Liquidity trap of a different sort

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As the Fed Funds rate gets close to zero, pundits have been worrying about a pending liquidity trap. While I think these worries are well placed because the Fed is running out of bullets, I am more concerned about inflation right now.

We are in the midst of a credit crisis. Banks are having to write off hundreds of billions of dollars of bad debt and are under-capitalized as a result. Banks do not lend in this environment. Moreover, money velocity slows and the Fed ends up pushing on a string as it lowers interest rates. The result is a liquidity trap where the lower interest rates just are not passed on to consumers in the form of new credit. As interest rates near zero, the Fed runs out of interest rate cuts as an option to stimulate the economy. This is what most economists fear is taking place right now.

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I fear a different kind of liquidity trap. As the Fed increases liquidity in the market, this extra money is supposed to go to consumers so that they can borrow at lower rates. However, with the housing market and stock market as unlikely places to want to put money, it is the commodity market to which this money is now flowing. The Fed has learned (wrongly) time and again that it should flood the market with liquidity in order to counteract economic weakness in the U.S. economy. The result has been repeated bubbles in the global and U.S. economy. Now, the list of asset classes where the world’s punters can invest is dwindling and commodities do seem like the surest bet (see articles here and here). As a result, we are getting an enormous increase in commodity prices.

The problem with a rise in commodity prices is that the liquidity the Fed is adding that only showed up in asset prices in previous bubbles is now showing up in consumer price inflation. Even Chinese manufacturers are beginning to pass through price increases to consumers in the U.S. and elsewhere. And that’s bad news for the Fed, because when inflation rises, it limits the Feds policy options. And this may actually mean that the Fed will have to raise interest rates sooner rather than later.

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The Fed has no one to blame but itself here. While there are many reasons for agricultural, metal and oil-related commodity prices to increase, the Fed’s increased liquidity is going right into those markets making a commodity bubble the likely result. Flooding the market with liquidity after an asset bubble pops is not the way to deal with bubbles.

So, yes, a liquidity trap is in the offing, but it’s just not the one the Fed expected.

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