A liquidity trap arises when nominal interest rates are low enough to remove the opportunity cost of holding cash instead of bonds–> traditional monetary policy that operates through buying and selling Treasuries in order to steer money supply becomes ineffective as everybody prefers to hold cash rather than an IOU in this situation (Krugman reviewing Keynes)
- Dec 9: The Treasury sold $30 billion of four-week bills at zero percent for the first time since it began selling the securities in 2001. The government received bids for the bills totaling more than four times the amount sold–> “It’s the year-end factor with those four-week bills,” said Chris Ahrens, an interest-rate strategist at UBS.
- Dec 8 Bloomberg: The Treasury sold $27 billion in three-month bills at 0.005%, the lowest rate since it started auctioning the securities in 1929 amid record demand for the safety of U.S. debt during the worst financial crisis since the Great Depression. Yields on two-, 10- and 30-year securities declined early December to the lowest levels since the Treasury began regular sales of the debt.
- Additional Fed policy tools include buying assets directly in order to unclog lending but the Treasury just reversed course by steering the Troubled Assets Relief Program (TARP) away from troubled assets and towards direct bank capital injections. Nevertheless, banks continue to hoard all the liquidity the central bank is injecting directly instead of lending it out (i.e. Fed is ‘pushing on a string’).
- Roubini: The consequence of falling prices (i.e. the prime reason why nominal interest rates should be that low) is that the real value of nominal liabilities will rise as do real interest rates once the nominal interest rate hits the zero bound. The incentive towards hoarding cash and saving instead of investing is thus self-reinforcing as the deflationary spiral takes hold. Any increase in money supply (like quantitative easing) goes into servicing higher real debt levels–-> breaking a deflationary spiral therefore requires fiscal stimulus or balance sheet restructuring or both.
- FT Editorial: Only a prolonged period of falling prices could entrench expectations of deflation. This might occur if recession turns into a severe slump where banks remain unwilling to lend, consumers reluctant to spend and companies hesitant to invest. Interest rates in the Eurozone and in the UK will have to come down further. At 1 per cent, the target interest rate in the US is already low. Even such loose monetary policy may not be enough to reverse cash-hoarding in the economy. Fiscal policy, therefore, has a crucial role to play.
- Phelps: Traditional Keynesian policies such as infrastructure investment by the government that are being advocated now are not the right medicine for modern times. We should move on as Keynes wanted to himself with his theory before he died.
- Heise (Allianz): A balance sheet crisis like the present one requires balance sheet restructuring. Monetary and fiscal policies are both limited and inadequate.
- Guha: The risk of deflation could lead Ben Bernanke to approach the new administration and Congress next year about adopting an inflation target at the Federal Reserve as an obvious deflation-fighting strategy, some experts believe. Some members of Congress fear that this would lead the Fed to prioritize inflation over growth.
- CEPR: The liquidity trap possibility arises in a theoretical inflation-targeting framework when the zero bound of nominal interest rates is taken into account and when the assumption of only small fluctuations around a target level of inflation is dropped. These two simplifications have serious consequences for aggregate stability.