Wednesday, July 15, 2009

Liquidity Trap

Watch how you use the word "liquidity!"


Look at the Fed's minutes released today:

"However, participants also judged that improved market conditions and declining use of the facilities warranted scaling back, suspending, or tightening access to several programs, including the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF)."

Now look at McCulley's first paragraph today over at PIMCO on his Global Central Bank Focus:

The whole world, it seems, is wrapped around the axle about exit strategies from putatively unsustainable policies: (1) the Fed’s bloated balance sheet, with some $800 billion of excess reserves sloshing ‘round the banking system, in the context of an effective zero Fed funds rate; and (2) the Treasury’s huge budget deficit, unprecedented in peace time and set to stay huge, implying a Treasury debt/GDP ratio approaching 100% within a decade’s time.

So what do you do, when you want rates too be kept low, and you desperately do not want the Fed to have any exit stratgey?

Argue "liquidity trap!"

You quote Krugman in 1998, of which McCulley does today:

“The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.”

If reason doesn't work, irresponsibility does!

That's what happens when you are stuffed in bonds, even though PIMPCO has a giant derivative short position in Govvies!

The liquidity trap, is when people expect so much deflation, that all they want to do is save, which prevents the economy from growing, and thus re-employment.

But instead of reading that, you will read this:

"Or to put it yet another way, one that is closer to the language of applied macroeconomics: if people have low expectations about their future incomes, then even with a zero interest rate they may want to save more than the economy can absorb. (In this case, of course, the economy cannot absorb any savings - but I will come to that point below). And in that case, no matter what the central bank does with the current money supply, it cannot reflate the economy sufficiently to restore full employment."

But what the bears don't realize is, that if the policy fostered by McCulley is taken, stock prices could spiral UPWARD and spiral upward VICIOUSLY!

It's only a liquidity trap for the bears.

Because the market will take their liquidity!

1 comment:

X said...

Agree 100%. That McCulley writeup is one of his best.