Popular belief has it that the Fed is intervening in the market to keep rates suppressed at the zero bound.
But in reality cutting Fed Funds rates is actually all about driving short-term rates in risk-free assets below where they would otherwise trade via market forces, so as to incentivise risk-taking. This process hence stimulates the economy.
However, once market forces push ‘real’ rates below a level where a central bank can easily incentivise risk-taking, a liquidity trap situation may come into the making.
That is to say, no matter how much zero-rated money you push into the system, no incentive exists to draw that money into riskier assets.
So how does that apply to where we are now?
As ever, one place to look for clues is in the yield curve. Below you find the current state of the US Treasury curve, the US swap curve and the US Treasury-inflation protected curve:
For one, there seems to be an obvious convergence point around the 11-month mark, where Tips get propped back into positive territory, Treasuries yields begin to bounce higher, and the swap rate comes off rapidly.
In which case, is that the point where the Fed’s interventions are possibly supporting rates from falling through the zero bound, rather than suppressing them lower?
And would market forces otherwise force them into negative or special status?
Related links:
The perils of releasing the repo rate - FT Alphaville
Moving down the corridor…– FT Alphaville
Pimco’s Worah: Deflation ‘Extremely Unlikely’ – WSJ
Central banks can adapt to life below zero – FT