MP-Plus: An Overview, April 2013
The combination of exceptionally low policy interest rates and unconventional monetary policy measures are generally referred to as “MP-plus”. These measures include an extended period of very low interest rates as well as so-called unconventional policies—providing long-term liquidity to banks to support the flow of credit, lowering long-term rates through bond purchases, and stabilizing specific markets such as mortgage lending. These measures can be classified into four groups (with some overlap between groups):
Prolonged periods of very low interest rates, sometimes combined with forward guidance on the length of time for which rates are expected to remain low;
Quantitative easing (QE), which involves direct purchases in government bond markets to reduce yield levels or term spreads when the policy rate is at or close to the lower bound;
Indirect credit easing (ICE), in which central banks provide long-term liquidity to banks (sometimes with a relaxation in access conditions), with the objective of promoting bank lending; and
Direct credit easing (DCE), when central banks directly intervene in credit markets—such as through purchases of corporate bonds or mortgage-backed securities—to lower interest rates and ease financing conditions (and possibly mitigate dysfunction) in these markets.
Financial Stability risks associated with exit from Mp-plus policies
In considering the risks to financial stability of exit from MP-plus, it is useful to distinguish between two aspects, namely, an exit from low policy rates and the sale of central banks’ accumulated inventory of assets, most of which are debt securities.
In the current cycle, as in previous ones, the central bank will need to raise interest rates at some point to safeguard price stability. But the need to sell assets to tighten policy is less evident—central banks could simply hold them to maturity and use other policy tools; but other concerns, including political considerations, may still prompt asset sales. Hence, the challenges and risks of both types of exit must be anticipated and managed, especially since the use of MP-plus policies is uncharted territory for policymakers.1
The main financial stability risks of exit are associated with an unexpected or more-rapid-than-expected increase in interest rates, especially at the longer end of the yield curve. Hence, when the time comes to tighten financing conditions for banks and the economy, central banks would likely aim for an anticipated and gradual increase in interest rates, giving economic agents time to adjust. A disorderly increase or an overshooting—perhaps as a result of shifts in market sentiment—would make adjustment to the new financial environment much more difficult, heightening the risks listed below.
Many MP-plus policies are unprecedented, and they have now been in place for a relatively long time. It is therefore even more important than during a normal tightening cycle that exit strategies are well communicated to the general public as well as to markets, financial institutions, and other central banks. The risks below also underline the importance of efforts to ensure that bank soundness and market liquidity are restored as soon as possible to minimize the financial stability threats of a future exit from MP-plus.
Risks associated with increasing interest rates include the following:
Banks and other financial institutions may incur capital losses on fixed-rate securities. While the evidence suggests that a rise in interest rates increases net interest margins for banks, improving their profitability over time, losses on fixed-rate securities available for sale are immediate. In the short term, therefore, weakly capitalized banks could suffer. For financial institutions with long-term liabilities, such as pension funds, capital losses may be offset by a decrease in the net present value of liabilities.
Credit risk for banks may increase. Higher interest rates could weaken loan performance, especially if the rise is in response to an inflation threat rather than improved economic circumstances.
Spillovers to other countries or markets may occur. Shifting expectations of the path of future interest rates can lead to financial flows between markets and countries that could be sudden and potentially disruptive, especially if the timing of tightening differs across central banks.
Risks associated with asset sales include the following:
Shifts in market sentiment may lead to sharp increases in yields. Uncertainty about the necessity or willingness of central banks to sell their large portfolios of government bonds and other assets could lead to shifts in market sentiment when central bank asset sales materialize.
Policy missteps may disrupt markets. If central banks sell assets before underlying market vulner- abilities are addressed, dysfunction could resurface. This risk is heightened in markets where central banks hold a large share of outstanding securities or played an important market-making role, especially if ongoing market dysfunction is now masked by central bank intervention.
Banks may face funding challenges. Just as the counterpart of purchases of assets by central banks was an increase in banks’ excess reserves, the counterpart of asset sales would likely be a decline in banks’ excess reserves. This disintermediation of interbank liquidity by the central bank would have to be offset by a revival of private interbank markets. If this market is not fully restored, some banks could face funding challenges.
The Macroeconomic Effectiveness of MP-Plus
Central banks have deployed a variety of unconventional measures during the crisis. But is there a limit to their effectiveness in case of a potentially prolonged downturn?
A forthcoming IMF publication, “Unconventional Monetary Policies: Recent Experience and Prospects”, addresses three questions about unconventional monetary policies. First, what policies were tried, and with what objectives? Second, were policies effective? And third, what role might these policies continue to play in the future?
Central banks in key advanced economies adopted a series of unconventional monetary policies with two broad goals. The first was to restore the functioning of financial markets and intermediation. The second was to provide further monetary policy accommodation at the zero lower bound of policy interest rates. These two goals are clearly related, as both ultimately aim to ensure macroeconomic stability. But each relies on different instruments: the first on targeted liquidity provision and private asset purchases, and the second on forward guidance and bond purchases.
These policies largely succeeded in achieving their domestic goals, and were especially effective at the time of greatest financial turmoil. Market functioning was broadly restored, and tail risks declined significantly. Policies also decreased long-term bond yields, and in some cases credit spreads. Some evidence also suggests that these policies encouraged growth and prevented deflation, although this conclusion is less clear-cut, given the long lags and unstable relationships between variables, and the unresolved question of what would have happened without central bank policy intervention.
Unconventional monetary policies had a mixed effect on the rest of the world. Early policy announcements buoyed asset prices globally, and likely benefited trade. Later announcements had smaller effects and increased capital flows to emerging market economies, with a shift to Latin America and Asia. Sound macroeconomic policies can help manage these capital flows. Yet, when flows become excessive, with the risk of sudden reversals, they can give rise to policy strains in recipient countries.
Looking ahead, unconventional monetary policies may continue to be warranted if economic conditions do not improve or if they worsen. Yet, bond purchases in particular seem to exhibit diminishing effectiveness, and their growing scale raises risks. A key concern is that monetary policy is called on to do too much, and that needed fiscal, structural, and financial sector reforms are delayed.
Balance Sheet risks of Unconventional policy in Major central Banks
Risks on balance sheets of central banks have increased since the start of the crisis, with potential negative consequences for their financial strength and independence.
Enhanced liquidity provision, relaxation of collateral rules, and sizable asset purchases have led to increases in the absolute size of central bank balance sheets, an increase in the duration and diversity of assets, and a decline in asset quality. These changes pose risks, including:
Implicit or explicit valuation losses as a result of a rise in interest rates;
Declines in operating income when central banks increase their holdings of long-dated securities with low coupon interest rates; and
Possible impairment losses on assets with credit risk. The extent to which the various central banks are exposed to these risks differs, depending on the scope and nature of their unconventional policies (which themselves may be influenced by a central bank’s risk tolerance). The Federal Reserve, Bank of England (BOE), and Bank of Japan (BOJ) purchased large quantities of bonds to lower long-term yields and support economic activity, whereas the European Central Bank (ECB) mainly expanded the provision of liquidity to support bank funding (see Table 3.1). The Federal Reserve holds a large portfolio of Treasury securities and mortgage-backed securities (16 percent of GDP at end-2012), and it has extended the maturity of its holdings of Treasury securities considerably over time: its modified duration—a measure of interest rate sensitivity—increased from about 2 3⁄4 before the crisis to nearly 8 most recently. This means that a 1 percent increase in interest rates would reduce the portfolio’s market value by 8 percent; and taking into account bond price convexity, the drop in market value would correspond to a capital loss of about 4 percent of the Federal Reserve’s total assets.
The BOJ and BOE are also subject to interest rate risk given their sizable government bond holdings (about 24 percent of GDP each at end-2012). A 1 percent increase in interest rates could result in a loss of about 1 3⁄4 percent of total assets for the BOJ and 6 1⁄2 percent for the BOE.1 For the BOJ, this figure could increase on further implementation of its Asset Purchase Program. In addition, the BOJ is also subject to market risk from its holdings of private assets.2
The ECB increased its lending exposure to banks in euro area periphery countries from 20 percent of total refinancing operations in 2006 to about two-thirds in 2012, which raised its credit risk profile. These risks are mitigated to a considerable extent by collateral requirements. The ECB is also exposed, but to a lesser extent, to credit and interest rate risks arising from holdings of covered bonds and periphery sovereign bonds.
Central banks can mitigate these risks in various ways.
Shorten asset duration so that seigniorage income matches central bank policy expense (for example, central banks could negotiate an asset swap with national treasuries to boost income).
Increase the share of higher-yielding assets—this would most easily be accomplished by purchasing such assets during exit from MP-plus.
Increase capital buffers to cover potential losses, through profit retention or capital injection. For example, even before most of its interventions, the ECB doubled its subscribed capital to €10.8 billion at end-2010. Similarly, in 2011, the BOJ retained profits in excess of legal requirements to build up capital reserves.
Adjust haircut requirements to reflect changes in the quality of collateral.
Secure a full indemnity from national treasuries for losses associated with MP-plus. For example, the BOE’s Asset Purchase Facility is fully indemnified by its Treasury, and therefore the BOE does not face associated financial risks.
The extent to which these different measures can be used by central banks differs, depending on risk exposure and tolerance, institutional setup, and economic and financial circumstances.
In addition, the extent to which these holdings represent risks and are being recognized depends
on accounting rules and how central banks intend to use the securities. If they intend to hold the securities to maturity, potential capital losses will not be realized if interest rates rise (although interest income would be below markets rates until maturity). The Federal Reserve, the ECB, and the BOJ value their holdings of securities at amortized costs, although in certain circumstances they are required to take on “impairments” if values drop substantially. In contrast, the BOE uses mark-to-market accounting for government bonds and other securities. The current ECB portfolios are held to maturity (and therefore not subject to marking to market) but a possible future Outright Monetary Transactions portfolio would be marked to market. However, in all cases, market participants will likely impute the values of central bank holdings of securities to evaluate their overall safety and soundness. It behooves central banks, therefore, to manage their risks in a transparent and consistent fashion.
Experience in some jurisdictions (mostly emerging market economies) has shown that central banks can execute their monetary policy functions while experiencing large losses (or even while having negative net worth), but such situations may nevertheless threaten their independence and credibility. Historical evidence shows that financially weak central banks are prone to government interference (Stella, 2008; and Stella and Lönnberg, 2008), thereby potentially undermining their policy performance. The extent to which independence is compromised by financial weakness would depend crucially on other safeguards for independence that are in place for a particular central bank.
1 The BOE’s exposures are kept off-balance-sheet in the BOE Asset Purchase Facility Fund.
2 The BOJ’s holdings of private sector securities are small and thus pose relatively limited balance sheet risk despite occasional unrealized losses. The BOJ does not face substantial credit risk on its lending facility, as it requires pooled collateral. The BOE’s Funding for Lending Scheme also entails some credit risk, albeit only a limited amount given the small size of the program.
Risks from MP-Plus and Mitigating Policies
All photography by Jared Chambers