* Low nominal short-term rates, the failure of monetary policy easing to generate an economic recovery, and a sharp decline in the October producer price index have generated fears that deflation and a liquidity trap could develop in the United States.
* The likelihood of such an outcome is still very low. The Fed has room to ease further and most price trends (and inflation expectations) are still positive. Moreover, the Fed is having some success (finally) in making financial conditions more accommodative.
Risks of a Liquidity Trap Still Very Low
Lately, there has been intense speculation concerning the possibility of a deflation/liquidity trap scenario for the United States similar to what happened in Japan. This is understandable. After all, the Fed has eased aggressively this year, yet the economy is getting weaker. Moreover, the recent price indices are indicating deflation--at least over the short- term. The decline in the October producer price index was the biggest monthly decline in the history of the series.
Despite this, we believe that the risks of deflation and a liquidity trap are still very low:
1. Monetary policy still works. The reason monetary policy has not had much effect this year is that the impact of Fed easing on financial conditions has been offset by the weak equity market. Until very recently, financial conditions had not loosened at all, despite aggressive Fed easing. In contrast, over the last few weeks, Fed officials are starting to make progress. The Goldman Sachs financial conditions index is now below 96.6, down over 1/2 point since the beginning of the year. As a result, we can now expect monetary easing to begin to have a positive impact on economic activity within a few quarters.
2. Fed officials still have room to ease further. The nominal federal funds rate is 2%. Until it gets to zero, it is premature to worry too much about a liquidity trap. A liquidity trap arises when nominal rates cannot be reduced any further and there is deflation. In this case, real short-term rates are positive and cannot be pushed lower. In that environment, cash becomes the best investment. Bond yields cannot fall any further because the risk of capital loss offsets the higher coupon return available on bonds. The stock market does poorly as the decline in nominal GDP leads to earnings declines and a heavier and heavier debt burden. 3. The United States is not in a deflationary spiral. Looking at the inflation data generally, prices are still increasing. The consumer price index, for example, has risen by 2.6% over the past year, and even core producer prices are up by 0.8% over this period. Moreover, compensation inflation is also positive, with year/year gains in the 3%-4% area. In contrast, all major price indices are falling in Japan.
4. Fiscal policy is turning stimulative. If another round of tax cuts and spending cuts is ultimately enacted by Congress as still seems likely, the net fiscal impulse in 2002 is likely to be on the order of 1 1/2%-1 3/4% of GDP.
What would make us change our minds? There are four factors that would make us more nervous about a deflationary/liquidity trap scenario:
1. Renewed weakness in the equity market. This has been the principal mechanism that has undercut the power of monetary policy this year.
2. A decline in housing prices. If housing prices declined, this would exacerbate the negative wealth effect for the household sector and would also underscore the inability of monetary policy to provide lift to the economy.
3. A further decline in household and business confidence. A renewed round of terrorist attacks would seem to be the biggest risk here.
4. Mounting signs of credit problems and rising credit spreads. This would reduce the power of monetary policy and make cash a more attractive asset class.
Judging from the recent performance of the equity market, the risks of deflation and a liquidity trap appear to be declining, not rising. After all, if stock prices rise this makes monetary policy more effective. Moreover, a rising stock market is inconsistent with the dynamics of deflation and a liquidity trap, in which cash, not equities, becomes the dominant asset class.
Finally, it is important to recognize that liquidity traps are very rare. To my knowledge there have only been two during the past century--a generalized liquidity trap in the Great Depression and the liquidity trap that is plaguing Japan currently. The major problem in the post-World War II era has been in the opposite direction--too much liquidity from the monetary authority, which has led to persistent inflation.
Bill Dudley