JACKSON HOLE, Wyo., Aug 23 (Reuters) - The biggest risk facing the U.S. economy is a premature policy tightening by the Federal Reserve, officials were warned on Friday in the opening paper at the prestigious Jackson Hole symposium.
The annual conference, hosted by the Kansas City Federal Reserve Bank in the mountains of Grand Teton National Park, gathers central bankers from around the world and provides an update on the latest thinking among top monetary economists.
Stanford University economist Robert Hall, in a paper titled "The Routes Into and Out of the Zero Lower Bound," concluded that U.S. economic growth and hiring were slowly heading back to normal, but that the Fed must maintain an ultra-easy policy to keep the recovery on track.
"The central danger in the next two years is that the Fed will yield to intensifying pressure to raise interest rates and contract its portfolio well before the economy is back to normal," he wrote in the 31-page paper.
The U.S. central bank has held overnight rates near zero since December 2008 and has more than tripled its balance sheet to around $3.6 trillion through a series of bond purchase programs aimed at driving other borrowing costs lower.
Economists have traditionally watched the opening morning of the Jackson Hole conference for a signal on future Fed policy moves.
But the decision by Fed Chairman Ben Bernanke to stay away this year means there are no remarks scheduled from any of the top Fed officials attending, including Fed Vice Chair Janet Yellen, who will chair a policy panel on Saturday.
Absent a keynote Fed speaker, Hall's paper opened the conference, which will also hear presentations on the latest evidence on the impact of quantitative easing, as well as cross-border capital flows and global liquidity - both hot topics given a big sell-off in emerging market currencies in anticipation of a reduction in the Fed's bond-buying stimulus.
Hall argued that the tools central banks in the United States, Japan and Europe have to boost growth while inflation is low and interest rates near zero are weak. That helps explain why U.S. unemployment was still so high and the economy so tepid, despite five years of massive monetary stimulus, he said.
"The worst step the Fed could take would be to raise the interest it pays on reserves," he said, referring to the main tool the Fed plans to use to eventually mop up the cash it has pumped into financial markets.
The U.S. central bank has said that any move to raise borrowing costs is still a long way off. In projections released after a meeting in June, the Fed said that 14 of its 19 policymakers did not think a rate rise should occur until 2015.
That said, the Fed does expect to begin reducing its current $85 billion a month bond-buying pace later this year, and financial markets are betting the first reduction will come at the Fed's next meeting on Sept. 17-18.
Officials have gone out of their way to assure markets that any scaling back of their so-called quantitative easing, or QE, would not be a signal that their commitment to hold rates near zero for a considerable period is faltering.
Indeed, it has cemented its rate pledge by stating that it would not start to even think about raising rates until the unemployment rate has fallen under 6.5 percent, provided inflation does not look likely to rise above 2.5 percent. The jobless rate stood at 7.4 percent in July, while consumer prices have risen just 1.3 percent in the 12 months through June.
Hall was bluntly dismissive of the impact of both QE and this so-called forward guidance on rates.
"Both quantitative easing and forward guidance, as implemented by the Fed, are obviously weak instruments," he said, pointing to the failure of the U.S. economy to rebound strongly despite prolonged easy policy as evidence.
The problem lies in the inability of policymakers to drive inflation-adjusted interest rates sufficiently into negative territory when nominal rates are already at zero.
If inflation is only hovering around 1 percent, real rates cannot be driven lower than minus 1 percent, even though economic models demand a much deeper negative real rate to spur the spending needed to get the economy growing more vigorously.
The good news is that "most of the developments that led the United States and other advanced economies into zero lower bound slumps are self-correcting," said Hall. He noted that deleveraging by U.S. households and companies looked to be subsiding, and that higher stock markets were encouraging investment by lifting the risk premium for business income.
"The major potential exception to the good news is the hint of a move toward deflation," he said, noting that inflation remained well below the Fed's 2 percent target.