As pointed out by Paul Krugman on his blog, we may be quite close to a liquidity trap (read: Japan in 90s). The closing rates today for the 1 month and 3 month t-bills are 0.26 and 0.61 respectively. This leaves the Fed with little room to cut short term rates and at this point traditional monetary policy (open-market operations) essentially stops working. With a "slowing" economy and the financial markets having liquidity problems of their own (which is largely the reason t-bills have such low yields), this is quite a worrying sign.
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that is, of course, if you believe liquidity traps exist and that Japan actually had one.... an LT means that interest rates are so low monetary policy is ineffective, but krugman and others must remember to distinguish real and nominal interest rates... real rates matter, and if there was deflation in japan, which there was, then the real rate was much higher than 0.25% (or whatever it was)... thus the evidence for an LT becomes very suspect when one looks at Japan in the 90s and US in the 30s
see Anna Schwartz NBER paper refuting Krugman's assertion that an LT was experienced in Japan (i'll try to locate the link and post it here but i believe the title contained "setting the record straight" or something similar)
*the evidence being suspect for the US in the 30s obviously because of the deflationary effect making low nominal interest rates actually quite high real interest rates... by the way i hate the ISLM if you cannot tell
Interesting point, though in regards to real interest rates mattering, I've seen discussion of the idea that real rates have dipped below zero recently. If that is the case, wouldn't that bolster the argument? I'll see if I can find some info on that.
I was actually unaware of any serious contention surrounding the idea of liquidity traps, probably because I'm not too familiar with them. I'd like to take a look at that paper, so please post it if you find it. It'd be intriguing to see an argument against it.
i'll look around for the paper and will email to you when i find it.
as for the real rate currently dipping below 0... if it sustains below 0 and we continue to see the weakness in the economy without a let up in inflation, that might probably be the strongest evidence for an LT phenomenon we've ever seen. so maybe krugman can go back to writing textbooks and teaching courses on a regular basis, and give up his NYTimes spot, if we do have an LT...
http://research.stlouisfed.org/wp/2007/2007-048.pdf
sections 1 and 6 deal directly with LT i believe
Could someone help me past my difficulty with an elementary concept: why do low rates on T-bills nullify the open-market actions of the Fed? The Fed buys T-bills from its primary dealers and member banks, replacing T-bills on their balance sheeets with cash. The Fed prints the money for the purpose, so viola! more money in the economy. T-bills are yielding squat, so the Fed now has a low-yielding investment, but the dealers and banks still have cash. Why do the low rates nullify the Fed's actions? I'm having a hard time with Krugman's posts on the possible liquidity trap because I can't grasp this basic concept. Would someone be so kind as to help?
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