From chapter 3 of the IMF’s latest global financial stability report, in a section dealing with the risks to central banks from exiting unconventional monetary policy:
Risks associated with increasing interest rates include the following:
- Banks and other financial institutions may incur capital losses on fixed-rate securities.
- Credit risk for banks may increase.
- Spillovers to other countries or markets may occur.
Risks associated with asset sales include the following:
- Shifts in market sentiment may lead to sharp increases in yields.
- Policy missteps may disrupt markets.
- Banks may face funding challenges.
In the Fed’s case, I get the sense that many commentators remain confused about its available tools for tightening policy, once it needs to.
The use of interest on excess reserves has convincingly given the Fed control over the consistency of secured and unsecured short-term rates. As discussed ad nauseam in the economics blogosphere earlier this year, it’s a tool that could well be here to stay.
But even if you don’t think that the current “floor system” is permanent — i.e. if you don’t think that IOER will eventually become the new policy rate — the Fed can happily continue using it as such for a very long time. Eventually the Fed can revert back to using the federal funds rate as its primary policy tool (through altering the monetary base with asset purchases and sales), but there’s no rush if it is concerned that selling assets too quickly will cause market disruptions.
In 2010, Bernanke telegraphed his own preference for hiking IOER before starting asset sales when he said:
If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations.
I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery.
Raising IOER and selling assets are the two most straightforward and potent tools, but the Fed does have a few other options for quickly removing reserves from the banking system in the event of unanticipated complications. It now has an expanded list of counterparties against which to reverse repo its massive store of bonds, and it still can offer term deposits.
As for the possibility of losing control of the yield curve, the Fed can target-sell assets of specific maturities or (the more extreme option) manipulate the curve using some variation of Operation Twist — in reverse if necessary, buying the short-end and selling the longer-maturity debt. The latter possibility would keep the monetary base stable, if that’s preferable.
Not that it would be simple to calibrate, but keep in mind that these tools can be used in conjunction to offset potential disruptions in any one of them.
Some have also worried that these methods of policy “normalisation”, especially if they include holding onto its securities portfolio in a rising rate environment, present the risk of the Fed suffering losses and not remitting any money to the Treasury for several years. Maybe, but from both a logistical and economic angle this doesn’t really matter: the Fed has accounting options that allow it to defer the losses until later.
There might well be a political or public relations problem. The “losses” and the strangeness of the tools might again raise the hackles of certain politicians and inspire more headlines about the threat to central banking independence.
All the same, I think it’s worth remembering that by definition these problems are of the kind that will exist in a world where the economy is much stronger than it is now, which would undermine the political backlash.
At some point the Fed will have to decide which route it wants to take, and naturally it would help if it communicated its choice clearly. Indeed, solving its remaining communications issues would itself help avert the outcomes that people find worrying — making the exit less complicated than it needs to be. But just because exiting unconventional policy will itself be unconventional, the continued unconventionalness won’t necessarily matter.
Whatever the Fed does choose, the biggest risk is unlikely to be either a lack of potency or loss of control, but simply getting the policy right.