Less than six months ago, Europe topped everyone’s Wall of Worry, and seemed set to fall into a financial abyss. The Spanish 10-year government bond yield spiked up to a peak of 7.61% on July 24 of last year (Fig. 8). It has subsequently dropped to 5.10% as of yesterday.

Europe was saved not by a financial bazooka, but rather by ECB President Mario Draghi’s stealth bomber. At the end of July last year, he pledged to do whatever it takes to save the euro. So far, just that promise alone has been enough not only to avert disaster but also to ameliorate financial conditions in the euro zone, as evidenced by falling bond yields and rising stock prices. The euro zone's ZEW economic-expectations index, a gauge of investor sentiment, rose more sharply than expected in January, by 23.6 points to stand at 31.2, reaching the highest level since May 2010 (Fig. 9).

While investor confidence may be improving, there’s still plenty to worry about in Europe. Yesterday, Charles Dallara, who heads the Institute of International Finance (IIF), a Washington-based bank lobby group, told CNBC that Cyprus, rather than Spain, Italy, or Greece, poses the biggest sovereign risk to the euro zone. That’s right: tiny Cyprus.

(Based on an excerpt from YRI Morning Briefing)

At the end of last year, Japan’s new Prime Minister, Shinzo Abe, called for the BOJ to drastically loosen its monetary policy and to target 2% inflation--even before the start of official campaigning for the December 16 lower house election in which his Liberal Democratic Party won a landslide victory. Today, Kyodo news agency reported that Abe’s government and the BOJ will state an inflation target of 2% in their planned joint statement, to be released after the details are discussed at the BOJ's Policy Board meeting January 21-22.

Of course, the BOJ has been stepping on the monetary accelerator for quite some time. Reserve balances rose to a record 39.8 trillion yen during December of last year, up 142% during the latest round of quantitative easing over the last two years (Fig. 8). Abe’s goal seems to be to weaken the yen, thereby boosting both Japan’s exports and inflation. So far, he has succeeded in bringing down the yen relative to the dollar by 8.2% since December 4 (Fig. 9). January 10, 2013

(Based on an excerpt from YRI Morning Briefing)

At his press conference today, ECB President Mario Draghi declared:

Later in 2013 economic activity should gradually recover. In particular, our accommodative monetary policy stance, together with significantly improved financial market confidence and reduced fragmentation, should work its way through to the economy, and global demand should strengthen.

Needless to say, Draghi hedged his bets several times in other remarks he made during the press conference. After all, just last month, the ECB slashed its 2013 economic outlook for the euro zone to a contraction of 0.3% from a growth of 0.5%. There have been plenty of grim statistics recently coming out of the 17-member euro zone. The unemployment rate rose in November to 11.8% (Fig. 1). Industrial production fell 0.3% during November and 3.6% the past three months (Fig. 2). Even Germany’s export-led economy succumbed to the weakness of its neighbors during the Q4-2012, when real GDP contracted by 0.5% based on a preliminary estimate from annual data.

(Based on an excerpt from YRI Morning Briefing)

When the US jobless rate does fall to 6.5%, Fed officials are likely to regret that they didn't follow the lead of ECB President Mario Draghi. As David Wessel observed in his WSJ column today, in late July last year, Draghi “defused an intensifying crisis of confidence in the euro with two sentences scribbled in the margins of an otherwise routine speech. ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,’ he said. ‘And believe me, it will be enough.’ That may prove to be the most successful central-bank verbal intervention in history.” Wessel noted:

A few weeks later, the ECB pledged to buy bonds of governments shunned by markets if those governments made belt-tightening commitments accepted by fellow euro-zone countries. No government has sought that help so the ECB hasn't spent a single euro. Yet global anxiety about an imminent euro crisis has abated.

That’s been reflected in a dramatic drop in the 10-year yields on the bonds of Spain and Italy (Fig. 3). The imbalances among the members of the ECB's TARGET2 payments system have stopped deteriorating in recent months (Fig. 4). The size of the ECB's balance sheet has actually declined slightly by €146 billion since June 29 of last year through January 4 (Fig. 5). Another positive sign for the euro zone was the announcement last Thursday that not one bank has used the ECB’s emergency overnight marginal lending facility since August 2011. Banks are facing less stress, and interbank lending is rising. The FTSE Eurofirst 300 Banks Euro Index is up 8.1% since the start of the year and 44.3% since Draghi’s speech at the end of July (Fig. 6).

Contributing to the powerful rally in bank stocks was the proposal of the Council of the European Union for a Single Supervisory Mechanism (SSM) for banks in the euro zone. The SSM is the first step in the formation of the European Banking Union. It grants the ECB direct powers to supervise and regulate the euro zone banks, especially the large ones. Another boost for the bank stocks was last week’s easing of liquidity rules by the Basel Committee on Banking Supervision, as I discussed on January 2. Confidence in the future integrity of the euro zone is also reflected in the euro, which is up from last year’s low of 1.21 on July 24 to 1.33 this morning (Fig. 7).

(Based on an excerpt from YRI Morning Briefing)

The minutes of the December 11-12 FOMC meeting were released today. The members of the FOMC decided to add a new policy goal. They declared that their ultra-easy monetary policy would remain in force until the unemployment rate falls to 6.5%, as long as inflation doesn’t rise above 2.5%.

According to the minutes of the meeting, instead of “calendar-date forward guidance,” the Fed now will focus on “quantitative thresholds,” which “could help the public more readily understand how the likely timing of an eventual increase in the federal funds rate would shift in response to unanticipated changes in economic conditions and the outlook.”

The FOMC also announced on December 12 that the Fed will buy $45 billion a month in long-term US Treasuries starting January, with no limit on the total amount and no termination date. That adds up to $540 billion a year, though Fed Chairman Ben Bernanke said the latest version of QE would be “flexible.”

Of course, that’s in addition to the $40 billion on mortgage-backed securities per month that the Fed committed to start buying back at the September 12-13 meeting of the FOMC under QE3. The latest program, let’s call it "QE4," replaces Operation Twist, which expired at the end of last year. Under that program, the Fed swapped about $45 billion in short-term Treasuries for long-term Treasuries.

(Based on an excerpt from YRI Morning Briefing)

If Fed officials aren’t having second thoughts about QE and are about to proceed full-bore, maybe they should stop to reconsider. That seems to be the advice from the Bank for International Settlements (BIS). Today’s WSJ includes an article co-authored by Jon Hilsenrath, the newspaper’s plugged-in Fed watcher, titled, “Inside the Risky Bets of Central Banks.”

According to the article:

“Vocal critics include economists at the BIS, an international body based here that is increasingly an important staging ground for talks about the post crisis financial landscape. They say central banks, seeking faster growth, are stretched too thin. ‘Central banks cannot solve structural problems in the economy,’ said Stephen Cecchetti, who runs the BIS monetary department. ‘We've been saying this for years, and it's getting tiresome.’”

(Based on an excerpt from YRI Morning Briefing)

Today’s FOMC statement announced today that the Fed will buy $45 billion a month in long-term US Treasuries starting January with no limit on the total amount and no termination date. That adds up to $540 billion a year, though Fed Chairman Ben Bernanke said the latest version of QE would be “flexible.” The coupon income earned on those securities is sent back to the Treasury, less the 0.25% that the Fed will pay banks for the reserves they will accumulate as a result of this latest expansion of the Fed’s balance sheet.

Of course, that’s in addition to the $40 billion on mortgage-backed securities per month that the Fed committed to start buying back at the September 12-13 meeting of the FOMC under QE3. The latest program--let’s call it "QE4"--replaces Operation Twist, which expires at the end of this year. Under that program, the Fed swapped about $45 billion in short-term Treasuries for long-term Treasuries.

The FOMC statement, which was probably the longest on record, committed the Fed to keeping the federal funds rate near zero until the unemployment rate falls below 6.5%. Of course, tying the federal funds rate to the jobless rate wasn’t a surprise since the Fed now tends to leak its policy plans several weeks before they are implemented. FOMC meetings are now part of an ongoing (i.e., seemingly never-ending) and open forum discussing the next iteration of QE. Transparency is a wonderful idea, but it may be too much of a good thing, in my opinion. That’s because it perpetuates the myth that monetary policy is all-powerful and monetary policymakers are all-knowing.

Can monetary policy and its administrators really fix all of our problems by buying so much of our debts in such an open-ended fashion? I have my doubts. Apparently, Fed officials don’t have any doubts at all since they never even ask the question, with the exception of a couple of the usual dissenters on the FOMC. However, Mr. Bernanke did admit today that the “Fed's ability to ease further isn't unlimited.” He should have said that it is actually very limited.

(Based on an excerpt from YRI Morning Briefing)

Jon Hilsenrath and Brian Blackstone in an article in today’s WSJ titled, “Inside the Risky Bets of Central Banks,” describe how the major central bankers of the world meet every two months on Sunday evenings to exchange views over a fine dinner on the 18th floor of the BIS’s cylindrical tower in Basel, Switzerland, overlooking the Rhine. The talks are secret. No transcripts or minutes are kept:

Over Sunday dinners in Basel, which often stretch to three hours, they now talk of pressing, real-world problems with authority. The meals are part of two-day meetings held six times a year at the BIS. Dinner guests include leaders of the Fed, ECB, Bank of England and Bank of Japan, as well as central bankers from India, China, Mexico, Brazil and a few other countries.

The article notes that several members of the “clique” of central bankers are macroeconomists who received their PhDs from MIT. They emerged from their studies “with a belief that government could help to smooth out economic downturns. Central banks play a particularly important role in this view, not only by setting interest rates but also by influencing public expectations through carefully worded statements.” Here is a brief background on the BIS from the article:

The role of the Bank for International Settlements has broadened since it was formed in 1930 to handle reparation payments imposed on Germany after World War I. In the 1970s, it became the center of discussions on bank capital rules. In the 1990s, it became the meeting place for central bankers to talk about the global economy.

In the past, stock prices tended to rally on days that Fed Vice Chair Janet Yellen spoke in public forums about monetary policy. That’s because she is a leading dove on the FOMC and has been an unabashed advocate of quantitative easing. Stock prices drifted lower today even though Yellen spoke again, and once again advocated super-easy monetary policy. In her speech, she endorsed proposals by some of her colleagues to tie monetary policy to specific targets for economic variables, particularly the unemployment rate:

Going further, the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range. For example, Charles Evans, president of the Chicago Fed, suggests that the FOMC should commit to hold the federal funds rate in its current low range at least until unemployment has declined below 7 percent, provided that inflation over the medium term remains below 3 percent. Narayana Kocherlakota, president of the Minneapolis Fed, suggests thresholds of 5.5 percent for unemployment and 2.25 percent for the medium-term inflation outlook. Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.