february 2010 crisis and implications for central bank balance sheets: policies, effectiveness and...

February 2010

Crisis and Implications for Central Bank Balance Sheets: Policies, Effectiveness and Exit

Krishna SrinivasanResearch Department

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

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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

Central Bank Assets and Policy Rates

0

5

10

15

20

25

Jun-07 Dec-07 Jun-08 Dec-08 Jul-09 Jan-10

0

1

2

3

4

5

6

7Other

Credit market interventions

Liquidity facilities

Government securities

U.S. Federal Reserve(percent of 2008 GDP)

Fed Funds target rate (rhs)

0

5

10

15

20

25

Jun-07 Dec-07 Jun-08 Dec-08 Jul-09 Jan-10

0

1

2

3

4

5

6

7

Other (includes swaps)

Credit marketinterventionsLiquidity facilities

Government securities

Bank of England(percent of 2008 GDP)

Base rate (rhs)

0

5

10

15

20

25

30

35

40

45

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Jan-10

0

1

2

3

4

5

6

7OtherCredit market interventionsLiquidity facilitiesGovernment securities

European Central Bank(percent of 2008 GDP)

Refinancing rate (rhs)

0

1

2

3

4

5

6

7

8

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Jan-10

0

1

2

3

4

5

6

7

Other

Credit market interventions

Liquidity facilities

Government securities

Bank of Canada(percent of 2008 GDP)

Overnight target rate (rhs)

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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

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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.

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0

200

400

600

800

1000

1200

1400

1600

Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Currency swaps

Security lending

PDCF

TAF

Discount window

Repo

Fed Liquidity Facilities ($ billion)

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ECB Liquidity Facilities(euro billion)

0

200

400

600

800

1000

1200

Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Forex lending

Other lending to banks

LT refi

Main refi

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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.

13

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.

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

Fed Intervention in Credit Markets ($ billion)

0

200

400

600

800

1000

1200

1400

Jul-08 Jan-09 Jul-09 Jan-10

Agency Bonds

Agency MBS

TALF

CPFF

AMLF

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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)

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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.

Source: ECB Monthly Bulletin, April 2009.1/ Breakdown of the sources of external financing of non-

financial corporations.

Banks

Banks

Non-Bank

Non-Bank

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10

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30

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60

70

80

90

100

Euro area United States

Figure 3. Sources of Financing for Corporations 1/ (percent, average 2004-08)

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Effectiveness of Central Bank Actions

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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

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

0

50

100

150

200

250

300

350

400

Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Euro

Pound sterling

Canadian dollar

U.S. dollar

Three-month LIBOR-OIS spreads (basis points)

Source: Bloomberg, L.P.

0

1

2

3

4

5

6

7

Jul-08 Jan-09 Jul-09 Jan-10

Non-fin <AA

ABCP AA

Fin AA

Non-fin AA

AMLF CPFF

U.S. Commercial Paper Spreads over T-bill(in percent)

Source: Haver Analytics.

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U.S. Mortgage Spreads(in percent)

-1

0

1

2

3

4

5

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

30-year conforming mtg vs. 10-year T-note

Jumbo vs. conforming

Jumbo vs. Treasury

GSE takeover

Fed announces MBS purchase program

Fed announces MBS purchase program details

Fed scales up MBS purchase program

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Effectiveness of Government Bond Purchases is Questionable

-75

-50

-25

0

25

50

75

100

Jan-09 May-09 Sep-09 Jan-10

10y US Treasury10y UK Gilt

Gov. Bond Yield Spreads vs German Bond(basis points; 10 year)

Source: Bloomberg L.P.

Mar 5: BoE announces it will begin purchasing Gilts

Mar 18: Fed announces Treas. purchase program

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Exit Strategies

• Why worry about exit?

• When is the right time to exit? What is the optimal sequencing?

• Do central banks have adequate tools?

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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

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Fed Liabilities ($ billion)

0

500

1000

1500

2000

2500

3000

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Other

Reverse repos

Treasury deposits

Reserves

Currency

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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

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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

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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)

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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

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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.

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Other Exit Considerations

• Careful and consistent communication is essential

• Ensuring that unwinding does not compromise central bank independence

• Addressing international spillovers of differentiated exit

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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.