My Diary 466 --- Risk of a Liquidity Trap but Policy Are Availab

Risk of a Liquidity Trap but Policy Levers Are Available

October 30, 2008 Binit Patel [phone]

1. Fed cuts 50bp to 1%, as expected

The statement accompanying the unanimous decision to cut interest rates clearly signaled greater concerns about growth with inflation much less of a concern and expected to moderate in coming quarters. While we do not expect further rate cuts the risks are skewed to further easing in the months to come; Fed Fund futures are now pricing in a nearly 100% probability of a further 25bp cut by year end.

In terms of price action, US equities seesawed for most of the day on light volume as investors awaited the FOMC announcement, but sold off sharply into the close and ended the day -1.1% lower. Crude oil rallied 7.6% to settle at $67.50/bbl on the back of the biggest one-day decline in the US dollar since 1998.

Policy is also being loosened elsewhere. China cut rates another 27bp yesterday, the third such move in the past two months. We expect a further 100-150bp of rate cuts by end-2009. Taiwan’s central bank also announced an inter-meeting policy rate cut of 25 bp today. Asian stocks have posted strong gains overnight in the wake of this latest round of global rate cuts and the announcement from the Fed of extending FX swap lines to Korea (along with Brazil, Mexico and Singapore).

2. What is a liquidity trap?

With Fed cutting rates aggressively, and other central banks likely to do so in coming months, the topic of “liquidity traps” is being increasingly discussed. There is no agreement among economists whether the so-called liquidity trap is a real world phenomenon or just a theoretical construct. Part of the problem is that liquidity traps are rare events. Japan is commonly viewed as the only economy that has suffered from a liquidity trap in the post-World War era. Even here, some economists challenge the idea that Japan has experienced a liquidity trap. Instead they have viewed Japan’s economic malaise over the past 20 years as a failure of the Bank of Japan to inject sufficient liquidity as an over-inflated economic boom started to bust.

But what is a liquidity trap? In “normal” economic downturns, monetary policy has generally been an effective instrument to revive economic growth. By cutting nominal interest rates from high levels in an environment with positive inflation expectations, central banks can engineer steep falls of real short- and long-term rates, thus sending a strong expansionary impulse to economic activity.

Unfortunately it is not as straightforward in an environment when interest rates are already low and inflation is falling. With the room for nominal rate cuts limited (as interest rates cannot fall below zero) and inflation expectations very low, the ability of a central bank to cut real rates and thus to stimulate growth may become rather small.

In such an environment, an attempt by the central bank to increase money supply can become futile, because the demand for money effectively becomes infinite. Nominal interest rates on bonds are driven to such low levels (not necessarily zero but close to it) that money absolutely dominates bonds as a medium for savings. If the central bank attempts to pump more money into the system by buying bonds, the money is simply accepted by the private sector with interest rates remaining unchanged at very low levels. Nothing else really changes.

3. Rising risk of a liquidity trap

There is an increasing debate as to whether a liquidity trap could develop in the US. Certainly the risk of such a scenario is rising and should not be easily dismissed. After all, despite aggressive interest rate cuts by the Fed, monetary policy has so far been ineffective in stimulating the economy (something that is highlighted by tightening financial conditions). Moreover, credit markets continue to be in a state of stress despite the recent narrowing in spreads, equity markets are still vulnerable to further weakness, and there is likely to be a sharp drop in inflation in the months ahead (with risks tilted towards deflation).

At the same time, the risks should not be overstated. First, the nominal federal funds rate is 1% - as discussed above, until it gets to zero, fears of a liquidity trap would be premature. Second, the aggressive interest rate cuts and the gradual unfreezing of credit markets should help ease financial conditions and support the economy over the next several quarters. Third, even though deflation risks have risen, and while our US forecasts show headline inflation touching zero at some point in the second half of 2009, core inflation is still likely to end 2009 above 1.5% - hardly suggesting an economy that is in the grips of a deflationary spiral. Fourth, we are likely to get another large fiscal stimulus package of about $200bn (see US Economics Analyst, 24 October, 2008).

4. Policy is responding (and more can be done)

Importantly, if the risks of a liquidity trap do continue to rise, US authorities could try to circumvent the interest rate channel by flooding the economy with liquidity at zero interest rates. Arguably the Fed has already moved in the direction of using more “unconventional” measures to inject liquidity in the non-bank sector, such as its plan to purchase commercial paper. The Fed could, if needed, implement an even more aggressive approach by acquiring other risky assets (including equities).

So there are some potentially potent tools at hand to prevent a liquidity trap. But the key to policy success will be how credible the commitment of the central bank is to raising inflation expectations, which in turn would help push real interest rates lower and provide the desired stimulus to economic activity. If the commitment is seen as credible, then as the latest Fixed Income Monthly discusses, the depressed levels of breakeven inflation rates look somewhat mis-priced.

With regard to central bank credibility, it is important to highlight that Ben Bernanke was an important critic of the Bank of Japan's unwillingness to use such measures to stimulate nominal spending in his former life as an academic, and this suggests that the Fed's ability and willingness to be creative should not be underestimated.

Not surprisingly therefore, Bernanke also recently endorsed a second fiscal package. Indeed, budgetary expansion can also be a powerful tool (in a liquidity trap) as long as it can affect aggregate demand. This is because interest rates do not rise as demand increases, so there is no crowding out of the extra budgetary spending through tighter monetary conditions.

Elsewhere, the risk of a deflationary spiral and a consequent liquidity trap is arguably less of a concern than in the US. There is still plenty of scope for monetary policy to be eased in the Eurozone and the UK should this prove necessary – indeed, we expect the ECB and the Bank of England to cut rates to 2% over the next several months.

More broadly, with still some room for global monetary policy to be eased if necessary, global deflation fears are still too premature. However, we do think that the various shocks which have hit the global economy in the past few months have genuinely increased the risks in the system and this will complicate the task of the central banks in ensuring that nominal demand grows at an adequate pace, on a global basis.

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W: Have u thought about FED at the verge of liquidity trap and they'll have to rely on fiscal policy to stimulate econ? And with so much money used to buy toxic assets and bail out banks, buy CPs etc, how many bullets do they leave? Are we close to the last option-printing money?

M: Do not simply follow the market talk about –Liquidity Trap.
Do you know about the definition of liquidity trap? There is actually no definition of such in agreement.
Historically, there is only one case which is Japan. But arguably, BOJ did not inject enough money into the system initially.
Only during low interest rate and falling inflation expectation, that we will see a liquidity trap. Then central bank’s open market operation will be absorbed by private sector, as an substitute of saving….Nothing other changes…
We are not there yet, and simply, Fed is replacing its BS with Banks BS. This is not equal to real money printing, if you do understand the definition of various MONEY.

W: Zero interest rate-1%left
Inflation expectation-coming down
FED's actions is merely exchange BS with banks, exactly like u said. To really stimulate econ, they need to spend money and my concern is whether they can raise it thru Treasury bond auctions. If not, to me it seems print money is the only option.
Of coz many assumptions in the steps above, and I hope we don't get there but that is a tail risk we need to bear in mind?

M: Indeed, there are only 2 questions in our life…what about the furture? What is the possibility?
If fed can not carry out UST auction, then Dollar system dead….and it is not a liquidity trap….it is Dollar trap…DO you think central banks like PBOC will let it happened?
I am bearish, but I am not extremely bearish…..The current market return is a fat tail distribution already…

W: Let's see. UST auction this week and they'll also announce borrowing need for 4Q08 and 1Q09.

M: Anyway, please bear in mind, not all the auction money is for money creation. It mostly serves for bank’s recapitalization. This is not equal to base money J  There is 100bp to the zero rate and key is real interest rate…..that is the price of money not nominal rate….People just mix up the concepts and create the fears. I hope we do not follow the ordinary thought flows

W: I think we cannot simply assume that every disaster will be history and econ always rise from mistake. I.E I think the outcome to some extent is certain, the uncertaities are in the process/path to that destination.
We've seen countries go bankrupt before and with uncertainties on USA's solvency I'd like to err on the conservative side.
Commonsense tells me anything has an inherent limit. Abusing any tool in the end will lead to selfdestroy.
Now let me go back to my basics, hopefully today or next week I found myself worry too much:)

 

M: It is not about history, I think the power of human being is we learn the lesson. But the problem is we make new mistakes.

I do not believe in the “destination theory” but I agree all the results are path dependence. This is what George Soros believes in his reflexibility thesis. We are impacting the future.

As we discussed, we do not know how this crisis end, other wise we will be the richest person in the world. J

I do not like some strategists in the market as they simply use the 1929 or 1972 as the absolute benchmarks. Why not this time = 1929+ 1972?

I have no answer, but I keep my mind open and I remember not to worry too much about small possibility events. Other wise, the market will never recover as risk premium will not come down.

You do not need to read the basic, only need to go through Wiki…it is quite helpful. I use the website a lot J