Disarming the liquidity trap

What happens if the Fed lowers interest rates, but nobody cares?

This situation-- known as a "liquidity trap"--is becoming an increasingly relevant concern. A liquidity trap happens when a central bank lowers interest rates, but the money doesn't flow through the financial system to stimulate economic activity. Instead it gets trapped behind banks that are unable or unwilling to lend. In the liquidity trap scenario, traditional monetary policy becomes impotent. It is like pushing on a string.

The solution to a liquidity trap is to bypass the banks and inject the money directly into the economy. Some countries, notably Japan in the 1990's, have tried to do this through government spending. However, Japan's efforts resulted in the building of low yielding infrastructure projects that bloated government finances without jump the flagging consumer.

Milton Friedman suggests that the best way out of liquidity trap is for monetary authorities to "gift" money directly to consumers and companies. The Federal Reserve's decision yesterday to enter the commercial paper market directly is one example of how this could be done. I expect that will be a very effective measure and I applaud Ben Bernanke for taking this bold step.

A logical extension of this thinking is for the Federal Reserve to become a lender directly to the mortgage market. In the current situation, that could be a very potent remedy. If the liquidity crisis does not ease soon, I would not be surprised to see us go down this path. Stranger things have happened.