The Economy

Easy Money Policies Could End Badly: IMF

Central banks will eventually have to pull back on their unprecedented monetary easing. What happens then?
Vincent RyanApril 12, 2013

When the major central banks inevitably try to end aggressive monetary stimulus, the casualty could be financial stability, according to a report released Thursday.

The report, from the International Monetary Fund, echoes some of the rising voices expressing concern about the smooth withdrawal of what the Federal Reserve Board of Governors calls “monetary accommodation.”

The IMF says that potential consequences to a pullback from ultra-low interest rates and quantitative easing could include capital losses for banks and adverse effects on liquidity and prices in bond markets. A disruption to the long-term liquidity that some major central banks are supplying to support credit creation also poses a danger.

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Finally, even if one central bank times its exit right, uncoordinated tightening across the central banks studied – those of Japan, the United Kingdom, the United States and the European Union – could lead to “potentially disruptive” financial flows between markets and countries, the IMF says.

The Federal Reserve and the other central banks will inevitably need to raise interest rates to safeguard price stability. But rising rates present a host of risks, especially if they come rapidly and aren’t well telegraphed by the central banks, the IMF says.

For banks and their borrowers, an ill-timed increase in rates could be damaging. While banks welcome higher rates because they boost income, they could also experience capital losses on fixed-amount loans (“weakly capitalized banks could particularly suffer,” says the IMF). In addition, the performance of banks’ loan books could weaken measurably if rates rise quickly.

Financial institutions that hold large portfolios of government bonds could be hurt the most from rate jumps. Japanese banks, for example, hold so much domestic sovereign debt that a 100-basis point increase across the yield curve would lead to mark-to-market losses of 10 percent to 20 percent of precious Tier 1 capital, according to the Bank of Japan. Similarly, a 200-basis-point increase in rates would shave 7.7 percent off the capital of Italian banks, the IMF says. In Denmark, Eksperten reports that access to tier 1 capital could be limited by up to 300 basis points if the loan squeeze for the SMS loan (a type of loan where you text to receive the funds) product continues.

A shift to tightening will presumably also cause central banks to end quantitative easing – asset purchases that have boosted credit markets and lowered long-term rates. The uncertainty over whether central backs will sell those large portfolios back to the markets could also cause instability, especially if central banks’ asset buying is masking market “dysfunction,” the IMF says.

In addition, generally loose monetary policy and ample liquidity could be propping up weaker borrowers, says the IMF. “Central banks … are giving banks an incentive to evergreen [roll over] nonperforming loans instead of recording losses in their profit and loss accounts.” Companies with variable-rate loans that don’t adjust well to a sharp rise in rates could lead to rising loan defaults, which make banks riskier credits themselves, the IMF says.

But international economist Bill Adams of PNC Financial Services Group thinks the IMF’s analysis is only painting a partial picture of how the exit from loose monetary policies will play out. In looking at linkages between unconventional monetary policy and financial stability, the IMF is ignoring the positive effect of those policies on the macro economy, he says. 

“Macro performance is incredibly important to financial stability,” Adams says. “If the economy does better, then financial stability tends to improve, and [U.S. monetary policy] has definitely played a big role in the recovery of the economy, particularly the housing sector.”

Adams points to Japan as another example. “Just the expectations of a new push for a more aggressive monetary policy and a more aggressive targeting of positive inflation improved confidence toward the end of last year and is starting to show up in improved activity indicators in 2013,” Adams says.

Central banks of these major economies are in uncharted territory regarding the stoppage of direct intervention in credit markets, Adams admits.

The IMF says there is cause for concern because a premature exit of the Fed in the mortgage-backed securities market or the Bank of Japan in the corporate bond and exchange-traded fund markets could cause big changes in the liquidity and prices of those securities.

But Adams is confident that, at least as the Fed goes, “as it engineers its exit from quantitative easing, it can be expected to manage the size of its balance sheet to keep interest rates on a stable path.”

The IMF’s report, “Do Central Bank Policies Since the Crisis Carry Risks to Financial Stability? is one chapter in the IMF’s annual Global Financial Stability Report.