According to a new IMF report, unconventional monetary policies succeeded in stabilizing financial markets and lowering sovereign yields. Since protracted accommodation would invite excessive duration risk taking, the design of exit is becoming more important. Tightening may occur first through forward guidance or even rate hikes, before the vast outstanding excess reserves can be reduced back towards pre-crisis levels. This could imply greater volatility of interest rates, due to limited control of central banks over short rates and great uncertainty about the impact of tapered and reversed purchase programs on long–term yields.

“Global Impact and Challenges of Unconventional Monetary Policies”
IMF Policy Paper, published October 7, 2013

The below are excerpts from the paper. Cursive text and emphasis has been added.

What is unconventional monetary policy?

“Unconventional monetary policies comprise two types: [i] policies to restore market functioning and intermediation, and [ii] policies to provide support to economic activity at the zero lower bound.”

The initial measures…were more akin to central banks’ traditional role as lenders of last resort, in that they aimed to combat financial system dysfunction…Central banks provided liquidity in unprecedented amounts, to a much expanded set of recipients, and with a wider aim, namely to support market functioning…Central banks subsequently took steps to alleviate the drawn-out weakness of financial intermediation, to lower bank and household borrowing costs. These policies included the funding for lending scheme (FLS) in the United Kingdom (U.K)., the purchase of mortgage backed securities (MBS) and agency debt in the U.S., bank covered bonds in the euro area, and a variety of private assets in Japan.”

“Central banks… adopted a second set of unconventional policies to provide further accommodation at the zero lower bound… Central banks resorted to expanded forward guidance and… to bond purchases (especially in the U.S., U.K. and Japan), with the aim of lowering longer-term bond rates and loosening monetary conditions. Forward guidance and bond purchases were intended to signal a shift in policy towards maintaining rates low for a longer period than would have been warranted by central banks’ usual reaction functions. In addition, bond purchases aimed to reduce the stock of longer-term bonds in investors’ portfolios, inducing them to accept lower returns to hold scarcer assets (alternatively to require lower compensation for risk now partly removed from their portfolios).”

How effective was unconventional monetary policy?

In countries using unconventional monetary policies, policies to restore financial market functioning and intermediation were successful at overcoming acute instability. A financial meltdown with massive bank deleveraging and defaults was avoided, both following the Lehman bankruptcy and at the peak of the euro area sovereign crisis in the fall of 2011. The markets that had frozen— interbank, repo, ABS, euro area peripheral sovereign bonds—all regained at least basic function. Signs of acute market tensions [eased], notably the breakdown of standard arbitrage relationships, such as covered interest parity.”

Policies to support demand at the zero lower bound significantly decreased long-term bond rates, as envisaged. In the U.S., studies suggest 10-year bond yields decreased by between 90 and 200 bps due to the various bond purchase programs (since November 2008). In the U.K., estimates range from 45 to 160 bps (since January 2009), while in Japan they drop by about 30 bps (since October 2010), although Japanese yields started from a lower level.”

Policies to restore more drawn-out weakness in financial intermediation were not uniformly effective. Purchases of MBS and agency debt in the U.S. did seem to have noticeably decreased mortgage yields…But in the U.K., and especially in euro area countries under market stress, the financial system remains fragmented. Credit as a share of GDP has been contracting (especially non-financial corporate credit), and lending rates have remained stubbornly high relative to bond yields and policy rates.”

“Financial stability may be adversely affected if risk-taking behavior driven by persistently accommodative monetary policies (either unconventional or conventional) goes too far. Evidence suggests rising exposure to duration in global bond portfolios and high portfolio allocations to fixed income… This increases the interest sensitivity of bond portfolios. There is also evidence of riskier positioning by weaker pension funds and insurance companies, and delays in cleaning up bank balance sheets in unconventional monetary policies countries.”

Why is exit from unconventional monetary policy a challenge?

“Exit from unconventional monetary policies to support activity at the zero lower bound will involve a number of phases, some overlapping. The aim is to return to conventional monetary policy, where central banks determine only the short-term rate, and withdraw from the use of balance sheet instruments… The vast excess reserves created by asset purchases in some countries, as well as the complications from selling such assets, make the exit from unconventional monetary policies more challenging than a tightening of policy following past periods of low interest rates.”

“The operational complexity of the process, exit is likely to entail the following phases…[i] Adjustment of forward guidance on the future path of policy rates and asset purchases followed by an actual, gradual reduction (tapering) of asset purchases…[ii] Short-term policy rate increases might occur while or even before a substantial amount of excess reserves has been drained. In this period, which could last years, market rates would be guided by the central bank’s overnight deposit rate…[iii] Reducing asset holdings may be appropriate to help drain excess reserves, although this is not essential to increasing interest rates.”

“Looking ahead, central banks may face somewhat greater challenges in controlling market interest rates. Unconventional monetary policies operations… have left these markets with a large surplus of liquidity. In the U.S., reserve balances total around US$1.9 trillion versus pre-crisis norms of US$20–50 billion. In the U.K., reserve balances are nearly £300 billion compared with £20 billion. In the euro area, excess reserves were some €165 billion (as of August 6, 2013) compared with virtually zero pre-crisis. This extra liquidity has dulled competition for funds, loosening the relationship between the rates at which the central bank transacts with commercial banks and general market rates. While interbank rates are currently guided by the central bank’s interest on excess reserves (the policy rate floor), wholesale market rates have varied below this (as has been the case in the U.S. and Switzerland): non-banks cannot access the central banks’ deposit rate, and the stronger banks which attract deposits require a spread to cover overheads and regulatory costs.”

Potential reasons for increased volatility in long-term rates are…[i] uncertainty about the future path of policy rates due to limitations of forward guidance…In a classic problem of time inconsistency, central banks may leave rates lower for longer than usual and then be expected to tighten at a pace faster than suggested by past cycles, in order to catch up to their usual rate path…[ii] uncertainty about the ability of the central bank to perfectly control short-term market rates…[iii] uncertainty about the effects of asset sales on prices. The relationship between asset quantities and prices is not sufficiently well understood, and both announcement and actual sale effects should be expected, as seen with asset purchases…[iv] Reduced market liquidity could hamper price discovery and lead to a more fragmented market with higher credit costs, reducing credit intermediation and tightening financial conditions. In particular, broker-dealer inventories of fixed income instruments have steadily declined since 2007, particularly for corporate bonds, following efforts to reduce market leverage and a shift in funding and trading models.”