Effective monetary policy can still exist in a liquidity trap. Joseph Gagnon at the Peterson Institute makes a good point that the liquidity trap exists when interest rates are near zero because money and bonds are almost perfect substitutes; however, there still a lot that the central bank can do to effect the real economy through the credit spreads in financial markets. The fed has taken this approach with their credit easing. They have purchased mortgages as well as Treasuries. The activity of buying credit sensitive or mortgage products could tighten these spreads in order to stimulate borrowing and lending even when rates are near zero. The Fed strategy has worked and now some of their programs will roll-off. The Fed can also use its power to push down longer-term rates or try and change inflationary expectations.
The interesting part of the current credit environment is the strong supply of new corporate bonds. There is confidence that rates will remain low and spreads will tighten. In spite of the high Treasury issuance, corporate bond supply has exploded relative to last year. This credit channel is not coming through banks where there are high excess reserves.
One of the key issues that has to be addressed is better understanding the credit channels outside the bank system. The focus has be on regulating banks, yet the commercial paper and bonds markets have been the places where there has been the most upheaval.
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