Is the liquidity trap almost over?

LIQUIDITY traps: we can't stop talking about them. Since late 2008, the nominal interest rate target suggested by most standard monetary policy rules has been negative, leaving the American economy in a liquidity trap. Eddy Elfenbein recently ran a monetary policy rule devised by Greg Mankiw through the data and found that an exit from the trap might be closer than many think. The rule is:

Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)

And when run against the data it produces:

At this rate, it seems, the recommended policy rate will be positive in no time. Maybe. The recent, steep increase is unlikely to continue. Core inflation is expected to level off and might well decline in 2012. The recent decline in unemployment is also unlikely to continue. Labour force departures have overstated the health of the labour market as captured in the unemployment rate, and if the job market continues to strengthen, then rising labour force participation will prevent a too-rapid drop in the unemployment rate. The rule might recommend a positive rate by the end of the year (2% core inflation and an 8% unemployment rate would just about do it), but it's far from certain that it will.

Neither should the Fed follow the rule right away when it begins recommending rate increases. Monetary policy gains traction in a liquidity trap by raising expected inflation. To achieve that, the Fed has to promise to let inflation rise above what the rule might normally recommend; it needs to credibly signal that there will be some catch-up inflation.

That's a tough thing for a central bank to do, and it gives rise to a time inconsistency problem in liquidity-trap monetary policy. The Fed can promise to behave "irresponsibly" in the future, but if most people think that no matter what Ben Bernanke says now he'll keep inflation at 2% later on, then the Fed will struggle to spark a recovery. A policy that explicitly allows for catch-up inflation, as through a level target, would make liquidity-trap fighting more credible. The Fed is none too anxious to head in that direction, however, lest it "lost credibility" as an inflation fighter. Which, of course, is precisely what's needed.