liquidity trap

The Bank of England meets on Thursday with expectations running high that the MPC will announce a further large dose of quantitative easing. Even if they pass this month, which seems possible, this is likely to be only a temporary postponement. Whenever it comes, the next move will be another bout of “plain vanilla” QE, involving the purchase of £50-75bn of government bonds, and taking the overall Bank of England holdings to over one third of the total stock of gilts in issue.

Meanwhile, the Fed is still debating whether to increase its holdings of long dated securities, and if so whether to focus once again on government debt, or to re-open its purchases of mortgages. Any further QE would be contentious on the FOMC, but there is probably still a majority in favour.

Central bankers, unlike many others, have not lost faith in the efficacy of QE. The vast majority of them not only believe that additional asset purchases can further reduce long term bond yields at a time of zero short term interest rates, but also that this can increase real GDP growth, compared with what otherwise would have occurred. Are they right? 

Mount Fuji, Japan. AFP/Getty Images

Mount Fuji, Japan. AFP/Getty Images

Until recently, Keynes’ notion of a liquidity trap was of great interest to macro-economists, but was viewed by investors as a rare aberration which, outside Japan, could be safely ignored. In the aftermath of the 2008 credit crunch, all that has changed. Many developed economies seem to be falling into a liquidity trap, and may stay there for several years. What does this imply about asset returns? (This blog is a slightly longer version of an article which first appeared in the FT’s Market Insight column on 24 January, 2012.)