How low can the ECB go without falling into a trap?

January 16, 2009

    European Central Bank President Jean-Claude Trichet could not have been clearer about the short-term path of euro zone borrowing costs after cutting interest rates by another 50 basispoints on Thursday to match the historic low of 2 percent.
    “The next important meeting is in March, not February,” he told the ECB’s monthly news conference, signalling a month’s time-out from the current rate cutting cycle. 
    But Trichet’s new buzzword, that the ECB is keen to avoid a liquidity trap, caused confusion among journalists and economists alike.
    After Trichet cited avoiding a liquidity trap four times in answers to questions about how low rates could go, one reporter finally asked him for a definition, leading to the following exchange at the end of the news conference:
    Journalist: What is your exact definition of a liquidity trap? Is it in the Keynesian sense or how do you define it?
    Trichet: It is Keynesian if you wish, but the problem is that experience has demonstrated that once you were there it was very difficult to get out.”
    Journalist: There, where? You mean zero?
    Trichet: A very, very low interest rate.
    Economists saw his comments as confirmation that rates have further to fall, with most tipping a benchmark ECB rate of 1 percent by September.
    But they were puzzled by Trichet’s definition of a liquidity trap — as opposed to the more usual understanding of a combination of economic recession, low official interest rates, a high propensity to save, and deflation making central bank actions ineffective.
    “Since the ‘trap’ refers to the central bank’s inability to revive the economy, you cannot avoid the trap simply by stopping the rate cuts before you hit zero, if you have not yet had an impact on the economy,” UniCredit economist Marco Annunziata said, noting that the solution was unconventional policy such as direct purchases of assets, U.S. Federal Reserve-style.
    So far, the ECB has not embarked on this path, although Trichet says “non-standard action” is possible.

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