Definition of liquidity trap
What is a liquidity trap?
A liquidity trap is an economic situation in which the central bank is unable to generate inflation despite monetary stimulus. A liquidity trap marks the failure of conventional monetary policy (open market operations, standing facilities, minimum reserves).
A liquidity trap often follows a major economic crisis. The central bank then lowers its key rates to zero, but economic growth remains sluggish and there is more and more risk of deflation. This is a sign that the mechanisms of monetary creation no longer work.
Steps leading to a liquidity trap
By lowering its rates, the central bank allows commercial banks to refinance themselves in the short term at a lower cost. In theory, banks should then lend more to economic agents (households and companies), but this may not always be the case. This then leads to a liquidity trap. The money injected into the interbank market by the central bank is not reinjected into the real economy. Banks prefer to invest the money with the central bank.
In an attempt to get out of the liquidity trap, the central bank may then decide to use negative rates on deposits. This means that commercial banks must pay to deposit money with the central bank. If banks no longer have confidence in each other or the economy, they may prefer to pay interest rather than lend money to other economic agents. The liquidity trap is then fully open. The central bank's injection of liquidity is unnecessary and there is an increasing risk of deflation. To avoid this, the central bank may then decide to use other unconventional monetary policy instruments such as the asset purchase program (QE - Quantitative easing) and long-term refinancing operations (TLTRO).
Example of the liquidity trap in Japan
For several decades, Japan has not been able to pull out of deflation. As a result, the central bank is obliged to leave its policy rates at zero to continue to inject liquidity into the interbank market. As this monetary policy measure is insufficient to deal with the country's liquidity trap, the BoJ (Japanese central bank) has been implementing powerful monetary easing for several years with an asset purchase program (QE), particularly since 2013. This programme is bearing fruit as the country has emerged from deflation since then, but the inflation rate remains low (between 0 and 1.10%).
This case shows that getting out of a liquidity trap is very difficult. That is why central banks are more afraid of deflation than anything else. All other central banks carried out asset purchase programmes before falling into deflation, when inflation was still low but positive in their countries.