Strategies and Cheese

Today an interesting BIS working paper (292) was released. Anyone remotely interested in economics is probably by now aware that central banks all over the world have gone to great lengths to loosen monetary policy, not only by lowering interest rate levels. Otherwise technical terms such as ‘quantitative easing’, ‘credit easing’, ‘bank reserves policy’ (bank reserves do play a very special role, see the article) are thus commonly circulated in popular media and have almost gone mainstream. While it may be a stretch to call these measures unconventional, the extensive usage at central banks of means other than the interest rate as the main transmission channel of monetary policy has prompted many observers to label those measures creative money printing. Now that is something far more captivating to the general public than the dorky ‘quantitative easing’.

This new paper from BIS tries to classify and appraise the unconventional measures under the broad term balance sheet policies in order to differentiate them from conventional interest rate policies. They define the decoupling principle as paramount for our understanding of that differentiation — i.e. they stipulate that size and structure of a central bank’s balance sheet is independent of the interest rate policy that the central bank pursues.

This is particularly important as central banks need not unwind their balance sheets immediately after changing their interest rate policy, should the economy begin to recover and zero interest rates need to be abandoned. Similarly, the authors hold that specific separate exit strategies for the unconventional measures are necessary. As long as central banks have the same tools at their disposal as they had when creating these measures they can execute differently timed, decoupled policy exits.

I think that we will indeed see significant political pressures towards delays in cutting back on balance sheet policies. This relates merely to the fact, as highlighted by BIS, that central banks have certainly lost much autonomy from their governments and they have essentially taken a variety of further financial risks, including credit, market, exchange etc. Conflicting interests between the central bank and the goverment are hence very plausible. E.g. the government would like to inflate away its increased debt (think of the U.S.), but the central bank might want to get a hold of inflation at the same time (as soon as this becomes an issue).

Exit strategies will need to be well communicated in terms of intent and desired effect, so that their purpose is properly understood by the market, to render them effective. Technically, quantitative easing measures could be easily withdrawn just as liquidity facilities could no longer be extended. Higher collateral haircuts could be applied, etc. This should keep in control potential inflationary issues (at least in the short run; the longer run is more problematic and is explained in the aforementioned article). That is, if hopefully western economies start recovering faster and accelerated credit extension starts taking place, central banks will have the tools to prevent disproportionate and inflationary increase in the actual money supply in the wider economy. As I’ve seen in my current line of work, the ECB has started to pull out some liquidity facilities and has began to filter out eligible collaretal for refinancing much more carefully.

In the end of the day, central banks have also learned plenty. They will try to steer clear out of new imbalances.