Wednesday 17 December 2008
The ‘Liquidity Trap’ Could Happen
In the very near future, the Board of Governors of the Federal Reserve System could instruct the Open Market Committee in New York to target Federal Funds to a rate close to zero per cent. Such a position will be bullish for China’s positions in U.S. government bonds.
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The ‘Liquidity Trap’ Could Happen
Thomas Wilkins
17 December 2008
In the very near future, the Board of Governors of the Federal Reserve System could instruct the Open Market Committee in New York to target Federal Funds to a rate close to zero per cent. Such a position will be bullish for China’s positions in U.S. government bonds.
Mr. Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System posses great influences on this topic. He has done his home work in a paper entitled Monetary Policy Alternatives at the Zero Found. He is fortified if the Board of Governors votes to go down this path. The evidence and take home messages have been learned in Japan which followed a similar path after its bubble economy popped. Professor Kazuo Ueda, a former member of the Bank of Japan’s Policy Board, studied the Japanese central bank’s adoption of quantitative easing. His research used work done by his classmate from MIT, Fed Chairman Ben Bernanke. Ueda concluded that when the central bank spoke clearly by saying that zero rates would last until deflation was buried, this made a rallying effect on Japanese bonds due to lower interest rates. Hence, I think it is fair to expect:
The U.S. central bank to approach zero federal funds rates in the very near future while giving off a policy statement saying that this policy will last as long as it takes to whip deflationary concerns.
Currently, the market place is exhibiting an extreme preference to hoard financial liquidity. The reasons are (1) flight to safe assets, and (2) an economic slowdown. We can deduct this from the MV=PT equation of exchange which dates back to the 18th century Scottish thinker David Hume. As M (money supply) increases, as it is currently doing so, and as the economy (Prices multiplied by real activity) slows down, it is logical for the velocity of money to slow down. This means that people want more liquidity and we corroborate this and find evidence of this preference from the abnormally low U.S. Treasury Bill rates.
As inflationary concerns are now low, Fed’s activity will be geared to supplying liquidity to the banking industry to offset the loss of reserves due to the slowing economy. The Federal Funds will lose its significance for monetary policy as rates are reduced lower than its current 1% rate. As Federal Funds rates approach zero, the central banks can still provide liquidity through open market operations above and beyond what is necessary for whatever is the new targeted rate. What is the significance of such a policy? It means the Federal Reserve will most likely adopt a “Whatever It Takes” agenda to fund, directly and indirectly, any and all fiscal deficits which could be a trillion dollars in 2009 or 7% of our Gross Domestic Product. Ben Bernanke’s co-author of the “Zero Bound” study, was Vincent Reinhart, the Fed’s Director of Monetary Affairs until last year and now a scholar at the American Enterprise Institute in Washington. Reinhart pointed out in his November article in the American:
“What most people do not realize is that this target (the federal funds rate) is no longer the operative instrument of U.S. monetary policy, and that the real work is being done through the massive creation of bank reserve. The main liability of the Federal Reserve’s balance is now fiat money, which cannot be redeemed by the private sector …The federal funds rate target, is now irrelevant… Looking at the bigger picture, America has embarked on one of the great experiments in the history of monetary economics. We are testing the notion that the size of the central bank’s balance sheet matters more to the economy than the overnight interest rate that balance sheet produces in money markets.”
Interestingly enough, the economist who advocated large government pump priming, may have the last word in this episode. John Maynard Keynes coined the notion of a “liquidity trap.,” This described a condition when banks are reluctant to lend even when nominal interest rates came close to or equalled zero. Bankers do not have enough credit worthy borrowers. Borrowers too are not excited by the “carrot in the money market.” as they do not see enough justification to build new homes or factories or buy new automobiles. Does this sound familiar? If we do have a major U.S. recession with rising unemployment and a possible $1 trillion fiscal deficit, it may take a considerable amount of time to convince borrowers not to hoard liquidity.
(Thomas Wilkins, CFA is the Chief Executive Manager of Joseph Jekyll Advisers LLC at thomaswilkins5@charter.net.)
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