From time to time we hear suggestions that the eurozone economy is about to fall into a liquidity trap'. Indeed, this risk is still advanced as a reason for the ECB to cut interest rates. How seriously should we take this threat?
Keynes first talked about a liquidity trap in the context of the bond market. However, the concept now has a more general meaning. It is often used to describe a situation where companies expect such low returns that they do not think it is worth borrowing to invest, and where consumers expect prices to fall and would therefore rather hold cash than spend. This is a particular problem when inflation is already very low, or negative (i.e. deflation). The cost of borrowing represented by real interest rates (nominal rates minus expected inflation) may then be too high, even if nominal interest rates are also low.
In an extreme case where nominal rates have already been cut to their lowest possible level of zero, monetary policy would no longer be able to stimulate demand. Central banks would need to pre-empt this by cutting rates aggressively to prevent deflationary expectations from becoming entrenched - as the Fed did when it cut US rates to 1% in 2003.
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The liquidity trap has certainly been a problem for Japan, where the economy has only now begun to show a sustained recovery after interest rates were cut to zero in 2001. It is also a serious threat in Switzerland, where core inflation is just 0.4% and interest rates are being held at 0.75%. However, there are two good reasons to think that it is not yet a valid concern for the eurozone.
The first is simply the evidence from the lending data. Lending in the eurozone has now been accelerating for more than two years. Bank lending to the private sector increased by 7.9% year-on-year in June, up from 7.5% the previous month.
The highlight has been the strength of mortgage lending, which rose by 10.4% year-on-year in June. It is debatable whether this is driving the strong house price gains in many eurozone countries, or simply a response to the need to borrow more to get onto the housing ladder. Perhaps it is best seen as a bit of both. But either way, there is no evidence here of a reluctance to borrow. What's more, both consumer credit and lending to non-financial corporations have also accelerated.
The ECB's latest quarterly survey of bank lending standards (published on 5th August) is also encouraging. Since it began in 2003, this survey has reported a substantial relaxation of credit standards applied to loans to households and particularly those applied to companies. This trend is expected to continue.
This loosening in credit standards is attributed in part to greater confidence in the economic outlook, though increased competition from other banks has also been important. Thus, lending growth is accelerating due both to demand side and supply side factors.
The other main reason to believe that the eurozone will avoid a liquidity trap is that inflation expectations are rising again, according to the European Commission's survey of consumers' expectations for the general level of prices over the next twelve months. Price expectations did fall to dangerously low levels in 2004, but they have since revived. This may simply reflect the impact of record high oil prices. However, as headline inflation has remained fairly low despite higher oil prices, the pick up in price expectations is more likely to be due to greater confidence in the economic recovery.
The only major eurozone economy where price expectations are currently negative is Italy (which is also a prime candidate to experience deflation in the next major downturn, given the need to catch up on lost competitiveness). However, even in Italy, price expectations have recently begun to pick up again.
Admittedly, other measures tell a slightly more cautious story. The European Commission's survey of producers' price expectations and data from index-linked bond markets show that inflation expectations are still subdued. This means that there is no hurry for the ECB actually to raise rates. But overall, the recent data suggest the danger that the eurozone will fall into a liquidity trap has now past, at least for the current economic cycle. This supports our long-held view that the next move in eurozone interest rates is most likely to be up.
By Julian Jessop, Chief International Economist at Capital Economic
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