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Exiting quantitative easing – the need for a deft touch and some luck

In recent weeks, speculation the United States Federal Reserve may begin tapering its quantitative easing (QE) program has sparked volatility in bond and currency markets. This has underscored the uncertainty and risks associated with QE and the possibility that, if exiting QE is not handled well, it could have adverse implications for the global economy.

With official interest rates close to zero monetary authorities in the United States, Europe, Japan and the United Kingdom turned to unconventional monetary policy tools. QE involves central banks purchasing financial assets (such as government bonds, corporate bonds and mortgage-backed securities). It increases the money base with a view to driving down long-term borrowing costs. Currently, the US Federal Reserve is purchasing US$40 billion of mortgage-backed securities and US$45 billion of longer-term US Treasury securities each month.

The logic is that improved liquidity and lower borrowing costs will support higher household expenditure and encourage businesses to borrow to fund wealth and job creating long-term investments.

QE has always been seen as a temporary policy measure rather than a permanent change to the way monetary policy is conducted. In theory as economies recover and growth picks up, central banks will wind back QE and ‘mop up’ excess liquidity in the financial system. Monetary policy will then gradually be tightened, with interest rates heading back towards normal levels. If all goes well, inflation will remain contained and, importantly, inflationary expectations will remain firmly anchored. The question is, will we get this happy ending?

While many factors are likely to bear on this question, how well central banks exit QE is one of them.

The first conundrum for central banks is deciding when and how fast to exit. The obvious answer is to begin exiting once it is clear a sustainable recovery is underway and growth is picking up, and to calibrate the pace of withdrawal for the speed of the recovery. But in practice making these calls will not be easy. For one thing, the exceptional economic circumstances of recent years and presence of significant downside risks have made forecasting harder.

If it is clear economic activity is picking up and financial market distress has abated, judging the right time to start exiting QE will be easier. However, if the recovery is sluggish and there are conflicting signals, then the decision becomes more difficult. As the IMF recently observed, in this scenario weighing the benefits of continuing on with unconventional monetary policy against the associated costs is more challenging. This judgement is further complicated if after a certain point there are diminishing returns from QE in terms of its positive effects on growth.

Exiting too early or too fast carries the risk of choking off an economic recovery before it has a chance to take hold. On the flip side, leaving very loose monetary conditions in place for too long carries the risk of pumping up asset price bubbles, distorting financial markets and feeding inflation.

A second challenge for central banks is deciding how best to go about exiting QE and the sequencing of measures. The IMF has suggested the path back to normalising monetary policy may go something like this: (1) halting extraordinary interventions; (2) downsizing and normalising the central bank’s balance sheet; (3) selling purchased assets, if necessary; and (4) raising short-term interest rates. The US Federal Reserve articulated a set of ‘exit strategy principles’ in June 2011 which provides guidance on how they are likely to sequence measures to normalise monetary policy.

Such neat lists mask the complexity of decision making at each stage and the extent of uncertainty and risk. For example, there is a risk that withdrawing QE sparks excessive market volatility and investors begin selling off government bonds. In this scenario long-term interest rates could overshoot, driving up borrowing costs. Further, such volatility could result in large fluctuations in capital flows and exchange rates.

The major central banks will need to adopt a flexible approach to policy that reflects how they have implemented QE and economic and financial developments. With the normalisation of monetary policy likely to play out over a number of years and with the likelihood central banks will need to calibrate their policy approaches for market reactions along the way, we may yet see some further innovations in this space. Good communication by central banks will be essential if they are to avoid taking markets by surprise.

There is also a broad range of factors that are beyond the control of central banks but are nevertheless critical to how smoothly exiting QE goes. The transition will be made more difficult if it turns out businesses have used the availability of ‘easy’ money to fund poor investments. Further, the transition is vulnerable to negative external shocks.

Finally, as the IMF has emphasised, much will also depend on how well governments have used the breathing space provided by QE to put their fiscal affairs in order and implement much needed structural and financial sector reforms.

With the US tipped to recover more quickly than Europe, the US Federal Reserve’s management of the normalisation of monetary policy over coming years may provide valuable lessons for their European counterparts.