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Decimal Digest
15 Aug 2011

Liquidity Trap
The Event

The Federal Reserve of the USA announced on 9th August 2011: “….economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

The most noteworthy part of the above statement is the part that is missing from the statement. There is no mention of reversal of low rates policy in response to any unexpected inflation. The word “likely” is a very weak escape clause in the above statement.

There are two other recent examples of central banks explicitly stating that existing near zero rates will continue for a specified or very long periods (Canada in 2009 and Japan in 2003). In both the cases, the respective central banks kept explicit reversal conditions, should inflation increase beyond current expectations.

The Analysis

Now, let us see what might have prompted the Fed to avoid giving explicit proviso to its commitment. According to the research published by the New York Fedi,

“A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective. The modern literature, in contrast, emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive.

The liquidity trap arises when the zero bound on the short-term nominal interest rate prevents the central bank from fully accommodating sufficiently large deflationary shocks by interest rate cuts.

Monetary policy will increase demand at zero interest rates only if it changes expectations about the future money supply or, equivalently, the path of future interest rates. The Keynesian liquidity trap is therefore only a true trap if the central bank cannot do anything to stir expectations. There are several interesting conditions under which this is the case, so that monetary easing is ineffective.

At zero interest rates, if the public expects the money supply in the future to revert to some constant value as soon as the interest rate is positive, quantitative easing will be ineffective. This result applies if the public expects the central bank to follow a „Taylor rule‟, which may indeed summarize behaviour of a number of central banks in industrial countries. A central bank following a Taylor rule raises interest rates in response to above-target inflation and above-trend output.

Also, if a central bank is discretionary, that is, unable to commit to future policy, and minimizes a standard loss function that depends on inflation and the output gap, it will also be unable to increase inflationary expectations at the zero bound, because it will always have an incentive to renege on an inflation promise or extended „quantitative easing‟ in order to achieve low ex post inflation.

Hence, successful monetary easing in a liquidity trap involves committing to maintaining lower future nominal interest rates for any given price level in the future once deflationary pressures have subsided.

In the optimal solution the central bank commits to keeping the nominal interest at zero for a considerable period beyond what is implied by the inflation target rules; that is, interest rates are kept at zero even if the deflationary shock has subsided. Similarly, the central bank allows for an output boom once the deflationary shock subsides and accommodates mild inflation.”

The Conclusion

We believe that, based on the above analysis, the Fed believes that the USA is in a liquidity trap in the classical Keynesian sense. Without the support of fiscal policy going forward, the Fed is now actively considering either giving up inflation targeting or more accurately, substituting that with a price level target. In the price level target, the central bank is expected to target a fixed level of price, usually significantly higher than current prices.

If the Fed succeeds in achieving higher price levels, and in turn create jobs, the current market valuations may prove more than convincing. However, if the liquidity trap takes the path of Japan, the global asset market will trace the Japanese asset prices, albeit with a 20-year lag. Given the crisis of confidence stemming from Europe, it needs to be seen how fast the latest move by Fed stirs animal spirits necessary to achieve rising employment and output.

However, there is one asset which will benefit under both the scenarios, and our smart readers are already aware of that asset.

Sentences rearranged. Conjuctions added & wording simplified to improve readability of rearranged sentences


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