Liquidity trap

Posted By Darren Winters on Jul 12, 2019

Liquidity trap

Monetary policy has lost its mojo because the world’s central bank, the Fed is in a liquidity trap.

Deutsche Bank Securities chief economist recently published a report titled “QE no longer works”. Indeed, a decade on from $33 trillion in bailouts, an unprecedented amount of liquidity, zero interest rates and bubbly stock prices a string of investor titans are forecasting a US recession in 2020. 

Who will come to the market’s rescue in the next crisis if the Fed is caught in a liquidity trap with monetary policy shooting blanks?

Fed impotence, in the face of another economic downturn, could become a reality.

But first, let’s define a liquidity trap

The Fed’s liquidity trap is explained in Keynesian economics as a situation which injections of cash into the private banking system by a central bank fails to lower interest rates and hence fails to stimulate economic growth. 

Put simply a liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.

What are the signature characteristics of a liquidity trap?

Liquidity trap

The obvious one is that short-term interest rates are near zero. Interest rates in all G7 industrial economies are near historic lows. 

Another classic characteristic of a liquidity trap is when central banks embark on a policy which entails flooding the system with a massive amount of liquidity which then has little or no impact on inflation. 

The Fed has flooded the system with trillions of dollars of liquidity through a program known as quantitative easing QE which entails purchasing bonds, treasuries. The Bank of Japan has even extended its asset purchase to stocks. The European Central Bank has had its own version of liquidity creation know as its asset purchase program. 

In 2016 the ECB asset purchases reached a peak of 80 billion euros a month in 2016. Asset purchases have slowly fallen with monthly bond buys at 15 billion euros in the final quarter of 2018. But the ECB’s balance sheet has ballooned to about 4.65 trillion euros. 

The Fed’s balance sheet is estimated at around 4 trillion dollars. Moreover, the bank of England has £435bn stock of government bonds it acquired under its QE program.

So western aligned central banks around the world have already flooded the system with trillions of dollars of liquidity with little or no impact on demand-pull inflation.

The collapsing velocity of money is another characteristic of a liquidity trap.

Despite QE and near-zero interest rate policy households continue to stack funds away in deposit accounts. So the rate at which money moves in the economy remains low which has an adverse impact on aggregate demand. But declining aggregate demand leads to deflation. Moreover, falling prices mean lower profits for businesses which then causes underinvestment, higher unemployment, and lower aggregate demand and more deflation. This vicious cycle of decline prices and underinvestment higher unemployment triggered the last Great Depression. 

The collapsing velocity of money, a characteristic of a liquidity trap, means that monetary policy is no longer able to break this vicious cycle

Not even helicopter money, UBI is able to jump up aggregate demand as people chose to save the free money for a rainy day rather than spend it. 

So the Fed’s greatest fear of being caught in a liquidity trap in a deflationary spiral could be in play

From this chart, we can see that the Fed has been trapped for a long time

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