Subpar Growth with Unemployment, Quantitative Easing Inducing Global Yield Hunt and World Devaluation War

 

Subpar Growth with Unemployment, Quantitative Easing Inducing Global Yield Hunt and World Devaluation War

Carlos M Pelaez

Continuing subpar growth with unemployment is discussed in (I) followed by analysis of quantitative easing inducing global yield hunt in (II), the ongoing world devaluation war in (III), economic indicators in (IV), interest rates in (V) and the conclusion in (VI). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/).

I Subpar Growth with Unemployment. The current “upswing” from the credit/dollar crisis and global recession is characterized by subpar growth relative to the recent sharp contractions in 1957-1959, 1973-1975 and 1979-1982 (see earlier post of Aug 8, Jobs, Growth and the Stimulus, for the contractions of 1957 and 1973 http://cmpassocregulationblog.blogspot.com/search?updated-max=2010-08-29T09%3A01%3A00-07%3A00&max-results=7). The sharp contraction of 1981-1982 was followed by sharp growth in 1983 with GDP growing at 5.1 percent in 1Q83, 9.3 percent in 2Q83, 8.1 percent in 3Q83 and 8.5 percent in 4Q83, as shown in Table 1. The first four quarters of expansion 2009-2010 have been mediocre in comparison and characterized not by an increase in consumption and production, or demand, but by changes in inventories. This subpar performance has been labeled recovery without “vigor” (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm).

 

Table 1, Quarterly Growth Rates of GDP, % Annual Equivalent SA

Quarter	1981	1982	1983	2008	2009	2010
I	8.6	-6.4	5.1	-0.7	-4.9	3.7
II	-3.2	2.2	9.3	0.6	-0.7	1.7
III	4.9	-1.5	8.1	-4.0	1.6
IV	-4.9	0.3	8.5	-6.8	5.0

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=1&Freq=Qtr&FirstYear=2008&LastYear=2010 

 

The key consequence of this lack of economic “vigor” is persistent job stress for 26.8 million persons: 14.8 million unemployed (of which 6.1 million for 27 weeks and over, or 41.2 percent of the unemployed), 9.5 million involuntary part-time workers who had their hours cut back or cannot find a full-time job and 2.5 million persons “marginally attached to the labor force” who wanted and were available for work and had search for a job in the past 12 months (http://www.bls.gov/news.release/pdf/empsit.pdf

). Another measurement is the unemployment population ratio, or number of persons in the noninstitutional or civilian population of working age who actually have a job, which has remained at 58.5 percent. While in the past three sharp contractions in the postwar period in 1957, 1973 and 1982 heavy losses during GDP contraction were followed by sharp rises in jobs created, the current “upswing” is characterized by inadequate job creation. The data of the establishment survey of the Bureau of Labor Statistics (BLS) are shown in Table 2 for the contraction and upswing of 1981-1983 and the current experience 2008-2010. The not seasonally adjusted (NSA) data for the BLS in 2010 show total nonfarm employment of 130,564,000 in Sep 2010 almost equal to 130,243,000 in Sep 2009, or a gain of 321,000 jobs and private nonfarm employment of 108,510,000 in Sep 2010 relative to 107,964,000 in Sep 2009 or a gain of 546,000 jobs or growth by 5.1 percent. The seasonally adjusted (SA) data of the establishment survey of the Bureau of Labor Statistics (BLS) are shown in Table 2 for the contraction and upswing of 1981-1983 and the current experience 2008-2010. The comparison of 1983 and 2010 in total change of nonfarm payrolls is partly distorted by the hump in the series for the temporary hiring and subsequent layoff of workers for Census 2010. The private sector monthly data for 2010 in the last column of Table 2, updated with the latest estimates and revisions, shows unusually weak job creation by business, which is the consequence of recovery without “vigor.” Individual information provides evidence that employers are reluctant to add full-time employees, resorting to part-time hiring (http://professional.wsj.com/article/SB10001424052748703927504575540410327958280.html?mod=wsjproe_hps_LEFTWhatsNews

). The World Economic Outlook of the IMF finds that “unemployment remains a major economic and social challenge. More than 210 million people across the globe may be unemployed, an increase of more than 30 million since 2007. Three-fourths of the increase has occurred in advanced economies” (http://www.imf.org/external/pubs/ft/survey/so/2010/RES100610A.htm ). The number of unemployed in the US in Aug 2007 was 7.088 million, increasing to 14.759 million in Aug 2010 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlethttp://data.bls.gov/PDQ/servlet/SurveyOutputServlet). These data suggest that the US has 7 percent of the number of unemployed in the world, with population of only about 4.6 percent of world population (Pelaez and Pelaez, Globalization and the State, Vol. I, Table 1.2, 10 with population data from the World Bank), and the increase in unemployed of 7.7 million in the US is about 25.7 percent of the increase in unemployed of the world. The overall US economy contains a major social trauma in the form of about 27 million people in job stress and evidently without immediate relief, which is testing the limits of existing capacity in bridging these people to better times through the social and health safety net.

 

Table 2, Monthly Change in Jobs, Numbers SA

Month	1981	1982	1983	2008	2009	2010	Private
Jan	95	-327	225	-10	-779	14	16
Feb	67	-6	-78	-50	-1266	39	62
Mar	104	-129	173	-33	-213	208	158
Apr	74	-281	276	-149	-528	313	241
May	10	-45	277	-231	-387	432	51
Jun	196	-243	378	-193	-515	-175	61
Jul	112	-343	418	-210	-346	-66	117
Aug	-36	-158	-308	-334	-212	-57	93
Sep	-87	-181	1114	271	-225	-95	64
Oct	-100	-277	271	-554	-224
Nov	-209	124	352	-728	64
Dec	-278	-14	356	-673	-109

Source: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet

http://www.bls.gov/schedule/archives/empsit_nr.htm#2010

http://www.bls.gov/news.release/pdf/empsit.pdf 

 

II Quantitative Easing Inducing Global Yield Hunt. The employment report for Sep appears to have sealed a second round of quantitative easing. The objective function of money managers is to maximize the returns of the funds under management subject to control of risks to preserve principal. There are multiple tools of risk management that are all subject to the uncertainty of predicting financial variables with which to project cash flows and returns on investment toward the future and then discount them to present value by use of an appropriate rate of discount. Investors are constantly calculating the risks and returns of their positions to adjust them to new information or views on the future. Economic policy in the United States during the current decade has been dominated by efforts to prevent deflation using two tools: (1) near zero fed funds rates; and (2) quantitative easing. When fed funds rates are at the “zero bound,” or almost at zero, the Fed can still ease money by quantitative easing. The Fed can inject bank reserves by expanding its balance sheet with the purchase of long-term Treasuries or other securities. The policy focus is on the quantity of reserves and not on the fed funds rate (Ben Bernanke and Vincent Reinhart, Conducting monetary policy at very low short-term interest rates, AER 92 (2004), 87, cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224). Quantitative easing injects reserves that can result in rebalancing of portfolios by investors which increases prices of alternative long-term securities (Bernanke and Reinhart op.cit. 88). Investment and economic activity could be stimulated by lower long-term interest rates. Increasing reserves over what is needed can also create expectations on the willingness of the Fed in maintaining quantitative easing until improvement of the economy. There are substantial hurdles of implementation and communication of quantitative easing but the policy advice for central bankers is acting “preemptively and aggressively to avoid facing the complications raised by the zero lower bounds” (Bernanke and Reinhart op cit. 90). Innovation in central banking as in other economic activities is always productive but as with all new tools of policy there are operational hurdles even with optimistic empirical analysis (Bernanke, Reinhart and Sack, Monetary policy alternatives at the zero bound: an empirical assessment, BPEA 2004, cited with other literature on Japan in Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 95-107, and for more recent work on the current US experience see http://www.newyorkfed.org/research/staff_reports/sr441.pdf).

The Fed lowered its target rate of fed funds from 6.50 percent on May 16, 2000, to 6.00 percent on Jan 3, 2001, and then lowered the target continuously to 1.00 percent on Jun 25, 2003, raising the target by 25 basis points during 17 consecutive meetings of the Federal Open Market Committee (FOMC) beginning with a rate of 1.25 percent on Jun 30, 2004, and ending with 5.25 percent on Jun 29, 2006. The FOMC then lowered the target fed funds rate to 4.75 percent on Sep 18, 2007, and continued lowering aggressively until fixing it at 0 to 0.25 percent on Dec 16, 2008 (http://www.federalreserve.gov/monetarypolicy/openmarket.htm ). Quantitative easing in the first movement toward the zero bound with the target rate of 1 percent in Jun 2003 was in the form of the suspension of the issue of the 30-year Treasury for five years after 2001 with the objective of rebalancing portfolios of pension funds and similar investments with higher weight of 30-year mortgage-backed securities. The purchase of long-term mortgage-backed securities increased their prices or equivalently lowered their yields, leading to refinancing of mortgages that injected more funds to households in after-mortgage payments income than tax reductions. Fed policy during the credit crisis was not fundamentally different in principle with the fed funds rate lowered actually to 0 to 0.25 percent and quantitative easing in the form of aggressively expanding the balance sheet of the Fed. On Oct 6, the Fed balance sheet had credit of $2.3 trillion; the total Fed-owned portfolio of long term securities was $1.98 trillion composed of $752 billion of Treasury notes and bonds, $154 billion of federal agency debt securities and $1078 billion of mortgage-backed securities; and reserve balances at the Federal Reserve Banks were $997 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). A measure of aggregate economic activity in the US, GDP, is about $14.8 trillion in 2010. The Fed balance sheet is about 15.5 percent of GDP and another trillion would bring it to 22.3 percent of GDP. The purchase by the Fed of $1.7 trillion in assets between Dec 2008 and Mar 2010 represented 22 percent of the outstanding $7.7 trillion of agency, MBS and Treasuries. In a different measurement, the Fed purchased $850 billion of 10-year equivalents in the three asset classes that represented more than 20 percent of $3.7 trillion outstanding (http://www.newyorkfed.org/research/staff_reports/sr441.pdf). The purchase of another trillion could bring the Fed purchases to more than 30 percent of 10-year equivalents in various asset classes. There may not be a painless exit from the bloated Fed balance sheet.

The intentions of policy have differed with their actual consequences. The intention of the Fed in lowering rates to zero or near zero percent is to stimulate investment, consumption, production and employment. The stimulus of monetary policy works by providing nearly unlimited amounts of credit at close to zero interest rates for short-dated funds and at long-term rates below what they would have been without quantitative easing in an effort of flattening the yield curve. The consequences were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. The Fed distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. The policy has been inspired by fear of deflation. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the structured investment vehicles (SIV) created off-balance sheet to issue short-term commercial paper to purchase risky mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). Adjustable-rate mortgages (ARMS) were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perceived risk because the Fed guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. The housing subsidy of $221 billion per year created the impression of ever increasing house prices. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the Fed put option on wealth, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the Fed put on wealth created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).

The consequences of the global hunt for yields created by monetary and housing policy are shown in Table 3. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, a more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, an increase in the Shanghai Composite index of 444.2 percent in 2005-7, a rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and an increase in the UBS commodity index by 165.5 percent in 2002-2008. The zero or near zero interest rates fostered significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 on Jun 12, 2007, collapsing to 2.247 on Dec 31, 2008 and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. The combination of short-term zero interest rates, quantitative easing and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash and serious distortions in risk/return calculations.

 

Table 3, Volatility of Assets

DJIA	10/08/02- 10/01/07	10/01/07- 3/4/09	3/4/09- 4/16/10
∆%	87.8	-51.2	60.3
NYSE Financial	1/15/04- 6/13/07	6/13/07- 3/4/09	3/4/09- 4/16/10
∆%	42.3	-75.9	121.1
Shanghai Composite	6/10/05- 10/15/07	10/15/07- 10/30/08	10/30/08- 7/30/09
∆%	444.2	-70.8	85.3
STOXX Europe 50	3/10/03- 7/25/07	7/25/07- 3/9/09	3/9/09- 4/21/10
∆%	93.5	-57.9	64.3
UBS Commodity	1/23/02- 7/1/08	7/1/08- 2/23/09	2/23/09- 1/6/10
∆%	165.5	-56.4	41.4
10-Year Treasury	6/16/03	6/12/07	12/31/08	4/5/10
%	3.112	5.297	2.247	3.986
Dollar/euro	7/14/08	6/03/10	8/3/10
USD/EUR	1.59	1.216	1.323
New House	1963	1977	2005	2009
Sales 1000s	560	819	1283	375
New House	2000	2007	2009	2010
Median Price $1000	169	247	217	203

Sources: http://online.wsj.com/mdc/page/marketsdata.html

http://www.census.gov/const/www/newressalesindex_excel.html

 

In an article for the Financial Times on the Bernanke put, Michael Mackenzie and David Oakley perceptively capture the investors’ mantra of not going opposite the Fed with its trillion-dollar liquidity injections, observing that the dollar is collapsing while everything else, such as the Thai baht, UK gilt, gold, crude prices and whatever, is rising (http://www.ft.com/cms/s/0/c0c362a6-d304-11df-9ae9-00144feabdc0.html). Sovereign risk doubts in Europe are continuing; skepticism of double-digit growth of GDP in China still exists; and US economic data show weak economic conditions and persistent unemployment. Temporarily, risk exposures are divorced from economic performance to take advantage of perhaps another trillion dollars of bank reserves injected by the Fed via purchases of long-term securities. Table 4 shows the sharp rally of almost everything with the exception of the collapsing dollar. Is there a stealth devaluation target of monetary policy to promote economic growth by increasing exports? Or is it just a convenient side effect? Perhaps it could even be justified by the Fed’s objective of full employment and price stability, which in this case is avoiding deflation and unemployment. Equity markets have risen with full “vigor” from the trough on early July for double-digit increases in three months; commodities have rallied with oil venturing above $82/barrel; the 10-year Treasury dropped from 3.986 percent on Apr 5 to 2.396 percent on Oct 8 for a price increase of about 15 percent; while the dollar has dropped 14.5 percent from Jun 25, as shown in Table 4. A part of the rally in financial variables, with worldwide carry trade of shorting the dollar while borrowing short term at US near-zero interest rates, is caused by the expectation of quantitative easing.

 

Table 4, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 10/08	∆%Week 10/08	∆% T to 10/8
DJIA	4/26/10	7/2/10	-13.6	-1.7	1.6	13.6
S&P 500	4/23/10	7/2/10	-16.0	-4.3	1.6	13.9
NYSE Financial	4/15/10	7/2/10	-20.3	-10.1	1.7	12.8
Dow Global	4/15/10	7/2/10	-18.4	-4.3	2.3	17.3
Asia Pacific	4/15/10	7/2/10	-12.5	1.9	2.2	16.5
Shanghai	4/15/10	7/2/10	-24.7	-13.5	3.1	14.9
STOXX Europe	4/15/10	7/2/10	-15.3	-7.3	1.4	9.5
Dollar	11/15 /10	6/25/10	22.3	8.5	-1.2	-14.5
DJ-UBS Comm.	1/6/10	7/2/10	-14.5	-0.4	3.8	16.5
10-Year Treasury	4/5/10	4/6/10	3.986	2.396

T: trough

Source: http://online.wsj.com/mdc/page/marketsdata.html

 

Another part of the frenzy in risk markets is related to the uncertainty in business observed by Richard W. Fisher, president of the Federal Reserve Bank of Dallas (http://www.dallasfed.org/news/speeches/fisher/2010/fs101007.cfm):

Business leaders I interview cite nonmonetary factors—fiscal policy and regulatory constraints or worse, uncertainty going forward—and better opportunities for earning a return on investment elsewhere as inhibiting their willingness to commit to expansion in the US. Tax and regulatory uncertainty—combined with a now well-inculcated culture of driving all resources, including labor, to their most productive use at least cost—does not bode well for a rapid diminution of unemployment and the concomitant expansion of demand. If the fiscal and regulatory authorities are able to dispel the angst that businesses are reporting, further accommodation might not even be needed. The key is to remove or reduce the tax and regulatory uncertainties that act as an impediment to businesses responding to an increase in final demand. I think most all would consider this to be a far more desirable outcome than being saddled with a bloated Fed balance sheet

The expectation of a pause in legal restructuring of business models and regulation after Nov together with the use of $3 trillion of cash by corporations in attractive consolidation opportunities by mergers and acquisitions could be driving equity markets. The pause in policy induced changes in business models may also restore confidence in business, investment and hiring decisions.

IV World Devaluation War. Based on the experience of the Great Depression, the celebrated economist Joan Robinson argues that: “in times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others (Joan Robinson, “Beggar-my-neighbour remedies for unemployment,” Essays in the Theory of Employment, Oxford, Basil Blackwell, 1947, 156). Devaluation is one of the tools used in these policies (Ibid, 157). There have been government interventions by national monetary authorities throughout the world to maintain the competitiveness of their currencies and complaints of foreign exchange wars. The sharp fluctuation of selected foreign exchange rates is shown in Table 5. The euro devalued by 33.4 percent relative to the US dollar from Jul 2008 to Jun 2010 but has gained 14.4 percent recently. The Japanese yen has revalued by 25.5 percent since Jun 2008. The Australian dollar is one of several “commodity currencies,” characterized by high domestic interest rate differentials and correspondingly strong foreign exchange rates, recovering from significant devaluation to about even. Commodity or high-yielding currencies receive foreign capital inflows through the carry trade, which consists of short positions on the low-yielding currency, such as the US dollar, and long positions in fixed income, commodities and emerging market stocks (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). Japan entered into quantitative easing in an effort to devalue the yen relative to the dollar but the effort is being frustrated by the expectations in markets of further quantitative easing in the US. The International Monetary and Financial Committee of the Board of Governors of the International Monetary Fund (IMFC) issued a statement on Oct 8 underscoring “our strong commitment to continue working collaboratively to secure strong, sustainable and balanced growth and to refrain from policy actions that would detract from this shared goal” with one of the priorities being working “toward a more balanced pattern of global growth, recognizing the responsibilities of surplus and deficit countries” while addressing “the challenges of large and volatile capital movements, which can be disruptive” (http://www.imf.org/external/np/sec/pr/2010/pr10379.htm ). The managing director of the IMF, Dominique Strauss-Khan, warns about obstacles to the operation of the international monetary system: “tensions and risks have been building up in its operations, which manifest themselves in large official reserve accumulation, persistent global imbalances, and capital flow and exchange rate volatility” (http://www.imf.org/external/np/pp/eng/2010/100110c.pdf ). The interpretation of these statements is that there is no agreement by major countries on the world currency war (http://www.ft.com/cms/s/0/ec9e9390-d3e6-11df-a902-00144feabdc0.html

). An important proposal is to return to a framework similar to the doctrine of “shared responsibility” that originated in the Apr 2006 meeting of the IMFC (http://www.g7.utoronto.ca/finance/fm060421.htm cited in Pelaez and Pelaez, The Global Recession Risk, 8-11 and extensively analyzed in that volume; for analysis of the IMF see Pelaez and Pelaez, International Financial Architecture, Globalization and the State, Vol. II, 114-25, 192-7, Government Intervention in Globalization, 145-50). The IMF is the critical vehicle for coordination, monitoring and technical advice to avoid currency tensions and will advise policies of national adjustment without adverse repercussions in other countries (http://noir.bloomberg.com/apps/news?pid=20601087&sid=a6oYjItJmDZE&pos=1 ).

 

Table 5, Exchange Rates

	Peak	Trough	∆% P/T	10/8/10	∆% T 10/8/10	∆% P 10/8/10
EUR USD	7/15/08	6/8/10		10/8/10
Rate	1.59	1.192		1.3929
∆%			-33.4		14.4	-14.2
USD JPY	8/18/08	9/15/10		10/8/10
Rate	110.19	83.0		82.08
∆%			24.6		1.2	25.5
USD CHF	11/21 /08	12/8/09		10/8/10
Rate	1.225	1.025		0.9639
∆%			-16.3		-5.9	-21.3
GBP USD	7/15/08	1/2/09		10/8/10
Rate	2.006	1.388		1.5957
∆%			-44.5		12.9	-25.7
AUD USD	7/15/08	10/27 /08		10/8/10
Rate	0.979	0.601		0.9861
∆%			-62.9		39.1	-0.7

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; P: peak; T: trough

Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation

Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

 

IV Economic Indicators. Short-term economic indicators continue to show moderate expansion of the economy relative to earlier sharp contractions, which is insufficient to recover job losses. Manufacturers’ new orders SA fell 0.5 percent in Aug, following an increase by 0.5 percent in Jul but after declining 0.6 percent in Jun and falling 1.8 percent in May. Orders excluding transportation rose by 0.9 percent in Aug. Inventories rose 0.1 percent in Aug, increasing in seven of the last eight months. New orders for manufactured durable goods fell 1.5 percent in Aug after falling 1.2 percent in Jul (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Aug sales of merchant wholesalers SA rose 0.5 percent on a monthly basis and 12.4 percent from a year earlier. Sales of durable goods rose 0.5 percent in Aug and 14.4 percent from a year earlier while nondurable goods sales increased by 0.5 percent and 10.8 percent from a year earlier. Inventories of merchant wholesalers rose 0.8 percent in Aug and 5 percent from a year earlier while durable goods inventories rose 0.6 percent in Aug and 2.3 percent from a year earlier (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). The nonmanufacturing/purchasing managers’ index of the Institute for Supply Management rose 1.7 from 51.5 in Aug to 53.2 in Sep. While the business activity/production index fell 1.6 from 54.4 in Aug to 52.8 in Sep, new orders rose by 2.5 from 52.4 in Aug to 54.9 in Sep and employment by 2 from 48.2 in Aug to 50.2 in Sep (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). The Fed reported a decline of consumer credit at the annual rate of 1.75 percent in Aug, with revolving credit falling at the annual rate of 7.25 percent and nonrevolving credit increasing at the annual rate of 1.2 percent (http://www.federalreserve.gov/releases/g19/Current/ ). The pending home sales index of the National Association of Realtors, a forward-looking indicator of contracts that typically close with a two-month lag, rose by 4.3 percent in Aug and is above the Aug 2009 index by 20.1 percent (http://www.realtor.org/press_room/news_releases/2010/10/pending_show ). Initial claims of unemployment insurance SA were 445,000 in the week ending Oct 2, declining by 11,000 from 456,000 in the prior week while the four-week moving average was 455,750 for a decline of 3000 from the prior week of 458,750. Initial claims NSA fell by 1532 to 371,004 in the week of Oct relative to 372,536 in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).

V Interest Rates. The US yield curve continues to shift downwardly in expectation of quantitative easing that aims to flatten its shape. The 10-year Treasury yield fell to 2.4 percent on Oct 8 from 2.52 percent a week earlier and 2.76 percent a month before. The 10-year German government bond traded at 2.26 percent for a negative spread of only 13 basis points relative to the comparable Treasury as yields of Treasuries fell in expectation of quantitative easing. The US Treasury with coupon of 2.63 percent and maturing on 8/20 traded on Oct 8 at price of 102.13 or yield of 2.38 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-081010 ). If the yield were to back up to 3.986 percent as in Apr 6, the price for settlement on Oct 11 would be 88.9135 for a principal loss of 12.9 percent. There is a duration trap of quantitative easing in that duration, or price sensitivity of bond price to changes in yield (yield elasticity of price), is higher for low yields and coupons. An outflow of fixed income funds to equity funds because of pause in restructuring and regulation plus more mergers and acquisitions could cause major losses in fixed income positions resulting from rising yields.

VI Conclusion. The Fed appears decided on embarking in another wave of quantitative easing, using its balance sheet to purchase long-term securities with the objective of lowering their yields and stimulating consumption, investment and hiring. The earlier attempt of this policy in 2003-2004 resulted in a global hunt for yields and careless risk/return calculations that caused the credit/dollar crisis and global recession. The essential driver of the financial crisis was the pricing of risk at near zero induced by the illusory monetary policy put, or floor, on financial assets and on real assets such as housing through the fake guarantee and low cost of mortgages. The mere expectation of quantitative easing is causing portfolio reallocations worldwide with rise in returns on risk exposures in part through the carry trade of zero interest rates of the US by shorting the dollar and going long in commodities and riskier stocks. Further quantitative easing will seal the trap of duration that yield increases will result in proportionately larger declines in securities’ prices which would be magnified by fire sales in multiple classes of assets financed in sale and repurchase agreements. The world currency war is proliferating by quantitative easing that has devalued the dollar, triggering defensive purchases of all types of assets by Japan to devalue the yen. While most national exchange rate policies fail, the dollar successfully weakens and the renminbi remains relatively fixed to the dollar. Weak economic growth and employment creation create political conflicts in seeking coordination and technical advice from the international financial institutions. This environment resembles, with significant differences, the troubled world of “beggar-my-neighbor remedies” for unemployment created by uncoordinated national policies with adverse repercussions on the welfare of all nations analyzed by Joan Robinson (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

Regulation, Trade and Devaluation Wars, Dropping Rocks in Harbors and Quantitative Easing

 

Regulation, Trade and Devaluation Wars, Dropping Rocks in Harbors, and Quantitative Easing

Carlos M. Pelaez

The continuing recovery without sufficient vigor to generate employment is analyzed in (I), regulation, trade and devaluation wars in (II), quantitative easing in (III), risks of bonds and returns on equities in (IV), interest rates in (V) and conclusion in (VI). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Recovery without Vigor. The US economy continues to move forward but at a pace lower than in the expansion phase of the 1979-82 contraction with subpar growth that is insufficient for recovering the job losses during the recession. The report on personal income and outlays for Aug is encouraging (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). Personal income and disposable personal income both increased by 0.5 percent in Aug, higher than 0.2 percent and less than 0.1 percent in Jul, respectively, and personal consumption expenditures (PCE) rose by 0.4 percent in Aug at the same rate as in Jul. Inflation-adjusted disposable income rose by 0.2 percent in Aug in contrast with decline of 0.2 percent in Jul. The PCE price index rose by 0.2 percent in Aug equal to the increase in Jul and excluding food and energy, closely watched by the Fed, by 0.1 percent in both Aug and Jul. Real GDP, which consists of the output of goods and services produced in the US, rose at the annual seasonally adjusted rate of 1.7 percent in the second quarter, revised upwardly from the second estimate of 1.6 percent, after an increase by 3.7 percent in the first quarter (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp2q10_3rd.pdf ). Accelerating imports and decelerating private inventory investment were the factors causing the decline in the rate of growth in the second quarter that were compensated by increases in residential fixed investment, increases in state and local government spending and accelerations in nonresidential fixed investment and federal government spending. While real exports of goods and services grew by 9.1 percent in the second quarter, compared with 11.1 percent in the first quarter, real imports of goods and services rose by 33.5 percent in the second quarter, compared with a decline by 12.3 percent in the first quarter. The seasonally adjusted annual equivalent rate of construction spending increased by 0.4 percent in Aug relative to July but declined by 10.0 percent relative to Aug 2009 (http://www.census.gov/const/C30/release.pdf ). Construction spending in the first eight months of 2010 was $539.4 billion, which is 31.9 percent below $793.2 billion in the first eight months of 2006 (http://www.census.gov/const/C30/pr200608.pdf ). The business barometer index of the Chicago ISM rose from 56.7 in Aug to 60.4 in Sep, with production increasing from 57.6 to 64.3 and new orders from 55.0 to 61.4 (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20September%202010.pdf ). The national ISM report was less encouraging with decline of the general purchasing managers’ index to 55.4 in Sep from 56.2 in Aug, new orders to 51.1 in Sep from 53.1 in Aug, production to 56.5 in Sep from 59.9 in Aug and employment to 56.5 in Sep from 60.4 in Aug (http://www.ism.ws/ISMReport/MfgROB.cfm ). The Case-Shiller index of Standard & Poor’s shows deceleration in the rate of price increase in Jul 2010 relative to Jul 2009 from 4.1 percent in the composite 10-city index and 3.2 percent in the composite 20-city index compared with 5.0 percent and 4.2 percent, respectively, in Jun 2010 relative to Jun 2009 (http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us---- ). Large automakers in the US reported double digit increases in sales in Sep (http://professional.wsj.com/article/SB10001424052748703859204575525953404310076.html?mod=wsjproe_hps_LEFTWhatsNews). Initial jobless claims declined to 453,000 in the week ending on Sep 25 or by 16,000 relative to the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Initial jobless claims fell during the latter part of 2009 but have stabilized around 450,000 in 2010, which still remain at a high level.

II Regulation, Trade and Devaluation Wars. In her famous essay based on protectionism in the 1930s, the celebrated economist Joan Robinson argues that:

In times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others. As soon as one succeeds in increasing its trade balance at the expense of the rest, others retaliate, and the total volume of international trade sinks continuously, relatively to the total volume of world activity. Political, strategic and sentimental considerations add fuel to the fire, and the flames of economic nationalism blaze even higher and higher (Joan Robinson, “Beggar-my-neighbour remedies for unemployment,” Essays in the Theory of Employment (Oxford, Basil Blackwell, 1947, 156-57).

Joan Robinson argues that world economic activity is reduced by this collective behavior because of the loss of the gains from specialization of labor. In her analysis, interest rates fall in countries increasing their balance of trade while interest rates rise in countries experiencing a mirror fall in their trade balance. Monetary policy may accentuate these effects:

Owing to the apprehensive and cautious tradition which dominates the policy of monetary authorities, they are chronically more inclined to foster a rise in the rate of interest when the balance of trade is reduced than to permit a fall when it is increased. The beggar-my-neighbour game is therefore likely to be accompanied by a rise in the rate of interest for the world as a whole and consequently by a decline in world activity (Ibid, 157).

The tools of increasing the balance of trade considered by Joan Robinson include: (1) devaluation; (2) wage reduction, including increasing work hours at the same wage; (3) export subsidies; and (4) tariffs and quotas to restrict imports (Ibid, 157). Robinson also makes the famous remark that the argument that tariffs must be used in retaliation to imposition of tariffs by other countries “is countered by the argument that it would be just as sensible to drop rocks into our harbours because other nations have rocky coasts” (Ibid, 158).

Contemporary events in the 1930s were consistent with the concerns of Joan Robinson. From the second quarter of 1930 to the third quarter of 1932 imports by the US fell 41.2 percent and exports by a similar percentage (Douglas Irwin, Review of Economics and Statistics 80 (2, 1998) cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 208, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars, 179). A major part of this decline was caused by the contraction of US real GNP by 29.8 percent, inducing Americans to reduce the purchase of all goods, including imports, like never before. Ad valorem equivalent rates of duty on imports rose from 21.08 percent in the Act of 1913 and 34.61 percent in the Act of 1922 to 42.48 percent in the Smoot-Hawley Act of 1930 (Irwin, 327). Sophisticated econometric measurements conclude that about 20 percent of the 40 percent reduction of imports was caused by the higher tariff and the deflation effect that occurs because actual percentage tariffs increase as the price of imports declines (Ibid). The UK followed with the Abnormal Importation Act in November 1931 and the Import Duties Act in Feb 1932 and other countries imposed retaliatory duties (Joseph Jones cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 208). The volume of exports and imports of industrialized countries fell by about 30 percent between 1929 and 1932 (Jacob Madsen cited by Pelaez and Pelaez, Globalization and the State, Vol. II, 208-9).

The analysis of trade, devaluation and regulation wars after 2008 is more complex than during the 1930s. There have been government interventions by national monetary authorities throughout the world to maintain the competitiveness of their currencies and complaints of foreign exchange wars. The sharp fluctuation of selected foreign exchange rates is shown in Table 1. The euro lost 33.4 percent to the US dollar from Jul 2008 to Jun 2010 but has gained 13.5 percent recently. The Japanese yen has revalued by 24 percent since Jun 2008. The Australian dollar is one of several “commodity currencies,” characterized by high domestic interest rate differentials and correspondingly strong foreign exchange rates, recovering from significant devaluation to about even. Commodity or high yielding currencies receive foreign capital inflows through the carry trade, which consists of short positions on the low-yielding currency, such as the US dollar, and long positions in fixed income, commodities and emerging market stocks (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4).

 

Table 1, Exchange Rates

	Peak	Trough	∆% P/T	10/1/10	∆% T 10/1/10	∆% P 10/1/10
EUR USD	7/15/08	6/8/10		10/1/10
Rate	1.59	1.192		1.378
∆%			-33.4		13.5	-15.4
USD JPY	8/18/08	9/15/10		10/1/10
Rate	110.19	83.07		83.51
∆%			24.6		-0.5	24.2
USD CHF	11/21 /08	12/8/09		10/1/10
Rate	1.225	1.025		0.975
∆%			-16.3		-5.1	-20.4
GBP USD	7/15/08	1/2/09		10/1/10
Rate	2.006	1.388		1.573
∆%			-44.5		11.8	-27.5
AUD USD	7/15/08	10/27 /08		10/1/10
Rate	0.979	0.601		0.972
∆%			-62.9		38.2	0.7

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; P: peak; T: trough

Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation

Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

 

Currency intervention is extending throughout the world in a type of “hidden” currency war (http://www.ft.com/cms/s/0/8beeb262-ca56-11df-a860-00144feab49a.html ) with some countries in alert (http://www.ft.com/cms/s/0/33ff9624-ca48-11df-a860-00144feab49a.html ) . There are some six central banks trying to depreciate their currencies, with Japan in the leadership (http://professional.wsj.com/article/SB10001424052748703882404575519372149380764.html?mod=wsjproe_hps_LEFTWhatsNews ). Japan depends on exports for growth and employment and has been intervening by direct purchases of dollars to weaken the yen in what is becoming an important domestic political issue (http://www.ft.com/cms/s/0/cdb28962-c67d-11df-8a9f-00144feab49a.html). Earlier interventions were not very successful (Pelaez and Pelaez, The Global Recession Risk, 107-9). Daily trading in foreign exchange in the world has reached $4 trillion such that intervention is not likely to succeed even with purchases of $20 billion by Japan (http://www.bis.org/publ/rpfx10.pdf?noframes=1 ). Japan is also crafting another $55 billion stimulus package together with possible further action by the Bank of Japan with the objective of depreciating the yen (http://www.ft.com/cms/s/0/cedc5ea0-c987-11df-b3d6-00144feab49a.html). Several Asian central banks of exporting countries have been intervening without much success to depreciate their currencies relative to the dollar but have allowed some limited appreciation to contain inflation because appreciation of the yuan by China could maintain their competitiveness (http://professional.wsj.com/article/SB10001424052748704116004575521123462281554.html?mod=wsjproe_hps_MIDDLEThirdNews).

The US House of Representatives passed on Sep 29 the Currency Reform for Fair Trade Act (H.R. 2378). The intention of the legislation is to increase US manufacturing by approving countervailing duties to compensate for a “fundamentally undervalued currency”(http://www.speaker.gov/newsroom/legislation?id=0406 ).The characterization of China as a “currency manipulator” could trigger the extensive and damaging US process of antidumping and safeguards (Pelaez and Pelaez, Globalization and the State,Vol. I, 174-8, Government Intervention in Globalization, 95-7). While the legislation passed in the House by wide bipartisan vote of 348-79, it is not likely to be considered by the Senate this year and could still not be implemented by the executive (http://professional.wsj.com/article/SB10001424052748704116004575522401651849766.html?mod=wsjproe_hps_LEFTWhatsNews).

Martin Wolf finds the explanation of the currency conundrum by insufficient demand in the advanced economies that desire to grow by exports and a net capital outflow to emerging countries that run a compensatory current account deficit while the US attempts to inflate the economy and China maintains a strong currency, accumulating $2.5 trillion dollars in reserves (http://www.ft.com/cms/s/0/9fa5bd4a-cb2e-11df-95c0-00144feab49a.html ). Wolf concludes that the current episode of beggar-my-neighbor policies may not end well. The World Trade Organization finds that world merchandise trade increased by 25 percent in the first six months of 2010 relative to the same period in 2009 (http://www.wto.org/english/news_e/pres10_e/pr614_e.htm ) and forecasts growth of 13.5 percent for the entire year of 2010 (http://www.wto.org/english/news_e/pres10_e/pr616_e.htm ). Deceleration of world trade could further worsen employment creation in many countries.

III Quantitative Easing. There is no “vigor” in US economic recovery for creation of jobs and reduction of job stress but there is moderate recovery of economic activity. Sovereign risk doubts in various European countries have not been resolved with the potential of affecting banks throughout the region including large banks in France and Germany. Stress tests require four types of measurements that are difficult to obtain: (1) relatively accurate forecasts of the economy moving forward or at least risk events of substantial impact even if of low probability of occurrence, such as sovereign debt stress, growth and employment; (2) behavior of financial assets and prices related to the economic forecasts or events such as prices and yields of bonds and their derivatives, risk spreads of key transactions including loans and probabilities of default of sovereigns and financial institutions and their clients; (3) relation of major classes of assets and liabilities of banks and other financial institutions to the economic events and prices, probabilities of default and so on; and (4) measurements of the impact on bank balance sheets of the movements in major classes of assets and liabilities and probabilities of default (see Pelaez and Pelaez, International Financial Architecture, 101-62, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 57-74, Financial Regulation after the Global Recession, 164-6). If this knowledge were available, large financial institutions such as Lehman Bros and hundreds of regional banks would not have collapsed. There is no such thing as reliable stress tests of banks throughout the diverse complexity of European Union financial systems, or elsewhere, that can give comfort. Stress tests are an important ingredient of risk management that adds value but significant uncertainty may remain (Myron Scholes, Crisis and risk management, American Economic Review (90, 2 2000) cited in Pelaez and Pelaez, International Financial Architecture, 110). In fact, the allegedly perfect “economic science” of theory and policy, including exotic “shock and awe” quantitative easing, is as imperfect as risk management (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm#f15).The US dollar/euro rate reflects complex behavior of multiple determinants, including essentially the relative performance and stability of the financial systems and economies of the euro zone and the United States. The uncertainty about the euro zone is significant because of the doubts about stress tests while US data confirm subpar growth but significantly controlled financial system except for continuing failures of regional and smaller banks (http://professional.wsj.com/article/SB10001424052748704760704575516272337762044.html). There are still sovereign debt issues in medium-size countries plagued with large deficits relative to GDP (http://professional.wsj.com/article/SB10001424052748704654004575518091992302632.html?mod=wsjproe_hps_LEFTWhatsNews ). The upfront effects of bank bailouts in Ireland can result in a deficit of 32 percent of GDP this year (http://www.ft.com/cms/s/0/d8578e16-cc69-11df-a6c7-00144feab49a.html ) with possible hard repercussions in the European economy (http://professional.wsj.com/article/SB10001424052748704116004575523121071932284.html?mod=wsjproe_hps_TopLeftWhatsNews).

Why does the US dollar devalue relative to the euro? The ICE Dollar Index, measuring the US dollar index relative to a trade-weighted basket of currencies, touched on Friday the lowest point since Jan (http://professional.wsj.com/article/SB10001424052748704116004575523121071932284.html?mod=wsjproe_hps_TopLeftWhatsNews ). The prime suspect of dollar weakness is the statement of the need for “unconventional” measures, or quantitative easing, by a voting member of the Federal Open Market Committee (FOMC) and one that will vote next year (Ibid, http://blogs.wsj.com/economics/2010/10/01/feds-dudley-further-action-is-likely/ http://www.ft.com/cms/s/0/fe753938-cd66-11df-ab20-00144feab49a.html). The stage was set by earlier reports that the Fed is considering smaller-scale purchases of long-term bonds that it could roll back if the economy improves instead of the announcement in March 2009 of the purchase of $1.7 trillion of long-term securities that was somberly called “shock and awe” (http://professional.wsj.com/article/SB10001424052748703694204575518222145769804.html?mod=wsjproe_hps_TopMiddleNews). The combination of these statements suggesting zero short-term fed funds rates and declining long-term rates with strong manufacturing data in China stimulated risk positions in the carry trade from zero interest rates in the US to short the dollar and go long on commodities, emerging market stocks and high risks. There was a major rally in commodities with crude oil futures hitting $81.73/barrel, gold future $1320/ounce and copper 369.55 cents/pound (http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000 ).

The effects of the first round of quantitative easing and the expectation of a new round of quantitative easing create multiple distortions in risk/return decisions by financial and nonfinancial entities. Such distortions were an important cause of the credit/dollar crisis and global recession. An excellent example of firm-level distortions is that bank costs cannot fall below zero percent but revenues continue to decline, eroding operational margins in lines of business such as preventing funds to earn management fees, insurance companies to issue annuities and instruments at fixed rates and banks to earn a spread of loan rates relative to near zero CD rates (http://professional.wsj.com/article/SB10001424052748703882404575520020341772404.html?mod=wsjproe_hps_MIDDLEFifthNews). Financial repression occurred in emerging countries as a result of interest rate controls such as ceilings on deposit and loan rates (see books by Edward Shaw and Ronald McKinnon, both in 1973, and other literature cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 81). Quantitative easing is a form of controlling interest rates, in this case not only short-term rates but also long-term yields, distorting allocation by business models that can no longer choose projects by calculating relative net present values.

IV Risks of Bonds and Returns of Equities. The “shock and awe” quantitative easing by Fed purchasing $1.7 trillion long-term securities created what is probably the highest concentration of a bond portfolio with the Fed holding over 20 percent of 10-year equivalents of several classes of bonds (http://www.newyorkfed.org/research/staff_reports/sr441.pdf). Another “shock and awe” bond purchase or a succession of smaller bond purchases could raise the Fed holdings of asset classes over 30 percent of 10-year equivalents. The Fed could simply be adding to market risk, creating a disorderly future collapse of bond markets with possible adverse effects on the overall economy. Bond yields could surge at the mere hint of rolling back the Fed portfolio. The interest rate is closely related with aggregate wealth. It is possible to conceive of income as a flow, Y, that is obtained by applying a rate of return, r, to a stock of wealth, such that: Y = rW (Milton Friedman, A Theory of the Consumption Function, 1957). Dividing both sides of this equation by r, W = Y/r. As r declines toward zero, W increases without bound. The first round of near zero fed fund rates, reduction of the long-term interest rate by less direct quantitative easing of suspending auctions of the 30-year Treasury, housing subsidy of $221 billion per year, policy of affordable housing and purchase or acquisition of $1.6 trillion of nonprime mortgages resulted in increases in perceived wealth by households and business that caused the credit/dollar crisis and global recession, creating the illusion that there were no risks because monetary policy could prevent crises (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). Households and business were encouraged by government policy to take high risks using high leverage with minimal liquidity and unsound credit decisions. There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, the expected rate of return on physical investment, taxes, government policy and inflation” (Jonathan Ingersoll, Theory of Financial Decision Making, Rowman, 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). Unconventional monetary policy, with zero fed funds rates and flattening of long-term yields by quantitative easing, causes uncontrollable effects on risk taking that can have profound undesirable effects on financial stability. Excessively aggressive and exotic monetary policy is the main culprit and not the inadequacy of financial management and risk controls.

Quantitative easing is even less operational when there are legislative restructurings and regulation that frustrate investment and consumption, resulting in recovery without vigor. The minutes of the FOMC meeting on Aug 10 provides evidence on an important cause of weakness in investment, spending and hiring: “a number of participants reported that business contacts again indicated that uncertainty about future taxes, regulations, and health-care costs made them reluctant to expand their workforces” (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100810.pdf 7). Restructurings and regulation causing lack of vigor in the recovery are altering business models of firms that have hoarded cash because of the uncertainty in calculating rates of return of investment. The bond market is becoming a big bubble blown by the “little guy” or retail investors that allocated $375 billion to mutual bond funds in 2009 and $230 billion until presently in 2010 and households withdrawing $70 billion from US equity funds in 2010 even as the stock market has returned 4 percent (Jason Zweig, The bond “bubble”: are small investors taking too big a bet? WSJ, http://professional.wsj.com/article/SB10001424052748704029304575526172764480294.html?mod=wsjproe_hps_MIDDLEForthNews). Bloomberg estimates that US corporate bond offerings reached $340 billion in the quarter Jul through Sep, making it the busiest in history while Fed data show banks reducing commercial and industrial lending by 11.4 percent to $1.24 trillion in the week ending on Sep 8 compared with $1.4 trillion a year earlier (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aGFlWGfowKrQ&pos=4). Banks are reluctant to lend because of uncertainties, including regulation, making it difficult for smaller companies, dependent on bank loans, to borrow for investing in their projects. The issue of worldwide corporate bonds reached $145 billion in Sep alone, the highest in record. The issue of high-yield bonds in 2010 reached $191.4 billion, which exceeds the prior annual records with three months left in the year. Investment-grade corporate bond yields reached the lowest ever on Sep 28, 3.645 percent, much lower than 4.935 percent a year earlier, according to index data of Bank of America Merrill Lynch reported by Bloomberg (Ibid).

The potential risks of principal losses in bonds relative to capital gains in equities are illustrated by Table 1. The last column in the table shows the percentage change in major equity indexes, the dollar, commodities and the yield of the 10-year Treasury. Equities and commodities have experienced double-digit gains while the dollar has depreciated and the yield of the 10-year Treasury has collapsed from a peak of 3.986 percent to 2.513 percent. The returns on equity are simple instead of annual equivalent percentage changes. For example, the Dow Jones Industrial Average (DJIA) has gained 11.8 percent since Jul 2, that is, 11.8 percent in about three months, which under discrete compounding is equivalent to 56.2 percent reinvested in four periods. The recovery continues with moderate rates of growth. What could drive future stock market returns? Corporations are hoarding close to $3 trillion in cash that is beginning to be used with leverage in attractive consolidation by mergers and acquisitions. Changes after Nov 2 could create a pause in legislative restructuring and regulation that could reduce uncertainty, stimulating investment and consumption. The combination of a wave of mergers and acquisitions with reduction of uncertainties of legislation and regulation could cause an outflow of funds from bonds into equities. Bonds would suffer principal losses equivalent to rising yields while equity prices would rise. Another round of quantitative easing would run against investment decisions as it has happened during the legislative restructurings and regulation.

 

Table 2, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 10/01	Week 10/01	∆% T to 10/1
DJIA	4/26/10	7/2/10	-13.6	-3.3	-0.3	11.8
S&P 500	4/23/10	7/2/10	-16.0	-5.8	-0.2	12.1
NYSE Financial	4/15/10	7/2/10	-20.3	-11.6	-0.8	10.9
Dow Global	4/15/10	7/2/10	-18.4	-6.4	--	14.7
Asia Pacific	4/15/10	7/2/10	-12.5	-0.2	1.4	14.0
Shanghai	4/15/10	7/2/10	-24.7	-16.1	2.5	11.5
STOXX Europe	4/15/10	7/2/10	-15.3	-8.5	-2.2	8.0
Dollar	11/15/10	6/25/10	22.3	9.8	-2.0	-10
DJ-UBS Comm.	1/6/10	7/2/10	-14.5	-4.1	-0.8	12.2
10-year Treasury	4/5/10	4/6/10	3.986	2.513

T: trough

Source: http://online.wsj.com/mdc/page/marketsdata.html

 

V Interest Rates. The yield curve of US Treasuries shifted downwardly with the 10-year Treasury at 2.51 percent which lower than 2.62 percent a week ago and 2.71 percent a month ago. Risk flight in Europe caused the 10-year government bond of Germany to trade at 2.29 percent for a spread relative to the equivalent Treasury of -23 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1286119976582 ). The Treasury with coupon of 2.63 percent maturing on 08/20 traded on Oct 1 at a price of 100.84 or equivalent to a yield of 2.53 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-011010 ). The price would fall to 88.9135 for settlement on Oct 4 if the yield were to back up to the recent peak of 3.986 percent on Apr 4, for a loss of principal of 11.8 percent. Quantitative easing while investment funds are diverted from bonds back into equities is subject to a duration trap of heavy market losses.

VI Conclusion. Equities worldwide have rebounded with two-digit percentage gains since the lows of Jul 2, almost returning to the levels before the Apr sovereign risk doubts in Europe. Record issues of bonds at lowest historical yields have continued to attract funds from risk-averse investors who may realize the duration risks of principal losses resulting from rising yields as funds flow into equities. Another round of quantitative easing in this environment appears inopportune. Bond yields could back up with intolerable losses if markets anticipate sales of bonds from the Fed portfolio (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

Recovery without Vigor, Quantitative Easing, Financial Arbitrage of Monetary Policy and Rising Equities

 

Recovery without Vigor, Quantitative Easing, Financial Arbitrage of Monetary Policy and Rising Equities

Carlos M. Pelaez

This post relates monetary policy, financial institutions and the crisis in (I) to further quantitative easing in (II), financial arbitrage of monetary policy in (III), economic indicators in (IV) and interest rates in (V) with conclusion in (VI). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Monetary Policy, Financial Institutions and the Crisis. Chairman Bernanke distinguishes economics as a “science” explaining with theory and empirical generalizations the actions of households, institutions, markets and aggregate economies; “economic engineering” as the application of economic knowledge designing measures for solving specific problems; and “economic management” as the actual daily operation of private financial institutions and their public-sector supervision (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm#f15 ). Chairman Bernanke finds that knowledge on the working of the economy was useful in understanding the financial crisis and its consequences even if there were no descriptively accurate predictions of the complex interrelations. Conventional economic policy, such as the Bagehot Principle, or lender of last resort by the Fed, of providing credit to solvent institutions on the basis of sound collateral at punitive rates, was the correct policy (on central banking see Pelaez and Pelaez, Financial Regulation after the Global Recession, 69-90, Regulation of Banks and Finance, 99-116, Globalization and the State Vol. I, 30-43, Government Intervention in Globalization, 31-7, International Financial Architecture, 77-9). Unconventional policy in the form of quantitative easing, or purchases of long-term securities by use of the Fed balance sheet, was also an adequate response to the crisis. The failures were in economic engineering and management. First, economic engineering provided weak measurements and management of risk that together with inadequate business models led to “overreliance on unstable short-term funding and excessive leverage” (Ibid). Regulatory structures were devised for earlier periods, failing to capture risks outside control by supervision such as in the “shadow banking system.” Second, economic management in the private and public sector failed to anticipate risks and did not respond to them timely and adequately. A major problem in the private sector was allegedly remuneration on the basis of short-term performance because shareholders, or principals, did not have the same information as their agents, or managers, who took excessive risk in pursuit of short-term compensation in the form of cash bonuses instead of long-term holding of stock. Supervisors did not have the appropriate tools to respond to the crisis and did not use existing ones adequately. Policymakers have allegedly corrected the major problems of “engineering” and “management” by the Dodd-Frank financial regulation act and related regulatory measures: (1) Dodd-Frank has provided for oversight of the shadow banking system while private institutions have improved their management of risk and liquidity; (2) Dodd-Frank creates a Financial Stability Oversight Council to monitor systemic risk; and (3) many other measures strengthen capital and liquidity requirements, transparency and margins in trading derivatives and so on (Ibid).

There are two conclusion of this analysis: (1) economic policy was not a factor of the credit crisis; and (2) the Dodd-Frank act plus regulatory measures have addressed correctly all the causes of the crisis, providing a regulatory and supervisory framework to prevent future crises. These two issues are discussed in turn. First, monetary policy did actually encourage high risks, excessive leverage, low liquidity and unsound credit decisions. The problem may be the unfeasible statutory mission of the Fed: “the goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek to ‘promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates’”( http://www.federalreserve.gov/pf/pdf/pf_2.pdf 1). These conflicting unattainable goals continuously appear in the statements of the Federal Open Market Committee (FOMC) such as that of the last meeting before the congressional election of Nov 2 held on Sep 21: “The Committee will continue to monitor the economic outlook and financial development and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate” (http://www.federalreserve.gov/newsevents/press/monetary/20100921a.htm ). The FOMC lowered the fed funds target rate from 6.5 percent on May 16, 2000 to 1.75 percent on Dec 11, 2001 and then to 1.25 percent on Nov 6, 2002, culminating in 1 percent on Jun 25 2003 where it was held at that level until raised to 1.25 percent on Jun 30, 2004, reaching 5.25 percent on Jun 29, 2006 after 17 consecutive increments of 25 basis points per FOMC meeting (http://www.federalreserve.gov/monetarypolicy/openmarket.htm#2003 ). The lowering of the fed funds rate to 1 percent with forward guidance that it would be maintained at that level indefinitely, or until deflation fears subsided, encouraged the financing of everything with short-dated funds. There was a worldwide hunt for yields as risks were ignored because of huge amounts of cheap short-dated funds provided by the Fed, exemplified by a rise in the DJIA by 87.8 percent in 2002-7 and the increase in new house sale to the annual equivalent rate of 1283 thousand in 2005 falling to 375 thousand in 2009 (see Table 1 in the prior post of Sep 12, 2010 http://cmpassocregulationblog.blogspot.com/ ). The housing crisis was the result of the near-zero fed funds rate combined with the suspension of the auction of the 30-year Treasury, housing subsidy of $221 billion per year, general policy of providing housing at “affordable,” actually subsidized, prices and the purchase and guarantee of $1.6 trillion by Fannie and Freddie with leverage of 75:1 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). Second, the Dodd-Frank act is based on an incorrect diagnosis of the causes of the financial crisis, creating individual measures and a whole framework that is unpredictable and dependent on rules and studies by several regulators. The outcome is an inopportune reduction in the volume of credit, an increase in interest rates and further uncertainty when the economy requires financing for higher growth and employment creation.

II Quantitative Easing. On Sep 22, “Reserve Bank credit” in the Fed balance sheet stood at $2290 billion of which long-term securities held outright were $1984 billion, composed of $739 billion Treasury notes and bonds, $154 billion federal agency securities and $1091 billion mortgage-backed securities (MBS) (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The FOMC evaluated on its Sep 21 meeting that “inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate” and decided that “the Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings” (http://www.federalreserve.gov/newsevents/press/monetary/20100921a.htm ). The statement of the FOMC Aug 10 meeting sketched the policy and its rationale: “to help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature” (http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm ). The core personal consumption expenditures (PCE) price index, excluding food and energy, rose 0.1 percent in Jul compared with an increase of less than 0.1 percent in Jun (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). This is well below the 1.5 to 2.0 percent annual inflation range that could be interpreted as above the risk of deflation. The seasonally adjusted annual rate of change of the price index of PCE in 2Q10 is 0.0 percent and -3.6 percent for durable goods (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=67&Freq=Qtr&FirstYear=2008&LastYear=2010 ). The elections for Congress are on Nov 2 when the FOMC meets for a two-day meeting ending with decisions on Nov 3 (http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm ). With unemployment high and inflation lower than desired, will the FOMC engage in further quantitative easing or QE2?

Yields of long-term financial assets can affect spending, saving and investment because they are the cost of corporate debt used for investment of long gestation. Substantial increases in the money supply by purchases of long-term securities would result in rebalancing of portfolios of investors, raising long-term yields that could stimulate investment (Ben Bernanke and Vince Reinhart, http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224-5 and see The Global Recession Risk, 95-107 on the experience of Japan). Other effects could occur through expectations that the Fed will maintain low rates for a long period or that the shift of the government debt to the Fed balance sheet reduces expectations of taxation. In the simple return to maturity expectations hypothesis, the yield to maturity of a long-term bond is the product of all the one period proportionate forward yields plus one (Jonathan Ingersoll, Theory of Financial Decision Making, Rowman, 1987, 389-90). The differences in expected returns of bonds of different maturities are explained by the liquidity preference and preferred-habitat theories by risk arguments (Ibid, 401-5). The “term premium” in Treasury securities consists of the extra return above short-term yields required by investors in holding a security with fixed yield and high duration (http://www.newyorkfed.org/research/staff_reports/sr441.pdf ). Duration is the interest sensitivity of prices to changes in yields, which is typically higher for long-term securities, such that an increase in yields can result in substantial losses in price or principal. Quantitative easing has withdrawn securities with long duration, which may have resulted in lower overall duration in securities held outside the Fed and thus lower duration risk or term premium by investors. An additional effect derives from the purchase of MBS that because of negative convexity experience higher magnitudes of declines in prices when interest rates increase than magnitudes of increases in prices when rates decline. The decline in relative yields of the securities purchased by the Fed may spread to other fixed-income securities and increase liquidity of broad segments of assets also with beneficial effects on investment (Ibid). Fed purchases were relatively substantial. The purchase by the Fed of $1.7 trillion in assets between Dec 2008 and Mar 2010 represented 22 percent of the outstanding $7.7 trillion of agency, MBS and Treasuries. In a different measurement, the Fed purchased $850 billion of 10-year equivalents in the three asset classes that represented more than 20 percent of $3.7 trillion outstanding. The conclusion of research by the Fed staff is that “the overall size of the reduction in the 10-year term premium appears to be somewhere between 30 and 100 basis points, with most estimates in the lower and middle thirds of this range” together with additional benefits resulting from the increase in liquidity of markets and reduction of private-portfolio holdings of riskier securities with embedded options in the form of prepayment risk of MBS (Ibid, 28).

III Financial Arbitrage of Monetary Policy. Chairman Bernanke has coined yet another phrase, the recovery without vigor: “Although financial markets are for the most part functioning normally now, a concerted policy effort has so far not produced an economic recovery of sufficient vigor to significantly reduce the high level of unemployment” (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm http://professional.wsj.com/article/SB10001424052748703499604575512242273196062.html?mod=wsjproe_hps_LEFTWhatsNews ).Vigor of economic growth and hiring could be restrained mainly by coercive structural changes to business models at the time when households, business and even the public sector struggle to recover from the credit crisis and global recession. Quantitative easing could fail in these circumstances no matter how successful in lowering yields because of growth-inhibiting structural changes. The minutes of the FOMC meeting on Aug 10 provides evidence on an important cause of weakness in investment, spending and hiring: “a number of participants reported that business contacts again indicated that uncertainty about future taxes, regulations, and health-care costs made them reluctant to expand their workforces” (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100810.pdf 7). Even if required monetary policy impulses had been accurately measured and GDP forecast precisely, the structural shock to the economy resulting from restructurings and regulation affecting business models would have prevented fast or “vigorous” recovery and full employment. The expectation of increases of taxes because of the upward tilt of government spending is frustrating investment, consumption and hiring.

An important fact is that the default rate of corporate debt in the US is expected by Moody’s to fall to 3 percent at the end of 2010, substantially lower than the peak of 14.6 percent in Nov 2009 and even lower than the rate of 3.1 percent in Aug 2008 (http://professional.wsj.com/article/SB10001424052748703399404575506222148668414.html?mod=wsjproe_hps_LEFTWhatsNews ). The year-to-date total return of the Barclays Capital Treasury index is 16.95 percent and of long-term corporate debt 12.99 percent (http://online.wsj.com/mdc/public/page/2_3022-bondbnchmrk.html?mod=topnav_2_3000 ). Prices of high-yield bonds rose to the highest levels since 2007, which are nearly twice higher than during the trough of the credit crisis and Dealogic, as reported by the Wall Street Journal, estimates that sales of high-yield bonds posted a record of $172 billion in the first nine months of 2010 (http://professional.wsj.com/article/SB10001424052748704416904575502181908674958.html?mod=wsjproe_hps_LEFTWhatsNews ). Investors appear to have avoided equities, concentrating positions in fixed-income securities, in a first phase of arbitrage of economic policy that restricted investment and hiring by the private sector with legislative restructurings, regulation and expectations of higher taxes. In the second phase after November there could be an exodus out of fixed income into equities that could be reinforced by the use of $2 to $3 trillion of corporate cash in excellent available opportunities in consolidation by the capital markets through mergers and acquisitions. Equities would rise sharply while bond prices could drop. The private sector could invest and hire again with a revival of economic activity. Quantitative easing could be arbitraged away with rapid increases in long-term yields resulting from shorting high duration and convexity.

The downward trend of stock indexes in the US since the second half of Apr appears to be reversing, as shown in Table 1. The Dow Jones Industrial Average (DJIA) gained 2.4 percent in the week of Sep 24; is significantly below the decline of 13.6 percent from recent peak to trough; and has gained cumulatively 6.9 percent in the past four weeks. The S&P 500 gained 2.1 percent in the week and 7.9 percent in the past four weeks. The NYSE Financial gained 2.6 percent in the week and 6.2 percent cumulatively in the past four weeks. There may still be a late-year rally in US equities when markets sense a pause in legislative restructurings and regulation, funds flow away from fixed income into equities and consolidation through mergers and acquisitions realizes attractive opportunities.

 

Table 1, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 9/24	Week 9/24
DJIA	4/26/10	7/2/10	-13.6	-3.0	2.4
S&P 500	4/23/10	7/2/10	-16.0	-5.6	2.1
NYSE Financial	4/15/10	7/2/10	-20.3	-10.9	0.7
Dow Global	4/15/10	7/2/10	-18.4	-6.4	2.6
Asia Pacific	4/15/10	7/2/10	-12.5	-1.5	1.1
Shanghai	4/15/10	7/2/10	-24.7	-18.1	-0.2
STOXX Europe	4/15/10	7/2/10	-15.3	-6.4	0.1
Dollar	11/15/10	6/25/10	22.3	12.1	-3.4
USB Comm.	1/6/10	7/2/10	-14.5	-3.3	2.0
10-Y Tr	4/5/10	4/6/10	3.986		2.607

Source: http://online.wsj.com/mdc/page/marketsdata.html

 

IV Economic Indicators. Real estate and job markets are still weak with mixed results in sales and industry. After-tax profits of retailers with assets of $50 million or more, not seasonally adjusted, rose 0.9 percent in the second quarter of 2010 relative to the first quarter, reaching $16.1 billion, which is well above $13.1 billion in the second quarter of 2009. Nominal values have returned closer to the level of 2007 of $17.6 billion (http://www2.census.gov/econ/qfr/current/qfr_rt.pdf ). Inflation of producer prices between 2009 and 2010 has been 8.3 percent such that inflation-adjusted profits have declined. New orders for manufactured durable goods fell 1.3 percent in Aug, after declines in three of the past four months, but rose by 2.0 percent excluding transportation and by 1.2 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). Building permits were at the seasonally-adjusted annual rate of 569,000 in Aug, 1.8 percent above 559,000 in Jul but 6.7 percent below 610,000 in Aug 2009. Housing starts were at the seasonally-adjusted annual rate of 598,000 in Aug, which was higher by 10.5 percent relative Jul and 2.2 percent above 585,000 in Aug 2009 (http://www.census.gov/const/newresconst_200608.pdf ). Housing starts in the first eight months of 2005 were at 1471 thousand not seasonally adjusted (http://www.census.gov/const/newresconst_200608.pdf ) compared with 417 thousand in the first eight months of 2010 for a decline of 71.6 percent. Single-family sales of new houses were at a seasonally adjusted annual rate of 288,000 in Aug 2010, unchanged from Jul but 28.9 percent lower than 405,000 in Aug 2009. The median sales price of new houses in Aug was $204,700 and the supply of unsold houses was equivalent to 8.6 months at the current sales rate (http://www.census.gov/const/newressales.pdf ). Sales of new houses in the first eight months of 2010 were at the seasonally unadjusted annual rate of 234,000, which was lower by 74.1 percent than 906,000 in the first eight months of 2005 (http://www.census.gov/const/newressales_200608.pdf ). The National Association of Realtors estimates that existing home sales rose by 7.6 percent in Aug but are still down by 19.0 percent relative to Aug 2009 (http://www.realtor.org/press_room/news_releases/2010/09/ehs_move ). The house price index of the Federal Housing Finance Agency fell 0.5 percent from Jun to Jul and 3.3 percent in the 12 months ending in Jul. The index has declined by 13.8 percent since its peak in Apr 2007 (http://www.fhfa.gov/webfiles/16978/MonthlyHPI92210F.pdf ). Initial jobless claims seasonally adjusted in the week of Sep 18 rose by 12,000 to 465,000, which is still a relatively high level (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).

V Interest Rates. The 10-year Treasury fell to 2.61 percent from 2.74 percent a week earlier but is higher than 2.55 percent a month ago. The 10-year government bond of Germany traded at 2.35 percent for a negative spread relative to the comparable Treasury of 26 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1285461652138 ). The Treasury maturing on 08/20 with coupon of 2.63 percent traded at 100.13 on Sep 24 (http://markets.ft.com/markets/bonds.asp?ftauth=1285461652138 ). The price of the Treasury with 2.63 percent coupon maturing on 08/2020 would settle on Sep 27 at 88.98077 if the yield were to back up to the recent peak of 3.986 percent attained on Apr 2, for a loss of 11.1 percent. There is an ignored duration trap in quantitative easing. If funds stampede out of fixed income into equities, there could be major losses in portfolios long in duration resulting from fire sales. During the credit crisis, fire sales in a segment of fixed income, such as MBS, spread to other segments because of capital losses and increasing margins and haircuts that forced fire sales across asset classes (Markus Brunnermeier and Lasse Pedersen, Review of Financial Studies 22 (6, 2009) cited in Pelaez and Pelaez, Regulation of Banks and Finance, 223). The overall duration and convexity outstanding may be irrelevant because fire sales in typically concentrated portfolios may spread through all segments of fixed income.

VI Conclusion. If there is a pause in legislative restructurings and regulation, funds could flow away from investment in fixed income to equities, causing a late-year rally in US stock indexes. The rise in long-term yields in an improved economic environment with rising equities could make further quantitative easing unnecessary and likely harmful. Chairman Bernanke contributes yet another critical insight about economics: “Almost universally, economists failed to predict the nature, timing, or severity of the crisis; and those few who issued early warnings generally identified only isolated weakness in the system, not anything approaching the full set of complex linkages and mechanisms that amplified the initial shocks and ultimately resulted in a devastating global crisis and recession” (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm ) The FOMC is headed and supported by economists who master and contribute to the state of the art. This most important committee should ponder if it is possible to anticipate and simulate the consequences of another trillion dollars of quantitative easing that could bring its holdings close to 30 percent of 10-year equivalents in the target asset class. The Fed may simply distort again the risk spreads among asset classes of the same duration and the term risk spread within the same class with the same unpredictable consequences that plague economics on the pricing of risk that is critical in risk/return calculations and decisions not only in the financial sector but in the general economy. An important unpredictable consequence is what happens by increasing quantitative easing to more than 30 percent of 10-year equivalents of major classes of securities while structural restructuring by legislation and regulation withhold the vigor from the normal V-shaped recovery of recent strong contractions. Vigorous quantitative easing may contribute to restrict the vigor of economic recovery required for creating actual and not counterfactual or “saved” jobs (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

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