Battling a Liquidity Trap: Discovering More Tools in the Fed's Tool Chest

Oct 12, 2011, 16:13 ET from Mesirow Financial

CHICAGO, Oct. 12, 2011 /PRNewswire/ -- In the October issue of Themes on the Economy®, Chief Economist Diane Swonk takes a look at whether the U.S. has fallen into a liquidity trap, much as Japan did during the 1990s. Historically, the only way to combat a liquidity trap was to expand government spending, to compensate for reluctant private investment. Given new research and the reality that Washington is not in a spending mood, Swonk explains what tools the Federal Reserve could use now. Read this month's issue.

  • What is a liquidity trap? Banks are awash in capital, large companies in cash, but they are reluctant to open the floodgates and let this unprecedented liquidity flow into the economy.
  • To illustrate the dilemma, Swonk quotes the Romantic poet, Samuel Taylor Coleridge: "Water, water, everywhere, Nor any drop to drink," adding that, "I remember picturing a sailor dying of thirst," adrift on a sea of undrinkable salt water.
  • But the Federal Reserve is not helpless. "Central banks can and have shown an ability to affect output growth by shifting expectations, once the zero bound (on interest rates) is hit," Swonk said. "Naysayers worry that any such shifts in the expectations component of monetary policy, although sound in theory, could backfire in practice," or even "seed future bubbles," Swonk noted.
  • "It looks like the Fed is heading toward an unemployment target, before it goes all out on reflating the economy with a temporarily higher inflation target," she predicted.
  • Swonk argues that, "the key for policy makers is to provide some level of certainty," so that companies feel more comfortable investing.

The October issue of Themes on the Economy® as well as archived issues can be found at

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