In this post Nick Rowe asks THE question: “How can you get an economy INTO a liquidity trap?”
We spend a lot of time thinking about how to get out of a liquidity trap. Maybe we can think more clearly about that question if we instead ask the exact opposite question.
But let’s be a little more precise about our question:
How can you get an economy into a liquidity trap in such a way that someone else couldn’t get it back out of that same liquidity trap just by reversing whatever it is you were doing? Because it’s not really a “trap” if someone else can get the economy out of it.
And after toying with some metaphors he ‘stumbles’ upon a candidate:
I can only think of one plausible candidate that might work: inflation inertia. If there is inflation inertia, monetary policy still ultimately controls inflation, but the inflation rate has a lot of momentum, so that it’s hard to get it to speed up or slow down quickly. If there is sufficient inflation inertia, I might be able to get the Canadian economy stuck in a liquidity trap so badly it would be very hard for anyone else to get it out again.
And sums up:
Empirically the evidence seems to be mixed, at least to my eyes. During relatively normal times there looks like a lot of inflation inertia. It’s just too easy to forecast inflation, especially core inflation, from lagged inflation. But in abnormal times, when there is a clear change in monetary regime that changes expectations, inflation seems to change very quickly. We saw that when the Bank of Canada announced the original inflation targeting agreement. We saw it even more clearly in Sargent’s “The ends of four big inflations” (pdf). Dragging me out of the Bank of Canada and putting Steve Poloz back in charge would be a very big and obvious change in monetary regime.
Dunno. It might be possible to get an economy irreversibly stuck in a liquidity trap. But it’s a lot harder than you might think.
All that reminded me of the grand excuse in Brazil during the 20 years of ‘galloping’ inflation. It was said that monetary policy couldn´t do much because, you guessed, inflation was inertial! So policymakers tried alternatives: Price guidance, Price controls, Price freezes and culminating in the ‘sequester’ of people´s financial assets! And inflation kept climbing higher and higher…until one day (literally) it stopped à la Sargent. The equivalent alternatives to supposedly inertial low inflation are QE, forward guidance and the like. But like a sequence of price controls they don´t seem to change expectations.
Just as you cannot get irreversibly stuck in an hyperinflation, you cannot get irreversibly stuck in a liquidity trap. It´s always someone´s (usually the leading policymaker´s) choice.
Yes,” if there´s a change in monetary regime that changes expectations, inflation seems to change very quickly”. In addition to the examples of Canada, Sargent´s and Brazil, there is the dramatic price reversal in 1933 when the US delinked from gold and monetary policy became credibly expansionary (irrespective of interest rates).
My conclusion is different from Nick´s. It´s just as easy to get the economy stuck (not irreversibly) in high (hyper) inflation mode as it is to get it stuck in a liquidity trap. And it has nothing to do with the level of interest rates (ZLB or IUB (infinite upper bound)). It´s the policymaker´s CHOICE. And in this day and age it´s ‘politically correct’ to keep inflation ‘inertialized’ at 2%, come hell or high water!
In the comments Nick asks: “Tell us a little more about the day the inflation stopped, and especially about what caused people to stop believing in inflation inertia.”
The chart illustrates (For PC1, etc, read “Price Freeze”):
First there was a “trick” applied for a few months to ‘align’ relative prices (see here) and the exchange rate anchor introduced on June 30 1994, for some reason, was immediately credible. Credibility over an inflation target also garnered ‘instant’ credibility in March 99 when the exchange rate anchor was ‘pulled out’.