Article - Rethinking Central Bank intervention after unconventional monetary policies
There is a general consensus that the unconventional monetary policies implemented by the world’s major central banks in response to the global financial crisis prevented a deeper recession. These measures have been sustained during the past five years. This fall, the European Central Bank’s surprise cut to its interest rate - to a record low of 0.25% - and Janet Yellen’s recent nomination to chair the FED proved that ultra-loose monetary policies are still solidly in place.
Announcements for stronger growth in Europe and in the U.S. are paving the way for monetary normalization. Exiting at the right time is crucial to limit the risks associated with a prolonged period of monetary expansion.
Managing a smooth transition will be challenging. In the Global Financial Stability Report (October 2013), the IMF stated that economic agents could be facing a potential loss of $2.3 trillion if Central Banks cannot smoothly unwind the emergency measures carried out during the financial crisis. The stakes are high. Therefore, the question of long-term impacts of exit strategies from unconventional monetary policies must be addressed.
In this article, we argue that in addition to the foreseeable systemic risks, which will likely arise from a change toward less accommodative monetary policies, there will also be further long-term structural impacts to be addressed. These will force economic agents, and more particularly Central Banks, to reassess their role and their tools of intervention.
The time will inevitably come for Central Banks to rein in monetary expansion and prevent the emergence of new imbalances from excessively long periods of easy money.
Prolonged monetary support, beyond the needs of the crisis, would induce potentially costly distortions with the emergence of distorted signals of liquidity and credit risk. For example, the corporate sector may refrain from internalizing the costs associated to future higher interest rates or from cleaning their balance sheet by writing-off impaired assets. If the situation were to last, new vulnerabilities could pave the way for large-scale market distortions in asset prices, complicating again the conduct of monetary policy. Other distortions, such as liquidity hoarding, may prove damaging over the medium-term. Delays would also make the transition towards a new normal of tighter monetary transitions more difficult, and require structural adjustments from economic agents. Exit is required, but the question of how and when is still open.
How can Central Banks exit unconventional monetary policies?
Since the onset of the economic crisis, Central Banks have used three different instruments: (1) the policy interest rate, (2) the level of reserve balances (or the size of the central bank’s balance sheet), and (3) the composition of the central bank’s portfolio of assets.
In order to achieve the exit, the direction of change of all three is quite clear: the interest rate must be back to its normal level, the amount of reserves must decrease, and the proportion of assets dedicated to unconventional programs must be reduced.
The debates so far have dealt mainly with the timing of these changes, which should neither too early nor too late.
An early exit risks jeopardizing the recovery, with a tightening effect on consumption and investment. A late exit could lay the foundations of new distortions and fragilities.
Which of the two risks would pose the greatest issues for an economy? Several authors have suggested that policy authorities should deliberately opt for late normalization. Nouriel Roubini (2009) argued that an early tightening would be difficult to reverse, and could lead to a W-shaped recession. Raghuram Rajan (2013) considers that the sounder the economy is likely to be, the more resilient it will be to a monetary tightening. History shows that authorities have a preference for late rather than early exits. After the Great Depression, a second severe downturn took place in 1937-38, driven by a sudden monetary tightening. In the 2000s, Japan prematurely exited from unconventional monetary policies, first by raising its interest rates on several occasions and then by reducing the monetary base by 20%, and saw its economy slide back into deflation.
The pace of the exit, another important issue, needs to be gradual and contingent on economic conditions.
The actual reduction of asset purchases and increases in policy rates needs to be gradual to be fully foreseeable and understood by economic agents.
Exiting unconventional monetary policies will be a slow process, dictated by economic conditions. Communication, coordination, and transparency will be paramount. Over the past months, central banks have made it clear that any decision regarding the exit will be linked to underlying economic developments, such as growth, inflation and unemployment—hence guiding the expectations of economic agents. To prevent significant spillovers, it will prove crucial for Central Banks to take into account the status of recovery across other regions and to place important efforts in the harmonization of the unfolding of expansionary monetary policy exit.
Whilst the first signs of an exit from unconventional monetary policies will coincide with a strengthening of the economy, one must remain cautious as to how the markets will react.
Preparedness is important, as highlighted by Janet Yellen (2013), “in the aftermath of the crisis, regulators here and around the world are also implementing a broad range of reforms to mitigate systemic risk”. Indeed, the transition from an unconventional to a conventional monetary policy is unchartered territory.
At the national level, the most immediate risk is soaring of debt-service costs related to increases in nominal interest rates. This will affect the economy as a whole as it puts pressure not only on governments who have been issuing large amounts of sovereign debt since the beginning of the crisis, but also on households and corporations, who made the most of advantageous credit conditions. In the US for example, the Congressional Budget Office projects that the government’s net interest costs will jump from 1.25% of GDP to more than 3% over the next decade. According to a report recently published by McKinsey Global Institute, household debt-service cost on variable-rate mortgages and other forms of consumer debt could increase by 7% compared to 2012, for every 100-basis-point increase in effective interest rates on variable-rate debt, with most negative externalities falling back onto those who carry mortgages based on variable interest rates. Balance sheets of financial and non-financial corporations will also be put to the test. Further debt overhang would weaken potential growth. In an adverse scenario, financial market disruptions could be caused by fire asset sales where agents will anticipate borrowers’ default.
Because controlling long-term rates proves complex even for central bankers, a sudden change in nominal interest rates will trigger higher volatility on the financial markets. As liquidity is absorbed through tapering, credit spreads will decrease and short-term interest rates will catch up with long-term bond yields that fell significantly during the crisis. Since last September, when “taper talk” gathered momentum, the American treasury yield curve has narrowed significantly This will directly affect the corporations who fund their less liquid assets through short-term funding such as repos.
At the global level, the current emerging market turmoil is giving a measure of potential spillovers. Uncoordinated exits could hinder the economic recovery and financial stability through exchange rate and capital flow volatility—with effects on the eurozone (potentially a counter-intuitive appreciation of the real exchange rate) and emerging markets affected by an unwinding of carry trades and shifts in risk aversion.
If the transition is not properly dealt with, central banks could be tempted to reverse course with liquidity injections to mitigate the impact on financial stability. Unconventional monetary tools can be expected to remain an integral part of the monetary policy toolkit.
In the longer run, central banks will face increased responsibilities, including expectations of interventions in asset markets. The Great Recession has indeed conferred more power upon central bankers, forcing them to manage complex situations centered on economic and financial issues and stretching out to fiscal, prudential if not political components. Central bankers will be encouraged to “lean against the wind.” According to Mario Draghi, (2013), the success of the ECB’s action to tackle such issues will essentially depend on the effectiveness of the new macro-prudential policy framework in reining in the financial cycle and maintaining financial stability and on the effect of monetary policy on risk taking and financial stability. We see the mandate of central banks slowly evolving towards greater focus on financial stability, perhaps to the detriment of price stability, and, more worryingly, of their long-lasting independence.
Exiting unconventional monetary policies poses great challenges both for advanced and emerging economies. While short-term risks, though substantial, are well understood, there will also be major long-term changes where the role and the tools employed by central banks will be redefined. The financial sphere is entering a new era where the concepts of “conventional” and “independence” will embrace new meanings.
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