August 31, 2012 / 5:13 PM / 6 years ago

Central bankers holding blunt tools, Jackson Hole retreat warned

JACKSON HOLE, Wyoming (Reuters) - Central bankers are placing excessive faith in their powers to spur growth when interest rates are already ultra-low, and the other tools they have may prove much less potent than hoped, a top economist warned on Friday.

Addressing the annual Jackson Hole retreat for central bankers, Columbia University professor Michael Woodford also cautioned that policymakers risk undermining their own efforts by being worried about distant risks of inflation.

His paper argued the best way to defeat stubborn economic weakness was to keep monetary policy very easy for longer than would be suggested if central bankers were following typical rules for setting rates that weigh both growth and inflation.

Woodford, one of the foremost thinkers on how to escape from deflation, was tapping directly into a raging debate among central bankers as they argue about what they should do next to restore battered economies on both sides of the Atlantic.

“There seem to me to be fewer options that are likely to be effective, and that are likely to be attractive on other grounds, than central bankers sometimes suggest when seeking to reassure the public,” Woodford argued in a paper that he presented on policy options when rates are at their floor.

Noting central bankers were in a tough spot, Woodford advised they commit to keep rates ultra-low until reaching a particular target that might be an unemployment and inflation threshold, as advanced by Chicago Federal Reserve Bank President Charles Evans, or a target level for nominal economic output.

Central banks have slashed interest rates in the wake of the 2007-2009 global financial crisis. Benchmark rates are now close to zero in the United States and Japan, and at 0.75 percent in the euro zone and 0.5 percent in Britain, while growth continues to flag.

With limited scope for further reductions, central banks have aggressively printed new money in an bid to boost lending and broader economic activity, while some have also promised to keep rates ultra-low for a specified period into the future.


But they have also taken pains to assure the public that they will snap back quickly into inflation-fighting mode as soon as a recovery takes hold. Woodford argued that was undermining the efforts to stave off damaging recessions.

“Such assurances tend to contradict precisely the kind of signals that one would want such policies to send in order for them to be effective in providing people a reason to spend more,” he said in his paper presented at the Kansas City Fed’s annual symposium here.

Woodford studied policy responses designed to drive down long-term borrowing costs in bond markets and make household and business credit cheaper, and found the results to be unclear.

This was particularly the case when it came to figuring out how much financial markets had responded to central bank policy initiatives, and how much they were simply adjusting to a fresh, and decidedly grimmer economic outlook - a message the central bank was underlining through emergency measures to spur growth.

“Simply presenting a forecast that the policy rate will remain lower for longer than had previously been expected ... runs the risk of being interpreted as simply an announcement that the future is likely to involve lower real income growth ... information that, if believed, should have a contractionary rather than expansionary effect,” he said.

Fed officials, who have said they are likely to hold overnight rates near zero at least through late 2014, discussed the benefits of refining their forward-looking guidance by adding a statement that very easy monetary policy was likely to be maintained even as the recovery progressed, according to minutes of their July 31-August 1 meeting.

Many economists expect the Fed to push the late-2014 date further into the future at its next meeting on September 12-13.

Reviewing the best way to beat the so-called zero bound, when interest rates cannot be lowered any further but growth remains too weak, Woodford urged policymakers to hold their noses and pledge to keep rates low, even after the crisis had past and financial conditions had normalized.

The goal is to “provide a reason for market participants to expect easier future monetary and financial conditions than they may currently be anticipating, and that should both ease current financial conditions and provide an incentive for increased spending,” he said.

Reporting By Alister Bull; Editing by Neil Stempleman

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