The Federal Reserve’s bond purchases and guidance on future policy are “weak instruments” the central bank resorted to after pushing down the benchmark interest rate to zero, according to a paper presented at a Fed conference in Jackson Hole, Wyoming.
“It’s fairly obvious that monetary policy does not have instruments to restore ZLB economies to their normal conditions,” said Robert Hall, an economist at Stanford University, referring to the so-called zero lower bound.
Without the constraint from the zero lower bound, the U.S. economy would have weathered the downturn with less disruption because the inflation-adjusted cost of borrowing would have declined enough to sustain growth near normal levels, Hall said in a paper presented today at the Kansas City Fed’s annual meeting of economists and central bankers.
The U.S. central bank cut the main interest rate close to zero in December 2008 and has expanded its balance sheet to $3.65 trillion and pledged to maintain accommodation to bolster growth and reduce unemployment. Policy makers were “broadly comfortable” with Chairman Ben S. Bernanke’s plan to start reducing its bond buying later this year if the economy improves, minutes of their July meeting showed Aug. 21.
“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,” Hall said.
Receding risk aversion among investors and a waning need for households to reduce debt signal that the economy is gradually healing, Hall said.
“Most of the developments that led the U.S. and other advanced countries into ZLB slumps are self-correcting,” he said. “As output recovers, the lower bound will cease to be an impediment and normal conditions will prevail again.”
Hall also said economists should devise a new way to understand the relationship between unemployment and inflation, given that high joblessness after the recession didn’t lead to the deflation that characterized the Great Depression.
“The tradition of regarding high unemployment as a disequilibrium that gradually rectifies itself by price-wage adjustment may rest on a misunderstanding of the mechanism of high unemployment,” he said.
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