Exit Strategy and Other Risks

Unconventional monetary policy measures that increase the size and/or riskiness of the central bank's balance sheet raise the possibility of large capital losses on those assets, potentially to the extent of making the central bank insolvent. A central bank can to some extent repair its losses by printing money. However, this is limited by its operational target of price stability, since printing too much money could cause inflation. Therefore, if its losses are large enough, presumably the government would have to recapitalize the central bank. This would require the issuance of new debt, which would tend to put further upward pressure on bond yields and possibly undermine the currency.

Another issue for unconventional monetary easing that is receiving increasing attention is that of the exit strategy, i.e., how to unwind the unconventional policy measures once the economy is ready to go back onto a “conventional” policy track. The central bank has to strike a delicate balance and reduce its balance sheet in a timely and non-disruptive way to avoid potential inflation risk on the one hand and an overly abrupt monetary-tightening shock on the other. The key point is that the credit transmission mechanism does not function normally when the economy is in a liquidity trap, so that unconventional policies may lead to a very large expansion of the central bank's balance sheet without stimulating a commensurate increase in bank lending. However, once conditions in the financial sector normalize, the transmission belt could start up again, and bank lending could balloon rapidly, leading to unwelcome inflation pressure. Also, if the central bank holds large amounts of government bonds, it could suffer large capital losses on those bond holdings, which would undermine the central bank's capital position. Large-scale sales of such bonds could exacerbate capital losses in this situation. Moreover, if the central bank holds large amounts of illiquid assets such as asset-backed securities as a result of qualitative easing measures, it might find it very hard to reduce these holdings in a timely manner. Finally, if interest rates rise too rapidly as a result of rapid sales of assets, this could undermine the economic recovery.

A number of these issues are discussed in detail in Fujiki, Okina, and Shiratsuka (2001). One possible perverse effect would be that announcements by the central bank to buy government bonds would be perceived by the market as a loss of fiscal discipline, which could actually push up risk premiums and bond yields. They also argued that, if bond yields rise and the central bank suffers losses on its holdings of government bonds, it would have to sell more government bonds than it bought in order to reduce base money by the same amount, thereby leading to further upward pressure on bond yields and capital losses.

Bernanke (2009b) argued that it will be relatively easy for the Fed to wind down its balance sheet when the time comes, because: (i) many lending programs extend credit primarily on a short-term basis at above-normal market rates, so demand for them by banks and other institutions will dwindle once the economy recovers and credit market conditions normalize; (ii) the Fed can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves; (iii) some reserves can be absorbed by the Treasury's Supplementary Financing Program; and (iv) the Fed's ability to pay interest on reserve balances will encourage depository institutions to hold reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves.

Of course, the central bank could always raise the reserve ratio if it found other means to decrease the level of reserves to be too disruptive. There are other possibilities as well. Bini Smaghi (2009) suggested that the fiscal authority could issue debt securities and deposit the proceeds with the central bank. This would effectively transfer the liquidity previously created from the private to the public sector. Where allowed, the central bank could also issue such certificates, with essentially the same effect.

The Bank of Japan's experience of winding down the QE policy in 2006 was uneventful, which should provide some confidence on this subject. It managed to shrink its balance sheet dramatically by ¥39 trillion (25%) between February and May of that year without any obvious disruption of the markets. Roughly three-quarters of the reduction was accomplished by cuts of bills purchased, while the remainder came from sales of JGBs. JGB yields rose by about 35 basis points over that period, a measurable increase, but well within normal market fluctuations. Also, Figure 3 above shows that the Fed has been successful in shrinking some of its lending programs fairly rapidly, including the foreign currency swap arrangements. However, the real test will come when it has to sell down its outright holdings of US Treasuries and other less-liquid securities.

Download this Paper [ PDF 294.1KB| 34 pages ].

Comment(s)

There are [0] comment(s) for this entry. Post a comment.