Currency War: It won´t happen

Kocherlakota writes “Bring On the Currency War”:

The U.S. government seems concerned about what will happen if other big nations push down the value of their currencies against the dollar. Actually, it could be good for the global economy.

Ahead of this week’s meeting of finance ministers from the Group of Seven developed nations, Treasury Secretary Jacob Lew has warned that the U.S.’s counterparts — the three largest euro-area nations plus Canada, Japan and the U.K. — might undermine global growth if they engage in policies that cause their currencies to depreciate against the dollar. In my view, his concerns are misplaced.

That´s an obvious point, just look what happened to the countries that devalued (delinked from gold) in the early 1930s, but:

  1. The US has selectively (and Japan in the 1980s is the “representative” example) over time “warned” countries about letting their currencies depreciate against the dollar.
  2. The US position as a “monetary superpower” indicates that it dictates to a large extent the world´s currency “configuration”.

The charts below show, through some examples, how US monetary policy has ‘shaped’ the broad dollar index over time.

Currency War_1

Whenever US monetary policy is tightened (measured by an enlargement of the NGDP ‘gap’ relative to the “Great Moderation” trend, or a narrowing if coming from above), the dollar appreciates relative to a broad basket of currencies. If US monetary policy is “eased” (measured by the NGDP ‘gap’ narrowing, or enlarging if from above trend), the dollar depreciates.

Now, Japan is in the news. Actually, it´s described as “Elephant in the Room at This Week’s G-7 Is Sure to Be the Yen”:

When finance chiefs and central bankers from the Group of Seven countries gather this week at a hot springs resort in northern Japan, the official agenda has them focusing on ways to revitalize global growth and crack down on cross-border tax evasion.

Left off the discussion list is one of the most pressing concerns for the host nation: how to counter a 10 percent surge in the yen that’s squeezing an economy unable to escape a cycle of expansion and contraction. Cries for sympathy are likely to fall on deaf ears, given the tailwind corporate Japan got in the first years of the Abe administration from the currency’s sharp depreciation.

As the chart indicates, Abenomics was successful from inception because the expansionary monetary policy undertaken by Abe/Kuroda managed to depreciate the Yen by more than the Broad Dollar Index.

Currency War_2

But more recently, while Japan´s monetary policy has faltered, the US has relented on “tightening” (although this seems to have changed as indicated by the Minutes released yesterday). That was a “deadly” combination from Japan´s perspective.

In short, Japan did it to itself! If the US “tightening bias” is resumed and Japanese monetary policy makers rethink their strategy, the Yen will again depreciate. If the FOMC “lightens-up” again, as it did earlier this year, Japan´s monetary policy will have to be even “braver”!

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“Flipped out”

That´s what happened to economists at Deutsche Bank.

Before the FOMC´s rate decision:

According to David Folkerts-Landau, Chief Economist at Deutsche Bank, the central bank of the United States should start rising rates on Thursday considering that the longer it waits, the higher the risks.

Key quotes:

“We believe the Federal Reserve should press the button when it meets this week – although there is a good chance it won’t. Many economists, on the other hand, including those at the IMF and World Bank, are literally begging it not to.”

“Inflation is not a problem now, but zero rates are a recipe for excess inflation down the road. The longer the wait, the higher the risks. If inflation does break out, the Fed will be forced to tighten aggressively, causing far more damage to the US and global economy than starting now. The Fed should be aware of that.”

Delay carries other risks too. Rock bottom policy rates and repressed longer term market rates create distortions in resource allocation. Private savings are depressed while financial risk taking is encouraged for a generation of investors that view extreme lows in interest rates and money printing (quantitative easing) as normal. Some might even expect the Fed to support the markets if need be.”

It is never a good time to raise rates, as it is never a good time to go to the dentist. But delaying both for too long has consequences. The Fed needs to start normalising policy now.

And after the no hike decision:

Deutsche Bank

HT Joseph Weisenthal

Phillips Curve, the FOMC´s Lullaby

Just two days ago, I had something to say on the Fed and the Phillips Curve. Today, Tim Duy concludes, after a lengthy discussion of all the wrong arguments for a rate rise in September:

But if they take that risk, it won’t be because they want to send the markets a message that they are in charge, or that the “Greenspan put” needs to be put to rest, or that they can’t been seen as cowering to the markets, or that they need to stay the course because they already signaled a rate hike, or because foreign central bankers are demanding the Fed hike rates, or because they need to build ammo for the next crisis, or any other reason that comes from barstool moralizing after one too many. If they hike rates it will be for one simple reason: The recent market turmoil does little to shake their faith in the Phillips Curve. That would be the heart of their argument. And if you are arguing for September, that should be the heart of your argument as well.

Phillips Curve LullabyNo matter all the evidence against “Phillips Curvism” that has accumulated over the decades, the FOMC still finds “comfort” in it!

Where does the FOMC get these ideas?

We all know that Janet & Friends are trigger-happy, dying for a plausible excuse to begin the so-called “rate lift-off”. We also know that the labor market is the “star of the play”, being groomed to be the signal that will open “heaven´s gate”!

The “grooming” has changed “styles”. Initially it was 6 to 6.5 “inches” and over the past couple of years has been “trimmed” down to 5 to 5.2 “inches”.

How do they know that´s the “in style”? They don´t, really. They thought it was also “in” almost 20 years ago when Janet was not yet the Head-dresser. In 1997, together with like-minded “fashion guru” Laurence Meyer, she was advising Greenspan that he should raise rates because unemployment was too low! Larry described the “hair style” in detail in April 1997. You can easily see that the playbook today is the exact same:

I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process.

There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets.

Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool(!) in the macroeconomists’ tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate. But, it should also be noted that monetary policy has responded appropriately to this surprise. That is, monetary policy has been careful not to be tied rigidly to a constant estimate of NAIRU. Instead, in my view, monetary policymakers have, in effect, implicitly adjusted their estimate of NAIRU to reflect the incoming data; this might be viewed as following a procedure like the time-varying parameter estimation technique applied by Robert Gordon and others.

We were all very lucky that Greenspan didn´t “buy” their suggestion at the time. Unfortunately, now Janet is the Head-dresser, and has enticed others who appear to be like-minded, or that have come on board simply because that´s the best bet available to “open heaven´s gate”.

Look at their “drawing-board”:

Janet´s Salon_1

You can easily understand why the first “style” was 6 to 6.5 “inches”. That´s the unemployment point below which wages began to rise. However, that was during the years before the Fed messed-up, when it strived to keep nominal spending on an “even keel”.

When it did mess up, although unemployment rose, wage growth didn´t budge for quite some time (the flat part of the blue line). That´s evidence for wage stickiness!

When wage growth finally dropped, it´s growth remained about the same even though unemployment was falling. As required by the “playbook”, Janet is adjusting (“trimming”) her estimate of NAIRU to reflect incoming data.

Now we are at the April 2015 point (red). Janet´s view is that if unemployment crosses the “Rubicon”, wages will “take-off”. How fast they have no idea. I do.

Given the level and the rate at which nominal spending has been growing (4% and likely falling), wage growth will likely increase very little.

Why all the anxiety about the impact of wage growth on inflation? It´s a fixed and longstanding image in Janet´s head. Ordinary mortals’ can´t see it!

Janet´s Salon_2

What will happen? More likely they´ll keep “trimming” the NAIRU estimate “to reflect incoming data”.

Now, Bernanke obfuscates!

In his latest post Bernanke takes on the WSJ editorial “The Slow-Growth Fed?”:

The unemployment rate is a better indicator of cyclical conditions than the economic growth rate, and the relatively rapid decline in unemployment in recent years shows that the critical objective of putting people back to work is being met. Growth in output has been slow, despite solid job creation, because productivity gains have been slowperhaps as the result of the financial crisis, which hammered new business formation and investment in research and development, perhaps for other reasons. But nobody claims that monetary policy can do much about productivity growth. Where it can be helpful is in supporting the return to full employment, and there the record has been reasonably good. Indeed, it seems clear that the Fed’s aggressive actions are an important reason that job creation in the United States has outstripped that of other industrial countries by a wide margin.

The WSJ also argues that, because monetary policy has not been a panacea for our economic troubles, we should stop using it. I agree that monetary policy is no panacea, and as Fed chairman I frequently said so. With short-term interest rates pinned near zero, monetary policy is not as powerful or as predictable as at other times. But the right inference is not that we should stop using monetary policy, but rather that we should bring to bear other policy tools as well. I am waiting for the WSJ to argue for a well-structured program of public infrastructure development, which would support growth in the near term by creating jobs and in the longer term by making our economy more productive. We shouldn’t be giving up on monetary policy, which for the past few years has been pretty much the only game in town as far as economic policy goes. Instead, we should be looking for a better balance between monetary and other growth-promoting policies, including fiscal policy.

In “The Fed´s Lullaby”, I said that the Fed was happy with satisfying “the other mandate”! Note that BB doesn´t mention inflation!

“Growth in output has been slow, despite solid job creation, because productivity gains have been slowperhaps as the result of the financial crisis”. Not so subtly he says “it was not my (the Fed´s) fault. However, that argument doesn´t stand up to scrutiny.

The panel below puts productivity and unemployment side by side for the following periods: 1983.I – 1995.1; 1995.II – 2003.IV; 2004.I – 2014.IV.

Note that productivity growth rises when unemployment increases (as expected). That´s not so evident for 1995.2 to 2003.IV because throughout this time productivity was booming. Nevertheless, there´s a big difference in productivity growth between 1995.II – 2000.IV at 2.5% and 2001.I – 2003.IV, when unemployment was on the rise, at 3.6%.

BB Obfuscates_1

Note also that between late 1992 and early 1995 (top row) productivity growth was nonexistent, and lower than what has been observed since early 2011, nevertheless real GDP remained close to trend (see RGDP & Trend chart).

What Bernanke still fails to address after having blogged for one month is WHY the Fed, under his command, allowed a depression to materialize. If he had only acknowledged early on after 2008 the mistake of letting nominal spending (NGDP) tank he would have “guessed” the solution. Long-term real growth is not the province of the Fed. The best the Fed can do to allow the economy to “flourish” at the highest level is to maintain nominal stability, a task in which it failed miserably. It´s no good and no use now calling for “a better balance between monetary and other growth promoting policies”, whatever that means.

BB Obfuscates_2

As George Selgin wrote today, it may be late in the game to regain much of what was lost because:

You see, unlike some economists, although I’m happy to allow that an increase in the Fed’s nominal size, which is roughly equivalent to a like increase in the monetary base, is neutral in the long run, I don’t accept the doctrine of the neutrality of increases in the Fed’s relative size.  I believe that Fed-based financial intermediation is a lousy substitute for private sector intermediation, and that as it takes over, economic growth suffers.  The takeover is, in other words, financially repressive.

Which means that the level of spending is, after all, not the only relevant indicator of whether the Fed is or isn’t going in the right direction.  Another is the real size of the Fed’s balance sheet relative to that of the economy as a whole, which measures the extent to which our central bank is commandeering savings that might otherwise be more productively employed.  Other things equal, the smaller that ratio, the better.

And there, folks, is the rub.  If you want to know the real dilemma facing the FOMC, forget about the CPI, oil prices, and last quarter’s weather.  Here’s the real McCoy: NGDP growth is too low.  But the Fed is too darn big.

Yes, Bernanke, by your misguided policies you´ve made the Fed too big AND mostly useless!

What a difference one month makes in the views of John Williams

On March 23 it was “up, up and away”:

“Things are looking better–in fact, they’re looking downright good,” the official said in a speech to be delivered to an audience in Sydney and Melbourne via video.

Given how much the economy has improved and is likely to continue to gain ground, “I think that by mid-year it will be the time to have a discussion about starting to raise rates,” Mr. Williams said.

On April 20 another FOMCer is not so sure any longer:

Hopefully” the economic data will “support a decision to lift off later this year,” Mr. Dudley said, in reference to taking the first move to push interest rates off of their current near-zero levels.

But, “because the economic outlook is uncertain, I can’t tell you when normalization will occur,” he said. When it comes to rate rises, “the timing is data dependent. We will have to see what unfolds,” he said.

And on goes the FOMC, directionless!

PS Could have titled this post as “Random Walks at the FOMC”

Ben´s blogging has generated more heat than light so far

So far the former and wannabe Fed Chairmen crossed swords over the irrelevant and misguided concepts of GSG & SS. (I´ve given those things some thought here and here).

With big dogs growling at each other, Krugman simply could not help butting in (really to show he had been there before). And for very obvious reasons he ends up giving each a “bone”:

There’s been a really interesting back and forth between Ben Bernanke and Larry Summers over secular stagnation. I agree with most of what both have to say. But there’s a substantive difference in views, in which Bernanke correctly, I’d argue, criticizes Summers for insufficient attention to international capital flows – but then argues that once you do allow for international capital movement it obviates many of the secular stagnation concerns, which I believe is wrong.

As it happens, the role of capital flows in the logic of liquidity traps is an issue I tackled right at the beginning, back in 1998; and I’ve been trying to work out how it plays into the discussion of secular stagnation, which is basically the claim that countries can face very persistent, quasi-permanent liquidity traps. So I think I may have something useful to add here.

Start with Bernanke’s critique of Summers. The most persuasive evidence that the US may face secular stagnation comes from the lackluster recovery of 2001-2007. We experienced the mother of all housing bubbles, fueled by a huge, unsustainable rise in household debt – yet all we got was a fairly unimpressive expansion by historical standards, and little if any inflationary overheating. This would seem to point to fundamental weakness in private demand. But one reason for the sluggish growth in demand for U.S.-produced goods and services was a huge trade deficit, the counterpart of huge reserve accumulation in China and other emerging markets. So Bernanke argues that what Summers sees as evidence of secular stagnation actually reflects the global savings glut.

The 2001-2007 recovery is not evidence, let alone persuasive, of secular stagnation. Krugman is on the right track when he says this “would seem to point to fundamental weakness in private demand.” But at the last minute he veers off in the wrong direction by making the fundamental mistake of “reasoning from a (GDP) component change” (a close cousin of “reasoning from a price change”).

A huge trade deficit somewhere is always the counterpart of a huge reserve accumulation elsewhere. The important reasoning is to discover why this came about when it did and if it might be related to other stuff (such as the US housing boom). For an explanation, read here (below the fold).

If “movements in GDP components” had not distracted Krugman he would probably have found out that the post 2001 recession recovery was slow up to mid-2003, being due to the tightness of monetary policy, despite fast falling interest rates.

When the Fed made monetary policy more expansionary in mid-2003 by adopting forward guidance (FG), despite interest rates remaining put, the recovery took off, with nominal spending rising back to trend. Interestingly, many see this strong growth in nominal spending as reflecting a “loose/easy” monetary policy. Grave mistake. Faster NGDP growth was necessary to take nominal spending to trend. Monetary policy was “just right”!

At that point, unemployment begins to fall and core inflation rise towards the “target” level.

Bernanke had the bad luck to take over almost concomitantly with the peak in house prices. Initially house prices fell only a little, increasing the speed of fall after financial troubles erupted in some important mortgage finance companies.

Unfortunately, the Fed was exceedingly focused on headline inflation, fearful of the oil price rise. Interest rates remained elevated, only being reduced after August 2007, when three funds from Bank Paribas folded. However, the pace of interest rate reduction was deemed too slow by the market. In the December 11 2007 FOMC Meeting, for example, the markets were negatively surprised by the paltry 25 basis points reduction in the FF rate. On that day the S&P fell 2.5% and the 10 year TB yield dropped 17 basis points.

Rate reductions stopped in April 2008 (only resuming in October, after Lehman!). In the June 2008 FOMC, it came out that the next move in rates was likely up!

With all this monetary tightening, nominal spending decelerated and then fell at an increasing rate. One casualty was Lehman! The rest is history!

Give me a break and let´s stop talking “Gluts” and “Stagnations”. Bernanke would do much better if he starts shinning some light and blog about how monetary policy could really have been much better! Will he be daring?

The charts illustrate the story

Gluts & Stagnations_1

Gluts & Stagnations_2

Gluts & Stagnations_3

 

Matt O´Brien thinks it´s the opposite in “Larry Summers and Ben Bernanke are having the most important blog fight ever

Crap from “FOMC´ers”

Scott Sumner is his diplomatic self:

Stanley Fischer is one of the world’s most thoughtful monetary economists. And now he is also vice chairman of the Federal Reserve Board. He recently gave a speech on monetary policy, which as you’d expect contained many wise observations. However I was also deeply troubled by some of his comments.

And than proceeds to “trash” him:

However, I was also deeply troubled by some of his comments.

One “troubling” comment:

For over six years, the federal funds rate has, effectively, been zero. However it is widely expected that the rate will lift off before the end of this year, as the normalization of monetary policy gets underway.

The approach of liftoff reflects the significant progress we have made toward our objectives of maximum employment and price stability. The extraordinary monetary policy accommodation that the Federal Reserve has undertaken in response to the crisis has contributed importantly to the economic recovery, though the recovery has taken longer than we expected. The unemployment rate, at 5.5 percent in February, is nearing estimates of its natural rate, and we expect that inflation will gradually rise toward the Fed’s target of 2 percent. Beginning the normalization of policy will be a significant step toward the restoration of the economy’s normal dynamics, allowing monetary policy to respond to shocks without recourse to unconventional tools.

Stanley Fischer has been the Governor of the Bank of Israel, a country that managed to altogether avoid a recession in 2008-09 for the simple reason that, just like Australia, it was following a de facto NGDP level target. But as I have argued here, that was “luck”! Just before stepping down from the BoI Fischer made a speech:

In my work as a central banker, I have made much use of my knowledge of central banking history around the world. Many of the events that are taking place today remind me of events from the past, and knowing the lessons from the past helps us develop policy in the present.

A prominent example of this is that of Ben Bernanke, who learned the lessons and the mistakes in handling the Great Depression of the 1930s during his research, and knew how to deal with the most recent financial crisis differently and more efficiently than how they tried to handle the situation in the 1930s.

We, the central bankers, thought at the outset of the crisis that we were about to experience another great depression like in the 1930s, when the unemployment rate in the US reached 25 percent. I am not here to claim that the current situation is good, but during the current crisis, US unemployment rate hit 10 percent and then began to decline, and I am sure that the situation would have been very different had Bernanke not acted according to the knowledge that he acquired in the course of his research.

Apparently, learning was only partial and selective because he also said:

There are those who support setting a nominal GDP target. I think that this is very impractical. The data that we receive on nominal GDP are very unstable.  There are changes of whole percentage points between the various estimates of GDP. For this reason, I think that there is no reason to use nominal GDP as a target.

Maybe he thinks inflation, output gaps and natural rates are precisely defined and known!

So much for the Fed´s Vice-Chairman monetary policy “abilities”.

Another voting member this year is also “dying” to vote for a rate rise. This is SF Fed president John Williams:

NEW YORK–Federal Reserve Bank of San Francisco President John Williams reiterated on Monday his belief that central bankers should consider raising rates some time this summer.

Things are looking better–in fact, they’re looking downright good,” the official said in a speech to be delivered to an audience in Sydney and Melbourne via video.

Given how much the economy has improved and is likely to continue to gain ground, “I think that by mid-year it will be the time to have a discussion about starting to raise rates,” Mr. Williams said.

The strength of the U.S. dollar against a “broad index” of currencies is not an impediment to the U.S. economy reaching real GDP growth of 2.5% this year, he said .

“The U.S. economy has good momentum…even with what is a rather large appreciation of the U.S. dollar,” Mr. Williams said.

Fischer wants to raise rates to “restore(!) the economy´s normal dynamics”. Williams thinks things are looking “downright good”! So much crap with a straight face. Only FOMCers can do that and get away with it!

The charts illustrate what “significant progress”, “extraordinary monetary accommodation” “economy looking downright good” and “gradual climb of inflation to 2%” looks like.

FOMC Crap_1

FOMC Crap_2

Now, think for a moment while contemplating the charts above and the next one. If the Fed managed to keep NGDP growing at such a stable (3.95%) rate for the past five years, after the economy “lifted-off” from the depths of the “Great Recession”, don´t you think it would also be capable (if it wanted) to:

1. Give nominal spending an initial boost (6%-7%) for it to regain “height” and

2. Then “levelled ” it off at a 5% growth rate (or 4% if you prefer)?

FOMC Crap_3

Ask yourselves:

1. Would inflation be closer to target?

2. Would RGDP growth be closer to 3+%?

3. Would employment be so “structurally” constrained?

An elusive target is no target at all!

For some time the big monetary policy discussion revolved around a single word: “Patience”. And the word had a clear “sell date” once it was removed: Two FOMC Meetings. That was certainly a problem for the Fed who hates being “tied-up and gagged”. Everyone, without exception, expected the “word” to be removed at today´s FOMC Meeting, eagerly anticipating what would replace it.

The Statement “clears it up”:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.

The “sell date” has gone; the Fed has” untied and ungagged” itself! It also has lowered once more the unemployment threshold that would more clearly indicate an interest rate move was imminent. For those with a short memory, that threshold has been 7%, lowered to 6.5%, lowered again to 6%, and under Yellen, a NAIRU faithful, it has been put in the 5.2% to 5.5% range, which has now been lowered to the 5% – 5.2% range!

Fed officials have marked down considerably their view of the “Nonaccelerating inflation rate of unemployment,” or Nairu.

The new central tendency of the long run unemployment rate is 5 to 5.2%, down from 5.2% to 5.5%. Ms. Yellen told WSJ’s Jon Hilsenrath this may explain why so many FOMC members have marked down their path of interest rate increases: it implies more slack in the economy, less inflation pressure and a need for easy policy for longer.

Yellen´s “NAIRU faith” shows up clearly:

The Fed’s forecasts today contained a shallower path for interest rates going forward. Instead of increasing rates at 0.25% at every meeting, the median interest rate estimate from the Fed calls for only 7 increases over the course of the next 14 meetings.

Asked why, Ms. Yellen cited two factors underlying the slow rise of rates:

1) Inflation has come in further below the Fed’s target than they expected, and that calls for lower rates to bring it back.

2) The Fed has lowered its estimates of the normal rate for the unemployment rate. That means, the unemployment goal is a little bit further away than previously estimated. That too calls for somewhat lower interest rates, she said.

Later this year, with inflation remaining far below target, and unemployment continuing to fall as it has for the past 5 years, the “new range” for Yellen´s “beloved NAIRU” will be put at the 4.5% – 5% range. At this rate, in a few years’ time, Yellen will start believing 4% unemployment is the “real thing”!

Patience Gone_1

Maybe that´s possible, not because it is Yellen´s target, but because the Fed will have (re)learned how to conduct an “appropriate monetary policy”, that is, a monetary policy that maintains nominal stability at the appropriate level of activity.

Patience Gone_2