Unconventional Market Policy: Exit Strategy (7)

Getting the timing right in withdrawing additional liquidity

Getting the timing right in withdrawing additional liquidity is likely to be decisive in order to ensure a non-inflationary recovery. 

Generally speaking, the lower the reversibility of the non-conventional operations, the larger the risk of being behind the curve when the macroeconomic and financial market situation improves.

Indeed, to a large extent the speed of unwinding of unconventional measures would depend on their degree of reversibility. 

(A)  Some of the unwinding would happen automatically as central bank programmes become increasingly unattractive as financial conditions normalise. 

• For instance, many lending facilities provide liquidity at a premium over the main policy rate or with a high haircut applied to the required collateral, making interbank lending the more attractive option once normal lending activity among market participants is restored. 
• As a result, the central bank’s balance sheet would decline automatically as demand for its funds decreases. 
• As noted, the ECB’s current liquidity-providing operations imply an ‘endogenous’ exit strategy as banks would automatically seek less credit from the ECB when tensions in financial markets ease. 
• The speed of the reversibility would therefore largely depend on the speed of the resurgence of the financial system. 

(B)  In the euro area, the revitalisation of money markets is key to the ECB’s exit strategy and any future interest rate decision should therefore avoid a further disruption of money markets. 

• In this context, bringing the main policy rate too close to zero would risk hampering the functioning of the money markets as it would reduce the incentives for interbank lending. 
• This, in turn, could blur the important signals coming otherwise from the resurgence of interbank lending and the associated positive effect on the ECB’s balance sheet.

(C)  Obviously, the speed of tightening would also depend on the maturity of the assets bought by central banks within the framework of their easing programmes. 

• Differences in the maturity of assets will ensure that a tightening of the accommodative stance would come in gradual tranches. 
• This is important to avoid any abrupt tightening of credit conditions in the middle of the recovery. 
• At the same time, measures centered on assets that are longer-term in nature and less liquid could pose challenges to the future unwinding of these measures. 
• If market conditions were to improve faster than expected, an increase in the average maturity of the central bank’s portfolio would make it more difficult for financial markets to return to normal private sector functioning and would also heighten medium-term inflation risks.