America's Looming Liquidity Trap

In October 2008, the US unemployment rate hit 6.5%, a 14-and-a-half year high, as announced by the Labor Department. This lofty rate is likely to increase in the coming months in the wake of the ongoing financial crisis and adjustments in the real estate market. It also comes despite two 50 basis point cuts in the target federal funds rate made by the Federal Reserve during that month. These interest rate reductions brought the target fed funds rate down to 1%, a very low target rate by historical standards and close to the nominal rate floor of 0%. The Federal Reserve therefore finds itself in the thorny situation of having only 100 basis points left to work with for possible target rate cuts. (Note that a basis point represents 1/100th of a percentage point, so 1% is 100 basis points.)

The fed funds rate cannot go below 0% because a transaction at a negative nominal rate implies a negative nominal cost of borrowing funds. Furthermore, that implies a positive nominal payoff to the borrower and a positive nominal loss to the lender. Under typical, positive rates of inflation, the real costs and payoffs are amplified. This is shown in the following Fisher equation where i is the nominal interest rate, r is the real interest rate, and is the inflation rate:


This floor for the nominal fed funds rate brings up the very real possibility that the US will soon be mired in a liquidity trap—a situation in which "the monetary authority is unable to stimulate the economy with traditional monetary policy tools." One explanation for this weakness of monetary policy comes from the analysis on the real interest rate given above. In difficult economic times, why would financial institutions take on the risk of lending out money to a borrower who may default on the loan when the real return on even a fully repaid loan is negative!

An excellent source on how our nation might remedy its liquidity trap is given by the 2008 Nobel Laureate in Economic Sciences, Paul Krugman. His 1999 article "Thinking About the Liquidity Trap" offered policy solutions for springing the Japanese economy from the type of liquidity trap that now threatens the United States. Krugman's figure 1 from that paper shows a nice IS-LM example of the ineffectiveness of monetary policy. Wikipedia provides a good introduction to the IS-LM model. Below I present a modified version of Krugman's figure 1, in the context of current US interest rates, to represent traditional monetary expansion with a looming liquidity trap.



An economy may also happen to face declining consumption expenditures, as the US currently does, due to concerns about a rising unemployment rate, which can result in lower exogenous consumption and a falling marginal propensity to consume. In that case, the resulting leftward movements of the IS curve make monetary policy even less effective. Krugman's solution to the scenario is to have the monetary authorities credibly commit to sustained higher future inflation. The expectation that such higher inflation will eat away at the purchasing power of cash holdings should convince consumers to ramp up their spending and move the IS curve rightward.

President-elect Obama and the new Congress will undoubtedly undertake expansionary fiscal policy to attempt to move the IS curve rightward. However, our already massive national debt and the likelihood of waste involved in government spending, support Krugman's solution. Our newly elected officials and the Federal Reserve Board are facing unenviable policy choices.

Discussion Questions

1. Suppose that you were in control of US fiscal and monetary policy. What policies, if any, would you implement to improve US economic conditions?

2. Do you believe that America will soon face a liquidity trap? Why or why not?

3. The International Monetary Fund forecasts that the world's rich economies will collectively experience economic contraction for the first time since World War II. When was the last time America faced a liquidity trap? What circumstances led to that liquidity trap environment?

Financial Market Risks and Negative Nominal T-bill Rates

On September 17, in the immediate aftermath of the Lehman Brothers bankruptcy, the AIG bailout, and the mortgage crisis, negative nominal Treasury bill rates briefly appeared for the first time since January 1940. As Madlen Read points out, a negative nominal Treasury bill rate implies that “investors were willing to take a small loss on the security.”

At first glance, such behavior on the part of seasoned investors seems odd. Why pay more for a security than the amount the US Federal government guarantees to pay you in the future¹? One possibility would be that the general price level could fall so that the smaller future payment would represent more purchasing power than the current price of the security. That is, if the price level falls enough, the $1000 payment one receives in several months could buy more than, say the $1000.05 price of the bill could buy today. There is some evidence for this: the US Bureau of Labor Statistics reports that in 2008, on a monthly basis, the percentage change in the CPI was 1.1% in June, 0.8% in July, and –0.1% in August. However, if that is the case, one would still get more purchasing power by holding the $1000.05 in cash through the period of falling prices than by receiving only $1000 in the future. Yet, where can such cash be stored safely?

A more likely explanation is that growing fears of systemic risk have discouraged investors from holding any but the safest financial assets. One example of systemic risk comes from the Reserve Primary Fund, the oldest U.S. money-market fund, which lost two-thirds of its asset value due to its investment in Lehman Brothers’s debt. Wary investors fear that similar losses could threaten other financial institutions. Since US Treasuries are generally considered to be the safest investment possible, there was apparently a rush to invest in these securities. Therefore, an increase in demand for T-bills was likely accompanied by a reduced willingness to sell such securities. The latter represents a decline in the supply of T-bills. Both sides of the market then acted in unison to push up the price of T-bills to such an extent that their sales prices briefly exceeded their maturity values. The maturity value, represented on the graph below by the M=1000 line, is the amount, typically $1000, that the bill specifies will be paid to the owner at maturity.


We can solve for the negative nominal rate mathematically using the following formula:


where M is the bill’s maturity value, PB is the bill’s price, and r is its annualized rate of return on the bill when it is held to maturity.

To illustrate the negative rate phenomenon, suppose that for a $1000 maturity value, the market trades a 3-month T-bill at a price of $1000.05. The nominal rate of return, r, is therefore –.02%.

Negative nominal rates were described here in the context of the Japanese market by Daniel L. Thornton in the January 1999 issue of "Monetary Trends." In the article, Thornton states that “investors are willing to accept a negative nominal return on a risk-free asset because holding it is cheaper and less risky than transporting and storing cash.” So it seems that for one day at least, investors were willing to lock in a nominal loss on a safe asset rather than risk leaving cash in financial institutions.

Discussion Questions
1. The Lehman Brothers bankruptcy, the AIG bailout, and the mortgage crisis have apparently shaken investor confidence in financial institutions. Do you think their fears are justified? Do you believe that these financial events have had an impact on your life? If yes, how, and if not, then why not?

2. How might forecasts of a falling general price level in the near future help to explain investors' willingness to accept negative nominal T-bill rates?

3. The dramatic shifting of funds into the safety of Treasuries implies that funds left other sectors. With many financial sites available, you can find information the returns on various financial assets online. Which investment sectors had the largest declines on Sept. 17, 2008? Which investment sectors had the largest gains on that day? How would you explain the results that you found?
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¹ Recall that T-bills have zero coupons which means that they make no payment until the maturity date.

What's in Your Wallet?

Suppose you have two things in your wallet: a $20 bill and a frequent flier card. Which of these is considered money?

The formal definition of money is that it is (1) a medium of exchange, (2) a store of value, and (3) a unit of measure. The $20 bill clearly meets all three. The frequent flier miles are a tougher question.

These days, you can use frequent flier miles for a lot more than just booking plane tickets. Airlines have cross-promotions with magazines and home entertainment stores that enable you to cash in your miles for all kinds of goodies. At the same time, it's getting tougher to actually fly with frequent flier miles, as airlines reduce the number of seats eligible for frequent flier redemptions. Even if airlines stopped issuing miles, it would take people years to draw down their current stash of frequent flier miles. Hence, the pressure to create uses for miles that don't involve air travel, making miles a true medium of exchange.

In many ways, then, frequent flier miles act as a sort of mirror currency. Are they a good store of value, though? With airline bankruptcies mounting, David A. Kelly of the New York Times offers some free "Advice to Mileage Misers: Use the Hoard Now." He argues that evaporating opportunities to use miles amount to inflation of the frequent flier currency. That is, as the airlines reduce the number of redeemable seats, the purchasing power of frequent flier miles falls. Kelly quotes Tim Jarrell, publisher of Fodor's Travel Publications: "They're not bank accounts that earn interest." Another interesting quote from the article:

"Frequent-flier programs have turned into trading stamp programs without the stamps," said Terry Trippler, spokesman for CheapSeats.com. "Instead of opening up more seats for travelers, most programs are now offering magazine subscriptions, gift certificates or merchandise such as TVs instead. I sometimes wonder if the TV sets they're offering will last longer than the airlines themselves."

1. There are lots of other things that act like currency in our society, from Starbucks stored value cards to credits on iTunes. Some are even purely virtual, like currency in online fantasy games like Ultima. (See this BBC News article. Interestingly, the Gaming Open Market that it refers to is now closed, with a rather humorous sign-off.) Can you name a few more? What do they have in common with cash? What differentiates them from traditional currency? Do any of the stored value cards or credit systems gain value over time; are any of them worth hoarding?

2. A $20 Starbucks stored value card is clearly worth less than a $20 bill. Why do people buy stored value cards at face value?

3. Kelly has many useful nuggets of advice for using up your frequent flier miles. In many cases, he says, a trip from point A to point B may be possible, but it's made difficult because there are many possible routes that need to be checked. For example, he cites a case in which agents tell customers it's impossible to fly to Asia on frequent flier miles, while it is in fact possible, but only if you go through Amsterdam, which takes a bit longer. Why is it profitable for airlines to make it difficult to redeem miles? Is there an optimal level of difficulty? If you were in charge of an airline frequent-flier program, how would you find that optimal level?