, adding rows D+E+F+G+H in column “Net Debt USD billions 2017.” 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 $7,458.6 billion, which would be equivalent to 127.7 percent of their combined GDP in 2017. 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 217.9 percent if including debt of France and 154.9 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 I-8, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %

 

Net Debt USD Billions

2017

Debt as % of Germany Plus France GDP

Debt as % of Germany GDP

A Euro Area

7,776.3

    

B Germany

1,461.6

  

$7458.6 as % of $3423 =217.9%

$5302.4 as % of $3423 =154.9%

C France

2,156.2

    

B+C

3,617.8

GDP $5843

Total Debt

$7,458.6

Debt/GDP: 127.7%

  

D Italy

2,056.4

    

E Spain

990.5

    

F Portugal

245.8

    

G Greece

348.8

    

H Ireland

199.3

    

Subtotal D+E+F+G+H

3,840.8

    

Source: calculation with IMF data IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2017/01/weodata/index.aspx

There is extremely important information in Table III-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Mar 2017. German exports to other European Union (EU) members are 57.5 percent of total exports in Mar 2017 and 58.9 percent in cumulative Jan-Mar 2017. Exports to the euro area are 35.9 percent of the total in Mar and 36.8 percent cumulative in Jan-Mar. Exports to third countries are 42.6 percent of the total in Mar and 41.2 percent cumulative in Jan-Mar. There is similar distribution for imports. Exports to non-euro countries are increasing 7.8 percent in the 12 months ending in Mar 2017, increasing 5.7 percent cumulative in Jan-Mar 2017 relative to a year earlier while exports to the euro area are increasing 9.2 percent in the 12 months ending in Mar 2017 and increasing 7.0 percent cumulative in Jan-Mar 2017. Exports to third countries, accounting for 42.6 percent of the total in Mar 2017, are increasing 13.9 percent in the 12 months ending in Mar 2017 and increasing 11.4 percent cumulative in Jan-Mar 2017, accounting for 41.2 percent of the cumulative total in Jan-Mar 2017. 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 ∆%

 

Mar 2017 
€ Billions

Mar 12-Month
∆%

Cumulative Jan-Mar 2017 € Billions

Cumulative

Jan-Mar 2017/
Jan-Mar 2016 ∆%

Total
Exports

118.2

10.8

319.4

8.5

A. EU
Members

68.0

% 57.5

8.7

188.0

% 58.9

6.5

Euro Area

42.4

% 35.9

9.2

117.6

% 36.8

7.0

Non-euro Area

25.6

% 21.7

7.8

70.4

% 22.0

5.7

B. Third Countries

50.3

% 42.6

13.9

131.5

% 41.2

11.4

Total Imports

92.9

14.7

259.1

10.0

C EU Members

61.1

% 65.8

13.5

169.6

% 65.5

8.9

Euro Area

41.3

% 44.5

12.5

114.7

% 44.3

8.1

Non-euro Area

19.8

% 21.3

15.7

54.9

% 21.2

10.8

D Third Countries

31.8

% 34.2

17.1

89.5

% 34.5

11.9

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

Source: Statistisches Bundesamt Deutschland

https://www.destatis.de/EN/PressServices/Press/pr/2017/05/PE17_149_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:

(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)

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

MtV(it, ·) = PtYt (5)

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

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

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

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

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

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

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

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017.

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