Flash Point: Liquidity Traps; Lie Traps

In his Jackson Hole speech, (see our posts: The Hole in Jackson Hole, Flash Point: What We Missed the First Time Round), Bernanke reported on the two tools that the Fed has at its disposal and the various implementations and policies that they have used in this crisis. The first set of tools are designed to affect interest rates. The second set of tools are their communication programs used to affect market psychology. We will argue that the first set of tool have resulted in a liquidity trap. We will argue that the second set of tools have created a lie trap.

The Liquidity Trap

The New York Fed has produced a good discussion on liquidity traps. From the opening section:

A liquidity trap is defined as a situation in which the [1] short-term nominal interest rate is zero. The old Keynesian literature emphasized that [2] increasing money supply has no effect in a liquidity trap [3] 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 [4] managing expectations about the future money supply in [5] states of the world in which interest rates are positive.

We have emphasized and numbered five points in the above paragraph and discuss them in sequence:

  1. This condition was reached in 2009 as we have written about in several places (search on ZIRP).
  2. The result is a liquidity trap in which the central bank cannot force additional liquidity into the economy by lowering short-term rates. Their attempt to do by successive LSAP programs has resulted in the buildup of reserves of depository institutions on deposit with the Fed.
  3. This is where the Fed stands with respect to traditional interest rate manipulation tools.
  4. Here the other tool set of the Fed, its communication programs, are used to influence rates though a stated intention of what they expect to do in the future. This is seen in the last several FOMC minutes where they state how far into the future they expect to maintain zero rates and what LSAP programs might be implemented affecting the monetary base.
  5. This point confounds us. It appears to admit that their tools don’t work at home so they will try and produce positive effects in other economies whose interest rates are not zero. We figure that might be Zimbabwe, but certainly not Japan or Europe (sure they’re holding at 0.75 % but it might as well be 0 as far as the Fed is concerned).

What has become apparent to us (Flash Point: What We Missed the First Time Round) is that the Fed is creating policy based on the output of their models rather than observation of what their policy tools are doing to the economy. Their communication policies and unorthodox LSAP programs have not altered the fact that they are in a liquidity trap.

The Lie Trap

Communication is actually a very powerful tool. If Bernanke gave a speech in which he said that Fed policy was ineffectual, that the Fed has no ability to assist in economic recovery and that the effect of actions to date had been to unnaturally distort markets forcing equities into a mini-bubble while destroying the retirement hopes of millions of Americans through depriving them of expected interest income on savings (all true statements), markets would crash.

So he has to somehow sound reassuring in the face of an economic situation that is anything but. Further he has come out and said the opposite: that Fed policy works. Well it does in the wonderland of his models.

So he has to lie. As with politicians, the options to not being called a liar are to be called naive or incompetent, neither of which is more flattering. Any attempt to tell the truth will collapse the economy. The Fed is caught in a lie trap.

Powered by WordPress | Designed by: photography charlottesville va | Thanks to ppc software, penny auction and larry goins