Unconventional Monetary Policy: Exit Strategy (3)

What are the implications for the sequencing of unwinding conventional and unconventional policy measures? 

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?

(A)  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. 

(B)  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. 

(C)  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. 

(D)  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. 

(E)  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.