Should Unconventional Balance Sheet Policies Be Added to the Central Bank toolkit? a Review of the Experience so Far

Contributor Notes

Author’s E-Mail Address: mstone@imf.org; kfujita@imf.org; and kishi@imf.org

What is the case for adding the unconventional balance sheet policies used by major central banks since 2007 to the standard policy toolkit? The record so far suggests that the new liquidity providing policies in support of financial stability generally warrant inclusion. As the balance sheet policies aimed at macroeconomic stability were used only by a small number of highly credible central banks facing a lower bound constraint on conventional interest rate policy, they are not relevant for most central banks or states of the world. Best practices of these policies are documented in this paper.

Abstract

What is the case for adding the unconventional balance sheet policies used by major central banks since 2007 to the standard policy toolkit? The record so far suggests that the new liquidity providing policies in support of financial stability generally warrant inclusion. As the balance sheet policies aimed at macroeconomic stability were used only by a small number of highly credible central banks facing a lower bound constraint on conventional interest rate policy, they are not relevant for most central banks or states of the world. Best practices of these policies are documented in this paper.

I. Introduction and Summary

1. The shift of major central banks to balance sheet policies beginning in 2007 reversed the late 20th century trend toward a narrow and well-defined central bank policy scope.2 Central banking began at the end of the 17th century to help governments issue debt and thereafter central banks took on a succession of broader policy responsibilities from issuer of reserve money to lender of last resort, and in some cases supervision. By the middle of the 20th century, the remit of many central banks was extended into a range of quasi-fiscal activities. The problems posed by fiscal mission creep and related high inflation led to a narrowing and clarification of the policy role of central banks during the “golden age” of central banking from around 1990 to 2008 (Gerlach and others, 2009).

2. The recent crisis necessitated a return to a more expansive central bank reach. Many central banks provided massive amounts of both domestic and foreign exchange liquidity to prevent stress in key markets from hitting the real economy. The lower bound constraint on monetary policy interest rates forced several major central banks to switch to purchases of long-term public bonds and even foreign exchange to further ease their policy stance. These policies broke from the conventional (pre-crisis) framework and brought central banks back into overlap with fiscal and other policies.

3. Central banks around the world are today deciding whether, and, if so, how, these unconventional policies should be added to their toolkit. This paper documents what central banks did, reviews the burgeoning theoretical and empirical work and discusses whether and how unconventional balance sheet policies should be added to the toolkit. Enough time has passed to provide sufficient empirical evidence to form at least preliminary views on the effectiveness of most balance sheet policies. The costs and risks of balance sheet policies, however, stretch out over the longer term. Thus, more time will be needed for a definitive judgment.

4. The experience of the large advanced and emerging market economy (major) central banks that use a short-term interest rate as the operating target of monetary policy is covered here. However, given the widespread interest in these policies, the assessment of the paper is meant to be relevant to a wide range of central banks—not just those that recently employed unconventional balance sheet measures. The use of unconventional policies by major central banks since 2007 is described in some detail and the burgeoning literature on them is reviewed. The positive assessment of which policies may warrant addition to the toolkit is based on consideration of their relevance for a given central bank, effectiveness against the costs and risks, and whether the central bank is best suited to implement the policy compared to other public entities. Finally, a set of best practices is offered.

5. In summary, most of the unconventional balance sheet policies used by the major central banks appear to have been effective, albeit to varying degrees. Against these apparent benefits must be weighed the risks posed by the overlaps of these policies with other policy spheres, the need for an exit strategy, and risks to the balance sheet.

6. More specifically, the policies used to support financial stability broadly warrant inclusion for use to counter systemic financial stress (Table 1). Liquidity provision to funding and credit markets and the provision of foreign exchange liquidity to local markets reduced the impact of financial stress on the real economy, and have for the most part been wound down without disruption. Further, the systemic importance of financial markets can be, if anything, expected to increase, and thus they warrant a broad set of liquidity provision tools. Some of the elements of the broadening of liquidity provision put in place during the crisis could be kept on permanently, depending on what the new financial landscape looks like. Inclusion of liquidity provision policies to the toolkit should be complemented by fully effective regulation and supervision to mitigate against the moral hazard problem.

Table 1.

Unconventional Central Bank Balance Sheet Policies

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7. The policy relevance of macroeconomic stability balance sheet measures is limited to the highly credible central bank facing a lower bound constraint on conventional interest rate policy. Purchases of long-term public bonds are an option for these central banks when the interest rate is constrained by the lower bound, but their effectiveness is probably limited and their considerable overlap with fiscal policies and exiting can pose problems. Large-scale foreign exchange intervention may stem appreciation, at least in the short run, but they can also impose important costs and risks, including in the multilateral sphere. The case for central bank provision of credit to the private sector—which has been used only on a limited basis—is weak for any central bank except in the most exceptional circumstances, since this is distortionary and inherently fiscal.

8. Adding balance sheet policies to the toolkit raises tricky implementation issues. They must be fit into the broad macroeconomic policy framework with respect to coordination and implementation. A set of best practices is proposed in this paper drawing from conventional policies and actual implementation during the crisis to enhance the effectiveness of unconventional policies and minimize the risks. Choosing the right degree of transparency and balancing effectiveness against distortions are perhaps the most difficult challenges here.

9. Much work lies ahead to fold balance sheet policies into the new post-crisis economic policy frameworks. As a result of the crisis, the full range of economic policies is today in flux. The new central bank market liquidity support policies must be integrated into revised and more far-reaching crisis management frameworks. The macroeconomic stability policies will eventually need to be wound down and the special circumstances under which they could be used in the future established.

10. The addition of balance sheet policies to the toolkit during the post-crisis period of financial reform and heavy fiscal burdens warrants a note of caution. Central banks and governments are faced with a host of post-crisis challenges, including fiscal consolidation. The misuse of central bank policies could potentially contribute to a downside destabilizing dynamic of fiscal dominance and a loss of central bank independence. Authorities will need to meet head on the post-crisis challenges to avoid this downside scenario and preserve the historically large measure of credibility gained by central banks during the pre-crisis golden age.

11. This paper is organized as follows. The next section lays out the comparative policy advantages of central banks and reviews the conventional pre-2007 policy frameworks. Section III documents and discusses in some detail the unconventional central bank balance sheet policies utilized since 2007. Section IV discusses which of these policies may warrant inclusion in the toolkit. The implementation of balance sheet policies is elaborated in section V, and section VI briefly concludes. Three appendices describe liquidity support for individual financial institutions during the crisis, detail the financial risks posed by bond purchases and document and discuss the best practices of central banks.

II. Background

12. This section sets the stage by discussing what makes central bank policies work generally and describing the conventional pre-2007 policy framework. Consideration of what gives central bank policies traction facilitates analysis of how they were able to widen the scope of their policies and for judging which unconventional policies could be added to the toolkit. A review of the pre-crisis monetary policy framework provides a point of departure for describing unconventional policies and informs how they can fit into the post-crisis policy framework.

What makes central bank policies work

13. The power of central banks to influence the economy arises from a combination of their legal mandate, functional responsibilities, and expertise:

  • Legal mandate for policy objectives—Most major central banks have a legal mandate for some form of price stability and a few are charged with other macroeconomic objectives. An explicit or implicit mandate for financial stability (often cast in terms of the payments system) is also common.

  • Reserve money creation—Central banks have the exclusive right to issue reserve money. This allows them to provide domestic liquidity during times of stress. Reserve money creation also facilitates the control of short-term interbank market rates.

  • Market operations role—Central banks implement monetary policy by regularly intervening in domestic and foreign exchange markets. This longstanding role has given them a unique capacity to monitor and analyze market developments.

  • Foreign exchange policy role—In almost all economies, central banks implement foreign exchange rate policies, whether or not they actually shape them.

  • Conditional access to public sector resources—Central banks usually have de facto access to fiscal resources sufficient to allow them to effectively implement their policies. This fiscal autonomy can allow them to operate quickly and flexibly.3

  • Information and analytical advantages—The above special powers of central banks, as well as their economies of scale in data collection and analysis, and role as government advisor can provide them with an information and analytical advantage over the markets and the public (Romer and Romer, 2000). Major central banks tend to be trusted as a credible source of information not just on their own policy preferences but also on the state of the economy. These advantages, together with their policy responsibilities, make it worthwhile for the markets and the public to pay careful attention to the views of the central bank on monetary and financial conditions.

Conventional pre-2007 policies

14. During the “great moderation,” the central banks of almost all advanced economies and of many large emerging market economies arrived at a broadly similar monetary framework in support of macroeconomic stability. Almost all came to target inflation, whether explicitly or implicitly (Stone and Bhundia, 2004). Monetary policy became more forward-looking and aimed at influencing inflation expectations, which can be considered as an intermediate objective (Svensson, 1997). Major central banks gained independence in monetary policy, and central bank laws often specify independence in monetary operations. Transparency and accountability were also enhanced, in part to enhance monetary policy effectiveness (Roger and Stone, 2005) but also to preserve legitimacy of the central bank’s independent status in a democratic framework. There is some consensus that at least some of the decline in inflation and output variability that marked the “great moderation” of the 1990s and 2000s can in part be attributed to the consensus regarding key aspects of monetary policy frameworks (Bernanke, 2004; Gali and Gambetti, 2009).

15. The conventional monetary policy framework employs two main instruments in support of macroeconomic stability:

  • Interest rate policy—Conventional monetary policy is implemented with a single short-term policy instrument (BIS, 2009a). Over time, a buildup of policy credibility has increased the importance of the “signaling channel.” Markets can bring about an announced interest rate change without any actual injection or withdrawal of liquidity by the central banks (Disyatat, 2008; Friedman and Kuttner, 2010). Further, interest rate policy influences the shape of the yield curve (Eggertsson and Woodford, 2003).

  • Foreign exchange intervention—Some central banks, mostly of more open emerging market economies, intervene in foreign exchange markets mainly to smooth short-run exchange rate shocks or restore exchange rate equilibrium (Stone and others, 2009a). These operations are typically sterilized so that they do not alter the targeted interest rate.

16. Most major central banks adhere to certain monetary operations “principles.” These reflect the central bank’s commitments to maximizing the effectiveness of monetary policy, safeguards to protect their independence in monetary policy, and delineate monetary policy from fiscal policy:

  • Market and counterparty neutrality—interest rates are to influence aggregate demand and inflation, rather than the distribution of resources (a fiscal policy function).

  • Flexibility—monetary operations are designed to be flexible so as to smooth liquidity shocks and ensure effective transmission of monetary policy.

  • Balance sheet protection—risk management ensures that central bank independence is not threatened by a need for fiscal resources.

Of course, differences in financial systems mean that the parameters (range of eligible collateral and counterparties) of monetary operations vary considerably.

17. Prior to the recent crisis, measures in support of systemic financial stability were relatively rare (IMF, 2010c). From the 1990s through the late 2000s, financial systems were stable in advanced economies compared to earlier periods (Laeven and Valencia, 2010). Variations in liquidity provision to financial institutions were usually small in scale compared to reserve money and were sterilized to preserve the monetary stance and overall liquidity conditions. On a few occasions, central banks undertook short-lived liquidity injections to maintain stable systemic liquidity conditions such as during the Long Term Capital Managmenet (LTCM) crisis, the Y2K transition, and after September 11, 2001. Japan in the late 1990s and early 2000s, when the Bank of Japan (BoJ) launched a wide variety of balance sheet measures, was an exception.

III. The Experience with Unconventional Central Bank Balance Sheet Policies

18. Consideration of the wide array of unconventional central bank balance sheet policies employed during the crisis requires some sort of taxonomy. A consensus about definitions of unconventional measures has yet to be reached reflecting the few years in which they have been in place and the different approaches taken by central banks.4

19. In this paper, balance sheet policies are divided first according to whether they are aimed at financial or macroeconomic stability. In almost all respects, these two objectives are quite different with respect to mandate, institutional arrangements and accountability. The financial stability role of central banks usually involves mitigation policies—for example, market and bank monitoring or in some cases regulation and supervision—as well as crisis management. The balance sheet measures considered here are for the purpose of crisis management (although, as discussed later, crisis management and mitigation policies should be coordinated).

20. Unconventional balance sheet policies are broken down further by how they transmit. Financial stability policies are divided into domestic and foreign exchange liquidity provision to local markets since these transmit differently and because the central bank has much more control over the liquidity of domestic instruments vis-à-vis foreign exchange. The three macroeconomic stability policies are intended to stimulate the economy in different ways. Bond purchases transmit mainly via long-term yields, credit provision by boosting spending of targeted sectors, while large-scale foreign exchange intervention works mainly through the exchange rate channel. Examples employed by the major central banks have taken since 2007 are shown in Table 2.

Table 2.

Examples of Central Bank Unconventional Balance Sheet Policies

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These measures have some elements of central bank credit provision to the private sector as defined here.

Sources: Central bank websites and press reports.

21. This paper seems to be the first to provide a comprehensive review of the unconventional balance sheet measures used by major central banks since 2007. A number of central banks have issued studies of their own measures and theoretical and empirical research is well underway as documented in this paper. The few cross-country studies have focused on either the largest of the advanced economies (Lenza and others, 2010; Borio and Disyatat, 2009; Klyuev and others, 2009) or on emerging economies (Ishi and others, 2009; Moreno, 2011).

The large advanced economies depended the most on unconventional policies

22. The large advanced economy central banks leaned heavily on unconventional balance sheet policies. The Federal Reserve (Fed), Bank of England (BoE) and the European Central Bank (ECB) utilized these policies the most, reflecting the complexity of their financial systems and the concomitant degree of stress (Figure 1) and the related lower bound constraint on policy interest rates. The smaller advanced economies generally used unconventional measures less, reflecting their more stable bank-based financial systems. Exceptions here are Israel and Switzerland which undertook large foreign exchange purchases, as well as Sweden.

Figure 1.
Figure 1.

Accumulated Balance Sheet Changes, Major Central Banks

(In percent of GDP)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

23. For emerging market economies, the relatively limited provision of liquidity to domestic financial markets was due to the lower degree of systemic stress. Many emerging market economies did provide large foreign exchange liquidity support. The policy interest rate in only a few emerging market economies fell to near a lower policy bound, reflecting their higher and more volatile inflation and real interest rates to compensate for the extra risk faced by investor, including of a sudden stop. Thus, they did not face the exceptional circumstance of interest rates constrained by the lower bound and had no need to resort to macroeconomic stability balance sheet policies.

24. For emerging market economies, the relatively limited provision of liquidity to domestic financial markets was due to the lower degree of systemic stress. Many emerging market economies did provide large foreign exchange liquidity support. The policy interest rate in only a few emerging market economies fell to near a lower policy bound, reflecting their higher and more volatile inflation and real interest rates to compensate for the extra risk faced by investor, including of a sudden stop. Thus, they did not face the exceptional circumstance of interest rates constrained by the lower bound and had no need to resort to macroeconomic stability balance sheet policies.

Policy objectives shifted in early 2009

25. The focus of unconventional balance sheet policies shifted from an exclusive focus on financial stability to include macroeconomic concerns after early 2009 (Figure 1). The provision of sterilized liquidity to stressed domestic markets and on a limited basis to local

foreign exchange markets by several advanced economy central banks in July 2007 marked the advent of unconventional balance sheet policies. The failure of Lehman brothers in September 2008 triggered a massive increase in the scale and breadth of both domestic and foreign exchange liquidity provision. During the spring of 2009, systemic financial stress abated but the sharp global growth slowdown focused policy mainly on macroeconomic stability.

A. Financial Stability Balance Sheet Policies

26. Unconventional balance sheet financial stability policies provide liquidity to stressed and systemically important markets. Stress in a market or institution can be deemed as systemic when it threatens to disrupt real sector activity. Systemic financial stress induced by insolvency is best handled by the government because the mobilization of real resources for recapitalization must involve the exercise of fiscal authority. The significant amounts of conventional liquidity support for individual financial institutions provided by several advanced economy central banks is not a focus of this paper; this support is described in Appendix I.

Liquidity support for domestic funding and credit markets5

27. This measure aims to restore stable conditions in systemically important markets deemed far away enough from equilibrium to adversely affect the real economy. Usually, market liquidity support is expected to lower the targeted market interest rate and restore volumes. Reserve issuance is a prerequisite for large-scale central bank support to domestic markets. Central bank knowledge of markets and access to supervisory information allows them to identify market stress and central bank’s detailed knowledge of the economy allows them to determine when such stress can become systemic. In addition, information and analytical advantages of a central bank can allow it to boost confidence sapped by systemic instability. Funding support to domestic markets overlaps with monetary policy in the sense that it can be at least partially motivated by a need to unfreeze monetary transmission.

28. In the summer of 2007, central banks began to modify existing operations to alleviate stress in funding markets (Chailloux and others, 2008). Duration was shifted from counterparties to central banks by extending the maturity of liquidity provision, the frequency of operations was stepped up, collateral standards were in many cases broadened, and in a few cases the number of counterparties was increased (Figure 2). In most cases, the maturity of liquidity provision was extended by lengthening the tenor of operations.6 Central banks drew a clear distinction between the monetary policy stance and the provision of liquidity to financial institutions (cf Stark, 2008) and these measures were sterilized.

Figure 2.
Figure 2.

Maturing and Collateral Composition of Liquidity Support, Reserve Bank of Australia

(January 2007–September 2009)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

29. In September 2008, large advanced economy central banks expanded liquidity support to funding markets and began to provide extensive support to credit markets (Figure 3). Examples of systemically important markets included commercial paper, corporate bond, mortgage backed securities, and asset backed securities.7 Bank reserves and central bank balance sheet sizes rose sharply (Figure 4). The decision to no longer sterilize market liquidity support after September 2008 seems to have been driven by the perceived need to err on the side of providing liquidity to the system and as a way of signaling central bank commitment to addressing the acute problems in the face of plummeting confidence. By mid-2010, most central banks had stopped purchases of credit instruments for financial stability purposes. In May 2010, the ECB initiated a Security Market Programme to address the malfunctioning of securities markets and to restore monetary policy transmission.

Figure 3.
Figure 3.

Liquidity Support to Domestic Funding

(In percent of GDP)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

Figure 4.
Figure 4.

Liquidity Support to Domestic Credit Markets

(In percent of GDP)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

30. Market liquidity providing policies varied considerably across advanced economy central banks. The very large differences in the magnitude and modalities of liquidity injection across central banks seem to reflect varied market structures and degrees of financial stress, as gauged by the spread between the 90-day LIBOR and the treasury bill rates (TED) (Figure 5) (Lenza and others, 2010). The different responses can also be attributed to the complexity of financial markets and to variations in pre-crisis monetary operation frameworks across economies. For instance, the central banks that conducted open market operations with a broader range of counterparties and against a wider variety of collateral (ECB, BoJ) before the crisis introduced fewer changes in these respects than other central banks.

Figure 5.
Figure 5.

Maximum TED Spread and Maximum Domestic Market Support

(In percentage points and percent of GDP)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

31. The domestic liquidity easing measures of emerging market economy central banks were on a smaller scale (Ishi and others, 2009; Moreno, 2011). They cut reserve requirements—which some use on a regular basis—expanded eligible reserve assets and some also widened the list of eligible collateral for monetary operations, broadened counterparties, and extended the maturity of liquidity providing operations. In a few cases, the government was actively involved in providing liquidity. The use of domestic liquidity easing measures was positively related to the size of the economy, possibly reflecting the associated size of the financial sector, and negatively related to international reserves, which may have mitigated the impact of external liquidity shocks (Ishi and others, 2009).

Liquidity support tended to be transparent and stricter for credit markets

32. Central banks often used spreads or interest rates of funding markets as de facto operating targets. Some sort of operating target is needed for communication and accountability. Spreads of London Interbank Offer Rate (LIBOR) over overnight indexed swap (OIS) or treasuries was often used as a de facto operating target. In some cases, outstanding market amounts were cited as “operating indicators” (e.g., commercial paper volume) while in other cases (e.g., unsecured money markets in some countries) data are not available on market quantities.

33. Liquidity providing operations tended to be relatively transparent. In most cases, the objectives, instruments implementation of liquidity support were transparent and in some cases heavily publicized, as central banks aimed to signal their commitment to improve market and overall confidence.

34. The terms of credit market support was generally stricter compared to that for funding markets. Central banks generally charged higher interest rates for support to credit markets to speed exiting and possibly to cover credit risk (Table 3).8 For credit markets, purchase prices were often set at a level attractive only under stressed conditions to reduce the risks that markets become overly dependent on central banks’ operations. Further, most central banks purchased only investment grade securities and required larger haircuts for lower credit quality collateral.

Table 3.

Terms of Funding Market and Credit Market Liquidity Support Operations

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Sources: Central bank websites and press reports.

35. Exit strategies for credit market support were more explicit compared to funding market operations (Table 3). Credit market support was provided with an explicit termination date, with the termination usually conditioned on improved market liquidity.

36. Loss sharing arrangements between the central bank and government were agreed in some countries. For instance, the BoE has been fully indemnified by the government from loss arising from purchases of corporate bonds and commercial papers. The Fed agreed with the government that the first loss amounting to 10 billion US$ from its term auction lending facility (TALF) program shall be burdened by the government. The 5 billion euro increase in the subscribed capital of the ECB at end–2010 was largely seen by markets as a means to share possible losses arising from the ECB’s liquidity support measures to funding and government bond markets.

Liquidity support reduced market stress at limited costs but also supplanted markets

37. The empirical literature, with few exceptions, concludes that central bank market liquidity provision reduced funding costs. Taylor and Williams (2008) argued that the Federal Reserve’s TAF did not reduce premia because these reflected credit risk. In contrast, McAndrews and others (2008) and Wu (2010) found that the TAF decreased premiums during end–2007 to mid–2008. Artuç and Demiralp (2009) found that the Fed’s primary credit lending facility stabilized the federal funds market. Reserve Bank of Australia (2009) concluded that their easing measures helped decrease the spreads of money market rates over OIS rates during mid–2007 to early 2009. Baba and others (2006) assessed that the massive injection of liquidity by the Bank of Japan during 2001–2006 reduced the funding costs of financial institutions. Aït-Sahalia (2009) also found that liquidity supports by central banks since the summer of 2007 contributed to stabilizing interbank markets in large advanced economies. Fleming and others (2010) found that the Federal Reserve operations to provide treasury securities against less liquid assets such as agency and mortgage-backed securities (TSLF) reduced repo rates against these securities in comparison with repo rates against treasury securities. Hirose and Ohyama (2010) concluded that market operations by the Bank of Japan stabilized commercial paper markets.

38. Assessing the impact of liquidity provision on credit conditions is more difficult. Adrian and others (2010) note that the Fed’s Commercial Paper Funding Facility made up over 20 percent at its peak in late 2008 of the total outstanding amount of commercial papers. Then the use of the facility declined as the spread of commercial paper rates dropped and the outstanding amount in the market stopped decreasing. The Fed also reported that the issuance of consumer asset-backed securities was “solid” during the second quarter of 2010, as the use of TALF declined toward its expiration date at end–June. Fahr and others (2010) and Giannone and others (2011) employ (value at risk) VAR models focusing on interest rates spreads to conclude that the ECB’s enhanced credit support program facilitated conventional monetary transmission and credit flows.

39. At the same time, central bank liquidity support likely contributed to a long-lasting contraction of some funding markets (IMF, 2010d). Of course, this may also be driven by what can now be seen as inherent weaknesses in some of these markets, for example related to the shadow banking sector. Information is not available on the losses of market infrastructure or distortions arising from market support.

40. Central banks have unwound some, but not all, of the expansions in eligible collateral and changes in counterparty arrangements made during the crisis (IMF, 2010a). While the Fed and the Bank of Canada (BoC) have been restoring the pre-crisis arrangements for open market operations counterparties and collateral, the Reserve Bank of Australia maintains the extended collateral framework. The BoJ also maintains an expanded collateral list for some foreign government bonds in the context of so-called cross-border collateral and has been running down the active use of private instruments. Meanwhile, the BoE has proposed a wider range of collateral to provide liquidity insurance to the banking system.

41. Central bank losses on liquidity providing operations seem to have been minimal. Liquidity providing operations have been wound down for the most part and have posed relatively limited credit and market risks for central banks. Reflecting the strict terms of support, no financial losses have materialized from those unconventional balance sheet policies as of end-August 2010, though several facilities continue holding legacy assets (Table 4).

Table 4.

Credit Risk Exposures Associated with Credit Market Liquidity Support

(In percent of GDP)

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Liquidity support for local foreign exchange funding markets

42. Liquidity support for foreign exchange funding markets aims to alleviate stress that can carry over to the real sector. Foreign exchange funding support follows from the central bank’s foreign exchange policy role as well as its market operations role and information advantages. Foreign exchange liquidity provision can be financed by a willing reserve currency central bank. This measure is distinct from standard foreign exchange intervention aimed at smoothing short-term exchange rate shocks.9

43. Central banks provided a considerable amount of foreign exchange liquidity mostly in U.S. dollars.10 The ECB and SNB started providing U.S. dollar liquidity in late 2007 to prevent the illiquidity of U.S. dollar funding markets from posing systemic risks. Dollar provision by central banks to local foreign exchange markets sharply increased toward the end–2008 and temporarily accounted for large shares of advanced economy central bank balance sheets. In addition, other several reserve currencies—euro and swiss franc—were also provided through foreign central banks.

44. Many emerging market economy central banks eased foreign exchange liquidity conditions using a wide array of measures (Ishi and others, 2009; Moreno, 2011).11 They relaxed the terms of existing foreign exchange facilities, extended maturities of foreign exchange swaps or introduced new facilities providing foreign exchange repos, loans.12 13 Many opened foreign exchange selling auctions and eased foreign exchange liquidity or borrowing limits. Furthermore, some central banks lowered the required reserve ratio for bank foreign currency liabilities. Many provided foreign exchange liquidity at penalty interest rates. Empirical evidence suggests that it was the larger emerging market economy with more developed financial sectors, flexible exchange rate regimes and lower foreign exchange reserves that utilized foreign exchange liquidity easing measures (Ishi and others, 2009).

45. Cross-central bank swaps in support of foreign exchange liquidity provision was a novel aspect of the crisis (Figure 6). These are bilateral agreements between central banks that in essence involve the provision of liquidity from a central bank whose currency was in demand to another central bank for distribution by it to local institutions. These arrangements accounted for most of the foreign exchange liquidity provision. Swaps can increase the availability of foreign exchange liquidity to local institutions and buttress market confidence. The Fed established dollar swap arrangements with fourteen central banks and the ECB and the Swiss National Bank (SNB) also supplied liquidity in their currencies.

Figure 6.
Figure 6.

The Maximum Amount of Bilateral Swaps with the Fed

(In percent of GDP)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

Operational design reflected global market conditions and exit strategies

46. The terms of central bank local dollar liquidity provision sourced from the Fed changed with the acceleration of global stress in September. Early in the crisis, when stress was concentrated in a few markets, the Fed swap arrangements were limited in quantity and the liquidity-receiving central banks distributed dollars locally at close to the rate in U.S., as gauged by the TAF interest rate (Figure 7). In September 2008, the Fed shifted to providing unlimited dollar access to selected countries. Thereafter, liquidity-receiving central banks charged a premium, presumably to help limit the overall amount of demand and ensure that only counterparties most in need of liquidity would borrow. 14 This premium pricing probably facilitated the rundown of dollar provision as market conditions improved.

Figure 7.
Figure 7.

Selected Central Banks, Terms of Foreign Exchange Liquidity Provision Sourced from the Federal Reserve

(December 2007–February 2010)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

47. Many central banks employed an exit strategy. Foreign exchange liquidity was in many cases provided with an explicit termination date, often conditioned on improved market liquidity.

Foreign exchange liquidity provision was effective and benign for central bank balance sheets

48. Central bank support for foreign exchange funding markets has been found to have been effective in reducing funding costs (Goldberg and others, 2011). According to market participants, central bank swap facilities improved term funding conditions in major off-shore funding markets (Baba and Packer, 2009). Mancini and Ranaldo (2010) found that central bank foreign exchange swaps reduced excess covered interest parity profits with a one-week lag. Aizenman and Pasricha (2010) found short-term but not long-term benefits from the Fed’s swaps. Baba and Packer (2009), Stone and others (2009b), and Fung and Yu (2010) provide empirical evidence that central bank liquidity support and the Fed’s extension of dollar swap lines reduced local foreign exchange market stress.

49. The impact of foreign exchange liquidity provision on the financial positions of central banks and local foreign exchange markets seems to have been minimal. No central banks appear to have incurred losses in providing foreign exchange liquidity. Nor did these operations appear to have caused a lasting contraction in foreign exchange market activity.

B. Macroeconomic Stability Policies15

50. Several advanced economy central banks facing a lower interest rate bound turned to unconventional balance sheet policies in support of macroeconomic stability. Emerging market economies have not turned to these policies because they are not constrained by a lower bound on interest rates (Figure 5), did not experience as severe economic downturns as did the advanced economies, and for them large increases in domestic liquidity could lead to destabilizing capital outflows (Ishi and others, 2009). These policies are in many respects outside the traditional purview of central banks.16

Bond purchases

51. Central bank bond purchases for macroeconomic objectives are to overcome the lower policy interest rate bound and are intended to lower long-term yields and boost aggregate demand.17 18 The potency of bond purchases follows from the capacity of the central bank to control its balance sheet, its potential access to fiscal resources as well as its market operation role and information advantages and monetary policy communication legacy. Bond purchases can be viewed as a shift from fixing a conventional short-term interest rate target to aiming to lower long-term yields.19

52. By mid-2009, bond purchases took over from conventional interest rate policy as the main monetary policy tool for the Fed and the BoE. Bond purchases began in March 2009 prompted by the dwindling effectiveness of conventional monetary policy culminating in policy interest rates brought to their lower bound (Figures 8 and 9). By mid-2010, the Fed and BoE bond purchases comprised large shares of the total outstanding stocks (Figure 10) and during some periods accounted for the bulk of government financing (Figure 11). In November 2010, the Fed announced another round of long-term government security purchases for the first half of 2011.

Figure 8.
Figure 8.

Selected Countries, Policy Interest Rates

(January 2007–December 2010)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

Figure 9.
Figure 9.

Bond Purchases and Policy Interest Rates

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

Figure 10.
Figure 10.

Holders of Public Securities, Stocks

(In percent of GDP)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

Figure 11.
Figure 11.

Holders of Public Securities, Flows

(In percent of GDP)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

Figure 12.
Figure 12.

Exchange Rate, Policy Interest Rate, and Foreign Exchange Purchases

(In percent of GDP)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A001

There is no consensus on how bond purchases transmit

53. Bond purchases are often presented as transmitting to a large extent through portfolio rebalancing.20 21 The reduction in the outstanding stock available to market of the purchased security raises its price and lowers its yield, possibly by reducing the premium for duration or other types of risks (Gagnon and others, 2010; Krishnamurthy and Vissing-Jorgensen, 2010a).22 The yields on long-term assets, such as corporate bonds and possibly bank loans, which are near substitutes for the security purchased by the central bank, are also reduced as investors rebalance their portfolio.

54. A number of other channels from bond purchases to yields have been proposed (Krishnamurthy and Vissing-Jorgensen, 2010b). These include: safety premium (purchases reduce yields for assets that serve a distinct safety role), interest rate commitment signal, default risk (bond purchases reduce likelihood of default), inflation expectations (purchases increase inflation expectations and lower real interest rates), and prepayment risk (MBS purchases lower yields). Some of these channels work through market segmentation that is at odds with the operation of portfolio balance effects.

55. A variety of financial frictions have been employed in theoretical macroeconomic models for effective bond purchases.23 The model of Cúrdia and Woodford (2010), which has heterogeneous households to motivate intermediation, financial frictions, and large financial shocks, imparts a policy role for central bank asset purchases. Gertler and Karadi (2009) allow for financial intermediaries with endogenous balance sheet constraints and central bank lending directly in private credit markets. Gertler and Kiyotaki (2009) go further by incorporating liquidity risks a la Kiyotaki and Moore (2008) and suggest that when private intermediaries are financially constrained central bank direct lending in private credit markets contribute to expansion of the overall supply of credit; otherwise, the central bank displaces private credit. The model of Del Negro and others (2010) imposes a liquidity constraint to get effective central bank bond purchases.

56. Bond purchases may also depreciate the exchange rate and lower yields on foreign assets. Under uncovered interest rate parity, a surprise decline in domestic long-term yields relative to those on foreign assets would lead to a one-off depreciation. Bond purchases could spill over into lower foreign yields to the extent that they are substitutable. Garcia-Cicco (2011) models balance sheet policies in an open economy setting.

Bond purchases pose communication and exiting challenges

57. In many respects, but not all, bond purchases have been implemented in different ways compared to the conventional monetary framework. The Fed and the BoE have made clear the objective of those bond purchases aimed at macroeconomic stability. Inflation expectations seem to be a forward-looking intermediate target—as with conventional monetary policy.24 In other respects, central banks are “learning by doing.” The experience with bond purchases is so limited and transmission to inflation so uncertain that central banks seem to assign weights to other intermediate indicators such as key credit interest rates and flows as important indicators of ongoing effectiveness (e.g. Bernanke, 2009b). The yields on the purchased security are not quite an operating target under the control of the central bank (needless to say, central banks have only partial control over the outstanding stock of bonds) but could be viewed as an “operating indicator.”

58. The Fed and the BoE have provided considerable guidance on their exit strategies. The exit strategy involves timing the reduction of asset holdings and raising of policy rates and choosing the pace and measures of asset reduction. As these decisions will depend largely on future macroeconomic conditions, neither the Fed nor the BoE committed to a specific exit path. Nonetheless, both central banks have provided general guidance to avoid disorderly reactions from financial markets. For instance, both central banks have emphasized that the reduction of the asset and conventional monetary tightening can be undertaken separately; conventional tightening is likely to precede bond sales—if they are sold at all.25 In addition, the BoE, which holds around one fifth of government bonds, indicated that it will work closely with the debt management office in its resale of gilts (Fisher, 2010).

Empirical work suggests that the recent bond purchases boosted asset prices and possibly aggregate demand as well26

59. A number of event-type studies have concluded that bond purchases can alter asset prices. Studies of the U.K. and of the first round of bond purchases in the U.S. (Gagnon and others, 2010; Joyce and others, 2010; Dale, 2010; Krishnamurthy and Vissing-Jorgensen, 2010b; D’Amico and King, 2010) suggest that long-term security purchases may have reduced yields by 50–100 basis points on impact, and have lowered yields on near substitute securities. Gagnon and others (2010) argue that the impact of bond purchases on yields operated through lower risk premiums, including term premiums, as opposed to lower expectations of the future path of short-term policy interest rates. The announcement of the first round of bond purchases in the U.S. seemed to have boosted inflation expectations and thus contributed to a large reduction in real yields. The second round of bond purchases in the U.S. seems to have had a more limited effect (Krishnamurthy and Vissing-Jorgensen, 2010b). The event study of Lam (2011) found that government bond yields by the BoJ had a significant but small announcement impact on yields.

60. Several VAR and large model studies suggest that bond purchases provided the intended stimulus. Chung and others (2011) using a large policy model of the U.S. modified to capture the relationship between the term structure and Fed asset holds and estimate that the bond purchases of the Fed had a large expansionary impact. Using a time varying VAR model, Baumeister and Benati (2010) conclude that the bond purchases of the Fed and the BoE averted risks of deflation and large output contractions. Liu and others (2011) apply a regime-switching VAR model to the U.S. and conclude that the Fed’s large scale asset purchases helped lower yields and contributed to lowering the unemployment rate and boosting inflation.

However, the empirics is marked by analytical problems with offsetting implications

61. Macroeconomic models do not capture the depression counterfactual and thus may be underestimating the benefits of bond purchases. The current state of the art models do not allow for the downside nonlinearities generated by systemic financial stress. This precludes assessment of the distance between actual outcomes and the depression counterfactual and thus inherently underestimates the policy benefits.

62. At the same time, standard analytical tools do not pick up the mostly forward-looking costs and risks. Many of these risks arise from the fiscal-like aspects of bond purchases, including their distributional consequences, as well the perception that these are to finance government spending. Others relate to central bank independence such as the exposure of central banks to vested interests. Exit challenges are a further risk. These risks and costs are quite hard to capture in a standard model.

Central banks have not incurred losses so far

63. The recent Fed and BoE bond purchases so far seem not to have incurred central bank losses. Central bank purchases of government bonds from the private sector financed by new bank reserves creates a maturity mismatch, leaving it vulnerable to an increase in interest rates.27 Further, bond purchases shorten the duration of the consolidated liabilities of the public sector.

Large-scale foreign exchange purchases

64. Large-scale foreign exchange purchases are mainly aimed at countering protracted upward pressure on the exchange rate also in the context of impaired transmission of conventional monetary policy.28 These purchases are unconventional in that they are of a larger order of magnitude than the amounts of two-sided intervention typical for the flexible exchange rate regimes operated by most major central banks. They can be used to counter protracted upward exchange rate appreciation pressure which can be costly for small open economies. There may also be a portfolio balance effect if demand is increased for other securities that transmit into higher aggregate demand. This policy is made possible by the central bank’s foreign exchange policy role and information advantages which make it well-suited to judge whether the exchange rate is overvalued and that intervention is warranted. Large-scale foreign exchange purchases have not been sterilized and thus involved the creation of reserve money, which is another special power of central banks.

65. The Bank of Israel (BoI) and SNB undertook large foreign exchange purchases. The swiss franc and shekel appreciated rapidly beginning early in the crisis probably reflecting their “safe haven” status. Meanwhile, the policy interest rates of the BoI and SNB were reduced to historically low levels (Figure 9). The SNB purchases began in March 2009 and over the next year doubled the stock of reserves.29 The SNB stated that it bought foreign exchange to prevent further appreciation of the Swiss franc and thereby counter the growing risk of deflation. The BoI’s intervention began in March 2008 in the context of rapid currency appreciation and its strategy of building up international reserves, continued in the format of regular amounts until early August 2009 and shifted to intervention in varying sums depending on market conditions. The reserves of the BoI also doubled. In both cases, reserve money rose broadly in line with foreign exchange reserves, suggesting that the purchases were not sterilized.

Large-scale intervention seems to have been effective in the short-run but also costly

66. These policies seem to have at least temporarily countered appreciation pressure. Sorezcky (2010) found that the foreign exchange intervention of the BoI during 2008–09 resulted in a more depreciated value of the shekel than would have been the case otherwise. According to the SNB (2010), “The appreciation of the Swiss franc in early 2009 came to an abrupt halt following the SNB announcement in mid-March that it would prevent further appreciation by intervening in the foreign exchange market.” The intervention was seen by the SNB as countering appreciation pressures through the rest of 2009.

67. The BoI and SNB incurred large losses in 2010 from their exchange rate purchases. The appreciation of the Swiss franc and shekel generated losses for the BOI and SNB of 2.2 percent and 3.8 percent of GDP respectively. Foreign exchange valuation losses are not uncommon for central banks.30 However, the relatively large losses of the BoI and SNB is controversial.

Central bank involvement in credit provision

68. Central banks have taken measures to facilitate the provision of credit to a targeted sector to boost output. The transmission of central bank credit provision to domestic demand is more direct compared to bond purchases. Effective credit provision requires borrower demand at the dictated terms and feed through of the credit flow into higher aggregate demand and output. The need for credit provision need not follow from impaired monetary transmission. Central banks are able to undertake credit provision mainly due to their access to fiscal resources to deal with the contingent liability posed by credit risk.31 In developing economies, central banks may have an information advantage in identifying suitable projects or in discerning market failures.32

69. Since 2007, major central banks have only taken a few measures with some aspects of credit provision. In the past, many central banks undertook credit provision on a large scale, but major central banks have generally stopped this practice.33 The measures with some elements of credit provision followed the hitting of the lower interest rate bound on conventional monetary policy. The later MBS/GSE bond purchases of the Fed have an element of credit provision in that they were intended to benefit the housing sector, although these securities are claims on another public entity and thus pose no credit risk to the Fed. The “Asset Purchase Program” announced by the BoJ in October 2010 includes the purchase of commercial paper, corporate bonds, exchange-traded funds and real estate investment trusts. In June 2010, the BoJ announced a facility to provide collateralized low interest rate long-term funds to banks to finance credit to sectors deemed to strengthen the foundation for economic growth. The BoJ stepped up its credit provision facilities following the earthquake and tsunami of March 2011. Again, these measures have not posed meaningful credit risk to the BoJ.

70. Assessment of the success in boosting credit of these measures is difficult. Central banks undertook credit provision in the past, but in many cases incurred losses and moved away from this role (Fry, 1993). The impact of the Fed’s MBS/GSE purchases on credit flows is difficult to gauge and the aforementioned facilities of the BoJ have not been in place long enough to assess.

IV. Adding Balance Sheet Policies to the Standard Central Bank Toolkit

71. This section discusses addition of the recent unconventional balance sheet policies to the central bank toolkit. Many central banks—not only those that recently utilized them—are considering adding unconventional balance sheet policies to their toolkit. This section is meant to inform these considerations.

72. It is worth emphasizing again that the following discussion is preliminary and necessarily general. This reflects, first, a lack of counterfactuals. Ideally, any policy assessment compares outcomes of when the policy is used and when it is not. However, there have been too few episodes of systemic financial instability and a binding lower interest rate bound in modern times to afford analysis of the counterfactual. Further, the discussion here is cast in general terms, but, of course, the decision to adopt unconventional balance sheet policies depends very much on the country specifics.

A. Financial Stability Balance Sheet Policies

73. Unconventional financial stability balance sheet policies are relevant for any country with systemically important credit, fund and foreign exchange markets. Thus, they warrant consideration by a large number of central banks.

The case for including liquidity support to domestic markets in the toolkit is strong

74. There is by now considerable empirical evidence supporting the effectiveness of market liquidity support. Empirical analysis broadly concludes that liquidity provision has alleviated stress in the targeted markets. In almost all cases, this support has already been exited from with apparent little disruption.

75. The main risks involve market risks to the central bank balance sheet, the moral hazard of further future support, and crowding out of markets (Box 1). Market support inherently involves credit risk. Encouragingly, central banks do not seem to have incurred losses from domestic liquidity support. The moral hazard of enhanced expectations of support in the future is another risk. The supplanting of markets by central bank liquidity provision is another potentially important consequence with costs that may be realized over the long run. Differentiating this support from monetary policy is another challenge.

76. Central banks are certainly best suited to undertake market liquidity support. Credit market liquidity support involves credit risk and some degree of government involvement, although central banks are best suited to conduct this policy but because of their information and operational advantages as well as the need for coordination with monetary policy.

77. Some of the liquidity broadening elements introduced by central banks during the crisis may be worth retaining (IMF, 2010a). Enhanced flexibility of liquidity provision could facilitate liquidity management during normal circumstances and provide more options during periods of systemic stress. Particular elements of expanded liquidity provision that could be retained are higher reserve levels (especially for economies in which the level of required reserves in normal conditions is low), a sufficient set of counterparties for flexible liquidity provision, sufficient and properly priced eligible collateral, measures to reduce stigma (a bank being unwilling to borrow from the central bank owing to its concern that by doing so it would send a signal to the markets that it was uncreditworthy) such as anonymity in liquidity access, and effective funds-absorbing tools (central bank bills and an ability to remunerate central bank deposits) can enhance liquidity management during normal conditions and absorb large-scale liquidity injections.

Challenges and Risks Posed by Liquidity Provision

Many of the challenges and risks are posed by both domestic and foreign exchange support:

  • Coordination of liquidity provision with monetary policy—Central banks can face the challenge of ensuring that liquidity provision for financial stability purposes is not confused for an unwanted loosening of monetary policy (cf Stark, 2008).

  • Market distortions—Liquidity provision targeted at particular markets can tilt the playing field in favor of the selected market players. Central banks providing access to liquidity cannot know for sure which counterparties would not be able to obtain financing otherwise, or which counterparties are healthy and taking advantage of easy terms.

  • Moral hazard—Large-scale liquidity provision can lead to expectations of support in the future.

  • Crowding out of funding markets—The supplanting of money markets by the central bank can, over time, shrink the supporting infrastructure, and lead banks to cut back on their own market-based liquidity management. Once markets do recover, the fixed costs of rebuilding these capabilities would have to be repaid.

  • Potential credit risks for the central bank—In a crisis situation, central banks cannot be assured that their financing is addressing a liquidity or solvency problem.

  • Exposure of central banks to vested interests—The liquidity provision to targeted borrowers leaves central banks vulnerable to pressure from vested interests eager to take advantage of easy access to liquidity even after conditions improve.

Others are specific to foreign exchange liquidity support:

  • Coordination of foreign exchange liquidity provision with exchange rate policy—Central banks must draw a line to the extent possible between foreign exchange intervention to influence the exchange rate for macroeconomic objectives and measures to boost foreign exchange liquidity. This is more difficult for countries that intervene regularly and with discretion.

  • Insurance issue and coordination with international arrangements—To the extent that foreign exchange liquidity provision serves an insurance function should be assessed together with other insurance mechanisms, such as the appropriate level of international reserves, IMF facilities, and access to market borrowing.

Likewise, a strong case can be made for foreign exchange liquidity support

78. Foreign exchange liquidity measures also seem to have been effective. Again, there is considerable empirical support that these measures reduced local foreign exchange funding costs and enhanced availability. Further, central bank swaps seem to have played an important role in reducing market stress.

79. The main risks seem to be with respect to foreign exchange policy and moral hazard (Box 1). Separating out foreign exchange liquidity provision from exchange rate policy can be problematic. Markets may have incentive to take riskier behavior if foreign exchange liquidity support can be expected in times of stress. Foreign exchange liquidity provision seems not to have crowded out local markets or caused central bank losses.

B. Macroeconomic Stability Balance Sheet Policies

80. The use of macroeconomic stability balance sheet policies by only a few central banks facing a lower interest rate suggests that their forward-looking policy relevance is fairly limited. These policies were employed by highly credible central banks with reserve or safe haven currencies that are so credible that investors are willing to hold them even when they earn an almost zero nominal return. The lower interest rate bound compels these central banks to turn to bond or foreign exchange purchases. Central banks that do not face the lower interest rate bound need not resort to macroeconomic stability balance sheet policies. Further, adding these policies to the toolkit does not mean they should be an ongoing tool; rather, their use should be conditional on being at the lower interest rate bound.

Bond purchases have been effective to a degree and there are risks

81. Bond purchases almost surely pushed down long-term yields in the U.S and U.K. The feed-through from lower yields to aggregate demand seems to have been positive but is not well established. The effectiveness of bond purchases probably declines on the margin. They are a relevant policy for highly credible banks constrained by the lower interest rate bound.

82. Bond purchases do pose a range of potential costs and risks (Box 2). Exiting may prove to be challenging. Costs include a loss of market pricing information, and a potential balance sheet impact for the central bank. There are also adverse potential fiscal implications, such as monetization of a government deficit, which can delay fiscal consolidation and, in the worst case, can undermine confidence in the fiscal authorities.

83. The central bank can be seen as the best-suited vis-à-vis the government to implement bond purchases for the purpose of influencing aggregate demand. The distributional implications of bond purchases are inter-temporal and relatively limited. The central bank has considerable information advantages over the government in assessing the effectiveness and transmission of bond purchases. Further, bond purchases to reduce yields is a logical extension of interest rate policy conducted by the central bank.

Challenges Posed by Bond Purchases and Credit Provision

Some of the challenges and risks are common to both bond purchases and credit provision:

  • Distributional consequences—Lower long-term yields generated by bond purchases bring an inevitable intertemporal distortion by helping debtors (usually young) at the expense of savers (usually old). Credit provision is necessarily targeted at specific borrower classes and thus generates intersectoral distortions. Democratic accountability is a guiding precept for any public sector entity that implements policies with distributional effects, and thus these policies are not well-suited for central banks.

  • Loss of market price information—The market price of intervened securities will, if policy is effective, be distorted, removing a key market indicator.

  • Financial impact on the central bank—A increase in bond yields causes valuation losses for the central bank if the purchased bonds or loans are valued at market prices. The central bank will incur a capital loss from outright sales of the securities if yields have increased. If the central bank chooses to hold the securities to maturity, its net income will decrease as the central bank raises policy rates and liability costs rise. Credit provision can expose central banks to credit risks, depending on the design.

  • Exposure of central banks to vested interests—The channeling of credit to targeted borrowers leaves central banks vulnerable to pressure from vested interests eager to access these resources. Such pressure could compromise the autonomy that is important for effective central bank financial and macroeconomic stability policies. Further, vested interests could strive to complicate or delay exiting from credit provision or bond purchases.

Other challenges and risks are specific to bond purchases:

  • Communication challenges—Central bank communication of bond purchases is challenging because their transmission is not well understood. Further, markets are accustomed to receiving information about supply conditions of government bonds from debt managers, rather than from central banks.

  • Exit challenges— An exit strategy is needed as these purchases are motivated by temporarily impeded conventional monetary policy (IMF, 2009) and because they are long-term. Exiting from bond purchases is more challenging than tightening conventional monetary policy as it requires decisions regarding involving liquidity absorbing, raising the policy interest rate from its lower bound, and taking a view on how to treat long-term yields.

  • Impact on consolidated public sector balance sheets and income—Bond purchases shorten the duration of consolidated public sector debt and thus alter the expected path of public financing costs (Appendix III). The “capital loss” and “income loss” of the central bank described above would increase the effective financing costs on a consolidated sovereign basis. In addition, this could raise rollover risk for economies with large fiscal burdens.

  • Perception of monetization of government debt—Central bank bond purchases in the context of a fiscal deficit can be perceived as (indirect) monetary financing and lead to volatile and higher bond yields to compensate for the risk of inflationary financing.

Large-scale foreign exchange intervention seems to have been effective in the short-run but also costly for central banks

84. This policy seems to have had some short-run success in alleviating upward exchange rate pressure. However, a definitive conclusion cannot be drawn here owing to the many factors that drive exchange rate movements. Further, the alleviation of upward pressure on the exchange rate may not be sustainable.

85. There are considerable national and multilateral risks. The risks for the country are to the perceived commitment of the central bank to a flexible exchange rate and the exposure of the financial position of the central bank (and the public sector) to exchange rate risk from large foreign exchange holdings. From a multilateral perspective, foreign exchange intervention on a large scale has the potential to generate foreign exchange policy reactions from other countries that could lead in a worst case scenario to a devaluation spiral across countries.

The case for credit provision by central banks is weak

86. Central banks are not well suited for undertaking targeted credit provision. Most major central banks have limited or no information advantage over the private sector in identifying creditworthy projects. Credit provision has distributional implications and involves fiscal resources and is thus best undertaken by the government which is more democratically accountable than the central bank. Except in the most exceptional circumstances credit provision is best done by the government, possibly in cooperation with the central bank.

87. The risks for a central bank are high, including market risks, moral hazard, and potential threats to central bank independence. The historical experience of directed central bank credit provision has often been quite negative, as it was seen as compromising central bank independence and monetary policy objectives.

V. Implementing Balance Sheet Policies

88. Adding balance sheet policies to the toolkit poses tricky challenges. This section briefly considers how these policies fit into the broad policy framework, discusses best practices, and presents a forward-looking downside scenario as a note of caution.

Unconventional balance sheet policies within the broad policy framework

89. Fitting balance sheet policies into the policy framework raises novel choices and tensions. Of course, identifying the exceptional circumstances that warrant their use is a central challenge in employing unconventional central bank balance sheet policies. A related issue is coordinating them with regulatory, liquidity and fiscal policies—a point which is stressed in the next subsection. A few specific observations on the policy mix in different settings follow.

90. A credible fiscal consolidation when interest rates are at their lower bound can enhance the effectiveness of macroeconomic stability balance sheet policies. Research (IMF, 2010b; Christiano and others, 2009) suggests that fiscal consolidation has a bigger output cost for an economy at the lower bound than otherwise because the central bank cannot lower rates to cushion the contractionary fiscal impulse. In this setting, not only can bond purchases help ease monetary conditions but their risks are attenuated by the positive signal conveyed by fiscal consolidation.

91. When systemic financial stress is the primary concern, liquidity providing operations can be set apart from monetary policy. This helps reassure markets that the central bank is meeting liquidity needs rather than possibly boosting inflation above its target. Such was the situation in most of the large advanced economies during mid–2007 to late–2008 and in the euro area since mid–2010.

92. When systemic financial stress prevails and the policy interest rate is at its lower bound, a single balance sheet policy can help both the financial system and the economy at large. In these circumstances, bond purchases can both help relieve bond market stress and reduce long-term yields. Liquidity provision relieves stressed financial markets and facilitates monetary transmission. Further, these policies can help improve overall confidence by signaling the resolve of the authorities.

Best practices of implementing balance sheet policies

93. Appendix III elaborates best practices balance sheet policy implementation drawn from a review of central bank practices and the pre-crisis experience with conventional policies.34 As noted in section II, in many respects monetary policy frameworks converged during the “golden age” of central banking. However, there is not yet a consensus for best practices for unconventional balance sheet policies. The discussion here is motivated by the unique aspects of these policies including their conditionality and limited duration, policy overlaps and coordination, the associated disequilibria of markets and economies, and the concomitant balance sheet risks. Not taking these differences fully into account in designing and implementing balance sheet policies can result in the realization of the risks laid out in boxes 1 and 2 (Shirakawa, 2010).

94. The elaboration of best practices is meant to help the pitfalls (Box 3). Enough experience has been gained with these policies to begin to point to best practices. Thus, Appendix III is meant to provide initial guidance and help advance thinking on how to implement unconventional balance sheet policies. They are based on what can be viewed as the successful elements of balance sheet policies used by central banks, as well as on what was learned from the development of the pre-crisis framework. In some respects, implementation does not involve difficult tradeoffs; for example balance sheet protection and policy coordination. However, there are two particularly difficult challenges.

95. The first challenge is finding the right balance on transparency. Transparency can be defined in the context of this paper as the public’s ability to understand the central bank’s motives and actions (Carpenter, 2004). It is generally recognized that there are limits on transparency in monetary policy (Mishkin, 2002). In particular, the conventional balance sheet policies of liquidity support to banks and foreign exchange intervention are less transparent than monetary policy (IMF, 2005). Real time transparency in support to stressed banks or other financial institutions runs the risk of generating a destabilizing run on deposits, thus the practice of “constructive ambiguity” (Enoch and others, 1997). If the public underestimates the degree of uncertainty surrounding the desired policy outcomes expressed by central banks, than guidance that turns out to be inaccurate ex post could be destabilizing. Clearly, systemic financial instability and impaired monetary transmission—the circumstances that warrant unconventional balance sheet policies—are highly uncertain states of the world.

96. Implementing balance sheet policies poses a difficult transparency challenge. Transparency in the goals and instruments of balance sheet policies would seem to enhance their effectiveness. In contrast, there may often be too much uncertainty for full clarity in their implementation, especially in how the central bank communicates its views on transmission. However, central banks can look at the “substitutability” of different aspects of implementation (e.g. trading off transparency on the timing of versus the conditions for exiting).

97. Ex post transparency of balance sheet policies facilitates democratic accountability. While ex ante transparency may not be desirable given the uncertainties associated with balance sheet policies, ex post transparency on their implementation and outcome fosters accountability and overall central bank credibility.

98. The second challenge has to do with the tradeoffs between effectiveness and distortions. While conventional monetary policy aims at market neutrality, balance sheet policies by their nature are targeted at specific markets. The narrower the targeted market, the greater the risk of distortion. Central banks can face difficult tradeoffs between the costs of these distortions against attainment of their policy objectives. Not much more can be said about which way to lean on this tradeoff except that this is conditional on the country setting and stability considerations.

The downside fiscal dominance scenario

99. In the post-crisis setting, adding central bank policies to the toolkit has the potential to contribute to a downside destabilizing dynamic. The recent crisis was unexpected and severe led to large increases in the size and interlinkages of the balance sheets of governments, central banks and financial sectors. Risks remain in the outlook and some small steps have been taken that undermine central bank independence (Stella, 2010).

Best Practices of Central Bank Balance Sheet Policies

Objectives, Transparency, and Accountability

  1. The objectives and broad framework of balance sheet policies should be clearly set out in terms of the central bank policy mandate.

  2. The central banks should explain to the extent possible the expected transmission mechanism and risk of balance sheet policies.

  3. The central banks should make public the details of the operational design of balance sheet operations, including terms and conditions of auctions and their actual use.

  4. The central banks should periodically explain progress in achieving policy objectives through balance sheet policies.

    Policy Coordination

  5. Financial stability balance sheet policies should be complemented by supervisory and regulatory measures and consistent with the crisis management strategy.

  6. Central banks’ balance sheet policies should be clearly delineated from fiscal policies.

    Operational Designs and Exit Strategies

  7. Central banks should have sufficient legal and operational flexibility for balance sheet policies.

  8. Balance sheet policies should be designed to minimize distortions, including moral hazard and resource misallocation.

  9. Exit strategies from balance sheet policies should be developed and clearly communicated at the time of their introduction.

    Central Bank Balance Sheet Protection

  10. Measures to protect central bank balance sheets should be clearly communicated.

  11. For lending operations, risk management tools, such as collateral, pricing, and haircuts, should be used based on the differential risks of each policy.

  12. Private debt instruments for outright purchase or collateral for lending operations should be high quality.

  13. The central banks should have sufficient financial strength and the extent of their risk taking should be agreed with the government, including an ex ante mechanism to transfer resources to the central bank if needed.

100. The destabilizing dynamic begins as follows. A major central bank may not be able to exit from its balance sheet policies (sell government bonds and foreign exchange, withdrawing from money markets) for years.35 A moral hazard arises under which the government pressures its increasingly “captured” central bank to further widen the policy scope. A government with a relatively short-term horizon has reason to take behavior risky for the economy at large feeling confident that it can depend on the central bank to provide support if these policies fail. The prospect of this support gives the government less reason to pursue politically painful fiscal consolidation and financial reforms.36

101. Importantly, this dynamic could repeat with larger social losses in each round. First, increasing “fiscal capture” means that the central bank intervenes earlier and on a larger scale. Second, under Ricardian equivalence, the impact of central bank quasi-fiscal policies on aggregate demand would be offset by higher private savings. Third, these policies increase the public debt and taken to the extreme will be counterproductive. The downside risk is that this repeated game scenario boosts economic and financial volatility. This was the case in the past with some developing and emerging market countries where governments dominated the central bank.

102. Sound application of unconventional policies and other supporting policies would militate against this scenario. As stressed earlier in this section, balance sheet policies should be used only in special circumstances for financial and macroeconomic stability purposes and when other instruments are not effective. Much has been learned in the past three years and application of the best practices of central banks documented in Appendix III would help. A clear delineation between fiscal, monetary and financial sector policies also as described in Appendix III helps prevent the government from pressuring the central bank to move into the quasi-fiscal realm. Of course, long-term fiscal consolidation takes the pressure off monetary policy and the central bank. Finally, any measures that impinge on central bank independence should be avoided.

VI. Conclusion

103. Many of the recent central bank unconventional balance sheet policies likely warrant inclusion in the toolkit depending on the country and the circumstances. The adoption of these policies probably marks one of the most radical and rapid shifts in policy in recent central bank history. The financial stability balance sheet policies look to warrant inclusion in the toolkit of many central banks. Bond and foreign exchange purchases for macroeconomic stability policies are relevant for highly credible central banks in the unusual circumstances of the lower interest rate bound. The case for central bank credit provision is weak. A definitive judgment on balance sheet policies won’t be possible for some years, especially with regards to the risks.

104. Adding unconventional balance sheet policies is not straightforward because they involve a wide array of policies. Folding balance sheet policies into the new post-crisis economic policy frameworks will be part of the fundamental review of economic policies now underway (Blanchard and others, 2010). The financial stability balance sheet policies will need to be integrated into new crisis management and regulatory frameworks. This is a short-term priority because the market liquidity support policies have been mostly exited from with success and thus can be designed with some confidence and there may be lingering stability risks in the global financial system.

105. A cautionary final thought is in order. Central banks and governments are faced with the challenges of exiting smoothly from balance sheet and other crisis intervention policies, clarifying the new wider set of central bank policy responsibilities, and reducing in some cases very large fiscal burdens. As noted in the previous section, this setting raises the potential of a downside scenario involving the misuse of balance sheet policies and a loss of central bank independence. The preservation of the historically large measure of credibility gained by central banks during the pre-crisis golden age will hinge on meeting successfully these challenges.

Should Unconventional Balance Sheet Policies Be Added to the Central Bank toolkit? a Review of the Experience so Far
Author: Kotaro Ishi, Mr. Kenji Fujita, and Mr. Mark R. Stone
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    Accumulated Balance Sheet Changes, Major Central Banks

    (In percent of GDP)

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    Maturing and Collateral Composition of Liquidity Support, Reserve Bank of Australia

    (January 2007–September 2009)

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    Liquidity Support to Domestic Funding

    (In percent of GDP)

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    Liquidity Support to Domestic Credit Markets

    (In percent of GDP)

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    Maximum TED Spread and Maximum Domestic Market Support

    (In percentage points and percent of GDP)

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    The Maximum Amount of Bilateral Swaps with the Fed

    (In percent of GDP)

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    Selected Central Banks, Terms of Foreign Exchange Liquidity Provision Sourced from the Federal Reserve

    (December 2007–February 2010)

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    Selected Countries, Policy Interest Rates

    (January 2007–December 2010)

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    Bond Purchases and Policy Interest Rates

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    Holders of Public Securities, Stocks

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    Holders of Public Securities, Flows

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    Exchange Rate, Policy Interest Rate, and Foreign Exchange Purchases

    (In percent of GDP)