Subpar US Growth, European Sovereign Risk, Financial Turbulence and Policy Failure

 

Subpar US Growth, European Sovereign Risk, Financial Turbulence and Policy Failure

Carlos M. Pelaez

©Carlos M. Pelaez, 2010

Subpart US growth with job stress, European sovereign risk doubts, policy failure and concerns with growth in China are contributing to financial turbulence. The contents of this post are as follows:

I Subpar US Growth

II European Sovereign Risk

III Financial Turbulence

IV Policy Failure

V The Global Devaluation War

VI Economic Indicators

VII Interest Rates

VIII Conclusion

I Subpar US Growth. The main economic issue in the US is that the economy is growing at subpar rates relative to recovery from earlier contractions such that there are 26.6 million people in job stress. The Bureau of Economic Analysis (BEA) estimates real Gross Domestic Product (GDP) as “the output of goods and services produced by labor and property located in the United States” (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp3q10_2nd.pdf 1). Real GDP increased from the second to the third quarter of 2010 at the seasonally adjusted (SA) annual equivalent rate of 2.5 percent. This growth rate is subpar relative to past expansions from strong contractions in the 1980s, 1970s and 1950s. Statements comparing the global recession in 2008-2009 and the Great Depression are misleading. Real GDP fell in the US by 8.6 percent in 1930, 6.4 percent in 1931, 13.0 percent in 1932 and 1.3 percent in 1933 for cumulative decline of 25.6 percent. Nominal GDP without adjustment for inflation fell by 45.6 percent (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 151, Globalization and the State, Vol. II (2008b), 206; for analysis of the literature on the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217). The rates of decline of GDP in 1981-1982 are comparable with those of 2008-2009 but both contractions are quite different from the Great Depression. The current expansion is mediocre compared with past rebounds of economic activity from US contractions. Real GDP grew by 10.8 percent in 1934. The rates of growth of GDP in the first five quarters after the contraction were 5.1 percent in IQ83 (first quarter 1983), 9.3 percent in IIQ83, 8.1 percent in IIIQ83, 8.5 percent in IVQ83 and 7.1 percent in IQ84 (see columns 3 and 4 in Table 1) while the growth rates in the first five quarters of expansion currently have been 1.6 percent in IIIQ09, 5.0 percent in IVQ2009, 3.7 percent in IQ10, 1.7 percent in IIQ10 and 2.5 percent in IIIQ10 (see columns 7 and 8 in Table 1). Relative to the same quarter a year before, GDP grew at: -2.7 percent in IIIQ09, 2.4 percent in IQ2010, 3.0 percent in IIQ2010 and 3.2 percent in IIIQ2010 (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp3q10_2nd.pdf Table 8, 11). The consequence of subpar growth is that there are 26.6 million persons in job stress in the US in Oct composed of: 14.8 million unemployed (of whom 6.2 million unemployed for 27 weeks or longer or 41.8 percent of total unemployed), 9.2 million “employed part-time for economic reasons” (because their hours were reduced or could not find a full-time job) and 2.6 million “marginally attached to the labor force” (who are not part of the labor force but are willing and available for work and had looked for employment in the past 12 months) (http://www.bls.gov/news.release/pdf/empsit.pdf).

 

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

Quarter	1981	1982	1983	1984	2008	2009	2010
I	8.6	-6.4	5.1	7.1	-0.7	-4.9	3.7
II	-3.2	2.2	9.3	3.9	0.6	-0.7	1.7
III	4.9	-1.5	8.1	3.3	-4.0	1.6	2.5
IV	-4.9	0.3	8.5	5.4	-6.8	5.0

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr

 

The BEA provides an important breakdown of the rate of growth of GDP by percentage points (pps) contributions of various components shown in Table 2: PCE (personal consumption expenditures), GDI (gross domestic investment), trade (exports of goods and services less exports of goods and services) and GOV (government consumption, expenditures and gross investment). The comparison in Table 2 of the expansion of the US economy during five consecutive quarters from IIIQ09 to IIIQ10 shows much lower percentage point contributions to GDP growth than those in the first five quarters of expansion IVQ83 to IVQ84 in the critical items of private aggregate demand, PCE, or consumption, and GDI, or investment. PCE contributes 70.4 percent of GDP in the US (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&FirstYear=2009&LastYear=2010&Freq=Qtr). In the revision of IIIQ10, the contribution of 1.97 pps by PCE is the highest in the first five quarters of expansion, breaking down into subcomponents of 0.81 pps by goods and 1.16 pps by services. A weakness is in GDI, contributing 1.51 pps, which breaks down into only 0.20 pps contributed by fixed investment and 1.30 pps by change in private inventories, ∆ PI, which is also shown in a separate column in Table 2. Change in private inventories was important but not dominant in GDI in the 1982-1983 expansion. The key to growth with rapid employment creation is growth of aggregate demand or PCE (private consumption) and GDI (private investment). Actual policies followed and alternative policies available are discussed in section IV on policy failure.

 

Table 2, Contributions to the Rate of Growth of GDP in Percentage Points

	GDP	PCE	GDI	∆ PI	Trade	GOV
2010
I	3.5	1.33	3.04	2.64	-0.31	-0.32
II	1.7	1.54	2.88	0.82	-3.50	0.80
III	2.5	1.97	1.51	1.30	-1.76	0.81
IV
2009
I	-4.9	-0.34	-6.80	-1.09	2.88	-0.61
II	-0.7	-1.12	-2.30	-1.03	1.47	1.24
III	1.6	1.41	1.22	1.10	-1.37	0.33
IV	5.0	0.69	2.70	2.83	1.90	-0.28
1982
I	-6.4	1.62	-7.50	-5.47	-0.49	-0.03
II	-2.2	0.90	-0.05	2.35	0.84	0.50
III	-1.5	1.92	-0.72	1.15	-3.31	0.57
IV	0.3	4.64	-5.66	-5.48	-0.10	1.44
1983
I	5.1	2.54	2.20	0.94	-0.30	0.63
II	9.3	5.22	5.87	3.51	-2.54	0.75
III	8.1	4.66	4.30	0.60	-2.32	1.48
IV	8.5	4.20	6.84	3.09	-1.17	-1.35

Note: PCE: personal consumption expenditures; GDI: gross private domestic investment; ∆ PI: change in private inventories; Trade: net exports of goods and services; GOV: government consumption expenditures and gross investment

GDP: percent change at annual rate; percentage points at annual rates

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr

 

II European Sovereign Risk. The BIS Quarterly Review, Sep 2010, provides the exposures of banks from various jurisdictions to Greece, Ireland, Portugal and Spain at the end of the first quarter of 2010 at $1102.6 billion with the highest exposures by French banks of $244.2 billion, German banks $217.9 billion and US banks $186.4 billion (http://www.bis.org/publ/qtrpdf/r_qt1009.pdf#page=19 Table 1, 16). The Joint External Debt Hub of the BIS, IMF, OECD and World Bank provides international debt securities: Portugal $162.1 billion, Ireland $1199.4 billion, Greece $277.5 billion and Spain $1303.5 billion (http://www.jedh.org/jedh_creditor.html). Table 3 provides GDP, debt/GDP ratios and current account/GDP ratios for various countries in the euro area, the US, UK, Japan and China. The dimensions of countries confronting sovereign risk issues are small in terms of GDP: Portugal $224 billion, Ireland $204 billion and Greece $305 billion, for total $733 billion or 6.1 percent of total euro area GDP of $12,067 billion. Adding Spain’s GDP of $1275 billion, the total for the countries confronting sovereign risk issues increases to $2000.8 billion or 16.6 percent of the euro area’s GDP. Financial institutions and markets in other countries could be affected through the linkages to the banking and debt markets of countries resolving sovereign risk issues

 

Table 3, GDP, Debt/GDP and Current Account/GDP for Selected Countries

	GDP $ Billions	Debt/GDP 2010 %	Debt/GDP 2015 %	Current Account % GDP 2010	Current Account % GDP 2015
Euro Area	12,067	53.4	67.4	73.8	0.2
Germany	3,652	58.7	61.8	6.1	3.9
France	2,865	74.5	78.7	-1.8	-1.8
Portugal	224	79.9	93.6	-9.9	-8.4
Ireland	204	55.2	71.4	-2.7	-1.2
Italy	2,037	98.9	99.5	-2.9	-2.4
Greece	305	109.5	112.6	-10.8	-4.0
Spain	1,275	54.1	72.6	-5.2	-4.3
USA	14,624	65.8	84.7	-3.2	-3.4
UK	2,259	68.8	76.0	-2.2	-1.1
Japan	6,517	120.7	153.4	3.1	1.9
China	5,745	19.1	13.9	4.7	7.8

Source: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx

 

The 16 member states of the euro area provided on May 9, 2010 for the creation of the European Financial Stability Facility (EFSF) after decisions within the Ecofin Council (http://www.efsf.europa.eu/about/index.htm). A company, EFSF, was registered under Luxembourg law and owned by the 16 member states of the euro area, to issue bonds guaranteed by the 16 member states in value of up to €440 billion “for on-lending to euro area member states in difficulty, subject to conditions negotiated with the European Commission in liaison with the European Central Bank and International Monetary Fund and to be approved by the Eurogroup” (Ibid). Standard & Poor’s and Fitch Ratings have assigned their highest credit rating to EFSF. The mechanism is similar to that of the multilateral development banks: Inter-American Development Bank, European Investment Bank and Asian Development Bank. These banks issue debt with their AAA rating, derived from the sovereign rating of their member countries, to fund investments and loans within their mission objectives (Pelaez and Pelaez, International Financial Architecture (2005), 72-74, Globalization and the State, Vol. I (2008a), 27-8). In both cases, the AAA-rating of sovereign members is transferred to an institution to enhance the volume of funding and reduce interest payments. The objective of the EFSF is of an emergency nature of preventing crises in euro area member states instead of the long-term objectives of economic development of the multilateral banks. The debts of multilateral development banks have not experienced stress during decades of operations and constitute an important part of the international financial institutions together with the IMF, BIS and World Bank. The risks of the EFSF are higher because of the stress of the sovereigns experiencing emergency funding needs. The total value of the rescue package of the sovereigns in potential need of emergency funding is €750 billion, consisting of the €440 billion of the EFSF, €60 billion from an emergency lending facility provided by the European Commission from the budget of the European Union and €250 billion from additional resources that would be provided by the IMF.

The Wall Street Journal provides important analysis on the actual amount of funds that can be used in sovereign funding emergencies (http://professional.wsj.com/article/SB10001424052748704526504575634913516773290.html?mod=WSJ_hpp_MIDDLTopStories). The IMF cannot commit the €250 billion in advance. Member countries must approve loans on an individual country basis. Although denial of a loan is not likely, there is no full guarantee of support. The €440 billion of the EFSF provides loans instead of cash. The bonds must have AAA-rating, requiring that countries hold 40 percent of the cash proceeds as cash guarantees. Thus, the total available from the EFSF for lending is only €250 billion, which becomes €310 billion when adding the European Commission’s emergency lending facility of €60 billion, instead of €440 billion.

The volume of resources required by a country facing sovereign risk issues has been quite difficult to predict and in many cases estimates are frequently revised upwardly. Exposures of financial institutions are difficult to measure with multiple uncertainties on their evolution under alternative assumptions and the linkages among financial institutions and the rest of the economy. The process is even more complex when various countries are involved. The estimate of funding for Ireland is €60 billion from the EFSF and €30 billion from the IMF (Ibid). Portugal’s use of the EFSF could be between €50 and €100 billion. The rollover needs of Spain’s sovereign debt are around €300 billion (Ibid). The total needs from the EFSF could be €460 billion, exceeding the effective resources of the EFSF of €310 billion (Ibid). Portugal and Spain have not expressed need for funding from the EFSF or IMF. The head of the Bundesbank advised that the rescue facility could be expanded to prevent pressure on the euro (http://professional.wsj.com/article/SB10001424052748703572404575635320548229734.html?mod=wsjproe_hps_LEFTWhatsNews). A proposal by the European Commission to double or expand the EFSF was vetoed by a major member state (http://professional.wsj.com/article/SB10001424052748704638304575636580416827208.html?mod=WSJ_hpp_MIDDLETopStories). There is the possibility of a change in attitudes with approval of an increase in the rescue package if more countries need assistance (http://professional.wsj.com/article/SB10001424052748703572404575635320548229734.html?mod=wsjproe_hps_LEFTWhatsNews). The situation appears to be changing rapidly.

III Financial Turbulence. There are four key factors of turbulence in international financial markets. First, unresolved sovereign risk doubts in Europe, discussed in section II, recur periodically with strong effects on returns on financial assets. If the doubts remained concentrated in Greece and Ireland, the European rescue package, probably with higher funding, would provide bridge to better markets and economic conditions. Debt restructuring could not be ruled out in a more troubled adjustment. If the sovereign risk doubts also affect Portugal and Europe, resolution may be more complex, requiring higher funding and enhanced cooperation. Debt restructuring could be far more complex. The larger countries would require internal measures to ensure that banks and debt markets do not experience challenges. It is difficult operationally to find a definite fix for these sovereign risk challenges because of the changing rescue estimates and the spread to countries and financial institutions. Perhaps one important lesson of this experience is parsimony in budget management.

Second, there are also recurring doubts on the continuance of high rates of growth in China. China is an important source of demand at the margin for raw materials and deceleration of its growth rate could cause declines of commodity prices. There are repercussions of oscillations of commodity prices in countries exporting raw materials to China. Disruption of the web of interregional trade between China and other Asian countries could decelerate Asia-Pacific growth, affecting the world economy. The increase in inflation in China and concerns with property prices may prompt further measures of monetary policy tightening that could decelerate economic growth.

Third, regional international conflicts affect financial variables. These conflicts are not predictable. There are repercussions also on the willingness to engage in international financial and economic cooperation in solving issues of trade and capital flows.

Fourth, subpar economic growth in the US generates alternative views on the future pace of recovery. Monetary policy of quantitative easing, or large-scale purchase of financial assets, is based on the current view of the Fed of slow growth and continuing unemployment. The issue of policy failure in the US is discussed in the following section.

IV Policy Failure. The minutes of the meeting on Nov 2-3 of the Federal Open Market Committee (FOMC) constitute the most important official document on policy at the moment (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20101103.pdf). Members of the FOMC concluded that the economy was not making sufficient progress in moving toward what they considered consistent with their “dual mandate of maximum employment and price stability” (Ibid, 8). Most members of the FOMC “judged it appropriate to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with the Committee’s mandate” (Ibid, 8). The action consisted in maintaining the target range of fed funds at 0 to ¼ percent and to reinvest payments on the existing portfolio of securities in long-term Treasury securities. The FOMC also decided on another round of quantitative easing “to purchase a further $600 billion of longer-term Treasury securities at a pace of about $75 billion per month through the second quarter of 2011” (Ibid, 8).

The FOMC had a meeting by videoconference on Oct 15 in which a rather unusual policy was discussed (Ibid, 10):

“Finally, participants discussed the potential benefits and costs of setting a target for a term interest rate. Some noted that targeting the yield on a term security could be an effective way to reduce long-term interest rates and thus provide additional stimulus to the economy. But participants also noted potentially large risks, including the risk that the Federal Reserve might find itself buying undesirably large amounts of the relevant security in order to keep its yield close to the target level”

There is no indication of what yield would be targeted by the Fed and in what segment of the Treasury yield curve. If the target were to fix the 10-year Treasury yield at 2.5 percent, for example, the Fed would have to buy unlimited amounts of 10-year Treasury securities at 2.5 percent (http://www.ft.com/cms/s/0/63b58a42-f737-11df-9b06 00144feab49a.html#axzz169o4Rp2r).

The FOMC soundly did not purse this policy option. It is part of what is called financial repression or setting ceilings on deposit rates and sometimes on lending rates with disastrous consequences (Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 81-6). The Banking Act of 1933 (12 U.S.C. § 371a) prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks implemented by Regulation Q (12 C.F.R. 217) (Peláez and Peláez, Financial Regulation after the Global Recession (2009a), 57). This depression rush to regulation was motivated by the erroneous belief that banks provided high-rate risky loans to pay high competitive market interest rates on deposits, which allegedly caused banking panics in the 1930s. An added motivation was the allocation of savings to housing by maintaining low interest rate ceilings benefitting savings banks and savings and loan associations that complained of unfair competition from higher deposit rates of commercial banks. Friedman (1970) analyzed that the rise of inflation above Regulation Q interest rate ceilings caused halving of issuance of certificates of deposit (CD), which was the banking innovation created to finance rising loan volumes. Banks accounted higher-rate CDs in their European offices as “due from head office” while the head office changed the liability to “due to foreign branches” instead of “due on CDs.” Friedman (1970, 26-7) predicted the future as revealingly as his forecast of 1970’s stagflation: “the banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York” (cited by Pelaez and Pelaez, Financial Regulation after the Global Recession (200a), 58). People of modest means with lower income and wealth having no alternatives other than bankbook accounts received rates on their savings below those that would prevail in freer markets. Regulation transferred income from poorer depositors to endow banks with market power. The financial system was forced into costly readjustments while highly-paid financial jobs and economic activity were exported to foreign countries. The interest rate is the main compass of allocating savings and capital in a market economy but it was distorted by ill-conceived Great Depression regulation that is still emulated currently. The new Dodd-Frank financial regulation bill will also harm the most people of modest means.

The Fed is repeating the same policy that led to the credit/dollar crisis and global recession of 2008-2009: fixing the short-term interest rate near zero percent while withdrawing supply of securities in long-term segments to lower their yields and related long-term borrowing costs. The Fed began to lower the fed funds rate from 6.50 percent on May 16, 2000, to 6.0 percent on Jan 3, 2001, and then rapidly to 1.75 percent on Dec 11, 2001 with further lowering to 1.25 percent on Nov 6, 2002 (http://www.federalreserve.gov/monetarypolicy/openmarket_archive.htm). At the meeting of Jun 26, 2003, the Fed fixed the fed funds target at 1.00 percent and left it at that level until Jun 30, 2004, when it lifted the target to 1.25 percent (http://www.federalreserve.gov/monetarypolicy/openmarket.htm). The FOMC increased the fed funds rate target by 25 basis points in 17 consecutive meetings beginning on Jun 30, 2004 and ending on Jun 29, 2006. The FOMC began to lower the fed funds target aggressively on Sep 18, 2007, until Dec 16, 2008 when it was fixed at 0 to ¼ percent, where it has remained (Ibid). The mechanism is the same as what would have occurred under the term target for long-term bonds: the open market desk of the New York Fed engages in daily open market operations adding or withdrawing reserves as required in maintaining the FOMC rate decision at the target level.

The rationale for lowering the fed funds rate to 1 percent was fear of deflation (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm). When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. Lowering the nominal fed funds rate would lower the real rate of interest, or the nominal rate less expected inflation, encouraging personal consumption expenditures and gross domestic investment or aggregate demand. Increased economic activity would set upward pressure on prices and generate higher employment. Treasury suspended auctions of 30-year bonds effective February 2002 (http://www.treas.gov/press/releases/po749.htm).

An important channel of transmission of quantitative easing is that “if money is an imperfect substitute for other financial assets, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. In turn, lower yields on long-term assets will stimulate economic activity” (Bernanke and Reinhart 2004, 88). The commitment of the Fed to purchasing long-term securities is designed to impress on investors that prices will increase and yields decline for asset classes that are related to long-term borrowing costs of firms, such as corporate debt and asset-backed securities collateralized with loans. In the framework of Tobin (1969), the withdrawal of supply of 30-year securities would cause rebalancing of portfolios in that segment (Andrés et al. 2004). Pension funds would match pension benefits payments with income obtained by buying mortgage-backed securities with similar maturities, increasing their prices, which is equivalent to lowering their yields. Homeowners would refinance mortgages, lowering their monthly payments, which released cash in higher magnitude than tax rebates. As it is the case currently, the Fed was concerned with its dual mandate that inflation was too low and unemployment too high and took actions.

The policy of near-zero short-term interest rates created arbitrage opportunities. Professional investors and the public borrowed as much short-term money as they could to buy risky financial and real assets with the highest possible returns. This is carry trade financing with short-term borrowing a long position in financial assets. The communication of the policy by the Fed was in the form of a forward guidance that rates would remain at low levels until warranted by economic conditions. A widely accepted interpretation consisted of the “great moderation,” by which centrals banks had mastered technically how to control inflation with fewer recessions resulting in lower loss of economic activity and employment. Investors and the public perceived that interest rates would remain low forever. Financial and real assets that comprise the wealth of investors and the general public are inversely related to interest rates. The policy of near-zero interest rates created the impression that wealth was increasing to permanently higher levels, inducing further borrowing for consumption and investment.

Professional investors felt comfortable with higher leverage and risks because the Fed would maintain rates at low levels indefinitely. Creditors relaxed the requirements of loan to value ratios in houses, or the value of the mortgage relative to the actual price of the home, that is, there was relatively little equity contributed by homeowners to cushion potential declines in home prices. Low interest rates forever as in the forward guidance of the Fed guaranteed high and increasing prices in the future. A housing subsidy of $221 billion per year, affordable housing policies and the purchase and guarantee by Fannie and Freddie of $1.6 trillion of nonprime mortgages fueled further housing construction. Arbitrage consisted of borrowing with short-term financing to profit from increases in prices of financial and real assets. Nearly all term credit was grouped into long-term securities that were financed in short-term overnight sale and repurchase agreements to earn the spread between the short- and long-term rates. Homeowners could afford more expensive houses by adjustable rate mortgages that were related to the near-zero lower fed funds rate such that monthly mortgage payments were much lower than under conventional 30-year mortgages that had much higher rates. Credit standards were relaxed on the belief that nothing could be wrong because the Fed would maintain low rates indefinitely, guaranteeing high and increasing prices of all assets. The price appreciation of the home of a subprime borrower would cover the mortgage and even leave a small profit. Monetary policy in 2003-2004 induced high leverage, excessive risks, low liquidity, short-term financing and unsound credit decisions that were the primary cause of the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4).

The consequences of the global hunt for yields induced by monetary and housing policy are shown in Table 2. 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 2005-2007, jump in the Nikkei Average by 131.2 percent between 2003 and 2007, rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates induced significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and debt securities, junk bonds 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 (2009b), 203-4, Government Intervention in Globalization (2009c), 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 percent on Jun 12, 2007, collapsing to 2.247 percent 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. Central bank policy induced the financing of nearly everything with short-dated funding at very low interest rates. When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. The combination of short-term zero interest rates, similar effects to quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.

 

Table 4, Volatility of Assets

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

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

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

 

V The Global Devaluation War. A simplified explanation helps in understanding the mechanism of transmission of monetary policy. The objective of quantitative easing is lowering yields of long-term Treasury securities, in particular those with 5 to 6 years of maturity. The open market desk of the New York Fed withdraws supply of Treasury securities, which causes increases of their prices that is equivalent to lowering their yields. In a preferred-habitat model of the term structure, the carry trade of arbitrageurs consists of borrowing at the near-zero short-term rate and going long in the Treasury securities in the target segment of the Fed (Vayanos and Vila 2009, Greenwood and Vayanos 2010, D’Amico and King 2010, Hamilton and Wu 2010).

Lower yields of Treasury securities would process through the capital asset demand functions in the Tobin (1969, 18-9) model (see Pelaez and Suzigan, 1978, 120-3). The demand for a capital asset depends on its own rate of return, the rates of return of other capital assets and other variables. The Tobin model consists of asset demand functions, A_j of j = 1, 2, ∙∙∙ m assets or sectors depending on a vector of rates of returns of i = 1, 2, ∙∙∙ n assets, including the own rate of the asset and rates on other assets, and other possible variables. Quantitative easing enters in the capital asset demand functions by a reduction in the rate of return or yield of Treasury securities. Relative returns of alternative capital assets increase, causing portfolio rebalancing in the form of increasing purchases of bonds backed with mortgages, credit card receivables, auto loans, consumer loans, leverage equity transactions, corporate debt, junk bond and so on. The yields on bonds providing financing for credit would decline. Personal consumption expenditures in consumer durables would increase because of more attractive rates of financing. Gross domestic investment would increase for production of goods to meet rising demand. Companies would hire again, reducing unemployment.

There is a major wedge between quantitative easing and increase in aggregate demand, consisting of uncertainty in consumption and investment decisions by the private sector. Fed policies are now being processed during major transformation of the economy by legislative restructurings and regulation. Fiscal policy of increasing expenditures to 24.7 percent of GDP while revenue declined to 14.8 percent of GDP in 2009 created record deficits and debt/GDP ratios since World War II (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml). The expectation of future tax increases has added to the uncertainty, frustrating growth of investment and consumption.

Quantitative easing is being implemented jointly with a policy of symmetric inflation target. The Fed would take monetary easing measures to bring the rate of inflation from its low level of 0.9 percent in 12 months for PCEs to somewhat less than 2 percent but would also take monetary-tightening measures to prevent inflation from rising above 2 percent. Inflation in Europe has risen to 1.9 percent in the 12 months ending in Oct and to 4.4 percent in China. In the prior near-zero interest rate policy US inflation jumped from 1.9 percent in 2003 to 4.1 percent in 2007. Calibrating inflation by monetary policy may be unpredictable especially if 26.6 million people continue in job stress.

The yield of the 10-year Treasury stood at 3.835 percent on Dec 31, 2009, staying above 3 percent in 2010 and reaching a peak of 3.986 percent on Apr 5. The sovereign risk crisis and uncertainties with growth in China caused flows of funds away from risk financial assets into the temporary safe haven of Treasury securities, resulting in decline of the 10-year yield to 2.385 percent on Oct 7. An added downward pressure on yields was the sequence of statements by FOMC members, beginning on Aug 27 at the Jackson Hole meeting, suggesting the Fed would engage in another round of quantitative easing. The 10-year yield stood at 2.481 percent on Nov 4, one day after the announcement of $600 billion of new purchases of securities by the Fed but then rose to 2.964 percent on Nov 15 and closed at 2.869 percent on Nov 26 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_bnd_dtabnk&symb=UST10Y&page=bond). The upward trend of 10-year yields in Nov is in opposite direction of the objectives of quantitative easing. The 10-year yield rose on Nov 24 by 1 9/32 or 1.28 percent (http://professional.wsj.com/article/SB10001424052748703572404575634420088971074.html?mod=wsjproe_hps_LEFTWhatsNews). If the long position was not reversed, it would have lost $12,800 per one million dollars, but the capital of a trader financing with leverage of 10:1 would have lost 12.8 percent of $100,000. Professional traders would have reversed the position, probably explaining the magnitude of decline. The rise in yields in Nov raises doubts as to a painless exit strategy from quantitative easing. The Fed balance sheet stood at $2.3 billion on Nov 24 with a portfolio of long-term securities of $2 trillion, consisting of $877 billion of Treasury bonds and notes (including inflation indexed), $148 billion of agency securities and $1 trillion of mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). There is no simple exit strategy from this position without pains of sharp interest rate increases.

The zero cost of carry resulting from FOMC policy with uncertainty wedge on private-sector decisions may stimulate the carry trade of borrowing at near-zero interest rates and going long in commodities, equities, currencies and high-risk fixed income. The sovereign risk doubts have resulted in more oscillations in the upward trend of risk financial assets benefitting from the carry trade of zero fed funds rates. The last column of Table 5 still shows a vigorous upward trend of risk financial assets together with dollar devaluation of 11.1 percent. Quantitative easing may stimulate demand for risk financial assets, creating threats of future declines of asset prices when conditions change that could have adverse effects on financial markets.

 

Table 5, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 11/26	∆% Week 11/26	∆% T to 11/26
DJIA	4/26/10	7/2/10	-13.6	-1.0	-0.9	14.5
S&P 500	4/23/10	7/20/10	-16.0	-2.3	-0.9	16.3
NYSE Finance	4/15/10	7/2/10	-20.3	-13.6	-3.4	8.5
Dow Global	4/15/10	7/2/10	-18.4	-5.2	-2.4	16.2
Asia Pacific	4/15/10	7/2/10	-12.5	0.8	-2.1	15.1
Japan Nikkei Average	4/05/10	8/31/10	-22.5	-11.9	0.2	13.8
China Shanghai	4/15/10	7/16/10	-24.7	-9.3	-0.6	18.5
STOXX 50	4/15/10	7/2/10	-15.3	-6.9	-1.5	9.9
DAX	4/26/10	5/25/10	-10.5	8.2	0.01	20.8
Dollar Euro	11/25 2009	6/7 2010	21.2	11.1	3.2	-11.1
DJ UBS Comm.	1/6/10	7/2/10	-14.5	0.9	0.9	18.0
10-Year Tre.	4/5/10	4/6/10	3.986	2.870

T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)

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

 

Dollar devaluation is an important ingredient in forecasting the US economy as revealed by the following statement in the FOMC minutes (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20101103.pdf 6):

“In light of asset market developments over the intermeeting period, which in large part appeared to reflect heightened expectations among investors that the Federal Reserve would undertake additional purchases of longer-term securities, the November forecast was conditioned on lower long-term interest rates, higher stock prices, and a lower foreign exchange value of the dollar than was the staff’s previous forecast. These factors were expected to provide additional support to the recovery in economic activity”

Devaluation of the dollar is a favorable but perhaps not intentional consequence of quantitative easing in raising inflation toward the level desired by the FOMC and also increasing exports and economic activity in accordance with the employment mandate of the Fed. Table 6 shows the update of exchange rates for the week of Nov 26. Many countries complain that the US is promoting a global competitive devaluation of the dollar with the purpose of growing the US economy out of its current employment stress.

 

Table 6, Exchange Rates

	Peak	Trough	∆% P/T	Nov 26 2010	∆% T Nov 26	∆% P Nov 26
EUR USD	7/15 2008	6/7 2010		11/26 2010
Rate	1.59	1.192		1.324
∆%			-33.4		9.9	-20.1
JPY USD	8/18 2008	9/15 2010		11/26   2010
Rate	110.19	83.07		84.09
∆%			24.6		-1.2	23.7
CHF USD	11/21 2008	12/8 2009		11/26 2010
Rate	1.225	1.025		1.003
∆%			16.3		2.1	18.1
USD GBP	7/15 2008	1/2/ 2009		11/26 2010
Rate	2.006	1.388		1.559
∆%			-44.5		10.9	-28.7
USD AUD	7/15 2008	10/27 2008		11/26 2010
Rate	0.979	0.601		0.964
∆%			-62.9		37.7	1.6
ZAR USD	10/22 2008	8/15 2010		11/26 2010
Rate	11.578	7.238		7.14
∆%			37.5		1.4	38.3
SGD USD	3/3 2009	8/9 2010		11/26 2010
Rate	1.553	1.348		1.319
∆%			13.2		2.1	15.1
HKD USD	8/15 2008	12/14 2009		11/26 2010
Rate	7.813	7.752		7.762
∆%			0.8		-0.1	0.6
BRL USD	12/5 2008	4/30 2010		11/26 2010
Rate	2.43	1.737		1.7278
∆%			28.5		0.5	28.9
CZK USD	2/13 2009	8/6 2010		11/26 2010
Rate	22.19	18.693		18.663
∆%			15.7		0.2	15.9
SEK USD	3/4 2009	8/9 2010		11/26 2010
Rate	9.313	7.108		6.992
∆%			23.7		1.6	24.9

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough

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

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

 

VI Economic Indicators. The US economy continues to expand with some improvement in the decline of new jobless claims but continuing weakness in real estate. Personal income rose 0.5 percent in Oct and 4.1 percent relative to a year earlier while personal consumption expenditures rose 0.4 percent in Oct and 3.6 percent relative to a year earlier. The price index of personal consumption expenditures excluding food and energy rose 0.9 percent (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm). Corporate profits increased $44.4 billion in the third quarter compared with $47.5 billion in the second quarter (http://www.bea.gov/newsreleases/national/gdp/2010/gdp3q10_2nd.htm). New orders of durable goods fell 3.3 percent in Oct and 2.7 percent excluding transportation (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf). Durable goods is a very volatile indicator and of difficult interpretation. New single-family sales of new houses seasonally adjusted fell 8.1 percent in Oct relative to Sep and stood 28.5 percent below the level in Oct 2009. Sales of single-family houses not seasonally adjusted in Jan-Oct were 279,000 (http://www.census.gov/const/newressales.pdf Table 1, 2), or 74.9 percent lower than 1,115,000 in Jan-Oct 2005 (http://www.census.gov/const/newressales_200510.pdf Table 1, 2). The National Association of Realtors informed that existing home sales fell 2.2 percent in Oct relative to Nov and 25.9 percent relative to Oct 2009 (http://www.realtor.org/press_room/news_releases/2010/11/october_retreat). Initial jobless claims seasonally adjusted fell 34,000 in the week ending Nov 30 to 407,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm).

VII Interest Rates. The US 10-year Treasury traded at 2.87 percent on Nov 26, which is slightly lower than 2.88 percent a week earlier but higher than 2.72 percent a month earlier. The 10-year German government bond traded at 2.74 percent with a negative spread of 13 basis points relative to the comparable Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1290895073435). The Treasury with coupon of 2.63 percent maturing in 11/20/20 traded at price of 97.89 or equivalent yield of 2.87 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-261110). The loss of principal in a backup of yield to 3.986 percent traded on Apr 5, 2010, would be 9.2 percent and 18.8 percent in a backup of yield to 5.297 percent traded on Jun 12, 2007.

VIII. Conclusion. A combination of sovereign risk doubts, concerns on China’s growth, subpar growth and job stress in the US and failures of economic policy is introducing renewed financial turbulence. Because of uncertainties of legislative restructuring, regulation, tax and interest rate increases quantitative easing may increase valuations of assets of risk financial assets instead of aggregate demand. (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 )

References

Andrés, Javier, J. David López-Salido and Edward Nelson. 2004. Tobin’s imperfect asset substitution in optimizing equilibrium. Journal of Money, Credit and Banking 36 (4, Aug): 665-90.

Bernanke, Ben S. and Vincent R. Reinhart. 2004. Conducting monetary policy at very low short-term interest rates. American Economic Review 94 (2): 85-90.

D’Amico Stefania and Thomas B. King. 2010. Flow and stock effects of large-sale Treasury purchases. Washington, DC, Federal Reserve board, Sep. http://www.federalreserve.gov/pubs/feds/2010/201052/201052pap.pdf

Friedman, Milton. 1970. Controls on interest rates paid by banks. Journal of Money, Credit and Banking 2 (Feb 1): 15-32.

Greenwood, Robin and Dimitri Vayanos. 2010. Bond supply and excess bond returns. San Francisco, AFA Meetings Paper, Jan 8. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1012607&rec=1&srcabs=1076644

Hamilton, James D. and Jing Wu. 2010. The effectiveness of alternative monetary policy tools in a zero lower bound environment. San Diego, University of California San Diego, Nov 3 http://dss.ucsd.edu/~jhamilto/zlb.pdf

Pelaez, Carlos M. and Carlos A. Pelaez. 2005. International Financial Architecture. Basingstoke: Palgrave Macmillan. http://us.macmillan.com/QuickSearchResults.aspx?search=pelaez%2C+carlos&ctl00%24ctl00%24cphContent%24ucAdvSearch%24imgGo.x=26&ctl00%24ctl00%24cphContent%24ucAdvSearch%24imgGo.y=14 http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2007. The Global Recession Risk. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2008a. Globalization and the State: Vol. I. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2008b. Globalization and the State: Vol. II. Basingstoke: Palgrave Macmillan.

Pelaez, Carlos M. and Carlos A. Pelaez. 2008c. Government Intervention in Globalization. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2009a. Financial Regulation after the Global Recession. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2009b. Regulation of Banks and Finance. Basingstoke: Palgrave Macmillan.http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos Manuel and Wilson Suzigan. 1978. Economia Monetária. São Paulo, Atlas.

Tobin, James. 1969. A general equilibrium approach to monetary theory. Journal of Money Credit and Banking 1(1, Feb): 15-29.

Vayanos, Dimitri and Jean-Luc Vila. 2009. A preferred-habitat model of the term structure of interest rates. New Orleans, AFA Meetings Paper, Nov 1. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=971439

NYC 11/28/10

©Carlos M. Pelaez, 2010

Quantitative Easing Theory, Evidence and Debate and the Global Devaluation War

 

Quantitative Easing Theory, Evidence and Debate and the Global Devaluation War

Carlos M. Pelaez

©Carlos M. Pelaez, 2010

The objective of this post is to analyze the theory and evidence on quantitative easing by the Fed to probe the heated debate on Fed large-scale purchase of Treasury securities and the repercussions on the dollar and other currencies. The contents are as follows:

Introduction

I Theory and Evidence of Quantitative Easing

II Debate on Quantitative Easing

III Global Yield Hunt

IV Global Devaluation War

V Economic Indicators

VI Interest Rates

VII Conclusion

References

I Theory and Evidence of Quantitative Easing. The critical issues of quantitative easing are the theoretical framework explaining how massive injections of base money in large-scale asset purchases (LASP) prevent deflation, increase aggregate demand and motivate private-sector hiring and what empirical evidence supports these intended effects. This section considers a specific explanation of how quantitative easing by LSAP of Treasury securities can lower yields by appeal to the preferred-habitat theory of the term structure of interest rates (Culbertson 1957, 1963; Modigliani and Sutch 1966) as reformulated by Vayanos and Vila (2009) and analyzed empirically by D’Amico and King (2010).

The central issue is deriving theoretically how changes in the quantity of securities held by the public by monetary policy affect yields of securities, that is, how massive withdrawals of long-term Treasury securities reduce yields in the target maturity that in turn could reduce borrowing costs to the private sector, motivating investment and hiring. Quantitative easing is often referred as “unconventional” monetary policy such as in the statement by Bernanke (2010KC) on Aug 27 (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm): “the [Federal Open Market] Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary.” Conventional monetary policy consists of reducing fed funds rates that jointly with subdued inflation expectations by the private sector result in lower short-term real interest rates, or nominal interest rates less inflation expectations (Svensson 2003, 146) lower real rates of longer maturities that stimulate aggregate demand and output, moving the economy out of recession. Conventional policy is not feasible when fed fund rates are as currently at 0 to ¼ percent.

The expectations hypothesis of the term structure of interest rates states “that the relationship between interest rates on different maturities is determined in the main by expectations as to the future course of interest rates” (Lutz 1940, 62). Consider an example by Kessel (1965, 6) that the one-year rate is 2 percent and the two-year rate 3 percent. The forward rate is the rate implied between the one-year and two-year rates. The current price of the one-year security is exp (-0.2) = exp (-0.02) = 0.98020 and the price of the two-year security is exp (-0.2x3) = exp (-0.06) = 0.94176. The forward rate between the two-year security and the one-year security is: ln (exp(-.rn)/exp(-.r(n-1)) = ln (exp -0.02/exp(-0.06) = 0.04 or 4 percent, where ln is the natural logarithm, r the yield of the security and n the number of periods. The unbiased expectations hypothesis states that “the forward rates are unbiased estimates of future short-term rates. Four percent is not only the forward rate—it is the expected one-year rate one year hence, i.e., it is what the market thinks the one-year rate will be one year hence” (Kessel 1965, 6).

In conventional monetary policy the effects on long-term yields are processed through the lowering of short-term interest rates, such as lower fed funds rates in the US. Lutz (1940, 37) argues that in an economy with (1) perfect foresight or accurate forecasting, (2) zero investment costs for borrowers and lenders and (3) borrowers and lenders shift throughout all maturities, the long-term rate can be conceived “as a sort of average of the future short-term rates.” Let f(t, T) be the forward rate that is derived, as 4 percent in the example, from the rates at time t, one-year security in the example, and time T, two-year security in the example, that is the rate that applies from extending maturity by one year from t (one year) to T (two years). Let r_T be the one-year rate at time T, then in the certain economy f(t, T) = r_T for all t ≤ T. This equality is assured by the lack of arbitrage opportunities because otherwise arbitrageurs could obtain a profit trading in bonds of periods T and T+1. The unbiased expectations hypothesis states that E[r] = f(t, T) for all t ≤ T (Ingersoll 1987, 387-92). It is not possible to find a specification for effects on yields of altering quantities of securities by monetary policy withdrawals in the expectations hypothesis (D’Amico and King, 7-9).

An optimizing model from microeconomic foundations is developed by Andrés et al. (2004) with the assumption of imperfect substitution between different classes of securities. The estimates of this model using quarterly data for the US from 1980 to 1999 “confirm that some of the observed deviations of long-term rates from the expectations theory of the term structure can be traced to movements in the relative stocks of financial assets, just as claimed by Tobin (1969)” (Andrés et al, 688). The traditional channel of transmission of monetary policy is by influencing long-term interest rates with changes in the expected path of short-term rates. The “unconventional” or “quantitative easing” channel of monetary policy is processed by increases in base money that alter relative prices of financial securities, thus reducing long-term yields and increasing aggregate demand.

Another approach is by the preferred-habitat models proposed by Culbertson (1957, 1963) and Modigliani Sutch (1966). This approach is formalized by Vayanos and Vila (2009). The model considers investors or “clientele” who do not abandon their segment of operations unless there are extremely high potential returns and arbitrageurs who take positions to profit from discrepancies. Pension funds matching benefit liabilities would operate in segments above 15 years; life insurance companies operate around 15 years; and asset managers and bank treasury managers are active in segments around 15 years (Ibid, 1). Hedge funds, proprietary trading desks and bank maturity transformation activities are examples of potential arbitrageurs. The role of arbitrageurs is to incorporate “information about current and future short rates into bond prices” (Ibid, 12). Suppose monetary policy raises the short-term rate above a certain level. Clientele would not trade on this information, but arbitrageurs would engage in carry trade, shorting bonds and investing at the short-term rate, in a carry “roll-up” trade, resulting in decline of bond prices or equivalently increases in yields. This is a situation of an upward-sloping yield curve. If the short-term rate were lowered, arbitrageurs would engage in carry trade borrowing at the short-term rate and going long bonds, resulting in an increase in bond prices or equivalently decline in yields, or carry “roll-down” trade. The risk premiums of bonds are positively associated with the slope of the term structure (Ibid, 13). Fama and Bliss (1987, 689) find with data for 1964-85 that “1-year expected returns for US Treasury maturities to 5 years, measured net of the interest rate on a 1-year bond, vary through time. Expected term premiums are mostly positive during good times but mostly negative during recessions.” Vayanos and Vila (2009) develop a model with two-factors, the short-term rate and demand or quantity. The term structure moves because of shocks of short-term rates and demand. An important finding is that demand or quantity shocks are largest for intermediate and long maturities while short-rate shocks are largest for short-term maturities.

The research by D’Amico and King (2010) analyzes the impact of the purchase of $300 billion Treasury securities by the Fed between Mar and Oct 2009. The effects of LSAP of Treasury securities may have broader implications especially now that an additional $600 billion may be purchased while the maturing portfolio is reinvested in Treasury securities. The model of Vayanos and Vila (2009) permits a specification of the term structure including both short-rate and quantity independent variables. The empirical results suggest a “flow” effect of decreasing bond yields by 3.5 basis points in the days of Fed purchases and a “stock” effect of downward shift of the yield curve by 50 basis points over the period of the program with strongest effects in the 10 to 15-year segment.

II Debate on Quantitative Easing. A group of academics, market participants, political and economic analysts and former senior government officials sent a letter to Fed Chairman Ben Bernanke published on Nov 15 (http://blogs.wsj.com/economics/2010/11/15/open-letter-to-ben-bernanke/). The letter advises that quantitative easing should be reevaluated and abandoned because it is not appropriate or required under current conditions. There are risks of dollar devaluation and inflation without attaining the objective of increasing employment. The letter quotes Chairman Bernanke on the inability of the Fed to solve on its own all the problems of the economy. Promoting economic growth would require adjustment in tax, spending and regulation but not additional monetary stimulus. The letter challenges the need to increase inflation and expresses the concern that financial markets will be distorted by more LSAPs with interest rates near zero after a year of recovery from recession. Efforts by the Fed to normalize monetary policy in the future would be jeopardized.

Chairman Bernanke explained again the policy of quantitative easing on Nov 19, arguing that it is adequate in current conditions (http://www.federalreserve.gov/newsevents/speech/bernanke20101119a.htm). The effects of quantitative easing are similar to conventional monetary policy but acting more directly in lowering long-term interest rates that “support household and business spending” and proved effective because “financial conditions eased notably in anticipation of the Federal Reserve’s policy announcement” (Ibid, 6). The Fed will maintain inflation not higher than 2 percent or lower than “a bit less” of 2 percent, in what is known as a symmetric price target. Bernanke reiterated that the Fed has tools with which to increase interest rates again whenever warranted by economic conditions. Bernanke summarizes the policy dilemma as follows (Ibid, 7):

“On its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank alone. The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combined near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.”

III Global Yield Hunt. Chairman Bernanke argues that LSAP or quantitative easing affects “the yield on the acquired securities and, via substitution effects in investors’ portfolio, on a wider range of assets” (Ibid, 6). D’Amico and King (2010, 7) find that there are two conditions for quantitative easing to meaningfully reduce private interest rates: Condition 1 requires that LSAP reduce Treasury yields; and Condition 2 requires that private-sector credit interest rates depend on Treasury yields. There is apparent contradiction in these conditions. Financial assets related to private-sector credit, such as securitized bonds of mortgages, credit cards, vehicle purchases, consumer loans, bank loans, corporate debt and the like, must be close substitutes for Treasury securities acquired by quantitative easing. There is a dimension issue in that “the pool from which the Treasury LSAP program was draining included not just Treasuries themselves but at least some portion of the vast markets for mortgages, consumer credit and corporate debt—to say nothing of foreign securities—and by this standard $300 billion would appear to be an almost trivial amount” (Ibid, 7).

McKinsey & Co (2007, 32) provides measurements of a broad financial aggregate of the financial stock in 2005, including equities, bonds, loans and deposits, that was $51 trillion in the US, $38 trillion in the euro area and $20 trillion in Japan, without counting emerging markets (see Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 168-79). The near zero interest rates in 2003-2004, in an earlier fear of deflation at the Fed, caused the carry trade of borrowing at near zero in the US and taking long positions in commodities, emerging market stocks, exchange rates and financial assets that caused the world hunt for yields documented in Table 2. Vayanos and King (2009) calculate the price of risk of the short-term interest rate. The near-zero interest rate caused mispricing of this risk. Fed policy, the US housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie distorted risk/return calculations in the financial sector that resulted in excessively high risks and leverage, low liquidity and unsound credit decisions that caused the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4).

The consequences of the global hunt for yields induced by monetary and housing policy are shown in Table 2. 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, jump in the Nikkei Average by 131.2 percent between 2003 and 2007, rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates induced significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and debt securities, junk bonds 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 (2009b), 203-4, Government Intervention in Globalization (2009c), 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 percent on Jun 12, 2007, collapsing to 2.247 percent 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. Central bank policy induced the financing of nearly everything with short-dated funding at very low interest rates. When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2008 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. The combination of short-term zero interest rates, similar effects to quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.

 

Table 1, Volatility of Assets

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

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

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

 

IV Global Devaluation War. Bernanke reminds that coordinated policy actions by many countries, such as in monetary policy by central banks, were instrumental in recovering from the global recession (http://www.federalreserve.gov/newsevents/speech/bernanke20101119a.htm). National interests are diverging from those of the global economy as a whole because of the “two-speed recovery” manifested in output 8 percent below pre-crisis levels in advanced countries and only 1.5 percent below pre-crisis levels in emerging countries. Output has grown by 70 percent in China since the beginning of 2005 and by 55 percent in India. In the US, the unemployment rate has remained just below 10 percent in the past 18 months. The “two-speed” recovery requires continuing easing of monetary policy in the advanced countries while the emerging countries face tightening as inflation resurfaced. Bernanke argues that dollar fluctuation reflects risk aversion shocks with the dollar appreciating when risk aversion increases and depreciating as capital flows to risk assets again. Bernanke argues that “to a large degree, these capital flows have been driven by perceived return differentials that favor emerging markets, resulting from factors such as stronger expected growth—both in the short term and in the longer run—and higher interest rates, which reflect differences in policy settings as well as other factors” (Ibid, 9). A key factor is the expectation of further appreciation of currencies in emerging countries because appreciation reflecting fundamentals is, according to Bernanke, incomplete as a result of intervention by authorities to prevent or contain full appreciation. In this view, some countries, primarily China, have undervalued their currencies pursuing a long-term export-led growth strategy that have created global imbalances, such as a projected current account surplus in 2015 in China of 7.8 percent of GDP and a mirror projected current account deficit in the US of 3.3 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx). Monetary policy easing is required to accelerate growth in the US without which global growth would not be adequate, harming the welfare of the world as a whole. Bernanke reminds the experience with the gold standard that contributed to the Great Depression because of national policies that prevented adjustment, causing worldwide reduction of welfare (for a survey of literature on the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217). A mechanism to promote adjustment of global imbalances would be required currently to promote rebalancing of growth that can ensure prosperity for the world economy as a whole and for all countries.

There is a more convincing analytical narrative of carry trade arbitrage in world capital markets. Reserve bank credit in the Fed balance sheet on Nov 17 stood at $2.297 trillion, with a portfolio of long-term securities of $1.993 trillion, consisting of $0.806 trillion of US Treasury notes and bonds, $0.149 trillion of federal agency debt securities and $1.038 mortgage-backed securities. Reserve balances of depository institutions with the Federal Reserve stood at $0.986 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The Fed balance sheet would reach $2.9 trillion if the LSAP or quantitative easing of an extra $0.6 trillion is fully executed. The US dollar continues to be the reserve currency in the world, as Bernanke finds, in exit into dollars from risk financial assets in search of temporary haven during shocks of turbulence originating recently in European sovereign issues and doubts on restraint of growth in China because of accelerating inflation. The target of the fed funds rate, or key short-rate, in the US economy has been 0 to ¼ percent since Dec 16, 2008 (http://www.federalreserve.gov/monetarypolicy/openmarket.htm).

The carry trade of borrowing at close to the fed funds rate of 0 to ¼ percent and taking long positions in higher maturity Treasury securities is the advisable trade with an upward-sloping yield curve. It is also the mechanism of transmission of monetary policy from short-term interest rates to long-term Treasury yields. The long position in Treasury securities of higher maturities by arbitrageurs increases the prices of Treasury notes and bonds or equivalently lowers yields. Banks and other financial institutions accomplish maturity transformation by mismatching asset/liability maturities, funding with short-term deposits, paying close to the fed funds rate, and lending at higher long-term rates. Arbitrageurs face alternative allocations of financial assets to take long positions while borrowing at near-zero short rates. High returns in commodities, equities and other risk financial assets are more desirable to professional investors. The carry trade from near zero short-term interest rates to long-term Treasury securities probably occurred as suggested by the research of D’Amico and King (2010). It is likely dwarfed by the carry trade from near zero short-term rates into higher risk financial assets.

Tobin’s q variable is the ratio of the market value of capital to the reproduction cost of capital. The concept of capital extends to houses, plants, equipment, durable goods and others (Tobin 1969, 29). Money, M, in Tobin’s complete model of money, physical capital, securities and banks is “high-powered money,” consisting of currency held by the public and reserves of commercial banks at the Fed. Tobin derives the sensitivity of q to M as ∂q/∂M > 0, that is, an increase in base money, M, causes an increase in q, which is the price of the market value of capital relative to its reproduction cost. Current production and asset accumulation increase (see also Pelaez and Suzigan 1978, 120-3). According to Tobin (1969, 25-6): “the essential characteristic is that the interest on money is exogenously fixed by law or convention, while the rate of return on securities is endogenous, market determined. If the roles of the two assets in this respect were reversed, so also would be the economic impacts of changing their supplies. The way for the central bank to achieve an expansionary monetary impact would be to buy money with securities!” The effect of an increase in the supply of an asset with non-fixed rate is a change in its own rate of return. When the rate of return is determined exogenously, as in the case of outside money, the adjustment is by changes in the rates of return of other assets or equivalently their prices. Large scale purchases of securities, or quantitative easing, inject high-powered money or bank reserves in exchange for withdrawal of the supply of duration-rich bonds, reducing their rates of return or increasing their prices. The intended effect is to lower the reproduction cost of capital, or long-term borrowing costs, such that Tobin’s q or its expectation increases, augmenting the demand for physical assets such as plant, equipment, houses, durables goods and the like.

The lack of pass-through from quantitative easing to private-sector investment, consumption and hiring is not insufficient monetary stimulus but the uncertainties created by legislative restructuring, regulation, persistent unemployment, anticipations of large increases in taxes and the lack of belief that the Fed can bloat its balance sheet to $3 trillion without major future increases in interest rates. Lowering short-term interest rates to near zero while injecting $3 trillion of base money does not create growth stimulus but rather excites carry trades on a world financial stock of some $100 trillion. The Fed has to rethink the risks of creating distortions of financial markets, in particular the illusion of near zero price of risk.

The anticipation of another LSAP program or quantitative easing gained traction after the speech of Chairman Bernanke on Aug 27 (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm). Table 2 is updated in this blog every week to track the financial turbulence created by events such as sovereign risk doubts in Europe and recurring inflation and growth fears in China. The last column provides what daily market participants have been observing that the dollar has depreciated by 14.7 percent from its high on Jun 7, 2010, while all risk financial assets have gained by high double digit percentages in a few months. The major effect of unconventional monetary policy or combination of near-zero short-term interest rates with injection of trillions of dollars of base money is carry trade into risk financial assets without much repercussion in increasing investment, consumption and hiring. Unconventional monetary policy has created an illusory put on financial wealth that creates professional carry trade by realizing profits rapidly instead of believing in long-term trades as in the earlier incarnation after 2003. Who wants to be long when the Federal Open Market Committee (FOMC) evaluates that inflation is accelerating and rate increases are desired? Expectations cause bond price debacles now and not on the date of the announcement of tight monetary policy.

 

Table 2, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 11/19	∆% Week 11/19	∆% T to 11/19
DJIA	4/26/10	7/2/10	-13.6	-0.02	0.1	15.6
S&P 500	4/23/10	7/20/10	-16.0	-1.4	0.04	17.3
NYSE Finance	4/15/10	7/2/10	-20.3	-2.8	-0.3	19.1
Dow Global	4/15/10	7/2/10	-18.4	-2.7	0.1	19.2
Asia Pacific	4/15/10	7/2/10	-12.5	2.9	-0.5	17.6
Japan Nikkei Average	4/05/10	8/31/10	-22.5	-12.0	3.1	13.6
China Shanghai	4/15/10	7/16/10	-24.7	-8.7	-3.2	19.2
STOXX 50	4/15/10	7/2/10	-15.3	-5.5	-0.7	11.6
DAX	4/26/10	5/25/10	-10.5	4.3	1.7	16.5
Dollar Euro	11/25 2009	6/7 2010	21.2	9.5	0.1	-14.7
DJ UBS Comm.	1/6/10	7/2/10	-14.5	-0.01	-1.9	16.9
10-Year Tre.	4/5/10	4/6/10	3.986	2.877

T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)

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

 

Advice to the Bank of Japan by Bernanke before joining the Fed emphasizes the needs to devalue to escape deflation (http://www.iie.com/publications/chapters_preview/319/7iie289X.pdf 161): “The BOJ could probably undertake yen depreciation unilaterally; because the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its mandated objective.” Is depreciation of the dollar the best available tool currently for achieving the dual mandate of higher inflation and lower unemployment? Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):

“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the US deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”

Should the US devalue the dollar following the example of Roosevelt?

Fed policy is seeking, deliberately or as a side effect, what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher, 1933, 350). The Fed has created not only high volatility of assets but also what many countries are regarding as a competitive devaluation similar to those criticized by Nurkse (1944). There is increasing unrest within the G20 and worldwide about the appreciation of exchange rates of most countries while the dollar devalues, as shown in Table 3. Global coordination of policies with free riders in an institution of diverse interests such as the G20 is unlikely. Distortions of financial markets in the US and worldwide depend only on more sober evaluation of risks of unconventional policies at a body without free riders, the FOMC.

 

Table 3, Exchange Rates

	Peak	Trough	∆% P/T	Nov 19 2010	∆% T Nov 19	∆% P Nov 19
EUR USD	7/15 2008	6/7 2010		11/19 2010
Rate	1.59	1.192		1.367
∆%			-33.4		12.8	-16.3
JPY USD	8/18 2008	9/15 2010		11/19   2010
Rate	110.19	83.07		83.54
∆%			24.6		-0.6	-24.2
CHF USD	11/21 2008	12/8 2009		10/22 2010
Rate	1.225	1.025		0.999
∆%			16.3		2.5	18.5
USD GBP	7/15 2008	1/2/ 2009		11/19 2010
Rate	2.006	1.388		1.598
∆%			-44.5		13.2	-25.5
USD AUD	7/15 2008	10/27 2008		11/19 2010
Rate	0.979	0.601		0.986
∆%			-62.9		39.0	0.7
ZAR USD	10/22 2008	8/15 2010		11/19 2010
Rate	11.578	7.238		6.986
∆%			37.5		3.4	39.7
SGD USD	3/3 2009	8/9 2010		11/19 2010
Rate	1.553	1.348		1.295
∆%			13.2		3.9	16.6
HKD USD	8/15 2008	12/14 2009		11/19 2010
Rate	7.813	7.752		7.764
∆%			0.8		0	0.8
BRL USD	12/5 2008	4/30 2010		11/19 2010
Rate	2.43	1.737		1.716
∆%			28.5		1.2	29.4
CZK USD	2/13 2009	8/6 2010		10/22 2010
Rate	22.19	18.693		18.038
∆%			15.7		3.5	18.7
SEK USD	3/4 2009	8/9 2010		11/19 2010
Rate	9.313	7.108		6.857
∆%			23.7		3.5	26.3

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough

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

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

 

V Economic Indicators. The economy is expanding moderately without consumer price inflation but higher producer price inflation while employment markets remain weak. Consumer price inflation has risen in the euro area to an annual rate of 1.9 percent in Oct 2010 relative to a negative annual rate of 0.1 percent in Oct 2009. Advanced US retail and food services sales seasonally adjusted (SA) rose 1.2 percent in Oct relative to Sep and 7.3 percent relative to Oct 2009. In the quarter Aug to Oct 2010 US retail and food services sales rose by 6.3 percent relative to the same quarter in 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf). Manufacturers’ distributive trade sales and shipments SA rose 0.5 percent in Sep relative to Aug and 8.9 percent relative to Sep 2009 while manufacturers’ and trade inventories rose by 0.9 percent and 6.3 percent relative to a year earlier (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf). Housing starts in Oct were at a SA annual rate of 519,000 or 11.7 percent below the revised Sep estimate and 1.9 percent below the rate of 529,000 in Oct 2009. Housing permits were higher by 0.5 percent in Oct relative to Sep and 4.5 percent below the rate in Oct 2009 (http://www.census.gov/const/newresconst.pdf). Housing starts not seasonally adjusted (NSA) were 508,000 in Jan-Oct 2010 (http://www.census.gov/const/newresconst.pdf Table 1, 2) or a decline by 72.2 percent relative to 1,825,200 in Jan-Oct 2005 (http://www.census.gov/const/newresconst_200510.pdf Table 1, 2). Total industrial production in the US was unchanged in Oct after declining by 0.2 percent in Sep but manufacturing output rose by 0.5 percent in Oct after falling by 0.1 percent in Sep. Total industry capacity utilization was unchanged at 74.8 percent in Oct, 6.6 percentage points above the low in Jun 2009 but 5.8 percentage points lower than the average from 1972 to 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm). The Empire State Manufacturing Survey of the New York Fed for Nov was disappointing with a decline of the general business conditions index by 27, reaching -11.1. The decline in the new orders index was atrocious, by 37 points to -24.4 (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html). The Philadelphia Fed business outlook survey was extremely good with the index of current activity jumping from 1.0 in Oct to 22.5 in Nov, for the highest reading since Dec 2009. Indexes of new orders and shipments also rose by 15 points (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2010/bos1110.pdf). Initial claims SA were 439,000 in the week ending on Nov 12 for an increase of 2.000 from the previous week’s revised estimate of 437,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm). The consumer price index rose 0.2 percent SA from Oct and 1.2 percent NSA relative to Oct 2009. The core index, excluding food and energy, SA, was unchanged in Oct for the third consecutive month and increased by 0.6 percent relative to a year earlier (http://www.bls.gov/news.release/pdf/cpi.pdf). The producer price index SA rose 0.4 percent in Oct for three consecutive monthly increases by 0.4 percent in Aug to Oct. The index NSA rose by 4.3 percent in the 12 months ending in Oct 2010 (http://www.bls.gov/news.release/pdf/ppi.pdf). Annual inflation in the euro area was 1.9 percent in Oct 2010, higher than 1.8 percent in Sep and minus 0.1 percent in Oct 2009 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16112010-AP/EN/2-16112010-AP-EN.PDF).

VI Interest Rates. The yield curve continues to move upwardly. The yield of the 10-year Treasury was 2.88 percent on Nov 19, higher than 2.76 percent a week ago and 2.54 percent a month ago. The 10-year government bond of Germany was 2.70 percent for negative spread relative to the comparable Treasury of 17 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1290359527848). On Nov 19, the US Treasury with coupon of 2.63 maturing in 11/20 traded at price of 97.86 or equivalent yield of 2.87 percent (http://markets.ft.com/markets/bonds.asp?ftauth=1290359527848). The same bond would trade at price of 100.7896 or yield of 2.54 percent a month earlier for a loss of 2.9 percent in one month, at price of 88.9135 or yield of 3.986 percent traded on Apr 4, 2010, for loss of 9.1 percent, and at price of 79.5131 or yield of 5.297 percent traded on Jul 12, 2007, for a loss of 18.7 percent. The eventual back up of short-term rates and yields undermines exit strategies of quantitative easing because of the pain caused on investors and the balance sheet of the Fed.

VII Conclusion. The jump of euro zone annual inflation from minus 0.1 percent in Oct 2009 to 1.9 percent in Oct 2010 and of consumer price inflation in China to 4.4 percent illustrate the risks of a symmetric inflation target that may attempt to raise inflation to 1.99 percent but may overshoot to 4 percent. Who wants to own risk financial assets in that overshooting? Unconventional monetary policy encourages high-risk carry trades that could cause another financial crisis if unwound suddenly but cannot jump-start investment and consumption decisions that have been shocked by legislative restructurings, regulation and fears of taxation and increases in interest rates.

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©Carlos M. Pelaez, 2010