13 December 2013

Charles Wyplosz: Exit strategies [prepared for ECON MD]

After the end and reversal of non-standard monetary policies, it is unlikely that balance sheets will return to their initial levels and compositions. Ideally, monetary policy will not have to be engaged into exit until after the sovereign debt crisis is over and all weak banks have been restructured.

This briefing paper was prepared for the ECON Committee's Monetary Dialogue on 16.12.13.

The major central banks have innovated in very many ways during the financial crisis and, as regards the ECB, during the eurozone sovereign debt crisis, which is not yet over. When the situation normalises, monetary policies will also normalise. Exit will have to combine two normalisations: raising the interest rate and reducing the size of the balance sheet. The issues at stake include the scheduling of the two processes and the speed of action.

The ECB’s and Fed’s balance sheets increased in similar proportions but at different speeds and for different reasons. As a consequence, while the Fed will want to reduce the size of the balance sheet when it considers that monetary policy does not need to be expansionary, the ECB will move when the sovereign debt crisis is over and when the interbank market is not fragmented anymore.

The increase in interest rates rise will impose valuation losses in central banks, which is likely to lead to considerable caution. The exit strategy will also be constrained by its impact on public debt sustainability: if the interest rate rises faster than the growth rate, the debt GDP ratio will become unstable.

Is one objective of exit to bring the size of the balance sheet back to its pre-crisis level? The liability side is the money base, so the question is whether after the crisis the base will play the same role as it did before. There is no reason to presume that this is the case, although it is much more difficult to detect in which direction the change could go. The other big question concerns the withdrawal of central bank support to governments and segments of the private sector. The ECB will not want to increase government borrowing rates by quickly disposing of the debt instruments that it holds if these governments have not recovered market access.

Central banks may well decide to keep longer-term assets. Because forward guidance will remain more art than science, the central banks are likely to continue the practice of intervening at longer maturities to affect the corresponding long-term interest rates.

Central banks no longer claim that their sole objective is price stability. They now accept that they bear some responsibility for financial stability. This does not imply that flexible inflation targeting is a strategy of the past, however. But it means that there will be periods when the flexible inflation targeting strategy must be suspended, or at least qualified, which will not be easy to implement.

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