Economics
Monetary policy
Is the liquidity trap almost over?
Jan 11th 2012, 19:59 by R.A. | WASHINGTON
LIQUIDITY traps: we can't stop talking about them. Since late 2008, the nominal interest rate target suggested by most standard monetary policy rules has been negative, leaving the American economy in a liquidity trap. Eddy Elfenbein recently ran a monetary policy rule devised by Greg Mankiw through the data and found that an exit from the trap might be closer than many think. The rule is:
Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)
And when run against the data it produces:
 |
At this rate, it seems, the recommended policy rate will be positive in no time. Maybe. The recent, steep increase is unlikely to continue. Core inflation is expected to level off and might well decline in 2012. The recent decline in unemployment is also unlikely to continue. Labour force departures have overstated the health of the labour market as captured in the unemployment rate, and if the job market continues to strengthen, then rising labour force participation will prevent a too-rapid drop in the unemployment rate. The rule might recommend a positive rate by the end of the year (2% core inflation and an 8% unemployment rate would just about do it), but it's far from certain that it will.
Neither should the Fed follow the rule right away when it begins recommending rate increases. Monetary policy gains traction in a liquidity trap by raising expected inflation. To achieve that, the Fed has to promise to let inflation rise above what the rule might normally recommend; it needs to credibly signal that there will be some catch-up inflation.
That's a tough thing for a central bank to do, and it gives rise to a time inconsistency problem in liquidity-trap monetary policy. The Fed can promise to behave "irresponsibly" in the future, but if most people think that no matter what Ben Bernanke says now he'll keep inflation at 2% later on, then the Fed will struggle to spark a recovery. A policy that explicitly allows for catch-up inflation, as through a level target, would make liquidity-trap fighting more credible. The Fed is none too anxious to head in that direction, however, lest it "lost credibility" as an inflation fighter. Which, of course, is precisely what's needed.
In this blog, our correspondents consider the fluctuations in the world economy and the policies intended to produce more booms than busts. Adam Smith argued that in a free exchange both parties benefit, and this blog's aim is to encourage a free exchange of views on economic matters.
Advertisement
Money talks audio
- Analects | China
- Americas view | The Americas
- Babbage | Science and technology
- Bagehot's notebook | British politics
- Banyan | Asia
- Baobab | Africa
- Blighty | Britain
- Buttonwood's notebook | Financial markets
- Charlemagne's notebook | European politics
- Clausewitz | Defence, security and diplomacy
- Democracy in America | American politics
- Eastern approaches | Ex-communist Europe
- Elysée | France’s presidential election
- Free exchange | Economics
- Game theory | Sports
- Graphic detail | Charts, maps and infographics
- Gulliver | Business travel
- Johnson | Language
- Leviathan | Public policy
- Lexington's notebook | American politics
- Newsbook | News analysis
- Prospero | Books, arts and culture
- Schumpeter | Business and management
Most commented
- The euro crisis: The Greek run
- Foreigners in China: Barbarians at the gate, again
- Brazil’s economy: A bull diminished
- Russia and NATO: Rethink the reset
- Gay marriage: North Carolina begs the question too
- Nationalism online: Backfired
- Turkey’s cultural ambitions: Of marbles and men
- Greece and the euro: Exodus, chapter 1
- India-China relations and the media: Blame the messenger
- Politics and private equity: Bringing the Bain
Over the past five days
Most recommended
- The euro crisis: The Greek run
- Greek politics: Slouching towards the drachma
- Foreigners in China: Barbarians at the gate, again
- Brazil’s economy: A bull diminished
- The euro crisis: Going, going, gone?
- Jacob Zuma: Portrait of a president
- Rival versions of capitalism: The endangered public company
- Bo Xilai v Chen Guangcheng: Who is the mightier?
- Facebook goes public: Not top of the pops
- France and Germany: The Frangela show
Over the past seven days
Advertisement
Readers' comments
The Economist welcomes your views. Please stay on topic and be respectful of other readers. Review our comments policy.
Sort:
To avoid the liquidity trap the system needs to be modified so that the central bank deals directly with the public, not just a handful of companies in the financial sector. That way the economy wont be dependant on commercial bank lending for new demand to enter the economy.
I don't really understand the recent infatuation with G. Mankiw's equation. All it does is describe past monetary policy as it was. Maybe the Fed was wrong all along. I don't believe in liquidity traps, but if I did, this graph would just tell me: If the Fed keeps behaving as it used to it, might soon raise interest rates.
As P. Krugman has been pointing out, there is more to macro than monetary policy. Believing that there is light at the end because in the past the FED raised rates at this point on the Taylor curve is living in the same dream world that sees austerity induced unemployment, slow growth and decreased demand as the means to build bond market confidence and stimulate investment.
It is the an irrational expectation. Time to reconsider faith-based economic policy.
Can we call this irrational disexuberance?
PS tell me when ecconomic policy hasnt been faith based. :)
I'm not betting any of my money on an imminent escape from the liquidity trap.
"The rule is: Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)"
I am amazed that this is uncritically taken to be a forecasting tool. Past correlation does not imply causation. Nor does it imply future correlation.
The formula might as well be a shaman's incantation. Perhaps it is.
A good post and good thinking, and I sort of agree, except the problem with promising catch-up inflation is that it relies on the credibility of the FED. If congress were running the FED, it would have no credibility and many would take the message to say there will be no discipline.
In corrupt states you cannot win...Today 12th January 2011, Zanzibar was taken by the main land Tanganyika to form Tanzania; President Karume wanted all the Asians out and the Emir of Muscat back to Muscat. Karume wanted the inter marriages between Asians and African so all Asian left the island. It is just like our great nation and our Navy to rescue Iranian sailors who could be aboard a future vessel that would fire upon our Navy. The Iranian government have threatened the US. No threat should be brushed off. A constant vigil over a brave act should to calculate and weighed before the United Nations. The US should make sure that this act should be advertised as an act of the humanitarian quest for peace between nations. The US Battle group should be recognized and the individual personnel aboard the US vessels. The US should not take this lightly. It is a chance to show the peaceful intent of the United States to the world. Not a pessimist but no one then took notice of this. I love the Intel coming pack more in the cell etc. Makes the pages of Steve, run faster. Obama’s friend leaves him; The politics of USA is all over the TV and the net. Sort gets boring but I love the jokes. We will not be above the recession until 2014. .
hypochondriac
noun: One who is excessively and chronically preoccupied with imaginary or innocuous symptoms as indicators of some serious disease.
ETYMOLOGY:
From Greek hypochondrios (abdomen, which was believed to be the seat of melancholy), from hypo- (under) + khondros (cartilage [of the breastbone]). Earliest documented use: 1599.
USAGE:
"'Gadhafi was described as a hypochondriac who insisted that all examinations and procedures be filmed and then spent hours reviewing them with physicians whom he trusted,' the ambassador reported."
Joshua Norman; U.S. Envoy to Libya Wikileaks' First Casualty?; CBS News (New York); Jan 5, 2011.
A THOUGHT FOR TODAY:
Remorse is a violent dyspepsia of the mind. -Ogden Nash, poet (1902-1971) I thank you Firozali A.Mulla DBA