The possible consequences of the liquidity trap on ForEx markets

The liquidity trap is a well-known economic phenomenon that occurs when interest rates are at zero (or below zero) and a central bank’s monetary policy loses all effectiveness in producing beneficial effects on the real economy. In other words, monetary policy does not produce the proper functioning of the transmission mechanism from financial institutions to the market. Japan is the classic example where this phenomenon has been occurring for several years. In Japan, the Bank of Japan has long since cut rates, carried out ultra-expansive bond buying programmes, and yet this is not enough to bring inflation to the desired level and to regularize the money market.

The Japanese syndrome is now rapidly spreading in the major western economies. Complicated by the globalization of markets, which produces the lowering of labor costs and capital, including the financial one, European and North American macro-areas have entered a situation of “lowflation” or even chronic deflation. The attempts made by the European Central Bank and the Federal Reserve with the cut of interest rates and quantitative easing programess have failed to bring inflation back to the optimal level and full employment, especially in Europe.

We are therefore destined to live from now on in a context characterized by zero interest rates, zero or even negative sovereign yields, as we are currently observing for most European countries, and inflation rates systematically under the expected threshold of 2.0%? It is a possibility that we cannot definitely discard. If so, in the world we would have achieved a sort of “Nash equilibrium” of monetary policies and interest rates, equal to zero. A steady state from which it is difficult to escape. A logical result in a globalized economy. Or a trap, precisely. With obvious consequences also for the ForEx markets. Because if central banks lose their power to stimulate the economy through interest rates, and these do not vary, it is clear that even the main exchange rates, such as the euro-dollar or the euro-yen stabilize accordingly. In other words, we should expect a stabilization of the medium and long term trend. The consequences on the traders’ operations are obvious: they will have to optimize their strategies on much smaller variations than those recorded in the past.