Lorenzo Bini Smaghi: Reflections on the exit strategy
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Sveriges Riksbank, Stockholm, 21 January 2010.
* * *
A lot of attention has been devoted in recent policy discussions to the exit strategy from the
expansionary monetary and fiscal policy stance adopted since the outbreak of the crisis, and
to the interaction between the two. Designing an optimal exit strategy should, in theory, not
be too difficult. In an ideal world, fiscal stimuli should be withdrawn before monetary policy is
tightened in order to ensure that public debt remains sustainable and that monetary policy is
not overburdened.
We know however that first-best solutions are often hard to implement, because they are
based on unrealistic assumptions relating in particular to the rationality of expectations and
the ability of policy-makers to rapidly make decisions and to change them if needed.
Furthermore, policy-makers have to take account of the prevailing uncertainty and of the
impact of their decisions on agents' expectations. For instance, fiscal policy is normally
decided once a year, through an elaborate budget process, but is not implemented until the
following year. This process introduces significant rigidities into the decision-making and
makes it somewhat less likely that fiscal policy can exit before monetary policy, which is
typically a much more flexible instrument.
Today I would like to focus my remarks on the exit from the accommodative stance of
monetary policy. I will not consider the phasing-out of the non-standard measures that
central banks have adopted over the last few months.
The discussions so far have centred mainly on the timing of the exit decision, which should
neither be premature nor tardy. There are counter-effects in both scenarios. If the decision to
exit is made too early, the economic recovery may be put at risk, as higher interest rates will
produce a tightening effect on consumption and investment decisions at the very time when
the pick-up in the economy is still fragile. Furthermore, it might further restrict credit
conditions while the banking system is still restructuring its balance sheet. If, on the other
hand, the decision is taken too late, monetary conditions will remain too lax for too long,
sowing the seeds of the next crisis. In addition, the later the tightening, the sharper it needs
to be, thus producing valuation changes that may reduce banks' profitability and undermine
their ability to support the economic recovery.
Given the difficulty of the timing, the discussion has turned to the second-best option. In
other words, which of the two risks - being too early or being too late - would pose the
biggest problems for the economy? Several authors, including international organisations,
have suggested that the policy authorities should err on the side of being late. They argue
that an early tightening is difficult to reverse and tends to hit the economy early in its
recovery, and may give rise to a double-dip recession. On the other hand, a late tightening
allows more time to bring things back to normal. In addition, the stronger the economy is
likely to be, the more resistant it will be to the shock produced by the tightening of monetary
conditions.
Overall, history shows that policy authorities have largely erred on the side of being too late
than of being too early. Indeed, late exits have been quite numerous; they were either the
result of deliberate policy decisions to boost the economy, which was probably the case in
the 1970s and early 1980s, or of forecast errors made in over-estimating deflationary risks
and under-predicting the subsequent recovery, which might be the case of the decade just
ended.1
The monetary and fiscal policy tightening that took place in the United States in 1936, which
led to the 1937-38 recession, is regarded as a text-book example of too early an exit, of a
mistake not to be repeated. There are not many other examples of early exits. The slight
increase in interest rates by the Bank of Japan in 2000 has been considered by some as an
early exit, but recent analysis has downplayed it.2
In fact, examining closely the 1936 episode in the US, it might not even be considered as an
early exit. The very restrictive monetary and fiscal policies that were adopted at that time
might deserve to be categorised as a case of "brutal" exit, the effects of which could in fact
have occurred at any time, exit or no exit. Between mid-1936 and early 1937 reserve
requirements for banks were doubled in a series of three steps. The general government
budget contracted by almost 4% of GDP. These measures appear to have been
disproportionate, even with an economy that had started to recover, with inflation picking up
and credit aggregates accelerating. The severe negative effects of these measures do not
mean that no measure should have been taken at all. They should simply not have been so
abrupt and not have taken economic agents by surprise. In other words, the 1936 episode
might be considered as an example of a badly calibrated and badly communicated exit,
rather than a wrongly timed exit.
In this context, it is worth mentioning the 1994 episode, when the Fed's 25-basis-point
increase in its funds rate caused turmoil in the bond market. Even with the benefit of
hindsight, that decision can be regarded as neither tardy nor brutal. The problem was that it
took markets by surprise and led to a major reassessment of the yield curve, with substantial
valuation losses on long-term positions.
These experiences confirm that not only is the timing of the exit crucial, but also its
communication to market participants. Indeed, the impact of any withdrawal of monetary
stimulus on financial market participants depends on whether they have fully anticipated it. If
they have, then the decision tends to have less impact on the yield curve, and thus on the
valuation of banks' assets and on the rate that banks charge to their customers, especially
on fixed rate loans. As confirmed by a growing body of literature, the main mistake relating to
the 1936-37 decisions was that they were badly communicated to economic agents.3
To sum up, a key element of the exit strategy is that the policy authorities must guide
expectations. How can they do this?
Let me first of all consider how it should not be done.
First, it may be better for central banks not to become embroiled in the debate on whether
exiting too early or too late is better or worse, and especially not to give signals that the latter
is less risky. Such an approach could encourage market participants to become less
riskaverse and to expect the period of low interest rates to be extended beyond what is
necessary. This would induce them to take on further risks, in particular in terms of maturity
mismatches - borrowing short-term to buy long-term bonds - which might be profitable in the
short term but could lead to substantial capital losses when the exit takes place.
Second, any commitment to prolonged periods of low interest rates is risky. If the aim is to
lower long-term rates, it may also encourage market participants to take substantial long
positions in the fixed income market. As a result, the risk of major losses arising at the time
of the exit increases considerably, as the 1994 experience shows. This may induce the
central bank to further delay the exit to avoid penalising banks. This seems to be the
experience of 2002-2004. As a result, interest rates may remain below the desired level for
too long, fuelling a possible bubble.
Third, central banks need to be very careful in using information extracted from market data
when conducting monetary policy. The anchoring of inflation expectations is a very important
benchmark for assessing whether the stance of monetary policy has become too
expansionary and whether there are risks of falling behind the curve. However, the pre-crisis
period and the crisis itself have shown that expectations are not always formed in a rational
way and might themselves be influenced by the behaviour of the monetary authorities. Quite
often markets participants form their expectations by looking at central banks' behaviour, on
the assumption that the latter have better and more information about underlying inflationary
pressures. Under these circumstances, market-based inflation forecasts tend to be biased
and may react in a perverse way following a tightening of monetary policy. In particular,
inflation expectations may be revised up, rather than down, after an interest rate increase,
especially at the beginning of a tightening cycle. If the monetary authorities' assumption that
inflation expectations are well anchored proves to be wrong, the whole yield curve might
move upwards and the decision to increase the rate of interest may result in a much sharper
tightening than expected.4
Another problem with inflation expectations concerns their measurement, especially in
periods of financial turbulence, when the liquidity of the underlying instruments can affect
their signalling content. A further distortion may arise when the central bank is itself a major
buyer and holder of indexed-linked assets, which may distort prices and thus the information
content. Measurement problems arise also with other components of the analytical
framework, such as the output gap. Experience shows that measurement of the output gap
varies over time. For instance, when measured ex post, with the data available until 2008,
the US output gap over the period 2002-2004 turned out to be very small, even non-existent,
while ex ante it was estimated at around 2% of GDP.5
So what should a central bank do to implement and communicate an appropriate exit
strategy? Let me make a few comments on this.
To ensure that the exit strategy does not come as a complete surprise, it has to be well
communicated. Over recent months, central banks have devoted a lot of time to explaining
their exit strategies, both in terms of content and conditions. At the ECB we have made it
clear that, as in the past, any decision - even one concerning the exit - will be linked to the
underlying economic conditions and in particular to the re-emergence of inflationary
pressures. Market participants should thus form their expectations on future interest rates on
the basis of projected economic developments rather than on specific unconditional
commitments.
In order to promote understanding of how monetary policy needs to adapt to changing
economic conditions, and eventually exit from its very accommodative stance, central banks
would do well to explain how the stance itself is affected not only by the level of the interest
rate they control, but also by the underlying economic developments, such as projected
growth and inflation. In this respect, it is interesting to note that over the last six months,
while economic activity and inflation have picked up, interest rates, both in nominal and real
terms, have continued to fall. Spreads on different types of bond, except those of some
governments, have continued to come down. The slope of the yield curve has slightly
increased, in particular in the US (see Annex).
Finally, an exit is more easily communicated, and understood, by market participants if it is
gradual. Any interest rate adjustment - even a slight one - entails some form of discontinuity,
which may affect the whole yield curve. A credible gradual exit, if well communicated,
minimises shocks to interest rate expectations. However, a gradual exit strategy is more
likely to be credible if it is implemented in a timely way. If it gives the appearance of being
late, the first step by the central bank is likely to cause a substantial revision of interest rate
expectations and thus of the yield curve, strengthening the impact of the tightening.
To sum up, experience suggests that what matters most in any exit strategy is that markets
are well prepared, so that when the decision is ultimately made they are not taken by
surprise and suffer negative repercussions. Communicating an exit strategy is, in the end,
not that different from communicating monetary policy in normal times. Given the state of
uncertainty about the recovery, market participants have to base their expectations, and their
trading decisions, on projected economic fundamentals rather than trying to read between
the lines of policy announcements.
Chart 1: Economic growth reached its through in 2009
Q1 and now displays a slow recovery
Real GDP growth
Quarterly growth Year-on-year growth
5 5
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3
96 96 97 98 99 99 00 01 02 02 03 04 05 05 06 07 08 08 09
Source: Eurostat.
Chart 2: ECB interest rates and the EONIA
6.0
EONIA
5.0
marginal lending rate
4.0
main refinancing rate
3.0
2.0
1.0
deposit rate
0.0
Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10
Chart 3: Credit spreads decreased rapidly in the euro
(basis points)
area
Non-Financial AA Non-financial BBB Financial AA Financial BBB (rhs)
500 3000
450
2500
400
2000
350
300
1500
250
1000
200
150
500
100
0
50
0 -500
Jun.07 Dec.07 Jun.08 Dec.08 Jun.09 Dec.09
Source: Thomson Financial Datastream and ECB calculations.
Chart 4: Corporate bond spreads in the euro area
(basis points)
Financial Non-financial
Financial AAA Financial AA Non-Financial AAA Non-Financial AA
3000 600
Financial A Financial BBB Non-Financial A Non-Financial BBB
2500 500
2000
400
1500
300
1000
200
500
100
0
0
Jul.08 Jan.09 Jul.09 Jan.10
Jul.08 Jan.09 Jul.09 Jan.10
Source: Datastream.
Note: The benchmark bond index used is EMU triple A government bond index calculated by BofA Merrill
Lynch.
Latest observation: 19-Jan-10.
Chart 5: Corporate bond spreads in the United States
(basis points)
Financial Non-financial
Financial AAA Financial AA Non-financial AAA Non-financial AA
2000 900
Financial A Financial BBB Non-financial A Non-financial BBB
1800
800
1600
700
1400
600
1200
500
1000
400
800
300
600
400 200
200
100
0
0
Jul.08 Jan.09 Jul.09 Jan.10
Jul.08 Jan.09 Jul.09 Jan.10
Source: Datastream.
Note: The benchmark bond index used is US Treasury 3-5year maturity government bond index calculated
by BofA Merrill Lynch.
Latest observation: 19-Jan-10.
BIS Review 8/2010
Chart 6: MFI bank lending rates in the euro area
(percentages per annum)
Short-term Long-term
small loans to nfc (over 5 years)
small loans to non-financial corporations
large loans to nfc (over 1 and up to 5 years)
large loans to non-financial corporations
large loans to nfc (over 5 years)
loans to households for house purchase
loans for house purchase (over 5 and up to 10 years)
loans to households for consumer credit
loans for house purchase (over 10 years)
three-month Euribor
7-year government bond yield
10.0
6.5
9.0
6.0
8.0
5.5
7.0
5.0
6.0
4.5
5.0
4.0
4.0
3.5
3.0
3.0
2.0
1.0 2.5
0.0 2.0
2003 2005 2007 2009 2003 2005 2007 2009
Source: ECB and ECB calculations.
Latest observation: November 2009 for MIR rates and December 2009 for market rates.
Chart 7: Bank lending rates on loans to non-financial
(percentages per annum)
corporations in the euro area
Short-term Long-term
small loans (over 1 and up to 5 years)
small loans
small loans (over 5 years)
large loans
large loans (over 1 and up to 5 years)
three-month Euribor
large loans (over 5 years)
7.0
7-year government bond yield
7.0
6.0
5.0 6.0
4.0
5.0
3.0
4.0
2.0
3.0
1.0
2.0
0.0
2003 2005 2007 2009
2003 2005 2007 2009
Source: ECB and ECB calculations.
Latest observation: November 2009 for MIR rates and December 2009 for market rates.
BIS Review 8/2010
Chart 8: Bank lending rates on loans to households in
(percentages per annum)
the euro area
Short-term Long-term
house purchase house purchase (over 5 and up to 10 years)
house purchase (over 10 years)
consumer credit
consumer credit (over 1 and up to 5 years)
three-month Euribor consumer credit (over 5 years)
house purchase (over 1 and up to 5 years)
10.0 7-year government bond yield
10.0
9.0
9.0
8.0
7.0
8.0
6.0
7.0
5.0
6.0
4.0
5.0
3.0
4.0
2.0
3.0
1.0
2.0
0.0
2003 2005 2007 2009 2003 2005 2007 2009
Source: ECB and ECB calculations.
Latest observation: November 2009 for MIR rates and December 2009 for market rates.
(percentages)
Chart 9: Real overall costs of financing
Jun-07 Oct-09 Nov-09 Dec-09 Jan-10
Overall cost of financing
4.31 3.10 3.07
Real short-term MFI lending rates
3.33 1.81 1.81
Real long-tem MFI lending rates
3.20 1.60 1.65
Real cost of market-based debt 3.41 2.51 2.36 2.22 2.24
5.40 6.39 6.28 6.00 5.92
Real cost of quoted equity
8 8
7
7
6
6
5 5
4
4
3
3
2 2
1
1
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Jul-08 Jul-09
Jan-08 Oct-08 Jan-09 Apr-09 Oct-09 Jan-10
Apr-08
Sources: ECB, calculations, Thomson Financial Datastream, Merrill Lynch and Consensus Economics
Forecast. Last observation: MFI lending rates: November 2009; Cost of equity and cost of market-based debt:
6 January 2010.
BIS Review 8/2010
Chart 10: Nominal implied forward curves for the euro
(percent per annum)
area and the United States
United States
Euro area
7
7
30-Jun-09
30-Jun-09
6
30-Sep-09 6
30-Sep-09
15-Jan-10
15-Jan-10
5
5
4
4
3
3
2
2
1
1
0
0
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
Source: EuroMTS, ECB, FED. Notes: euro area based on triple A government bonds. The underlying
curve of the United States excludes on-the-run bonds.
Chart 11: Break-even inflation rates in the euro area and
(percent per annum)
the United States
Euro area United States
5-year BEIR (seas. adj.)
5-year BEIR
10-year BEIR (seas. adj.)
10-year BEIR
5-year forward 5 years ahead BEIR (seas. adj.)
5-year forward 5 years ahead BEIR
4.00
4.00
3.00
3.00
2.00
2.00
1.00
1.00
0.00
0.00
-1.00 -1.00
-2.00
-2.00
Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10
Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10
Source: Reuters, ECB calculations, and R. Gürkaynak, B. Sack, and J. Wright (2008), "The TIPS Yield
Curve and Inflation Compensation", Federal Reserve Working Paper.
Latest observation: 19-Jan-10 for the euro area, 15-Jan-10 for the US.