Liquidity trap in the US?

The comparisons with Japan of the nineties and early part of this decade look increasingly appropriate for the US economy. By cutting the Federal funds rate, the rate which banks charge each other on overnight loans, by 50 basis points to 1%, the Fed has opened up strong possibility of a zero rate scenario, commonly called "Zero Lower Bound".

The Japanese Central Bank had kept interest rates at zero for five years from 2001 to 2006, in an effort to combat persisting deflation and to stimulate an economy that tanked into recession in the aftermath of the bursting of the property and financial market bubbles. Like Japan’s, American banks have become so decimated by losses in real estate that they are either unable or unwilling to resume normal lending.



However, the rate cuts may not mean much as the economy’s problems have less to do with interest rates than the reluctance of banks and financial institutions to lend money. Even though the Fed has lent almost $600 billion to financial institutions in the last month alone, banks are still reluctant to lend to businesses or consumers. Since the credit crisis began in August 2007, the Fed has slashed the overnight lending rate from 5.25%. But interest rates for 30-year fixed-rate mortgages are about 6.3%, roughly where they were when the credit crisis began.

The prospect of zero rates will limit the traditional monetary policy options. The remaining options would involve "quantitative easing" by effectively printing more money and injecting it into the eocnomy. The Fed could start buying Treasury securities with longer maturities, which would push up their prices and drive down longer-term interest rates. If that didn’t work, the Fed could start buying up privately-issued debt, like corporate bonds. All these options have adverse long term implications on the macroeconomic balance, if they fail.

If the Fed funds rate did drop to zero, it would not mean free money for consumers or businesses. The zero rate would only apply to the reserves that banks are required to maintain and that they lend to one another. Customers would still have to pay some interest, but the rates could be extremely low for some business borrowers.

The rate cut comes even as the Fed acknowledged that the economy had lost steam on almost every front — consumer spending, business investment, financial markets and even exports, which had been the one bright spot recently. Further, so early in a downturn, the US economy has shed more than 700,000 jobs so far this year, and the unemployment rate has climbed to 6.1%, from 5% in January, and is estimated to reach atleast 8%. Credit card companies, facing sharp increase in defaults, have made sharp cuts in their lending.



Interestingly, with rates approaching zero, it is important that the US economy experience some amount of inflation, or else fall into a liquidity trap similar to the one that Japan faced. Some amount of inflation is desirable under such low interest rate conditions, so as to both encourage spending and give enough room for flexibility in case of rates being forced down further. But the falling commodity prices may have exactly the opposite effect, stoking off deflationary pressures.

Update 1
Now comes the first statistical confirmation of a recession, with personal consumption falling at an annual rate of 3.1% in the third quarter of this year, its biggest drop since 1980, when the economy was in a deep recession. The last quarter in which consumers reduced their spending came in 1991. All this translates into an annualised shrinkage of the economy by 0.3%, a figure that is certain to worsen as the recession deepens.

Update 2
Mostly Economics explains Zero Interest Rate Policy (ZIRP), deflation and the liquidity trap.