03 May 2013

ECB/Cœuré: Where to exit to? Monetary policy implementation after the crisis

Exit from non-conventional policies will come one day, and lessons drawn from the crisis times will help us chart out our path. The debate on exit has chiefly concentrated on strategies, i.e. on monetary policy reaction functions on the way out of these policies and over the new steady state.

But it is fair to say that – with only few exceptions – participants in the debate have been less active in discussing the operating framework of monetary policy.

Here, a few interesting questions remain unanswered. Will central banks go back to their pre-crisis operating framework once conditions return to normal? Or should some of the novel instruments remain in their toolbox ready for use, or even as standing instruments replacing old practices?

Three main developments during the crisis:

First, central banks collectively moved towards instruments that can effectively disentangle interest rate decisions from decisions concerning the size of their balance sheets. ECB entered the crisis with a corridor system and an elastic operating framework.

Second important development during the crisis: central banks in a large part of the world engaged in non-conventional measures aimed at absorbing liquidity risk and duration risk from the market. The ECB has primarily concentrated on liquidity risk.

Finally, the third important development during the crisis was that central banks had to substitute for the sudden disruption of interbank market activity and became de facto the “money market intermediary” of last – and sometimes first - resort. For the ECB this was facilitated by the broad range of counterparties accepted in monetary policy operations and its broad collateral framework.

The ECB entered the crisis with a tradition of conducting policy through a corridor – others would say, a “channel” – system. The ECB’s corridor is determined by the two overnight standing facilities: the marginal lending facility and the deposit facility

Before the crisis, the intermediation role of the ECB was limited to filling the structural “liquidity deficit” of all the banks vis-à-vis the monetary authority. The pre-crisis weekly liquidity provision through variable rate competitive auctions was thought to be best suited to reveal banks’ “true” liquidity demand, incentivise interbank transactions, and enhance market scrutiny of banks’ credit standing, beyond the quality of the collateral that they could pledge in our lending operations.

But, during the crisis, we have moved to a system in which the central bank is de facto the “market intermediary” of last – and sometimes – first resort. This has further weakened banks’ incentives to trade liquidity in the market.

Exiting the crisis mode could pose risks to financial stability in the current environment, which is marked by a prolonged period of low yields and reduced volatility, making it challenging for the financial sector to properly accommodate interest rate risk. The exit could be associated with a steepening of the yield curve as expectations of low short-term rates are reversed and central banks reduce their holdings of long-term securities. Uncertainty on the path of exit from unconventional policies may trigger a rise in volatility at the long end of the yield curve, exposing banks and investors to substantial losses. These effects would be more pronounced if the speed of interest rate adjustment were to exceed market expectations.

At the same time, delaying the exit from “crisis” monetary policies beyond what central banks’ reaction function would warrant could also entail risks to financial stability, by inducing a further build-up of the very same exposures that render exit more challenging in the current environment.

Finally, let me stress that a sound financial system is a necessary condition for an orderly exit, hence the importance of a swift implementation of the banking union in the euro area.

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