Liquidity Trap, Delfation, ZLB

Lots of people have said to me both on and off line that we don't have to worry about the Japan Scenario because we have a solid inflation buffer in the US.

While the inflation buffer gives us more room in a sense, it is important to remember that it is not deflation per se that causes a liquidity trap. It is that the equilibrium interest rate is below zero.

It is possible that the equilibrium risk free interest rate is a real negative 3% in this crisis, which implies that we still won't be able to get there with 2.7% inflation.

Exploding risk premiums could drive the equilibrium real rate that low because what matters is credit availability to firms and consumers.

So we are not in a position were we can ignore the liquidity trap possibility. On top of that is the issue that there are increasing deflation pressures in the decline collateral values, falling consumption and the potential for dramatically slower global growth. While ultimately they might not override inflationary effects of recent Fed policy, they are not to be ignored.

In short deflation cannot be ruled out and the liquidity trap remains a threat even in a moderately inflationary environment.