Tesfaselassie, Mewael F.

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Tesfaselassie, Mewael F.
Research Report
Looking forward: Exiting unconventional
monetary policy
Kiel policy brief / Institut für Weltwirtschaft an der Universität Kiel, No. 13
Provided in cooperation with:
Institut für Weltwirtschaft (IfW)
Suggested citation: Tesfaselassie, Mewael F. (2009) : Looking forward: Exiting unconventional
monetary policy, Kiel policy brief / Institut für Weltwirtschaft an der Universität Kiel, No. 13,
http://hdl.handle.net/10419/32849Looking Forward: 
Exiting Unconventional Monetary Policy 
Mewael Tesfaselassie 
No. 13│October 2009 
 
Kiel   Policy Brief 
Institut für Weltwirtschaft Kiel 
Kiel Institute for the World Economy   Kiel Policy Brief 13  1 / 7 
I. Introduction 
The near collapse of the world financial system triggered by the current financial crisis has 
led to unprecedented intervention by major central banks, including conventional and uncon-
ventional means.
1 Thanks to this massive intervention, accompanied by huge fiscal stimulus 
packages, including government bailouts, the worst of the crisis has been averted. Most 
recent data show some signs of stabilization.  
As the financial crisis ends, the recession bottoms out, and recovery begins around the 
world, central banks are under pressure to work out their exit strategy from various forms of 
unconventional monetary policy, including quantitative easing, credit easing, and in the case 
of the ECB, enhanced credit support programs. For instance, recently the OECD said: “There 
needs to be a clear and credible plan and timeline for phasing out the emergency measures 
as the recovery takes hold. It is critical to consider these exit strategies now in order to pre-
vent new risks in the years ahead.” The reason for such remarks could be the fear of higher 
inflation. Central banks can not ignore this concern because they can be imbedded into infla-
tion expectations.  
In this policy brief, we discuss issues related to exit strategies by central banks. What 
considerations receive importance when contemplating an exit strategy? What tools are 
available when the time comes for tightening monetary policy? Do central banks need new 
tools to implement monetary policy? The message is that, for an exit strategy to work it is not 
necessary for central banks to sell private sector securities. They can absorb liquidity by 
selling government securities, as they have done in the past, or paying higher interest rates 
on reserves. And if a time comes for these assets to be sold, market conditions must return 
to normal and liquidity restored. Otherwise, the sell off can trigger disruptions in the financial 
markets.  
II.  The Financial Crisis and Unconventional Monetary Policy 
Under normal circumstances, conventional monetary policy is characterized by the setting of 
official interest rates. To achieve a certain target for the official rate, open market operations 
are conducted using government bonds, the most liquid assets in an economy. And when it 
comes to ensuring financial stability, policy involves no more than liquidity provision to banks, 
at a given official rate and provided the borrowing banks are solvent. There is no or little 
coordination with fiscal policy, with monetary policy chosen as the main stabilization tool. 
Conventional monetary policy has worked pretty well in the past, and at the start of the 
current global financial crisis, when central banks around the world intervened to prop up the 
liquidity position of financial institutions, it was hoped that it would work this time as well. 
However, as financial conditions deteriorated further and the prospects for a long and deep 
global recession became apparent central banks were forced to slash their target rates in 
                                                  
1   See Tesfaselassie (2009).   Kiel Policy Brief 13  2 / 7 
aggressive moves over the past year. Currently, the US Fed’s target hovers between zero 
and 0.25 percent, down from 5.25 at the beginning of the crisis, and the Bank of England’s 
target is at 0.5 percent, the lowest since it was founded in 1694. The ECB and other central 
banks have also followed suit.  
A major turning point for the conduct of monetary policy occurred when financial markets 
around the world seized up following the collapse of Lehman Brothers, an investment bank, 
in September 2008. Faced with the zero lower bound for the official interest rate, central 
banks resorted to unconventional monetary policy that led to expansion in their balance 
sheets (see chart). The Fed adopted what its chairman, Ben Bernanke, called credit easing 
program, which involves buying $300 billion of Treasuries, $200 billion in bonds issued by 
Fannie Mae and Freddie Mac, as well as $1.25 trillion of their mortgage-backed securities. 
These purchases were meant to drive down long-term interest rates, including mortgage 
rates. Likewise the Bank of England introduced a quantitative easing program of buying up 
to £175 billion of gilts (government bonds) and corporate bonds to boost the money supply.  
 
Assets of selected central banks, % of GDP 
 
Source: The Economist 
The ECB has focused on helping banks. The enhances credit support program involved 
(i) extending the maturity of loan facilities from 6 months to 12 months and (ii) buying € 60 
billion of private sector debt, in particular covered bonds (which are backed by mortgages 
and other loans). The ECB also relaxed collateral requirements by accepting less liquid 
assets as collateral in its lending programs. The Bank of Japan went even further, imple-
menting programs to support stock market prices. 
III.  Uncertainty about Economic Outlook and Cautious Approach  
to Policy Tightening 
According to some recent data, the worst of the financial and economic crisis might be over. 
Consequently some international bodies have revised their short term and medium term 
forecasts for the world economy. For instance, in its latest Economic Outlook, the OECD has 
revised up its projections for the OECD area economies. It said, “The slowdown in OECD   Kiel Policy Brief 13  3 / 7 
economies is reaching bottom following the deepest decline for more than 60 years.”
2 The 
good news is that this is the first in two years that OECD projections for growth for the area 
as a whole have been revised upwards. At the same time, the latest IMF report for the world 
economy, says that “economic growth during 2009-10 is now projected to be about half a 
percentage point higher than forecast by the IMF in April, reaching 2.5 per cent in 2010.”
3 In 
addition, market sentiments about future economic prospects are up. For instance, according 
to Germany’s Ifo economic institute, the “Business Climate Index for industry and trade in 
Germany rose again in July. They are again less skeptical regarding business developments 
in the coming half year. It seems that the economy is gaining traction.” 
However, it is too early for central banks to contemplate an exit strategy because the 
recovery may turn out to be fragile. Despite revising its projections, the OECD warns that 
“recovery is likely to be weak and fragile, and the economic and social damage caused by 
the crisis will be long-lasting.” In fact, while the situation in most emerging markets and the 
US are improving, “the prospects for the euro area this year have worsened and Japan’s 
have changed little since the OECD’s previous projections were published in March.”  
While the recession is ebbing, labor markets are still weak. For instance, the unemploy-
ment rate almost has doubled in the US and some European economies. Moreover, the 
financial crisis has inflicted huge damage on banks’ balance sheets. Their continued delever-
aging is accompanied by restrictions on new lending, and thus slowing the pace of business 
recovery. It will take a while before unemployment rate declines to pre-crisis level, financial 
markets function properly and banks are well capitalized for them to resume lending to 
support economic growth. As a reflection of these developments, there will be continued 
downward pressure on inflation over the medium term. Under this sort of circumstance, no 
central bank would want to exit from its unconventional interventions.  
It is also worth mentioning that central banks are still in a vigilant mood because of 
heightened uncertainty about the future. For instance, as reported by The Independent news-
paper recently, the Bank of England governor Mervyn King said he was "more uncertain now 
than ever" over the path of the recovery in the UK. The big question is whether financial 
market activities are back to normal; that is, to pre-crisis conditions. This is very important as 
far as the timing of exit is concerned because financial markets are very crucial for the trans-
mission of monetary policy. Finally, there is uncertainty whether potential output has been 
affected by the financial crisis. This is a challenge even for hard nosed central banks, which 
focus on price stability. As is well known, what matters for inflation is the level of output rela-
tive to potential.  
Under theses circumstances, it is very unlikely for central banks to start tightening mone-
tary policy and reversing their unconventional interventions in financial markets. At best, it 
will take several years before the size and composition of central bank balance sheets return 
to pre-crisis levels. 
                                                  
2   OECD Economic Outlook No. 85, June 2009. 
3   World Economic Outlook Update, July 8, 2009.   Kiel Policy Brief 13  4 / 7 
 IV.  The Need for an Exit Srategy 
Recently, some central banks, including the Fed and the ECB, have been communicating 
about the exit strategies from their unconventional programs. It is clear that the articulation of 
an exit strategy have been forced up on central banks by market participants. The reason is 
uncertainty regarding the effects of unconventional policy on the economy. Faced with 
uncertainty, market participants naturally look for guidance about the future path of monetary 
policy. The concern is driven mainly by uncertainty about future inflation. Such a concern is 
not unreasonable, given the massive interventions by monetary authorities that led to a sharp 
rise in their balance sheets. Consider for example the excess reserves of about $800 billion 
that banks have with the Fed, compared with the typical pre-crisis level of only $10 billion. 
Whether the inflationary consequences of excess reserves is real or perceived, it should be a 
matter of great concern to central banks, as inflation expectations could be embedded in long 
run inflation, making it harder for monetary policy to achieve price stability. Rising inflation 
expectations are the last thing a credible central banker would like to see.  
Thus, even if central banks do not have to start exiting from their unconventional 
interventions soon, it is important to respond to public concerns by coming up with a credible 
exit strategy. Exit strategy must be understood as stipulating a roadmap for a tightening of 
monetary policy when the time is right; in other words, it is about being clear about the end 
game once the economic environment returns to normal. One must see the strategy as 
specifying the tools that central banks may use when it is time to tighten monetary policy.  
V. Monetary  Policy  Tools 
To foster a common understanding about their exit strategies, central banks need to explain 
what available tools they have − both conventional as well as unconventional − and how they 
intend to use them. First and foremost, it should be made clear that when the recovery is 
solid, financial markets are back to normal and credit risk spreads narrow to a comfortable 
level and the risk to inflation over the medium term rises, then central banks will start 
tightening monetary policy. In this case there are no economic constraints in adopting the 
main tool of conventional monetary policy − open market operations − to push the official 
target for interest rates (and thus borrowing costs) up. Central banks can engage in outright 
sales of (or reverse repurchase agreements on) government bonds, the most liquid and safe 
financial assets.  
Open market operations can be augmented by a new tool − raising the interest rate on 
banks’ reserves at the central bank. The benefit of this action would be to make sure that any 
excess liquidity in the banking system is stashed back at the central bank, thereby preventing 
excess credit creation and ultimately inflation. In any case, rising interest rates (official and 
market rates) will be part of any balance sheet reduction by central banks and raising the 
reserve rate will have effects beyond banks reserves.
4  
                                                  
4    This point seems to be ignored in some policy discussions; see for e.g., Hall and Woodward 
(2009).    Kiel Policy Brief 13  5 / 7 
Of course, due to uncertain time lags in the effects of monetary policy, the timing of an 
intervention is very crucial but hard to know in advance because the intervention will repre-
sent a turning point in the monetary policy stance. Any signal given by central banks about 
the timing of an exit strategy would increase yields on long-term bonds via the term structure. 
The fear is such a preannouncement could drive up interest rates prematurely, derailing the 
already fragile recovery.  
A thornier issue is the unwinding of the asset purchase programs targeted at the private 
sector. One can not expect the central banks to start selling these assets before the respec-
tive financial markets return to normality. Of course, whether central banks will make a profit 
or suffer a loss when selling private sector assets is unclear. The reason is that, during the 
crisis, asset prices tumbled partly due to excesses that priced these same assets above their 
fundamental values and partly due to market panic accompanied by a flight to quality, espe-
cially after the collapse of Lehman Brothers in September 2008. If central banks are patient 
enough to wait until markets return to normality, supporting higher asset prices, they could 
make profits out of their asset sales. However, the ultimate goal of any intervention should be 
to support growth and maintain price stability. 
In some sense, calls for an exit strategy are reminiscent of the debate on whether central 
banks should announce projections of future interest rate.
5 Under normal conditions, central 
bank decisions are based on output gap and inflation projections. Policy stance is captured 
by the so-called Taylor rule, which proposes how interest rates should respond to inflation 
and output gap.  
The main objection against publishing interest rate projections of central banks comes 
from the complexity of decision making by committees. Almost all central banks have 
committees that make monetary policy decisions. Naturally, there is more disagreement 
among members regarding the future state of inflation and output gap than the current levels. 
It is not difficult to imagine that the current extraordinary conditions imposed by the financial 
crisis mean that besides output gap and inflation, assessing normality of financial markets in 
the future will also play a key role in monetary policy. This creates more challenges for cen-
tral bank committee members to agree on the future state of the economy and the appro-
priate course of action. It could, therefore, be counterproductive to dwell into specifics of the 
exit strategy, in particular the timing of future interventions to be taken by central banks 
regarding their unconventional policy. The focus should be on remaining alert to the risks 
posed by inflation and taking appropriate actions when necessary, including rolling back part 
of the various support programs. 
VI.  Coordination with Fiscal Policy 
It is important that there is scope for coordination of monetary policy with fiscal policy. For 
one thing, any increase in interest rates means a higher debt servicing burden for the fiscal 
authorities. Likewise, if central banks start raising the interest rates they pay on banks’ 
                                                  
5   See for e.g., Goodhart (2009).   Kiel Policy Brief 13  6 / 7 
reserves, then reserves will compete with government bonds as investment vehicles. This 
could drive up government borrowing costs and create tensions with fiscal policy. A possible 
resolution is to have clearly defined path for fiscal sustainability and let monetary policy focus 
on fighting inflationary pressures in the economy. This can happen with the full support of 
governments. They need to understand that the massive fiscal stimulus packages and pri-
vate sector bailouts can not continue indefinitely. Fiscal authorities should devise their own 
exit strategies in a way that contributes to the effectiveness of monetary policy in supporting 
sustainable growth and price stability.  
References 
OECD, Economic Outlook No. 85, June 2009, http://ww.oecd.org/oecdEconomicOutlook 
Goodhart, Charles, “The Interest Rate Conditioning Assumption,” International Journal of Central 
Banking, Vol.5, No.2, June 2009. 
Hall, Robert and Susan Woodward, “The Fed Needs to Make a Policy Statement,” April 13 2009, 
http://woodwardhall.wordpress.com/2009/04/ 
IMF, World Economic Outlook Update, July 8, 2009,  
http://www.imf.org/external/pubs/ft/weo/2009/update/02/pdf/0709.pdf 
Tesfaselassie, Mewael, “How Challenging is Unconventional Monetary Policy?” Kiel Institute Focus, 
No. 4, 2009.  
The Independent (UK), “Bank of England Governor ‘More Uncertain’ about Economy”, June 14, 2009 
Issue.  
http://www.independent.co.uk/news/uk/politics/bank-of-england-governor-more-uncertain-about-
economy-1717287.html   Kiel Policy Brief 13  7 / 7 
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http://ww.oecd.org/oecdEconomicOutlook Goodhart, Charles, “The Interest Rate Conditioning Assumption,”

Langhammer Supervisory authority:

The Fed Needs to Make a Policy Statement,”

The Independent (UK), “Bank of England Governor ‘More Uncertain’ about Economy”,

Looking forward: Exiting unconventional monetary policy.

http://www.econstor.eu/bitstream/10419/32849/1/614932505.pdf

Looking forward: Exiting unconventional monetary policy.

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