Friday, February 8, 2008


It's February 8th, 2008 and the Fed has now cut interest rates at the most aggressive pace in decades. In January alone, the Fed cut 1.25% from the Fed Funds Rate. As the FFR now stands at 3%, the Federal Reserve is running out of bullets. To wit, the stock market (S&P 500) is lower than it was when the Fed first started lowering rates, and spreads between Treasury ("risk free") bonds and junk bonds are at their widest point in years, reflecting growing risk premiums.

This suggests the inevitability of a "Liquidity Trap". A liquidity trap is a situation where interest rates are lowered to such a point (i.e. 0-1%) that the Fed's standard tools for stimulating the economy no longer work. At very low interest rates, lenders are unwilling to lend, because it's not worth taking risk to receive such low returns. Would you put your money in a bank a) if you only received .5% interest and b) you were worried that you might never see your money again? Neither would I. So, those lucky few who actually have money, end up stashing it under their mattress or caching it in the backyard.

That's when the Government turns to "printing money", as in handing out "Stimulus checks", which is what Congress voted to do this week.

As this decline unfolds, I predict many more rounds of stimulus checks, however, each round will be less and less "stimulating". As I've indicated in my earlier post, the forces of deflation will exert a far greater contractionary force than can be offset by a few rounds of charity checks, especially when foreigners catch on and start pulling their money out of the U.S.

The fact that there are so few economists (any?) who see a liquidity trap on the horizon, is one of the most troubling aspects of this whole debacle.