(Following is the first of four reports based on papers presented at the 2013 Jackson Hole Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City.The reports will be published as soon as the authors present their papers to the symposium.)
Pent-up demand for investment on business plants and equipment, homebuilding and consumer durables will strengthen the U.S. economy and the main danger over the next two years is that the Federal Reserve contracts its portfolio of assets or raise rates on reserves before the economy has returned to a normal state, according to a paper delivered to the Jackson Hole symposium.
Most of the forces that led the U.S. and other advanced economies into the 2007-2009 recession are self-correcting and Robert E. Hall, professor of economics at Stanford University, found that investment flows are beginning to return to normal and the labor market has returned to normal in terms of jobs value notwithstanding the continued high unemployment rate.
In his paper “The Routes into an out of the Zero Lower Bound,” Hall finds that the deleveraging pressure on households has subsided and the rise in the stock market since 2009 means that the risk premium for business income is more or less back to normal so as output continues to recover, investment should return to normal.
Since 2007 capital stocks have fallen far below their normal growth paths, with existing stocks now ageing and investment too low to avoid a deterioration in business equipment. Hall sees this as a consequence of the high risk premiums that investors assigned to business income, which then held back investment and job creation.
“The major potential exception to the good news is the hint of a move toward deflation,” Hall said, advancing the hypothesis that businesses have not engaged in rampant price cutting because they perceive this to have higher costs than benefits.
But if his hypothesis is wrong, Hall admits that his generally optimistic view could be quite mistaken and the “bottom could fall out of the economy as it did in the Great Depression.”
The central danger Hall sees in the near term is that the Federal Reserve “will yield to the intensifying pressure to raise interest rates and contract its portfolio well before the economy is back to normal.“
“The worst step the Fed could take would be to raise the interest rate is pays on reserves,” Hall said, referring to the Fed’s move to pay interest on banks’ reserves at the Fed since 2008.
“Every percentage point increase in the reserve rate drives the real interest rate up and contracts the economy by the principles discussed here,” Hall said.
The Fed’s policy of paying interest to banks on their reserves of more than $1 trillion has often been the subject of a debate and at the 2012 Jackson Hole symposium economist Michael Woodford argued that the Fed should reduce the 25 basis point rate the Fed currently pays on reserves.
Hall backs Woodford’s argument and adds that banks prefer to hold reserves over other assets when the interest rate on reserves is in excess of the market rate.
“They protect their reserve holdings rather than trying to foist them on other banks,” Hall said.
“An expansion of reserves contracts the economy. The Fed could halt this drag on the economy by cutting the rate paid on reserves to zero or perhaps minus 25 basis points.”
The Fed’s argument for not cutting the reserve rate is that short rates would fall and money-market funds would go out of business.
But Hall says money market funds could easily charge their customers a modest fee in the form of deductions for interest paid by using a floating net asset value as done by conventional stock and bond funds.
“The SEC may accelerate this move by requiring all money funds to use floating NAVs,” Hall said.
In his paper, Hall also takes issue with the traditional understanding of inflation based on the Phillips curve from the 1950s that said inflation depended on economic tightness or slack.
“Yet extreme slack has done little to reduce inflation over the past 5 years,” Hall said.
In order to study inflation and the zero lower bound on nominal interest rates, Hall draws on the so-called DMP economic model, which was developed by three economists that received the Nobel Prize in economics in 2010.
“One central implication of the models is that there is no fixed “natural” rate of unemployment which the actual unemployment rate revolves around. Rather, the observed level of unemployment varies according to driving forces and is always an equilibrium,” Hall writes.
The DMP model helps Hall understand why inflation largely has been steady despite years of economic slack.
“The stability of inflation arises from the inertia in the wage bargain,” Hall said, adding that workers hired between bargaining times inherit their wages from the most recent bargain, explaining why wages have been so sticky.
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