The Liquidity Trap Cometh...

Today's Treasury yield curve:

And Paul Krugman sends us to the TED spread--the risk and liqudiity premium big banks are demanding over Treasuries for the loans they make to each other.

Think of the TED spread as an indicator of financial fever--with something like 0.3% per year being normal. Think of the short end of the yield curve as an indicator of how powerful the Federal Reserve's standard medicine of swapping Treasury securities for bank reserves is.

Be afraid. Be somewhat afraid.

Comments

[Barkley Rosser]

Well, heck, no inverted yield curve. Therefore, no reason to worry about a recession. Looks like good times ahead!!!

[rex]

The yield on the 1-month plunged as low as 0.12% today. It closed at 0.21%. The trap is close.

[anne]

http://krugman.blogs.nytimes.com/2008/03/20/fed-funds-question-seriously-wonkish-and-possibly-dumb-too/

March 20, 2008

Fed Funds Question (Seriously Wonkish, and Possibly Dumb Too)
By Paul Krugman

The target Fed funds rate is now 2.25%. Everyone expects it to be reduced further; Citi economists predict * that it will be down to 1% by mid-year.

But I have a possibly naive question: can the Fed really cut the Fed funds rate that far? I don't mean "can" in the sense that other concerns will give them pause; I mean literally — does the Fed really have that ability?

Bear with me while I talk this through. The Fed actually conducts monetary policy through open-market operations in Treasuries: the FOMC tells the open-market desk to buy or sell Treasuries from banks until the Fed funds rate is close to the target. Normally this puts Treasury interest rates close to the Fed funds rate, since one short-term loan to a very safe customer is a lot like another.

But right now Treasury interest rates are much, much lower than the Fed funds rate — around half a percent on both 1-month and 3-month bills. Weirdness like negative rates on repos ** aside (I'm still trying to wrap my mind around that one), basically the Fed can only drive Treasury rates down by about another half-point — which would still seem to leave Fed funds well above 1%.

How is it possible for the Fed funds rate to be higher than the Treasury rates? Well, one interpretation is that banks don't trust each other — not even for overnight loans. Fed fund loans, after all, are unsecured.

In other words, the Fed funds rate may be more like LIBOR than the Treasury rate — and it may be being held up by a premium similar to the TED spread. ***

Am I being really stupid here? Or is it possible that the fear factor will soon make it impossible for the Fed even to achieve its target on the interest rate it supposedly controls?

* http://blogs.wsj.com/economics/2008/03/20/citi-economists-interest-rate-cuts-ahead-lots-of-them/

** http://www.aleablog.com/negative-repo-rates-today/
*** http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND

[William Smith]

Actually, I find the potential for the Fed to essentially lose its power and purpose to be absolutely frightening. Not that I care what happens to the CEO of Bear Sterns, et alia, provided it doesn't involve golden parachutes.

What does frighten me is the fact that a massive sell-off of these securities, runs on leveraged non-bank-yet-banklike institutions would essentially destroy 401(k)s and other investment-backed retirement packages for many real Americans (I use real to denote working jobs that do not involve financial speculation). Losses in that arena would certainly entail massive cutbacks in spending in order to make up in savings, especially considering that the housing bubble is deflating.

Think of the 2010's version of Howl as:
I saw the best minds of my generation destroyed by bankruptcy...

[Kaleberg]

I gather that a liquidity trap is what happens when people need a lot of money, but aren't willing or able to pay for it. I'd be willing to lend my money out for more than 2%, if I could find someone willing to pay that. Unfortunately, most borrowers are lucky if they can pay 0.25%, so the lender of last resort is the Fed.

[christofay]

In the last recession, 2000- , deflation was used as the WMD story line. There was scant evidence of deflating prices beyond falling used car prices. The fear of deflation did provide an excuse for Greenspan's unprecedented ultra-low rates. And after rates for Treasuries were ultra-low, it helped herd investors into the new securities Wall St was peddling with slightly higher "rates" and much higher risk.

[christofay]

Can you have an economy based on investment banks trying to off load junk on a willing Fed?

It's hard work putting junk on our families.

[RWB]

Wow. Given that the monthly inflation rate in February was .34% (according to inflationdata.com), that implies a negative real interest rate. Buyers of one month T-bills will actually be paying the government to hold their money. Assuming there are any buyers of one month T-Bills.

[Jonathan King]

I don't get a "hoisted from comments" post for having posted the URL that showed this fact yesterday? Oh well...

[Matt]

Banks undergoing technology change, not a problem in general, except we have an unwilling monopoly at the moment.

All the central banks of the world are doing a little top spin at the moment, sort of a stable state of huge potential energy. We will come out of it soon, with our normal stability, but based upon a much more liberated monetary system in the world.

What Ben is doing is going to be standard operation for all the major monetary authorities around the world. More and more, these banks will gain independence and act more like arbitrage traders than anything else. Large institutions will have a more powerful hand, and more vulnerability, in monetary variances.

Its an effect of the emergence of global institutions, an environment where any single central bank cannot do its job unless it accommodates the monetary power of externals. The era of deregulation of money.

[Neal]

How to escape the liquidity trap
Samuel Brittan: Financial Times 28/03/03

The hottest topic among highbrow financial analysts is: what can be done if official short term interest approach zero but are still not low enough to revive an economy? Have the central banks then "run out of ammunition"? The issue could arise if the end of the Iraq war is not sufficient to galvanise the animal spirits of business and world economies remain sluggish.

The question has become serious enough for the Bank of England to include in its Spring Quarterly Bulletin an article by a senior official Tony Yates on the subject. Last November B. Bernanke, a new Fed governor, gave a well publicised lecture entitled "Deflation: making sure it doesn't happen here."

The problem is quite easily stated. Short term nominal interest rates cannot fall below zero, as no-one would have any incentive to lend at negative rates. In fact the problem is worse. For most businessmen cannot borrow at the best prime rates but have to pay a couple of percent more to allow for commercial risk.

In the 1930s Lord Keynes suggested that the lower bound to interest rates - which he called a liquidity trap - might prevent monetary policy from being sufficiently effective to restore normal output and employment. Milton Friedman in his post-war reply did not deny the theoretical possibility of such a trap. His view was that the Fed could have increased the money supply in 1931, but chose not to do so. The historical controversy still rages.

Mr Yates is also anxious to play down the likelihood of such a liquidity trap. He tends, perhaps too easily, to dismiss the US in the 1930s and Japan today as suffering from conditions remote from the present day UK, where interest rates could still fall several percentage points. He reinforces this by a consideration of various economic models purporting to show in what a small proportion of time an economy would be subject to the zero interest rate bound at varying, but low rates of inflation.

But he does not really expect his readers to be reassured. One tempting way, which he mentions only to dismiss, of preventing the liquidity trap from arising would be to aim at substantial inflation rates, so that real rates could become negative during periods of recession and stagflation. This may indeed be one of the reasons why the world did not go into prolonged deep recession after the 1973 oil shock. But he dismisses the idea as bringing too many disadvantages as well as being politically "not on".

A popular course, frequently advocated for Japan, is pre-announced devaluation. This would both raise price expectation and provide a direct stimulus to exports. The biggest problem with this remedy is that it would be quite inappropriate if the threat of slump were international rather than confined to one country. The zero bound to interest rates seems most likely to strike next in the case of Germany where the single currency makes a national depreciation impossible.

Yet it surely ought not to be beyond human wisdom to prevent or at least treat a slump in a world of unmet needs that unemployed workers could be used to supply. Governor Bernanke remarks: "If we do fall into deflation we can take comfort that the logic of the printing press asserts itself and a sufficient injection of money will ultimately always reverse a deflation."

Friedman indeed once contemplated dollar notes dropped from helicopters. A more respectable suggestion is that central banks, instead of limiting their pump priming operations to very short dated government securities, should buy a much wider range of assets,including private sector bonds. The Bank of England author discusses whether such operations could be reinforced by central bank guarantees to maintain near zero interest rates for some period ahead. But unlike Governor Bernanke he wonders whether such guarantees would be either credible or desirable.

The most unorthodox expedient he examines is a tax on money, if not spent by certain dates. This was proposed by academics a century ago, but is not as cloud cuckoo as it seems. When the Swiss were trying to repel short money inflows ago they imposed a tax on overseas held bank deposits. This surely could have been extended to cover domestic deposits as well. Admittedly notes would have been a more difficult proposition, but not impossible with modern electronic means.

In discussing remedies the Bank of England analyst mentions first fiscal policy, that is tax cuts or public spending boosts. But this does not get the Bank off the hook altogether. For the effects of such stimuli would be controversial and uncertain unless they were financed by monetary creation rather than by long term borrowing. As governor Bernanke argues: "A money financed tax cut is essentially equivalent to the helicopter drop." Both EU rules and Gordon Brown's monetary and fiscal framework appear to rule out such expedients. But all these rules could surely be bent if the world were faced with utterly different dangers to those feared at the they were drawn up. The real problem is that monetisation of a new flow of public debt requires, as Adair Turner of Merrill Lynch has reminded us, "co-ordination, us between fiscal and monetary authorities, and that would be more difficult to achieve with one central bank and 12 fiscal authorities". This is one further reason for countries outside the euro to stay outside for some time to come. My own preference would be for temporary cuts in consumer taxes, which would be reversed automatically at a stated date. This would be adequate to fight a temporary recession and not require unorthodox financing. In the face of more deep seated stagnation or slump something more would be required. The obvious weapon would be public investment. The hole in the economy would arise because of the failure of private investment to keep up with attempted savings. So it would be sensible for public projects to take up the slack as Keynes originally suggested to Lloyd George.

There is an obvious danger of crying "wolf" too soon and bringing back inflation or overblown government spending through errors of pessimism. But the best defence against such panic reaction is the knowledge that the authorities have in their cupboard weapons for coping with deficient as well as excess demand.

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(A glimpse into the options)
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[christofay]

Matt, it sounds like you're mixing in too much physics and too much cosmology with your central banking. Bear in mind that our Fed is close to shooting out all of its assets buying i-bank junk bonds, and the recession still hasn't fully hit. I don't see any sign of "stable state", but I do see signs of throwing any kitchen sink available into the breach.

[Neal]

Or was the inflation option already exercised by the Fed? And now we are back at where we started--only weaker?

[Barkley Rosser]

Regarding this business of negative interest rates that Krugman noted for repos, it does apparently happen from time to time, although I confess that I do not understand how it works. Thus, there was a brief period during the 90s when the target interest rate in Japan went negative. I also remember being told by the individual who handled dealings between the Fed and Freddie Mac at the time that on Dec. 31, 1986, the last day of the old tax code before simplification, that there were huge gyrations in the fin markets as people strove to close deals that day, and the fed funds rate supposedly oscillated between about 18% at its peak and negative 1/2% at its pit, although this was not explained to me then either. But, apparently nominal interest rates can be negative, although it looks like this does not go on for very long when it does happen, however it does so.

[a]

Recessions are like forest fires.

There was a time over fifty years ago when the Forest Service fought all fires, because they destroyed trees and killed animals and created an ungodly sight. Then the Forest Service finally realized that fires served beneficial purposes - for example, clearing dried brush which accumulates on the forest floor - and that allowing everyday forest fires to proceed actually was the best way to prevent really huge cataclysmic fires.

Economists have equally thought that it is necessary to fight all recessions. Recession threatening? Lower interest rates, cut taxes, increase spending! Do everything in one's power to stop that recession from coming, by golly. So now we haven't had a recession in a while, and economists are astonished - just astonished - that there comes a point when their little tricks won't work, and a really deep recession looms which we aren't going to be able to do anything about.

Americans have overconsumed for a generation - A GENERATION. They have been encouraged in this by economists, who have preached the benefits of consumption to keep the economy moving. But accumulating debt is great only until you can't do it anymore. And now Americans have reached that point. They will now need to consume less, even much less. They will need to become poorer, even much poorer. All because they listened to the "experts", who thought they could finetune the economy.

[howard]

actually, a, the forest service does not, by and large, simply let fires proceed.

the forest service plans "controlled burns" to serve the forest fire function.

so to extend your analogy, economists do not, as such, recommend repealing the business cycle. economists recommend ameliorative measures so that the natural behavior of the business cycle does not cause a huge forest fire that spreads out of control and does much more than clearing away the dried brush.

[a]

Nah,I don't think that's not the correct analogy. The correct analogy to a "controlled burn" would be a "recession deliberately started but supposed to be limited." Is that what economists recommend?

[JonF]

Re: Losses in that arena would certainly entail massive cutbacks in spending in order to make up in savings, especially considering that the housing bubble is deflating.

Maybe not. Many people are already at the limit of what they can cut back on, due to rising prices. So instead they might just end up accepting an underfunded retirement. Meaning they will end up working longer and the constituency for not messing with Social Security will grow stronger.

[Acrossthepond]

Have to say I find the metaphor of forest fires and recessions intriguing, and quite possibly accurate (at least from the little I understand on this issue). To take it one step further, if the animals and the trees in the forest had a vote, and thought the way people think, they would probably not like controlled burning either. And instigating recessions, or letting them spiral out of control for that matter, is a sure way of *not* getting re-elected. So that road's really closed.

I guess what you have to do is keeping the excess in the economy down during the good times via regulation. It's a question of intelligent moderation really, with all the lobbyists and the get-rich-quickn'dirty crowd hanging around it's a hard thing to do. What might "cure" this is an 1930:s style crash... Time will tell.

[joe]

Negative interest rates on repo's? Yes! If I believe that the security will decrease in value more then the lesser amount money I will receive when I give the security back then I will lend the money take posession of the security, immediately sell it and then buy it for a lesser amount when I have to sell it back for less money then I had lent originally. Make sense? Further if we consider this a kind of a futures market, what is the futures market saying about the current TED spread?

[phryon]

doesn't anybody here read..or even google..
The N.Y. FED covered this... in research piece several years ago..

Negative repo rates have been a fact of life in the US markets for quite some time... Repo (and recall one man's repo is another man's reverse repo) are basically ways that the dealer community borrows and lends securities...

When rates are low as they are now in T bills.. and even GC... what is the incentive of someone to "lend his securities" to someone else? Forget the rate.. the risk is that you won't get back the asset you've just lent out...
After reading bout Bear Stearn's how much would you demand "extra' for the credit risk of giving your nice clean Treasury security to someone else.. hoping they return it...

Another antedeluvian feature of the US market that the FED has to deal with... fortunately the growing use of Tripartite in repo are making these trades more and more a dying residual.

[marcf]

Ok, so I did google it and here is the link on negative repo rates: http://ideas.repec.org/a/fip/fednci/y1996isepnv.2no.10.html
.