Europe?s bank falls into a false-logic trap By Wolfgang Münchau
Financial Times Published: February 1 2009 18:13\
Question: ?What does the ECB understand a ?liquidity trap? to mean? ?
Answer: ?We do not intend to have interest rates so low that their efficiency is meaningless.?
From a Financial Times interview with Yves Mersch, a member of the governing council of the European Central Bank, January 26
Mr Mersch is effectively saying that, by not cutting interest rates, one can avoid getting into a liquidity trap. It is hard to think of a statement about monetary policy simultaneously more absurd and more dangerous.
A liquidity trap is a situation in which the conventional tools of monetary policy lose traction. Such a situation usually arises when official and market interest rates are all close to zero. In that case, the central bank cannot cut official rates, or achieve much by buying government bonds.
But let us not mix up cause and effects. It is the liquidity trap that causes monetary policy to be ineffective. It is not that a particular level of interest rates causes the liquidity trap. This is the logic of a driver who refuses to brake when confronted with a potential accident for fear of losing traction.
Take the example of an economy with deflation of 5 per cent. If the central bank were to cut nominal rates to zero, then the real interest rate ? the nominal rate minus expected inflation ? would be 5 per cent. The economy would be trapped. But if the central bank had left interest rates at a positive 2 per cent, the economy would be even more trapped, since the real interest rate would then be 7 per cent.
When faced with such a situation, a central bank should always cut rates to zero, not worry about efficiency and let fiscal policy do the rest. Mr Mersch?s reverse logic is false: not cutting interest rates would not avoid a liquidity trap.
So how realistic is a liquidity trap in the eurozone? Some people have argued that we are already in a liquidity trap because the problem for borrowers at the moment is not the price of the loan, but getting the loan in the first place. However, a credit crunch does not mean that interest rate cuts have no macroeconomic effect. For example, borrowers whose mortgage or business loans are tied to the Euribor money market interest rate are currently enjoying a significant fall in repayments. Monetary policy undoubtedly has traction. The question is whether it is sufficient to a avoid a liquidity trap later in the year.
I would characterise the probability of a liquidity trap as low but rising. The latest estimate for annual inflation during January was
1.1 per cent according to Eurostat, the European Union?s statistics office. The International Monetary Fund expects average inflation rates in industrialised countries to remain below 1 per cent both in 2009 and 2010. The growth of credit to companies and households in the eurozone is now negative. The latest unemployment figures for Germany were awful. The eurozone economy has developed such a negative dynamic that we would be foolish to seek solace in the mean-reverting trend of our economic forecasts.I am not arguing, as some economists do reflexively, that real interest rates should be negative most of the time. Lorenzo Bini Smaghi, a member of the ECB?s executive committee, is right when he says that a sustained period of this could give rise to future asset price bubbles. But another rate cut from present levels implies a negative real interest rate only if current inflationary expectations are well anchored to the ECB?s target of ?below but close to 2 per cent?. Are they?
Inflation expectations are not a constant, nor are they a daily number you can look up in a financial newspaper. Even the market-based indicators of inflationary expectations, such as inflation futures or inflation-linked bonds, are not always helpful. They tell us mostly what we already know. We know that inflation expectations can change very quickly during sharp and long recessions. We may find that inflation expectations are indeed well anchored ? until they are not. Then what?
Obviously, the ECB can always wait and see. But that would contradict the notion of a forward-looking monetary policy. On the basis of what we know now, there is a greater risk of inflation expectations falling below 1 per cent than rising above 3 per cent. For that reason mainly, I would favour a 100 basis point cut now. If the optimists are right and growth resumes in the third quarter, they can always tighten policy without any danger of creating an inflationary boom. But if the optimists are wrong, as I suspect they are, the central bank can then cut rates to zero relatively quickly.
I know that some central bankers are reluctant to cut interest rates to such historically low levels for fear of repeating the mistake of the US Federal Reserve when it cut interest rates to 1 per cent during
2003 and 2004. But at that time, the global economy was expanding. Asset price bubbles were building up in various sectors. The financial services industry was booming. Today, we are on the verge of a systemic financial collapse, the worst global economic downturn since the Great Depression and falling asset prices. Surely, this is not the same situation.But whatever course of action the ECB takes, it needs to explain it with greater clarity and precision. And council members should be able to answer that liquidity trap question without getting trapped.
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