Unconventional Monetary Policy: Exit Strategy (7)

KEYNOTE LECTURE AT THE INTERNATIONAL CENTER FOR MONETARY AND BANKING STUDIES (ICMB),
GENEVA, 28 APRIL 2009

HOW ARE UNCONVENTIONAL MEASURES IMPLEMENTED?

1 Direct Quantitative Easing

2 Direct Credit Easing

3 Indirect (or Endogenous) Quantitative/Credit Easing

Exit strategy

Let me now turn to the last of the four questions that I posed earlier on: how and when do central banks need to unwind the extra monetary stimulus? The simple answer to this question would be – of course – when the economy rebounds and inflationary prospects are back in line with the central bank’s price stability objective. Unfortunately, for a number of reasons, formulating an adequate exit strategy is not such an easy task. Why? Let me mention two choices that need to be made: first, devising the right sequence for the phasing out of the conventional and unconventional monetary policy accommodation; second, deciding on the speed at which the unconventional accommodation is removed.

Let me first clarify what it means, in practice, to unwind unconventional monetary policy operations. In the case of quantitative easing and credit easing policies, it normally implies selling assets outright, and in significant amounts. In the case of the endogenous easing measures, the unwinding happens automatically, since banks should naturally reduce their demand for central bank money and increase interbank lending as their situation normalises.

Starting with the problem of the right sequence, it should be reminded that an environment of extremely low interest rates and ample liquidity aims at favouring borrowers and penalising lenders, over the medium term, when the policy is reversed. On the other hand, most of the unconventional measures put in place are designed to stimulate lending, to convince savers to hold risky longer-term assets. The effectiveness of these measures therefore mainly depends on the readiness of banks to go back to their main business of lending to households and firms rather than parking excess reserves with the central bank. Clearly, an increase in policy rates – and in particular in the deposit rate – risks undermining banks’ incentive to re-engage in funding the private sector. In a similar vein, prospects of rising interest rates may discourage private savers from purchasing longer-term assets, as a tightening of monetary policy inevitably implies a capital loss for those who bought these assets. Raising policy rates, or the expectation of such increases, when confidence is not fully restored could therefore be counterproductive.

What, then, are the implications for the sequencing of unwinding conventional and unconventional policy measures? In simple terms, it means that non-standard measures that aim mainly at restoring the orderly functioning of money markets, such as supplementary longer-term refinancing operations or an extended menu of eligible collaterals, might have to be rolled back before interest rates are increased again. Why?

First of all, because raising interest rates in an environment in which such unconventional measures were still judged to be necessary would risk undermining a sustained recovery by money markets. If concerns about the required and available amounts of short-term funding still prevailed among market participants, raising rates might reinforce these fears and could lead to further, unwarranted upward pressure on overnight rates. Second, supplying extra liquidity to the markets through non-standard measures while, at the same time, tightening monetary policy would send mixed signals on the effective monetary policy stance. Measures to alleviate the strains in money markets could in fact be seen as a continued easing of the monetary policy stance. Third, with non-standard measures such as the unlimited provision of liquidity still in place it might be more difficult for the central bank to steer the level of market rates consistent with its policy target. For example, a fixed rate tender with full allotment usually leaves the banking sector with a large daily liquidity surplus, which needs to be mopped up by additional fine-tuning operations towards the end of the reserve maintenance period in order to avoid a sharp drop in the overnight interest rate. This, however, causes extra volatility in the markets as well as large interest rate fluctuations that are undesirable from the point of view of an effective signalling of the monetary policy stance. Fourth, with markets still in need of additional non-standard measures, the pass-through of an increase in policy rates would probably be hampered. The orderly transmission of any monetary tightening would only resume once trust among market participants has had been restored and money markets were operating normally again. Finally, in any bank-dominated system of fund intermediation, in which the recovery of the economy largely depends on the soundness of the banking system, inflationary pressures that would require a tightening of monetary policy are likely to appear only when the banks take up their normal lending activity again. This, in turn, implies that non-standard measures should ideally be rolled back before interest rates were increased.

This reasoning might not hold for measures taken to revitalise the flow of credit in certain market segments – such as through the purchase of corporate bonds. These measures are primarily designed to bypass the financial sector and to ensure that non-financial corporations still have access to external financing. Now, in theory, by stimulating longer-term investments and hence aggregate demand, these measures might induce inflationary pressures in the medium to long-term, independent of the functioning of money markets and lending by banks. The strength of this channel depends on the depth of the corporate bond market. If policy-makers were to react to these inflationary pressures by raising interest rates pre-emptively while money markets were still weak, the consequences for the banking channel of intermediation could be severe – for the reasons I have just given. If, however, markets were to function properly again, there would be no reason to postpone the unwinding of ‘credit easing’ policies to a date longer than needed. Taken together, this reasoning suggests that purchases of privately issued securities should be unwound before or at the same time as interest rates are raised back to normal levels.

This raises the question of the reaction that financial markets might have to the start of the unwinding of the direct easing measures. For instance how would markets react to the central bank starting to sell the government bonds it purchased under the direct quantitative easing policy? Such a start would signal presumably that the tightening cycle is close and could affect yields. Furthermore, if the amount of assets to be sold is significant, this can have an impact on the market conditions of the underlying assets, possibly further depressing its price.

Naturally, the question remains: how quickly should policy-makers reverse their policies? On the one hand, withdrawing liquidity in such large quantities will trigger a substantial contractionary monetary policy shock. The large size of many easing programmes will make it difficult to sell assets without a significant market impact. If it happens too quickly or abruptly, policy-makers risk choking off the economic recovery or imposing heavy capital losses on lenders. For instance, in the corporate bond or commercial paper market, even small sales of securities by the central bank could cause spreads to widen considerably and to sharply tighten credit conditions for firms. On the other hand, with policy rates at record low levels and additional liquidity-providing measures adopted in so many countries, the possibility of inflation risks emerging sometime later is not something that can be excluded. Retaining such exceptional policy measures for too long might aggravate the upside risks to price stability and sow the seeds for future imbalances in financial markets.

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. As I already noted, 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. 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.

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.

Overall, special operations other than the traditional repurchase agreements might be needed to sterilise the effects of unconventional policy measures at the appropriate time in the future. One option would be to have the fiscal authority issue debt certificates to the market and deposit the proceeds with the central bank. The switch in the ownership of government debt from the private sector to the monetary authority would alleviate the inflationary pressures arising from the additional liquidity. Another option would be for the central bank to issue debt certificates itself, as the ECB for example can do according to its Statute. In this way the central bank would essentially change the composition of the liabilities side of its balance sheet, moving away from excess reserves and towards less-liquid debt securities. The effect, compared with government debt issuance, would in essence be the same.

An important final element related to the exit strategy, but which should be considered carefully already when deciding to embark on unconventional measures, is that when the central bank sells the assets their value is likely to have declined considerably, given the higher rate of interest. This implies a financial loss for the central bank. The consequences for the financial – and overall – independence of the central bank should not be downplayed.