Forex Flash: What to expect out of Japanese policymakers – Goldman Sachs

Beyond the question of whether Japanese policymakers achieve success, a good anchoring point is to look at what a complete exit from a deep liquidity trap like Japan’s would look like across asset markets. According to the Economics Research Team at Goldman Sachs, “As an economy moves into a liquidity trap, nominal rates become unable to fall below the zero bound. The result is that real rates remain above where they would naturally be and the real (and nominal) exchange rate tends to be stronger than it would otherwise be. As a result, local asset markets are also weaker than otherwise, reflecting an excessively high real interest rate structure.”

A successful exit essentially involves the reversal of these asset market effects. With little scope to lower nominal interest rates, the only way to push real interest rates lower is to raise inflation expectations. Precisely because the economy is in a liquidity trap, real rates are higher than they would be without the zero bound, so rising inflation expectations would not be expected to raise nominal interest rates, at least over the zone in which the liquidity trap was binding. So, the main shifts should involve a downward shift in the real rate curve, not an upward shift in the nominal rate curve.

“As a result of falling real rates, equities and other local assets should rise. The currency should also weaken. Because the shift in interest rate markets should push real rates lower while leaving nominal rates stable, the weakness in the spot currency rate should be accompanied by an equivalent shift in long-dated currency forwards.” The team adds. This, we shall see, is an important and underappreciated feature of a liquidity trap exit. And it means that stable nominal interest rate differentials alongside a depreciating currency are not an anomaly, though the exact combination you should expect to see from a successful liquidity trap exit.