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

IMF Blog, April 11, 2013

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

Context: 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.
Core concern: The end of unconventional monetary policies may pose threats to financial stability because of the length and breadth of their unprecedented reign.
Guiding principle for exit: Economic objectives of central banks (low and stable inflation and—for some—low unemployment) and market conditions will guide the exit from extraordinary policies.
Key recommendation: Policymakers should be alert to risks and take gradual and predictable measures to address them.

Main risk: An unexpected or more-rapid-than-expected rise in interest rates, especially longer-term interest rates.
Transmission mechanism: Central banks increasing interest rates and potentially selling bonds purchased during the crisis could prompt private investors to sell bonds en masse, leading to a spike in interest rates.
Adverse consequences listed:
- 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 tend to increase net interest margins, 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.
- Credit risk for banks may increase as 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.

Context: Outright sale of assets purchased in large quantities over the past several years may not be necessary to tighten policy, but sales could occur depending on factors such as political pressure.
Potential adverse consequences of sales:
- Market overreaction: Uncertainty about the necessity or willingness of central banks to sell large portfolios could lead financial markets to overreact when sales begin, prompting private investors to dump bonds and causing sharp increases in interest rates.
- Policy missteps could disrupt markets: Selling assets before policymakers address underlying market vulnerabilities could resurface market dysfunction seen during the crisis. This risk is heightened where central banks hold a large share of outstanding issues or played an important market-making role, especially if underlying market dysfunction is masked by central bank intervention.
- Banks could face funding challenges as central banks drain excess reserves to make monetary policy implementation more effective; some banks will need to turn to the interbank market for funding and may find the transition challenging.

Emphasize gradualness and predictability:
- Eventual policy changes should be as gradual and predictable as possible.
- A more normal policy environment implies—at a minimum—substantial increases in interest rates; given the prolonged period of very low rates, such increases will require more adjustment in markets, companies and financial institutions.
Communication and planning:
- Central banks should carefully plan and communicate their exit strategies well in advance to markets, financial institutions, and other central banks to minimize potential disruption.
Bank supervision and recapitalization:
- Bank supervisors should ensure that banks repair their balance sheets and generally get their proverbial house in order while unprecedented policies are still in place, so they can thrive once central banks decide to exit from their extraordinary policies.
Timing of complementary reforms:
- Complete any necessary bank restructuring and recapitalization as soon as possible to reduce vulnerability to short-run capital losses from rising interest rates.

Erik Oppers; April 11, 2013

Chapter 3: Do Central Bank Policies Since the Crisis Carry Risks to Financial Stability?
- Chapter 3: Do Central Bank Policies Since the Crisis Carry Risks to Financial Stability? (Markdown version)
- Chapter 3: Do Central Bank Policies Since the Crisis Carry Risks to Financial Stability? (PDF)