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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.

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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.

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  • $\begingroup$ If I followed you correctly what you are saying is that the interest rate that governs bonds might not be the interest rate that approaches to zero in a liquidity trap. Thus, in a liquidity trap situation the central bank short term rate is almost zero which fails to stimulate the inter bank rates which are governed by trust. Bond rate might not be zero. What I didn't get is then why don't people hold bonds as it might still be giving some return and how is this distrust among banks and the inability of central bank to improve it gets translated to such a huge glut and recession in economy ? $\endgroup$ – Sub-Optimal Nov 25 '15 at 11:21
  • $\begingroup$ The start of what you said is absolutely correct. If the Fed Fund Rate (the rate at which bank charge other for short term debt) falls then this doesn't mean that bond rates will fall. $\endgroup$ – user2662680 Nov 25 '15 at 23:13
  • $\begingroup$ It really is more of a banking problem and bankers like to make it seem more like a non-banking problem to get more welfare. Why don't banks hold bonds in a liquidity trap? Because that isn't the problem...the solvency of their short term debt is. The public won't hold bonds because they aren't money. You can spend checking deposits but not bonds. $\endgroup$ – user2662680 Nov 25 '15 at 23:21
  • $\begingroup$ Could you please have a look at another answer below by Arthur. He says that people hoard bonds (government bonds) in such times. Is there some difference between your answer and his answer. $\endgroup$ – Sub-Optimal Nov 26 '15 at 10:16
  • $\begingroup$ The relationship between a liquidity trap and public bonds is complex. On one hand money is being literally destroyed. Less money to buy bonds = lower priced bonds. On the other hand banks are desperate for short term assets during a liquidity fire and will sell long term assets on the open market. Lower priced long term assets will hurt a banks credit rating and force it sell even more. So it is IMO a liquidity crisis will result in very cheap bonds. $\endgroup$ – user2662680 Nov 26 '15 at 15:58
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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.

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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.

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  • $\begingroup$ I actually found your answer contradictory to what I read in standard textbooks say, " during liquidity traps the interest rates are close to zero hence people don't prefer to hold bonds as bond prices are too high and they are expected to certainly fall thereby giving a loss in capital. Any attempt by central bank to infuse more liquidity is futile as any amount of additional liquidity will be absorbed at the prevailing interest rate." I am really puzzled. If everyone is holding bonds then the firms issuing those bonds must be having money to invest. Then how is the liquidity trapped. Puzzled $\endgroup$ – Sub-Optimal Nov 25 '15 at 11:29
  • $\begingroup$ @AbhinavArya The central bank's key interest rate does not (directly) affect corporate bond yields. Corporate bonds are a whole another story. Corporate bonds market is rather tiny compare to government bonds one. They usually refer to US treasuries as "bonds". Can you link the title and author of that book? My guess is it is either pre-2008, by an unknown author, or both. $\endgroup$ – Arthur Tarasov Nov 25 '15 at 11:41
  • $\begingroup$ I think I got your point when I relate it to the different interest rates prevailing and higher interest rates on corporate bonds owing to higher term and risk premium due to declining investor confidence. Maybe the author was referring to something else. FYI: Book Title : Principles of Macroeconomics by Soumyen Sikdar, Oxford University Press India. The author says what I quoted in my previous comment. $\endgroup$ – Sub-Optimal Nov 25 '15 at 13:44
  • $\begingroup$ The book is published in 2006 so the author had no knowledge of a string of successful anti—deflation policies by Fed, ECB, Bank of England, and Bank of Japan post 2008. Just think of that sttement as somewhat correct at the time but outdated now. $\endgroup$ – Arthur Tarasov Nov 25 '15 at 22:57

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