Central Bank Exit Strategies Domestic Transmission and International Spillovers

IMF Working Papers, March 29, 2024

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Canonical URL: Central Bank Exit Strategies Domestic Transmission and International Spillovers

Authors: Christopher J. Erceg, Marcin Kolasa, Jesper Lindé, Haroon Mumtaz, Pawel Zabczyk
Published: March 29, 2024
Series: IMF Working Papers
DOI: https://doi.org/10.5089/9798400270864.001

Studies alternative approaches to the withdrawal of prolonged unconventional monetary stimulus (“exit strategies”) by central banks in large, advanced economies.
Empirical and theoretical analysis focuses on how large-scale asset purchases compare to conventional short-term policy rate changes in affecting exchange rates, domestic and foreign term premiums, and domestic GDP.
Builds and calibrates a two-country New Keynesian model with segmented bond markets, cognitive discounting, and strategic complementarities in price setting to assess domestic transmission and international spillovers of exit strategies.

Large-scale asset purchases affect the exchange rate and domestic and foreign term premiums more strongly than conventional short-term policy rate changes when normalizing by the effects on domestic GDP.
Quantitative easing (QE) has distinct and stronger international transmission channels through exchange rates and term premiums relative to policy-rate changes.

Model components: segmented bond markets; cognitive discounting; strategic complementarities in price setting.
Consistency: The model is consistent with empirical finding that asset purchases have outsized effects on exchange rates and term premiums per unit of domestic GDP impact.
Effective lower bound implications:
- QE is the only effective way to provide monetary stimulus when policy rates are persistently constrained by the effective lower bound.
- QE is likely to have larger domestic output effects than quantitative tightening (QT).

Exit strategies by large advanced economies that rely heavily on QT can trigger sizeable inflation-output tradeoffs in foreign recipient economies through the exchange rate and term premium channels.
Tradeoffs are likely to be stronger in emerging market economies, especially those with fixed exchange rates.

Reliance on QT as a primary exit strategy by large advanced economies can produce adverse international spillovers, raising inflation-output tradeoffs abroad.
When policy rates remain constrained at the effective lower bound, QE remains an essential tool to provide monetary stimulus.
Consideration of exchange rate and term premium channels is critical for assessing cross-border effects of central bank exit strategies, with heightened concern for emerging market economies and fixed-exchange-rate regimes.

Subject: Bonds, Central bank policy rate, Exchange rate arrangements, Financial institutions, Financial services, Foreign exchange, Inflation, Monetary policy, Prices, Unconventional monetary policies
Keywords: appendix E. term premium, asset purchase, Bonds, central bank exit strategies, Central bank policy rate, Exchange rate arrangements, Global, Inflation, inflation surge scenario, International Spillovers, Monetary Policy, open economy, Policy conduct, Quantitative Easing, Unconventional monetary policies