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:

• Banks and other financial institutions—including even central banks—would incur capital losses on fixed-rate assets such as bonds. While a rise in interest rates can be good for banks in that it tends to increase net interest margins (their main source of profits), it also leads to immediate losses on bonds. Because these losses are immediate and higher profits take a while to materialize, in the short run, weakly capitalized banks could suffer. This risk makes it very important that any necessary bank restructuring and recapitalization is completed as soon as possible.

• Credit risk for banks may increase. Higher interest rates make it harder for bank customers to pay back their loans, especially if the rise is in response to an inflation threat rather than improved economic circumstances.

• Spillover effects to emerging markets. Shifting expectations of the path of future interest rates can lead to sudden and potentially disruptive financial flows between markets and countries, especially if the timing of tightening differs across the central banks.

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:

• Uncertainty about the necessity or willingness of central banks to sell their large portfolios of government bonds and other assets could lead financial markets to overreact when central banks begin to sell these assets. Fears that central bank sales could lead to falling bond prices may prompt private investors to dump bonds, which could lead to the previously mentioned sharp increases in interest rates.

• Policy missteps could disrupt markets. If central banks sell assets before policymakers address underlying market vulnerabilities, the market dysfunction we saw during the crisis could resurface. This risk is heightened in markets where central banks hold a large share of outstanding issues or played an important market-making role, especially if underlying market dysfunction is now masked by central bank intervention.

• Banks could face funding challenges. As central banks drain excess reserves to make monetary policy implementation more effective, some of the banks that will need to turn to the interbank market for funding will find the transition challenging.

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.