The Liquidity Trap Does Not Make Monetary Policy Ineffective

November 11, 2009 9:30 AM

With short-term, risk-free interest rates essentially at zero in the major developed economies, conventional monetary policy is in a liquidity trap. As a number of commentators have observed, printing zero-interest-rate money to buy zero-interest-rate assets has no real economic effect because the assets are near-perfect substitutes for money. But does that mean that central banks have lost their power? Jim Hamilton asserts that central bank purchases of other assets with positive yields can always create inflation, though he is silent as to whether they can affect output. Building on Gauti Eggertsson and Michael Woodford, Scott Sumner argues that central banks can boost output and inflation despite zero interest rates by raising the public's expectations of future inflation and thus lowering the real rate of interest. According to Sumner, purchases of a variety of assets are one way central banks can bolster these expectations.

Is there any evidence on the effect of central bank purchases of longer-term or riskier assets?

In recent months, central banks have purchased large quantities of longer-term assets. These purchases appear to have been effective at pushing down longer-term interest rates, which should stimulate economic activity. For example, the Federal Reserve (Fed) has purchased large quantities of longer-term, agency-backed securities and Treasury bonds. The following table shows that Fed communications about such purchases had substantial effects on a range of long-term interest rates, including on assets that were not included in the purchase program, such as interest rate swaps and corporate bonds.

Interest rate movements after Fed communications on asset purchases (basis points)

Nov. 25 Dec. 1–2 Dec. 16–17 Jan. 28–29 Mar. 18–19
Buy more Buy more Buy more Buy less Buy more

10-year Treasury –24 –27 –33 30 –40
10-year swap –32 –23 –53 5 –37
10-year + corporate* –16 –27 –57 23 –29

*Based on Barclay's long-term corporate aggregate price index, assuming 6-percent coupon and 12 years to maturity.
Note: Event windows are one day for morning announcements and two day for afternoon announcements.
Source: Datastream.

Since March 19, the Fed has not made any substantive changes to its planned purchases of longer-term assets. Over this period, the 10-year Treasury yield has risen about 75 basis points and the corporate yield has fallen about 200 basis points, reflecting a relaxation of the extreme financial strains and flight-to-quality that characterized the first few months of this year. Conventional fixed mortgage rates, a key target of the Fed's policy easing, have changed little on balance since late March.

Paul Krugman has argued that potential gains and losses when long-term interest rates move make a policy of purchasing such bonds especially risky, and that fiscal stimulus is a safer bet. However, central banks, including the Fed, have always held risky assets, including long-term bonds, foreign exchange reserves, loans to private banks, and even equities. In many cases, such assets comprise the bulk of the central bank's portfolio.

A good definition of expansionary monetary policy is the printing of money to purchase financial assets. Expansionary fiscal policy is the selling of financial assets to purchase goods and services, to cut taxes, or to increase transfers. On these definitions, both monetary and fiscal policy can be effective when short-term interest rates are zero.

This commentary was also posted on the blog Econbrowser.