Financial Times: Be ready to print money like crazy


Ways Out of the Liquidity Trap

From the Financial Times, London
Monday, November 3, 2008

It is hard to credit now but, until early this summer, policymakers regarded inflation as a serious threat. No longer. Deflation is the spectre now haunting the advanced economies. This rapid shift in focus highlights the impact the credit crisis has had on the real economy. But inflation, though falling, is still relatively high in most large economies, and much will depend on what policies are put in place over the coming weeks and months.

Consumer prices may fall temporarily if commodity prices continue to tumble. However, this is no immediate cause for concern. Big central banks have an explicit or implicit inflation target, anchoring expectations of future price growth.

As headline inflation rose earlier this year because of the spiralling cost of raw materials, inflation expectations were slow to follow. Core inflation -- excluding items relating to food and energy from headline inflation -- also barely moved in many high-income countries. Similar inertia should hold on the way down: only a prolonged period of falling prices could entrench expectations of deflation.

This might occur if recession turns into a severe slump where banks remain unwilling to lend, consumers reluctant to spend and companies hesitant to invest. Policymakers around the world have shown that they will do whatever it takes to avoid a deflationary trap. They must continue to do so.

In the eurozone and the UK, official interest rates will have to come down substantially. Markets expect the European Central Bank and the Bank of England to cut rates by half a percentage point this Thursday. Bolder cuts may well be needed.

At 1 per cent, the target interest rate in the US is already low. Even such loose monetary policy may not be enough to reverse cash-hoarding in the economy. Fiscal policy, therefore, has a crucial role to play. The leading high-income countries do not currently face binding borrowing constraints, and are unlikely to do so for some time, provided ex­pansionary policies are temporary and credible. Indeed, yields on many governments' debt have fallen because of a flight to safe assets.

If ordinary policies fail to avert slump and deflation, the monetary printing press is the final tool at the disposal of policymakers. The government could borrow directly from the central bank and distribute the newly created money to households and firms. This worst-case scenario is a long way off. Yet events in recent months have validated the most pessimistic predictions. Authorities must now make full use of all traditional policies, while having contingency plans to hand.

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