The Fed, The Sell Off and The Future

Posted by: : Shayne HeffernanPosted on: October 16, 2014 The Fed, The Sell Off and The Future

The Fed, The Sell Off and The Future

The Fed’s policy setting committee meets Oct. 28-29 and plans to end its bond-buying program then. Its language will be watched particularly closely for evidence of how deeply recent world events have affected its thinking.

“We have seen a lot of sizable ups and downs in recent days and we don’t know where the dust will settle,” said Antulio Bomfim, a former Fed economist and senior managing director at the Macroeconomic Advisers consulting firm. “I don’t think this fundamentally moves the (Federal Open Market Committee) in a different direction, (but) it does throw more caution into a committee that was already cautious.”

Central bank officials from Washington to Tokyo face questions that have dogged them in recent years: Is recent volatility just a sign of markets adjusting to a host of issues, from the potential for rising interest rates to tensions in the Middle East? Or is the world economy backsliding?

Those who still have wiggle room have already been using it with central banks in Sweden, Poland and South Korea cutting interest rates over the past few days. Beijing is also expected to use its policy leeway to keep rolling out stimulus measures to keep the world’s second-largest economy from cooling too much.

It is a greater challenge for the Fed, the Bank of England, the European Central Bank and the Bank of Japan, which have long hit the limits of conventional monetary policy.

Welcome to the Liquidity Trap

Shayne Heffernan warns on a bloated US economy in 2014, the excess of money printed and the asset bubble.

A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels

In its original conception, a liquidity trap refers to the phenomenon when increased money supply fails to lower interest rates. Usually central banks try to lower interest rates by buying bonds with newly created cash. In a liquidity trap, bonds pay little to no interest, which makes them nearly equivalent to cash. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate.

In the wake of the Keynesian revolution in the 1930s and 1940s, various neoclassical economists sought to minimize the concept of a liquidity trap by specifying conditions in which expansive monetary policy would affect the economy even if interest rates failed to decline. Don Patinkin and Lloyd Metzler specified the existence of a “Pigou effect,” named after English economist Arthur Cecil Pigou, in which the stock of real money balances is an element of the aggregate demand function for goods, so that the money stock would directly affect the “investment saving” curve in an IS/LM analysis, and monetary policy would thus be able to stimulate the economy even during the existence of a liquidity trap. While many economists had serious doubts about the existence or significance of this Pigou Effect, by the 1960s academic economists gave little credence to the concept of a liquidity trap.

The neoclassical economists asserted that, even in a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of the Bank of Japan in 2001, when it embarked upon quantitative easing. Similarly it was the hope of the central banks of the United States and Europe in 2008–2009, with their foray into quantitative easing. These policy initiatives tried to stimulate the economy through methods other than the reduction of short-term interest rates.

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Shayne Heffernan holds a Ph.D. in Economics and brings with him over 25 years of trading experience in Asia and hands on experience in Venture Capital, he has been involved in several start ups that have seen market capitalization over $500m and 1 that reach a peak market cap of $15b. He has managed and overseen start ups in Mining, Shipping, Technology and Financial Services.
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