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How To Make A Graceful Exit: The Potential Perils of Ending Extraordinary Central Bank Policies

This spring monetary policy is the talk of the town.  It is everywhere you look, it’s unique, and you’ve never seen anything quite like it before: short-term interest rates at zero for several years running, and central bank balance sheets swelling with government bonds and other assets in the euro area Japan, the United Kingdom, and the United States.

But the meteoric rise of this once dusty topic can’t last.  The end of these unconventional monetary policies will come and may pose threats to financial stability because of the length and breadth of their unprecedented reign.  Policymakers should be alert to the risks and take gradual and predictable measures to address them.

The risk of a rapid rise in interest rates

Our new analysis in the latest Global Financial Stability Report looks at the consequences for financial stability of recent central bank policies, and also touches on the issue of how to end them and return to normal policies. The economic objectives of central banks, like low and stable inflation and—for some—low unemployment, as well as market conditions will guide this so-called exit.

Market conditions are important. The main risks of an exit are associated with an unexpected or more-rapid-than-expected rise in interest rates, especially longer-term interest rates. Exit will mean that central banks start increasing interest rates, and they may also decide to sell some of the bonds they bought during the crisis.  If private investors—fearing bond price declines from these central bank exit policies— respond by selling bonds en masse, this could lead to a spike in interest rates. Such a spike could have adverse consequences:

The downside of selling off your assets

There are also risks associated with efforts by central banks to shrink their balance sheets. While an outright sale of assets purchased by central banks in large quantities over the past several years may not be necessary to tighten monetary policy, whether sales materialize will depend on a number of factors. Central banks may use other instruments to drain liquidity; but there may be pressures—for example, political—to sell these assets anyway. These sales could also have adverse consequences:

How to make a graceful exit

What can policymakers do to prevent these risks from posing a serious threat to financial stability?

Most importantly, the eventual changes in policy should as much as possible be gradual and predictable. A more normal policy environment implies—at a minimum—substantial increases in interest rates, and given the prolonged period of very low rates such a substantial increase will require more adjustment in markets, companies and financial institutions.  A gradual and predictable exit would facilitate that adjustment.

So central banks should carefully plan and communicate their exit strategies well in advance to markets, financial institutions, and other central banks to minimize the potential for disruption. Bank supervisors should ensure that banks repair their balance sheets and generally get their proverbial house in order while these unprecedented policies are still in place, so they can thrive once central banks decide to exit from their extraordinary policies.