Posted by: Dirk | July 5, 2012

Monetary policy in a liquidity trap: v.0.75

The NY Times comments:

The E.C.B. cut its benchmark rate to 0.75 percent from 1 percent, which was once regarded as the lower bound on the official rate. Economists and political leaders are likely to welcome the cut, which was expected by most analysts, as offering welcome relief from strains in the euro zone. But it also carries risks.

With interest rates now close to zero, the bank and its president, Mario Draghi, will have a dwindling selection of conventional monetary policy tools they can use to combat the crisis. The cut Thursday is likely to increase speculation that the E.C.B.’s next step to contain the crisis would be massive purchases of government bonds, similar to the quantitative easing undertaken by the U.S. Federal Reserve.

I don’t know whether what is reported here is true for the right reasons. Economists are likely to welcome to the cut? It should have been done much earlier. And the reason why this needs to happen is to prove that we are in a liquidity trap. Investment will not be jump-started, since that depends not only on the ECBs interest rate. Anyway, the ECB made sure that it’s latest policy step is successful.

The FT understands the important part:

The ECB also cut the interest rate on its deposit facility to zero, marking a bold step in its attempts to reduce general market interest rates and stimulate interbank lending.

The deposit rate is what the ECB pays banks for their overnight deposits with it. It in effect sets a floor for market rates, since banks have no incentive to lend to each other for less reward than they get for parking money safely at the central bank.

So, banks no longer get money for nothing, or, well, parking funds overnight at the central bank, which is a couple of key strokes more than nothing. As the euro declines against the US dollar right now, I would expect that banks move available funds from Europe to the US. They still pay the .25 over there. If this happens, it will show up in the data soon. Whether this has any consequences for the real economy is doubtful. If it doesn’t, there is no denying: conventional monetary policy (cutting interest rates) won’t do it. I would guess that exotic monetary policy (quantitative easing) won’t do it either.

At least we are getting somewhere now. The ECB will not be blamed for not firing its last bullets before the situation deteriorates further …

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