That is the very important question posed in a chapter of the IMF’s most recent Global Financial Stability Report (GFSR). During this current crisis, we have moved into uncharted waters regarding monetary policy. The chapter in the latest GFSR, however, has done us a great favour. It has eased concerns about the immediate risk of unconventional policies, but highlighted the possible concerns about the medium term. It has also provided much needed guidance on the possible exit from these extraordinary measures.
What is unconventional monetary policy? MP-Plus!
To be clear about what we are talking about, the GFSR has organised the various unconventional monetary policy measures into 4 groups. Firstly, there are ‘prolonged periods of very low interest rates’. For example, in December 2008 the US Federal Reserve cut the interest rate to between 0% and 0.25%, whilst also giving forward guidance that these low rates may remain for ‘some time’. Secondly, quantitative easing (QE), which involves the direct purchases of government bonds to reduce interest rates along the yield curve. Chairman Bernanke first signalled his intention for QE at the start of December, 2008. Thirdly, there is ‘direct credit easing’, where the central bank directly intervenes in certain markets to ease financing conditions. This may include the purchases of corporate bonds or mortgage backed securities (MBS), something that the Fed started in November 2008 when they announced the program to purchase $500 billion in MBS and $100 billion in agency debt. Finally, there is ‘indirect credit easing’, where banks provide long term liquidity to banks with the aim of encouraging lending. The GFSR refers to these policies as monetary policy plus, or MP-Plus.
To summarise the possible risks associated with MP-Plus, the GFSR highlights the following concerns:
- Prolonged periods of low interest rates can affect the profitability and solvency of financial institutions. For example, the flattening of the yield curve puts pressure on banks’ net interest margins.
- QE could exacerbate shortages of safe assets, as well as making financial institutions addicted to this central bank policy
- Direct credit easing could induce distortions in the targeted markets if the central bank becomes the dominant buyer
- Indirect credit easing could again make financial firms addicted to central bank funding, delaying the restoration of private funding markets.
Are these risks evident now? No, but medium term risks could be rising.
While the WEO chapter did not find evidence of these risks now, they did find signs that the medium term risk to MP-Plus may be rising. Firstly, they are of the view that balance sheet repair of banks may be being delayed from these policies. This may be having a negative effect on loan provisioning. Secondly, as some banks in particular countries are holding large amounts of government bonds, a rate rise in the near term could hurt these holdings. Finally, there may be an issue with interbank markets when MP-Plus comes to an end. It is not clear if this lending will return to pre-crisis levels without the support of monetary policies.
The exit from MP-Plus will need to be well articulated
The WEO made a special point of the actual exit policy of MP-Plus. The box in the chapter looked at two associated risks from this exit: interest rates and asset sales. Looking first at rising interest rates, the most important point the WEO stresses is that these should be well communicated, as sharp or unexpected rises could be damaging for banks, financial institutions and households. For banks and financial institutions, sharp rises in rates may result in large capital losses on their holdings, which would be a concern especially for weakly capitalised banks. An interest rate rise may also increase credit risk, as it could weaken loan performance.
There are also risks associated with central bank sales of assets. For one, shifts in market sentiment could lead to a sharp rise in yields. The timing of asset sales needs to be well-judged, as any underlying vulnerabilities could surface if these are conducted too soon. Moreover, as mentioned above, banks may be facing funding shortages, so an exit to MP-Plus could open this issue for banks.
Tools & Policies to support stability
So after all this, what does the IMF suggest to counter these medium term and exit risks? The WEO states that micro and macro-prudential policies need to be in place to add support to MP-Plus, applied to areas of vulnerabilities as the authorities recognise them. On bank balance sheet repair, the IMF insists that supervisors encourage this vigorously, as this needs to be complete before the exit of MP-Plus. Counter-cyclical capital rules should be in place to address market risk, such as that from asset price declines and declines in bank profitability. Forward looking liquidity requirements should also be used, such as those in Basel III. According to the IMF, these have the ability to take into account systemic effects, which may be necessary as central banks exit MP-Plus.
Overall, as the WEO mentions, this is uncharted territory, both in the use of MP-Plus and its eventual completion. We are also in uncharted territory with the use of micro and macro-prudential policy measures. All of this means that central banks and policymakers need to remain vigilant to both the macro-economy and financial stability. Thanks to this very timely WEO chapter, we now have a quick view of where to look for signs of instability and what to look out for in the future.
 Global Financial Stability Report, Old Risks, New Challenges, April 2013. International Monetary Fund.