I was studying about liquidity traps and understood it fairly well that according to widespread beliefs the monetary policy turns out to be ineffective as nominal interest rates are close to zero and the public has deflationary expectations. Since nominal rates are close to zero nobody wants to hold financial assets and prefer cash instead. My question here is that in such a condition when nobody is investing in bonds, should not the central bank raise interest rates to give higher incentive to bond holders. I know I am missing some point but can someone please explain this relationship between interest rates, inflation and bonds in the context of liquidity trap.
A very good question, but first some clarifications.
The banking sector is unique from all other industries in that it creates its own liquidity. Banks borrow short term low yield debt and invest in high yield long term assets. The maturity mismatch that occurs in the aggregate is tremendous and not sustainable. Banks are always reliant on individuals perpetually rolling over such short term debt as in the aggregate it can never be redeemed.
Many argue that such maturity mismatching is reckless and not responsible. That banks should suffer the consequences when they gamble by with such outrageous maturity differences. Instead the Fed makes the problem worse, by constantly guaranteeing a source of short term debt to constantly proper up long term assets banks have no business owning.
So you can't equate interest/investment with the economy at large with what banks do. Banks are unique! They're problems should not necessarily be our problems.
As for a liquidity trap...it is constantly happening and CB's like the Fed are constantly bailing them out by injecting short term debt into the fed funds market through the "open market".
Banks mostly rely on other banks for their sources of reserves. When banks stop trusting each other, the money multipliers collapses and the means by which short term debt can be redeemed starts to vanish. I like to think of this as a liquidity fire instead of a liquidity trap as the banks have promised more reserves than they have in the aggregate...and when they scramble to claim their chairs when the music stops, it will just make the problem worse.
When a central bank talks about interest rates approaching zero, they're not talking about real investments (like securities and mortgages). They're just talking about the rate they are trying to manipulate banks to lend each other. Bank to bank debt. Given that such a rate is determined by bank trust, such a rate does not necessarily have to correlate to the greater market rate at all.
Raising the fed funds rate will great increase a liquidity trap (not necessarily a bad thing). More bonds won't make a difference...the banking system's ponzi scheme is being exposed and they need more reliable short term assets...not long term like bonds.
Kind of a long answer...but I hope you found this somewhat helpful. The question is important.
In rough terms the central bank wants the nominal interest rates low so as a) to incentivize people to consume their income rather than save it and b) to make loans more attractive as they are linked with lower interest, thus bolstering consumption (again). During a crisis however, consumption remains low as expectations of economic growth deteriorate. Moreover, as interest rates are low, there is no point in saving money into the banks. Thus, people choose to hoard money, essentially removing it from the economy. With less money in the banking system and a generally pessimistic economic environment, banks become more skeptical towards providing loans as they doubt that they will get their investment back. All these processes empower the endurance of the vicious circle of the liquidity trap.
In theory, such prolonged periods of near zero interest rates would mean higher inflation. However, the recent crisis has proven that zero interest rates and stable inflation can co-exist. Therefore, the central bank has, up until now, been reluctant towards increasing the interest rates and in the past years it has made sure to inform the public that it is going to keep them quite low for some time (forward guidance). There is a whole debate of whether low interest rates are or should be linked with high inflation during financial crises and recently we see a drift, especially in the US, towards an interest rate increase even though it has not yet materialized.
Bonds are not considered a "go to" solution under a liquidity trap as their demand is really low. This stems from the fact that when a government faces a recession, its bonds are not considered a safe investment as they are paired with a high interest rate. Thus, the public awaits that they are unlikely to be honoured in the future. And if the recent financial crisis has taught us anything is that even bond holders are not safe.
Cash and bonds are almost identical from financial and economic perspective. Most institutional investors and banks keep much of their cash in bonds. Physical cash is becoming a bit obsolete so the notion of "hoarding cash" no longer means taking out bags with dollar bills and stuffing them under the mattress or into the safe box. Hoarding cash nowadays is pretty much moving money from equity to bonds or cash accounts, but not taking out physical bills, like it may have been before digitalization of financial markets. So in a liquidity trap you will have everyone practically "hoarding bonds". Increasing interest rates in such situation will cause even more money to move out of the equities into bonds and exacerbate deflation. That is what has been happening to Japan and arguably happened in the US in 2009 when Fed responded with setting rates to ~0 and buying back about a trillion dollars worth of bonds (QE). However, liquidity traps are hard to define empirically. Any situation where you have rates near zero and inflation near zero or deflation, can be argued to be a liquidity trap.