Liquidity Trap

Ben Bernanke knows this scenario. It’s not been admitted yet, but it’s looking very much like a liquidity trap. Rates on T-bills are already precipitously close to zero. Paul Krugman wrote in September (emphasis ours):

You still see people saying, in effect, “never mind the zero interest rate, why not just print more money?” Actually, the Bank of Japan tried that, under the name “quantitative easing;” basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn’t have any other advantages. As a result, monetary base and T-bills – the two sides of the Fed’s balance sheet – become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact. That’s why the liquidity trap makes conventional monetary policy impotent.

How impotent? Consider the numbers: the Fed has an $800bn balance sheet to operate in a $50 trillion credit market. The only thing that gives it power is its ability to create monetary base, and in a liquidity trap, that power is useless.

Krugman’s point then was that Bernanke had come up with a third-way alternative to escape a liquidity trap, but that the alternative was, in practice, failing.

That alternative being a quantitative-easing type expansion of the balance sheet, but not to buy T-bills, but other assets – mortgage securities, for example. A Bernanke Twist.

In 1961, the Fed launched the first – formally, only – “Operation Twist”. The idea was that the Fed would use its powers in open market operations to target asset prices: specifically, to flatten the yield curve. The Fed operated directly in the long term Treasuries market in an effort to depress long-term borrowing costs (and thus stimulate economic growth) while simultaneously seeking to prop the dollar by supporting shorter term rates. Krugman again:

I guess the Fed had to try the “Bernanke twist.” And it did – the old Fed balance sheet, in which T-bills were the vast bulk of assets, is no more. But the effects have been disappointing, especially weighed against the risk, which I know is making Fed officials very nervous.

Bernanke though, now doesn’t look like he is giving up on the twist, as Krugman thought the advent of the TARP signalled. Indeed, the realisation seems to be, that as now a mere $800bn player in a $50 trillion market, the Fed needs more ammunition. Brad DeLong writes:

…the natural answer appears to be open-market operations working not on the liquidity premium but on the risk premium–Operation Twist on a Pan-Galactic scale.

How to fund that? You could issue T-bills. But as Brad Setser points out fundamental changes in the T-bill buyer market make that a risky proposition.

So you could just admit you were in a liquidity trap and use all those excess bank reserves to your advantage instead. As Cloherty writes at BoA:

If the Fed is going to pay target, it suggests that they may scrap the SFP bill program (there is less need to drain reserves to try to keep funds above the target). If that happens, that is $630bn of outstanding SFP bills that are no longer needed. Any reduction in SFP bills would likely be replaced by regular Tbills. But this means much less need for larger auction sizes out the curve-fewer SFP bills means fewer 2yr and 5yr notes.

The Fed’s move last night is the first big signal, then, that it will pursue a policy of quantitative easing.

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At its core, the Bernanke Twist is a direct effort to try and support prices; to stop destructive debt deflation. We are in uncharted territory though. The Fed is not just trying to game the market in US government debt. It’s trying to support the entire asset-backed debt market.

Which is particularly risky when the the Fed is effectively supporting those prices by positioning itself as a risk sump.

No wonder, as Krugman says, Fed officials are “nervous”. This is an all-out gamble.

It isn’t clear just how much the Fed will need to throw into that system to actually prop it: so far, the Fed’s balance sheet alone has not been enough. The TARP doesn’t look like it has enough either. Consider the fact that total capital raised by the banking system is actually less than total writedowns taken to date.

There’s a big danger here for the Fed: that it is trying to catch a falling knife. The Fed is risking things it’s never risked before. That’s not to say we’re in apocalyptic territory at all; consider the firepower the Fed has behind it. It is though, to use a hackneyed, but apt phrase, paradigm shifting.

In Japan, where quantitative easing failed, the central bank’s balance sheet swelled to a size equivalent to 30 per cent of GDP. The Fed’s balance sheet is currently equivalent to 12 per cent of GDP.

Where we go from here then very much depends on how severe you see this crisis relative to Japan.