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)

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

Financial Arbitrage of Economic Policy, Rising Equities and Recovery

 

Financial Arbitrage of Economic Policy, Rising Equities and Recovery

Carlos M. Pelaez

Long-term yields may fall and rise again with arbitrage opportunities resulting from more purchases of long-term securities by the Fed and a pause in legislative restructuring/regulation after November that can also result in higher equity valuations together with higher growth and employment. The subpar recovery and job stress is discussed in (I), Basel capital requirements in (II), arbitrage of monetary policy in (III), financial turbulence 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 Recovery and Job Stress. The critical historical perspective is that average quarterly rates of growth in the expansions after a severe recession were incomparably higher than during the current expansion: 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975, 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter in 1983 and only 3 percent in the first four quarters and 2.9 percent forecast in the first 12 quarters after the trough in the third quarter of 2009 (Michael Boskin, http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html ). Short-term indicators do not show signs of recurring recession but rather present mixed symptoms of subpar growth accompanied by lower number of people with jobs and over 26 million persons in job stress. The estimate of household net worth, or difference between the value of assets and liabilities, is estimated by the Fed at $53.5 billion at the end of the second quarter, which is lower by $1.5 trillion relative to the previous quarter. Household debt fell at an annual rate of 2.25 percent in the second quarter, which is lower than the decline at 4.25 percent in the earlier quarter. State and local government debt fell at the annual rate of 1.25 percent but federal debt rose at 24 percent or 4 percentage points more than in the earlier quarter (http://www.federalreserve.gov/releases/z1/Current/z1.pdf ). The ninth consecutive decline in household debt was mostly due to defaults of mortgages and credit-card debt. The decline in debt of $77 billion is close to the mortgage debt and credit-card debt wrote off by banks and other investors after default by borrowers. Household debt is at 119 percent of annual disposable income, which is high but much lower than 130 percent at the peak in Sep 2007 (http://professional.wsj.com/article/SB10001424052748703904304575497783824078838.html?mod=wsjproe_hps_TopMiddleNews ). Second quarter 2007 seasonally unadjusted (SUA) after tax profits of manufacturing corporations reached $134.5 billion and sales $1546.3 billion (http://www2.census.gov/econ/qfr/press/qfr072mg.pdf ). SUA second quarter 2010 after tax profits of manufacturing corporations reached $127.5 billion and sales $1459.1 billion (http://www2.census.gov/econ/qfr/current/qfr_mg.pdf ). Thus, profits are 5.2 percent below 2007 and sales 5.6 lower than in 2007. The inflation adjusted decline is much higher because the SUA producer price index of finished goods rose from 165.8 in Aug 2007 to 179.6 in Aug 2010 or by 8.3 percent such that inflation-adjusted profits dropped 12.5 percent and sales fell 12.9 percent (http://www.bls.gov/ppi/ppi_dr.htm ). Total retail and food services sales rose 0.4 percent in Aug 2010 and 3.6 percent relative to a year earlier and sales excluding motor vehicles and parts rose 0.6 percent in Aug relative to Jul and 3.7 percent relative to a year earlier. In the first eight months of 2010 total SUA retail sales rose 6.0 percent relative to the same period in 2009 and 5.6 percent when excluding motor vehicles and parts (http://www.census.gov/retail/marts/www/marts_current.pdf ). Seasonally adjusted (SA) inventories of manufacturers, retailers and merchant wholesalers rose 1.0 percent in Jul 2010 relative to Jun after increasing by 0.5 percent in Jun relative to May and are higher by 2.4 percent relative to Jul 2009. The percentage increases of SA inventories in Jul were in all segments: 1.0 for manufacturers, 0.7 for retailers and 1.3 for merchant wholesalers. There were lower percentage increases in sales than in inventories in Jul in all segments: 0.7 total, 1.1 manufacturers, 0.3 retailers and 0.6 wholesalers (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). Total industrial production in Aug rose 0.2 percent relative to Jul after increasing by 0.6 percent in Jul while manufacturing rose 0.2 percent in Aug after increasing 0.7 percent in Jul and 6.3 percent relative to Aug 2009. Total industry capacity utilization reached 74.7 percent in Aug, which is higher by 4.7 percentage points than in Aug 2009 but still 5.9 percentage points below the average from 1972 to 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The Sep index of general business conditions of the Empire State Manufacturing Survey of the New York Fed fell 3 points from 7.1 to 4 suggesting that “business activity was little changed over the month” (http://www.newyorkfed.org/survey/empire/september2010.pdf ). This was compensated by an increase in the new orders index from -2.71 to 4.33, of shipments from -11.5 to -0.27 and unfilled orders from -10.00 to -5.97. In contrast, the business outlook survey of the Philadelphia Fed was worrisome: general index -0.7, new orders -8.1, shipments -7.1, unfilled orders -8.5, inventories -16.7, prices received -13.9 and average employee workweek -21.6. The conclusion about the future is that: “the survey’s broad indicators of future activity continue to suggest that the region’s manufacturing executives expect growth in business over the next six months, but optimism remains below levels earlier in the year” (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0910.pdf ). The deficit of the current account of the US worsened from $109.2 billion in the first quarter of 2010 to $123.3 billion in the second quarter of 2010. The deficit in trade of goods and services worsened from $114.5 billion to $131.6 billion in the same period. The current account has deteriorated in four consecutive quarters after the deficit of $84.4 billion in the second quarter of 2009, which was the lowest since the third quarter of 2009 (http://bea.gov/newsreleases/international/transactions/transnewsrelease.htm ). The US has now again increasing fiscal deficits and current account deficits that may constrain policy and growth. The SA producer price index rose 0.4 percent in Aug after increasing 0.2 percent in Jul and declining 0.5 percent in Jun. The SUA index rose 3.1 percent in the 12 months ending in Aug. Excluding energy and food the index rose 0.1 percent in Aug for a tenth consecutive monthly increase (http://www.bls.gov/news.release/pdf/ppi.pdf ). The SA consumer price index rose 0.3 percent in Aug but was flat excluding food and energy. The SUA index rose 1.1 percent in the 12 months ending in Aug and 0.9 percent excluding food and energy (http://www.bls.gov/news.release/pdf/cpi.pdf ). Initial claims for unemployment insurance SA fell to 450,000 in the week of Sep 11 or by 3000 from the revised estimate for the earlier week. Claims were 547,000 a year earlier. The four-week moving average fell to 464.750 or by 13,500 from the earlier week. SUA claims fell to 339,838 in the week of Sep 11 or by 38,145 relative to the earlier week and much lower than 411,126 a year earlier (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). While unemployment claims fell through large part of 2009, they have fluctuated above 450,000 in 2010. The number of employed persons in Aug 2009 was 139.433 million, declining to 139.250 million in Aug 10 or 183 thousand less people employed (http://www.bls.gov/news.release/pdf/empsit.pdf ). In Aug 2010, there were 26.090 million people in job stress composed of 14.860 million unemployed, 8.860 million working part time because they could not find another occupation and 2.370 million marginally attached to the labor force. SA industrial production was stable in the 16 countries composing the euro area after falling 0.2 percent in Jun and was stable in Jul in the 27 countries composing the European Union (EU27) after increasing 0.1 percent in Jun. In the 12 months ending in Jul 2010, industrial production rose 7.1 percent in the euro area and 6.8 percent in the EU27 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-14092010-AP/EN/4-14092010-AP-EN.PDF ). Exports of the euro area rose 18 percent in the 12 months ending in Jul 2010 while imports increased by 24 percent. SA exports of the euro area fell 0.6 percent in Jul and imports declined by 1.5 percent. The trade balance surplus of the euro area with the rest of the world was EUR6.7 billion in Jul down from EUR 11.9 billion in Jul 2009 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/6-16092010-AP/EN/6-16092010-AP-EN.PDF ).

II Basel Capital Requirements and the Dodd-Frank Act. Soft law consists of nonbinding declarations of intentions of international conduct that are much easier to negotiate and adopt than international treaties (Pelaez and Pelaez, Globalization and the State, Vol. II, 123-5, Government Intervention in Globalization, 145-150). Treaties require constitutional and legislative actions while soft law may be processed through smoother regulatory action. International standards and codes of conduct are important vehicles of reaching international cooperation to promote stability of institutions required for growth. There are multiple international standards and codes that were enhanced during efforts of improving international financial architecture of which one of the most influential is the Basel capital accord (Pelaez and Pelaez, International Financial Architecture, 239-300, Globalization and the State, Vol. II, 114-48, Government Intervention in Globalization, 150-4, Financial Regulation after the Global Recession, 54-6, Regulation of Banks and Finance, 69-70, 229-33). The doctrine of shared responsibility for common international policies to address external imbalances through the International Monetary Fund (IMF) was another attempt to solve international issues through cooperation not requiring legislative action by treaties (Pelaez and Pelaez, The Global Recession Risk, 9, 11, 18, 214, 227, 229).

Banking theory considers functions of banks of which one of the most important is converting loans for illiquid projects with gestation in the future into immediately available liquidity such as demand deposits. Securitization can also convert loans for buying houses or any other physical assets into a bond that can be financed in short-term sale and repurchase agreements (SRP) to provide instant liquidity. Because of this transformation function of illiquid physical assets into immediate liquidity banks and financial entities may have a fragile structure that requires sufficient capital to face runs in the form of withdrawal of deposits, as it happened to certain banks in 2008. There is also fragility in the liquidity transformation of securitization that is the foundation of most credit. There were also failures to refinance SRPs, with fire sales of securities increasing haircuts and margins, spreading through various segments of the financial sector in 2008 notoriously initially by structured investment vehicles (SIV) and other types of asset-backed commercial paper (Pelaez and Pelaez, Financial Regulation after the Global Recession, 48-52, Regulation of Banks and Finance, 58-66). Banks and financial institutions operate with leverage or borrowing money by issue of deposits as does most of the financial system to meet large demand for loans or financing of positions and securitization with SRPs to meet credit demand. Thus, capital is only a fraction of total assets and must be sufficient in absorbing losses that could prevent the failure of the bank under conditions of stress of its assets. Similarly, capital must be sufficiently high to avoid fire sales of securities that may spread to all segments. Regulation of banks has relied on imposing capital requirements of which the Basel Capital Accord of 1988 was the gold standard followed by Basel II in 2005 and now the ongoing efforts in Basel III. A key effort in the Basel accords is to maintain a “level playing field” by which banks are not deprived of competitiveness in international markets, which means that the accord should not bias capital requirements to benefit banks of some jurisdictions at the expense of others originating in different jurisdictions. The process of the Basel agreements involves consultations of the major monetary authorities of the world, academics, financial industry and so on, which enriches knowledge on finance and central banking. Technical issues tend to dominate politics with more adequate policy proposals and implementation.

Capital requirements under the Basel accords are divided into Tier 1 capital and Tier 2 capital. The Basel Committee on Banking Supervision (BCBS) has emphasized equity capital and disclosed reserves for three reasons: (1) common use in all banking systems; (2) transparency in published statements and use in market evaluation of capital adequacy; and (3) critically importance in profit margins and banks’ competitiveness. The BCBS finds Tier 1 capital critical in determining quality of banks’ capital position. Equity capital is defined as “issued and fully paid ordinary shares/common stock and non-cumulative perpetual preferred stock (but excluding cumulative preferred stock)” (http://www.bis.org/publ/bcbs128.pdf?noframes=1 14). Basel II required two capital tiers: Tier 1 capital consisting of equity capital and “published reserves from post-tax retained earnings” to be at least 50 percent of total required capital; and Tier 2 capital of not more than 100 percent of Tier 1 capital, consisting of “supplementary capital elements” such as undisclosed reserves, revaluation reserves, general provisions and general loss loan reserves, hybrid capital instruments with equity and debt characteristics and subordinated term debt (Ibid, 14-8). The total capital ratio “must be no lower than 8%” of risk-weighted assets (RWA). Total RWAs are obtained “by multiplying the capital requirements for market risk and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting figures to the sum of risk-weighted assets for credit risk” (Ibid, 12). The use of common equity as core capital of banks can be justified by three related arguments: (1) it is immediately loss absorbing and evident in valuation of shares in stock markets; (2) equity is a residual after payment of debt such that a company defaults when the value of debt is equal to or exceeds the market value of assets; and (3) shareholders may create incentives for management to avoid total loss of shareholder value. Share prices declining toward zero were relatively accurate in predicting the demise of financial entities in 2008.

The Group of Governors and Heads of Supervision of 27 countries, acting in oversight capacity of the BCBS, reached an agreement on Sep 12 to strengthen existing capital requirements, which together with definitions of capital, leverage requirements and a global liquidity standard will be introduced to the Seoul G20 Leaders summit in Nov plus higher leverage requirements for trading, derivatives and securitization that will be completed at the end of 2011 (http://www.bis.org/press/p100912.htm ) The minimum common equity requirement is raised from 2 to 4.5 percent together with an additional “conservation buffer” of 2.5 percent composed of common equity, resulting in total common equity requirements of 7 percent. The objective of the conservation buffer is “to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress” (Ibid). There is a window of eight years for implementation of the new requirements or “phase-in arrangements” (http://www.bis.org/press/p100912b.pdf ). The increase of common equity to 4.5 percent of capital and of Tier 1 to 6 percent will be effective as of Jan 1, 2015. The agreement also includes a voluntary “countercyclical buffer” of 0 to 2.5 percent of common equity or other loss absorbing capital determined by national authorities. Minimum capital plus conservation buffer will eventually be 7 percent in common equity, 8.5 percent in Tier 1 capital and 10.5 percent in total capital plus the nationally-determined countercyclical buffer of 0 to 2.5 percent that could raise total capital to 13 percent (http://www.bis.org/press/p100912a.pdf ). In addition, the agreement includes a Tier 1 capital leverage ratio of 3 percent that is general and not based on risk, which will be tested during the phase-in period with the objective of incorporating it in Pillar 1 after review and calibration by Jan 1, 2018. The Financial Stability Board (FSB) and the BCBS “are developing a well-integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt” (http://www.bis.org/press/p100912.htm ). The FSB will finish by Oct 2010 “a policy framework of concrete recommendations for measures to address the moral hazard risks associated with systemically important financial institutions (SIFIs)” proceeding on three directions: (1) reduction of the likelihood and effects of SIFIs failure; (2) effective resolution for firms in trouble; and (3) enhancement of financial markets to avoid “interconnectedness and contagion risks” of SIFIs (http://www.financialstabilityboard.org/publications/r_100627c.pdf 4).

The intent of H.R. 4173 or “Dodd-Frank Wall Street Reform and Consumer Protection Act” is “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes” (http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173enr.txt.pdf ). The 848 pages of the Dodd-Frank act generate multiple regulatory rules and studies with nil probability of accomplishing the intents. While the law was being negotiated, Fannie and Freddie were given unlimited bailout resources, became the largest realtor in the country and acquired the new distinction of “too politically important to fail.” The same government institutions that designed and implemented the bailouts were given the suspect power of taking over companies not to allow bailouts again. The result may simply be exemptions with new definitions of what is too big to fail for whatever reason. Consumers will have the same fate with the consumer protection agency as they had with the Credit Card Accountability, Responsibility and Disclosure Act of 2009 (CARD) (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). CARD was signed into law on May 22, 2009, and entered into effect on Feb 22, 2010. CARD harmed the credit card industry and its users who are nearly everybody with lower volumes of credit at higher interest rates. Taxpayers will involuntarily contribute to the unending bailout of Fannie and Freddie, which are “too politically important to fail.” According to a European Parliament view, naked short sales, hedge funds, derivates and credit default swaps were not the causes of the financial crisis such that attention must be focused on the adequacy of bank capital requirements (http://www.ft.com/cms/s/0/ff935886-bdad-11df-9417-00144feab7de.html ). The Dodd-Frank act unbalanced the playing field against US banks by imposing onerous regulation that will make them less competitive worldwide. Proprietary trading was not a factor of the banking crisis but it has been banned in banks, forcing a loss of revenue and a change in banking business models for no valid reason (http://noir.bloomberg.com/apps/news?pid=20601087&sid=auLsSZ1C0O7E&pos=5

). The legislative restructurings and regulation replace existing business models with government decisions and allocations, causing the inertia of investment and consumption that result in subpar growth and job stress. The Dodd-Frank act has created less stable banking and financial markets with lower capacity for providing the credit required for employment and job creation resulting from a rush to legislate and urgency to implement compared to the careful phase-in process of Basel III.

III Arbitrage of Monetary Policy. An important feature of the Fed flow of funds report for the second quarter of 2010 is that households and nonprofit organizations acquired $798 billion of financial assets in the second quarter of 2010 while decreasing net liabilities by $203 billion (http://www.federalreserve.gov/releases/z1/Current/z1.pdf 18). Corporations have $2 to $3 trillion in cash. Market turnover in global foreign exchange markets rose by 20 percent between Apr 2007 and Apr 2010 to reach $4.0 trillion per day (http://www.bis.org/publ/rpfx10.pdf?noframes=1 ). Since the Plaza Accord of 1985 to the present, intervention by governments of the G7 to turn around trends in foreign exchange rates have not been successful. Monetary policy may drive short-term rates to zero for significant periods, as it is the case of the fed funds rate of 0 to 0.25 percent fixed since Dec 16, 2008 (http://www.federalreserve.gov/monetarypolicy/openmarket.htm ). Research by the Wall Street Journal finds that the average expected return of the 15 largest public pension systems is 7.8 percent and that the National Association of State Retirement Administrators surveyed 100 US public pension plans finding that the median expected investment return is 8 percent (http://professional.wsj.com/article/SB10001424052748704358904575477731696162858.html?mod=wsjproe_hps_LEFTWhatsNews ). In contrast, the WSJ finds that: (1) the Dow Jones Industrial Average (DJIA) is at 10,607, 85 close to the 10,000 level that was first punctured in 1999; (2) the yield of the 10-year Treasury is 2.743 percent; and (3) the SUA consumer price index rose 1.1 percent in the 12 months ending in Aug and 0.9 percent excluding food and energy It is far more difficult for quantitative easing, or purchase of trillions of dollars of long-term securities by the Fed, to fix the risks spreads between short and long-term securities and among risk categories. The expectation of more purchases of long-term securities, probable interruption of legislative restructurings/regulation after November and increasing taxation from trillion-dollar deficits are already causing a hunt for yields, initially in fixed income markets but later likely also in equities. The arbitrage of more unconventional or exotic monetary policy may consist of two phases. In the first phase, the trade is to take highly leveraged long positions in fixed income securities, actually not as much in Treasuries as in other higher-yielding corporate debt, securitized bonds and junk bonds. The initial-phase trade will benefit from the property of duration that the percentage increase in price, other things constant, is higher for bonds with low coupons and low yields (see the earlier post of this blog The Duration Trap of Monetary Policy, Sep 12, 2010). Bloomberg has already reported that investors are taking positions in bonds backed with consumers having poor credit scores because of all-time yield lows (http://noir.bloomberg.com/apps/news?pid=20601087&sid=anxz2cT1MYqU&pos=6 ). Another symptom is the marketing of $319 billion of leveraged loans in the US in 2010 compared with only $173 billion a year earlier as reported by Dealogic and quoted by the WSJ (http://professional.wsj.com/article/SB10001424052748704394704575496242084611612.html?mod=wsjproe_hps_LEFTWhatsNews ). The sharp shocks of the credit crisis and global recession have created profitable opportunities for M&As. In the second phase, the interruption of legislative restructuring, less cautious attitude by investors and consumers and M&As may channel the hunt for yield from fixed income to equities. Investors may benefit from shorting fixed income securities in the expectation of rising yields of Treasuries because of financing higher debt by the federal government and because of the flight of funds back into equities. Repressed yields by quantitative easing may unleash the same risk taking that accompanied the earlier combination of near zero interest rates, suspension of the issue of 30-year Treasuries, housing subsidy of $221 billion per year and purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie with leverage of 75:1 that caused the credit 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). There must be consideration in the Federal Open Market Committee (FOMC) as to whether it can use exotic policy to control risk/return decisions of the entire economy, including risk spreads over all financial markets, maturities and segments without causing yield hunts and adverse repercussions in production, investment and consumption. Another round of trillion dollar purchases of Treasuries or other securities by the Fed could seriously affect growth and employment in different direction than intended by policy.

IV Financial Turbulence. A much better investment mood has returned to US equities, as shown in Table 1. Recent gains have reduced the losses to the trough hit during the sovereign risk difficulties in Europe to almost one half for all three indexes on Sep 17 and gains on the week: DJIA from -13.6 to -5.3 percent and a gain in the week of 1.4 percent, S&P 500 from -16.0 to -7.5 percent and a gain in the week of 1.4 percent and NYSE Financial from -20.3 to -11.5 percent and a gain in the week of 1.2 percent. US indexes are more sensitive to a pause in restructuring after November and an eventual flight from fixed-income into equities after the full effects of a potential purchase of one trillion dollars of long-term securities by the Fed. Risk taking, investment and consumption could return with higher returns on financial investment and a livelier rate of economic growth and employment. This scenario depends critically on a change or interruption in restructuring and regulation.

 

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

	Peak	Trough	% Trough	%9/17	Week 9/17
DJIA	4/26/10	7/2/10	-13.6	-5.3	1.4
S&P 500	4/23/10	7/2/10	-16.0	-7.5	1.4
NYSE Financial	4/15/10	7/2/10	-20.3	-11.5	1.2
Dow Global	4/15/10	7/12/10	-18.4	-8.7	1.8
Asia Pacific	4/15/10	7/2/10	-12.5	-2.6	2.1
Shanghai	4/15/10	7/2/10	-24.7	-17.8	-2.4
STOXX Europe	4/15/10	7/2/10	-15.3	-6.4	-1.4
Dollar	11/25/10	6/25/10	22.3	16.0	-2.8
USB Com	1/6/10	7/2/10	-14.5	-4.6	2.1
10-Y Tr	4/5/10	86/10	3.986	2.743

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

 

V Interest Rates. The 10-year Treasury fell to 2.74 percent from 2.80 percent a week earlier but rose from 2.58 percent a month earlier (http://markets.ft.com/markets/bonds.asp?ftauth=1284915921732 ). The 10-year government bond of Germany stood at 2.44 percent for a negative spread of 31 basis points relative to the 10-year Treasury. The US Treasury maturing on 08/20 with coupon of 2.63 was traded on Sep 17 at a price of 98.95 for equivalent yield of 2.75 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-170910 ). If the yield were to backup to the recent peak of 3.986 percent on Apr 2, 2010, the bond would settle on 09/20 at a price of 88.9135 for a loss of principal of 10.1 percent. Raising or lowering long-term yields when duration is high because of low coupons and yields can result in strong fluctuations of prices of fixed-income securities.

VI Conclusion. The combination of quantitative easing in the form of long-term purchase of treasuries or other securities by the Fed with a pause in legislative restructuring/regulation could cause an initial decline in yields of long-term fixed income securities followed by an increase in yields and a flow out of fixed income positions into equities reinforced by much higher M&A deals. The legislative pause of aggressive restructuring/regulation could cause higher growth and reduction of job stress. (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 )

The Duration Trap of Monetary Policy

 

The Duration Trap of Monetary Policy

Carlos M. Pelaez

Monetary policy would appear faster in execution than politically deadlocked fiscal stimulus in the effort to increase demand and accelerate growth. This post considers the adverse consequences of the duration trap of monetary policy. Section (I) recapitulates the past experience with the global hunt for yields resulting from zero interest rates and quantitative easing, (II) alternatives for monetary policy and (III) the duration trap. Economic indicators are covered in (IV), financial turbulence in (V), interest rates in (VI) and the conclusion in (VII). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I The Global Hunt for Yields. The objective function of money managers is to maximize the returns of the funds under management subject to control of risks such that the principal is preserved. 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. 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 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 Fed lowered its target rate of fed funds from 6.50 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 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 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 zero percent or 0.25 percent and quantitative easing in the form of aggressively expanding the balance sheet of the Fed. On Sep 8, 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 $724 billion of Treasury notes and bonds, $156 billion of federal agency debt securities and $1103 billion of mortgage-backed securities; and reserve balances at the Federal Reserve Banks were $1.04 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ).

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. The loss in the value of collateral by debtors because of deflation in the 1930s was an important restriction of the volume of credit, together with the dismantling of intermediation services by the banking panics, contributing to the propagation and unusual depth of the Great Depression (Bernanke, Nonmonetary effects of the financial crisis in propagation of the Great Depression, AER 1983, cited in Pelaez and Pelaez, Regulation of Banks and Finance, 201). However, a study of 17 countries over 100 years finds that in 90 percent of the cases of deflation there was no depression (Andrew Atkeson and Patrick Kehoe, Deflation and Depression, AER 94 (2004), cited in Pelaez and Pelaez, Regulation of Banks and Finance, 201). 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 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 1. 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, high-yielding 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 1, Volatility of Assets

DJIA	10/8/02-10//1/07	10/1/07-3/4/09	3/4/09-4/16/07
% Change	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
% Change	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
% Change	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
% Change	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
% Change	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 $ 1000s	169	247	217	203

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

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

 

II Alternatives for Monetary Policy. The Wall Street Journal asked six authorities on monetary policy what the Fed should do next (http://professional.wsj.com/article/SB10001424052748704358904575477580959771188.html?mod=WSJ_hpp_RIGHTTopCarousel_5 ). John Taylor and Alan Meltzer concur on a return to rule-based policy such as using the Taylor rule by which the target of fed funds is set equal to 1.5 times the rate of inflation and 1.5 times the gap of actual and potential GDP plus one, with more focus on the long term. Richard Fisher uses the statement in the FOMC that “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) to withhold further expansion of the Fed balance sheet until fiscal and regulatory policy are closer to the needs of employment creation. Frederic Mishkin warns about monetizing the debt and the high costs of using quantitative easing in normal circumstances. Ronald McKinnon proposes fed funds rate of 2 percent and long-term rates of 4 percent to avoid the liquidity trap of zero interest rates. Vincent Reinhart reminds the Fed statutory need for action when growth and employment are weak and inflation low that in the presence of zero interest rates leaves only unconventional policy as an alternative.

III The Duration Trap. A critical issue of monetary policy is the future consequences of lowering long-term interest rates. The Fed is now reinvesting the maturing portions of its portfolio into long-term Treasury securities of similar characteristics. Professionals use a variety of techniques in measuring interest-rate risk: (1) the full-valuation approach in which securities and portfolios are shocked by 50, 100, 200 and 300 basis points to measure their impact on asset values; (2) stress tests requiring more complex analysis and translation of possible events with high impact even if with low probability of occurrence into effects on actual positions and capital; (3) value at risk (VaR) analysis of maximum losses that are likely in a time horizon; (4) short-hand convenient measurement of changes in prices resulting from changes in yield captured by duration and convexity; and (5) careful consideration of yield volatility (Frank Fabozzi, Gerald Buestow and Robert Johnson, Measuring Interest-Rate Risk in Handbook of Fixed Income Securities, http://www.amazon.com/Handbook-Fixed-Income-Securities/dp/0071440992/ref=sr_1_1?s=books&ie=UTF8&qid=1284300146&sr=1-1#_ ). Frederick Macaulay introduced in 1938 the concept of duration in contrast with maturity for analyzing bonds (http://www.nber.org/books/maca38-1 ). Duration is the sensitivity of bond prices to changes in yields. In economic jargon, duration is the yield elasticity of bond price to changes in yield, or the percentage change in price after a percentage change in yield, typically expressed as the change in price resulting from changes of 100 basis points in yield, with the mathematical formula being the negative of the yield elasticity of the bond price or -(dB/d(1+y))((1+y)/B) where d is the derivative operator of calculus, B the bond price, y the yield and the elasticity does not have dimension (http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=89567 4). The duration trap is that duration is higher the lower the coupon and higher the lower the yield, other things being constant. Coupons and yields are currently very low and quantitative easing may lower further both coupons and yields. Consider a simplified example. A 10 year bond with semiannual coupon of 7.5 percent issued at price of 100 with yield of 15 percent. If yield increases to 16 percent the price of that bond falls to 95.0909 for a loss of 4.91 percent. On Sep 10, the yield of the 10-year Treasury was 2.795 percent. If a bond were issued at price of 100 with semiannual coupon of 1.3975 percent (2.795 divided by 2) and the yield were to increase from 2.795 percent to 3.795 percent, its price would fall to 91.7428 for a loss of 8.26 percent. Bloomberg reports that duration in Bank of America Merrill Lynch indexes of corporate debt reached a record of 5.69 on Aug 31 (http://noir.bloomberg.com/apps/news?pid=20601087&sid=a_4aQI_skhqE&pos=4 ). A note with coupon of 5.25 percent maturing in 2055 would lose 6 percent of face value after an increase of yield by 50 basis points. The consequences of zero interest rates and quantitative easing in the form of yield hunts have not been considered in monetary policy. Duration dumping during a rate increase may trigger the same cross fire selling of high duration positions that magnified the credit crisis. Traders reduced positions because capital losses in one segment, such as mortgage-backed securities, triggered haircuts and margin increases that reduced capital available for positioning in all segments, causing fire sales in all segments (Markus Brunnermeier and Lasse Pedersen cited in Pelaez and Pelaez, Regulation of Banks and Finance, 223). In fear of deflation, Fed policy has been inflating and deflating investor positions and wealth allocations by distorting risk/return calculations.

IV Economics Indicators. Economic indicators continue to show deceleration of the US economy and weak employment conditions. The Beige Book of the Fed confirms deceleration of the US economy: “reports from the twelve Federal Reserve Districts suggests continued growth in national economic activity during the reporting period of mid-July through the end of August, but with widespread signs of a deceleration compared with preceding periods” (http://www.federalreserve.gov/fomc/beigebook/2010/20100908/fullreport20100908.pdf i).

Trade in goods and services in Jul reduced the current account deficit, which is good news because the trade deficit contributed negatively to GDP growth in the second quarter. The trade account of the US registered a deficit of $42.8 billion in Jul equal to exports of goods and services of $153.3 billion less imports of $196.1 billion, which was lower than $49.8 billion in Jun. Exports in Jul were $2.8 billion higher than $150.6 billion in Jun, or 1.8 percent, while imports were lower by $4.2 billion relative to $200.3 billion in Jun or 2.1 percent lower. US exports of goods in Jan-Jul 2010 reached $722 billion or higher by 22 percent than $590 billion in the same period in 2009 while imports were $1082 billion or 25.9 percent higher than $583 billion a year earlier (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). Information-sector revenue increased by 0.8 percent in the second quarter of 2010 relative to the first quarter and is higher by 2.7 percent than in the second quarter of 2009 (http://www2.census.gov/services/qss/qss-current.pdf ). The lag in new orders in data from the index of the ISM for industry is being reflected in involuntary inventory accumulation. Seasonally adjusted (SA) inventories of merchant wholesalers increased by 1.3 percent in Jul relative to Jun and by 2.5 percent from Jul 2009. Sales of merchant wholesalers rose by 0.6 percent in Jul relative to Jun and by 12.7 percent from Jul 2009. The increasing accumulation of inventories with lagging sales resulted in an inventory/sales ratio for Jul of 1.16, which is still lower than 1.27 in 2009 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). The Fed finds an annual equivalent decline of consumer credit of 1.75 percent in Jul with revolving credit falling at 6.25 percent and nonrevolving credit increasing at 0.5 percent (http://www.federalreserve.gov/releases/g19/Current/ ).

The Mortgage Bankers Association unadjusted purchase index rose 4.0 percent in the week of Sep 8 and was 38.8 percent lower relative to the same week in 2009 (http://www.mbaa.org/NewsandMedia/PressCenter/73876.htm ). SA initial claims of unemployment insurance fell to 451,000 in the week of Sep 4, or by 27,000 from the earlier week’s revised 478,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The revision may bring in more information because nine states were estimating data in the midst of the labor holiday.

V Financial Turbulence. Improvement in financial markets and economic recovery has been accompanied by continuing volatility or financial turbulence of financial variables shown in Table 2. The factors of financial turbulence have been: (1) uncertainty on the growth rate of China that may affect commodity prices and Asian interregional trade and economic growth; (2) sovereign risks in Europe with doubts on bank exposures and adequacy of stress tests to measure risks; (3) decelerating economic growth and weak employment markets in the US; (4) fiscal and regulatory uncertainties in the US that restrict investment, consumption and hiring; and (5) uncertainties that monetary policy consisting of quantitative easing my trigger another global hunt for yields. Most major indexes registered gains in the week ending on Sep 10, especially in Asia Pacific and Europe but in markets characterized by hesitation and low volumes.

 

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

	Peak	Trough	% Trough	% 9/10	Week 9/10
DJIA	4/26/10	7/2/10	-13.6	-6.6	0.1
S&P 500	4/23/10	7/2/10	-16.0	-8.8	0.5
NYSE Financial	4/15/10	7/2/10	-20.3	-12.5	-0.3
Dow Global	4/15/10	7/2/10	-18.4	-10.3	0.6
Asia Pacific	4/15/10	7/2/10	-12.5	-4.5	1.6
Shanghai	4/15/10	7/2/10	-24.7	-15.8	0.3
STOXX Europe	4/15/10	7/2/10	-15.3	-5.1	1.4
Dollar	11/25/10	6/25/10	22.3	19.4	1.7
USB Com	1/6/10	7/2/10	-14.5	-6.5	0.5
10-Y Tr	4/5/10	8/6/10	3.986	2.795

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

 

VI Interest Rates. The yield curve shifted upward for the first time in several weeks on Sep 10 with the 10-year Treasury rising to 2.80 percent (rounding 2.795 percent) above 2.71 percent a week earlier and 2.74 percent a month earlier (http://markets.ft.com/markets/bonds.asp?ftauth=1284306977315 ). Increasing risk positions in other fixed income with new placement of corporate debt may explain part of the increase in Treasury yields. The Wall Street Journal quotes data from Dealogic and S&P’s Leveraged Commentary & Data Group that in two days before Sep 8, $51 billion of new corporate bonds and leveraged loans went to market, with $19 billion in new high-grade bonds on Sep 8 alone (http://professional.wsj.com/article/SB10001424052748703453804575479712501514050.html?mod=wsjproe_hps_LEFTWhatsNews ). The 10-year government bond of Germany traded at 2.40 percent for a negative spread of 40 basis points relative to the equivalent Treasury. The Treasury with 2.63 coupon maturing in Aug 2020 traded at 98.53 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-100910 ). If the yield were to backup to the recent peak of 3.986 on Apr 5, the price for settlement on Sep 13 would be 88.9880 for a loss of principal of 9.7 percent. Further quantitative easing may be an inopportune policy option.

VII Conclusion. Financial and regulatory shocks constrain economic growth and prevent job creation. Increasing purchases of long-term securities by the Fed may create a duration trap with adverse effects in the future. Economic policy is at a low level of credibility, requiring drastic reformulation that aligns policy measures with the needs for growth and employment creation. (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 )

The Credibility Gap of Economic Policy and Unavailability of Jobs

The Credibility Gap of Economic Policy and Unavailability of Jobs

Carlos M. Pelaez

This post analyzes the unavailability of jobs in (I), relating it to three policy credibility gaps: (IIA) fiscal policy, (IIB) monetary policy and (IIC) regulation. Economic indicators are considered in (III), financial turbulence 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 Unavailability of Jobs. Indicators of job availability show significant stress in the United States. The number of employed persons in Aug 2009 was 139.433 million, declining to 139.250 million in Aug 10 or 183 thousand fewer people employed (http://www.bls.gov/news.release/pdf/empsit.pdf ). The relative availability of jobs is measured by the employment/population ratio, or percent of the civilian labor force to the civilian noninstitutional population in working age, that has declined from 59.1 percent in Aug 2009 to 58.5 percent in Aug 2010. The mediocre recovery of economic activity after four quarters of growth of GDP has been accompanied by fewer people in working age with jobs. Another measurement is the calculation of people in job stress, which has declined by only 0.9 percent in the 12 months ending in Aug 2010. There were 26.340 million people in job stress in Aug 2009 composed of: 14.993 million unemployed, 9.077 million working part-time because they could not find any other occupation and 2.270 million marginally attached to the labor force. In Aug 2010, there were 26.090 million people in job stress composed of 14.860 million unemployed, 8.860 million working part time because they could not find another occupation and 2.370 million marginally attached to the labor force.

The proper reference for comparison of employment during recovery from the current recession is with the recession of the early 1980s. Both recessions were severe in magnitude and in both cases misleading comparisons have been made relative to the Great Depression (for review of the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance, 198-217, and Globalization and the State, Vol. II, 205-9). The largest banks in the US in the 1980s, called money center banks because of buying money to lend by issuing certificates of deposit and borrowing short-dated bank reserves from smaller regional and local banks, had exposures to emerging markets that grew rapidly in the 1970s to finance balance of payments deficits originating in oil price increases. The fed funds rate for loans of reserves among banks rose from 9.61 percent in Aug 1980 to 19.08 percent in Jan 1981 and the rate on the six-month certificate of deposit reached 17.98 percent in Aug 1981 (http://www.federalreserve.gov/releases/h15/data.htm ). The increase in interest rates by the Fed in the US to break rising inflation forced foreign debtors of US banks into debt moratorium. If US banks had marked loans to an observable market value, the largest US banks, with the exception of Morgan Guaranty, would have had negative capital. In the meetings of the Federal Open Market Committee (FOMC) in 1983, then Chairman Paul Volcker remarked, with the advice “that comment doesn’t go in this report [that] there is a rising sense of nervousness underneath the surface and I think a lot of it is related to the perception that Brazil is not doing very well. If they need more money, they are out of compliance with the [International Monetary Fund requirements. They] must be able to make a Fund drawing on May 31 and aren’t going to be able to make it through. There is some feeling that the Brazilians may not be the most avid people in the world in following through on the strong program” (Paul Volcker, Meetings of the Federal Open Market Committee, May 24, 1983, 4, cited in Pelaez and Pelaez, International Financial Architecture, 181-2, 324, 337). Brazil did adjust remarkably, reducing the current account deficit from $16.8 billion in 1982 to $6.8 billion in 1983 and nil in 1984. GDP grew at 0.8 percent in 1982, fell by 2.9 percent in 1983 and grew by 5.4 percent in 1984 (Ibid, 182). Banks borrowed short-dated funds to lend long-term loans especially borrowing with short-dated savings deposits to lend 30-year mortgages. The increase in rates of short-dated funds raised funding costs while revenue from fixed-rate mortgages was unchanged, causing unbearable losses in banks. In 1983-90, 1150 commercial and savings banks, about 8 percent of the industry in 1980, failed, and 900 savings and loans, or about 25 percent of the industry, were closed, merged or placed in conservatorship by federal agencies. The cost to taxpayers of resolving insolvent savings and loans amounted to $150 billion (George Benston and George Kaufman cited in Financial Regulation after the Global Recession, 56), which was about 2.6 percent of 1990 GDP equivalent to $367 billion of 2009 GDP. The Congressional Budget Office estimates that in mid February 2010 the capital purchases and other support for financial institutions of the Troubled Asset Relief Program (TARP)had resulted in a net gain of $2 billion to the government(https://www.cbo.gov/ftpdocs/112xx/doc11227/03-17-TARP.pdf), that is, a gain to taxpayers instead of the loss to taxpayers of $367 billion from the banking crisis of the 1980s. In the upswing after the recession of 1979-82, the employment ratio jumped from 57 to 63 percent in 1990. The policy shift currently requires focus on promoting the proper incentives for rapid job creation by the private sector (Henry Olsen in the Wall Street Journal http://professional.wsj.com/article/SB10001424052748704388504575419280283794598.html ). Table 1 provides the monthly change in thousands of jobs seasonally adjusted (SA). During a worldwide debt and balance of payments crisis in the 1980s, large banks with negative capital and failure of 8 percent of commercial and savings banks and 25 percent of savings and loans banks, the US grew rapidly and created jobs in accelerated pace. There is nothing unique in the current recession in terms of policy challenges compared with the 1980s except for the lower growth in the current expansion and fewer jobs for the population in working age.

Table 1, Monthly Change in Jobs, Thousands SA

Month	1981	1982	1983	2008	2009	2010	Private
Jan	95	-327	225	-10	-779	14	56
Feb	67	-6	-78	-50	-726	39	62
Mar	104	-129	173	-33	-753	208	158
Apr	74	-281	276	-149	-528	313	218
May	10	-45	277	-231	-387	432	74
Jun	196	-243	378	-193	515	-175	61
Jul	112	-343	418	-210	-346	-54	107
Aug	-36	-158	-308	-334	-212	-54	67
Sep	-87	-181	1114	271	-225
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

IIA Credibility Gap of Fiscal Policy. In the view of the outgoing Chair of the President’s Council of Economic Advisers (CEA), Professor Christina D. Romer of the University of California at Berkeley, the current recession has been difficult to reverse with policy measures because of its uniqueness (http://www.whitehouse.gov/administration/eop/cea/ ). According to this view, the current recession does not resemble the experience of the 1980s when interest rates were high before the recession such that lowering rates by monetary policy stimulated construction, spending and business investment. The current recession was allegedly caused by “regulatory failures and unsound practices that contributed to a housing bubble and eventually a full-fledged financial crisis” (Ibid, 2). The recession is allegedly unique and without prior parallel except for the Great Depression: “an all-out financial meltdown in the world’s financial system is something the world has experienced only once in the past century—in the 1930s. Thus, the President took office in the midst of a recession of historic proportions, but for which history provided little guidance” (Ibid, 2). In fact, the recession and recovery during the 1980s occurred during a major worldwide debt crisis that nearly wiped out the largest banks and a decade-long banking crisis in the United States, as documented in the previous section. Another feature in this view is the speed and depth of the contraction of the productive or real sector of the economy as a result of the credit crisis. GDP was initially forecast to decline by an annual SA rate of 3.8 percent in 2Q08 but the actual decline was 6.8 percent. In fact, the largest SA annual quarterly contractions in the current recession were 6.8 percent in 4Q08 and 4.9 percent in 1Q09, which are comparable with those in the 1981-1982 recession: -4.9 percent in 4Q81 and -6.4 percent in 1Q82 (see Table 1 in the prior post of this blog of Aug 29, 2010). There were simultaneous declines of GDP in major economies worldwide in the current recession. The response of the administration was the American Reinvestment and Recovery Act of 2009 (ARRA) with an effective increase of spending by $862 billion. Additional efforts consisted of the Financial Stability Plan (FSP) that ended mostly as stress tests instead of the unfeasible purchase of distressed assets held by banks (Pelaez and Pelaez, Financial Regulation after the Global Recession, 164-6, Regulation of Banks and Finance, 226-7). Banks recovered their own balance sheets and stress tests merely measured that effort. Other policies were the use of $50 billion of TARP funds to prevent foreclosure of house loans and the restructuring of two automotive producers.

The CEA finds substantial benefits from policy: GDP has been growing during four consecutive quarters and employment has been growing again in 2010 (http://www.whitehouse.gov/administration/eop/cea/ ). However, the CEA acknowledges that growth has been insufficient to increase employment as desired. The original report estimated that the effects of ARRA would increase GDP by 3.75 percent and payroll employment by 3,675,000 jobs (http://otrans.3cdn.net/45593e8ecbd339d074_l3m6bt1te.pdf 4) “relative to what otherwise would have occurred” (http://www.whitehouse.gov/administration/eop/cea/ 8). The CEA contends that “there is widespread agreement that the Act is broadly on track to meet these milestones” (Ibid, 8). Unemployment has stuck at around 9.5 percent, not rising more because of people being dropped out of labor force statistics, instead of the forecast 8 percent. The CEA explains this discrepancy by the sharper than expected contraction of the economy: “our estimates of the impact of the Recovery Act have proven quite accurate. But we, like virtually every other forecaster, failed to anticipate just how violent the recession would be in the absence of policy, and the degree to which the usual relationship between GDP and unemployment would break down” (Ibid, 9). The current sad state of the economy is explained by the CEA by unpredictable features of the recovery such as the continuing housing slump that causes increases in savings to replenish lost wealth, again in similarity with the Great Depression. The response has been additional “temporary recovery measures” of $266 billion in the 2011 budget. The failure of Congress to enact all that was proposed by the Administration has prevented the additional support needed for economic recovery (Ibid, 11). The diagnosis by Professor Romer is that “GDP by most estimates is still about 6 percent below trend. This shortfall in demand, rather than structural changes in the composition of our output or a mismatch between worker skills and jobs, is the fundamental cause of our continued high unemployment. Firms aren’t producing and hiring at normal levels simply because there isn’t demand for a normal level of output” (Ibid, 12). The policy prescription could include a combination of low-cost initiatives such as exporting more with implementation of regulation that front loads benefits. In the short run, the CEA finds the need for “the government to spend more and tax less” (Ibid, 13).

Professor Michael Boskin of Stanford, former Chairman of the CEA, provides different analysis in an article for the WSJ (http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html ). The critical historical perspective is that average quarterly rates of growth in the expansions after a severe recession were incomparably higher than during the current expansion: 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975, 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter in 1983 and only 3 percent in the first four quarters and 2.9 percent forecast in the first 12 quarters after the trough in the third quarter of 2009. The uncertainty plaguing the recovery is not concentrated on the economy alone but also on economic policy. 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 the stimulus 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 recovery and full employment. The expectation of increases of taxes because of the upward tilt of government spending is frustrating investment, consumption and hiring.

IIB Credibility Gap of Monetary Policy. Fed Chairman Bernanke provides an explanation of the financial crisis in terms of triggers, originating the crisis, and vulnerabilities, amplifying its depth and reach to production and employment (http://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm ). The $1 trillion of subprime mortgages is a commonly considered trigger but it is insufficient to explain the crisis and recession. Another trigger was the contraction of asset-backed commercial paper (ABCP) that finances significant part of credit. The reform-oriented approach focuses on laxity in the private financial sector and public policies. The private sector vulnerabilities analyzed by Bernanke are: (1) reliance on volatile short-term funding through securitization, money market funds, investment banks, mortgage banks and many others that financed securities with long-term maturity with short-dated funds such as sale and repurchase agreements (SRP); (2) weak risk management by financial institutions; (3) excessive leverage; and (4) derivatives with high risk and leverage without observable prices. The shortcomings of public policy were: (1) lack of regulation for the shadow bank system; (2) failure in using existing authority; (3) lack of resolution authority for large financial companies; and (3) growth of financial entities because of the “too big to fail” doctrine. A major credibility issue of monetary policy is that an alternative interpretation attributes the origins of the crisis to monetary policy. The misallocation of resources and loss of employment was primarily caused by monetary policy jointly with housing policy considered in turn (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). First, the Fed lowered interest rates to 1 percent between Jun 2003 and Jun 2004 with the objective of preventing deflation while simultaneously Treasury suspended the issue of 30-year Treasuries with the objective of increasing purchases of 30-year mortgage-backed securities to lower yields and stimulate housing. Policy is not very different currently except in much higher dimensions with the fed funds rate at 0 to 0.25 percent and directly attempting to lower mortgage rates by a Fed portfolio of $1.98 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) instead of suspending the auctions of 30-year Treasuries. Monetary policy created problems instead of reckless management of financial institutions. Near-zero interest rates and the effort to reduce long-term interest rates created the impression that financial assets would never decline in value, encouraging high leverage, low liquidity, excessive risk and careless credit decisions, which are the vulnerabilities in this view that amplified the crisis. The wording of the Federal Open Market Committee (FMOC) “forward guidance” created the illusion of near-zero interest rates forever such that the Fed would prevent losses in financial exposures, which was similar to the Fed writing a put option, or floor, on asset values. In fact, as it happens currently, Fed policy intended to encourage risk and spending to pump the economy by creating the illusion that brakes would not be applied indefinitely. Financial institutions are now blamed with hindsight for taking the risk that Fed policy induced and intended in 2003-2004 and currently for not taking risks again with the same policies while regulation lowers credit volumes and increases interest rates. Second, the near-zero interest rates and suspension of the issue of 30-year Treasuries merely magnified the effects of a yearly subsidy of housing measured in 2006 at $221 billion, policy of affordable housing, capital by Fannie and Freddie of $900 per $200,000 mortgage (Edward J. Pinto http://professional.wsj.com/article/SB10001424052748704407804575425231311880538.html) and acquisition or guarantee by Fannie and Freddie of $1.6 trillion of nonprime mortgages (http://www.aei.org/docLib/20090116_kd4.pdf 7 cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-8, Regulation of Banks and Finance, 219-20). Fannie and Freddie were under lax oversight by tax-creating political institutions compared with oversight by boards and internal controls of for-profit financial institutions. The effort now is to perpetuate Fannie and Freddie which are “too politically important to fail.”

IIC Credibility Gap of Regulation. The Chair of the FDIC, Sheila Bair, finds “three pillars of financial reform needed in the wake of the crisis: resolution authority, systemic oversight and consumer protection” (http://www.fdic.gov/news/news/speeches/chairman/spsep0210.html ). The Dodd-Frank act of financial regulation consists of an extremely complex and draconian regulatory framework with unpredictable consequences for individual provisions and a black hole for the whole law after rules and other decisions left to regulators. Dismembering financial institutions will make them and the financial system more vulnerable to crisis. Resolution authority and systemic oversight will not eliminate risks of institutions failing because of failure of others but rather creates a new risk of regulatory errors in preventing a market exit by change of control instead of the devastating mess of liquidation. Concentration of banks on lending by transferring proprietary trading and other lines of business to hedge funds will make banks less diversified and riskier and the system more prone to crisis. Regulatory zeal will increase the costs and reduce the volume of bank capital, ultimately raising interest rates and reducing volume of credit to all. Credit is used by households, business and financial institutions such that an increase in its cost and reduction of its availability will restrain investment, spending and hiring, making this jobless recovery a unique prolonged event.

III Economic Indicators. Short-term economic indicators of the US economy continue to show a moderately expanding economy but not at a sufficient pace to stimulate employment. Personal consumption expenditures increased by 0.4 percent from Jun to Jul in current dollars and by 0.2 percent adjusted by inflation. Personal income in current dollars grew by 0.2 percent after being flat in Jun and disposable personal income adjusted for inflation fell 0.1 percent. The price index of personal consumption expenditures increased 0.1 percent in Jul (http://bea.gov/newsreleases/national/pi/pinewsrelease.htm ). The business barometer index of the Chicago ISM fell to 56.7 in Aug from 62.3 in Jul, suggesting strong but decelerating growth and new orders slowed from 64.6 in Jul to 55.0 in Aug (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20August%202010.pdf ). The ISM manufacturing index increased from 55.5 in Jul to 56.3 in Aug but the index of new orders fell from 53.5 in Jul to 53.1 in Aug (http://www.ism.ws/ISMReport/MfgROB.cfm ). The nonmanufacturing index of the ISM fell from 54.3 in Jul to 51.5 in Aug and the index of new orders from 56.7 in Jul to 52.4 in Aug (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). The SA rate of construction spending in Jul of $805.2 billion was 1.0 percent below the revised Jun estimate of $813.1 billion and 10.7 percent below the Jul 2009 estimate of $901.2 billion (http://www.census.gov/const/C30/release.pdf ). New orders of manufacturers rose 0.1 percent in Jul after falling 0.6 percent in Jun and 1.8 percent in May (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Business nonfarm labor productivity fell at a 1.8 percent annual SA rate in the second quarter of 2010 with hours increasing 3.5 percent and output 1.6 percent. The average annual rate of increase of productivity in 2000-2009 was 2.5 percent (http://www.bls.gov/news.release/pdf/prod2.pdf ). Initial claims for unemployment insurance increased to 472,000 in the week ending on Aug 28 or by 6000 from the revised 478,000 a week earlier. Nonseasonally adjusted claims fell by 6400 to 378,511 in the week ending Aug 28 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The index of pending home sales of the National Association of Realtors increased 5.2 in Jul but is lower by 19.1 percent relative to Jul 2009 (http://www.realtor.org/press_room/news_releases/2010/09/pending_rise ).

IV Financial Turbulence. Major world stock indexes rose in the week ending on Sep 3, partly because of the relief that economic data are showing deceleration of the rate of growth but without any indications of the economy falling back into recession. The purchasing managers’ indexes for many countries provided by WSJ research confirm moderate growth worldwide (http://blogs.wsj.com/economics/2010/09/01/world-wide-factory-activity-by-country-8/ ). Commodities also gained in the week with oil moving toward $74/barrel. Treasury yields backed up to 2.713 percent.

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

	Peak	Trough	% Trough	% 9/03	Week 9/03
DJIA	26-Apr	2-Jul	-13.6	-6.8	2.9
S&P 500	23-Apr	2-Jul	-16	-9.3	3.7
NYSE Financial	15-Apr	2-Jul	-20.3	-12.3	4.9
Dow Global	15-Apr	2-Jul	-18.4	-10.9	3.7
Asia Pacific	15-Apr	2-Jul	-12.5	-6.0	2.7
Shanghai	15-Apr	2-Jul	-24.7	-16.1	1.7
Europe STOXX	15-Apr	2-Jul	-15.3	-6.4	3.7
Dollar	25-Nov	25-Jun	22.3	18.5	-0.5
DJ USB Com	6-Jan	2-Jul	-14.5	-9.3	2.6
10 Year Treasury	5-Apr	27-Aug	3.986	2.713

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

V Interest Rates. The 10-year Treasury yield backed up to 2.71 percent on Sep 3 relative to 2.65 percent in the prior week but was still lower than 2.95 percent a month earlier. The 10-year Treasury maturing in 08/2020 with coupon of 2.63 percent was priced on Aug 27 at a yield of 2.647 percent or equivalently at a price of 99.78 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-270810 ). The price on Sep 3 of that Treasury was 99.28 or equivalent yield of 2.71 for a capital loss of 0.5 percent in the week (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-030910 ). The price corresponding to the yield of 3.986 at the peak of Apr 5 for settlement on Aug 7 would be 88.908 for a capital loss of 10.4 percent. The price for yield close to 3 percent one month ago would be 96.824 for a capital loss of -2.5 percent. Further purchases of Treasuries by the Fed could depress yields even more, creating a trap of capital losses as portfolio managers dump duration during a backup of yields, which was one of the vulnerabilities that amplified the financial crisis.

VI Conclusion. The Bank of Japan took exceptional measures to ease monetary policy in an effort to reverse the appreciation of the yen that is hurting exporters and overall economic activity (http://professional.wsj.com/article/SB10001424052748703618504575460662350463290.html?mod=wsjproe_hps_TopLeftWhatsNews ). Earlier exchange-rate interventions by Japan and the G3 have not been very successful (Pelaez and Pelaez, The Global Recession Risk, 107-9). Monetary authorities may not be able to manipulate currencies in an FX market that has grown to $4 trillion of daily volume (http://www.bis.org/publ/rpfx10.pdf?noframes=1 ). Monetary policy is confronting the zero bound of interest rates with a Fed portfolio of $1.98 trillion of long-term securities and the risk of creating a duration trap of capital losses in attempts to lower long-term yields further. Fiscal policy is also reaching the limits of how much more government spending can increase after creating trillion dollar deficits indefinitely. Policy must shift from restructurings of economic activity to reducing uncertainty in decisions by business and households within existing business models and structures to provide breathing room for the private sector to create employment (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 )