Thursday, September 15, 2016

Is The Fed Stuck in a Liquidity Trap?

When both stocks and bonds are overpriced, and commodities which were considered overpriced less than five years ago and are now well on the way to correcting, where can an investor turn? It's sort of a trick question, because the answer is cash. Well enough, the Fed and most other major central banks are maintaining very accommodative monetary policy stances, providing ample dollar supplies to match the growing secular demand for liquidity. Institutional money inspired by the Fed Quantitative Easing (QE) programs has inflated and benefitted from the inflation of both stock and bond prices.

Now that the Fed's Large Scale Asset Purchase (LSAP) programs have ended, and the road to alleged monetary policy normalization has been embarked upon, the institutional investors no longer see the need for broad-based accumulation of financial assets. With no buyer-of-last resort, financial market participants (on the institutional level) will have to go back to relying on market demand to support the prices of the assets they buy and sell daily. This phenomenon is apparent in the mid-term price patterns of the S&P500, and the Dollar Index, which have both been advancing higher. Especially when compared to the price patterns of crude oil, gold, and the US 10-year interest rate, which have all been retrogressing.

According to a 2014 issue of The Regional Economist, by the St. Louis Fed, the article titled "The Liquidity Trap: An Alternative Explanation of Today's Low Inflation", states ...Conventionally, the expansion of the money supply will generate inflation as more money is chasing after the same amount of goods available. During a liquidity trap, however, increases in the money supply are fully absorbed by excess demand for money (liquidity) investors hoard the increased money instead of spending it because the opportunity cost of holding cash --the foregone earnings from interest-- is zero when the nominal interest rate is zero. Even worse, if the increased money supply is through LSAPs on long-term debt (as is the case under QE), investors are prompted to further shift their portfolio holdings from interest-bearing assets to cash.

To get away from this scenario, which sounds a lot like the one the US economy is in now, the article prescribes that the Federal Reserve attempt to raise inflation expectations by manipulating long-term interest rates. The idea is to not just stop the LSAPs and let the securities mature on the Fed's balance sheet, but rather to reverse the LSAPs and sell securities in the open market. A direct result would be financial asset prices falling as the market would seek to clear the increase in supply. This would push long-term interest rates higher, and theoretically lift long-term inflation expectations, which would in turn drag short-term inflation up with it. A downward trend in financial asset prices should prompt investors to shift portfolio holdings towards real and commodity based asset classes, pushing those prices higher, and further perpetuating short-term price increases.

The logic appears to be direct, so much so that it's a wonder that the Federal Reserve has not yet adopted and started implementing a similar policy. The issue may simply be that the real world does not flow as seamlessly as the theoretical world of financial economics, meaning the disconnect can represent years of waiting for sticky prices to adjust to economic fundamentals and for new market equilibria to be achieved. Pivots in monetary policy can be very disruptive to macroeconomics, which is why fiscal policy should be introduced to smooth out economic readjustments. This mix of monetary policy and fiscal policy can only be utilized effectively however, if there are no major budgeting constraints on the fiscal side, i.e. too much existing debt.

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