How To Exit Liquidity Traps
With economic activity indicators softening and fiscal policy retrenching, some fear that we are heading for a period of sub-par growth in the developed world. A chief concern, voiced in a front page article in the Financial Times last Friday, is that with short term interest rates very close to zero, as is the case in all the large, developed economies, central banks are out of ammunition. But that is a misunderstanding.
The idea seems to be that since the major central banks' policy rates are essentially zero, their economies are caught in what economists call a liquidity trap - a situation where the short term real rate of interest is stuck at a higher level than the rate that causes aggregate demand to be equal to potential supply. The problem with this line of reasoning is that while economies might fall into liquidity traps, it's a fallacy to think that they have to remain there. Economies escape from liquidity traps by themselves over time; and if the invisible hand works too slowly, liquidity trapped economies can be resuscitated by monetary policy. Both the equilibrating market mechanism and the monetary policy tools have been researched by economists.
First, how does an economy escape from a liquidity trap on its own?
Assume that monetary policy is on hold with the policy rate at zero, and that markets expect the purchasing power of money to increase two percent per year. Then the real short term rate of interest is two percent. If the market clearing short term real interest rate, i.e. the rate that equilibrates aggregate demand and potential supply, is one percent, the economy is trapped. How does the economy adapt? It adjusts by rapidly increasing the purchasing power of money until the expected further increase in the value of money falls to one percent per year - that is, until markets expect one percent annual deflation. The real interest rate gap thus vanishes, and aggregate demand is aligned with potential supply.
What if the market clearing rate is negative, say minus one percent? Then the purchasing power of money will rapidly overshoot, increasing until markets from then on expect a one percent annual decline in the value of money - that is, until people expect one percent annual inflation. This again clears the markets; a zero policy rate minus one percent annual inflation means that the real rate is equal to the market clearing rate at minus one percent.
This, I venture, was how recessions caused by weak demand typically ended in the era of the gold standard, when prices were flexible and people expected stable price levels over time.
In 1920, for example, the US had a severe recession, where industrial production fell 33 percent from its peak in 1920 to its nadir in 1921. But the price level tumbled too - consumer prices dropped 19 percent from mid 1920 to early 1922. And that sudden increase in the purchasing power of the dollar in all likelihood led markets to expect inflation. Inflation expectations then brought down the real interest rate relative to the market clearing rate. This stimulated aggregate demand, and the economy boomed. From 1921 to 1925 industrial production surged 72 percent, while consumer prices climbed 8.2 percent. Amazingly, the Federal Reserve did not cut the policy rate until after the recession. Unaided, therefore, the economy climbed out of an artificial, policy imposed liquidity trap. Note that what's crucial here is that prices are allowed to fall. Frustrated deflation - slow-motion disinflation in the face of a negative demand shock - signals a dysfunctional price system; actual deflation relieves a liquidity trapped economy.
Since the end of the classical gold standard, government interventions and expected trend inflation have made prices less downwardly flexible. And with sticky prices, it takes more time for economies to heal themselves through a recalibration of price expectations. But it does not take forever.
Some have suggested that Japan has been in a liquidity trap since the mid 1990s. That is doubtful. Japan was trapped in the mid 90s and was likely trapped again in 2008, but actual deflation has probably improved price flexibility and thus made the economy more resilient to prolonged demand shocks. Also, I don't think the UK still is trapped. Core prices fell in the autumn of 2008, and currently there is scant evidence of frustrated deflation. The price level has risen quite rapidly since January 2009, and short term inflation expectations have increased to around three percent per year.
The US and the EMU, on the other hand, are probably in liquidity traps. There has not been an adjustment in the purchasing power of money; the core consumer price level never fell during the recession, indicating pervasive price stickiness. Short term inflation expectations, therefore, have declined to around 0.5 percent in the US and one percent in the EMU. With effective policy rates at 0.25 percent, the real rate is thus approximately minus 0.25 percent in the US and minus 0.75 percent in the EMU. That's probably well above the respective market clearing rates.
What, then, can monetary policy do in liquidity traps?
It's instructive to note what happened in the US in early 1933. Treasury bills yielded zero percent and economic activity was severely depressed. Consumer prices had fallen since 1929, but not as rapidly as in 1921 - probably due to president Hoover's labour market interventions. Soon after Roosevelt's inauguration it became clear that the new president would target a higher price of gold, and treasury gold purchases began to lift the price of gold from mid 1933.
Gold standard mentality meant that markets quickly saw the implications this would have for prices in general - they would increase. Inflation expectations then cut the real interest rate. The resulting economic turnaround was stunning. Industrial production, which was 52 percent below its 1929 peak level in March 1933, shot up 45 percent during the next 12 months, and then grew rapidly until 1937. Consumer prices, which fell 9 percent in the twelve months to March 1933, grew 5.8 percent in the following 12 months.
Back to the current predicament. What can be done?
First, the Federal Reserve and the ECB could shift from inflation targeting to price level targeting. If so, they should target a price level that grows two percent per year. Moreover, they should make the price level target retroactive; taking into account the shortfall of actual inflation from the targeted two percent inflation since the recession began.
Finally, they should commit to hit the new target within two years. Core price levels in the US and the EMU are both approximately 1.5 percent lower than they would have been if the central banks had hit this type of target since January 2008. Now, if markets thought such a central bank commitment to hit a higher price level was credible, this would immediately have lifted inflation expectations. Over the next two years they would have increased from around one percent to circa three percent per year in both the US and the EMU. This would have reduced real interest rates significantly, from around minus 0.5 percent to around minus 2.5 percent - without any change in policy rates.
It may be, though, that announcing a new policy target in itself would not be enough to change inflation expectations. The Federal Reserve and the ECB, therefore, might have to back up new policy targets by adjusting monetary policy implementation, i.e. by changing their deposit rates. But with both deposit rates at 0.25 percent, surely there isn't that much further to go? I don't think so.
While there is a floor to policy rates, it's probably not zero. Admittedly, at zero interest the opportunity cost of holding coins and notes is nil. But storage and security costs are not negligible, and currency is less handy than deposits for large scale payments.
While I'm unsure what the relevant cost parameters are - and hear I can't rely on research economists, I suspect both the Federal Reserve and the ECB could lower their deposit rates to at least minus one percent without there being a significant drain of central bank deposits into bank vaults (nor a drain from bank deposits into safes or under mattresses). In addition to signal commitment, cutting policy rates below zero would have a direct impact on real interest rates, decreasing them to around minus 3.5 percent in both the US and the EMU. That is probably close to the current market clearing rates in both economies.
Price level targeting is not a novel idea. Lars Svensson, deputy governor at Sweden's Riksbank and former Princeton professor, has advocated price level targeting for several years. Also, the Reserve Bank of Australia has practiced a kind of price level targeting for some years, and the Bank of Canada is presently studying it. Moreover, Ben Bernanke some years ago proposed such a policy regime shift to the Bank of Japan. So, if there is a new leg to the global recession, I expect price level targeting - and, quite possibly, less than zero short term interest rates - to become widespread.