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Liquidity trap

August 27th, 2010 · 1 Comment

Nasty stuff, that. The Fed saved the day, for now, by hinting another round of QE if the economy gets even worse. But what would QE actually achieve under the present circumstances? Very little..
With all kinds of tools, the Fed can affect the price of credit in the economy. However, credit is already cheap and it’s hard to imagine lower credit prices will boost credit demand. Households are delevaraging, paying off credit. Firms sit on excess cash and excess capacity and are facing weak demand. So it’s unlikely credit demand will increase from the private sector.

This is called a liquidity trap. The price of credit having no longer much effect on the demand for it.

It leaves the public sector to do the job, and by buying Treasuries, the Fed’s renewed QE (light) is indeed cheapening the credit for the public sector (although any new stimulus is unlikely for political reasons).

However, the price of credit is already falling because of deflationary fears. Funny enough, insofar the Fed’s action manage to allay those fears, it could even be somewhat counter-productive (the first sign of this we see in the currency market where the dollar is selling off as a result of the Bernanke speech this morning).

And there are more problems, as Alan Blinder explains in the WSJ:

The Fed Is Running Low on Ammo
It still has options if more monetary easing is needed. But they’re not very effective.

You may have noticed that the complexion of the U.S. economy has turned a bit sallow of late. The Federal Reserve definitely has. At its Aug. 10 meeting, the Federal Open Market Committee (FOMC) shifted attention away from its former concern—how to tighten a bit—and toward a new concern: how to loosen a bit. By central bank standards, this turnabout came at warp speed.

Chairman Ben Bernanke has told the world that the Fed is not out of ammunition. It still has easing options, should it need to deploy them. The good news is that he’s right. The bad news is that the Fed has already spent its most powerful ammunition; only the weak stuff is left. Mr. Bernanke has mentioned three options in particular: expanding the Fed’s balance sheet again, changing the now-famous “extended period” language in its statement, and lowering the interest rate paid on bank reserves. Let’s examine each.

From exit to re-entry. The first easing option is to create even more bank reserves by purchasing even more assets—what everyone now calls “quantitative easing.” The FOMC took a baby step in that direction at its last meeting by announcing that it would no longer let its balance sheet shrink as its holdings of mortgage-backed securities (MBS) mature and are paid off. Instead, it will reinvest the proceeds in Treasury securities.

Two distinct policy shifts are embedded in this announcement. Most obviously, the gradual shrinkage of the Fed’s balance sheet—a key component of its exit strategy—comes to a screeching halt.

Less obviously, the purpose of quantitative easing changes. When the Fed buys private-sector assets like MBS it is trying to shrink interest rate spreads over Treasurys—and thereby to lower private-sector borrowing rates such as home mortgage rates—by bidding up the prices of private assets, and so lowering their yields. Judged by this criterion, the MBS purchase program was pretty successful.

But when the Fed buys long-dated Treasury securities it is trying to flatten the yield curve instead—by bidding up the prices on long bonds. That effort also seems to have succeeded, perhaps surprisingly so given the vast size of the Treasury market. Now put the two together. By reducing its holdings of MBS and increasing its holdings of Treasurys, the Fed de-emphasizes shrinking risk spreads and emphasizes flattening the yield curve. That strikes me as a bad deal for the economy because the real problem has been high risk spreads, not high Treasury bond rates.

If the FOMC is serious about re-entry into quantitative easing, it should buy private assets, not Treasurys. Which assets? The reflexive answer is: more MBS. But with mortgage rates already so low, how much further can they fall? And would slightly lower rates revive the lifeless housing market?

To give quantitative easing more punch, the Fed may have to devise imaginative ways to purchase diversified bundles of assets like corporate bonds, syndicated loans, small business loans and credit-card receivables. Serious technical difficulties beset any efforts to do so without favoring some private interests over others. And the political difficulties may be even more severe. So the Fed will go there only with great reluctance.

• What’s in a word? The FOMC has been telling us repeatedly since March 2009 that the federal-funds rate will remain between zero and 25 basis points “for an extended period.” This phrase is intended to nudge long rates lower by convincing markets that short rates will remain near zero for quite some time.

The Fed’s second option for easing is to adopt new language that implies an even longer-lasting commitment to a near-zero funds rate.

Frankly, I’m dubious there is much mileage here. What would the new language be? Hyperextended? Mr. Bernanke is a clever man; perhaps he can turn a better phrase. But market participants already interpret the “extended period” as lasting deep into 2011 or beyond. How much longer could any new language stretch that belief?

Interest on reserves. In October 2008, the Fed acquired the power to pay interest on the balances that banks hold on reserve at the Fed. It has been using that power ever since, with the interest rate on reserves now at 25 basis points. Puny, yes, but not compared to the yields on Treasury bills, federal funds, or checking accounts. And at that puny interest rate, banks are voluntarily holding about $1 trillion of excess reserves.

So the third easing option is to cut the interest rate on reserves in order to induce bankers to disgorge some of them. Unfortunately, going from 25 basis points to zero is not much. But why stop there? How about minus 25 basis points? That may sound crazy, but central bank balances can pay negative rates of interest. It’s happened.

Charging 25 basis points for storage should get banks sending money elsewhere. The question is where. If they just move money from their accounts at the Fed to the federal funds market, the funds rate will fall—but it can’t fall far. After all, it has averaged only 16 basis points since December 2008. If banks move the money into Treasury bills instead, the T-bill rate will fall. But even if it drops all the way to zero, that’s not a big change from its 12-month average of 11 basis points (for three-month bills). So charging 25 basis points is no panacea.

But suppose some fraction of the $1 trillion in excess reserves was to find its way into lending. Even if it’s only 10%, that would boost bank lending by 3%-4%. Better than nothing.

A fourth way out. There is a fourth weapon, which the Fed chairman has not mentioned: easing up on healthy banks that are willing to make loans. Given bank examiners’ record of prior laxity, it is understandable that they have now turned into stern disciplinarians, scowling at any banker who makes a loan that might lose a nickel. That tough attitude keeps the banks safe, but it also starves the economy of credit.

Well, quite a few of those bank examiners happen to work for the Fed. It would probably do some good, maybe even a lot, if word came down from on high that some modest loan losses are not sinful, but rather a normal part of the lending business.

So that’s the menu. The Fed had better study it carefully, for if the economy doesn’t perk up, it will soon be time to fire the weak ammunition.

Mr. Blinder, a professor of economics and public affairs at Princeton University and vice chairman of the Promontory Interfinancial Network, is a former vice chairman of the Federal Reserve Board.

———[End of article]———-

Here is another one arguing the powers of QE are overstated, from TPC:


The topic of quantitative easing (QE) has rapidly become the most important discussion in the investment world.  As deflation becomes the obvious risk and the economic recovery looks increasingly weak investors are again looking to the Fed to save their skin from a Japan style deflationary recession.  The irony here is so thick you could choke on it, however, like some sort of sick masochist, investors continue to return to the trough of the Federal Reserve so they can gorge on half-truths and misguided policy responses.

There is perhaps, no greater misunderstanding in the investment world today than the topic of quantitative easing.  After all, it sounds so fancy, strange and complex.  But in reality, it is quite a simple operation. JJ Lando a bond trader at Goldman Sachs has eloquently described QE:

“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”

Some investors prefer to call it “money printing” or “stimulative monetary policy”.  Both are misleading and the latter is particularly misleading in the current market environment.  First of all, the Fed doesn’t actually “print” anything when it initiates its QE policy.  The Fed simply electronically swaps an asset with the private sector.  In most cases it swaps deposits with an interest bearing asset.  They’re not “printing money” or dropping money from helicopters as many economists and pundits would have you believe.  It is merely an asset swap.

The theory behind QE is that the Fed can reduce interest rates via asset purchases (which supposedly creates demand for debt) while also strengthening the bank balance sheet (which entices them to lend).  Unfortunately, we’ve lived thru this scenario before and history shows us that neither is actually true.   Banks are never reserve constrained and a private sector that is deeply indebted will not likely be enticed to borrow regardless of the rate of interest.  On the reserve argument the BIS explains in great detail why an increase in reserves will not increase borrowing:

“In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.

The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 – by far the most common – in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively.

The main exogenous constraint on the expansion of credit is minimum capital requirements. By the same token, under scheme 2, an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. This is true in both normal and also in stress conditions. Importantly, excess reserves do not represent idle resources nor should they be viewed as somehow undesired by banks (again, recall that our notion of excess refers to holdings above minimum requirements). When the opportunity cost of excess reserves is zero, either because they are remunerated at the policy rate or the latter reaches the zero lower bound, they simply represent a form of liquid asset for banks.”

The most glaring example of failed QE is in Japan in 2001. Richard Koo refers to this event as the “greatest monetary non-event”.  In his book, The Holy Grail of Macroeconomics, Koo confirms what the BIS states above:

“In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession.  If there were many willing borrowers and few able lenders, the Bank of Japan, as the ultimate supplier of funds, would indeed have to do something.  But when there are no borrowers the bank is powerless.”

In the same piece cited above, the BIS also uses the example of Japan to illustrate the weakness of QE.  The following chart (Figure 1) shows that QE does not stimulate borrowing (and the history of continued economic weakness in Japan is coincidental):

“A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly.”


(Figure 1)

Koo goes a step further in describing the failure of QE to promote private sector recovery.  His simple example is one I have used often:

“The central bank’s implementation of QE at a time of zero interest rates was similar to a shopkeeper who, unable to sell more than 100 apples a day at $100 each, tries stocking the shelves with 1,000 apples, and when that has no effect, adds another 1,000.  As long as the price remains the same, there is no reason consumer behavior should change–sales will remain stuck at about 100 even if the shopkeeper puts 3,000 apples on display.  This is essentially the story of QE, which not only failed to bring about economic recovery, but also failed to stop asset prices from falling well into 2003.”

Koo continues by emphasizing how ineffective monetary policy is during a balance sheet recession:

“Even though QE failed to produce the expected results, the belief that monetary policy is always effective persists among economists in Japan and elsewhere.  To these economists, QE did not fail: it simply was not tried hard enough.  According to this view, if boosting excess reserves of commercial banks to $25 trillion has no effect, then we should try injecting $50 trillion, or $100 trillion”

After years of placing more apples on the shelves the Bank of Japan finally admitted that the policy had been a failure:

“QE’s effect on raising aggregate demand and prices was often limited” (Ugai, 2006)

That all sounds too eerily familiar, doesn’t it?  No, no – Mr. Bernanke hasn’t failed.  He just hasn’t tried hard enough….But perhaps the reader believes Japan is different and not applicable.  This is a reasonable objection.  So why don’t we look at the evidence from the last round of QE here in the USA.  Since Ben Bernanke initiated his great monetarist gaffe in 2008 there has been almost no sign of a sustainable private sector recovery.  Mr. Bernanke’s new form of trickle down economics has surely fixed the banking sector (or at least bought some time), but the recovery ended there.  It did not spread to Main Street.  We would not even be having this discussion if we were in the midst of a private sector recovery.  The surest evidence, however, is in the Fed’s own data.  We can also look at the Fed’s recent Z1 to show that households remain hesitant to borrow (see Figure 2).  Friday’s consumer credit data was yet another sign of contracting consumer credit and a lack of demand for borrowing.  Despite the Fed’s already failed attempt at QE (see Figure 3) we are convinced that Mr. Bernanke just needs to throw a few more apples on the shelves.  The historical evidence is clear – QE will do little to stimulate borrowing and help generate a private sector recovery.


(Figure 2)


(Figure 3)

In addition, there is one great irony in all of this misunderstanding.  The hyperventilating hyperinflationists and those investors calling for inevitable US default are now clinging to this QE story as their inflation or default thesis crumbles before their very eyes.  The new hyperinflationist theme has become a story of “if this, then this, then THIS!” – the ludicrous 3 step investment thesis that the economy will become so fragile that the government will pile on with more stimulus, which will worsen matters and force them to stimulate further which will then result in hyperinflation and/or default. Most investors have enough trouble predicting what the next event will be – connecting the dots two or three steps down the line is not only ill-advised, but is hardly even worthy of consideration….Let’s just call a spade a spade – the inflationistas have been wrong and the USA defaultistas have been horribly wrong.

What is equally interesting (in addition to the fact that QE is not economically stimulative) with regards to this whole debate is that this policy response in time of a balance sheet recession is not actually inflationary at all.  With the government merely swapping assets they are not actually “printing” any new money.  In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits.  This might have made some sense when the credit markets were frozen and bank balance sheets were thought to be largely insolvent, but now that the banks are flush with excess reserves this policy response would in fact be deflationary not inflationary.  Why would we remove interest bearing assets from the private sector and replace them with deposits when history clearly shows that this will not stimulate borrowing?

All of this misconception has the market in a frenzy.  Portfolio managers and day traders can’t wait to snatch up stocks on every dip in anticipation of what they believe is an equivalent to the March 9th 2009 low that was cemented by government intervention.  As I have long predicted Ben & Co. have failed.  If there is one thing that we know for certain over the last 24 months it is that Mr. Bernanke’s monetary policy has done very little to get the private sector back on its feet.  This man failed to predict the crisis (was in fact oblivious to its potential), initiated the wrong trickle down policy response and yet now we turn to him to save us from a double dip and his Committee responds with more discussion of QE?  Will we ever learn?

In describing the negligence of such monetary policy Richard Koo uses the analogy of a doctor who simply tells his patient to take more of the same medicine he originally prescribed:

“At the risk of belabouring the obvious, imagine a patient in the hospital who takes a drug prescribed by her doctor, but does not react as the doctor expected and, more importantly, does not get better. When she reports back to the doctor, he tells her to double the dosage. But this does not help either. So he orders her to take four times, eight times, and finally a hundred times the original dosage. All to no avail. Under these circumstances, any normal human being would come to the conclusion that the doctor’s original diagnosis was wrong, and that the patient suffered from a different disease. But today’s macroeconomics assumes that private sector firms are maximizing profits at all times, meaning that given a low enough interest rate, they should be willing to borrow money to invest.. In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession.”

Dr. Bernanke has misdiagnosed this illness one too many times.  At what point does someone tell him to put the scalpel down and step away from the table before he does even greater harm?


BIS (2009)

Koo, R (2009) The Holy Grail of Macro Economics

Ugai, H (2006) Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses.  Bank of Japan Working Paper Series no 6-E-10

This paper is also available for download in PDF format at SSRN:

Tags: Credit Crisis · Economy

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