JACKSON HOLE, Wyo. — A host of Federal Reserve officials Friday heard that neither large-scale asset purchases to reduce long-term interest rates nor forward guidance on the path of short-term rates have been very effective tools for reviving the economy, but that fortunately the economy is recuperating on its own.
Unemployment remains far too high and inflation too low, but the economy is on the mend as higher stock prices improve household wealth and post-crisis deleveraging gives way to spending and investment. But this gradual healing process has little to do with the Fed's extraordinary monetary exertions, participants in the Kansas City Federal Reserve Bank's annual symposium were told.
Further expansion of the Fed balance sheet through bond buying risks having a contractionary effect, unless banks can be disincentivized from holding excess reserves, e.g. by slashing the rate of interest the Fed pays on those reserves (the IOER). The worst thing the Fed could do would be to prematurely raise the IOER.
So argues Stanford University Professor and Hoover Institution Senior Fellow Robert Hall in a paper prepared for presentation to the symposium - a gathering of Fed officials and other central bankers from around the world.
Hall, also director of research on economic fluctuations and growth at the National Bureau of Economic Research, says the United States and other advanced countries are "closing on five years of flat-out expansionary monetary policy that has failed in all cases to restore normal conditions of employment and output."
The U.S. and others "have been in liquidity traps, where monetary policies that normally expand the economy by enlarging the monetary base are ineffectual," he writes. "Reserves have become near-perfect substitutes for government debt, so open-market policies of funding purchases of debt with reserves have essentially no effect."
A "liquidity trap" occurs when the central bank find itself unable to spur growth because nominal short-term interest rates, e.g. the federal funds rate, are so low and inflation so low that it cannot reduce the real rate of interest (the nominal interest rate minus inflation) enough to stimulate weak demand. With the funds rate trading at about 10 basis points and inflation running well below the Fed's 2% target, Hall puts the real interest rate at minus-170 basis points when, he says, it needs to be minus-400 basis points.
"With stable low inflation, as the U.S. and all other advanced countries have experienced for a lengthy period, the zero lower bound on the nominal rate places a bound on the real rate that is a huge constraint on the economy," Hall acknowledges. "With, say, 2% inflation, the real rate cannot fall below minus 2%, which the experience of the past five years teaches is well above the market-clearing rate."
Hall calls the zero lower bound (ZLB) "a disease" created ironically "by adopting what seemed to be healthy policies of low inflation."
But that doesn't mean efforts by the Fed and other major central banks to surmount the zero lower bound dilemma are prudent or effective, he contends.
Since reaching the zero bound for the funds rate in December 2008, the Fed has been using unconventional methods to stimulate the economy. It has done three rounds of large-scale asset purchases or "quantitative easing" to lower long-term interest rates. And it has used "forward guidance" on the path of the funds rate to persuade financial markets it will keep that rate very low well into the future.
Hall basically says those measures have been a flop - a contention which runs quite counter to assertions by Fed Chairman Ben Bernanke, Vice Chairman Janet Yellen and others that their policies have ameliorated the worst effects of the financial crisis and recession and assisted recovery.
"It's fairly obvious that monetary policy does not have instruments to restore ZLB economies to their normal conditions, else much more progress back to normal would have occurred," he writes.
"The Fed has undertaken a huge expansion of its portfolio and announced that it will continue to keep the funds rate close to zero and maintain an expansionary stance until in inflation breaks out or unemployment approaches normal," he notes, but "this combination has not yet closed much of the shortfall in output. Unemployment remains well above any reasonable target and inflation below a reasonable target and forecasts are for a continuation of those clear signs of inadequate stimulus."
Hall declares that "both quantitative easing and forward guidance, as implemented by the Fed, are obviously weak instruments."
In fact, they may even be counterproductive, he maintains, at least so long as the IOER exceeds the funds rate, as it does now. While the funds rate is targeted between zero and 25 basis points and has been trading closer to zero, the IOER is a guaranteed 25 basis points, making it marginally profitable for banks to park excess reserves with the Fed.
Although expanding the central bank's balance sheet through asset purchases is designed to boost economic activity, "With an interest rate on reserves above the market rate, the process operates in the opposite direction: Banks prefer to hold reserves over other assets, risk adjusted," Hall writes. "They protect their reserve holdings rather than trying to foist them on other banks."
"An expansion of reserves contracts the economy," he continues, adding, "The Fed could halt this drag on the economy by cutting the rate paid on reserves to zero or perhaps -25 basis points."
Former Fed Vice Chairman Alan Blinder, among others, has urged slashing the IOER or even making it negative, i.e. charging banks to hold reserves, but the Fed has thus far resisted doing so, in part out of fear that doing so would disrupt the money market fund industry.
Hall mocks such concern, saying it "amounts to an accusation that the funds are not smart enough to figure out how to charge their customers for their services."
"Traditionally, funds imposed charges ranging from 4 to 50 basis points in the form of deductions from interest paid," he notes. "A money-market fund using a floating net asset value can simply impose a modest fee, as do conventional stock and bond funds."
Hall expresses hope that the Securities and Exchange Commission "may accelerate this move by requiring all money funds to use floating NAVs." New York Fed President William Dudley, among others, has spoken favorably of such reforms.
As for forward guidance, Hall echoes Columbia University Professor Michael Woodford's argument at last year's Jackson Hole conference that the central bank needs to make a "credible commitment" to holding short-term rates very low beyond the point at which they would ordinarily be raised.
"The central bank has to promise to deviate in the expansionary direction
from its hard-earned reputation for having solved the fundamental commitment
problem of avoiding the temptation to over-expand," he writes.
Beginning last September, not long after Woodford made his presentation here, the Fed's policymaking Federal Open Market Committee pledged that "to support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens."
Then in December, after announcing an $85 billion per month program of Treasury and mortgage backed securities purchases, the FOMC revised its forward guidance to assert that "a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens." And it quantified that guidance by announcing thresholds of 6.5% for unemployment and 2.5% for inflation.
However, there is considerable skepticism, even within the Fed, that these commitments are in fact "credible." Many doubt whether the FOMC would actually hold the funds rate near zero "for a considerable time" if and when economic growth and job creation accelerate.
Hall observes that convincing markets the Fed will keep rates down is "hard to accomplish."
The best way out of a "liquidity trap" recession is to let the free market work, he suggests.
"Most of the developments that led the U.S. and other advanced countries into ZLB slumps are self-correcting," he writes. "In the U.S., some evidence suggests that deleveraging pressure on households has subsided. The substantial rise in the stock market since 2009 means that the risk premium for business income is more or less back to normal. Investment flows are beginning to return to normal. In the labor market, the job value is already back to normal, but unemployment is still well above normal."
Hall adds a caveat that "the hint of a move toward deflation." But he minimizes the danger, saying, "So far, inflation has fallen only slightly and remains in positive territory."
His comments largely mirror those contained in the July 31 FOMC statement. The FOMC acknowledged that "inflation persistently below its 2% objective could pose risks to economic performance," but added "it anticipates that inflation will move back toward its objective over the medium term." And it attributed below-target inflation partially to "transitory influences" while observing that "longer-term inflation expectations have remained stable."
While suggesting the Fed not overdo its unconventional stimulus efforts, Hall cautions against premature conventional tightening, including IOER hikes.
"The central danger in the next two years is that the Fed will yield to the intensifying pressure to raise interest rates and contract its portfolio well before the economy is back to normal," he warns. "The worst step the Fed could take would be to raise the interest rate it pays on reserves ... . Every percentage point increase in the reserve rate drives the real interest rate up and contracts the economy."
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