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The Liquidity Trap

|Includes: GLD, QQQ, SPDR S&P 500 Trust ETF (SPY)

We are in a liquidity trap, and because of that I am suprised that the FOMC today decided to resume quantitative easing.

A liquidity trap is theoretically NOT when nominal interest rates reach the zero bound, although it is likely to occur at this point. The liquidity trap occurs when the demand for money becomes perfectly elastic (horizontal on a graph). When the demand for money is perfectly elastic, no matter what the supply of money (quantitative easing and generally most accomodative monetary policies increase the supply of money) the quantity demanded of interest bearing instruments ("bonds") will not increase. This is likely to occur at the zero bound because bonds no longer pay interest, so they are no more appealing than money while they still bear a risk of default.

It seems that this has occured at in the United States. Despite $1.65 billion of quantitative easing from late 2008 to early 2010, banks are holding cash and cash-equivalents. Excess reserves at the Federal Reserve increased roughly 250% in this crisis and remain extremely elevated. The same thing probably happened in Japan during their Lost Decade. Even many Bank of Japan officials have come out and said that their QE was not effective in effecting the real economy.

The purpose of QE is to decrease long-term interest rates to stimulate investment and hopefully bring employment a little higher and increase the inflation rate. In order for this investment and stimulation to occur banks need to shift funds to riskier assets like corporate bonds, real estate securities, and loans. Since the economy is at the zero bound this will not happen. Banks will continue to hold cash and cash equivalents, while the QE will just add to the elevated stock of hot money and eventually fuel inflation when the economy recovers and employment returns to the natural rate.

So are we screwed? No, the Federal Reserve still has more tools at its disposal. It needs to increase inflationary expectation. If the Fed accomplishes this, regardless of the real or nominal interest rate, households and businesses will being to spend their money now. These rational expectations can have a larger effect on growth than the portfolio-balance channel decreasing long-term interest rates can have.


Disclosure: LONG SPY & GLD