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February 2010

Crisis and Implications for Central Bank Balance Sheets: Policies, Effectiveness and Exit Krishna Srinivasan Research Department. February 2010. The views expressed are my own and should not be attributed to the Staff, Management, or the Executive Board of the International Monetary Fund.

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February 2010

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  1. Crisis and Implications for Central Bank Balance Sheets: Policies, Effectiveness and Exit Krishna Srinivasan Research Department February 2010 The views expressed are my own and should not be attributed to the Staff, Management, or the Executive Board of the International Monetary Fund.

  2. Roadmap of Presentation • Crisis-Related Intervention Policies by Central Banks • Effectiveness of the Central Bank Policies • Exit Strategy

  3. Crisis-Related Intervention Policies by Central Banks

  4. Response of Central Banks to the Crisis Pre-Lehman • Interest rate cuts • Liquidity provision Post-Lehman • More aggressive interest rate cuts • Greater recourse to unconventional measures

  5. Reasons for Recourse to Unconventional Measures • Large shock to aggregate demand • Intensifying strains in financial markets • Elevated spreads • Disrupted transmission mechanism • Frozen credit markets • Zero interest-rate floor

  6. Central Bank Assets and Policy Rates

  7. Unconventional Measures • Commitment to keeping policy rates low • Broad provision of liquidity to financial institutions • Purchases of long-term public sector securities • Direct intervention in impaired credit markets

  8. Commitment to Low Policy Rates • Aimed at anchoring market expectations that monetary stimulus will not be withdrawn until durable recovery is in sight. • Easy to announce, and useful when policy uncertainty is high. • Effectiveness hinges on credibility; commitment has value only to the extent that it restricts future options.

  9. Provision of Liquidity • Aimed at alleviating frictions in term money markets, owing to counterparty risk, uncertainty about banks’ financing needs, and shortage of acceptable collateral. • Actions included offering liquidity at longer maturities, to a wider set of financial institutions, broader set of collateral. • Easy to implement, little credit risk, no market risk, reduces risk of bank runs. • Risk that it won’t translate into credit to the real economy. • If designed well, easy to exit.

  10. Purchase of Public Sector Securities • Aimed at reducing long-term interest rates across broad range of financial assets. • Banks could use extra reserves to extend credit. • Minimum credit risk; some market risk; and could signal commitment to keep accommodative policy. • But risk that substantial purchases may be needed to move rates, and may have little impact on prices of private and risky securities.

  11. Direct Intervention in Credit Markets • Aimed at alleviating strains in impaired markets. • Purchases of private-sector assets by central bank (commercial paper, corporate bonds, asset-backed securities). • Credit to financial institutions for purchase of private securities (securities can be used as collateral). • Exposes central banks to credit risk; may distort relative prices.

  12. Credit Market Intervention U.S. – large scale; BoE, BoJ, ECB – small scale

  13. Diversity in Central Bank Approaches • Commitment to keep low policy rates – United States and Canada. • Liquidity provision – Across all major advanced and emerging market economies. • Purchases of public sector securities – Fed, BoE (large-scale), BoJ. • Credit market intervention – Fed advanced far; limited purchases by BoE, BoJ; ECB (through acceptance as collateral)

  14. What Explains the Diversity? • Disagreement on usefulness of explicit commitment to keep low policy rates. • Differences in country circumstances • the impact of the crisis • depth of recession • role of banks in the economy • institutional arrangements • actions of non-monetary authorities.

  15. Effectiveness of Central Bank Actions

  16. Effectiveness of Unconventional Policies • Liquidity provision and credit intervention policies have largely been effective in alleviating market stress and facilitating flow of credit -- conditions in financial markets have improved • Spreads fell more in supported than in unsupported markets • Conforming vs. jumbo mortgages • High-rated vs. low-rated ABCP • TALF-eligible ABS vs. HEL ABS • Volumes picked up and maturity lengthened in ABCP markets

  17. Improvement in Broad Liquidity Indicators and in Markets Supported by the Central Banks

  18. Effectiveness of Government Bond Purchases is Questionable

  19. Exit Strategies • Why worry about exit? • When is the right time to exit? What is the optimal sequencing? • Do central banks have adequate tools?

  20. Exit – What are the Concerns? • Banks hold large excess reserves • Will liquidity translate into fast credit growth and inflation? • Can the central bank control monetary conditions with outsized balance sheet? • Would balance sheet contraction be disruptive? • Will monetization of government deficits loosen fiscal discipline and push up long term yields? • Loss of central bank independence and credibility

  21. Where are We in Recovery Cycle? • Multi-speed and policy-driven recovery is underway • Recovery in major advanced economies will be sluggish • Output gaps closing in major emerging economies. Risks of overheating and credit booms • A multi-speed recovery implies differentiation in the timing and sequencing of exit from crisis-related intervention policies

  22. Sequencing of Exits • In major advanced economies, ensuring fiscal sustainability is a key priority • Given a path for fiscal policies, monetary policy can be set to achieve a desired level of overall stimulus, tightening as needed to counter inflationary risks and maintain price stability • In major emerging (and some advanced) economies experiencing faster recoveries, monetary may have to lead fiscal tightening

  23. Exiting from Central Bank Policy Actions in Advanced Economies • Central banks have adequate tools to control monetary conditions even if balance sheets remain large • Tightening monetary stance need not await an normalizing of central bank balance sheets to more normal levels • Pay interest on reserves to ensure that overnight rate does not decline to below the target rate • Tightening through substitution on the liability side (raise reserve requirements, accept term deposits from commercial banks, issue central bank bills, or conduct reverse repos to reduce excess reserves)

  24. Exiting from Unconventional Measures • Short-term credit operations are unwinding naturally. • The scale of intervention was determined by private demand • As market conditions normalize, recourse to liquidity measures is declining • Central banks can scale back access gradually to existing facilities or introduce new liquidity-absorbing instruments • Central banks are allowing special liquidity facilities to expire and/or shortening the maturity of liquidity providing operations • Central bank currency swaps have shrunk as dollar funding in non-U.S. markets has improved, and the arrangements were allowed to expire

  25. Unwinding Medium and Long-Term Asset Purchases May be More Challenging • Unwinding involves both a “flow” and a “stock” decision. • The “flow” decision is straightforward (could be timed with economic recovery, based on market indicators) • The “stock” decision will be a long-run issue (large-scale sales could raise the yield curve and widen market spreads). • Given the large size of many credit-easing programs, it may be difficult to sell assets without a significant market impact. • There may be merit in central banks holding some assets to maturity, which would help avoid capital losses and not jeopardize economic recovery • Holding long-term private securities on their balance sheet exposes central banks to significant credit risks, and transfers resources to specific economic sectors or even individual counterparties.

  26. Other Exit Considerations • Careful and consistent communication is essential • Ensuring that unwinding does not compromise central bank independence • Addressing international spillovers of differentiated exit

  27. Conclusions • Unconventional monetary policies were used to address an unprecedented aggregate demand shock and strains in the financial markets. • Appear to have been effective in alleviating market stress and boosting aggregate demand. • Their scale and scope varied across countries depending on their circumstances. • In the multi-speed world, optimal timing and sequencing of exit from extraordinary policy interventions will vary across countries. • Central banks have the tools to ensure an orderly exit.

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