There Is No Liquidity Trap: Understanding 21st Century Monetary Policy

With short-term interest rates near zero in the major advanced economies, bloggers and pundits have argued about whether we are in a "liquidity trap," in which monetary policy is no longer able to boost spending and economic activity. The liquidity trap hypothesis has some validity, but only if one arbitrarily restricts the definition of monetary policy to purchases of short-term risk-free bonds. There is no economic reason, and not even a historical precedent, for such a limited view of monetary policy. A broader view of monetary policy shows that we are far from any liquidity trap and it is difficult to imagine that we ever could be in a liquidity trap.

Monetary policy consists of printing money to buy assets. This is true whether the aim is to lower the federal funds rate, the mortgage rate, or any other rate of return. Fiscal policy consists of selling assets to buy goods, cut taxes, or increase transfers. (Milton Friedman's famous "helicopter drop" of money to fight deflation is really a combination of monetary and fiscal policy.) As long as there exist assets whose price would be pushed up (and rate of return pushed down) by extra demand, monetary policy remains effective and there is no liquidity trap. Fiscal policy may be a useful alternative or complement to monetary policy in certain circumstances, but it is not a necessary alternative even when the short-term risk-free interest rate is zero.

Central banks have always held risky assets, including long-term bonds, loans to banks, gold, and foreign exchange reserves. Some central banks also hold equity and real estate. Conducting monetary policy when short-term interest rates are near zero requires central banks to take on more risk, but this is only a difference of degree and not of kind. My colleague Adam S. Posen has argued forcefully that central banks should not abjure a wide range of policy tools and instead should design strategies for using all the tools at their disposal to maintain stable growth with low inflation.

A recent outpouring of research confirms that central banks do have the ability to influence long-term bond yields and mortgage rates significantly.1. There is no reason to doubt that central bank purchases of equity or real estate could significantly influence the prices of those assets. Indeed, the Hong Kong Monetary Authority conducted a spectacularly successful stabilization of the Hong Kong stock market in 1998 during the Asian financial crisis.

Macroeconomic models suggest that central bank purchases of long-term bonds and other risky assets can provide significant macroeconomic stimulus.2 Moreover, as I discussed in a previous blog post, the risk of losses to central banks that undertake such purchases is small compared to the overall fiscal benefits. These results make monetary policy far more attractive than fiscal policy in providing macroeconomic stimulus, even when short-term rates are near zero.

The only question is why the major advanced-economy central banks have been so timid in using their powers and allowed inflation—and for the United States, employment—to fall below their targets.3

Notes

1. See appendix table 2 in Unconventional Monetary Policies—Recent Experience and Prospects.

2. See, for example, a recent speech by Federal Reserve Vice Chairman Janet Yellen.

3. The Bank of England is a notable exception, as UK inflation has exceeded its target on average in recent years.